Contents

Indices

Roll call

iTraxx Series 11 to provide fewer technically-driven distortions

The Markit iTraxx financials indices reached all-time highs this week, with the senior index trading above the iTraxx Main - only the third time this has happened in recent history. While trends such as this have been providing market participants with simple and effective trading opportunities, the roll into Series 11 on 20 March is expected to offer fewer technically-driven distortions. The influx of new accounts attracted by the clearing house mechanism is also likely to bring more stability to the index.

Over the past year, the crossing of senior financials above the main index occurred on two occasions: in March 2008 when Bear Stearns was taken over by JPMorgan; and in September 2008 when Lehman Brothers defaulted. "The iTraxx senior financials widening above iTraxx Main creates a good opportunity to go long on protection on the Main versus short on protection on the senior financials," says Jochen Felsenheimer, co-head of credit at Assenagon.

But the index crossing is clearly not a healthy sign and is reflective of a rise in systemic stress, note BNP Paribas' credit portfolio strategists. "In the past, it only lasted for a short period of time. However, going forward, we expect that the decompression between senior financials and the main could persist as solvency concerns lead to some degree of haircut for senior bondholders also - a fact being reflected in cash bonds over the past month," they say.

Markit today, 11 March, announced the provisional list of names to be included in iTraxx Series 11. It is estimated that the new index is likely to launch and trade substantially tighter than the current Series 10 index. According to credit analysts at Barclays Capital, there are two key reasons for this: first is that the IG CDS curve is inverted - and the duration extension results in a tighter spread; and second is that the exiting constituents are trading relatively wide and will be replaced by substantially better credit quality entities trading at tighter spreads.

"The new iTraxx roll will undoubtedly create some interesting distortions, but - given that there are fewer credit hedge funds and fewer bank prop desks participating in this area - I think there will be fewer trades off the back of those distortions," says Felsenheimer.

He adds: "The role of clearing houses will most likely prompt a huge inflow of participants into the CDS universe, which should be a stabilising factor in the indices. The clearing house function will also remove a lot of the technically-driven distortions."

Unlike the last index roll, only one rule change will affect the IG iTraxx indices. In Series 11 the autos and industrials buckets will be combined into one bucket comprising 30 entities.

Combining the auto and industrials sectors will prevent illiquid names from entering the index when more liquid alternatives are available from the industrials sector. "This implies that the new S11 index should be substantially less autos-exposed than S10," concludes BarCap.

AC

Operations

CCP alternative

Different approach to CDS central clearing on offer

The ICE Trust became the first central counterparty to open its doors for US CDS clearing on Monday, 9 March, having received regulatory approval at the end of last week (see News Round-up). But some unease over the use of clearing houses for CDS remains.

"We believe that the transfer of CDS clearing to central clearing houses does not remove counterparty risk, but just concentrates it to a new and untested entity for the asset class," says Lucio Biase, ceo of NetDelta, which offers one alternative CDS clearing solution.

The firm, which offers a proprietary CDS settlement system, allows for the real-time netting of overlapping CDS positions. Under NetDelta's 'pooled credit' approach, participants face each other bilaterally under pre-set credit limits, ensuring that participants can actively monitor and manage their counterparty credit exposure.

"Our service offers an alternative approach to central clearing that we believe could be very attractive. We are already seeing interest from the top sell-side firms in the marketplace, who will essentially be our target client base," adds Biase.

Andrew Scott, coo at NetDelta, comments that there is a lot of scepticism over the central clearing of CDS in the marketplace, particularly with respect to single name trades. "People do not know what each clearing house's risk model is," he notes. "Also, everyone that clears trades through the clearing house is essentially on the hook for trades they haven't participated in - if the guarantee fund is insufficient to cope with, for example, another Lehman Brothers scenario, the reality is that every trade would have to be unwound or terminated. "

He adds that in this environment it is difficult to require participants to fund and to guarantee a third party.

The role of central clearing houses for CDS clearing is, however, expected to bring a number of new entrants to the CDS space and potentially iron out technically-driven distortions in the indices (see separate News Analysis). Kevin McPartland, senior analyst at TABB Group and author of a new TABB report entitled 'Credit Default Swaps: Industry Projections', suggests that the new regulatory structure - including central clearing and increased electronic trading - will streamline the market, lower barriers to entry for buy-side firms and ultimately increase volumes.

"However, beyond the ubiquitous counterparty risk issue, concerns over operational efficiency issues continue to plague the CDS market at the same time that global regulators are pushing the industry to adopt central clearing for CDS trades and increase market transparency," he says. "Even when single names are added, only the most liquid contracts will be accepted for the foreseeable future. Central clearing will accept only standardised contracts for the foreseeable future, leaving a large portion of the OTC CDS market 'as is'."

Nevertheless, McPartland estimates that CDS market revenues from central clearing, electronic trading and existing trade migration will rise to US$174m, growing at 12% CAGR (compound annual growth rate) through to 2011.

AC

Distressed assets

Whole loan breakthrough

Distressed servicing opportunities gather pace

The last few months have seen a breakthrough in holders of distressed whole loan portfolios seeking realistic solutions to their problems. Opportunities are consequently ripe for residential mortgage servicers to become involved with new investors in the sector, but their reach could potentially extend to mitigating losses within securitisations themselves.

Mike Culhane, ceo of Oakwood Global Finance, says that holders of troubled whole loan portfolios have finally begun capitulating over the last few months (in comparison, the market was frozen at the end of the year). "By capitulation, I mean finding solutions and/or liquidity for their portfolios. One obvious way is to sell them; another is to bring in expertise to mitigate losses. Servicers can help in both instances," he explains.

Indeed, two new constituencies have recently emerged for residential mortgage servicers: incoming investors, mainly hedge funds and private equity funds, looking to take advantage of distressed asset opportunities; and banks with pre-existing portfolios of loans on their balance sheets that are trying to figure out how to deal with rising delinquencies. "The funds know they can buy troubled mortgage pools cheaply, but the mechanics of dealing with live borrowers on a daily basis is less obvious," adds Culhane. "So, servicers sit in the middle, providing legal title cover and best practice regarding loss mitigation - meaning that the fund can enjoy the economic upside of beneficial ownership without having to establish a servicing infrastructure."

Typically, a fund will initially bid for a portfolio based on statistical analysis. Servicers prefer to become involved in the process once the fund has been granted exclusivity by the seller, in which case they can help price the bid according to their due diligence on each underlying loan. If the bid is successful, a servicer can then roll out its business plan for each loan immediately.

"A number of different hedge funds are looking at distressed whole loan portfolios, but the challenge has been to match buyers' and sellers' expectations on price," confirms Culhane. "These expectations have moved closer in recent months."

One hedge fund manager believes that the type of funds that would buy whole loan portfolios would be at least several billion in size, given the scale needed to efficiently manage individual mortgages. "The larger funds would probably handle everything in-house, so they have greater control," he says.

However, he concedes that smaller funds would likely need to build strategic relationships to handle the servicing of such acquisitions. "In theory, investment in distressed loans should be profitable enough to mean that servicer fees are unlikely to be an issue and will certainly cost less than setting up your own infrastructure."

Equally, while many balance sheet holders prefer bespoke solutions for each underlying borrower as the best way of realising the collateral, they may not have the capacity to provide them. As such, for borrowers who can't pay (as opposed to those who won't), servicers can make an assessment as to whether a payment holiday, principal reduction or even selling a house in conjunction with the borrower is the best way of minimising loss.

One banker is skeptical about the need to outsource servicing of mortgage portfolios because ideally the holders of the loans should be able to undertake work-outs themselves. But he suggests that opportunities for servicers could arise if 'bad banks' are established in the future.

Another opportunity for servicers to potentially become involved in is investment bank warehouse lines that were extended to non-bank lending businesses in the UK and Europe, which have since disappeared. Consequently, the banks are left with the portfolios but don't necessarily have the expertise/infrastructure to undertake the servicing/collections on the loans.

"We can export our expertise in these cases and manage their exposure for them by creating a mini-servicing platform," continues Culhane. "Hopefully, in the medium term we can expand into different jurisdictions off the back of these run-off platforms."

Culhane says that the servicing business is differentiated from typical investment advisory firms by the fact that servicers understand securitisation structures at the loan level and therefore offer a more granular approach to bottom-up portfolio analysis. Indeed, one further area he is interested in exploring is a different approach to loss mitigation within securitisations, essentially to protect what value is left.

"The idea would be to get all the different investors across the capital stack together and service the deal away from the constraints of its documentation in order to achieve a better result for everyone," Culhane explains. "This could be done by changing the servicing agreement to allow shortfall sales and principal forgiveness, but it would require noteholders voting in agreement. Another potential issue would be trustee liability."

CS

CLOs

Rated Indian microfinance CLO debuts

IFMR Capital and Equitas Micro Finance India have completed the first rated Indian MFI CLO. With notes amounting to R157m, the underlying loan portfolio comprises priority sector urban micro loans originated by Equitas. IFMR Capital structured and arranged the transaction.

CRISIL has rated the Series A1 and A2 pass through certificates (PTCs) double-A and triple-B respectively. The PTCs will be issued by IFMR Trust Pioneer I SPV, set up specifically for the purpose of this securitisation. IFMR Capital will provide mezzanine financing in the form of an investment in 100% of the Series A2 securities, while the Series A1 securities have been fully underwritten by a bank investor.

This transaction is expected to open up new sources of debt capital, such as mutual funds, foreign banks and non-bank financial services companies (NBFCs), for microfinance institutions. "The deal is in tune with IFMR Capital's goal of creating valuable new asset classes, increasing marketability of asset classes to a broader universe of investors and expanding access to capital for micro-finance institutions," says Sucharita Mukherjee, svp IFMR Trust and ceo IFMR Capital. "This will be the blueprint for further securitisations and a benchmark for other MFIs."

AC

Indices

Counterparty risk index reaches all-time high

Credit Derivatives Research's counterparty risk index (CRI) broke through 300bp on 9 March, reaching an all-time high. Eleven index members traded wider (more risky) and none traded tighter.

Barclays and Citi led the way wider, according to CDR, both moving by 30bp. Furthermore, BofA traded at all-time wides, even as its stock is rallying, while Citi traded at 600bp - the widest of any name in the index.

CDR data indicates that counterparty risk among the world's largest derivative market-makers has risen by 75% since the start of the year, with the bulk of that rise coming in the last three weeks.

"Each time we have seen the CRI spike higher like this, there has been significant corrective action by the government," analysts at CDR explain. "Despite the 'big bang' in CDS that we expect to see in two weeks and the ongoing efforts with regards to clearing, recent DTCC data shows that CDS volumes have stopped falling as investors (albeit at a slower pace) use the CDS market to manage their exposure (whether to new or secondary issues). The cash-CDS basis (although volatile) is seemingly narrowing, but between real money hedgers, speculative traders, capital structure arbitrageurs and CDO dealers the perceived risk of failure among the major OTC derivative market-makers is in its highest percentile - with the gap between Europe and US names the widest it has ever been."

CS

Trading

Insider knowledge

Dean Atkins, md of Structured Credit Trading Solutions, answers SCI's questions

Dean Atkins

Q: How and when did you/your firm become involved in the structured credit market?
A: Structured Credit Trading Solutions (SCTS) was officially incorporated in September 2008. It is essentially an advisory company and does exactly what it says on the tin. It had become all too clear that there is not enough understanding of the complex structured assets that are in focus at the moment, and therefore a potential market for our services.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: The potential client base stretches across the whole market from the investment banks, investors and asset managers on one side to the regulators, central banks and even law firms on the other. Our current client list reflects this breadth. We have also spent some time with academic institutions to try and make sure there's a link to the real world in terms of undergraduate/graduate students' understanding of recent events.

The idea is to be as broad as possible in terms of who we can deliver a service to. In essence structured credit is still a niche product; however, it touches a broad range of institutions, so I believe the structured credit space is big enough to focus on. We count simple ABS and MBS to the most complex CDOs and correlation trades amongst our areas of expertise.

Q: How do you differentiate yourself from your competitors?
A: The difference with SCTS is that we have been practitioners in the exact market that we are advising on. I've been in the ABS, RMBS and structured credit areas for the last 15 years.

The SCTS team has run global trading businesses across various markets and managed investment portfolios in a range of different structures. It's the specific inside knowledge of those products and the marketplace that we're using to differentiate ourselves from our competitors. However, only time will tell - we'll see who differentiates themselves successfully.

A case in point would be several of the credit opportunity funds launched last year that didn't seem to be well founded - they were looking for both the capital to get started as well as the expertise, and that's why I think so many of them didn't get off the ground. They just had the idea that it might be the right time to do it. At least with our advisory firm it's being set up by people in the know; it would be very difficult for me to set up something like SCTS without actually having relevant expertise myself.

There are precious few individuals around (in Europe) that have more than five to ten years' experience in the ABS/structured credit space. The ABS market is relatively new in Europe and didn't get critical mass until at least the early 2000s. To be senior in these markets you have had to be there since its inception.

When I tried to hire a senior ABS trader in 2005, having looked round the street in Europe, I very quickly narrowed the selection down to two people. I had no interest in hiring any of the other street traders, as they had all been in it for five minutes. Therefore the credit opportunity start-ups would have also had a hard time finding the right level of expertise for their funds.

Frankly, I think some of them will be quite glad. They would likely have been badly burned, had they started investing last year.

Q: Would you ever consider investing in the structured credit space?
A: I don't have any plans to take SCTS into the investing side right now. I have thought a lot about it, but it raises thorny issues of conflict of interest with people that we advise.

I'm sure there are ways round it, but we're focusing on advisory at the moment and building up a broad client base. If we do take a step into the investment side, it would mean excluding some types of clients and certain parts of the business, but maybe at a later stage.

Q: What major developments do you need/expect from the market in the future?
A: I'm pretty bearish on the ABS market as a whole. If the ABS market comes back, it's going to be a pretty slimmed down model of what we've seen in the past.

I don't see securitisation being a source of revenue growth for banks in the near term. I think the housing market still has a long way south to go too.

I also think there will be a very strong push to separate the major operations of a bank into the more plain vanilla retail and commercial banking side on the one hand and the 'casino' side of the bank on the other. Regulatory frameworks are pushing people along this line so that in future you can let the casino side fail if necessary. Wholesale changes to the way people are incentivised will also be a key feature of the next wave of regulation.

About Structured Credit Trading Solutions
SCTS was set up in order to provide expertise in structured asset and complex credit risk markets to the whole range of market participants and stakeholders. It has many decades of front-office experience across trading, structuring, syndication, marketing and asset management at both buy-side and sell-side institutions. Areas of specific expertise include all types of ABS and CDOs, structured credit, correlation/tranche trading, property derivatives, real estate finance and liquidity risk.

SCTS specialises in advisory projects for organisations with exposure to structured products, securitised assets or credit derivative investments, along with more general issues within the fields of asset management and trading. A particular focus is one-on-one advice for senior executives who are removed from the daily management of investment portfolios or trading books, but with whom responsibility for their performance ultimately remains.

AC

CDS trading duo appointed

The latest company and people moves

Deutsche Bank has taken on two credit traders from Bank of America Merrill Lynch. Masaya Okoshi and Sean George will join the bank as mds in global credit trading within DB's Global Markets division. Based in New York, Okoshi and George will trade investment grade and high yield bonds and credit derivatives, reporting to Nick Pappas, md and head of flow credit trading for North America.

Okoshi will join the bank after more than ten years in Bank of America's investment grade and high yield trading group, where he was most recently head of investment grade trading for North America. George was most recently head of credit derivatives trading for North America.

Ex-global credit head recruited
Moelis & Company has confirmed that Chris Ryan has joined the firm as an md based in New York. Ryan will advise clients on risk and balance sheet-related matters and continue the expansion of the firm's capital markets capabilities. He has over 25 years of investment banking and fixed income experience, including trading, structuring, capital markets, research, sales and risk management, as well as extensive experience building and managing fixed income businesses around the world.

Prior to joining Moelis & Company, Ryan spent nine years at UBS Investment Bank, where he was global head of credit fixed income. Before UBS, he was global head of syndicated loans at Lehman Brothers, which he joined in 1992. He was the sole founder of the firm's loan business.

Fund hires business development md ...
NewOak Capital has appointed Ed Napoli as md of business development to help market the firm's advisory, asset management and capital markets services and to act as assistant general counsel. He brings extensive experience acting as counsel to financial institutions, asset managers and financial guarantors in connection with structured finance and derivatives transactions.

Napoli's previous experience includes positions with Skadden Arps and a start-up monoline financial guarantor. He was most recently with Dechert in New York.

... and announces partnership with FCCP
NewOak Capital has also announced a partnership with Fundamental Credit Capital Partners (FCCP), naming its founder - Candice Workman Nonas - md of NewOak Capital to help market the advisory, asset management and capital markets platform.

Nonas set up FCCP in 2008, having previously worked in mortgage credit and risk management at Moody's, West LB, Barclays Capital and most recently at Fortis Investments.

Global credit head named
F&C has appointed Michael Heemelaar as head of global credit. He joins from AEGON Asset Management, where he was head of investment grade credit. At F&C he will be based in Amsterdam, reporting to Patrick Hendrikx, head of credit.

Heemelaar has over 12 years' experience in financial markets, eight of which were spent at AEGON. He joined the company as a portfolio manager with the fixed income team, becoming responsible for the firm's investment grade credit strategies four years later. In this latter capacity, he was responsible for asset allocation decisions and managed a team of portfolio managers and analysts.

At F&C, he will head up the global credit team of five portfolio managers and one portfolio analyst. Hendrikx comments: "We are delighted to have Michael joining our team as head of global credit to reinforce our capabilities in this key area. His background in the insurance sector means Michael brings a wealth of knowledge of investment strategies for insurance and pension fund clients, combined with a great understanding of global credit markets."

MBS traders recruited
KBW has enhanced its MBS trading team with the additions of Peter Ma, who will lead the firm's efforts in the non-agency market, and Greg Hargraves, who joins the firm as senior agency pass-through trader. Both appointments are effective immediately.

Ma brings to KBW nearly two decades of experience in the MBS business. He was most recently at UBS, where he was an executive director on the firm's MBS trading desk.

Hargraves also has nearly twenty years of relevant experience, all of them spent in the mortgage business at Merrill Lynch, where he was the senior GNMA trader and had responsibility for the firm's middle markets mortgage business. Both hires will both report to Don Ullmann, head of KBW's MBS and agency trading areas.

"With these outstanding new hires, we have broadened and deepened our ability to execute value-added trades for our customer base," comments Craig Coats, evp and head of KBW's fixed income division. "We are very pleased to have been able to attract professionals of this caliber."

Broker-dealer gains new md
John McWilliams has been named md and head of asset finance and specialty finance at Cohen & Company Securities, the institutional broker-dealer focused on debt securities. McWilliams' appointment, which is effective immediately, is part of an ongoing phased expansion of Cohen & Company's fixed income capital markets business, which has included the recruitment of multiple senior-level executives in the fixed-income space with expertise in corporate debt, mortgage securities and ABS. In his new role, McWilliams will be based out of Cohen & Company's New York offices and report directly to Christopher Ricciardi, the company's ceo.

Previously, McWilliams was md and co-head of asset finance at Credit Suisse, with responsibility for all US asset-backed primary issuance. Prior to that, he managed the consumer asset finance group at Credit Suisse responsible for auto, equipment, credit card and student loan areas.

While at Credit Suisse, McWilliams also gained extensive experience covering financial institutions for general capital raising and advisory activities as an md in its financial institutions group. His focus was on companies in the specialty finance group.

Ricciardi says: "We are very pleased to welcome John to our capital markets platform, which continues to enjoy robust expansion. John is an industry veteran, who brings a wealth of experience in assisting financial institutions with their debt and securitisation issuance needs. His considerable experience in capital-raising for financial institutions is matched only by his expertise on consumer loan securitisation, an area in which he is a recognised authority."

He adds: "We believe this is an opportune time to bring John on board, as government-sponsored financing alternatives for financial institutions continues to increase, and as there is a growing realisation that securitisation and other forms of financing in the consumer loan industry are vital to a properly functioning modern economy. We fully expect John to lead our effort to be an active participant in these important markets, as we continue to identify and execute on opportunities for profitable growth."

Delacote returns to BNP Paribas
BNP Paribas has re-hired Stephane Delacote, the bank's former global head of structured credit trading and arbitrage. Delacote is understood to be working in a broad risk management role, not credit specific, and reports to Guillaume Amblard, global head of fixed income trading. Delacote left the bank last year and was later replaced by Benjamin Jacquard.

Structured credit pro on the move
Andrew Palmer, md at Scotia Capital, has left the firm. Before taking up his position at Scotia Capital, Palmer was global head of structured credit marketing and distribution at JPMorgan in London.

Broker hires CDO expert for fixed income expansion
FSI Capital Holdings has appointed Andrew Phelps as president of FSI Securities. In this role, Phelps will be responsible for the day-to-day activities of FSI Securities and will lead the expansion of the platform in fixed income.

In addition to Phelps, Joseph Gambino has joined FSI Securities as a director and Andrew Frank has joined as a vp. Phelps is said to have previously worked as head of the CDO syndicate desk at Merrill Lynch in New York.

SLCG takes on CDO expert
The Securities Litigation and Consulting Group (SLCG) has hired Joseph Prendergast, an expert in sub-prime MBS and CDOs, as principal in its Virginia office. Prendergast was previously principal and director of mortgage research at Smith Breeden Associates in Durham, North Carolina, where he was employed for 11 years as a member of the investment management group. He has worked extensively with mortgage-related investments, including agency and cash MBS and synthetic CDOs.

Credit broker hires general counsel
Interdealer credit and equity derivatives broker Phoenix Partners Group has appointed John Bolton as general counsel, a new position at the firm. Bolton is responsible for overseeing the firm's global legal and compliance functions, and will oversee the firm's relationships with regulatory authorities. He also serves on Phoenix Partners Group's management committee.

Bolton joins from Nixon Peabody, where he was a partner and provided legal counsel to Phoenix Partners Group. His practice focused on complex business and corporate litigation and a variety of commercial and tort matters. He has also litigated numerous non-competition and trade secret claims, shareholder disputes, corporate disputes and derivative actions.

Manager hires loans head
Aladdin Capital has appointed William Fish as senior md of Aladdin's global loan group. He will be based in Aladdin's Stamford, Connecticut headquarters and reports directly to Neil Nealinger, vice-chairman and chief investment officer of Aladdin.

Fish joins Aladdin from Dresdner Kleinwort, where he was head of global loans and transaction services. In this role he oversaw all international lending, leveraged finance, loan syndications, loan sales and trading, trade finance, correspondent banking and international cash management.

CDO manager replaced
Annaly Capital Management's subsidiary, Fixed Income Discount Advisory Company (FIDAC), has been appointed the collateral manager for McKinley Funding III, a CDO that has experienced an event of default due to downgrades. McKinley III was formed in 2006 with US$1.5bn original face amount of RMBS and CMBS and other financial assets. FIDAC was appointed to help restructure the CDO to maximise value for the bondholders and to perform asset management services on the portfolio on an ongoing basis.

"We're pleased to be able to provide restructuring and portfolio management services to McKinley," comments Wellington Denahan-Norris, Annaly's vice chairman, cio and coo. "We believe that EODs and other portfolio problems will continue to emerge in the marketplace, but solutions other than liquidations can be implemented that minimise losses and avoid further market dislocations. Our team, led by Choudhary Yarlagadda, co-head of structured products, has deep experience and discipline in CDO and securitisation management, surveillance, restructuring and liquidations, and we look forward to applying these skills to other transactions in the future."

RMBS trading platform launched
Manhattan Bancorp, the holding company of Bank of Manhattan, has entered into an agreement to invest in a new capital markets business with Bodi Advisors. Bodi (founded by Greg Jacobson, Hal Hermelee and Tad Dahlke) and a new subsidiary of Bancorp, MB Financial Services, will capitalise a new limited liability company formed to conduct business under the name BOM Capital. BOM Capital will be a capital markets and advisory firm, focused on the trading, for the accounts of customers, of RMBS and mortgage loans.

The business will also have the ability to expand into the origination, brokerage and sale of residential mortgage loans. The transaction and business are subject to regulatory approval, licensing or notice requirements of various governmental agencies, including the Federal Reserve Board and the Financial Institutions Regulatory Authority.

Hypoport closes ABS investor business
Hypoport has officially shut down its loss-making Europace business division for ABS investors (see SCI issue 108). The subsidiary company has been sold to an investment firm based in North Germany.

As such, the company will no longer be included in Hypoport Group's scope of consolidation from 2009 onwards and will therefore cease to burden its results in the future. The profitable business with ABS issuers, which is located in Amsterdam, is not affected by the closure and will continue to operate normally.

Pricing Partners and Microsoft France team up
Pricing Partners, a software editor of pricing tools and services for independent valuation of financial products, has signed a strategic partnership with Microsoft France within the IDEES programme to accelerate the kick-off of its independent valuation platform for financial structured products.

Pricing Partners develops and sells a pricing library for financial products based on an intuitive language describing cashflows. This language allows the pricing of virtually any financial product, from the vanilla to the most exotic financial derivatives products on most assets (including credit, life insurance and hybrid products).

Pricing Partners has created 'Price-it Online', a platform for independent valuation in SaaS format, using the latest Microsoft.net technologies. This platform allows users to book, analyse and price derivative products, providing a neutral and fair valuation for hard to value and complex products that have no listed prices.

CLO manager surveillance supplemented
In light of rapidly changing market dynamics and the severely stressed economy and capital markets, S&P is supplementing its process for gathering information about the systems, personnel and other resources available to managers of CLOs it rates. Managers use these resources to monitor their transaction portfolios and carry out other related key functions. Amid the current market turmoil, the agency believes it appropriate to supplement its normal process of updating this information on an annual basis or when we rate a new transaction.

As a first step in supplementing the process, S&P will soon send out a questionnaire to managers of CLO transactions. The agency says it believes this questionnaire is particularly relevant to CLO managers, given the current loan market dislocation, increasing corporate defaults and growing stress on overcollateralisation ratio tests due to an increase in the proportion of loans from triple-C rated obligors.

S&P's goal is to gather the most current information about CLO manager resources, staffing and risk management systems, so that it can update its assessment of their adequacy for purposes of managing within the structural constraints embedded in CLOs, and monitoring the creditworthiness of the loans within the CLOs. At this time, S&P will primarily focus on gathering information relating to the managers' credit processes and infrastructure, with the goal of identifying potential significant risks or deficiencies.

The agency will factor the results of the questionnaire into its monitoring process for CLO transactions and intends to follow up more directly with managers if it identifies potential issues or have questions. If a manager fails to respond to these questionnaires, or provides incomplete information, S&P may consider withdrawing the ratings assigned to the manager's transactions.

AC & CS

Credit events managed in an 'orderly manner' ...

A round up of this week's structured credit news

Senior financial supervisors from seven countries (collectively, the Senior Supervisors Group) have issued a report that assesses how firms manage their CDS activities related to the settlement of credit derivatives transactions terminated by the occurrence of a credit event. Surveyed participants reported that recent credit events were managed in an orderly manner, with high participation rates and no major operational disruptions or liquidity problems.

The report, entitled 'Observations on Management of Recent Credit Default Swap Credit Events', summarises a review that the Senior Supervisors Group initiated in December 2008. The observations in the report are based on discussions with senior members of selected institutions, comprising major dealers, buy-side firms, service providers and an industry association. This review was conducted to support the priorities established by the Financial Stability Forum, including enhancing the infrastructure for OTC derivatives markets and encouraging market participants to act promptly to ensure that the settlement, legal and operational infrastructure underlying these markets is sound.

Overall, the review confirmed the effectiveness of the existing auction-based settlement mechanism. The report's main conclusions are designed to ensure that market participants continue to improve their processes to effect timely and orderly settlement of CDS contracts.

The report highlights that effective credit event management depends upon certainty and full participation. Thus, market participants' support of ISDA's auction supplement to its 2003 Credit Derivatives Definitions, as well as publication of a 'big bang' protocol will help to reduce uncertainty and make credit event management more operationally efficient.

Equally, access to accurate CDS counterparty exposure data is essential to efficient credit event processing, according to the report. Therefore, having all CDS trade information in one centralised infrastructure will make it easier for firms to identify affected trades.

It can also facilitate handling of various lifecycle events, such as settlement and credit event processing. To this end, firms are continuing to load existing CDS client trades into the DTCC Trade Information Warehouse (TIW).

Furthermore, engagement of all market participants in decision making with regard to all phases of the credit event management process will help promote a broader market consensus and encourage more equitable market prices, while formalising market-wide and internal procedures should reduce operational risk. Additionally, periodic reevaluation and enhancement of the auction process may prove beneficial.

Finally, investment by firms in the necessary operational infrastructure and training resources for credit event management will assure efficiency, accuracy and timeliness of CDS settlement.

"All of these conclusions reinforce the current industry and regulatory initiatives for the over-the-counter derivatives markets. The prudential supervisors that have been involved in these initiatives will continue to monitor and assess the ongoing progress," the report concludes.

... but inconsistencies noted in price verification processes
In a separate report, entitled 'Observations on risk management practices during the recent market turbulence', the Senior Supervisors Group was less enthusiastic about price verification processes for illiquid securities. The report notes that some firms had not created robust internal processes prior to the turmoil to verify or challenge their business units' own estimates of the value of their holdings. For example, some firms that retained super-senior tranches of ABS CDOs, which rarely traded, benchmarked those instruments to spreads realised on primary market transactions.

The use of information from primary market transactions may have given false comfort about the true value of retained positions in the absence of secondary market trading, the report notes. In addition, some firms tended to rely too heavily on rating agencies' assessments that complex securities, such as CDOs, were equivalent to the highest quality assets and consequently continued to value them at par for too long into the period of market turmoil.

However, the supervisory group says that some firms had established robust price verification processes prior to the onset of the turmoil, and, using those tools, were more sensitive to the potential for their exposures to certain complex assets to fall in value. They adopted a more active approach to verifying their sense of valuations using internal resources, often in a coordinated, centralised fashion.

The few firms that used valuation models for exposures to super-senior tranches related to sub-prime mortgages prior to the third quarter of 2007 were able to begin to consider at an early enough stage counter measures, such as the sale of positions or the purchase of hedges. Such firms were thus generally successful in avoiding significant unexpected write-downs in those portfolios.

Firms that adopted more active approaches to valuation typically devoted considerable resources to establishing specialised product financial control staff able to perform a fundamental analysis of the underlying positions. Some firms also enforced discipline internally in marking their assets to their estimated prices.

This discipline was evident, for example, in the use of consistent marks across both proprietary positions and financed counterparty positions. Such firms furthermore factored position size (to account for the market impact of immediate sales of such size) and the dispersion of observed prices into their valuation marks.

ICE kick-starts CDS clearing
The ICE Trust began processing and clearing CDS index transactions on 9 March. Markit CDX indices are the first instruments to be cleared, followed by liquid single name CDS in the coming months. ICE Trust has entered into an agreement with Markit to produce daily settlement prices required for mark-to-market pricing, margining and clearing.

ICE US last week received regulatory approval to become a member of the Federal Reserve System and to serve as a clearing house and central counterparty for CDS. It also completed the acquisition of The Clearing Corporation (TCC) on Friday. TCC has developed the CDS risk management framework, operational processes and infrastructure for ICE Trust's clearing operations.

Aleris LCDS settled ...
Creditex and Markit, in partnership with credit derivative dealers, have announced the results of a credit event auction conducted to facilitate settlement of LCDS trades referencing Aleris International. The final price was determined to be 8%.

... while auction terms for Station Casinos are prepped
ISDA is to launch a CDS auction protocol to facilitate the settlement of credit derivatives trades referencing Station Casinos Inc, the Las Vegas-based casino company. Station Casinos was reported to have failed to make a payment due on 1 February on US$450m of 6.5% notes due in 2014. The 30-day grace period expired on Tuesday 3 March. ISDA will facilitate the process by publishing the protocol and auction terms on its website in due course.

LevX names cut, sub index roll cancelled
Changes have been announced for the Markit iTraxx LevX indices. The LevX Senior index will comprise 50 names instead of 75, as of its roll into Series 4 on 20 March 2009. This is to ensure that only the most liquid entities are selected for inclusion in the index.

The LevX Subordinated index will not roll into Series 4. Series 1 to 3 of the Subordinated index remain tradable, Markit notes.

Both decisions were taken based on dealer polls conducted by the firm.

CRD amendments approved
Legislation aimed at improving risk management, transparency and the supervision of the financial system has been approved by the EU Economic and Monetary Affairs Committee. Amendments to the Capital Requirements Directive were approved with 21 votes in favour, four against and eight abstentions.

Among the amendments is a proposal to ensure that an institution issuing a securitisation retains a material interest in the performance of the transaction. The retention rate is, as a general rule, at least 5% of the total value of the securitised exposures. In addition, the committee proposes an 'explicit and unconditional warranty' to be issued by the originator of the securitisation with respect to due diligence criteria.

The amendments also call on the Commission to put forward, by the end of 2009, legislative proposals to regulate the CDS market and set up a central counterparty (CCP) supervised by the EU.

MEPs in the committee also support reinforcing the existing rules on the large exposure regime, including interbank trading. Under the rules, a bank won't be able to expose more than €150m or more than 25% of its own funds to a client or a group of clients, if the proposed legislation enters into force.

Member States will have to require all credit institutions to report to the supervisory authorities on their large exposure, according to an amendment approved by the committee. Members also agreed to ask the Committee of European Banking Supervisors to provide national authorities with uniform guidelines before the end of 2011.

In addition, the committee voted to establish a college of supervisors to facilitate cooperation among national authorities dealing with cross-border financial institutions. However, this is expected to only be a temporary step towards a more integrated system of supervision.

IASB enhances financial instruments disclosures
IASB has issued amendments that improve the disclosure requirements about fair value measurements and reinforce existing principles for disclosures about the liquidity risk associated with financial instruments. Responding to the calls of policymakers, many investor groups and other interested parties, the IASB is bringing IFRS disclosure requirements more closely into line with US standards.

The amendments to IFRS 7 'Financial Instruments: Disclosures' introduce a three-level hierarchy for fair value measurement disclosures and require entities to provide additional disclosures about the relative reliability of fair value measurements. These disclosures will help to improve comparability between entities about the effects of fair value measurements.

In addition, the amendments clarify and enhance the existing requirements for the disclosure of liquidity risk. This is aimed at ensuring that the information disclosed enables users of an entity's financial statements to evaluate the nature and extent of liquidity risk arising from financial instruments and how the entity manages that risk.

Home affordability programme outlined ...
The US Treasury has released further details about its US$75bn mortgage foreclosure relief plan. The initiative provides refinancing for GSE-owned first lien mortgages up to US$730,000 where LTVs have risen above 80% and mortgage modification for 2008 and prior vintages, whereby lenders recieve a cash payment from the government to offset both a US$5,000 principal cut on loans and reduced margin/payment holidays. The US government has also endorsed the draft cramdown legislation (see last week's issue).

... while home price decline is revised downwards
LoanPerformance home prices dropped by -12.29% annualised, non-seasonally adjusted, in January compared to -22.04% and -17.58% in December and November respectively. ABS analysts at JPMorgan project the terminal value for December and January to be respectively -23% and -21% non-seasonally adjusted, which translates into roughly -18% and -16% on a seasonally-adjusted basis.

"This is a clear reversal of the previously observed improvement in seasonally-adjusted home prices. We capitulate on our expectations of another 5%-10% decline and recognise that is not in the cards. We expect an additional 20%-25% decline, with risks of further declines," the analysts note.

They add that this shift back to a more negative housing picture is also driven by the policy failure to address the core problem of the crisis - negative home equity. The peak-to-current HPI now stands at -30.48% and a further 20%-25% decline would result in 40%-45% peak-to-trough HPI.

37 out of the 50 states and the District of Columbia have a negative one-month annualised HPI (not seasonally-adjusted). 17 states have a -20% price decline or more. Arizona and Maine are down the most at -31.87%, followed by Ohio at -31.34% and Nevada at -30.82%.

DTCC data implies systemic risk reduction
Analysts at Credit Derivatives Research note that last week's DTCC data indicates a move to reduce systemic risk. Gross CDS notionals rose by 2.5% to just above US$28trn as single names saw a US$132bn risk reduction (protection buying), with a net notional US$10.8bn flow of dealers selling protection to end-users.

Index trades accounted for the largest increase in notional outstanding in both percentage and absolute terms (74% and US$501bn). "Notably, investors appeared to be reducing risk (buying protection) in some of the vintage iTraxx Europe indices. Main 5 and Main 6 saw dramatic increases in gross and net notional, as tail risk hedging becomes more important and covering of old bespoke CDO hedges (or rolling up to more recent vintages) appears to be taking place," the analysts comment.

CDX IG4 and IG5 saw significant re-risking (net notional reduction) as auto hedges were unwound or rolled into single names, while IG10 and IG11 saw re-risking activity due to what the CDR analysts suspect was covering on the latter and lack of conviction in the former.

CRE CDO update to impact US$112bn notes
Moody's is to update four key parameters in its rating and review of US CRE CDOs, supplementing the parameter revisions it adopted in December 2008. These changes bring into alignment the agency's modelling of CRE CDOs with its expectations for the performance of the underlying real estate collateral and is expected to impact approximately US$112bn of securities.

First, for CRE CDOs with CUSIP collateral, the additional default probability stress sometimes applied to resecuritisation collateral will not be applied to Moody's review of conduit and fusion CMBS collateral from the 2006 to 2008 vintages, due to a recent ratings sweep of these transactions. Second, in its cashflow modelling, Moody's will assume a delay in the default timing to better reflect its expectation of how the underlying real estate-based collateral will perform in this recession.

Third, for CRE CDOs with non-CUSIP collateral, Moody's is eliminating the additional default probability stress in CDOROM v2.5 that is applied to corporate debt, as it anticipates that the underlying non-CMBS collateral will experience lower default rates and higher recovery rates. Finally, for CRE CDOs with non-CUSIP collateral, Moody's is reducing the maximum over-concentration stress applied to correlation factors by half, due to the diversity of tenants, property types and geographic locations inherent in the collateral pools. For those deals that are significantly less diversified, we will add back over-concentration stress as warranted.

Based on Moody's current expectations for commercial real estate performance, the agency has migrated the ratings for recent vintage CMBS to levels that it believes will remain relatively stable for the next 12 to 24 months. As such, Moody's has eliminated the vintage stress factor and default probability resecuritisation stress from its analysis of deals with recent vintage CMBS collateral.

For deals with pre-2006 CMBS collateral, Moody's is adopting the default probability resecuritisation stress assumptions contained within CDOROM v2.5 to capture the leveraging effect and potential ratings volatility of the underlying collateral. For CMBS, this factor is equivalent to two times the probability of default (PD) for non-Aaa and six times the PD for Aaa-rated collateral.

For CRE CDOs, this factor is equivalent to four times the probability of default (PD) for non-Aaa and twelve times the PD for Aaa-rated collateral. The lower stress for CMBS is due to the historical stable performance of this asset class, Moody's notes.

Moody's review of the 109 transactions that were placed on review for downgrade in December 2008 initially focused on transactions with more than 75% pool concentration in CMBS collateral and issued prior to January 2006. Moody's has completed reviews and taken action on 30 of the 109 transactions.

The agency is now embarking on the second phase of its CRE CDO review, which will include transactions with CMBS collateral issued post-2005. Moody's will also revisit nine transactions where the previous modeling parameters were applied along with the 79 remaining CRE CDO transactions with CUSIP collateral that are currently on review for downgrade. Moody's anticipates completing reviews of all 109 transactions by 31 March 2009.

A final phase of Moody's CRE CDO ratings sweep will focus on 52 CRE CDOs collateralised primarily by non-CUSIP collateral, including whole loans, B-notes and mezzanine debt. While initial phases of Moody's CRE CDO review involved mostly static deals, the final phase will involve transactions that have a revolving period and profile tests.

For the 30 transactions that Moody's has completed reviews on and taken action, the Aaa-rated CRE CDO classes were downgraded by eight to 10 notches, on average. Low investment-grade and speculative grade bonds were downgraded by four to eight notches, on average.

For the remaining 79 CRE CDO transactions with CUSIP collateral, Moody's anticipates that the downgrades on all rated classes will range from two to eight notches in most cases. But for deals with significant exposure to 2006-2008 vintage CMBS, the magnitude of the downgrades is expected to be at the maximum end of the range.

For the 52 CRE CDOs collateralised primarily by non-CUSIP collateral, Moody's anticipates that the downgrades on all rated classes will range from seven to 12 notches in most cases. The actual magnitude of the ratings migration will vary based on the collateral performance, contributing factors and coverage tests.

CDS liquidity analysed
Liquidity in the CDS market hit an all-time low on 6 January 2009, when the Fitch Global CDS Liquidity Index reached 11.37. This compares to the index's all-time liquid high of 9.87 on 19 September 2008, as a result of the Lehman Brothers bankruptcy.

Although the December holiday period always shows a decline in liquidity, the fall off in liquidity in 2008 was significantly worse than in the previous two years, according to Fitch. Liquidity has since begun to return to the market, with the index closing at 10.65 on 6 March 2009 - largely being driven by a significant increase in liquidity in the Americas since 2 March 2009.

This increase in liquidity has predominantly been influenced by increasing uncertainty about the future direction of the US economy, following the recent February 2009 worse-than-expected unemployment and growth figures, exacerbating credit market stress. The Americas market is now more liquid than Europe's, closing at 9.86 on 6 March 2009 (compared to Europe at 10.06).

Latin America continues to dominate liquidity in the sovereign CDS sector, with Mexico becoming the most liquid name due to its exposure to the US economy.

Meanwhile, General Electric Capital (GE) dominates the top spot amid concerns about the impact of the potential loss of its triple-A rating. The firm is currently trading at over 900bp in the CDS market.

However, banks are also beginning to dominate liquidity, with Merrill Lynch joining Bank of America Corporation in the top five due to concerns surrounding the health of the financial system. Citigroup is now in sixth place with a liquidity score of 6.31.

As in the Americas, banks are beginning to feature more in the European list alongside telecoms companies, with HSBC Bank entering the top five off the back of plans to raise US$17.7bn through a rights issue to shore up its balance sheet. However, the broader top-10 liquidity table comprises another four banks, including Unicredit, BBVA, Lloyds and UBS.

And South Korean banks continue to dominate liquidity in the Asia-Pacific market. Given the thinness of trading in the market, the liquidity of the CDS on these banks is all the more striking.

S&P offers CRA regulatory recommendations
S&P has released a White Paper on the regulation of credit rating agencies (CRAs), which provides its recommendations for what regulations should accomplish generally, as well as specific recommendations that should be instituted globally for CRAs. The agency says that the paper is being offered "in a spirit of cooperation and openness to promote independent, credible ratings and to foster investor confidence in the capital markets". The paper also considers the current use of ratings in regulations and investment guidelines.

S&P says it believes regulation can play an important role in this process and it welcomes proposals that would, on a globally consistent basis, increase transparency and preserve the analytical independence of rating agencies' opinions and analytical processes. The rating agency suggests that any new regulatory architecture should focus on the following goals:

• Safety and soundness of financial markets;
• Business conduct based on transparency and fair dealing;
• Efficiency and cost-effectiveness by aligning responsibilities among different participants across the marketplace;
• Consistency of regulation across similar businesses;
• Internationally consistent standards and coordinated enforcement;
• Adaptability to accommodate future innovations and changes in market structure;
• Flexibility to foster fair competition to benefit investors;
• Promote credit ratings that are analytically sound, independent and unbiased; and
• Promote competition among rating agencies and differing views on creditworthiness.

In order to address areas where investors and policymakers have identified gaps and key issues in the current regulatory regime for credit rating agencies, S&P highlights the significant investor concerns and expectations it has heard and how regulation might enhance the process. These points include:

1. Independently derived, credible and unconflicted credit ratings.
2. Transparency regarding issuer and rating agency communication.
3. The meaning and use of ratings should be clear, including the level of risk inherent in the rating.
4. Consistency and comparability of ratings across asset classes and geographies - accountability for ratings quality.
5. Transparency and soundness of credit rating analysis.
6. Clear and consistent applications of policies to lessen 'surprises' when and if ratings are changed.
7. Ratings on new and different securities should be differentiated.
8. Availability of information, particularly for structured finance ratings.
9. Confirm that rating agencies are following through on their commitments.
10. Competitive market for ratings with more and varying views on credit quality from qualified providers.

One potential model for an international regulatory approach is the IOSCO Code of Conduct, recently updated in May 2008, S&P notes. The agency warns that regulators in any country should take care before seeking to exceed existing standards, given the effect such an approach could have on rating agencies operating in multiple jurisdictions. These agencies may face conflicting rules that could ultimately harm ratings consistency due to country- or region-specific requirements.

According to S&P, a sound regulatory framework for rating agencies globally should have the following components: registration, performance measurement, disclosure of rating methodologies, control over non-public information and disclosure of underlying data, organisational transparency, development of a code of ethics, elimination of potential conflicts of interest, prohibitions on anti-competitive activity, transparency of models, accessibility, effective oversight, analytical independence, accountability and international consistency.

Lloyds APS participation finalised
Lloyds Banking Group has announced its intention to participate in the UK government's Asset Protection Scheme, thereby substantially reducing its risk weighted assets and significantly strengthening its capital position. The bank has also agreed to replace the £4bn of preference shares held by HM Treasury with new ordinary shares that will be offered to existing shareholders on a pre-emptive basis.

Lloyds intends to participate in the scheme in respect of assets and exposures on its balance sheet with an aggregate par value of approximately £260bn (expected to be approximately £250bn net of December 2008 impairment provisions and write-downs). The covered assets are expected to include residential mortgages (around £74bn), unsecured personal loans (around £18bn), corporate and commercial loans (including commercial real estate and leveraged finance loans - around £151bn) and treasury assets (including the Group's Alt-A portfolio - around £17bn). Approximately 83% of the covered assets will come from HBOS legacy lending books and the balance from Lloyds TSB legacy books.

The bank will bear a first loss amount of up to £25bn (after taking into account historic impairments and write-downs). After the first loss, it will retain an exposure of 10% of any further losses incurred in respect of the covered assets, with the remaining 90% of further losses being borne by HM Treasury. The scheme will apply to losses incurred in respect of assets and exposures on the balance sheet as at 31 December 2008, regardless of when they are incurred.

Upon accession to the scheme, Lloyds will pay a fee to HM Treasury of £15.6bn, which will be amortised over an estimated seven-year period. The proceeds of this fee will be applied by HM Treasury in subscribing for an issue by Lloyds Banking Group of B Shares, carrying a dividend of the greater of 7% per annum and 125% of the dividend on ordinary shares.

Lloyds has committed to increase lending for the twelve-month period ending 1 March 2010 to creditworthy borrowers by a total of £14bn - £3bn for mortgage lending and £11bn for business lending. A further £14bn is committed for the twelve month period thereafter.

The spotlight will now turn to Barclays, which is expected to begin negotiating with the government imminently.

Royal Park to purchase more assets
Fortis Holding, BNP Paribas and the Belgian State have reached a new agreement regarding the structured credit assets to be bought be the SPV, Royal Park Investments (SCI passim). The new agreement provides that the SPV will purchase about €2bn of additional lines from the structured credit portfolio of Fortis Bank, of which about €1bn will be in replacement of redemptions that occurred since 31 August 2008 on the original portfolio.

These additional lines will be selected in mutual agreement between parties from the remaining portfolio of Fortis Bank. As a result, the conventional purchase price is therefore expected to increase from €10.4bn to about €11.4bn (at currency rates of 31 August 2008).

Under the terms of the proposed new agreement, Fortis Holding's funding obligation in respect of, and maximum exposure to, the SPV will be limited to €760m, corresponding to 45% on a total equity of €1.7bn. The financing by Fortis Holding will consist of equity only. The other parties will provide €740m (SFPI/FPIM) and €200m (BNP Paribas) in equity.

The remainder of the SPV funding will be provided by way of debt financing by BNP Paribas and by Fortis Bank, partially guaranteed by the Belgian State. Fortis Holding will also have the benefit of a loan of about €1bn from Fortis Bank to fund its commitments towards the SPV.

European CMBS delinquencies rise
February's European CMBS loan level performance continued the increasing delinquency trend S&P has reported in recent months, with three additional loans going into default. Of these loans, two loans defaulted because they were not refinanced (the CPFM loan in European Property Capital 3 and the Belgian Bonds loan in Odysseus (European Loan Conduit 21). The agency says that this indicates perhaps that refinance risk has begun to materialise at the loan level in European CMBS (see last week's issue).

By the end of February, of the roughly 1,100 loans that collateralise European CMBS rated by S&P, the number of reported delinquent loans rose to 15 from 12. (This loan pool does not include loans in non-performing loan securitisations or small loan securitisations.) The delinquency rate in this period rose very slightly on January's rates.

For sterling-denominated loans, the delinquency rate remains at 2.8% of outstanding sterling-denominated senior balance, despite the addition of one loan to the 'delinquent' group. This is primarily due to amortisation in the delinquent group. For euro-denominated loans, the delinquency rate moved from 0.8% of outstanding euro-denominated senior loan balance at end of January to 0.85% at the end of February.

UK NC RMBS hit by recession
The UK non-conforming RMBS market has been severely affected by the UK recession, says Moody's in its latest report for the sector. Both macro-economic and RMBS market-specific performance indicators are showing exceptionally weak levels.

"Delinquencies increased from 7.6% in Q407 to 13.5% in Q408. During the same period the outstanding repossessions and cumulative losses more than doubled reaching 3.5% and 0.60% respectively," says Georgij Ludmirskij, a Moody's senior associate and co-author of the report. The deterioration in performance has largely followed the deterioration of the economic environment.

During Q408, Moody's downgraded 61 classes of notes in ten different transactions in the UK non-conforming market. All downgraded transactions showed weaker-than-expected performance. Exposure to unhedged interest and currency risks, as well as other operational risks also prompted certain transaction downgrades in Q408.

GDP fell by 1.5% quarter-on-quarter in Q408 and unemployment has increased to 6.3%. "As the economy contracts, more jobs are expected to be removed from the market. Personal insolvencies have risen sharply and we also expect to see an increase in personal insolvency filings over 2009," says Nitesh Shah, a Moody's economist and co-author of the report entitled 'UK Non-Conforming RMBS Q4 2008 Indices'.

Transaction activity in the housing market is low and consumer confidence is depressed - pointing towards continued falls in house prices. Moody's Economy.com expects house prices to fall another 7% by the trough.

Expectations worsen for house market stability
In the latest Fitch Ratings/Fixed Income Forum Survey of Senior Fixed Income Investors, conducted in January, expectations for stability in the housing market were pushed further back, with 57% of respondents not expecting normal conditions to return before 2010. However, most investors believe that credit market stability will return sometime in 2009 (77% expressed this view).

In a notable reversal from the mid-2008 survey, and clearly a consequence of the speed and severity of the economic downturn, the recent survey showed greater receptivity on the part of investors to the expanded role of government in the credit markets. Banks' reluctance to lend received the most votes as a high risk to the credit markets over the next 12 months and nearly 40% of respondents believe that banks' willingness to lend will not stabilise this year.

Liquidity standards welcomed
The Joint Trade Association (JTA) has welcomed the proposed UK FSA rules outlined in its Consultation Paper (CP) 08/22 'Strengthening Liquidity Standards'. The qualitative elements of the FSA's proposals sit well alongside the recent Basel Committee for Banking Supervision (BCBS) 'Principles for Sound Liquidity Risk Management and Supervision', which themselves reflect many of the recent improvements that large firms have put in place to better manage liquidity risk today, the association says.

The industry fundamentally agrees that liquidity risk needs to be given a higher profile within a firm's systems and controls and where appropriate be reflected by the strengthening of adequate liquidity buffers. The industry is also in favour of appropriate reporting in order to assist the benchmarking of liquidity metrics and providing early warning systems for future liquidity stresses.

In particular the association urges the FSA to create a new liquidity regime that predominantly focuses on systemically significant firms under its supervision while offering a proportionate approach for simpler firms. The new liquidity regime should not dissuade the diversity of firms in the UK financial markets from continuing to be active there. The association believes that firms should be granted waivers wherever a significant proportion of their core funding is provided from an overseas parent and they are not significant participants in the UK retail deposit market.

Bank's SIV sales result in US$1.2bn loss
Legg Mason has eliminated all of the remaining securities issued by SIVs and other similar conduits from its money market funds. The company and the funds separately sold a total of US$1.8bn of par value SIV securities from five different issuers. Of this amount, US$1.4bn represented SIVs held by four of the company's money market funds, US$57m in SIVs held by the company and US$355m of SIVs that had been supported through a total return swap with a major bank.

As a result of these transactions, there was a net cash outflow to the company of US$1.2bn. It is retaining US$49m in SIVs (current carrying value) from two issuers that it has been carrying on its balance sheet.

PREPS series downgraded
Fitch has downgraded the PREPS series of German mezzanine CLO transactions (PREPS 2004-2, 2005-1, 2005-2, 2006-1 and 2007-1), removed the notes from rating watch negative (RWN) and assigned rating outlooks. The notes were initially placed on RWN on 31 July 2008 to reflect the potential for downgrades as a result of Fitch's new global rating criteria for corporate CDOs. While the rating actions are the result of the updated rating criteria, they are mainly driven by continued negative performance of the underlying portfolio companies and the high obligor concentration in the pools.

The number of performing portfolio companies has decreased in all transactions as a result of early terminations, insolvencies and payment defaults. The top obligor concentration in these transactions ranges between 3.3% and 4.2%, with the top five obligors accounting for 16.3% to 20.8%. In particular, Fitch notes that the PREPS 2005-2 and 2006-1 Class B notes' ability to withstand default events of these largest obligors has decreased to two and three top obligors respectively.

In addition, the portfolios have experienced negative rating migration. The credit quality for the majority of the portfolio companies is determined by a mapping approach, with Fitch's Issuer Default Rating (IDR) scale being mapped to the internal rating scales from HVB, Credit Suisse and ING Bank.

Having tracked the performance of 11 Fitch-rated German Mezzanine CLOs (including the PREPS transactions), which were initially assessed by means of mapping, Fitch notes that the average credit quality of the borrowers in these transactions lies one notch below Fitch's initial credit assessment. In resolving the RWN status of the PREPS series, Fitch assumed the same average portfolio migration (one notch lower) and combined this assumption with the available portfolio information.

Currently, all PREPS transactions, apart from PREPS 2005-1, show debits in the principal deficiency ledgers (PDL) that have not yet been reduced to zero by the application of excess spread. Based on Fitch's analysis, the credit enhancement derived from both subordination and excess spread is not sufficient to justify the previous ratings of the notes.

Rating impact of DDO substitutions analysed
In response to inquiries from CLO managers seeking to amend their indentures to permit deep discount obligation (DDO) substitutions (see last week's issue), Moody's has confirmed that certain types of DDO substitution proposals may not have a negative impact on the ratings of the associated CLOs. Moody's anticipates that most amendments that are in line with the DDO substitution provisions in its June 2004 publication should not, in and of themselves, result in downgrades or withdrawals of its ratings at the time of such amendments.

However, the credit implications of each amendment will be considered on an individual basis. In addition, Moody's may consider, on a case-by-case basis, other CLO amendments to allow for DDO substitutions that do not conform to some or all of the conditions discussed in its June 2004 publication. Each amendment will be assessed as to whether or not Moody's expects it to have a negative ratings impact.

DDOs refer to assets that are purchased by a CLO at a price significantly below par. They are generally defined in CLO indentures as: (1) loans purchased below 80% of par, regardless of their ratings; or (2) loans purchased below 85% of par if rated below B3. Typical provisions in CLOs effectively limit DDO purchases by requiring the CLO to account for DDOs at their purchase price for the purpose of calculating overcollateralisation ratios.

Whether an obligation is a DDO is considered on an asset-by-asset basis and not by averaging the prices of several assets purchased at the same date. These provisions are intended to mitigate potential adverse selection and to facilitate the proper operation of the overcollateralisation and cash diversion mechanisms in the CLOs. However, the current dislocation in the loan market has created a situation in which a loan price of 80% to 85% no longer signals a deep discount relative to the average market price.

Before providing a rating agency confirmation (RAC) for a proposed DDO substitution amendment, the proposal will be reviewed by a Moody's credit committee which will consider the performance of the specific CLO and collateral manager and the specifics of the proposed amendment and the particular structure of the CLO.

Nightingale Finance affirmed
S&P has affirmed and removed from credit watch negative its credit ratings on the senior debt issued by Nightingale Finance. At the same time, it affirmed the issuer credit rating on Nightingale and revised the outlook to negative.

The rating actions follow the affirmation and removal from credit watch negative of the ratings on AIG Financial Products Corp. Nightingale is a SIV managed by AIG-FP Capital Management Ltd. AIGFP provides support via a combination of repurchase and note purchase commitments, so the rating on Nightingale is credit-linked to the rating on AIGFP.

Further SF CDOs ...
Moody's has downgraded its ratings of 94 notes issued by 26 CDOs that consist of significant exposure to one or more of Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. The agency says that the rating actions reflect certain updates and projections and recent rating actions on underlying assets on these asset classes.

... and CSOs downgraded
Moody's has downgraded its ratings of 180 notes issued by certain CSOs. The rating actions are the result of: (i) the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of corporate synthetic CDOs; and (ii) the deterioration in the credit quality of the transaction's reference portfolio.

Negative outlook for Japanese CDOs
In 2008 CDO deals rated by Moody's Tokyo office declined slightly in both volume and number from the previous year, according to a new report entitled '2008 Japanese CDO Market Review and 2009 Outlook'. Moody's Tokyo office rated 37 CDO deals totalling approximately Y1trn, a decline in number of six (or 14%) from the previous year and a drop in volume of Y130bn (or 12%).

Activity slowed as investors became wary of purchasing CDOs in general, influenced by the US sub-prime crisis and the ensuing weakening of business confidence worldwide. However, the direct impact of the US sub-prime concerns on Japan's CDO market was limited and the market's decline was comparatively modest.

Moody's Tokyo office also rated nine balance-sheet CDOs (including CDOs backed by loans to SMEs) totalling Y0.729trn and 26 deals totalling Y0.249trn of arbitrage CDOs and other related deals. The volume of balance-sheet CDOs rose from the previous year due to transactions backed by loans to medium-sized or large companies. Another characteristic of the market in 2008 was the growing demand for simply structured CDOs.

Moody's outlook on the performance of underlying assets for both of SME CDOs and Balance Sheet CDOs (Large Corporates) is negative.

'Contradictory behaviour' adds to commercial property uncertainty
Fitch says that contradictory behaviour among UK banks is adding to uncertainty in the commercial property sector by creating a hiatus in property transactions. Commercial mortgage origination is largely suspended, triggering a rise in loan defaults, while lenders appear reluctant to commence liquidation of defaulted loan securities.

The sharp reduction in lending reflects a fear that UK property values will fall, whereas the reticence to commence liquidation could imply that banks anticipate an improvement in market conditions. By failing either to provide new finance or call in existing loans, banks are suppressing the impetus towards price discovery that would accompany property transactions, Fitch notes.

"In a downturn, such inconsistency may reflect motivations peculiar to banks. On the one hand there is strong pressure for banks to rebuild cash reserves and one way to achieve this is by reining in new lending. On the other, banks are keen to avoid punching more holes in their balance sheets, and so they are holding off from crystallising loan losses that would accompany liquidation in the current climate," explains Euan Gatfield, senior director in Fitch's EMEA CMBS team.

He adds: "There is also a risk forced sales would accelerate and even exacerbate price declines, triggering a downward spiral of further forced sales. Whatever reasons are causing banks to behave in this manner, telling some customers not to buy and others not to sell is contradictory."

Until conditions in the banking system ease, Fitch expects equivalent rental yields to converge on equity rates of return achievable elsewhere. While this continues to translate into widening yields and falling values, negative rating migration for UK CMBS will persist - especially for bonds legally due to mature in the short- to medium-term.

"Concerns about the risk of declines in rental income are legitimate and shouldn't be downplayed. In the near term, this will be reflected in negative rating migration in the sector," says Andrew Currie, md in Fitch's EMEA CMBS team. "However, the unusually high disparity between swap rates and property yields suggests future rents are already being heavily discounted by valuers. It is something of a paradox that rental yields reportedly in double digits are unable to stimulate purchases of commercial real estate on anything like the scale seen when they were much tighter."

DTCC welcomes CDS standardisation
The DTCC says it expects the proportion of North American corporate single name credit derivative contracts that do not define restructuring as a credit event to rise once counterparties begin utilising the new standard contract developed by ISDA and planned for launch in April 2009. According to the DTCC's Trade Information Warehouse, approximately 14% of all OTC North American corporate single name CDS registered as of early March 2009 do not include the restructuring credit event.

Because the definition and incidence of corporate restructurings have been subject to interpretation and dispute, the inclusion of restructuring as a type of credit event in CDS contracts has contributed to uncertainty and risk in this market. Disclosure of the Warehouse contract data, along with industry initiatives to minimise the inclusion of restructuring in contract terms should reduce these risks and uncertainties, the DTCC notes.

"We have been working closely with our customers and the industry to create a level of transparency to protect the OTC derivatives market and to provide support for corporate single name credit derivative contract, known as the 100/500 contract, which will bring about standardisation and help reduce risk in the processing of these transactions," comments Peter Axilrod, DTCC md, business development and Deriv/SERV.

DTCC believes the industry's effort to adopt the new standard contract will help address the 86% of North American contracts that still include restructuring as a credit event. For the entire population of single name contracts registered in the Warehouse (North American, as well as overseas corporates and sovereigns), 9% do not include restructuring in the definition of a credit event.

DTCC Deriv/SERV will support both the 100/500 contract and the industry's new auction hardwiring process, as defined in ISDA's auction supplement and 'big bang' protocol.

European auto ABS shows deterioration
Fitch says in a new report that European auto ABS transactions showed some signs of deterioration during Q408. The agency's latest review of European auto ABS transactions reveals that the overall increase in delinquencies during the period was primarily driven by Spanish transactions.

The Fitch 60-180 day Delinquency Index (Fitch DI) increased to 1.3 in Q408 (+0.1 versus Q308). The Fitch DI has increased 33% since December 2007 and further increases in the index are expected to occur going forward.

The Fitch Net Loss Index (Fitch NLI) fell to 0.1 from 0.3 during the fourth quarter of 2008, primarily as the result of the positive impact of a single transaction. Comparing individual transactions to corresponding base case expectations, 19 of the 22 transactions continue to report positive net loss levels.

The Fitch Excess Spread Index (Fitch ESI) remained stable during the quarter at 2.3%.

The increase in European auto ABS delinquencies occurred against a background of negative external factors. EU consumer confidence fell to another historic low in Q408 and new car registrations dropped further in all jurisdictions represented in the index, led by Spain, the UK and Italy.

New issuance levels were buoyant during the quarter, which saw nine transactions launched with volumes totalling €6.3bn (a 127% increase compared with Q407). However, Fitch notes that the majority of these were not publicly placed.

CS & AC 

Trading

Trading ideas: time to close

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on Boston Scientific Corp

Most companies that we track have had CDS trading tight to fair value since the beginning of the year. The trend reversed this week as credit underperformed equity. However, Boston Scientific's CDS remains near recent tights, even as its equity deteriorates.

This creates an excellent opportunity to bet on equity outperformance in the near term by buying CDS protection and buying equity in the company. Our directional credit model also points towards a CDS sell off, further bolstering our desire to buy BSX protection.

Delving into the data
Our first step when screening names for potential trades is to look where equity and credit spreads stand compared to their historical levels. To judge actual richness or cheapness, we rely on a fair-value model and consider the empirical relationship between CDS, implied volatility and share price.

Exhibit 1 plots five-year CDS premia versus fair value over time. If the current levels fall below the fair-value level, then we view CDS as too tight or equity as too cheap. Above the line, the opposite relationship holds.

Exhibit 1

BSX's CDS has remained tight to fair value since October. We view this as a sign that our model is not picking up an important dynamic between CDS, equity and vol for BSX. However, in the past month, BSX equity has underperformed CDS dramatically and we believe that either the company's equity will rally or its CDS will move closer to fair value.

Exhibit 2 charts BSX's market and fair CDS levels (y-axis) versus equity share price (x-axis). The red diamond indicates our expected fair value for both CDS and equity when CDS, equity and implied vol are valued simultaneously.

Exhibit 2

The green circle indicates the current market values for CDS and equity. The red line is the modelled relationship between CDS and equity.

With CDS too tight compared to equity, we expect a combination of equity rallying and CDS widening. Even if equity does not recover, BSX's CDS is still trading far tighter than when equity traded in a similar range. We also note that our directional credit model points towards deterioration in BSX CDS.

Risk analysis
The main trade risk is if the name begins trading under a different regime and the current vol-equity-CDS relationship no longer holds.

Each CDS-equity position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a different than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Government actions: Bailouts, stimulus packages and other governmental interventions have distorted the credit-equity relationship among certain names.

Mark-to-market: In our view, credit and equity markets operate largely independently and this can lead to trade opportunities. At the same time, any relative mispricing may persist and even further increase, which could lead to substantial return fluctuations. Additionally, the trade faces a fairly substantial bid-offer to cross in CDS.

Overall, frequent rehedging of this position is not critical, but the investor must be aware of the risks mentioned above.

Liquidity
Liquidity (i.e. the ability to transact effectively across the bid-offer spread) in the equity and CDS markets drives any longer-dated trade. Our data on liquidity, created from the volume of bids, offers and trades that we see each day, reassure our trading in BSX. BSX is a moderately liquid name and CDS bid-offer spreads are around 15bp-20bp.

Buy US$10m notional Boston Scientific Corp 5-Year CDS at 190bp.

Buy 200,000 shares Boston Scientific Corp at US$6.26 to pay 190bp of carry.

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

Copyright © 2009 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).