Contents

Ratings

Work in progress

Future role of rating agencies debated

HVB's SME CLO Geldilux TS 2008, a deal rated less than a year ago, was put on downgrade review by Moody's and subsequently S&P last week (see separate News story). The action has brought into question rating agencies' ability to rate deals through the cycle, as well as rating consistency in structured finance.

UniCredit securitisation research analysts point out that Moody's assigned ratings to the Geldilux 2008 transaction based on credit enhancement provisions one year ago when the credit crisis was already in full swing. "Any downgrade or revision of last year's assigned ratings one year later would automatically raise doubts as to whether the agency has failed to really fully rate through the cycle," they suggest.

Zeshan Ashiq, founding partner at Shooters Hill Capital, comments that the agency's decision to change the definition of its idealised default curve is puzzling. "What happens in two to three years time when the financial environment becomes more benign - will they change it again? Such changes question the rating agency's credibility, especially as these ratings assigned to deals are supposed to last through the cycle," he says.

Ashiq believes that the rating agencies will ultimately be regulated, given current political pressure. "I think that the rating agencies are conscious of this and so they are putting their houses in order now," he adds.

The role of rating agencies has been debated since the beginning of the credit crisis (SCI passim), including the argument that ratings only addresses a part of what they should. One structured credit consultant suggests that rating agencies will become redundant if they continue to produce the same output as they do at the moment.

However, he agrees that markets need independent reviewers, analysis of risk transfer and measures of capital adequacy - but says that the future banking landscape will ultimately define the role of rating agencies.

"No-one has yet worked out what the nature of banks will be in the future," the consultant explains. "By that I mean that in the recent past there has been some ease in identifying the sell-side contingent - i.e. issuers, banks, rating agencies - and the buy-side. People are still trying to figure out what role banks will play and if so-called 'safe' commercial deposit-taking aspects will be split from the trading activities of parts that gamble on the markets."

He continues: "Then there is a knee-jerk overreaction going on fuelled by politicians looking to blame anyone but themselves, where there is likely to be so much regulation that very little in the way of risk creation takes place."

The consultant suggests that, rather than demonising wholesale markets and at one extreme only allowing banks to lend if the loans are covered by their deposit base, one of the ways to solve the current problems would be to create a different form of wholesale markets that is more transparent - with a clearer idea of how to frame a consensus on risk analysis through time. "A 'new' evolved independent risk analysis entity can then work alongside other market participants, but with a rating output that is much more involved," he concludes.

AC

CMBS

Real estate realities

US CMBS tightens as TALF overpowers fundamentals

The inclusion of vintage triple-A CMBS for TALF and PPIP financing is already producing positive results for the sector, at least at the senior level. While negative news in the commercial real estate market continues to filter through, the TALF factor appears to have overwhelmed fundamentals for now, as spread levels embark on a rapid contraction that could potentially result in a 400bp-600bp tightening from current levels.

US CMBS triple-A spreads have already dropped by around 200bp, in some cases, and a number of investors have also moved back into the sector. Among them are those that are short-covering in the anticipation of spreads tightening, as well as money managers who are anticipating significant yields on credit-protected assets.

"In the CMBS market spreads are impacted by both technicals and fundamentals - but over the past few days CMBS technicals have really overwhelmed the fundamentals," says Precilla Tores, md of commercial real estate at NewOak Capital. "The anticipated availability of financing that will be provided by TALF is expected to attract more investors to the space, as levered returns on relatively credit-protected assets will generate returns in their target area, thus causing the spread tightening that occurred."

Yet only yesterday (31 March) Fitch reported that it expects commercial real estate loan defaults to increase and prepayments to continue to slow considerably during 2009, leading it to assign a negative outlook to the global commercial real estate market and CMBS ratings for the current year. Downgrades are expected to significantly outweigh upgrades in 2009 across all rating categories and ratings across the capital structure are expected to be hit, including double-A and triple-A bonds (see News Round-up).

"The tightening of spreads over the past few days should not be confused with a recovery in the market," Tores adds. "While much bad news is priced into spreads, the dynamics of real estate fundamental performance in response to the general economic dislocation is still unravelling."

She continues: "Spread movements are not necessarily an indication of fundamental performance. There are many factors at work, including available financing, forced selling and short covering, which can cause spreads to move in a direction unjustified by the fundamental expectation of performance."

In a conference call hosted earlier this week by JPMorgan, analysts predicted that TALF financing will be extremely powerful for CMBS. Although loan terms, loan sizes, haircut and lending rates are yet to be determined for the inclusion of CMBS, the analysts anticipate that - regardless of haircuts eventually imposed by the TALF - triple-A CMBS spreads will tighten by 400bp-600bp over swaps from their current level, with investors still likely to receive an approximate 20% levered yield. JPMorgan has made the assumption that the haircut will be between 15%-25%.

"It seems as though some sort of financing will soon be available, which should tighten cash market spreads. Investors with risk capital are looking at absolute returns - if financing is not available, then spreads have to widen out to compensate," Tores concludes.

AC

RMBS

Non-conforming concerns

Warning over future severity of losses for non-conforming RMBS

Loss severities revealed in investor reports last week for a number of UK non-conforming RMBS have shocked the market. But an analysis undertaken by one mortgage investment company indicates that losses could ultimately come close to impairing the principal repayments of single-A noteholders in the sector.

Quarterly losses for the RMAC 07-1, 06 NS3 and 06 NS4 transactions reached 45%, 37% and 33% respectively, according to the March investor reports. At the same time, Eurosail 07-1 - which was downgraded last week - is exhibiting total arrears of 45% and loss severities at almost 38%.

An analysis of a typical UK non-conforming RMBS that closed in March 2007 undertaken by specialist mortgage investment company Mars Capital shows that cumulative default rates in the sector could ultimately increase from 2.5% to 42%. "A mechanical process exists to work out loss given default based on house prices and the consensus appears to be that prices will see a peak-to-trough decline of around 40%; we estimate that the market has seen 25% so far," explains Matt Gilmour, md at the company. "What is less visible is the storm of defaults around the corner when non-conforming mortgages originated over the last 2-3 years begin building up significant negative equity and are unable to refinance."

The company projects that 90% of loans in 2007 pools, for example, will be in negative equity within the next 12 months. Furthermore, 60% of borrowers are already failing to refinance their mortgages because a realistic LTV is in excess of that offered by high street lenders (75%-80% is considered to be the norm now) and sub-prime mortgages are obviously no longer available.

High loss severity levels indicate that repossessed homes are being sold at far lower levels than house price indices would imply, according to securitisation research analysts at Deutsche Bank. This is potentially being driven by weak demand for housing increasing the quick sale discount, as well as adverse selection seeing houses with below-index price growth repossessed more frequently.

"Weaker origination practices in the bull housing market should perhaps not be ruled out, however. While older vintages are also seeing rises, the lower [loss severity] levels and deal deleverage mean that such transactions are typically more resilient," the analysts add.

In terms of borrowers defaulting, their ability to pay is tricky to assess because, although the current low interest rate environment means that many loans are resetting to floating rates lower than their initial fixed rates, interest rates will go up again - thereby impairing many borrowers' ability to pay, especially if combined with unemployment. Willingness to pay, however, depends on whether there is any equity left in a property to protect. Added to this, many borrowers are heavily indebted with unsecured personal finance, creating severe stress on household income and so bankruptcy becomes an easier decision to make.

Consequently, from an investor's perspective, extension risk is significant because prepayments are likely to dry up. Although it depends on the pool, Mars Capital estimates that triple-A noteholders will likely have seven to eight years of duration left to bear on their non-conforming 2007 RMBS investments. Additionally, 2% of underlying loans are expected to move from performing to arrears every month, with transaction reserve funds being wiped out within 14 months.

"In this scenario losses come close to impairing the principal repayments of single-A noteholders," warns Gilmour. "Gross credit enhancement levels suggest that double-A bonds will default, but ultimately it depends on a deal's excess spread and how much it will offset losses."

Rating agencies are, however, currently making far less severe assumptions (in the low single-digit region) with respect to losses in the sector. Gilmour says that Mars has analysed around £5bn worth of both performing and non-performing whole loans, which provided access to data that isn't normally publicly available. The granularity of this information has thus given the company increased visibility as to the likelihood of loan performance.

By way of comparison, while servicers have access to this underlying data, they don't have the mandate to make it accessible to investors in a consistent manner. "Servicers' hands are tied within the confines of securitisation documents and the conflicts of interest among different noteholders. Information is key, but it isn't readily available to investors," confirms Gilmour.

Mars aims to bring clarity to this process by, for example, offering an independent view on a distressed deal's performance for those making the decision to buy, sell or hold. However, the caveat is that UK non-conforming bond cashflows suggest that they trade at a level too low to capture any value.

"We believe that indicative market values are overly conservative, given the cashflow expectations, which is due in part to the lack of transparency in the secondary markets," Gilmour concludes.

CS

CLOs

Triple-A CLOs to feel the heat?

Moody's has completed the first stage of its two-stage review of US and EMEA cashflow CLOs that it announced on 4 March. As of 23 March, the agency had downgraded approximately 2,071 tranches from 668 transactions, totalling US$46bn. Analysts now expect certain triple-A rated CLOs to be impacted in the second stage of the review.

Structured credit strategists at JPMorgan note that, while downgrade ratios for mezzanine-rated CLO tranches are already at shocking levels as per the Moody's mass re-rating, from a market perspective arguably the worst is yet to come. Valuations have dropped to IO-type levels for the sector over the last 6-12 months so in any case, the market had already re-rated the bonds to the probability of receiving very little interest and possibly some principal at the very back end.

"While the triple-A downgrade ratio is still close to 0%, it is only a matter of time before Moody's examines triple-A rated tranches on a case-by-case basis in Stage 2," the strategists explain. "Although Moody's has not necessarily been as clear as some of the other rating agencies in terms of the average rating notch impact on triple-As, if we were to use our expectations we expect the average triple-A will drift to a Aa-type rating in the coming weeks and months, with weak transactions trending even lower to single-A or Baa at that stage."

Some price declines are likely for even the best quality triple-A bonds, according to the strategists, albeit by a matter of points - providing the top-quality triple-As (trading in the mid-70s to low-80s) remain at least Aa3 rated. For mid-tier triple-As in the 50s to 60s range, bonds that remain at least investment grade may also experience price declines in the points (and not tens of points) range.

All tranches downgraded during the first stage of Moody's review were previously rated single-A or below. Of the 2,071 affected tranches, 50% were downgraded by four notches, 33% by five notches and the remaining 17% by six to eight notches. A total of 1,604 downgraded tranches were from 528 US CLOs, with the remainder from European securitisations.

During this first stage, the agency also placed 36 senior-most triple-A CLO tranches on review for downgrade. These negative review decisions were a result of significantly weaker than average structures and portfolio performance.

On 4 March, Moody's announced that it had placed nearly all rated tranches of US and EMEA cashflow CLOs on review for possible downgrade, except for the most senior triple-A rated tranches (SCI passim). This affected approximately 3,600 tranches totalling US$100bn from 760 transactions.

The action followed a revision of certain key assumptions that the agency uses to rate and monitor CLOs. These revised assumptions incorporate Moody's expectation that corporate default rates are likely to greatly exceed their historical long-term averages and reflect the heightened interdependence of credit markets in the current global economic contraction.

In the completed Stage I review, Moody's used a parameter-based approach for most cashflow CLOs to calibrate downgrades of tranches rated single-A and below. In Stage II, which will begin immediately, Moody's will perform a more comprehensive analysis by modelling each CLO individually, including all deals that were analysed in Stage I.

At that time, additional rating actions will be taken as necessary for all rated liabilities, including tranches currently rated Aa and Aaa. Although Moody's expects most senior triple-A ratings to be confirmed, there will be a number that will be downgraded, in most cases to the double-A rating category, the agency says.

CS & AC

CLOs

Manager modifies discount obligation definition

Cypress Tree Investment Management has successfully modified the definition of the discount obligation in two of its CLOs - the Hewett's Island CLO V and VI deals. The amendment allows the issuer to purchase assets at discounted prices using proceeds from the sale of an existing asset that was not a discount obligation at the time it was purchased and, subject to certain conditions, to have such purchased assets excluded from treatment as discount obligations.

These conditions include: (i) the purchased obligation being purchased at a price at least equal to the sale price of the obligation sold and not less than 65% of par; and (ii) having a default probability rating at least equal to that of the obligation sold. The aggregate par amount of purchased assets excluded from treatment as discount obligations must not be more than: (i) 5% of the pool par amount (or 2.5% of the pool par amount if such obligations have been purchased at an average price less than 75% of par) at the time of such measurement; and (ii) 10% of the initial pool par amount when considering all such assets purchased since the closing date up to the time of such measurement.

The modification conforms in its entirety with Moody's methodology, the rating agency reports, and it has not taken any rating actions on the deals as a result.

AC

Indices

Sovereign CDS index debuts

Credit Derivatives Research (CDR) has launched the first index designed to track the credit risk of leading industrial nations' sovereign debt. The new CDR Government Risk Index (GRI) provides a unique indicator of investors' growing concerns over burgeoning government debt and is expected to be useful in tracking sovereign risk over time, as well as comparing sovereign risk to corporate risk.

The GRI tracks the CDS spreads of the US, the UK, Germany, France, Italy, Spain and Japan. The index began to skyrocket last autumn, rising from 20bp to a high of 120bp in January and February this year, with all of the components widening together. Recently the index has traded tighter - see data.

"Rapidly increasing budget deficits and debt levels, nationalisation of large failing financial institutions, deepening recessions, disproportionate foreign holdings (e.g. by China) and loosening monetary policies have led many investors seriously to consider the possibility of a credit event by one of the major sovereign borrowers, or at least to speculate on their credit quality," comments Arthur Rosenzweig, president of CDR.

CDR also publishes the widely followed Counterparty Risk Index (CRI), which tracks the credit risk of the fourteen banks that are the most prominent credit derivative counterparties. "The GRI and the CRI are not as correlated as you might suppose," says Dave Klein, manager of CDR's credit indices. "Initially, government risk lagged concern over the large financials. More recently, the difference of CDS levels between the two groups varied on investors' perception of nationalisation risk."

CDS on Treasuries now trade near 70bp, up from 20bp last autumn. In other words, US sovereign CDS now trade well above where the CDS of the major banks traded at the beginning of the credit crisis two years ago, CDR notes. The current CDS spread levels of the other countries in the GRI are 115 for the UK, 55 for Germany, 60 for France, 145 for Italy, 105 for Spain and 90 for Japan.

CS

Ratings

Analysts criticise SF rating consistency

Securitisation analysts at UniCredit have criticised Moody's decision to include Geldilux transactions, issued by HVB, among those SME CLOs put on review for downgrade last week (see last week's issue). They note that the comprehensive mass-review by Moody's - with potential negative implications for sound performing senior notes, such as those in Geldilux - is a further example of rating agencies' current "bustling activity given the serious economic downturn".

"While agencies have become much more conservative, uncertainty about rating consistency has become very high, especially in the structured finance sector [see also separate News Analysis]," the analysts say.

They report that the current performance of Geldilux transactions is exceptionally good and eventual pool deterioration is well protected by triggers. All trigger levels at present are far away from being breached and, moreover, the Geldilux definition of default is much tighter than in other transactions, since loans are classified as defaulted if they are more than 30 days overdue (rather than the usual 90 days). Overall delinquencies have been negligible, defaults minimal and losses none, according to UniCredit.

"The potential downgrade for Geldilux 2008 by Moody's also raises questions about rating consistency from a timing perspective," the analysts add. "Moody's assigned ratings on the Geldilux 2008 transaction based on credit enhancement provisions one year ago when the credit crisis was already in full swing. Any downgrade/revision of last year's assigned ratings one year later would automatically raise doubts as to whether the agency has failed to really fully rate through the cycle."

UniCredit's view on Geldliux is also underlined by market spreads. "When comparing average German SME CLO spreads (excluding mezzanine CLOs), the Geldilux transaction-specific spread was quoted, in general, lower over the past one and a half years of spread widening, which reflects lower risk and higher liquidity associated with this specific type of CLO," the analysts conclude.

AC

Ex-Lehman ABS director hired for sukuk fund

The latest company and people moves

European Finance House (EFH) has appointed Aleksandar Devic as fund manager of its soon-to-be-launched Global Sukuk Fund. Devic was formerly a director on the securitised products research desk at Lehman Brothers in London.

At EFH Devic will be responsible for managing the new Luxembourg-based Global Sukuk portfolio launched from EFH's Shariah-compliant mutual fund platform. In addition, he will be working with the team on the bank's ongoing structured note issuance programme.

CRE CDO exec recruited
CWCapital Investments (CWCI), a commercial real estate investment management firm, has hired Anthony Sfarra as svp. Sfarra is charged with expanding CWCI's separate account investment management business.

His specific duties include developing new business opportunities, creating investment joint ventures with financial institutions, establishing structured financing vehicles for clients and raising equity for new investment funds. He reports to Hugh Hall, an md at CWCI.

Sfarra was previously executive director at Morgan Stanley, where he was involved in the execution of over US$100bn in CMBS and CRE CDOs, financial institution coverage and capital raising. Prior to Morgan Stanley, Sfarra worked as a director at Fitch in its commercial real estate group.

Bank hires two for ABS push
Sandler O'Neill has appointed Thomas Oh and Christopher Connors to its fixed income group. Connors is an md working in fixed income sales and Oh is an associate director working in fixed income trading.

Both are based in Sandler O'Neill's New York offices. Together, the two have more than 25 years of ABS experience and have been hired to establish the firm as a key player in the ABS market.

Connors most recently worked as md at Banc of America Securities, where he spent seven years running its ABS secondary desk in New York and London. In late 2008 Connors moved into institutional sales.

Oh joins Sandler O'Neill after spending ten years with Credit Suisse as a member of its structured products group, where he held a variety of positions focused on ABS. Most recently he served as vp and dealt specifically with consumer and residential products.

Both Connors and Oh report to Alan Roth, a principal at Sandler O'Neill responsible for building out the fixed income business.

Structured credit advisory firm expands
Shooters Hill Capital, the structured credit advisory firm established by ex-FSA staffers Zeshan Ashiq and Farook Ahmad, has hired Martin McDermott, a former director of European capital markets at CIFG. At CIFG McDermott managed the European ABS and CDO portfolio.

Before working at CIFG, he spent four years at MBIA UK Insurance (London/Paris) as a director of structured credit. He also spent time as a CDO product manager on the structured debt syndicate of Société Générale in London. Back in 1999, McDermott was a manager at Enron Credit, where he set up its credit trading and CDO arbitrage business.

According to Ashiq, McDermott's hire will enable the firm to expand its growing advisory franchise in multiple areas, such as ABS/CDO portfolio valuation and restructurings.

Firm taps Deutsche for RMBS structurer
NewOak Capital has appointed Samuel Warren as director of RMBS structured solutions to direct the firm's RMBS structuring solutions team. Warren was previously an MBS trader at Deutsche Bank, most recently responsible for the issuance of over US$8bn in re-REMIC securitisations.

Prior to that, at Deutsche Bank Warren led the Alt-A new issue team of the MBS trading desk, which issued over US$20bn of securities. He also previously worked at Lehman Brothers, where he was a member of the banking and structuring team, which completed US$9bn of RMBS/HEQ issuance and created multiple ABCP conduits for third parties.

"Non-agency mortgages continue to be a source of concern for many financial institutions because of continued credit deterioration and lack of clarity as to the impact of the new government programmes. Sam brings a great deal of structuring and loan experience in the residential mortgage space and complements our deep bench," says Ron D'Vari, ceo and co-founder of NewOak Capital.

"Sam brings a wealth of experience and a successful track record in the restructuring of clients' structured credit portfolios to NewOak Capital. Sam is joining a group that already has a great deal of depth in the RMBS, CMBS and CDO/CLO space and we're excited to be adding such a strong leader for a strategy that we believe is a timely solution for a number of our clients", adds James Frischling, president and co-founder of NewOak Capital.

NewOak has also hired Fan Huang as an associate. Huang has five years of experience at Woori Global Markets Asia, Deutsche Bank and S&P. At Deutsche Bank, Huang was an associate in the structured products group focusing on re-REMICs, RMBS and mortgage loan acquisitions. In her new role she will be working with Warren to secure and execute risk management and restructuring strategies for a broad array of financial institutions and money managers.

In addition, Krystle Tharani has joined NewOak as an associate, moving over from Fidelity Investments, where she focused on ABCP conduits, CLOs and municipal derivatives. She will be supporting the firm's marketing/sales team through the use of market research and her prior knowledge of the structured market to grow NewOak's advisory client base as well as its asset management arm.

Inter-dealer broker hires EM head
Niels Nooy has joined the London office of Phoenix Partners Group as European head of emerging markets. Nooy will be responsible for the day-to-day running of the emerging markets area, reporting to partner Alex Hucklesby.

Nooy joins Phoenix Partners from Global Evolution in Denmark, an emerging market asset manager, where he was head of international sales and distribution across all products, including long-only funds, CDOs and hedge funds. Prior to this, he was at Merrill Lynch for four years trading emerging markets debt with a focus on Russia and Eastern Europe.

EM securitisation pro hired
ANZ has appointed Drew Riethmuller as global head of financial institutions and public sector. Riethmuller returns to Australia after a 17-year career with Citibank, most recently in London as European head of non-financial institutions, conduits and emerging markets. During his time at Citi, Riethmuller was involved with a number of benchmark emerging market securitisations.

Prior to this, he worked in Sydney with Citibank and Salomon Smith Barney, where he was co-head of securitisation for Australia and New Zealand, and head of product management/vp retail funds management.

Asset manager hires chief economist
Martin Hüfner has joined Assenagon Group as chief economist. Hüfner has previously been a director of the economics department of Deutsche Bank in Frankfurt and chief economist of HypoVereinsbank in Munich.

He was the first chairman of the Economic and Monetary Affairs Committee of the European Banking Association in Brussels. In addition, he spent ten years as deputy chairman of the Economic and Monetary Policy Committee of the German Banking Association.

"We are happy to have won one of the most renown German bank economists for our company," says Hans Günther Bonk, founding partner of Assenagon.

Firms team up for illiquid trading solution
Broadridge Financial Solutions and Beacon Capital Strategies have announced a multi-year strategic alliance. Through this alliance, the firms say they are positioned to better serve their clients who actively trade less liquid fixed income securities, including agency MBS, ABS and CMOs.

Broadridge is a fixed income securities processing provider and currently handles on average over US$3trn in notional value of US fixed income securities transactions daily. Beacon established the first trading platform tailored to the specific dynamics of the less liquid fixed income market, which is open to all participants on an anonymous and equal basis. This alliance is expected to help the firms' clients locate difficult-to-find securities in the less liquid fixed income segment, thereby enhancing liquidity and efficiency to the overall marketplace.

By utilising Broadridge's Impact and MBS Expert products and Beacon's Trade Discovery platform, clients will be able to search through the largest universe of less liquid fixed income securities, find the other side of the trade for instruments that meet specific investment criteria and transact on liquidity that otherwise would not be publicly advertised in current trading channels.

Alternative investment firms develop FOF product
Ramius Fund of Funds Group and Hatteras Capital Investment Management have entered into a joint venture to develop and manage an institutional-quality fund of funds product for the US financial adviser market. Preliminary registration statements for Hatteras Ramius 1099 Fund and Hatteras Ramius 1099 Institutional Fund were filed on 27 March.

Thomas Strauss, ceo of Ramius Fund of Funds Group and a managing member of Ramius, states: "We are very pleased that Hatteras has chosen to partner with Ramius to develop alternative investment products for their client base. The timing of this venture coincides with what we believe is an excellent opportunity set in alternative investments and we look forward to working with Hatteras."

Fitch reshuffles senior SF roles
Fitch has reshuffled responsibilities among its most senior ABS and structured credit staff following the departure of John Bonfiglio, head of US structured finance, and the appointment of Kevin Duignan, former head of the US ABS group, to head of global corporate communications.

Duignan was a senior analyst in Fitch's US structured finance group for 15 years and head of the US ABS group for the past four years. Group md John Olert will now oversee the US ABS group in addition to his current responsibilities for US structured credit.

Bonfiglio, who was named head of US structured finance in early 2007, led the US RMBS and US CMBS group. He has left the company to pursue other interests. Group md Huxley Sommerville will assume Bonfiglio's responsibilities.

Reval opens Hong Kong office
Reval has opened a Hong Kong office and has appointed Will Marsden as sales director, Asia. Marsden joins Reval from Mergermarket, where he was responsible for setting up, recruiting and leading the sales team for the launch of the Asia Pacific data-set and for growing the business in the region.

"There has been strong demand in the region for Reval's derivative risk management and hedge accounting solutions from financial institutions and corporations seeking compliance with IAS 39 regulations for hedge effectiveness," comments Jiro Okochi, ceo and co-founder of Reval.

SF lawyer appointed to Middle East office
Norton Rose has appointed Donald Francoeur to its Middle East practice as a banking and projects senior legal counsel based in Riyadh. Francoeur specialises in project finance, structured finance and debt capital markets, with additional experience in joint ventures and cross-border mergers and acquisitions. His appointment is expected to enhance Norton Rose's offering in project finance, structured finance and debt capital markets.

Opportunity fund reports 222.8% net gain
Mooring Intrepid Opportunity Fund delivered a net gain to investors of 222.8% for the two-year period from inception on 1 March 2007 through to 28 February 2009. Year-to-date through to 28 February 2009 the fund showed a net gain of 21.7%.

Mooring Intrepid Opportunity Fund invests across multiple strategies, starting with a disciplined top-down macroeconomic outlook. The fund's managers then target favourable sectors for long and short positions, and perform bottom-up analysis of individual investments within those sectors.

ISDA Determinations Committees announced
ISDA has announced the composition of the Credit Derivatives Determinations Committees, a key element of the CDS hardwiring process through which the auction settlement provisions are incorporated into the 2003 ISDA Credit Derivatives Definitions. As of 8 April, the Determinations Committees will make binding determinations, such as whether a credit event has occurred, whether an auction will be held and what obligations are deliverable for purposes of the auction.

There will be one Committee for each region, each comprising ten dealers and five non-dealer (buy-side) members (SCI passim). Under the Determinations Committees Rules, the dealer group comprises the eight largest global dealers that are common to each Committee, and the two largest dealers in the relevant region measured by reference to CDS trade volumes provided by the DTCC. The buy-side members are selected at random from ISDA's Non-dealer Committee, which is made up of hedge funds, traditional asset managers and other non-dealer financial institutions. Each Committee will also include two non-voting dealers, one non-voting regional dealer per region and one non-voting non-dealer member.

Dealer members comprise: Bank of America/Merrill Lynch, Barclays, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley, RBS and UBS. Non-dealer members comprise: Elliott Management Corporation, Legal & General Investment Management, PIMCO, Primus Asset Management and Rabobank International. The dealer and non-dealer voting members are the same for all regions (Americas, EMEA, Japan, Asia Ex-Japan and Australia/New Zealand).

Global non-voting dealers (for all regions) are BNP Paribas and HSBC, while the regional non-voting dealer (for Americas, Europe, Japan and Australia/New Zealand) is Societe Generale. The regional non-voting dealer (for Asia Ex-Japan is Standard Chartered and the non-voting non-dealer (for all regions) is Prudential Investment Management.

AC & CS

Regulatory reform plan unveiled

A round up of this week's structured credit news

US Treasury Secretary Tim Geithner revealed his proposed regulatory reform programme on Monday, 30 March. The programme comprises four broad components, further details of which will be presented in the coming weeks: addressing systemic risk; protecting consumers and investors; eliminating gaps in the regulatory structure; and fostering international coordination.

Geithner's testimony before congress focused on systemic risk because financial stability is critical to economic recovery and growth, and because systemic risk is expected to be a primary focus for discussions at the G20 Leaders' Meeting on 2 April. He plans to tackle systemic risk by introducing: a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems; higher standards on capital and risk management for systemically important firms; registration of all hedge fund advisers with assets under management above a moderate threshold; a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market; and new requirements for money market funds to reduce the risk of rapid withdrawals.

Among other aspects, the plan encompasses regulating CDS and OTC derivatives and subjecting all dealers in OTC derivative markets to a strong regulatory and supervisory regime as systemically important firms. Additionally, all standardised OTC derivative contracts will be "forced" to be cleared through central counterparties, while non-standardised derivatives will also be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices and close-out practices.

Central counterparties and trade repositories will also be required to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to appropriate federal regulators.

Derivatives losses revealed
US commercial banks reported a US$9.2bn trading loss for Q408, according to the Office of the Comptroller of the Currency in its 'Quarterly Report on Bank Trading and Derivatives Activities'. For 2008, banks reported an annual trading loss of US$836m, compared to trading revenues of US$5.5bn in 2007.

"While banks reported reasonably strong client demand and wide intermediation spreads in the fourth quarter, large write-downs on legacy credit positions continued to take a toll on trading results," explains deputy comptroller for credit and market risk Kathryn Dick. "Trading results continue to reflect large changes in the fair values of derivatives receivables and payables, based upon market participants' views of the credit quality of both banks and their counterparties."

She adds that trading results suffered from an unfavourable combination of higher overall corporate credit spreads and lower bank credit spreads, each of which result in trading losses.

The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$25trn (14%) in the fourth quarter to US$200trn. The increase resulted from the migration of investment bank derivatives activity into the commercial banking system. Credit derivatives fell 2% to US$16trn.

The OCC also reported that net current credit exposure, the primary metric the OCC uses to measure credit risk in derivatives activities, increased by US$364bn, or 84%, during the quarter to US$800bn. Dick also notes that, similar to the notional derivatives increase, migration of derivatives activity from investment banks into the commercial banking system accelerated the growth in credit exposure.

Among other things, the report also noted that:

• Derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 96% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%.
• CDS are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.
• The number of commercial banks holding derivatives increased by 33 in the quarter to 1,010.

Commerzbank details bad-bank plans
Commerzbank has revealed its plans to de-risk its balance sheet by transferring a number of problematic structured finance assets into a 'divisional restructuring unit' (DRU). In a presentation given on Friday, the bank stated that - via the planned de-risking by the DRU, in particular in the area of structured finance - it expects a significant decrease in credit spread during the course of 2009.

Commerzbank estimates that the management of its ABS portfolio, together with its leveraged acquisition finance portfolio poses the greatest challenge in 2009. It has published details of the assets it currently holds, which show that government-wrapped ABS amounting to €5.8bn constitute the biggest sub-asset class on its books.

Of the €5.8bn, some €4.1bn constitutes US student loan ABS. Negative P&L effects are not expected on the student loan ABS assets; however, the bank sees further P&L risks with regard to its CDO (€2.3bn US ABS CDO), RMBS (€0.9bn US RMBS and €2.6bn non-US RMBS) and CMBS (€1.3bn CMBS/CRE CDO) positions.

The bank also says the economic value of its ABS positions hedged by monolines are in doubt. The current replacement value of the relevant CDS hedges amounts to €2.6bn, it estimates.

K2, the former Dresdner Kleinwort SIV taken on by Commerzbank last year, resulted in a P&L hit in 2008 of €681m, due to market value deterioration of the assets. However, the bank says it sees potential for write-ups in the case of a market recovery, given the good quality of the ABS portfolio.

Station Casinos settled ...
Markit and Creditex, in partnership with credit derivative dealers, have announced the results of a credit event auction conducted to facilitate settlement of CDS trades referencing Station Casinos Inc. The final price of Station Casinos bonds for the purpose of settling CDS transactions was determined to be 32% of par value.

According to analysts at Credit Derivatives Research, this is the second auction in a row where the final price was above the IMM, but it also received the lowest total bid on record at US$42m. Additionally, the bid-to-cover of 57% was huge compared to previous auctions. The highest bids were from RBS and Credit Suisse.

... while four more credit events are announced
ISDA is to launch CDS auction protocols to facilitate the settlement of CDS trades referencing Idearc Inc, Abitibi-Consolidated Inc, Charter Communications Holdings and Capmark Financial Group Inc. In addition, Markit LCDX index dealers have voted to run a credit event auction to facilitate settlement of LCDS trades referencing Charter Communications Inc.

Idearc Inc, the Dallas-based phone-directory publisher, has filed voluntary petitions to reorganise under Chapter 11 of the US Bankruptcy Code. AbitibiBowater, which was formed in 2007 through the merger of US-based Bowater and Canada's Abitibi-Consolidated, failed to make a payment on its loan debt on 13 March, while Charter filed a Chapter 11 petition in the US Bankruptcy Court for the Southern District of New York at the end of last week. On 24 March Capmark announced that it failed to make a payment due on its bridge loan agreement that matured on 23 March.

The auctions for Capmark and Idearc bonds have tentatively been scheduled for 22 and 23 April respectively. In addition, LCDX dealers are expected to vote on whether to hold an auction for LCDS transactions referencing Idearc.

New counterparty risk criteria options proposed
Fitch is proposing new counterparty risk criteria options, reflecting concerns that structural mechanisms based around counterparty triggers alone may not be sufficient to isolate securitisation transactions from the credit risk of the counterparties on which they rely. The agency is seeking market feedback on these new proposals.

The new criteria options address the potential interaction between rating triggers and so-called 'cliff' risk, which has been highlighted by recent bank failures. This relationship can itself undermine the effectiveness of rating triggers as a mitigating factor, as the extent of actions which have to be taken on trigger breaches can further impact the counterparty's credit profile in the near term. Other aspects discussed include jump-to-default risk and the relative ability to replace counterparties when necessary.

"Fitch's proposed criteria options suggest that there are a number of alternatives to the current approach, including posting collateral from day one, raising triggers to higher levels or supplementing rating triggers with Fitch's support floor ratings. All provide enhanced mitigants to problems, such as cliff risk, but equally each option has its own drawbacks as well as advantages," says Stuart Jennings, md at Fitch.

Fitch is planning to update its structured finance counterparty criteria to reflect the significant evolution in the market environment in recent months. Following extensive internal discussion and analysis, the agency has published an exposure draft in which it outlines a number of possible options through which counterparty risk could be addressed in the rating of structured finance transactions. Given generally increased counterparty risk for structured finance transactions, Fitch believes that existing structural protections based around rating triggers need to be either supplemented or replaced.

"Likelihood of counterparty replacement has also been a focus of the review. Esoteric and off-market counterparty positions have always been a feature of structured finance transactions," says Andreas Wilgen, senior director at Fitch Ratings. "Sourcing replacement counterparties for the most 'plain vanilla' counterparty exposure in the current market environment is difficult. The exposure draft also examines ways in which the replaceability of a counterparty position might be better assessed."

Fitch recognises that - depending upon market reaction - changing counterparty criteria with respect to its structured finance ratings could have an impact on its ratings. It could also impact the way market participants choose to address counterparty risk when structuring new transactions.

The intention of the report is to open a dialogue with the market on this issue and the options outlined, with the aim of gathering extra information and hearing different points of view. In particular, the agency invites comments on the various questions that are framed throughout the report. The information gathered will be factored into developing the final criteria amendments to be developed after the consultation period.

EC consults on resecuritisation risk-weightings
The European Commission has opened a public consultation on further risk-weighting penalties for resecuritised products, such as CDO-squareds. ABS analysts at SG note that potential higher risk weightings would reflect the complexity and illiquidity of such bonds, which have the potential to destabilise the banking system.

Market participants have until 29 April to make counter proposals. The new proposal is based on three elements:

• strengthening trading book capital requirements. The trading book securitisation position could be given the same risk-weighting (RW) treatment as the banking book position. However, this might be overruled by the Basel Committee's proposal to apply 100% RW to all net positions in the trading book;
• raising capital charges for certain kinds of securitisation exposure. Resecuritised products such as ABS CDOs or CDO-squareds would have a special RW grid, with a potentially dilutive capital charge;
• upgrading risk management and disclosure standards for securitisation positions. The Commission is open to any necessary changes, but considers that the European legal framework is sufficient at this stage and coherent with the recommendations of the Basel Committee. If necessary, the Commission is ready to implement further disclosure standards following accordance with requests from regulatory bodies.

CSO manager actions scrutinised
Fitch says in a new special comment that the ability of IG CSO managers to trade has been dramatically reduced, due to structural constraints, a lack of market liquidity and unprecedented spread widening. These liquidity and operating pressures have partly resulted from a reduction in the number of credit derivatives dealers and the capital allocation to correlation desks, the agency explains.

In this context, IG CSO managers have refrained from executing trades that would reduce the amount of available subordination or would result in a breach of one or more other portfolio parameters. This has led to a number of transactions becoming virtually unmanageable, leaving them exposed to potential credit events.

Fitch says that the commentary is intended to highlight several key factors hindering the ability of IG CSO managers to trade and what solutions market participants are considering in an attempt to improve the situation. For example, certain managers have shifted their primary investment objectives to preservation of capital from avoidance of tranche downgrades.

This entails the maximisation of the protection levels in order to absorb any potential losses resulting from a credit event or removal of a distressed name. As such, certain managers have stopped managing to a model for tactical spread/rating or tranche pricing optimisation, preferring to base their investment decisions on their own fundamental credit views.

Furthermore, most corporate synthetic CDO managers rated or reviewed by Fitch have attempted to increase the protection levels across the CDOs in order to absorb any potential loss from rising idiosyncratic risk. To do so, they increased their portfolio allocations to defensive sectors ahead of the downturn in 2007 and intensified their efforts until mid-2008, when trading conditions deteriorated further.

However, in most cases, managers were unable to implement their targeted allocations, due to the cost of substitution, initial portfolio industry and obligor concentrations and limited subordination.

Beyond a change in the overall management of the transaction, CSO managers have also pursued other paths in an attempt to relieve liquidity and operating pressures currently facing such transactions. These actions include increasing dialogue with arrangers and CDS traders regarding subordination calculations and price quotes to achieve fair pricing.

ABX ...
Default rates for the Markit ABX index in March rose to reach 18.87%, 22.15%, 18.96% and 17.35% for the 06-1 through 07-2 series respectively. CDR numbers have generally levelled off, likely reflecting the effects of foreclosure moratoriums and loan modification programmes, as well as seasonal and day count factors, according to structured credit strategists at JPMorgan.

60+ delinquencies are above 40% across all of the indices, while 90+ delinquencies and foreclosure buckets continue to increase. Cumulative losses increased by 83bp for the 07-2 index to reach 8.09% and rose by approximately 60bp-70bp for the other indices.

Out of the 480 ABX constituents, 66 deals have now been depleted, while a number of new tranches have begun taking write-downs concentrated in the 06-2 index. MSAC 06-WMC2 M-5 (06-2 constituent) and LBMLT 06-6 M-5 (07-1 constituent) continue to be the only single-As that have been written down completely, and the tranches currently taking write-downs are the ones second junior to the double-As.

"To-date, the 06-2 and 07-1 indices have been hit the hardest by write-downs and we expect that trend to continue; the 06-1 index is a better performer and therefore will not experience as serious write-downs as the more recent vintages, and the 07-2 is still not seasoned enough to be in line with the previous indices. It is only a matter of timing when the write-downs will come in at an increased speed for the 07-2 index," the JPMorgan strategists conclude.

... and CMBX remits in
US CMBS performance continues to deteriorate: the latest remits show that the overall 30+ days delinquency rate across the fixed rate universe rose by 28bp, to 1.98%. The pace of increase is slightly higher than the average 23bp jump over the past four months, note ABS analysts at Barclays Capital.

The delinquency rate of the 2000-2004 vintage loans over the past few months had been stable, but this month saw a 25bp increase in line with the more recent vintages. Across CMBX, Series 4 led the increase in non-performing loans with a 42bp jump, while CMBX.1 remained a relative outperformer.

Multifamily showed the biggest uptick among the recent vintage loans by property type in terms of 30+ day delinquencies, followed by retail. Multifamily delinquency rates are above 3% for all vintage stratifications, according to the BarCap analysts. They also note that a large volume of multifamily loans transferred to special servicing-current status in recent months.

"The volume of loans in special servicing-current status suggests that the pace of new delinquencies will increase," they explain. "For example, across 2007+ vintages, it is 1.21%, up 43bp from last month. Most of the loans entering special servicing-current status are aggressively underwritten pro forma loans, and we expect further deterioration."

Meanwhile, credit strategists at BNP Paribas note that, while the Geithner plan has had little impact on ABX.HE triple-A tranches, CMBX triple-As have rallied strongly. They suggest that this indicates that banks are more likely to sell their toxic commercial real estate portfolios than their housing portfolios, as the consumer recession gains strength going forward and unemployment has a significant impact on retail and office space.

Freddie Mac brings Reverse REMIC
Freddie Mac is to offer Reverse REMIC Giant PC securities, a new mortgage-related security intended to provide liquidity to the US residential mortgage market and new options for investors. The programme permits a pro-rata portion of all outstanding Freddie Mac REMIC security classes from a previously issued REMIC group - which, in aggregate, constitute a pass-through from the mortgage collateral backing the original REMIC group - to be recombined into a pass-through re-REMIC class. This pass-through re-REMIC class in turn becomes the collateral backing a new Freddie Mac Giant PC security that is eligible collateral for all Freddie Mac resecuritisation programmes.

Additionally, if the collateral backing the original REMIC met SIFMA TBA (to be announced) market good-delivery guidelines at origination, the new Giant security will also meet those same good-delivery guidelines.

"Freddie Mac Reverse REMIC Giant PC securities are designed to provide a new, additional dimension of liquidity to the residential mortgage-backed securities market," says Mark Hanson, vp for mortgage funding at Freddie Mac. "Historically, remaining tranches in REMIC securities lacked the liquidity sought by investors. Freddie Mac Reverse REMIC securities provide a new alternative investment vehicle by converting them into Freddie Mac Giant PC securities."

Barclays rejects APS participation
Barclays has announced that it will not participate in HM Treasury's Asset Protection Scheme (APS). In a statement, the bank said the board of Barclays determined that it would not be in the interests of its investors, depositors and clients to participate in the scheme.

Last week Barclays confirmed that its capital position and resources were expected to meet the capital requirements of the UK FSA after application of a detailed stress test to determine resilience to stressed credit risk, market risk and economic conditions.

Barclays says it continues to manage its balance sheet and capital position actively. Since the beginning of 2009, the bank has continued to sell credit market exposures following the disposals effected in 2008, and has done so at or around their carrying values.

Trading the XO range
Structured credit analysts at Barclays Capital expect Series 11 of the Markit Crossover index to trade in a 750bp-1050bp range for the next three months. The target reflects the intrinsically higher quality of the index, with any potential widening to the top of the range based on earnings disappointments for individual credits. Consequently, the analysts recommend trading the range by buying crossover protection under 750bp and selling protection beyond 1050bp.

Series 11 is currently exhibiting a -47bp skew. For the short term at least, the analysts expect more skew trading to occur, albeit the average skew on S11 is likely to be narrower than that of S10.

Meanwhile, with the market pricing in short-term default risk, BarCap expects the 5s/10s curve to stay inverted - if not flatten - at the current inversion of -171bp. Given the volatility on the index, the analysts prefer using the curve on single name default views rather than the index.

"We would execute on curve trades in the single name level, as some of these names are overpricing in front-end default risk," the analysts note. "The trades work on names that we do not expect to default over the course of the next year... Selling six months to one-year protection on a buy-and-hold basis is an attractive opportunity to add alpha to a portfolio."

Call for CDS transparency
CDS interdealer broker IDX Capital has submitted a petition to the SEC in response to the Commission's File Number S7-02-09, 'Temporary Exemptions for Eligible Credit Default Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default Swaps'. The firm's ceo Jamie Cawley comments in an open letter that "we have been an outspoken proponent of regulatory oversight and execution transparency since our founding in 2006. We strongly support the SEC's recent efforts to promote central counterparty clearing of credit default swaps."

The letter calls on other market participants to embrace a dialogue with regulators and "embrace the electronification of the asset class, so that we can prevent future events that threaten systemic risk". Cawley expounds on the need for transparency in credit derivatives, as well as the benefits of openness and fair dealing.

'Unique' CLO structure launched
Moody's has assigned a Aa3 rating to the US$560.79m Class A notes issued by KKR Financial CLO 2009-1, a managed cashflow deal backed by a portfolio of primarily US senior secured leveraged loans. The transaction structure is unique in a number of ways, according to the rating agency.

KKR CLO 2009-1's portfolio at closing will be entirely transferred from an existing market value CDO - Wayzata Funding - that closed in November 2007, with the original noteholders reimbursed at through delivery of the new notes. Clawback risk is consequently a potential issue on the transferred portfolio if Wayzata went bankrupt, although this is primarily mitigated by the fact that Wayzata is a bankruptcy-remote orphan SPV.

The final legal transfer of all obligations included in the initial portfolio may not be achievable at closing date and Wayzata will hold title to some of these obligations until final transfer. KKR CLO 2009-1 will remain exposed to some risk from Wayzata's legal title to these assets until the transfer is perfected.

51% of the shares issued by KKR CLO 2009-1 will be owned by an affiliate of KKR, while the remainder will be owned by an independent share trustee. The deal lacks the degree of independent ownership from that of KKR that Moody's would normally expect to achieve the level of bankruptcy-remoteness necessary for an issuer in a rated structured finance transaction. The absence of independent ownership is mitigated by the requirement in the constitutional documents of KKR CLO 2009-1 for a special majority vote of shareholders (equivalent to 66.6%) for corporate actions that would either wind-up, or otherwise dissolve the company or amend its constitutional documents.

Finally, there is no overcollateralisation test in the waterfall of payments, which usually is a way to protect noteholders against potential adverse selection risk due to haircuts on deep discount obligations being applied on the OC. Moody's explains that this transaction shows a negative carry of interest from the start, thus the analysis and therefore assigned ratings have a limited reliance on the potential diversion of interest flows to pay down the notes.

ABX influence on mortgage risk pricing analysed
The BIS has published a working paper entitled 'The pricing of sub-prime mortgage risk in good times and bad: evidence from the ABX.HE indices'. The paper investigates the market pricing of sub-prime mortgage risk on the basis of data for the Markit ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis.

After an introduction into ABX index mechanics and a discussion of historical pricing patterns, the authors use regression analysis to establish the relationship between observed index returns and macroeconomic news, as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007.

In particular, while fundamental factors - such as indicators of housing market activity - have continued to exert an important influence on the subordinated ABX indices, those backed by double-A and triple-A exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors, such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks' balance sheets - such as the TARP initiative.

Fair value proposals examined
Fitch has released a special report in response to the Financial Accounting Standard Board's (FASB) recent impairment and fair value proposals, which suggests that transparency and added disclosures by issuers would benefit investors. Because much of both proposals hinge on either the intent and/or estimations provided by management, the proposed qualitative disclosures by themselves may not be sufficient for financial market professionals' understanding of the impairment and fair value conclusions reached by an issuer, the agency says.

"Absent increased disclosures, investors and analysts may assume the issuer has taken the least conservative approach to valuation and impairment," notes Dina Maher, senior director at Fitch.

The FASB proposes to change the method for determining whether an investment is other-than-temporarily impaired and for identifying inactive markets and distressed transactions when measuring fair value (SCI passim). Fitch believes that, should these proposals be adopted, disclosures by issuers should be expanded to allow for thorough and meaningful analysis, regardless of the minimum requirements.

Alternative FDIC assessment proposed
An analysis of FDIC data as of end-2008 conducted by consultancy firm BancVue shows that commercial banks US$10bn or larger hold just over US$24 worth of credit derivatives for each dollar of equity. By comparison, the rest of the industry has essentially one-tenth of a penny of CDS for each dollar of equity.

Against this backdrop, the FDIC is seeking comments on whether the agency should use total assets or some other base for its proposed emergency premium special assessment. BancVue chairman Don Shafer suggests that part of the assessment should be based on the amount of credit derivatives a bank holds compared to their equity. "If you are going to unfairly burden smaller banks that played by the rules, the least the FDIC can do is base the levy on the banks that helped trigger the crisis," he concludes.

LLP RFC launched
The Federal Deposit Insurance Corporation (FDIC) has announced the opening of the public comment period for the US Treasury's new legacy loans programme (LLP). The FDIC is requesting comment from interested parties on the critical aspects of the proposed LLP by 10 April.

The programme is intended to boost private demand for distressed assets that are currently held by banks and facilitate market-priced sales of troubled assets (see last week's issue). It is necessary because uncertainty about the value of these assets makes it difficult for banks to raise capital and secure stable funding to support lending to households and businesses, the FDIC says.

The LLP will combine an FDIC guarantee of debt financing with equity capital from the private sector and the Treasury. The partnerships will purchase assets from banks and place them into public-private investment funds (PPIF).

Institutions of all sizes will be eligible to participate in the LLP to sell assets and it is expected that a range of investors will participate, according to the FDIC. "The programme will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors. Investors will be pre-qualified by the FDIC to participate in auctions," it notes.

For providing a guarantee, the FDIC will be paid a fee, a portion of which will be allocated to the Deposit Insurance Fund. The FDIC will be protected against losses by the equity in the pool, the newly established value of the pool's assets and the fees collected.

The FDIC will play an ongoing reporting, oversight and accounting role. In addition, it will structure the debt that the selling bank will take back when the legacy loans are sold. Participant banks may then resell the debt into the market.

TruPS CDO criteria revised ...
Credit deterioration among banks and thrifts that have issued trust preferred securities (TruPS) through CDOs has been rapid and significant over recent months. This performance has prompted Fitch to revise its criteria for reviewing the ratings of approximately US$38bn of CDOs backed by these assets.

Through to 22 March 2009, Fitch-rated bank TruPS CDOs have experienced defaults and deferrals of US$780m, which is in stark contrast to bank defaults and deferrals of US$103.5m observed in 2007. Increased bank failures and continued deferral activity are expected to curtail cashflows to bank TruPS CDOs, which may reduce their ability to meet payment obligations to noteholders.

The review criteria address Fitch's analytical treatment of assets that are defaulted, deferring or where the agency sees default or deferral as a real possibility in the future. Other changes to the review criteria include the analysis of concentrated portfolios of insurance assets and the qualitative credit given to other structural features, such as excess spread and cashflow redirection mechanisms.

The revised review criteria will affect CDOs backed by TruPS issued primarily by banks and thrifts (collectively banks) and, to a lesser extent, insurance companies, as well as real estate investment trusts and other structured finance assets.

Fitch's revised bank TruPS CDO review criteria begins with an updated analysis of the credit quality of the underlying assets from Fitch's financial institutions group. The credit enhancement measurement is adjusted for issuers that are currently defaulted, deferring on their TruPS obligations or scored in the lowest two sub-categories of Fitch's US bank scoring model scale of 1 to 5.

Specifically, the credit enhancement measurement assumes 100% loss on defaulted issuers, which is consistent with the deeply subordinated nature of trust preferred securities and Fitch's previously stated recovery estimates on these instruments. Credit enhancement is further adjusted for issuers that are currently deferring on their TruPS obligations. The analysis assumes that approximately 50% of deferring issuers may be unable to cure their deferral within the contractual five-year period and may migrate to default, should the current environment persist.

Finally, Fitch has observed that issuers with a Fitch bank score of 4.5 and 5 have generally exhibited high probability of deferral and default. As such, the revised review criteria assume that 25% of these issuers will ultimately default on their obligations.

The agency expects to conclude the rating review of its bank and insurance TruPS CDO portfolio using this review criteria within the next month. At that time, it will also resolve the rating watch status that is currently outstanding on 75 bank TruPS CDOs.

... and rating actions taken
Moody's has downgraded 429 tranches across 89 trust preferred (TRUP) CDOs, due to their exposure to trust preferred securities issued by small to medium-sized US community bank and insurance companies. Due to the continued credit crisis and weak economic conditions, the number of interest payment deferrals and defaults has sharply increased in the past year and is expected to continue to rise, the agency says.

As a result, the number of assumed problematic banks has increased from roughly 200 in November 2008 to about 300 as of today. This corresponds to a significant increase in FDIC problematic banks from 171 last September to 252 at year-end. Moody's believes that, while the various actions proposed by the Federal Reserve, Treasury and FDIC are positive developments for the financial sector, they may not be sufficient to prevent further deferral of interest payment on their trust preferred securities for the weaker banks and insurance companies in TRUP CDOs.

The rating actions are the result of using a combination of the following analyses: (1) coverage level and problem bank analysis; (2) event of default analysis; (3) cashflow analysis; (4) pass-through of the underlying portfolio credit analysis; and (5) break-even analysis.

In order to promote market transparency, Moody's encourages the underwriters and collateral managers for all TRUP CDOs to publish the list of collateral securities in each of their respective CDOs. TRUP CDOs with exposure to REITS will be reviewed in the coming weeks.

NY Fed reports MBS purchases
The New York Fed purchased US$33.15bn net (US$47.25bn gross) in agency MBS between 19 and 25 March under the Agency Mortgage-Backed Securities Purchase Programme. Purchases in agency MBS were made by investment managers acting as agents for the System Open Market Account (SOMA).

SecondMarket Ecosystem launched
SecondMarket has launched the SecondMarket Ecosystem, a network of product and service providers for buyers and sellers of illiquid assets (see SCI issue 123). With over 25 companies already participating and more than 250 other firms expressing interest in joining, SecondMarket's Ecosystem offers buyers and sellers free access to critical resources for trading illiquid assets, including valuation, research, data, analytics, legal and transaction advisory services.

The addition of the Ecosystem to SecondMarket's centralised marketplace creates a single location for buyers and sellers to not only trade illiquid assets, but also to access a global community of experts. This combination of trading and information ensures a more transparent, more liquid market for these assets, the firm claims.

Economic capital issues discussed
The Basel Committee has released a report, entitled 'Range of practices and issues in economic capital frameworks', which aims to address the challenges that banks face with respect to economic capital.

"[Economic capital] has increasingly become an accepted input into decision-making at various levels within banking organizations. Despite the advances that have been made by banks in developing their economic capital frameworks, the further use and recognition of risk measures derived from these frameworks remain subject to significant methodological, implementation and business challenges," the report notes.

As economic capital has - to varying degrees - become a component of many banks' internal capital adequacy assessment processes (ICAAP), the paper is addressed to banks that have implemented or are considering implementing economic capital into their internal processes. The paper is also aimed at supervisors, which are required under Pillar 2 (supervisory review process) of the Basel 2 framework, to review and evaluate banks' internal capital adequacy assessments.

Economic capital models and the overall frameworks for their internal use can provide supervisors with information that is complementary to other assessments of bank risk and capital adequacy. While there is benefit from engaging with banks on the design and use of the models, supervisors should guard against placing undue reliance on the overall level of capital implied by the models in assessing capital adequacy, the Committee notes.

The report outlines recommendations that identify issues which should be considered by supervisors in order to make effective use of internal measures of risk that are not designed for regulatory purposes. The areas covered include: the use of economic capital models in assessing capital adequacy; senior management; transparency and integration into decision-making; risk identification; risk measures; risk aggregation; validation; dependency modelling in credit risk; counterparty credit risk; and interest rate risk in the banking book.

SIV notes impacted
Moody's has downgraded its senior debt and capital note ratings of Carrera, a SIV sponsored and backed by HSH Nordbank. The rating action does not affect the short-term Prime-1 ratings of the Euro and US CP programmes.

The rating action on Carrera's Euro and US MTN programmes follows the downgrade on 20 February of HSH's long-term rating to A1 from Aa3. The direct linkage between the senior debt ratings of Carrera and those of HSH is based on the bank's commitment to support the SIV's senior debt through a note purchase and liquidity facility, as well as a committed repo facility. Under these agreements, the repo facility covers two-thirds of senior debt while the note purchase and liquidity facility makes up the balance of senior debt.

The rating action on Carrera's capital notes is the result of the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of CDOs, as well as further deterioration in the credit quality of the SIV's asset portfolio since the last rating action.

FGIC downgraded, ratings withdrawn
Moody's has downgraded to Caa3 from Caa1 the insurance financial strength (IFS) ratings of the main operating subsidiaries of FGIC Corporation, including Financial Guaranty Insurance Company and FGIC UK Limited. At the same time, Moody's affirmed the Ca ratings on FGIC's contingent capital securities, Grand Central Capital Trusts I-VI, and the senior debt ratings of the holding company, FGIC Corporation.

The rating action reflects Moody's expectation of higher mortgage-related losses arising from FGIC's insured portfolio, insufficient claims paying resources to cover Moody's estimate of expected loss and the constrained liquidity and financial flexibility of the holding company. The outlook for the ratings is negative.

Moody's has also announced that it will withdraw the ratings of FGIC and FGIC Corporation for business reasons.

According to Moody's, the rating action is the result of FGIC's substantial exposure to sub-prime mortgages and ABS CDOs. The rating agency currently estimates that the expected loss for FGIC's insured portfolio now exceeds claims paying resources. The negative outlook reflects the possibility of even greater than expected losses in extreme stress scenarios, with losses possibly reaching sectors beyond mortgage-related exposures as corporate and other consumer credits face a more challenging economic environment.

More CSOs and ...
Moody's has downgraded a further 118 CSO notes. The agency explains that 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 transactions' reference portfolio.

... SF CDOs downgraded
Moody's has downgraded its ratings on 118 notes issued by 30 CDO transactions that consist of significant exposure to Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. Moody's explains that the rating actions reflect certain updates and projections and recent rating actions on underlying assets on these asset classes.

Further deterioration expected for EMEA CMBS
The performance of a number of CMBS and multi-family transactions in EMEA deteriorated in Q408, says Moody's in its 'EMEA CMBS Q408 Surveillance Report'. Looking ahead, the agency expects a further deterioration in EMEA CMBS loan performance.

Throughout Q408, Moody's observed an increase in the cumulative number of loans within EMEA CMBS transactions that are on the respective servicer's watchlist, are in default and/or require special servicing. "Given that a total of approximately 660 loans in large multi-borrower transactions are currently monitored by Moody's, the rising absolute number of loans which have either defaulted, been transferred into special servicing or put on the respective servicers' watchlists is still at a low level, but it is expected to rise significantly over the next couple of quarters and years," says Stephan Ebe, a Moody's associate analyst and co-author of the report.

Moody's also notes a near doubling in the number of loans that suffered a payment default and a rise in the number of instances of loans breaching their ICR/DSCR covenants due to decreasing property cashflows. "This deterioration in property cashflows attests to the weakening of the occupational markets, with more tenants having difficulty making rental payments, the demand for space diminishing in certain occupational markets and non-recoverable costs for borrowers being higher than anticipated," adds Deniz Yegenaga, a Moody's associate analyst and co-author of the report.

The worsening state of the commercial real estate lending, investment and property markets in the various EMEA countries had a negative impact on the ratings to varying degrees. This affected both the junior and mezzanine notes in EMEA CMBS transactions, as well as some senior notes during Q408.

Overall, the ratings of a total of 35 classes of notes in 20 transactions were downgraded by Moody's during Q408. Moreover, 14 classes of notes in six transactions were placed on review for possible downgrade. An additional 39 classes of notes remained on review for possible downgrade during the quarter, having been placed on review in the previous quarter following the insolvency of Lehman Brothers.

Moody's expects the number of negative rating actions for EMEA CMBS to increase significantly in the coming months and quarters. In early 2009, amid the ongoing adverse development of EMEA commercial real estate markets and subdued commercial real estate lending and investment activity, the rating agency adjusted its EMEA CMBS central scenarios that are used to analyse EMEA commercial real estate loans and CMBS transactions. Moody's intends to finalise its property-by-property and loan-by-loan analysis of all outstanding EMEA CMBS deals against the background of these central scenarios during the course of H109. The rating agency anticipates that 20% to 30% of all senior EMEA CMBS notes that it rates are likely to be downgraded by one to four notches, and 50% to 60% of all Moody's-rated mezzanine (including junior Aaa notes) and junior notes will potentially be downgraded by three to seven notches.

SNAC CDS compliance for Quantifi
Quantifi has released Version 9.1.4 to support the new standard North American corporate (SNAC) CDS set to begin trading on 8 April. The upgrade will provide specific enhancements to pricing, risk management and operations to support the new contracts.

The enhancements include:

• The new ISDA CDS standard model to convert spreads to upfront fees and to calculate exact settlement payments
• Support for calibration of survival curves based on the new SNAC quoting convention
• The ability to calculate hedges and sensitivities based on the SNAC contract
• Trade capture support for the SNAC contract, along with ISDA-compliant validation to ensure accurate trade representation
• Support for the new Markit fixed coupon report, which contains quotes for the SNAC contracts.

Rohan Douglas, Quantifi ceo, comments: "There are profound changes occurring in the CDS market as part of the ISDA CDS 'big bang'. As these changes will have a significant impact on existing modelling and trading infrastructure, support for these new contracts before they begin trading on 8 April is crucial for all market participants. With this release, we are making sure our clients are fully prepared so that the transition is as seamless as possible."

Australian mortgage performance worsens
Fitch says in its latest report that Australian mortgage delinquencies have worsened through Q408 and are expected to continue through Q109 due, in part, to the seasonal effect of Christmas credit spending.

"Throughout 2009, there will be a steep contrast between those borrowers who continue to struggle and those who begin to really feel the relief provided by the five cuts in the official cash rate to 3.25% - only a portion of which has been passed on to borrowers. The key factor will be each borrower's ability to retain full employment during this continued global downturn," says Leanne Vallelonga, associate director in Fitch's structured finance RMBS team.

Australian mortgage performance - as measured by mortgage delinquencies - deteriorated in Q408, evidenced by the increase in the Fitch Dinkum Index for 30+ day delinquencies to 1.75% in Q408 from 1.50% in Q208, which is the measure for full-documentation loans. Most of the jump in delinquencies occurred in the 90+ day arrears.

Non-conforming low-documentation 30+ day delinquencies currently stand at a new record high of 19.73%, almost five times higher than conforming low-documentation 30+ day delinquencies of 3.95%. Fitch believes the non-conforming sector continues to suffer from an inability to refinance with the practical closure of the low-documentation origination market. The agency expects its low-documentation index to deteriorate at a consistently faster speed than the full-documentation index.

Negative outlook for global CRE
Fitch says in a new report that senior CMBS notes remained resilient to the extremely challenging economic environment and declining commercial property values during 2008. The agency notes that 99.4% of the agency's triple-A CMBS ratings were unchanged during the year. Further, more than 92% of all triple-B rated CMBS bonds either retained their rating or were upgraded.

However, for the first time, global CMBS experienced net negative ratings performance in 2008, with an upgrade-to-downgrade ratio of 0.7 to one. Fitch expects that loan defaults will increase, while prepayments will continue to slow considerably during 2009, leading it to assign a negative outlook to the global commercial real estate market and CMBS ratings for the current year. Downgrades are expected to significantly outweigh upgrades in 2009 across all rating categories.

"As most CMBS loans do not amortise greatly over their term, the largest current risk in global CMBS remains defaults on balloon maturity payments," says Rodney Pelletier, head of EMEA structured finance performance analytics at Fitch. "However, this refinance risk is partly mitigated by the fact that only a small volume of CMBS loans will mature in 2009 and 2010. More maturities will occur from 2011-2013, but most will occur after 2015."

"Given the global economic environment, performance is expected to decline further in 2009, reducing ratings stability - especially at single-A level and below," adds Charlotte Eady, associate director, EMEA structured finance performance analytics at the agency. "Fitch expects that triple-A and double-A rated bonds will also be affected negatively, but to a lesser extent."

In the US, Fitch expects retail and hotel properties to experience greater stress as performance of these assets is heavily dependent on consumer spending, as well as business and leisure travel - all of which have fallen off sharply. In European and Asian commercial property markets, challenges in the retail and financial sectors in particular are expected to pressure CMBS performance metrics.

Troubled company index deteriorates sharply
The Kamakura index of troubled public companies deteriorated sharply in March after holding steady in January and February, increasing by 1.1% to 24.3% of the public company universe. This is 0.3% above the current recession's previous peak of 24% reported for December 2008.

Kamakura defines a troubled company as a company whose short-term default probability is in excess of 1%. The all-time high in the index was 28%, recorded in September 2001. Credit conditions are now worse than credit conditions in 96.4% of the period since the index's initiation in January 1990.

The index has expanded its coverage to 23,900 companies, an increase of more than 1,000 firms since the previous month - predominately made up of Canadian public firms. Kamakura reports that the expanded corporate coverage has had no significant impact on the level of the index.

"On 2 March, Kamakura reported that Chemtura Corporation was among the rated companies with the largest one-month jumps in short-term default risk," comments Warren Sherman, Kamakura president and coo. "Chemtura filed for Chapter 11 bankruptcy on 18 March. This month, among rated public companies, the companies showing the sharpest rise in short-term default risk were Blockbuster Incorporated, Fairpoint Communications, Cumulus Media, Gannett Co and Eddie Bauer Inc."

Analytics functions analysed
Firms should adopt a joint approach to pricing functions in the front office, according to a new report entitled 'OTC Derivatives and Structured Product Pricing Practices: Trends and Technology Strategies for the Coming Market Reformation', published by financial research and consulting firm Celent.

The key finding of the report is that trends and developments towards greater transparency in pricing and valuation functions had been increasing even before the onset of the credit crisis. In a post-crisis period of financial reform and with a substantial pool of complex securitised assets and structured products, the market is now seeing unprecedented levels of scrutiny and requirements for firms to show procedural consistency in their complex deal pricing and portfolio valuation activities. Regulators, investor groups, quasi-governmental organisations and government agencies are pushing for greater transparency, independence and accountability, with the emphasis on having well-defined processes and ensuring that these processes are repeatable.

Celent consequently advises firms to: 1) move towards a federated 'publish & subscribe' organisational model for pricing functions; 2) improve consistency of pricing analytics front-to-back across the value chain; 3) define a coherent strategy for a model development infrastructure; 4) align front office, risk control and support interactions based on derivative product lifecycle dynamics; 5) establish pricing information transparency 'upstream' in order to inform control activities 'downstream'; and 6) rethink building blocks that play into a pricing/valuation architecture.

CS & AC

CLOs

Don't miss the trees for the forest

Madhur Duggar and Batur Bicer, structured credit strategists at Barclays Capital, find that turbo double-B CLO tranches have features that are ideally suited to wading through the wave of downgrades that likely lies ahead

With the market focused on the risk of imminent and systemic collateral downgrades, the temptation is to write off the value of turbo double-B tranches completely. However, our analysis shows that making any general conclusions with respect to turbo tranches can be misleading. We find turbo double-Bs show a great deal of heterogeneity with respect to structural nuances and portfolio quality, and have features that are ideally suited to wading through the impending wave of downgrades and defaults that likely lies ahead.

Since mid-2008, the average cushion underneath the double-B overcollateralisation (OC) test has deteriorated to 1.5 points from 4.5 points (see Figure 1). Deterioration in OC cushions has made a violation of junior OC tests imminent.

Failure of OC tests typically results in the diversion of interest proceeds to pay down senior tranches in the capital structure. However, in some CLOs interest proceeds can be used to accelerate the paydown of the double-B tranche first.

These tranches, known as turbo double-B tranches, accelerate principal payments when the double-B OC test is failing but the triple-B OC test is not. The deterioration in test cushions has increased the likelihood of accelerated paydowns on turbo double-B tranches.

This should help valuations. The risk, however, is that a systemic increase in defaults and downgrades could cause the OC tests on both the double-B and triple-B tranches to fail simultaneously, rendering the turbo feature worthless.

Sensitivity analysis
In this section, we analyse the sensitivity of a sample turbo double-B tranche to several key collateral and structural features such as default rates, triple-C bucket sizes, the BB/BBB turbo window and the weighted-average spread of the portfolio. The details of the deal are shown in Figure 2. We construct the deal to be representative of the 'average' CLO transaction in terms of its portfolio and structural characteristics.

We undertake the experiment of changing a given characteristic of the deal while keeping its other features constant. We discount all double-B cashflows at a 25% rate to reflect the equity-like nature of the tranche.

Default rates
Depending on the structure, turbo paydowns can be very sensitive to default rates. Therefore, valuing the impact of a turbo paydown by running a deterministic scenario of CDRs can be misleading for some turbo tranches.

Instead, investors must take a view on the volatility of default rates and value turbo features in a probabilistic framework to gauge the current fair price of the tranche. Alternatively, investors should seek out turbo double-Bs that have stable paydowns across a wide range of default rates.

In Figure 3 we plot the amount of principal acceleration for two different turbo double-B tranches across a range of default rates. The deals differ only in their double-B OC test level.

We also show our estimates for the probabilities under which these scenarios are realised. These probabilities are based on our estimate of the loss distribution for the portfolio.

For one deal, paydowns vary from 3% to 23% of the tranche's notional, as default rates vary between 6% and 12%. Investors who run a 12% default rate scenario are likely to value the turbo feature at three points, which is much lower than the probability-weighted value of the turbo feature, which is about 22 points. The other deal has a stable paydown profile, and running default probability scenarios is not as important here.

Figure 4 shows the non-linear relationship between default rates and the turbo window for our sample deal. The figure shows the period of time over which the turbo window is active and the PV of the cashflows that accrue over that period. The time taken to activate the turbo window decreases to 0.75 years from 6.25 years as default rates rise.

This increases the value of the turbo. However, the window of time over which the turbo is active also falls to 0.25 years from 5.5 years. This cuts the value of the turbo.

The combined affect of these two forces on the value of the turbo is ambiguous. Valuations rise initially to 21% from 0% as default rates increase to 7% from 1%. However, after that, valuations either remain flat or decline.

The figure also shows that turbo tranches can have CDR 'blind spots', ranges in which the tranche is shut off completely. In our example, the tranche does not have any paydowns for CDR levels between 14%-15%; above that level, the tranche becomes active again. All these factors make the relationship between default rates and turbo windows non-linear and argue for using a probabilistic framework and investing in portfolios of turbo double-Bs to reduce return volatility.

Triple-C haircut
In valuing turbo double-B tranches, investors should carefully analyse the impact of triple-C downgrades on valuations. Excess triple-C buckets will continue to be a concern for junior tranches of CLOs. Most CLO transactions are required to carry triple-C names in excess of a pre-specified threshold (e.g. 7.5%) at market value for purposes of calculating OC tests.

A violation of triple-C thresholds will accelerate non-compliance with the double-B and triple-B OC tests and cause cashflows to be diverted away from junior CLO tranches to pay down senior tranches. We estimate 60% of CLO transactions have currently exceeded their triple-C thresholds. This percentage is likely to grow in 2009 and 2010 as downgrades accelerate.

The impact of triple-C haircuts on turbo double-B valuations can be ambiguous. Modest increases in triple-C buckets can accelerate the time taken to break the double-B OC test, and this will improve valuations by generating faster paydowns. Larger and more permanent increases in downgrades will result in both the double-B and triple-B OC tests being hit at the same time, and this will reduce valuations.

Figure 5 shows our estimate of the average price of our sample turbo double-B tranche under two different downgrade scenarios. In our base-case scenario, we assume that downgrades rise to the indicated levels and stay there for two years, after which the bucket size decreases to 10% for the life of the deal.

In our bearish scenario, we assume that triple-C downgrades are persistent. Triple-C downgrades rise to the indicated levels and stay there for the life of the deal. We assume the deal has a 7.5% triple-C threshold.

For comparison purposes, we also show the price of the turbo feature without accounting for triple-C haircuts. Under the base case, prices drop to 10% from 38% as the triple-C bucket size increases to 50% from 10%. As expected, modest increases in the triple-C bucket actually add value to the tranche.

However, as downgrades increase beyond 20%, the triple-C haircut decreases in value. Tranche prices are much more severely affected in our bearish scenario where downgrades are persistent. In this scenario, tranche prices drop to zero the moment triple-C bucket sizes increase to 20% or more.

Investors should actively seek out turbo double-B tranches of portfolios that are likely to face fewer downgrades to triple-C. Selecting deals with higher credit quality and with more diversity across industries will be a mitigating factor. Alternatively, investors should look for transactions with high triple-C bucket thresholds.

BB/BBB turbo window size
Typical turbo double-B tranches accelerate principal payments when the double-B OC test is failing but the triple-B OC test is not. Therefore, the distance between the double-B and triple-B OC tests defines a window within which the turbo feature is active.

The wider the window, the greater the amount of principal paydown is likely to be. To fix ideas, we define the window as follows:

Defined this way, the Turbo Window measures the percentage of additional losses that the portfolio would have to sustain to break the triple-B OC test once the double-B OC test has already been hit. Figure 6 shows the amount of accelerated principal paydowns at different turbo window levels, assuming a 9% CDR. Principal payments increase as the turbo window increases.

Our analysis shows that principal paydowns can increase by 30 points for double-B tranches as the window size increases to 2.0% from 0.5%. We estimate the average CLO transaction has a 1% window.

Window sensitivity also depends on the default rate. Figure 6 shows principal paydowns at 12% CDR. Principal paydowns are lower across window sizes at higher default rates.

In addition, for window sizes below 1% there are few or no principal payments. This is because high default rates cause both double-B and triple-B tranches to be hit faster for deals with small windows. This results in little or no paydown to the double-B tranche.

Excess spread
We have previously discussed the rising trend of loan covenant amendments. Covenant amendments will continue through 2009-2010, a trend that will have the effect of pushing back defaults and increasing CLO collateral spreads.

Turbo double-B tranches of deals in violation of their double-B OC tests will benefit from covenant amendments. Given the thinness of double-B tranches and the substantial discounts at which they are trading, even small increases in excess interest will result in substantial increases to returns.

Figure 7 shows the sensitivity of turbo double-B tranches to CLO WAS. Turbo tranche paydowns increase to 23 points from about 17 points as CLO WAS increases to 4.5 points from 2.5 points.

On average, we find that tranche paydowns increase by 1-2 points for every 50bp increase in WAS. While 1-2 points is only a small fraction of the tranche notional, it is a significant fraction of the distressed levels (5-15 points) at which junior CLO tranches are trading.

Putting together a portfolio of turbo double-B tranches
As we have shown above, the extreme thinness of the double-B tranche (~2.5%) makes it sensitive to small changes in structure and portfolio performance. Thus, while the turbo feature of a double-B tranche can add significant value in a distressed environment, uncertainty around the actual level of defaults is likely to make the return on a turbo double-B tranche very volatile.

The right strategy, therefore, is to put together a portfolio of turbo double-B tranches that are not highly correlated. This will help to smooth out portfolio returns.

Even moderately independent portfolios are likely to result in significant reductions in portfolio volatility. In Figure 8, Panel A, we compare the return distribution of a single turbo double-B tranche to the return from a portfolio of 10 turbo double-B tranches. In the latter case, we assume the default rates on the underlying portfolio are 50% correlated.

For simplicity, we assume that all the tranches in our simulation are structurally identical to the sample CLO deal we describe in Figure 2. Panel A shows that portfolios of turbo double-B tranches are likely to have lower volatility than individual turbo tranches.

In Figure 8, Panel B, we show volatility levels and information ratios for portfolios at different default correlation levels. As the correlation level falls to 0% from 100%, portfolio volatility decreases to 1.1% from 3.4%, and the information ratio increases to 16x from about 5x.

In putting together turbo double-B portfolios, investors must take care to ensure diversity across portfolios. A simple way to do so would be to diversify across CLO managers. Managers are likely to prefer the same names and invest in those names across all their transactions.

S&P states in various reports that correlation levels are significantly lower for deals from different managers. It finds that the average portfolio overlap drops from 50% to 35% in the US as we move from deals issued by the same manager to deals issued across different managers. In Europe, intra-manager portfolio overlap is higher at 59%, while inter-manager portfolio overlap is lower at 26%.

© 2009 Barclays Capital. All rights reserved. This Research Note is an extract from 'US Credit Alpha', published by Barclays Capital on 20 March 2009.

Trading

Trading ideas: rolling along

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on RPM International

In our past few capital structure arbitrage strategy pieces, we noted that credit and equity reconnected after spending most of the year with equity trading too cheap compared to CDS. RPM International followed the rest of the market wider, peaking in early March. Since then, both its stock and CDS rallied.

However, the company's CDS did not keep pace with equity and now trades well wide of fair value, according to our CSA model. Our adjusted directional credit model also likes selling protection on RPM, especially due to its equity-implied default probability and equity-vol factors. With both CSA and directional credit pointing towards credit improvement, we recommend selling RPM CDS protection and hedging by shorting the company's stock.

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.

RPM's CDS widened dramatically this year. More recently its stock has outperformed its credit, sending fair value CDS below current market levels.

Exhibit 1

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

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

Exhibit 2

With CDS too wide compared to equity, we expect a combination of equity sell-off and CDS rally. We also note that our adjusted directional credit model points towards improvement in RPM CDS based on strong market factors (equity-implied default probability and equity vol), as well as strength in free cash.

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 RPM. RPM is a moderately liquid name and CDS bid-offer spreads are around 20bp.

Sell US$1m notional RPM International 5-Year CDS at 325bp.
Sell 20,000 shares RPM International at US$12.92 to receive 325bp of carry.

For more information and regular updates on this trade idea go to: http://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).