Contents

CLOs

Balance sheets bolstered

Barclays' US$20bn deal signals 2009 CDO issuance trends

The CDO primary market is to be dominated by balance sheet CLOs next year as the asset class reverts to its original purpose of hedging and transferring risk. Arbitrage CLOs are, meanwhile, predicted to struggle - although a number of new structures are expected to emerge that will pick up secondary loans at distressed prices.

As previously reported in SCI (see SCI issue 104), balance sheet CLOs are set to increase in importance as banks continue their de-leveraging exercises in the New Year. The recently-announced Newfoundland CLO 1 - a US$20bn balance sheet transaction from Barclays Bank - is the sort of deal the market can expect to see, according to observers, with the size of the transaction correlated to the size of the bank's balance sheet.

The US$16.6bn senior tranche of Newfoundland was assigned a triple-A rating by Moody's and is likely destined for use with the central bank repo facilities. It is backed by a portfolio of senior secured and unsecured corporate loans denominated in multiple currencies mainly originated by Barclays Bank.

The type of collateral referenced in balance sheet CLOs is also expected to expand. According to one CLO manager at a European bank, his institution is currently working on deals for the central bank repo facility that include project finance and infrastructure loans off the bank's balance sheet. He expects the deals to be the first batch of PFI CLOs structured in the balance sheet format.

In their 2009 Outlook, RBS structured credit strategists Gregorios Venezelos and John Schofield suggest that primary issuance will be limited to balance sheet deals, as the market reverts to its original purpose of hedging and/or transferring risk - mostly first loss or junior exposures, due to Basel II, which means small nominal sizes.

"The traditional 'arbitrage' CLO structure, for example, will likely struggle, as senior funding investors realise they had been selling tail protection far too cheaply and the cost of liabilities across the debt capital structure in general remains high - especially as leveraged loan defaults start to impact mezzanine tranches and reduce the credit enhancement of triple-As," they say.

"However, we do expect to see more vehicles created as a way of investing in secondary loans at distressed prices. Two-tranche structures and even unlevered funds will pick up paper cheaply from forced sellers. Both will feature term funding and be free of the mark-to-market pressures that have sunk many investors in 2008," they add.

A CLO manager that has traditionally managed arbitrage transactions also confirms that he is hoping to set up a very simple, unleveraged fund that will purchase discounted loans in the New Year.

Away from the primary issuance market, the CLO manager expects discussions with the rating agencies to continue in the New Year, particularly with regard to the downgrade of loans to the triple-C level. Market participants feel strongly that in some cases loans have been subject to downgrade without warning or consistency from the rating agencies. However, after lobbying some loans have been upgraded again, such as the Springer loan that was downgraded to Caa1 and subsequently upgraded to B3 within the same week.

AC

CLOs

New solution needed

Pressure on SME CLOs as banks remain unwilling to lend

The continued reluctance of banks to lend is weighing on SME CLO transactions as both refinancing risk and default likelihood rises. However, some within the industry are calling for the creation of a centralised European lending vehicle for SMEs - a solution that they suggest could be key to reversing the negative growth trend in regional economies.

Credit analysts at Unicredit expect defaults and substantial rating downgrades in the coming months within the SME CLO segment, as portfolio quality diminishes and rating agencies continue to revise their criteria inputs. Indeed, over the past week a handful of Spanish SME CLOs have been downgraded by both Fitch and Moody's, while a new default has emerged in Preps 2007-1, a mezzanine SME CLO.

One of the deal's portfolio companies, Company Number 35, faces insolvency after refinancing plans for a new production line failed to come to fruition. As a result, the next two coupon payments will not be paid to junior noteholders.

While not every SME CLO platform has imminent refinancing risk in their deals, there remains little or no chance of issuing new deals into the market in its current state. Lars Schmidt-Ott, md at Capital Efficiency Group (which manages the Preps programmes), comments that his firm has potential structures in place for refinancing their deals, but they are not inviting any investors to come in at the moment.

"The worst is to come in 2009 and we feel we would not be able to price the risk appropriately yet. In the longer run it remains to be seen if it becomes attractive again for private investors to invest alongside government sponsored banks," he says.

While the majority of companies referenced in SME CLO transactions are not dependent on the capital markets, it is impossible for them to remain isolated from the current economic climate. The more imminent refinancing risk for SME results, therefore, from the dependence on short-term bank funding that must be rolled over regularly. While government support for banks is clearly aimed at solving this issue, banks remain reluctant to even extend existing loans.

Schmidt-Ott suggests that a European programme needs to be put in place by the end of 2009 - for example, a specialised European bank where everything is on-balance sheet - that can provide long-term growth funding to smaller companies, which are usually at the bottom of the supply chain and therefore key in reversing the negative growth trend.

"Rather than €100m being thrown into one large company with an outdated business model, the governments of Europe collectively should get the money to small businesses, which will have a huge impact with new jobs. Particularly the push of the German government into renewable energy in the past has helped to create a healthy new industry with technology that is going to last," he concludes.

AC

Investors

Solid as a rock?

Future of bank finance debated

The decision by HM Treasury to wind down Northern Rock's RMBS programme, Granite (see last week's issue), has fuelled investor fears about extension risk and the future of other master trusts. However, the move has also prompted speculation around what the bank financing market will look like next year.

One London-based structured credit investor reports that, while he is now receiving monthly rather than quarterly cashflows from his Granite paper as the trust amortises, triple-A bonds are trading at distressed prices in the secondary market. In addition, valuations for ABS CDOs containing European RMBS have dropped to the mid-20s, reflecting the market's fear and uncertainty about the future of UK master trusts.

"Granite's seller share can't be repaid until the other noteholders have been paid. But, given that the government owns Northern Rock, does this mean that it will have to guarantee liabilities for 15-20 years or will it take a write-down? There is a large probability that the other master trusts will go into run-off and this will hit mezz investors, who hold the longer maturity paper," the investor explains.

Although the Granite unwind saw a number of forced sellers come to the market, most investors are continuing to hold their paper. Many banks, for example, have moved their UK RMBS holdings on to the available-for-sale (AFS) or banking books because they don't expect to sell it, but mezz paper might become impaired if prices fall any further, which means it will drop out of the AFS/banking books.

One ABS trader reckons that UK government-guaranteed RMBS in 2009 is likely to be undertaken through a new set of securitisation vehicles, albeit by the current crop of master trust issuers, such as HBOS. Whether this will ultimately kill off the master trust issuance market depends on how the government guarantees are used.

"My understanding is that the guarantee will apply to newly originated mortgages," the trader notes. "But you can't separate out new mortgages within a master trust structure, meaning that - if they're taking advantage of the guarantees - issuers could either have no mortgages to replenish the master trusts with or they may replenish them with high-LTV mortgages and thus run the risk of rating agency action. Either way, the demise of RMBS master trusts as we know them will be accelerated."

The investor says that this situation points to an interesting debate about the future of bank finance. "The introduction of government-guaranteed RMBS will essentially force banks to retain the associated credit risk - or force them to issue covered bonds or retained RMBS that can be repoed with central banks. It means that securitisation becomes a tool purely used for financing lending operations and not for risk transfer or accounting/capital purposes."

In this case, the question is what spread will investors demand for such product? By way of comparison, the price range for debt that has been issued by new government-guaranteed programmes is significant - from 10bp over Libor to 85bp over.

The investor suggests that government-guaranteed RMBS could attract institutional investors as an alternative to government bonds - albeit it doesn't have the same duration and so won't fit the traditional portfolio mix. "It could lead to a whole new sector of agency MBS for Europe, like in the US, where you get paid more than you do for government bonds because you're taking on prepayment risk but not credit risk, and amortising structures rather than bullet structures. The premium is likely to be 100bp-150bp over - in between the 25bp on average paid for bullet agency paper and the 300bp-400bp for prime Dutch RMBS," he argues.

However, whether lenders will even begin issuing RMBS remains uncertain because securitisation still isn't economic, according to the trader. "It could be that investors will have to take tighter spreads, but the current situation is unlikely to persuade them of this," he concludes. "As a first step, the market needs a track record of mortgage behaviour in a low interest rate environment."

CS

CDO specialists hired

The latest company and people moves

CDO specialists hired
Morgan Joseph has expanded the firm's analytics and trading group that operates in the secondary market for fixed income structured products with the addition of two new members to the team. Thomas Carter has joined as an analyst and marketing representative, while Andrew An will handle sales.

Carter has several years of CDO structuring and origination experience. Most recently he worked at Pali Capital as an md, where he headed its structured products activities.

An's most recent position was as vp, structured products group with Countrywide Securities Corp, where he covered large Tier 1 residential non-agency and agency MBS clients, focusing on below-investment grade cashflow analysis in both the fixed rate and ARM space

Structured credit pros on the move
Newedge has reportedly hired Maneesh Awasthi and Viru Raparthi from Broadpoint Securities. The pair was at Broadpoint for less than six months, having joined the firm's mortgage- and asset-backed team in July from Citi, where they both worked in the structured credit division.

CDO head exits
Leon Hindle, head of structured credit and CDOs at Nomura, is understood to have left the bank. A spokesperson for the bank was unable to confirm or deny the departure. Hindle was previously head of CDO & structured credit Asia-Pacific for Lehman Brothers before Nomura bought the business.

Portfolio manager departs after valuation breach
BlueBay Asset Management is winding down the BlueBay Emerging Market Total Return Fund. It has also confirmed the departure of Simon Treacher, portfolio manager of the fund.

Treacher resigned following a breach of internal valuation policy. The breach was recent, limited and resulted in no material impact on the NAV of the fund or of any other funds managed by the company, BlueBay says in a statement. "The company would like to stress that there is no connection between the breach concerned and either the recent losses incurred on the fund or the intention to wind the fund down."

The fund, which has run a relative value strategy in emerging markets fixed income since 2003, had lost approximately 53% of its value year to date as of 21 November, as financing and liquidity conditions have deteriorated dramatically in the markets in which it operates.

QWIL reduces dividend, leverage
Permacap vehicle Queen's Walk Investment Ltd (QWIL) has reported a net loss of €37.7m or €1.40 per ordinary share for the quarter ended 30 September 2008, compared to a net profit of €0.8m or €0.03 per share in the previous quarter. The company's board of directors has declared a dividend of €0.08 per share for the quarter, down from €0.15 the previous quarter.

The reduced dividend payout will allow QWIL to reduce debt and prioritise new investments. QWIL has also successfully negotiated amended terms on a reduced financing facility, involving a flexible two-year repayment schedule of the outstanding debt and has reduced the risk associated with material change clauses that could have forced a repayment of the debt on unfavourable terms.

The company's cash position remains solid with approximately €18.7m of cash on its balance sheet as at 30 September. This is down from €35.9m as at 30 June 2008, following its €15m tender offer for ordinary shares and purchase of €5.4 m of investment grade bonds. Cash generation for the quarter was in line with forecasts with total cash proceeds recorded from the investment portfolio in the quarter of €9.7m.

Syncora cfo lands new role
Guy Carpenter has appointed Elizabeth Keys as cfo. Keys fills the position previously held by Ajay Junnarkar. Prior to joining Guy Carpenter, Keys was svp and cfo of Syncora Holdings.

Structured finance lawyer promoted ...
Gibson, Dunn & Crutcher has promoted Darius Mehraban to partner. Mehraban's practice focuses on loan and other debt financing transactions, including syndicated credit facilities for leveraged and investment grade companies, project and equipment financing, and acquisition credit facilities, as well as structured finance transactions and swaps and other derivatives.

... while another is hired
Chadbourne & Parke has hired Jeff Browne as senior banking associate. He previously worked at Freshfields Bruckhaus Deringer in London and Mallesons Stephen Jaques in Melbourne. His experience includes syndicated lending, project finance, acquisition finance and debt capital market transactions, with particular experience in asset-backed and highly structured cross-border leveraged transactions, derivatives and structured products.

Associations join forces for industry response
A number of securitisation bodies have joined forces to offer a co-ordinated industry response to the global market crisis and restore confidence in the securitisation markets.

SIFMA, the ASF, the ESF and the AuSF have identified multiple factors which contributed to the current market crisis, and presented the near- and medium-term market outlook and outlined the significant threat to global economic growth if the securitisation sector does not recover. In addition, the industry bodies prioritised the areas of focus for the industry response which are likely to have the greatest near-term impact, and offered recommendations to enhance industry practices in the securitisation and structured credit markets.

"The global securitisation industry is firmly committed to developing and implementing practical, action-oriented solutions to restore confidence in the securitisation markets," says Tim Ryan, president and ceo of SIFMA. "The recommendations offered today have global reach and impact and are important steps to develop best practices and improve market infrastructure. Taken together with the Term Asset-Backed Securities Loan Facility in the US, as well as other government-led initiatives in Europe and Australia to encourage securitisation, we hope this will help restart the frozen credit markets."

The Global Joint Initiative has identified four priorities for immediate action by the industry. These are: 1) improve disclosure of information on underlying assets for RMBS; 2) enhance transparency with regard to underwriting and origination practices; 3) restore the credibility of credit rating agencies; and 4) improve confidence in valuations, methodologies and assumptions.

The following eight recommendations for restoring confidence in the securitisation markets have also been put forward:

1. Increase and enhance initial and on-going pool information on US non-agency RMBS and European RMBS into a more easily accessible and more standardised format.
2. Establish core industry-wide market standards of due diligence disclosure and quality assurance practices for RMBS.
3. Strengthen and standardise core representations and warranties, as well as repurchase procedures for RMBS.
4. Develop industry-wide standard norms for RMBS servicing duties and evaluating servicer performance.
5. Expand and improve independent, third-party sources of valuations and improve the valuation infrastructure and contribution process for specified types of securitisation and structured products.
6. Restore market confidence in the CRAs by enhancing transparency in the CRA process.
7. Establish a Global Securitisation Markets Group to report publicly on the state of the market and changes in market practices.
8. Establish and enhance educational programmes aimed at directors and executives with oversight over securitised and structured credit groups, as well as at investors with significant exposure to these products.

AC & CS

CDS liquidity scores introduced

A round up of this week's structured credit news

CDS liquidity scores introduced
Fitch Solutions has created new liquidity scores and percentile rankings for widely-traded credit derivative assets to help banks identify their exposure to the most liquid and least liquid assets, as well as strengthen their liquidity risk management procedures. The scores cover over 3,000 of the most widely-traded CDS assets. Each asset is assigned a score, representing the most through to least liquid names, and then given a global percentage ranking according to its liquidity profile against the overall CDS universe.

"Given the market focus on liquidity risk and recent Basel Committee guidance, understanding the relative liquidity of assets is critical for banks in assessing how they fund their short-term liabilities and helping them to meet regulatory commitments," says Thomas Aubrey, md, Fitch Solutions, London. "For the first time, risk managers will be able to compare the relative liquidity of assets across regions, sectors and rating bands, as well as having information on the liquidity of an asset and the broader CDS market over time."

The initial launch is open to member banks of Fitch's global pricing services consortium that provide it with pricing information on a variety of structured finance and fixed income derivative assets. The launch will be extended to buy-side market participants in the New Year.

Fitch has also published new research on liquidity risk in the CDS market which highlights that liquidity does not necessarily worsen as credit quality worsens; that the CDS market has in general become more liquid despite many assets becoming less liquid; and that specific credit events play a key role in determining the liquidity of an asset.

Credit event for Hawaiian Telcom, Masonite auction date set
LCDX dealers have voted to hold an auction for loan-only CDS transactions referencing Hawaiian Telcom Communications Inc, which announced this week that it has filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the US Bankruptcy Court for the District of Delaware in Wilmington. ISDA will facilitate the process by publishing the auction terms, including the auction date, in the next few weeks.

The auction terms will set out a settlement mechanism, which - unlike those used to settle recent credit events including Lehman Brothers and Washington Mutual - is already built into ISDA's standard loan-only CDS documentation, therefore no protocol is required. This will be the third time the auction has been used to settle loan-only CDS contracts, the first being Movie Gallery in October 2007 and the second being Masonite - the auction for which is scheduled for 9 December. Both auctions will be administered by Markit and Creditex.

RAM Re commutes MBIA exposure
RAM Reinsurance Company has entered into a commutation agreement to commute its entire US$10.6bn portfolio of business assumed from MBIA Insurance Corp and affiliates. The agreement is effective upon receipt by MBIA of a commutation payment of US$156.5m, which includes the return of US$51.5m of unearned premium reserves (calculated on a US statutory basis) and US$61.3m of estimated loss reserves and impairments (a non-GAAP measure) as of 30 September 2008.

The commuted portfolio of US$10.6bn par outstanding consists of:

• US$6.8bn par of structured finance transactions, including US$439.3m of CDS written on ABS CDOs, US$2.4bn of CMBS CDOs and US$453m of 2005-2008 vintage US RMBS
• US$3.8bn of public finance transactions, including US$1.2bn of international public finance transactions.

As of RAM's 30 September 2008 financial information, the commuted portfolio represented approximately:

• 98% of RAM's total unrealised losses on ABS CDO credit derivatives contracts
• 100% of total par outstanding of ABS CDOs, for which RAM has established credit impairments
• 37% of total loss reserves for RMBS transactions
• 45% of total par outstanding of RMBS, for which RAM has established case reserves
• 99% of total par outstanding of CMBS CDO transactions.

Vernon Endo, RAM's ceo, comments: "This commutation represents another milestone in RAM's efforts to restructure its insured portfolio. As a result of the MBIA commutation, we have reshaped our insurance portfolio by reducing our overall exposure to ABS CDOs and 2005-2008 vintage US RMBS by more than 64% and 27% respectively. After the commutation, US public finance exposure will increase from 51.3% to 60.1% of our portfolio."

Sigma MTNs downgraded
Moody's has downgraded Sigma Finance's Euro and US MTN programmes from Ca/Not Prime to C/Not Prime, affecting US$5.9bn of debt securities. Moody's says that, following further price declines since September 2008 when repo counterparties served notices of default to Sigma, recovery of any margins from repos now appears unlikely. In addition, the receiver conducted an auction of US$2bn of assets (reportedly mostly US CDOs) held by Sigma earlier this week. In Moody's view, the likely recovery value for MTN investors is consistent with a rating of C.

Basel Committee gives guidance on fair value ...
The Basel Committee on Banking Supervision has issued a consultative paper entitled 'Supervisory guidance for assessing banks' financial instrument fair value practices', which aims to help strengthen valuation processes for financial instruments. The main principles behind the guidance include: strong valuation governance processes; use of reliable inputs and diverse information sources; independent verification and validation processes; communication of valuation uncertainty to internal and external stakeholders; consistency in valuation practices for risk management and reporting; and strong supervisory oversight around bank valuation practices.

The guidance supports one of the key recommendations for enhancing transparency and valuation set out in the April 2008 report of the Financial Stability Forum on enhancing market and institutional resilience. Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, says that this work "is part of a broader effort by the Committee to strengthen firm-wide risk management practices. This guidance will help supervisors assess the rigour of banks' valuation processes and promote improvements in risk management and control practices".

... and focuses on the audit function
The Basel Committee on Banking Supervision has released a paper that summarises its key areas of focus regarding the audit function:

• Bankers' and supervisors' reliance on external auditors' expertise and judgments has increased
• High-quality audits, which enhance market confidence, particularly in times of severe market stress
• An increasing reliance on high-quality bank audits to complement supervisory processes
• The globalisation of major external audit firms has contributed to the complexity of their structures and a lack of transparency regarding their governance.

The Committee says it intends to build upon its ongoing efforts to address audit quality through continued support of groups with direct influence over external audit firms and promotion of enhanced sound audit guidance, practices and standards. It also calls for enhanced transparency over the structure and financial positions of global network audit firms.

In recent years, there has been a change in banking supervisors' reliance on audited information and in the nature of the major external audit firms, the Committee notes. The need for bank supervisors to be confident of audit quality has been reinforced by a variety of factors and events, including concerns about the risk of audit failures, the global expansion of the major audit firms and increased complexity of both accounting standards and financial instruments. In addition, the challenges associated with fair value estimation processes, which have been amplified by the current market crisis, have similarly underscored the importance of high quality audits.

The current market turmoil and demand for increased transparency suggests that reliable, clear financial information supported by quality audits are key elements in enhancing market confidence, according to the Committee. Thus, it says its continued involvement to promote audit quality is warranted.

Negative outlook for HFA sector
Moody's outlook for the state housing finance agency (HFA) sector is negative as it faces unprecedented challenges from the capital markets and a weakened real estate market. "Lower credit quality of counterparties, including financial institutions and mortgage insurers, further contributes to stress on HFA programmes," comments Moody's svp Florence Zeman.

Still, many state housing finance agencies entered the stressful market conditions with strong financial positions and should be able to withstand a certain amount of stress without affecting programme ratings. In addition to healthy finances, there are a number of positive credit factors that are likely to mitigate the market challenges that many of the HFAs are facing, the agency notes.

"Most HFAs are well positioned to handle these various pressures, due to strong asset quality of HFA portfolios and experienced management that may mitigate effect on programme ratings," says Zeman. "Many are managed by experienced teams who are actively responding to the challenges facing the industry."

She adds that the use of federal mortgage insurance and the securitisation of HFA loans into MBS issued by Ginnie Mae, Fannie Mae or Freddie Mac have mitigated the effects of the housing market downturn on HFA portfolio performance. "And, while counterparty risk has been highlighted by downgrades of financial institutions involved in HFA financings, counterparty diversification in many HFA portfolios should mitigate against the credit deterioration of a specific counterparty," notes Zeman.

But the pressures and conditions contributing to Moody's change in the sector outlook to negative are challenging and include increased interest costs on long-term bonds that have accompanied changes in the capital markets. Higher interest rates may pose difficulties for many HFAs to maintain the desired spread between bond costs and mortgage earnings.

"Volatile short-term markets and credit concerns about some liquidity providers have made variable rate debt more expensive, caused difficulties in remarketing and have - for the first time - resulted in material levels of bond purchases by liquidity banks," says Zeman.

Counterparty risk initiatives examined ...
A new report from Aite Group examines the different industry initiatives currently proposed concerning the clearing of CDS and the different aspects of counterparty risk under various types of contractual trading arrangements. The report also profiles a number of vendors that provide post-trade processing to the CDS market.

The existing bilateral trading arrangement for CDS has proven to be a contributor to systemic counterparty risk, Aite Group says. Without a central hub to assess real-time system-wide risk and manage collateral requirements, outstanding CDS contracts must currently be accounted for in a siloed fashion. With the credit crisis continuing, the Federal Reserve is looking to the private sector for clearing solutions to lower systemic risk in the CDS space.

CME/Citadel, ICE, NYSE Euronext and Eurex have responded to the call, and all hope to provide a counterparty clearing solution by way of an exchange model. NetDelta, on the other hand, is proposing a counterparty clearing solution that does not rely on mutualising risks. Whichever clearing solutions are adopted, they will work best for fungible, vanilla structures with widely followed underlying reference assets.

"In this rush for a solution to minimise systemic risk in the CDS space, market participants and regulators must be mindful of the different aspects of counterparty risk inherent in those solutions," says John Jay, senior analyst with Aite Group and author of the report. "The proposed solutions do not directly address legacy CDS positions and custom-made CDS structures. As such, with any trends toward standardised structures, dealer firms will need to weigh shrinking spreads against what they can make in more customised transactions."

... while WMBA clarifies clearing assumptions
The Wholesale Market Brokers' Association (WMBA) has released a statement that clarifies some assumptions regarding central counterparty clearing and emphasises that these benefits are also available in OTC markets.

"The OTC markets have traded, and need to continue to trade, separately from exchange markets for many reasons," explains WMBA chief executive Stewart Lloyd-Jones. "OTC markets are both larger in scale than exchange markets and may be customised to render them a flexible risk management tool. As such, their use benefits governments, corporations, investors and individuals worldwide."

He adds that an inaccurate distinction is often made between 'regulated' and 'unregulated' markets, with exchange markets often being presented as 'regulated' due to exchanges being mandated to regulate the content, behaviour and participation in specified products. The perception that all OTC markets are unregulated is incorrect; all major OTC financial market participants are individually regulated and supervised.

While the WMBA endorses the efforts of regulators to encourage the introduction of central counterparty clearing in OTC markets, it stresses that several OTC products - such as interest rate swaps and US Treasuries - are already fully compatible with the smooth operation of a CCP facility. For the purposes of counterparty risk, it is essential to note that in OTC markets the means of execution is not relevant as long as transactions are matched and confirmed electronically.

Asian CSOs impacted
S&P has lowered its ratings on 61 tranches relating to 53 Japanese synthetic CDO transactions and affirmed its rating on one deal, removing it from credit watch with negative implications. Among the 61 downgraded tranches, 23 tranches remain on watch negative and 38 tranches have been removed from credit watch. The actions reflect S&P's views on the impact of several events that have occurred since its previous rating actions on 30 October relating to the relevant portfolios, including rating migration, the credit event auctions for the Icelandic banks and revisions to its correlation assumptions.

At the same time, the agency downgraded the ratings on 68 tranches of Asia Pacific (ex-Japan) synthetic CDOs, with 21 tranches also being placed on watch negative the ratings on another two withdrawn. The SROC levels for the ratings that were placed on credit watch with negative implications fell below 100% at the current rating levels during the SROC analysis for November.

US$46.1bn of AIG's CDOs purchased
AIG reports that the financing entity recently created by the Federal Reserve Bank of New York (FRBNY), designed to mitigate AIG's liquidity issues in connection with its CDS and similar derivative instruments written on multi-sector CDOs, has been launched (see SCI Issue 112). To date, the new entity has entered into agreements with AIGFP's CDS counterparties to purchase approximately US$53.5bn principal amount of CDOs. US$46.1bn principal amount of such CDOs have been purchased and the associated notional amount of CDS transactions have been terminated in connection with such purchases.

AIG has provided US$5bn in equity funding and the FRBNY will provide up to approximately US$30bn in senior funding to the financing entity, of which approximately US$15.1bn has been funded to effect purchases of CDOs. The entity will collect cash flows from the assets it owns and pay a distribution to AIG for its equity interest once principal and interest owing to the FRBNY on the senior loan have been paid down in full. Upon payment in full of the FRBNY's senior loan and AIG's equity interest, all remaining amounts received by the entity will be paid 67% to the FRBNY and 33% to AIG.

Derivatives demand set to rise
Use of derivatives by fund managers will rise over the next 12 to 18 months despite market turbulence and record levels of redemptions from hedge funds, according to a new report from risk consulting company Protiviti Ltd. However, the report warns that changes need to be made to secure the operating environment for derivatives and ensure that UK firms maintain their competitive advantage.

According to a recent Protiviti survey, 79% of traditional fund managers, hedge fund managers and service providers expect their firm's use of derivatives to increase. As a consequence, most (84%) also plan to improve their derivative capabilities over the coming year.

The overwhelming driver behind companies considering making improvements to their derivatives capabilities is 'demand from the front office and competitive pressures' (68%), the survey shows. 'UCITS approval and the need for daily risk management' was the next most popular incentive to invest.

A minority of firms (16%) indicated that they are unlikely to invest in their derivatives capabilities, citing as their reasons cost and a view that derivatives will be less of a requirement for their firm going forward.

Although fund managers and the wider investment community are still pursuing derivatives, almost a third (31%) of those surveyed said that a lack of available skills and resources was the most significant risk they faced in managing derivatives in the future. 'Governance arrangements and the segregation of duties' was cited by 21% of those surveyed, with the remainder naming 'time constraints on daily processes', 'inaccurate data' and 'robustness of the control environment'.

According to Protiviti, a failure to provide a secure operating environment for derivatives could lead to a back-log of confirmations and settlements and consequent risk, compliance and fund reporting issues. The end result could be that clients would fail to award mandates or worse that mandates would begin to be taken away from fund managers who cannot demonstrate the robustness of their operations and risk management.

Rob Nieves, director, Protiviti comments: "We believe that the fund management industry has reached an inflection point in its use of derivatives and that they are here to stay as an asset class. While it's clear firms would like to improve their derivative capabilities, many are caught in a vicious cycle of being unable to free-up skilled staff who can then tackle more strategic issues like implementing new systems and getting better value from their outsource providers."

Troubled company index deteriorates again
Kamakura Corporation has revealed that its index of troubled public companies deteriorated again in November, representing the 15th decline in credit quality in the last 16 months. The Kamakura global index of troubled companies increased to 22.6% of the public company universe from 22% of the universe in October.

The all-time high in the index was 28%, recorded in September 2001. At the 22.6% level, the index shows that credit conditions are better than only 6.3% of the monthly periods since the start of the index in January 1990. The all-time low in the index was 5.4%, recorded in April and May 2006.

Kamakura defines a troubled company as a company whose short term default probability is in excess of 1%. The index covers more than 21,000 public companies in 30 countries using the fourth-generation version of Kamakura's advanced credit models.

Fitch clarifies REIT/CREL assumptions
Fitch has clarified the correlation and recovery assumptions it will apply to real estate investment trust (REIT) debt and commercial real estate loans (CREL) backing CDOs. Following issuance of final criteria, the agency will conduct a review of its existing portfolio of CDOs referencing structured finance assets. Fitch has also placed additional ratings from 11 CDOs backed primarily by trust preferred securities (TruPS) issued by REITs on rating watch negative, reflecting the potential for ratings to be affected by the proposed changes.

The update recognises that REITs as a corporate industry, because of their common exposure to the real estate sector, are more correlated to CMBS and RMBS than other corporate industries. The update also clarifies the recovery rate assumptions for REIT debt, which are the same as for other corporate industries and depend on the security position of the debt.

CMBS delinquencies to see upward trend
CMBX analysts at Barclays Capital comment that a relative spike in delinquencies last month, led by the retail sector, marks the beginning of a sustained upward trend. "We have repeatedly stressed that CMBS delinquencies are a lagging indicator of credit performance and tend to lag changes in employment by close to a year. Eleven months after the unemployment rate started to rise, the average non-performing rate across CMBX 1-5 increased 14bp this month to 0.53%," they say, adding that CMBX.2 was the worst performing series and saw a spike to 1.07%, an increase of 39bp.

At the property level, while multifamily and office showed an increase in 60+ day delinquencies across all series, the largest increase occurred in retail. Retail weakness was concentrated in CMBX.2, where the largest three loans to go delinquent are secured by retail collateral. BarCap analysts point to multifamily weakness across CMBX.1, 3 and 4.

"November also provided evidence of the lumpy nature of CMBS collateral, which should lead to a choppy rise in delinquencies/defaults as compared to other securitised credit sectors. For example, the average increase in the non-performing rate across the 25 deals in CMBX.2 was 39bp, with just under half of this contributed from only one deal," they say.

CS & AC

Real Estate

TALF-abet soup and the new Fed bid for MBS

Securitisation strategists at Barclays Capital view the US Treasury and Federal Reserve's new initiatives to help stabilise the ABS and MBS markets as positive for borrowers and consumers

At a minimum, the new US$500bn Fed backstop programme should act as a backstop bid for agency MBS. Figure 1 shows that our estimated net supply of 30-year agency MBS is US$420bn; therefore, this programme can potentially take down more than one entire year of net supply out of the market. So, even if the Fed does not buy aggressively, the mere existence of the programme should put a floor under agency MBS spreads (after sharp tightening) in the near to medium term, as few market participants would want to short the basis.

If the Fed starts purchasing aggressively (such as US$50-US$100bn over a month), we could see a continued rally in mortgage rates. Figure 2 shows that the FNMA current coupon is already at the lowest point in five years; another 50bp of decline could put the mortgage universe into a refinancing wave akin to the one experienced in 2004.

Prepayments should pick up significantly
Even if mortgage rates persist at today's level, refinancing activities should pick up significantly. Figure 3 shows the WAC distribution of 30-year agency mortgages during three periods: 2003, 2004 and now. The current WAC distribution is very similar to the 2004 experience.

With today's mortgage rate estimated at 5.40% (no-points rate), about 81% of agency borrowers have a refinancing incentive of 25bp or more. Although mortgage rates are near historical lows, negative HPA, tighter underwriting standards and risk-based pricing have severely curtailed borrowers' ability to refinance.

Currently, a large portion of existing agency borrowers cannot even qualify for mortgage insurance or GSE underwriting. Many of those that still qualify face sharply increased upfront guarantee (G)-fees and mortgage insurance premiums. As a result, the sensitivity of refinancing activities to rate changes has become extremely muted.

For example, in January 2008 the FNMA current coupon dropped to near the 2004 lows, but prepayments peaked at only 28 CPR, much slower than the 2004 experience. More recently, in September current coupon again briefly touched 5%, but conventional prepayments barely budged. As a result, although the current coupon has dropped below the 2004 lows, prepayments should be much slower than that episode.

Figure 4 shows our projected speeds for the 2007 FNMA coupon stack, assuming mortgage rates stay at the current level (5.4%). We expect speeds on 6s to be about 33 CPR, and those on 5.5s and 6.5s to be 25-30 CPR.

These compare with the peak speeds of over 50 CPR during 2004. If rates rally another 50bp, however, we are likely to enter a moderate refinancing wave with speeds peaking in the 45-50 CPR range.

One big question is what else could the government do? The GSE risk-based pricing and stringent underwriting have meant that a lower average mortgage rate does not necessarily lead to a better rate for distressed agency borrowers.

In other words, direct purchases alone are likely to primarily help good credit borrowers, who generally do not need the help, but leave out the real target - distressed borrowers. This means that directly purchasing MBS alone may not enough.

We think there is a chance that the Treasury, the FHFA and associated entities will take additional measures in conjunction with Fed purchases to lower mortgage costs for distressed borrowers. Possibilities include: 1) reversal of risk-based pricing with the GSEs, 2) waiving the reappraisal requirement for streamlined refinancings and 3) lowering mortgage insurance (MI) premiums for homeowners. As we discussed previously, one or a combination of these measures should lead to a further increase in involuntary prepayments.

Specifically, we estimate that eliminating the upfront G-fees should provide 11bp-26bp of additional refinancing incentive (depending on the coupon). On the other hand, unwinding private mortgage insurance premiums to pre-2007 levels should lower mortgage rates by 42bp-62bp, depending on the coupon. Finally, waiving the re-appraisal requirement for streamlined refinancing would allow a large number of borrowers - who otherwise would not qualify for a new agency loan - to refinance.

If all the three measures are adopted simultaneously and mortgage rates drop to a historical low of 4.9% (50bp lower than today), short-term prepayment speeds could spike to 60-65 CPR (Figure 5). Admittedly, this is an extreme scenario, given the costs of subsidising low mortgage insurance rates for high-LTV borrowers. Nevertheless, given the increased pressure to stem a further downward spiral in the housing market, this possibility can not be ruled out.

MBS purchases to be mildly positive for residential credit
Lower agency mortgage rates increase affordability for agency-eligible borrowers, but not for the majority of non-agency borrowers. For Alt-A and sub-prime borrowers, a simple prepayment model suggests that aggregate voluntary prepayments are six to seven times slower than would be the case historically, given the current rate environment.

This underscores the lack of mortgage credit availability to these borrowers, who will ultimately default unless delinquency transition rates fall, or they refinance. While low agency mortgage rates do not directly affect the vast majority of non-agency borrowers, indirect effects should represent mild positives.

Non-agency defaults should diminish if the housing downturn is even partially arrested. In hard-hit areas like California, where most existing home sales are from foreclosures, the distressed home overhang arguably represents the major downward pressure on home prices. Our REO/HPA model projects a further decline in California home prices of 35%.

However, if REO (real estate owned) liquidation rates increase by 25%, the decline is moderated to 29%. In the current unprecedented environment, it is difficult to estimate the degree to which, say, 100bp lower mortgage rates would increase demand for REO properties.

Historical regressions suggest that a 100bp decline in rates translates into about a 0.25% rise in existing home sales (as a percent of housing stock). Assuming marginal borrowers purchase discounted homes entirely from the distressed market, this translates into a roughly 12% increase in REO liquidation rates.

This back-of-the-envelope analysis implies an alleviation in remaining home price declines of about 2%-3% in California. This is a modest improvement over prior expectations and should incrementally improve non-agency MBS credit performance.

Over several quarters, sequestering roughly half a year's worth of gross agency MBS issuance should help the current coupon remain rich, increasing pressures on banks to seek alternative assets. Non-agency MBS should ultimately benefit from this dynamic, although we admit it is likely to take considerable time before this is noticeable.

How far will US$200bn go?
Meanwhile, Figure 6 details the estimated outstanding dollar amount of the various ABS sectors eligible under the new Term Asset-Backed Securities Loan Facility (TALF), as well as the annual issuance volume in each segment for the last four years. Aggregate outstandings total US$811bn, not including SBA securitisations, for which there are no reliable data (however, given SBA's share of issuance volumes over the last four years, it is not likely that there is a significant amount of SBA ABS outstanding).

In aggregate, issuance of ABS in the eligible segments averaged just over US$220bn during 2005-07; however, issuance in 2008 is off significantly due to the freeze in securitisation markets. Based on the data, we believe the US$200bn TALF could be a significant benefit to the ABS new issue market, at a minimum helping new issues for the better part of a year.

Notable items and suggested tweaks to the structure
We believe several items need to be tweaked in order for TALF to have the maximum impact on consumer ABS markets. Most importantly, we believe the one-year term needs to be lengthened.

Most consumer ABS have average lives longer than one year and the benefit of one-year non-recourse financing is lost on such a security. We believe a minimum term of 3-4 years is necessary to capture the full capital structure of retail auto ABS and a significant chunk of term financings for credit card ABS.

In addition, the definition of 'newly or recently' originated needs to be clarified. This is important for the first round of TALF borrowings as investors would likely turn to their current ABS holdings as collateral rather than buying a new issue ABS transaction in the hopes of lining up TALF financing. Thus, we believe that TALF ought to consider an otherwise eligible ABS transaction from 2008 to be recently originated.

One interesting stipulation of TALF is that originators of the credits securitised and pledged as collateral for a TALF loan must abide by the executive compensation requirements of the Emergency Economic Stabilization Act of 2008. This may not be an issue for bank credit card issuers that are already subject to such constraints (by virtue of having taken TARP money), but it may be a point of contention for captive and independent auto finance companies that have not (e.g. GMAC, Ford Credit).

Financing haircuts are an important feature, as they provide the most direct tool (by determining the amount of leverage) for influencing investor participation. Haircuts are currently not known, but we can look to other Fed facilities and to the repo market for clues as to what the outcome might be.

In the Fed's Term Auction Facility (TAF), the Fed assigned haircuts of 2%-7% for ABS. In addition, repo financing for three-year triple-A credit card ABS carries a haircut of 25%-30%. Based on this, we have a range from which to start, although we expect TALF haircuts to be closer to the 2%-7% in the TAF.

What do investors get?
In Figure 7 we calculate a hypothetical one-year return on equity assuming TALF financing. Our example uses a typical triple-A credit card ABS offered at new issue with a coupon of Libor (currently 1.43625%) plus 200bp.

Under terms of the TALF, investors submit bids as a spread over OIS (currently 0.65%). We show the one-year return on equity to an investor at various haircut/spread to OIS combinations. The shaded grey area represents one-year return on equity of greater than 15%, the typical bogey to get distressed money interested.

TALF a positive
In general, we view the TALF as a positive for consumer ABS, as it is a route to restarting the beleaguered market. We believe TALF shows that the Treasury and the Fed are strongly committed to the consumer ABS market and are taking the steps necessary to fix it and get credit flowing to consumers again. In our view, with minor modifications, the TALF is likely to be successful in re-opening the consumer ABS market.

© 2008 Barclays Capital. All rights reserved. This Research Note is an excerpt from 'Fed announces new initiatives to jump-start credit', first published by Barclays Capital on 25 November 2008.

Trading

Trading ideas: you can't beat the reality

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Coca-Cola Enterprises

Being a household name will not be enough to help companies such as Coca-Cola Enterprises make it through the current market unscathed. Coca-Cola Enterprises is heading into the darkness carrying a massive debt load, of which a significant portion matures over the next year. The investment grade new issue market is showing signs of life; however, companies pursuing this route are taking large concessions in the form of higher spreads.

Even though Coca-Cola Enterprises may use available credit facilities to offset the burden, we believe the pressure will keep its credit spread elevated. Coca-Cola now shells out close to US$600m per year in interest expense; any more due to newly issued debt may be too much to take.

This, combined with its decreasing margins, points to a highly uncertain future. In addition, our credit model points to a continued deterioration of Coca-Cola's credit spread, well beyond the wides it hit earlier this year. We recommend buying protection on Coca-Cola Enterprises.

Too much pressure
Digging into Coca-Cola Enterprises's financials reveals a few unrelenting pressures that may be brought to the forefront as the credit crisis continues into 2009. The company has more than US$9bn of outstanding debt, of which nearly US$3bn matures over the next year. Its total interest expense for the year will reach almost US$600m, leaving the company with an interest coverage ratio near only 3x.

Coca-Cola's margins are also under considerable pressure. Exhibit 1 is a time series of its gross margins and clearly they are in decline.

Exhibit 1

In the current environment, if management decides to turn to the new issue market to refi its maturing debt, they will see their interest payments increase. Even strong companies entering the new issue market are taking huge concessions to get deals done in the form of higher credit spreads. Cash is king right now.

One final issue caught our eye. In Q208 the company took a US$5.5bn impairment charge to its goodwill/intangible assets. This lowered the intangible asset value by roughly 50%; thus causing Coca-Cola's retained earnings to turn negative (by around US$1.7bn).

We know this is all just accounting (and we are clearly not equity analysts); but, as the asset side of the equation gets reduced (there is another US$6bn of intangible assets), it will keep pushing down shareholder equity with it. Coca-Cola's market cap is down 67% this year and we think it is prudent to keep an eye on this, as unhappy shareholders may start raising their voices.

Credit model
Our quantitative credit model attempts to replicate how a fundamental credit analyst thinks. While this is extremely arduous, the output provides a great way to select long/short trades.

The model ranks each issuer on a scale of 1 to 10 using seven factors (1 = poor credit, 10 = good credit). Exhibit 2 lists all the factor scores for Coca-Cola. We see a 'fair spread' of 300bp for its weak margins, free cashflow and interest coverage factors.

Exhibit 2

Our credit model has been bearish on Coca-Cola all year long. The persistent bearishness may be due to outside model factors, such as brand value or intangibles.

Exhibit 3 shows a time series of Coca-Cola's spread and expected spread. In recent weeks, though its spread increased with the credit crisis, its expected spread jumped even further. This signals a good opportunity to get ahead of the market and short Coca-Cola's credit.

Exhibit 3

Risk analysis
This trade takes a short position in Coca-Cola Enterprises' five-year CDS. The trade has negative carry and negative roll down, which must be offset by spread widening. Entering and exiting any trade carries execution risk and CCE's liquidity is good in the CDS market at the five-year tenor.

Summary and trade recommendation
Being a household name will not be enough to help companies such as Coca-Cola Enterprises make it through the current market unscathed. Coca-Cola Enterprises is heading into the darkness carrying a massive debt load, of which a significant portion matures over the next year.

The investment grade new issue market is showing signs of life; however, companies pursuing this route are taking large concessions in the form of higher spreads. Even though Coca-Cola Enterprises may use available credit facilities to offset the burden, we believe the pressure will keep its credit spread elevated.

Coca-Cola now shells out close to US$600m per year in interest expense; any more due to newly issued debt may be too much to take. This, combined with its decreasing margins, points to a highly uncertain future.

In addition, our credit model points to a continued deterioration of Coca-Cola's credit spread, well beyond the wides it hit earlier this year. We recommend buying protection on Coca-Cola Enterprises.

Buy US$10m notional Coca-Cola Enterprises 5 Year CDS protection at 145bp.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2008 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).