Job Swaps
CDO pros set up advisory firm
The latest company and people moves
CDO pros set up advisory firm
Jim Kane and Brian Zeitlin, former members of JPMorgan's structured credit group, have set up a structured credit advisory firm focused on financial restructuring. The GreensLedge Group officially launched last month.
Prior to forming GreensLedge, Kane worked at JPMorgan for more than three years as an md and head of capital markets for the global structured credit business. Prior to that, he was md and member of the global CDO group at Deutsche Bank. He specialises in developing and managing all aspects of origination and distribution with an emphasis on CLOs, CDOs, credit opportunity funds and a wide range of credit derivative products.
Zeitlin also worked at JPMorgan for more than three years as an md and head of the global structured credit business. He also previously worked at Deutsche Bank, running the global CDO group until leaving for JPMorgan in 2004. He specialises in developing and managing all aspects of a full-service structured credit banking platform with emphasis on CLOs, CDOs, credit opportunity funds and a wide variety of alternative asset fund products.
CDS traders hired
Steve James has joined the London office of Phoenix Partners Group, the inter-dealer broker specialising in OTC derivatives and related securities in New York and London. James has been trading high yield CDS since the conception of the European market almost 10 years ago. Most recently he was instrumental in setting up and subsequently running RBS's high yield CDS trading for over five years.
James will be responsible for the day-to-day running of the high yield area, reporting to current desk head and partner, Alex Hucklesby. Hucklesby will retain a hands-on involvement on the desk in the short- to medium-term, but will also begin to spend more time overseeing the growth and development of the London office.
James is joined at Phoenix Partners Group by former RBS colleague, Chetan Ladwa.
Gramercy founder recruited
CWCapital Investments (CWCI), a commercial real estate investment management firm, has hired Hugh Hall as md. He will report to CWCI president Charles Spetka and work to develop new capital sources and investment opportunities for CWCI, including the creation of a third-party, managed fund focused on mortgages and senior debt. Hall was a founder of Gramercy Capital Corp and served as its coo until its merger with American Financial Realty Trust (AFR) in April 2008.
Firm hires distribution head ....
Fritz Thomas, md and head of distribution for CDOs and other alternative investment products at Deutsche Bank, has joined Oak Hill Advisors in New York as an md. In his new role he will help lead the firm's business development and client coverage activities, as well as develop the firm's structured product investment activities.
.... while another loses theirs
Moez Ben Zid is said to have left SPQR Capital, where he was responsible for distribution and marketing. He joined the firm from Deutsche Bank, along with Bertrand des Pallières and Malik Chaabouni, when the firm was set up in May 2007. At Deutsche Bank Ben Zid was global head of distribution within principal finance, and before that he was co-head of European structured credit marketing at Merrill Lynch.
Babson promotes Finke
Babson Capital has promoted Thomas Finke, president of the firm, to chairman and ceo. He was also named as an evp and cio of the Massachusetts Mutual Life Insurance Company (MassMutual), Babson Capital's parent company. Clifford Noreen, head of corporate securities and vice chairman, will become president.
Finke will assume roles at MassMutual and Babson Capital previously held by Roger Crandall, who has become MassMutual's president and coo. He will continue to report to Crandall.
Noreen remains head of the corporate securities group and will report to Finke, as will Babson Capital's other investment business heads - Efrem Marder, quantitative management; Robert Little, real estate finance group; Ian Hazelton, Babson Capital Europe; and Russell Morrison and Marcus Sowell, US bank loan team. Cfo/coo James Masur will also continue to report to Finke.
Research head appointed
Amherst Holdings has hired Laurie Goodman as a senior md in charge of research, risk management and business development. She was most recently md and head of global fixed income research at UBS, where she also ran the securitised products research group.
Goodman will be based out of the company's office in New York. She worked as head of the securitised products research group at Paine Webber prior to the UBS-Paine Webber merger. Before joining Paine Webber, Goodman was vp and head of MBS strategy at Merrill Lynch.
Credit origination hires made
RBS has made some internal appointments for its Australasian credit market origination. Andrew Chick and John Martin have been appointed co-heads of credit market origination for the region, with responsibility for loans, project finance, structured finance, securitisation and principal investing. Chick was head of structured capital markets at RBS in Australia, while Martin was head of structured finance for the region at ABN AMRO.
All change at bank as ABS head leaves
UBS' head of ABS Ramesh Singh is leaving the bank after 19 years of service. UBS is subsequently refocusing its real estate and securitisation (RE&S) activities - the group will be headed by Bill Chandler, Jack McCleary and Jim Reichek, who will report directly to Jerker Johansson and Jeff Mayer, ceo and joint global head of fixed income, currencies and commodities respectively.
Chandler has been appointed head of transaction management for RE&S. In this role, he will be responsible for the portfolio management of several existing securities programmes and various other special situations. Jim Reichek will continue in his role as US head of real estate finance, with responsibility for all commercial loan origination in addition to all trading in CMBS.
Jack McCleary has been named head of ABS and MBS trading. He will oversee UBS' client-facing businesses, which will include selective market-making in non-agency securities, as well as portfolio analysis and restructuring services.
Fixed income team expanded
Evolution Securities (ESL) is to expand its fixed income business following the appointment of Guy Cornelius, formerly an md of Lehman Brothers, as head of fixed income. Further appointments are expected to follow in the near future.
ESL's chief executive, Andrew Umbers, says: "We believe that the current economic environment presents a significant opportunity to create a strong new fixed income business. Many of the traditional market players are having to reduce their commitment to the FI market due to their own financial constraints. We do not suffer from those constraints, and Guy is the ideal person to help us implement this key strategic development."
Prior to joining LBI, where most recently he was responsible for many of the firm's largest clients (especially asset managers, insurance companies, pension funds and hedge funds), Cornelius spent 11 years at UBS, latterly as head of fixed income sales for Europe and the Middle East.
Citi gains "protection"
The US Treasury and FDIC have injected another US$20bn into Citi in order to "provide protection against the possibility of unusually large losses" on an US$306bn asset pool of predominantly mortgage-backed assets. The US$29bn equity layer in the 'bad bank' (which remains on Citi's balance sheet) will be assumed by Citi; anything above that will be absorbed 90% by the government and 10% by Citi. The US Federal Reserve will fund the remaining pool of assets with a non-recourse loan, subject to Citi's 10% loss sharing, at 300bp over OIS.
CDPC commences share buy-back
Primus Guaranty has agreed to purchase approximately 3.2 million shares of its common stock in a privately-negotiated transaction that is expected to settle on 1 December. The company agreed to pay US$0.70 per share for a total cost of approximately US$2.2m.
The block trade was conducted under the company's previously-announced share and debt repurchase programme. Under the programme, the company is authorised to repurchase up to US$25m of its debt and equity from its available cash. All shares purchased under the programme will be retired.
"As we discussed during our recent third-quarter earnings call, our company's primary focus now is on preserving capital and unlocking value for shareholders," comments Thomas Jasper, Primus Guaranty ceo. "Today's share repurchase represents a very attractive use of capital and indicates the disciplined approach we intend to take to optimise shareholder value."
TSI hires for new European team
Trade Settlement Inc (TSI) has established European headquarters in London and hired a new executive director of sales for its expanding European business. Effective immediately, TSI is serving European clients out of London, providing hands-on support with all aspects of its settlement system. Ronnie Glenn has joined in a new sales position and will focus on building existing client relationships, as well as expanding the firm's business overall.
Glenn joins TSI from Barclay's Capital, where most recently she served as associate director in the European leveraged finance team. Earlier in her career, she held various positions related to the loan business at Goldman Sachs International and Bank of Tokyo Mitsubishi.
The new London presence follows on the heels of the October launch of TSI's automated settlement services for the European primary and secondary syndicated loan market, as well as the introduction of numerous new capabilities aimed at improving the speed and efficiency of post-trade processing.
Euroclear to buy Xtrakter
Euroclear and ICMA have signed an agreement whereby Euroclear will acquire 100% of Xtrakter, the ICMA subsidiary. Xtrakter owns TRAX, a trade matching and regulatory reporting system that also provides market and reference data.
Xtrakter will become a wholly-owned subsidiary of Euroclear and a sister company to the Euroclear group's international and national central securities depositories and EMXCo. The Xtrakter business will complement the OTC trade matching and routing service (ETCMS) offered by Euroclear Bank since 2000.
By the end of 2009, trade data already input into the TRAX system will be processed straight through to settlement at Euroclear, thereby eliminating trade matching duplication and reducing settlement fails, costs and risks.
Clearing development md named
CME Group has appointed Michael O'Connell as md, clearing business development. O'Connell, who will report to Kim Taylor, md and president of CME Clearing, will be responsible for developing CME Clearing products and services.
O'Connell joins CME Group from Northern Trust Corporation, where he most recently served as svp within corporate & institutional services and was part of its global consulting team. Prior to Northern Trust, O'Connell was md, head of equity derivative trading/risk at Bank One.
IVSC appoints two new boards
The International Valuation Standards Council (IVSC) has appointed two new boards to boost the oversight and implementation of global valuation standards. The International Valuation Standards Board (IVSB) and the International Valuation Professional Board (IVPB) will bring together the significant technical expertise of experienced valuation professionals from leading organisations across the globe.
Where the Standards Board has the task of defining standards for the undertaking and reporting of valuations in consultation with providers, users and regulators, the Professional Board has been created to provide a focus for the currently disparate valuation profession around the globe. Its remit will be to promote the profession generally and to benchmark educational and professional standards for valuation.
The chairman of the IVSB is Chris Thorne, technical head of valuation for Atisreal UK. Thorne has been vice chair of the former IVSC Standards Board and he is the IVSC representative on the FASB Valuation Resource Group.
Wagar is director, BCMP Architects, Canada. He was previously president of the Appraisal Institute of Canada (AIC) in 2003 and is currently a member of the AIC Standards Committee. He is also a member of the User Advisory Council of the Canadian Accounting Standards Board.
Markit Quotes/MarketAxess integrated
MarketAxess Holdings and Markit are to integrate Markit Quotes into the MarketAxess client-to-multi-dealer trading platform. Markit Quotes is a real-time quote parsing service that extracts indicative OTC prices from electronic messages. The integration of Markit Quotes with MarketAxess' fixed income electronic trading platform delivers a workflow across the entire trade lifecycle, including pre-trade, trade execution and post-trade tools for both bonds and CDS.
AC & CS
News Round-up
Fed set to fund securitisation
A round up of this week's structured credit news
Fed set to fund securitisation
The US Federal Reserve has announced two new initiatives that are expected to help stabilise the ABS and MBS markets. It is creating a Term Asset-Backed Securities Loan Facility (TALF) and a programme to purchase the direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks, as well as MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae.
Securitisation analysts at Deutsche Bank note one certain positive take-away of the plan: the recognition by policymakers of the importance of restarting the ABS market and recognition of the market's role in making credit available to consumers. They believe that re-starting the securitisation process is key to the stabilisation of markets and the eventual emergence from recession. However, they warn, it is not clear how far the TALF programme will go toward achieving that goal.
The TALF is designed to help market participants meet the credit needs of households and small businesses by supporting the issuance of ABS backed by student loans, auto loans, credit card loans and loans guaranteed by the Small Business Administration (SBA). Under the facility, the Federal Reserve Bank of New York will lend up to US$200bn on a non-recourse basis to holders of certain triple-A rated ABS backed by newly and recently originated consumer and small business loans. The FRBNY will lend an amount equal to the market value of the ABS, less a haircut, and will be secured at all times by the ABS.
The US Treasury - under TARP - will provide US$20bn of credit protection to the FRBNY in connection with the TALF.
Meanwhile, the Fed says the latter action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally. Purchases of up to US$100bn in GSE direct obligations under the programme will be conducted with the Fed's primary dealers through a series of competitive auctions, beginning next week.
Purchases of up to US$500bn in MBS will be conducted by asset managers selected via a competitive process, with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters.
Crosby report to revitalise UK RMBS?
The main recommendation of Sir James Crosby's report on UK mortgage finance involves the UK government guaranteeing the timely payment of scheduled principal and interest of RMBS and covered bonds eligible under the scheme. The guarantee - available to banks, building societies and specialist lenders - would be restricted to assets where the underlying collateral consists of sterling-denominated loans to borrowers for purchase of UK residential property, secured by first charge and originated after a specified date.
The guarantee would wrap senior tranches rated triple-A by at least two rating agencies and would only be available for assets backed by prime mortgages. Participating institutions would have to abide by high standards of disclosure and reporting that are compliant with standards proposed by trade bodies, such as the European Securitisation Forum.
Any losses made on the tranches under the guarantee would have to be made whole by the lender. Participating institutions would also be required to pay fees at commercial rates.
The report states that outstanding mortgages are likely to fall in 2009, as even the strongest players in the market are not willing to lend actively. Crosby indicates that savings cannot take the place of wholesale funding; therefore, government intervention is desirable to mitigate such market failures.
In his speech in the House of Commons the UK Chancellor noted the government would "proceed to work up a detailed scheme based on [Crosby's] recommendations", though he made clear that the proposal would have to clear State Aid approval hurdles with the European Commission.
Deutsche Bank securitisation analysts expect the clearing price of such government-guaranteed RMBS to be at a spread premium to guaranteed unsecured issuance. However, the auction pricing mechanism in setting the cost of the government protection should theoretically offset the higher cost of funding.
The report suggests issuing £100bn (subject to demand) in guarantees over the next two years. Guaranteeing £100bn of triple-A RMBS would imply total securitisation volumes of around £110bn-£115bn of mortgages, given a normal capital structure, with banks presumably retaining the junior bonds.
This can be compared to around £150bn-£160bn in annual gross mortgage origination for house purchase in 2006 and 2007 and to peak annual RMBS volumes in 2006 of £68bn. The proposal is therefore very bold in targeting the return of the mortgage and RMBS markets to pre-crisis norms, according to the Deutsche Bank analysts.
The guarantee would not cover bonds issued off any of the existing master trusts because it excludes remortgages and is limited to mortgages issued after a certain date. Lenders would therefore have to set up new programmes, most probably taking the form of senior-sub static or conventional structures, the analysts note.
"Sir James' report underlines the importance of securitisation as a source of funding for UK mortgages and the impact that the closure of this market is having on the availability of mortgage finance and on the economy in general," comments Mark Hickey, head of FI debt capital markets at RBS. "Government guarantees of mortgage-backed securities are likely to improve access to mortgage funding. We would welcome details of the guarantee scheme and implementation as soon as possible."
Citi winds down SIVs ...
In order to complete their wind-down, in a nearly cashless transaction Citi has committed to acquire the remaining assets of the SIVs it advises at their current fair value - estimated to be approximately US$17.4bn, net of cash, as compared to US$21.5bn at 30 September. The decline primarily reflects asset sales and maturities of US$3bn and a decline in market value of US$1.1bn since the end of Q308. Citi will record these assets as available for sale and, as a result, its GAAP assets will be reduced by approximately US$6bn and risk-weighted assets will be increased by approximately US$2bn.
The SIVs have been selling assets as part of an orderly asset-reduction plan to fund maturing debt obligations on a timely basis and have reduced long-term assets from US$87bn at the end of July 2007. The current fair value of Citi's support for its SIVs is US$6.5bn and is expected to be repaid upon completion of the transaction.
The transaction will result in the SIVs' having sufficient funds to repay maturing senior debt obligations. Citi's net incremental funding requirement at closing is estimated at US$300m.
... and the rating agencies react
Fitch has downgraded from triple-A to single-A plus and removed the rating watch negative of the long-term senior notes of the Citibank-advised SIVs Beta Finance, Five Finance and Sedna Finance. The senior note rating actions reflect Citi's announcement that it has agreed to purchase all of the SIVs' assets at the market price as of 18 November 2008.
In return Citi has agreed to provide funds to the SIVs so that they may pay in full the amounts under each of the senior note debt programmes as they fall due. The SIVs' senior note ratings are therefore linked to Citi's long- and short-term ratings.
Additionally, Fitch has downgraded Sedna's second priority senior (SPS) notes, issued from its MTN programmes, to single-C from triple-C and removed the RWN. The Sedna SPS note rating action reflects the fact that noteholders will not be paid in full at maturity as there are insufficient proceeds from the asset sale transaction after accounting for payments to the senior noteholders.
The financial impact for Citi of this action is modest, according to Fitch. The Citi-sponsored SIVs have already been consolidated onto its balance sheet and currently represent approximately 1% of the consolidated balance sheet.
Beta has US$7bn of senior notes, US$1.4bn of mezzanine support facility notes and US$0.9bn of capital outstanding. The average price agreed for the asset portfolio was approximately 78%, which is sufficient for the senior notes to be paid in full when due.
Five has US$2.9bn of senior notes, US$0.7bn of mezzanine support facility notes and US$0.6bn of capital outstanding. The average price agreed for the asset portfolio was approximately 73%, which is sufficient for the senior notes to be paid in full when due.
Sedna has US$1.5bn of senior notes outstanding, US$0.5bn of mezzanine support facility notes outstanding and US$0.8bn of SPS capital and subordinated notes outstanding. The average price agreed for the asset portfolio is approximately 78%, which is sufficient for the senior notes to be paid in full when due.
Meanwhile, Moody's has downgraded its ratings from Aaa to Aa1 for Beta Finance, Centauri Corporation, Dorada Corporation, Five Finance, Sedna Finance and Zela Finance. The rating actions affect twelve MTN programmes with a total debt outstanding of approximately US$20.6bn and are based on the forward transfer agreement between Citi and each of the affected vehicles.
In addition, S&P lowered to double-A from triple-A and placed on credit watch negative its long-term issuer credit ratings on, as well as its ratings on the MTNs issued by the Beta, Centauri, Dorada, Five, Sedna and Zela SIVs. The agency is also placing its A-1+ short-term issuer credit ratings and CP ratings on watch negative for the vehicles.
Under the forward transfer agreement, each of the vehicles will enter into the defeasance operating state, except for Five Finance and Sedna Finance which are already in defeasance/restricted funding. These operating states effectively prevent capital from exiting the structures.
The affected vehicles were restructured by Citi through a mezzanine capital facility in February 2008. The support facility took the form of a commitment to provide additional capital to each vehicle, should the market value of capital approach zero.
The total amount of the commitment provided in February 2008 for all the six vehicles was US$3.4bn. This amount has been drawn in full and, following further market value declines, Citi injected an additional US$1bn across the six vehicles in October 2008.
Panic in CMBS-land analysed ...
Though recent actions by the US Treasury have since helped stabilise prices slightly, the CMBS market imploded last week. Cash 10-year senior triple-A spreads widened by 600bp, while the CMBX market also gapped wider on heavy volumes.
A contributing factor to the panic was the transfer to 30-day delinquency status of two loans in recent vintage CMBS deals. The US$125m Promenade Shops at Dos Lagos in JPMCC 08-C2 (accounting for 10.8% of the deal) and the US$209m Westin Portfolio pari passu loan (split US$104m in the same JPMCC08-C2 deal (8.9%) and US$105m in JPMCC 07-C1 (8.9%)).
According to securitisation analysts at Barclays Capital, the delinquencies are noteworthy for two reasons: the lack of seasoning of each loan (both were originated in H207) and the concentrated exposure in one deal. The delinquent loans were the first and third largest loans in JPMCC 08-C2, representing 19.7% of the deal.
"We attribute the speed at which these loans went delinquent to a combination of weak local economies and/or aggressive, 'pro forma' underwriting trends. In particular, both loans are suffering due to secondary debt, which took overall leverage too high," the analysts note. Additionally, the news of the bankruptcy of a large real estate operator, DBSI Inc, likely fanned investor anxiety because it may mean a block of loans are transferred into special servicing in future months.
The BarCap analysts expect additional pro forma or low DSCR loans to struggle in the coming years as aggressive underwriting assumptions fall victim to a rapidly declining economy. Nevertheless, based on their latest estimates, the analysts find US$36bn of currently pro forma loans across CMBX Series 1-5 deals, or 10.7%, with the largest amount in Series 4. A large number of formerly pro forma loans have stabilised in more seasoned vintages, the analysts note.
In addition, after running 131 senior triple-A CMBS bonds with 30% enhancement through various default scenarios, the analysts found that 11 deals suffered collateral losses averaging 4.2%. The worst performing bond suffered a 19% write-down, yet still delivered a 15% yield at current pricing levels. Most bonds offered significant upside versus zero CDR yields, due to shortening average lives.
... and downwards rating pressure expected
The balance in supply and demand that is currently helping to support US commercial real estate prices is expected to give way to decreasing demand over the next several months, leading to lower rents and higher vacancies, says Moody's in a new report. The weakened conditions are likely to put downward rating pressure on the ratings of some CMBS, according to the rating agency.
"We do expect that the 2006 through 2008 vintages will experience more downward pressure on ratings than earlier vintages," says Moody's md Nick Levidy. "In particular, we are concerned about fixed rate deals with concentrations of pro forma loans - loans that were underwritten assuming continued strong macroeconomic tailwinds."
The performance of CMBS, however, will vary considerably from deal to deal, even within the same vintage and property type, says Moody's.
Two mitigating observations noted in the report are that 1) commercial real estate is entering this downturn with little excess supply, and 2) only a small percentage of the loans backing CMBS face refinancing in 2009.
Moody's nonetheless expects commercial property values to decline by 20%-30% from their peak in late 2007, with the market reaching a bottom in 2010-2011. Aggregate defaults in commercial real estate loans are also expected to increase several times over the next few quarters from the current historically low rate of under 1%.
Conditions across all markets and property types are under pressure. "The headwinds faced by the retail sector in particular appear to be strengthening, the hotel sector has been re-pricing for months, demand for office space appears to be on the decline in many markets and multifamily properties are buffeted by cross currents relating to unemployment, shadow rentals of unsold homes and condominiums and home affordability," says Levidy. "Meanwhile, industrial properties have been impacted by slower trade and retail sales."
Granite to be unwound ...
Northern Rock's RMBS master trust, Granite, is to be unwound following the occurrence of a non-asset trigger event - caused by the current seller share being less than the minimum seller share on two successive distribution dates. As a result, all principal will be directed first to the bondholders and second to the seller.
Fitch says that the breach of the non-asset trigger is unlikely to impact either the ratings assigned to the RMBS issued from the Granite master trust or the related Whinstone programmes. However, the agency cautioned that deteriorating collateral performance could lead to negative rating action on the lower rated tranches from these programmes.
... Whinstone deals negatively impacted?
Moody's has indicated that the Whinstone and Whinstone 2 transactions may be negatively impacted over time by the increase in the weighted average cost of funds in Northern Rock's Granite master trust, following last week's non-asset trigger breach, which may result in draws on the reserve funds in Funding and Funding 2. However, Moody's says that it has factored this possibility into its cashflow analysis and will continue to closely monitor excess spread available in the trust.
The following are the key issues that Moody's considered while analysing the consequences of these trigger breaches:
• The potential for new loan additions into the master trust portfolio is now limited, which decreases the risk of potential portfolio quality drift.
• The change in the issuer principal waterfall results in realignment of payment priorities across the different notes and in extension of the weighted average life of all junior notes and some senior notes.
• The change in the allocation of principal at the trust level will result in the seller absorbing the majority of the back-ended losses.
• The weighted average cost of funds in the trust is expected to increase over time, as cheaper senior notes are redeemed before more expensive junior notes and some junior notes step up. This will negatively impact excess spread available in the trust.
• The CPR in the trust may decrease over time, as a result of Northern Rock standard variable rates decrease and more risky borrowers with limited refinancing opportunities may remain in the portfolio.
Last triple-A monolines cut
Moody's has downgraded FSA and Assured, effectively implying that monolines with legacy problems cannot remain triple-A rated (see also separate news story). FSA's insurer financial strength rating was cut to Aa3, while FSA Holdings went to A3, with the outlook developing for both. Assured Guaranty's IFSR was cut to Aa2 and Assured Guaranty US Holdings was cut to A2, with the outlook stable.
The rating actions are thought unlikely to derail the acquisition of FSA by Assured. Moody's confirms that the acquisition would not adversely affect Assured's ratings, suggesting that it may even prompt positive action on FSA.
Ambac downgraded ...
S&P has cut Ambac's insurance financial strength rating to single-A (negative outlook) from double-A. The rating action reflects S&P's view that the company's exposures in the US residential mortgage sector and particularly the related CDO structures have been a source of significant and comparatively greater-than-competitor losses, and will continue to expose the company to the potential for further adverse loss development.
S&P credit analyst Dick Smith adds: "These losses have slightly more than offset the benefits to the company of lower capital requirements that result from a declining book of business."
In addition, to support funding needs at affiliate Ambac Capital Funding Inc (a provider of investment agreements) to meet increased collateralisation and termination requirements, Ambac has purchased assets from and made loans to the affiliate that have lowered slightly the credit quality of Ambac's investment portfolio and increased the gap between the book value and fair market value of the assets in the portfolio. Nevertheless, in S&P's opinion, the company still exhibits sound claims-paying ability at its current rating and adequate liquidity levels.
... while CDS are commuted
Ambac has commuted two CDO-squared exposures and two high grade ABS CDO exposures (see also separate news story). The four transactions, with an aggregate of approximately US$3.5bn notional outstanding at 30 September, were settled with counterparties in exchange for a total cash payment of US$1bn.
The two CDO-squared transactions originally comprised collateral consisting of single-A rated ABS CDO tranches, while the two high grade ABS CDO exposures originally comprised collateral consisting of ABS rated single-A minus or higher. Most of the collateral had been downgraded to below investment grade since the inception of the transactions. All four of the transactions had been internally downgraded to below investment grade.
"My immediate focus as Ambac's new ceo is to restore confidence in our balance sheet through aggressive risk reduction," says David Wallis, Ambac's ceo. "Ambac has consistently emphasised that in this period of extreme uncertainty in the capital markets, the de-risking and de-leveraging of our balance sheet is our highest priority. These settlements represent positive and tangible steps towards that goal."
FGIC strengthens statutory surplus ...
FGIC has disclosed that it took action to strengthen its statutory surplus to reduce the likelihood of breaching the minimum US$65m statutory capital limit under New York State Insurance Law. In October and November, FGIC tapped its soft capital facilities, issuing preferred stock into a committed capital facility and raising US$300m.
... but is downgraded by S&P
S&P has lowered its financial strength and financial enhancement ratings on FGIC to triple-C from double-B. The monoline's ratings have been removed from credit watch, where they had been placed with negative implications on 6 June 2008, although the outlook is negative. At the same time, S&P has lowered to double-C from triple-C the issuer credit rating on parent company FGIC Corp, with a negative outlook.
S&P's current loss estimates for FGIC's exposure to 2005-2007 vintages of non-prime and second-lien mortgages and related ABS CDOs of almost US$5bn remain in excess of the company's claims paying resources of about US$4.2bn. In particular, the company's unearned premium reserve has declined by about US$1bn, mostly due to FGIC's reinsurance transaction with MBIA Insurance Corp whereby FGIC ceded about US$166bn of well-performing municipal par exposure to MBIA.
While loss estimates have also declined due to commutation success for several transactions, S&P believes the potential for regulatory intervention remains. The triple-C financial strength rating is, in our view, more consistent with the current scenario of a financial guarantor very dependent upon commutations in order to meet its obligations. Also, continued adverse loss development remains a possibility and additional stress could come in the near term from FGIC's US$1.2bn exposure to troubled Jefferson County's sewer revenue bonds.
In addition, FGIC's risk profile has shifted in the agency's opinion and the monoline's insured portfolio has now become more concentrated and correlated, with structured finance insurance comprising a large majority of par in force. The negative outlook reflects the possibility of continued adverse mortgage loss development and capital reductions.
Basel tackles financial crisis
The Basel Committee on Banking Supervision has announced a comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks. Nout Wellink, chairman of the Basel Committee, says that "the primary objective of the Committee's strategy is to strengthen capital buffers and help contain leverage in the banking system arising from both on- and off-balance sheet activities". It will also promote stronger risk management and governance practices to limit risk concentrations at banks.
"Ultimately, our goal is to help ensure that the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy," Wellink adds.
The key building blocks of the Committee's strategy are the following:
• strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures);
• enhancing the quality of Tier 1 capital;
• building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen pro-cyclicality;
• evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system;
• strengthening supervisory frameworks to assess funding liquidity at cross-border banks;
• leveraging Basel II to strengthen risk management and governance practices at banks;
• strengthening counterparty credit risk capital, risk management and disclosure at banks; and
• promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.
The Basel Committee expects to issue proposals on a number of these topics for public consultation in early 2009, focusing on the April 2008 recommendations of the Financial Stability Forum. The other topics will be addressed over the course of 2009.
Effect of distressed sales on home prices analysed
The proportion of distressed home sales in the US reached 35%-40% in the third quarter, according to the National Association of Realtors. On a year-over-year basis, prices fell 9%.
House price declines, as measured by major indexes, are proving to be a significant drag on the economy, note structured finance analysts at Wachovia Securities. Nevertheless, it appears that most of the pain in house prices is coming from distressed sales.
"If prices of distressed homes have fallen by 20%-30%, and they make up 35% of the sales, then their contribution to the price decline is -7% to -10.5%," the analysts add. "That suggests that prices of non-distressed homes have not declined by much, if at all."
The Wachovia analysts believe that the purveyors of the major house price indexes have an obligation to the market to provide greater transparency. "A useful start would be to explicitly show the effect of distressed sales on the price indexes. That way, buyers, sellers and lenders would have a better view of conditions in the housing market," they conclude.
Primus breaks further listing standard ...
Primus Guaranty has been notified by NYSE Regulation that it is not in compliance with one of the continued listing standards of the New York Stock Exchange. The company is considered below criteria established by the Exchange because the average closing price of its shares of common stock was less than US$1.00 for 30 consecutive trading days. In accordance with NYSE procedures, Primus must acknowledge to the NYSE receipt of the notification within 10 business days of receipt and bring its share price back above US$1.00 within six months following receipt of the notification.
The company says that it intends to provide NYSE Regulation with the requisite acknowledgement and to take such actions as may be necessary or appropriate in order to bring it into compliance with the continued listing standards. Should Primus fail to meet this standard at the expiration of the six-month period, however, the NYSE will commence suspension and delisting procedures.
... and is downgraded by Moody's
Moody's has downgraded the counterparty rating of Primus Financial Products from Aa1 on review to A1 on review. The agency also downgraded to Ba3, from Ba1, the senior unsecured and issuer ratings of Primus Guaranty.
The rating actions are the result of deterioration in the credit quality of Primus' CDS reference portfolio, in particular its exposure to Kaupthing Bank, Lehman Brothers and the financial guarantors that have been downgraded recently by Moody's. These events have resulted in Primus not being adequately capitalised in respect of its previous ratings.
The downgrade of Primus Guaranty's ratings to Ba3 with a negative outlook was prompted by the continued credit deterioration at its main operating company and resulting uncertainty about the group's strategic direction. The stress at Primus Financial may also weaken the financial flexibility at Primus Guaranty, possibly restricting the ability of the CDPC to make dividends to its parent - though such concerns are somewhat mitigated by good liquidity at the holding company, Moody's notes.
OWIC trades reported
Of the US$700m OWIC circulating last week (see SCI issue 113) with triple-A CLO content, some US$252m traded. According to one trader, eight line items out of the 35 names on the list traded - the average DM was about 350bp - so fairly tight in reference to the perceived market spread levels. All but two offers put forward for the list traded - a level could not be decided for the two that did not trade.
Sub-prime expected losses analysed
Structured finance analysts at Wachovia Securities have used a loan-level option-adjusted spread model, based on 300 interest rate paths, to determine ratings for 3,165 sub-prime mortgage securities originated in 2005, 2006 and 2007. The credit risk measures are based on expected losses from the OAS model and correspond to Moody's idealised losses.
Based on the methodology, the analysts suggest that investors abandon traditional letter credit ratings and instead focus on the true metric of interest - the probability of loss and expected loss given default. This methodology would oblige investors to think explicitly about their level of risk aversion, tolerance for principal loss and the level of compensation required for those risks.
Wachovia projects collateral cumulative losses for each vintage (2005-2007) of 15%, 22% and 24% respectively, with the potential for further downgrades in senior bonds. "For the most part, we project rating migrations from Aaa to Aa. Based on both expected losses and probability of default, the Aaa sector offers an exceptional risk/reward profile, in our opinion," the analysts note.
Moreover, they do not foresee a significant number of further downward rating actions on mezzanine bonds. In fact, the analysis suggests that expected losses may be less than those implied by the current ratings. "Although we do not predict upward revisions, we believe that the sector represents strong ratings," the analysts conclude.
FSA succession event explored
Fitch has released a commentary focusing upon the likely outcome for CDS involving FSA, particularly the potential for its acquisition by Assured Guaranty to trigger a succession event in CDS that reference obligations of FSA and its subsidiaries. In order to assess the likelihood of succession events (under the rules-based approach set forth in ISDA 2003), an understanding is needed of how the acquisition transaction will change FSA's current corporate and debt structure, the agency says. It should be noted that a wrapped security may be considered a qualifying policy under the 2005 ISDA language and, being analogous to a qualifying guarantee, is thus deliverable into a CDS contract referencing a financial guaranty company (not the holding company), should a credit event occur.
For the purpose of this analysis, obligations of FSA and its subsidiaries can qualitatively be divided into several categories:
• Outstanding insured obligations of FSA - the primary financial guaranty entity. FSA Inc's insured portfolio on a gross par basis as of 30 September 2008 totalled US$548bn, and the majority was insured via financial guaranty policies rather than CDS. FSA Inc has no outstanding public debt.
• Outstanding direct debt of FSA - the current holding company. As of 30 September 2008, FSA reported outstanding direct debt of US$730m.
• Outstanding obligations of FSA's financial services business subsidiaries and affiliates. These obligations are primarily either guaranteed investment contracts (GICs) or MTNs. The GIC obligations are issued by subsidiaries of FSA, and the MTNs are issued by partially owned affiliates of FSA. Both the GIC obligations and the MTNs are insured by FSA Inc.
Assured has disclosed its current plans regarding several key aspects of the post-acquisition corporate structure, which are relevant for this analysis. At closing and for some period afterward, FSA is expected to remain a separate legal entity and continue its current public finance and infrastructure business activities as a standalone financial guarantor. This being the case, Fitch does not expect that the acquisition transaction would constitute a succession event at this time for CDS referencing obligations of FSA Inc.
The future of the holding company, FSA, is currently not as clear. Assured has indicated there is a possibility that FSA will be merged into its US holding company subsidiary. Whether or not FSA is merged into an Assured entity, its currently outstanding debt is expected to remain outstanding, possibly with a guarantee by Assured.
If FSA is merged into an Assured entity, it is likely this would constitute a succession event for CDS written on FSA. However, if FSA continues as a separate legal entity with its current debt structure, Fitch expects that the acquisition would not trigger a succession event.
The financial services entities are essentially special purpose entities, and it is unlikely that CDS have been written specifically referencing their obligations - making the successor issue largely irrelevant for them.
The structure of the transaction contemplates that FSA will remain the insurer of the financial products obligations and, in any event, these obligations as a percentage of FSA's total are of insufficient magnitude to breach the stipulated 25% threshold to potentially qualify as a succession event. Thus, the assumption of these obligations by Dexia would likely not trigger a succession event for FSA as the guarantor.
ABX deterioration continues
The latest remit reports indicate that, as expected, credit performance for the Markit ABX indices deteriorated in October, with CDRs, severities and losses up across the board. One-month CDRs were 22.78%, 25.85%, 19.07% and 16.81% for 06-1 through 07-2 respectively, up 5.13% for the 06-2, 3.03% for the 07-1, 2.70% for the 07-2 and 1.99% for the 06-1. Cumulative losses were up close to 70bp for the 06-2, 07-1 and 07-2, and 49bp for the 06-1 series.
The cumulative loss monthly change has been steadily increasing over the recent months, due to increasing liquidations and severities. Severities were up for all of the indices, by 1.33% on average, reaching anywhere from 53.85% for the 06-2 to 57.14% for the 07-1. Voluntary prepayments continue hovering around historic lows in the low single-digit area - 06-2 and 07-2 at 3.76%, 07-1 at 5.56% and 06-1 at 5.79%.
JPMorgan structured credit analysts note that an increasing number of ABX tranches took a write-down this month, including the first single-A constituent - MSAC 06-WMC2 M5. Twenty deals (a fourth of all the underlying deals) have an ABX reference entity experiencing a write-down, anywhere from the triple-B minus to the single-A tranche. Eight triple-B minus tranches are fully written down, compared to six tranches last month, and currently four triple-B tranches have been depleted.
Meanwhile, ABX prices rose by as much as 8-10 points at the open (albeit closing only modestly higher on the day) yesterday, 25 November, on the news of TALF. Nonetheless, the JPM strategists remain underweight ABX and recommend shorting the tranches with higher dollar prices and larger credit components (AAA/PENAAA for the 06-1 and 06-2 indices, and PENAAA for 07-1 and 07-2).
Methodology for non-performing RMBS released
S&P has released its methodology and assumptions for rating US RMBS backed by what it considers to be non-performing or re-performing mortgage loans. The analysis of non-performing and re-performing loans involves a customised analysis, which considers past performance and servicer-specific liquidation strategies.
Issuers typically include non-performing and re-performing collateral in 'scratch & dent' transactions. Other collateral such as document-deficient loans and loans originated outside the lender's standard underwriting guidelines may also be categorised as scratch & dent.
However, S&P's focus is on US residential mortgage loans that, in its view, have demonstrated performance deficiencies. Given the stresses in the 2008 market environment, the agency says that it has seen, and expects to continue to see, an increase in the volume of such collateral in transactions submitted to it for review.
Scratch & dent transactions may use a variety of securitisation structures, such as senior/subordinate, senior/subordinate/overcollateralisation or liquidating trusts. But S&P focuses only on its assessment of the credit risks associated with the collateral included in such a transaction, rather than the specific structures used.
The agency expects to consider the various securitisation structures that have been used in transactions backed by non-performing and re-performing collateral in the coming weeks. Specifically with regard to liquidating trusts, S&P believes that there are unique risks which must be considered when evaluating proposed structures.
TRUP CDO approach revised
S&P is revising its global methodology for rating CDOs of trust preferred securities (TRUPs), surplus notes and other hybrid securities issued by banks, insurance companies, real estate investment trusts (REITs) and homebuilders. The revised methodology reflects the agency's conclusions from analysing the characteristics and expected performance of hybrid securities issued by financial institutions, insurance companies, REITs and homebuilders. It also reflects S&P's concerns based on worsening economic conditions and the effect those conditions may have on the performance of these securities.
In its analysis, S&P generally focused on CDOs of hybrids and reviewed the likelihood that the issuer will default or defer payments, the estimated recovery prospects and the asset performance correlation within and among the industries present in these CDO transactions. The agency also researched these instruments' default timing and patterns, and consulted with S&P rating analysts who follow companies that issue hybrid securities.
S&P's methodology revisions include the following:
• updated assumptions for the likelihood of payment deferrals;
• changed industry code classifications for insurance companies and REITs;
• changed correlation assumptions for financial intermediaries, insurance companies and REITs;
• modified maturity profile assumptions;
• updated post-deferral recovery assumptions; and
• devised new assumptions for deferral/default timing patterns.
Further compression success
Creditex and Markit have announced the compression of US$1.036trn in notional value of CDS transactions since the successful launch of a coordinated programme of multilateral trade terminations in August this year. During the week of 17 November 2008, multilateral trade terminations administered by the two firms reduced the notional value of outstanding CDS trades referencing corporations in the consumer products, basic materials and financial services industries by more than US$220bn.
Since August, a total of 14 dealers have participated in 26 portfolio compression runs that have lowered outstanding notional amounts significantly, decreased counterparty credit exposure and reduced operational risk in the CDS market, according to the two firms. Creditex and Markit run portfolio compression cycles regularly and systematically across the major sectors to tear up trades in the most active single name CDS contracts.
Canadian structured credit methodology released
DBRS has published its methodology for rating Canadian structured credit products. With the new release, the agency has brought together into one document its rating approach to all elements of a Canadian structured credit transaction, including credit risk, the risk of a leveraged transaction facing a collateral call and counterparty risk. These elements had previously been addressed in a number of DBRS publications.
"DBRS expects structured credit issuance and innovation to remain subdued in the near term," says Andrew Fitzpatrick, avp, Canadian structured finance at DBRS. "However, as new products are presented for rating scrutiny, DBRS will seek appropriate methods to assess the risks that will be borne by holders of these new products."
UK FSA addresses CDS market abuse
The UK FSA has responded to questions as to whether a CDS is covered by the UK market abuse regime. Although CDS are not admitted to trading on a prescribed market, the Authority considers that most CDS are likely to be caught by the UK market abuse regime.
CDS will be caught by the insider dealing and disclosure of inside information provisions where they are 'related investments' (i.e. where they are an investment whose price or value depends on a price or value of a qualifying investment (such as the underlying bond)). They will also be caught by section 118(4) of FSMA (misuse of information), where the relevant behaviour occurs in relation to CDS whose subject matter is a qualifying investment.
In addition, market behaviour in relation to CDS may also be caught by the market manipulation, misleading behaviour and market distortion provisions, the FSA says. An example of abusive behaviour would be where the behaviour consists of effecting transactions in CDS which give, or are likely to give, a false or misleading impression as to the price of one or more qualifying investments (e.g. shares or bonds), other than for legitimate reasons.
Moody's updates US RMBS evaluations
Moody's has updated its approach to evaluating US RMBS in three new reports, which detail the agency's enhanced criteria for assessing originator quality, representations and warranties, and independent third-party reviews. Moody's says the move is part of its effort to encourage greater data integrity, accountability and transparency in RMBS securitisations.
According to Claire Robinson, senior md of Moody's structured finance group: "The enhancements will materially improve our ability, and the ability of the market, to assess credit risk in US RMBS by increasing the reliability and transparency of information on which the transactions are based."
The latest reports further describe Moody's approach to rating RMBS going forward and, according to Robinson, the guidelines will provide a higher level of information that analysts and investors can use to analyse new RMBS deals. "If a securitisation to be rated does not meet some of the criteria," she explains, "Moody's may decide that more credit protection is needed to achieve a given rating, we may decide to assign lower ratings or we may decline to rate the transaction. For example, Moody's will not rate any US RMBS that has not had an independent third-party review of the loans prior to securitisation."
Spanish SME CLO deterioration spreads
The overall outlook for asset performance of Spanish SME CLO transactions remains negative, says Moody's in its latest index report for the sector. Although the 2006 and 2007 vintages are the most affected, all are now showing signs of deterioration, the rating agency reports.
"A total of 61 Spanish SME ABS transactions rated by Moody's were outstanding as of Q308, with an outstanding portfolio balance of €37bn," says Ludovic Thebault, a Moody's senior associate and co-author of the report. "Performance indicators suggest that a stress scenario is emerging for all vintages."
Weighted-average 90-360 days delinquencies represent 1.27% of the outstanding balance of Spanish SME transactions at Q308, compared with 0.74% in Q208 and 0.33% in Q307. Eight transactions experienced reserve fund draws over Q308, up from four transactions in Q208. In addition, in Q308 delinquency ratios (90-360 Days/CB) exceeded 1% in 31 transactions (up from 14 in Q208), 2% in 11 transactions (up from 4 in Q208) and 3% in five transactions (up from 2 in Q208).
CPPI notes rated
Moody's has assigned Aa1 ratings to the €41.75m Credit Strategy Principal Protected Notes issued by BNP Paribas' SPV Aquarius + Investments vehicle, due February 2017. The proceeds of the notes will be used to purchase assets under a series of 90-day repurchase agreements with BNP Paribas, currently rated Aa1.
The repo assets will be selected by BNP Paribas and are subject to certain criteria. The exposure to the bank is collateralised by the assets under the repurchase agreement; however, due to the wide criteria Moody's has not given any credit to the assets or assessed the market value of the assets when liquidated upon an early redemption.
Valuation service to include non-performance risk
OTC Val has expanded its valuation service to include non-performance risk. Under FAS 157, non-performance risk refers to the risk that the obligation will not be fulfilled and thus affects the value at which the liability is transferred. Therefore, FAS 157 requires the fair value of the liability to include an adjustment for the non-performance risk related to the liability.
In order to comply with FAS 157 and prior to adjusting a liability's fair value by the non-performance risk, it is important to understand how a liability's value is derived, especially for hard-to-value derivatives with Level 2 or 3 inputs. For hard-to-value derivatives, which require models to derive their values, OTC Val has implemented a procedure to account for non-performance risk in its valuation process.
OTC Val employs multiple valuation techniques to address the Level 1, 2 and 3 input requirements of FAS 157. For derivatives that can be replicated with vanilla, liquidly-traded instruments and valued in a model-independent way, the focus is on mark-to-market valuation using high-quality market data from leading brokers and data vendors. For hard-to-value derivatives with limited price discovery and imperfect replication, OTC Val's market professionals offer mark-to-model valuation based on careful calibration of industry standard models.
CPDOs downgraded
Moody's has downgraded the ratings of five series of CPDO notes, both static and managed. These rating actions reflect the current lower leverage in the transactions, which makes it less likely for them to rebuild their substantially eroded NAV to par, should the respective leverages remain constant at their current values.
Synthetic RMBS on review
Moody's has placed on review the ratings of 52 tranches issued in 13 transactions from the RESI and RESIX shelves, and corrected the ratings of six tranches in two RESIX transactions. The RESI certificates are protected through subordination including a non-amortising unrated tranche. The synthetic transaction provides the owner of a sizable pool of jumbo mortgages credit protection similar to the credit enhancement provided through subordination in conventional RMBS transactions.
The reference portfolio includes prime conforming and non-conforming balance of primarily fixed-rate mortgages purchased from various originators. The portfolio is generally static, as in most RMBS deals.
Through an agreement with the securities issuer, the protected party pays a fee for the transfer of a portion of the portfolio risk. Investors in the securities have an interest in the holdings of the issuer, which include highly rated investment instruments, a forward delivery agreement and fee collections on the agreement with the protected party.
Investors are exposed to losses from the reference portfolio but benefit only indirectly from cashflows from these assets. Depending on the class of securities held, investors have credit protection from subordination.
IOSCO to focus on OTC oversight ...
IOSCO's Technical Committee has crafted a detailed work programme to address the market turmoil, focused on strengthening financial markets and investor protections.
Christopher Cox, chairman of IOSCO's Technical Committee, comments: "Being representative of over 100 securities regulators worldwide, IOSCO is central to developing coordinated regulatory solutions to deal with the current financial crisis. To be effective, the regulation of trading abuses must be coordinated across major markets. This is equally true not only of short selling, but also derivatives trading and activity by currently unregulated entities such as hedge funds."
The Technical Committee is forming a task force on each of these topics to help ensure that global capital markets address the current turmoil on a sound basis and in a well-coordinated way, IOSCO says. In particular, given the impact unregulated financial markets and products have had on global capital markets, the task force will examine ways to introduce greater transparency and oversight to unregulated market segments, such as OTC derivatives and other structured financial products.
... while New York CDS regulation postponed
In light of progress being made to create central counterparties for CDS with federal oversight, New York State Insurance Superintendent Eric Dinallo says that he will delay plan to regulate some swaps as per the Circular Letter issued on 22 September (see SCI issue 105).
"The best solution for a healthy market in credit default swaps is a single market. That won't happen if New York regulates some transactions under the insurance law, while the rest of the market is either unregulated or regulated under other laws. I am pleased to see that our strong stand has encouraged the industry and the federal government to begin developing comprehensive solutions. Accordingly, we will delay indefinitely regulating part of the market," he notes.
According to Dinallo, effective regulation of CDS should include the following provisions:
• All sellers must maintain adequate capital and post sufficient trading margins to minimise counterparty risk.
• A guaranty fund should be created that ensures that a failure of one seller will not create a cascade of failures in the market.
• There must be clear and inclusive dispute resolution mechanisms.
• To ensure transparency and permit monitoring, comprehensive market data should be collected and available.
• The market must have comprehensive regulatory oversight, and regulation cannot be voluntary.
CS & AC
Research Notes
CLOs
Redrawing the landscape
Siobhan Pettit, head of structured credit strategy at RBS, summarises the outlook for European leveraged loan pricing, defaults, recoveries and supply
The €400bn European leveraged loan landscape is being redrawn; loans are being transferred from highly leveraged to non-leveraged investors. This is not an orderly process; deleveraging and liquidations by leveraged players (total return swap lines, market value CLOs, hedge funds, investment banks) is happening in advance of new buyers appearing en masse. This has been the kiss of death for pricing.
LevX Senior, with a 575bp coupon, is trading at around 82 points - effectively pricing in a 30% recovery - whereas European loan recoveries have averaged 72% for the 23 years since 1985. Better quality loans have been hardest hit - the average flow-name cash loan bid is 65 points, an average discounted spread to maturity of 1250bp or - assuming three years to repayment - 2050bp.
1250bp is effectively pricing in 25% -30% annual default rates, assuming 50%-60% recoveries (see Exhibit 1). S&P reports the peak in annual European leveraged loan rates in 2001 was 4%, 8% in the US. Notwithstanding that forthcoming loan defaults will be much higher than previous downturns and recovery levels much lower, loans trade below even the most pessimistic expectations.
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| Exhibit 1 |
Leveraged loans look cheap to expected losses, but are they a "buy" and, if so, in what form? A short-lived rally into year-end is possible; however, we expect leveraged loans to be cheaper in H109 than they are now as deleveraging continues and fundamentals deteriorate in the coming months. That said, by year-end 2009 loans could be tighter than current levels if fear of systemic financial collapse has eroded and investors are able to price risk assets more accurately.
For market value-sensitive investors and investors with short-term horizons, buying now feels too soon. Mark-to-market volatility will remain high for the next three-six months.
For buyers that can withstand price volatility, now looks like a decent time for investing, given the collapse in risk appetite and serious technical factors at play. If you can invest on a two-year view or longer, we recommend scaling into carefully selected loans through Q1 and Q2 2009.
Key parameters of this recommendation are:
• Credit selection is paramount. Markets often don't finely discriminate between good and bad companies in periods of crisis. We are seeing this now; there's no credit reason for some good names to be trading where they are (including some of our picks: Amadeus B/C wrapped around 55, Casema B/C around 87, Nycomed B/C around 61, Phadia B/C around 86, Wind B/C around 85 and UPC M around 71/74). 2009 should see greater price discrimination. While we expect the broader loan market indicators to move wider in 2009, we do expect that senior loans from the very best performing high quality businesses - which are extremely attractive on a risk-return basis - may already be close to their lows. Weak names will cheapen further and bottom out later, as problems materialise.
• With spreads between 1200bp-1800bp, there is no need to be over-ambitious. We recommend foregoing some of these returns on offer to reduce risk; whether by hiring the very best-resourced managers with the deepest experience to ensure excellence in credit selection and loan work-out skills, or by hedging market risk by buying LevX or iTraxx XO protection or by buying on a credit-enhanced basis.
• Loan manager selection is critical; credit selection will be the differentiator of performance. It's a credit-intensive role to differentiate between cheap and value credits. Though defaults are set to rise, an experienced manager will be able to construct a portfolio of defensive assets that will provide a high return.
• Diversification is key to leveraged loan investing, and we recommend investing on a portfolio basis. A portfolio of senior loans bought at a 30% discount, even if we see record high default rates and low recoveries, should deliver IRRs of 20% or more - sufficient to compensate for the expected volatility in H109.
• It would be easy to find a portfolio of decent names in pretty short order, but we recommend scaling in gradually to take advantage of dips and volatility.
Our favourite route into leveraged loan product remains triple-A and double-A tranches of European cashflow CLOs, which are not only default remote, but can also actually benefit from rising defaults and downgrades (as defaults rise to certain levels, cashflows get diverted away from equity and mezzanine debt providers to further credit enhance the triple-A notes, or even pay them down early). With triple-As trading at 300bp-700bp and double-As at 500bp-1000bp, we recommend that investors with cash should avail of this safe and unlevered route into the asset class.
Triple-A tranches are en route to establishing firmer trading levels; government interventions to support banks is gradually alleviating fears over mass selling of triple-A assets by banks and IAS 39 removed a lot of triple-A securitised product for sale. This should result in fewer crazy marks and an establishment of truer trading levels.
We see merit in taking second loss risk on a managed loan portfolio in the form of a low levered CLO. A popular trade currently is the two-tranche structure, with equity providing 20%-30% first loss capital with a triple-A rated debt piece on top. We estimate triple-A debt for this structure would currently price at around 350bp or so.
Unlevered, managed loan funds
On our calculations, unlevered loan funds invested in a conservative selection of the 20-30 best leveraged loan names can offer high-teen IRRs now on an unlevered basis. The idea here is not to juice up the fund with story credits or look for trading opportunities; instead to carefully select names that are extremely resilient through a downturn, that will meet principal and interest and will not need financing or restructuring in the next couple of years.
This is not looking for pull to par or for profit through trading gains. The fund route offers diversified portfolios and manager expertise and the ability for a manager to scale in as opportunities arise.
Outlook for European leveraged loan pricing
October's loan prices were crushed by deleveraging and recession fears, as illustrated by Exhibit 2. We saw banks and leveraged investors (mainly hedge funds) jettison loan assets. S&P LCD counted €2.2bn European loan BWICs in October.
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| Exhibit 2 |
In response, unprecedented falls in loan prices triggered market value structures to unwind. Better quality, more liquid names were hurt most, as evidenced by flow-name loans falling 26% to 64 points and LevX Senior hitting 77 points.
As we write, selling pressure has eased off. We are seeing both sellers and buyers, and two-way flow has developed. The respite is due in part to generally less volatile markets and specifically due to the absence of new loan BWICs.
Governments' support of banks has stemmed some of the fire selling, and we estimate that IAS 39 has moved €15bn-€20bn of loans previously for sale into banking books and stemmed the supply of loans for active sale. This effectively erodes a major negative technical and there is scope for some firming in loan pricing off the back of it. LevX Senior is trading at 82 points, but cash is underperforming; the average flow-name cash loan bid stands at 65 points, an average discounted spread to maturity of 1250bp or, assuming a three-year life, 2050bp.
Short term: potential for a December rally
Our macro strategists see scope for a general risk-asset rally into year-end that, if it transpires, should filter down to the loan market, as long as further bank kitchen-sinking and hedge fund liquidations don't spoil the party. Leveraged investors are an ongoing threat; the fear of more BWICs and forced selling and further downward pricing pressure lingers in the loan markets.
Hedge funds continue to delever; their private nature means that volumes are impossible to quantify. Banks will continue to tidy their balance sheets, and to reduce trading desks' inventories.
LevX should fare better than cash loans as we head into year-end when cash concerns traditionally heighten. What patchy liquidity there is now will fade into year-end.
We expect loans to cheapen in H1 2009
In H109 we expect risk assets to reprice lower; we expect lower lows in equities and wider wides in credit (e.g. we expect to see S&P 500 trade below the lows of 2002, potentially down to 600+). Our strategist's multi-quarter and multi-year macro views on global growth, earnings, unemployment, ratings trends and defaults are firmly bearish. We do not believe that the full impact of this recession is yet factored into pricing and corporate earnings expectations.
We see no reason why leveraged loans would stand firm in the face of general market weakness and thus we expect leveraged loans to sell off too. In fact, as focus shifts to fundamentals, leveraged loans will under-perform better quality credit assets.
Early-2009, when investors make asset allocation decisions, we think leveraged loans will not get great allocation from real money; the preference will remain for higher rated credit assets. We are in the very early days of what will be a prolonged period of corporate distress; the spectre of huge volumes of restructurings and covenant breaches will keep non-specialists at bay for some time and keep a lid on loan prices.
We'd like to get more constructive for H209, but it's not easy. For spreads to be tighter by next December, we will need:
• To have seen major fiscal stimulus. Fiscal policy measures remain the big unknown and governments have scope to delight or disappoint. We should be getting a read on fiscal measures in Q109 and, if they are substantial and well received, then they might set the scene for spread tightening in H209.
• Investor confidence in the financial system to have been restored to be able to better establish a liquidity premium and enable more rational risk asset valuations.
• 'Real money' to have entered the market in size. Without this, prices will remain soft and rallies will prove flimsy. While current low prices are attracting modest interest and bargain hunters, it is mainly smaller buyers and leveraged buyers. We target real money because we need their scale to move the market, and their unlevered capital and longer-term hold to make any pricing shifts sustainable. While current prices bring us closer to piquing real money interest, we think it will be some while yet until 'real money' dives in in size; there is still a lot of loan product to be dealt with and real money will need to sense that technicals are bottoming out before they step in.
If these conditions are all met, spreads could tighten later in 2009 from 1800bp-2000bp now to 1100bp-1400bp - the sort of pricing we associate with high default periods (global high yield bond spreads were around 1,100bp in 2001-2002).
We expect more pronounced price differentiation between better and weaker prospects. Some loan product is extremely poor quality, even at what appears to be very cheap prices; whereas other names offer tremendous value.
The performing loans will tighten relative to, and bottom out sooner than, distressed names, which can still fall a great deal further. We expect subordinated loan prices to fall further too.
We expect the loan versus high yield bonds spread differential to correct. At present loans are cheaper than bonds (see Exhibit 3). This relationship feels wrong; loans are generally a better prospect than bonds, due to the bank support and first security charge across company assets.
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| Exhibit 3 |
However, loan issuance eclipsed HY bond issuance in recent years and there is a great deal more loan volume outstanding; these loans tend to be in more levered hands than HY bonds. As fundamentals loom large in 2009 and technicals gradually recede, we expect the relationship to revert to 'normal' (i.e. loans will become more expensive than bonds, but the differential will continue to be small).
Illiquidity and volatility will persist. Dealers have put a lot of product on to the banking book and will not be in the business of reloading trading book risk. Trading will shift to distressed names.
We anticipate protracted periods of low trading activity and static spreads, broken by periods of deleveraging and rallies which will keep volatility high. Through any rallies in risk assets, wherever it is possible, investors will probably be looking to offload leveraged loan assets, and borrowers will look to issue whenever that is available to them.
Add to this the fact that 2009 will see a sharp pick-up in default rates of speculative grade companies as funding becomes ever harder to obtain, and the scene is set for loans to under perform on a 12-month view. The severity of price swings should soften into the second half of 2009, as slowly and painfully the 'Great Deleveraging' gets done.
Fundamentals
Q3 reporting shows that the slowdown has started to bite
Q3 earnings show weakening operating performance and an increasing proportion of companies behind 2008 budget, especially in cyclical sectors. As Exhibit 4 shows, the proportion of companies within close distance of their original budget is declining.
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| Exhibit 4 |
Worryingly, some companies have stopped providing outlook projections. In the main, where there has been positive news in leveraged loan land, it was event-driven; e.g. Lucite on news of its sale - which, if it happens, will see debt repaid at par - and TDC from the sale of its Polish unit to Vodafone that will bring about a 0.5x deleveraging.
Waiver and restructuring requests are coming through thick and fast
Covenant waiver requests, restructurings and insolvency proceedings are increasing. Of more than 800 S&P-rated European public and private sub-investment grade credits, 38 had a covenant breach, waiver request or restructuring in the 12 months to October 2008.
Few of the recent waiver/covenant amendment requests in Europe have seen the lenders penalise the borrower severely via hefty consent fees or margin increases. Lenders are being flexible because they do not want defaults or to actually take the keys to the company.
So far private equity has stepped in to support underperforming companies and consensual conversations between debt and equity investors have taken place. S&P reports that cash injections by private equity as a response to a covenant breach, waiver or reset increased to 11 out of 24 deals - 46% in 2008, from 33% in 2007. How long this friendliness will continue is questionable.
Many companies are close to breaching covenants over the next few quarters, which bodes ill for default rates. Some European lenders are facing an unprecedented level of distress in their portfolios.
The stress individual companies are under as a result of weak performance will depend on how their covenants were structured. Loose documentation is helping some avoid ratings downgrades or covenant breaches, even though performance is deteriorating.
© 2008 The Royal Bank of Scotland. All rights reserved. This Research Note is an excerpt from 'European Leveraged Loans', first published by RBS Structured Credit Strategy on 19 November 2008.
