Contents

Indices

Volatility wanted

Listless muni CDS market seeks more action

The Markit MCDX index will celebrate its first birthday in the next few weeks. However, the index - along with the single name municipal CDS market - is experiencing a severe lack of liquidity that is unlikely to return, unless the possibility of credit events heightens.

When the MCDX was first launched in May 2008, traders were hopeful that the volatility in the municipal bond market experienced at that time would result in new participants using the index to express a view on the muni market, as well as encouraging existing investors to use the index to analyse their credit risks (see SCI issue 90). However, one year on, users report that the index is yet to gain traction, while single name muni CDS are subject to very few trades in a highly illiquid market.

The MCDX rolled into Series 12 on 3 April. Following a dealer vote, it was determined that there would be no change to the composition of the index.

"Municipal CDS are very illiquid," confirms Philip Fischer, municipal strategist at Bank of America Merrill Lynch. "They have been illiquid since the stimulus bill was passed [in February] and the municipalities were shored up with billions of dollars. The stimulus package took a lot of concerns off the table."

He continues: "As far as the CDS infrastructure is concerned, the market, the contracts and the traders are in place, but I believe it would take a credit event or the likelihood of a credit event to bring liquidity back into the municipal CDS market."

Municipal CDS tends to trade in its own segment, far higher than the underlying cash bonds, and with trades carried out by many non-traditional muni players. According to Matt Fabian, md of Municipal Market Advisors, one reason for this is that most municipal bonds are tax-exempt while CDS is taxable, so investors don't generally arbitrage the difference between the two, as they would in other sectors.

"Interestingly however, one of the issues with muni CDS is in handicapping the value of the cheapest-to-deliver option [muni CDS are all physical delivery]," he says. "With all the cash market price volatility in the last six months, these project to be cheaper and cheaper - and with an assumed 80% recovery in the contract, it pushes up the cost of protection too much. The good news is that, with the likely development of a taxable muni cash market through the stimulus, muni CDS-to-cash arbitrage might really help tie prices together."

Last week the US Internal Revenue Service (IRS) issued guidance on the new Build America Bonds. The programme allows state and local governments to issue taxable bonds for capital projects and to receive a new direct federal subsidy payment from the Treasury Department for a portion of their borrowing costs.

Fischer suggests that the introduction of a taxable muni cash market will not necessarily have any impact on cash and CDS spreads. "CDS is very much a credit question and, for the moment, muni credit spreads appear to have stabilised," he says.

However, Moody's decision to assign a negative outlook to the entire US local government sector - primarily states and municipalities - yesterday (7 April) could bring the question of volatility back into play. The agency cites the collapse in housing, turmoil in financial markets and the broadest and deepest national recession in recent memory as reasons for its outlook. Credit strategists at BNP Paribas believe this will force local governments to cut back their budgets significantly, as well as scale back infrastructure projects and employment.

AC

Operations

Judgement call

Increased opacity for bank balance sheets?

The FASB last week voted, as expected, to allow financial institutions to use "significant" judgement in valuing their assets under FAS 157. While the increased guidance on other-than-temporary impairments has been welcomed by some, sceptics suggest that the move will result in even more opacity around bank balance sheets.

The changes permit companies to value non-active assets on a cashflow basis in certain circumstances, essentially allowing the assets to be valued the same as they would be sold for in an "orderly" sale, as opposed to a forced or distressed sale (see News Round-up for more). By some estimates, bank earnings are expected to rise by as much as 20% as a result. However, exactly how much the rules will be relaxed by remains unclear.

According to Espen Robak, president of Pluris Valuation Advisors, there were two major weaknesses in the FASB Staff Position (FSP) issued: the presumption that a sale is "distressed" in an "inactive market"; and that the given example was too vague. However, the FASB stated in a release announcing its decisions on 2 April that it had responded to participants in the comment process by removing the presumption of distress and improving the fair value example.

Nevertheless, Robak says: "The proposal was put together so quickly that the details appear to have been overlooked. More than 300 comment letters were filed with the FASB by investor groups whose feedback was negative, so it's unclear who's actually in favour of the changes."

He adds: "The main concern for investors is whether the ultimate meaning of 'fair value' will be changed. If the FASB now changes the proposed FSP to make sure that the central measurement goal of fair value remains the same, then that's a great relief for investors."

Credit strategists at BNP Paribas nonetheless suggest that the new, more model-based approach means different banks could use different approaches in valuing similar securities. "We believe that such opacity is clearly not investor-friendly and will add to more investor scepticism once the dust has settled," the strategists note. "This also relatively penalises those institutions that had either marked appropriately or not held toxic securities in the first place."

However, Brian Weber, senior associate at Houlihan Smith & Co, points out that any time Level 3 assets are being dealt with, they will always be subject to professional opinion based on internal models. But, whereas previously financial institutions that hold these assets may have been pushed by their auditors towards using Level 2 inputs based off distressed sales in inactive markets, the new guidance means that banks no longer have to rely on such data.

Moreover, the previous guidance on other-than-temporary impairments versus temporary impairments was vague. According to Weber: "It is now possible to achieve a better indication of the extent of credit impairment by isolating, for example, the credit portion via looking at credit spreads or CDS levels. Before the new guidance was introduced, it was problematic to attribute a portion of the degradation in value to liquidity."

Another criticism of FASB's move is that it potentially reduces the effectiveness of the PPIP initiative. Weber reckons that a bank will be less likely to bring their poor assets to the PPIP because if the market values them at a lower level than the bank has marked them, it may be forced to take write-downs on the other assets on its book. "This will serve to reduce the liquidity that the PPIP would otherwise have brought to the table," he notes.

Weber anticipates that the changes will ease the pressure on financial institutions in terms of having to make further write-downs in the future, but whether the Street buys into this remains to be seen. "Certainly banks will have more control over their own financial statements, which may be matched by increased investor scepticism."

To increase transparency around the "illiquid" assets on bank balance sheets, Robak suggests that regulators could require banks to provide a list of all the positions on their balance sheet (like insurance companies do in their quarterly filings), which would enable investors to undertake their own valuations of a bank's book. Alternatively, the big four accounting firms could require their clients to use models with market-based inputs in order to yield results in keeping with market realities.

"The proposed move changes the accounting rules for the whole economy, so are we throwing away good accounting to please a small segment of the economy?" he asks. "A better solution would be to make it easier for banks to deal with capital adequacy problems on the regulatory side."

CS

CDS

Pay cuts hit structured credit the hardest

Those working in the structured credit industry received the largest pay cut across the capital markets in percentage terms, year-on-year, according to the latest Napier Scott Search survey. According to the survey - which polled information from around 4000 international bankers - structured credit practitioners were subject to an average fall of 86% in remuneration (see below tables for more detail). In comparison, foreign exchange traders experienced the smallest cuts in remuneration, with average pay packages falling by just 8%.

The overall average pay and bonus package for a London banker was also shown to have plummeted by 62% year-on-year, making the Square Mile the lowest paid of the major global financial centres for the first time in its history. Meanwhile, New York has regained pole position, after three years as runner-up to London, with Wall Street bankers receiving as much as 40% more than their UK counterparts.

The survey's overall 'winners' in the pay and bonus stakes were senior private bankers within the top financial institutions (Tier 1), who generally maintained their levels of remuneration from 2008. The Middle East experienced the lowest cuts - down by around 10%, compared to the average fall of 55% suffered by the rest of the banking world.

Shaun Springer, chief executive of London-based Napier Scott Search, says: "It has come as a great surprise to discover that London has gone from top to bottom in our remuneration survey in just one year. This is encouraging, however, as it illustrates that London is taking the global financial crisis seriously and is responding by introducing more conservative remuneration packages."

Springer warns that a continuation of widespread redundancies in London could have serious consequences for the premier financial centre's future status. "The City has already lost a great deal of talent in the past 12 months and we must not lose sight of the fact that it took 30 years for it to reach a position of financial supremacy and this status could be undone in a tenth of that time."

He adds: "Our survey shows that there is a 40% differential between what bankers can earn on Wall Street and in London, though one must take into account the 25% devaluation in sterling. This is an enormous polarisation between the City and Wall Street and, given the current political climate in the US, it will come as a very unpleasant surprise to the Obama administration, which is trying to rein in bankers' packages."

AC

Distressed assets

Irish 'bad bank' to be established

The Irish government has announced that it is to bring forward measures to address the issue of asset quality in the country's banking system. A National Asset Management Agency will be established on a statutory basis, under the aegis of the National Treasury Management Agency.

Assets will be transferred from Irish banks to the new National Asset Management Agency with the purpose of ensuring that they have a clean bill of health, their balance sheets are strengthened and uncertainty over bad debts is reduced. This will ensure a sustained flow of credit on a commercial basis to individuals, households and businesses in the real economy, the government says. The Agency will have a commercial mandate and will have the central objective of maximising over time the income and capital value of the assets entrusted to it.

"Because it is clear that the principal uncertainties in relation to asset quality in the Irish banking system lie in the banks' land and development loans and in the largest aggregate associated exposures in the banks, these will be transferred to the Agency. These assets pose the main systemic risk to the banking sector in Ireland and the most significant obstacle to the recovery and restoration of lending by the banking system," the government explains.

The Agency will purchase the assets through the issuance to the banks of government bonds. This will result in a significant increase in gross national debt, to be offset by the assets taken in.

The cost of servicing this debt will be offset, as far as practical, from income accruing from the assets of the new Agency. The debt will be repaid from funds raised through the realisation of those assets over time.

The potential maximum book value of loans that will be transferred to the Agency is estimated to be in the region of €80bn to €90bn, although the amount paid by the Agency will be significantly less than this to reflect the loss in value of the properties. In the longer term, if the Agency were to fall short of recouping all of the costs, the Irish government intends that a levy should be applied to recoup any shortfall.

The State will not assume all of the risk in the acquisition of these assets, which will be valued on a basis that is sustainable for the taxpayer. This will entail an assumption of losses by the financial institution whose assets are removed.

The State has already capitalised the Bank of Ireland for a 25% stake and is completing a due diligence of the Allied Irish Banks prior to capitalisation for a similar stake. If the crystallisation of losses at any institution requires additional capital, the State will insist on participation by way of ordinary shares in the relevant institution.

The government also intends, in line with its previous indication, to put a State guarantee in place for the future issuance of debt securities with a maturity of up to five years.

CS

Operations

PPIP criteria to be viewed 'holistically'

The US Treasury department has released additional guidance for potential investors in the securities portion of the Public Private Investment Programme (PPIP). The new guidance extends the deadline for application to the programme to 24 April and clarifies that participation criteria will be viewed holistically - failure to meet any one criterion will not necessarily disqualify a proposal. Additionally, the guidance highlights the Treasury's interest in programme participation by small, minority- and women-owned businesses; the potential for further expansion of participants and asset classes; and the interaction of the TALF with this programme.

In order to ensure broad-based participation in the programme, the Treasury will encourage small, veteran, minority- and women-owned businesses to partner with private asset managers. There are several ways smaller firms can partner with fund managers, it says, including as an asset manager, an equity partner or a fund raising partner. Other ways to participate include providing such services as trade execution, valuation and other important financial services.

The Treasury will allow smaller firms to partner prior to or after the application deadline, including after the selection of the initial group of pre-qualified fund managers. Innovative proposals are encouraged from fund managers that incorporate the highlighted options, as well as other potential options. In order to maximise the inflow of private capital into the market through the PPIP, the Treasury says it will consider opening the programme to fund managers that are not selected in the initial pre-qualification process after the initial pre-qualification of fund managers.

The legacy securities PPIP, which is currently limited to assets that include non-agency CMBS and RMBS issued prior to 2009, could also expand. The Treasury says it will solicit comment from fund managers regarding potential expansion of the legacy securities PPIP at a later date to include other asset classes.

AC

Rajendra recruited for new role

The latest company and people moves

Henderson Global Investors has appointed Ganesh Rajendra to the new role of head of advisory and research within the structured products team. He joins on 20 April and will report to Jim Irvine, head of structured products.

Most recently, Rajendra was an md in Deutsche Bank's global markets research group, where he led the securitisation research team for nearly eight years. Prior to this, he worked at Merrill Lynch in the international structured credit research team.

In his new role within Henderson's 15-strong structured products team, Rajendra will spearhead the firm's portfolio advisory and recovery business centred on the global structured debt markets, to include mortgages, ABS and leveraged loans. During 2008 Henderson expanded into the advisory business in response to greater demand from legacy risk holders of structured credit for specialist asset management and recovery expertise.

Structured credit head finds new home
Paul Horvath, former global head of structured credit origination, structuring and distribution at Merrill Lynch, has reportedly joined Orchard Global Asset Management as chairman and chief executive. The firm is a Singapore-based credit asset manager. Horvath left Merrill Lynch in July last year.

Consultancy hires structured credit managers
Huron Consulting Group has appointed Kevin Gibbons and Peter Walsh as mds in the accounting and financial consulting practice, focused on the financial services sector. Gibbons and Walsh join Huron from Six Degrees Capital Management, where they were both founding partners focused on structured credit asset management. They have extensive experience originating, structuring and investing in structured credit products, including ABS and complex derivatives, managing credit investment vehicles, restructuring securitised credit facilities and providing advisory services to financial companies.

Duo hired for MBS/CDO trading platform
SecondMarket has hired two former Credit Suisse directors to head up its new trading platform for MBS, whole loans and CDOs. Elton Wells, previously a director with Credit Suisse in its structured products group, will head SecondMarket's MBS and whole loans markets. Adrian Radulescu, former head of Credit Suisse's European leveraged finance CDO structuring desk in London, will head SecondMarket's CDO market.

Through SecondMarket, buyers and sellers are able to trade these assets in a robust, centralised marketplace that provides transparency, price discovery and an extensive network of market participants, the firm says.

SecondMarket's trading network includes 2,500 buyers and sellers, hundreds of whom have already expressed an interest in purchasing residential and commercial MBS, CDOs and portfolios of various whole loans, including residential, commercial, construction, consumer and industrial loans. To date, more than US$1bn in illiquid assets have been traded over SecondMarket.

Credit head appointed
Calyon has appointed Swaroop Patel as head of debt and credit markets (DCM) for Asia ex-Japan. Patel replaces Antoine Gros, who has been promoted to global co-head of securitisation based in Paris.

Patel will be based in Hong Kong and is responsible for strengthening and managing Asia ex-Japan DCM businesses, including origination, sales and trading. He will report to Frédéric Lainé, head of fixed income markets for Asia ex-Japan, and Jim Siracusa, global head of DCM.

Patel has been a key figure in Asian debt and credit markets for over a decade, most recently as head of debt capital raising for Asia-Pacific at Bank of America. Prior to that, he spent four years at ABN AMRO as head of G3 fixed income capital markets for Asia and also spent eight years at JPMorgan in various debt and corporate finance positions in Asia and New York.

Citi reorganises capital markets businesses
Citi has merged its client-facing capital markets origination (CMO) businesses and its global securitised products and conduits resources under one umbrella in EMEA. David Basra, head of global securitised markets (GSM) for EMEA, will move to CMO, and, while maintaining his current global securitisation responsibilities, will assume additional responsibilities for certain CMO businesses.

Ahmet Bekce will continue to run the emerging markets DCM, loans and energy and infrastructure finance teams and will now report to Basra. Bekce will also report to Eirik Winter, head of European debt capital markets, for EM DCM as Citi aligns its European and EM DCM teams.

Paul Simpkin and Richard Basham will continue to run the European loans and leveraged finance teams and will now report to Basra. All non-real estate and other portfolio GSM businesses, which include conduit, corporate and infrastructure, structuring and advisory will move to CMO under Basra's leadership.

Basra will report to Michael Lavelle and Atiq Rehman, co-heads of the EMEA capital markets group. In addition, he will continue to report to Marcus Giancaterino for real estate and legacy portfolio businesses, which will remain in GSM or migrate to the Special Asset Pool.

Distressed trading head named
Broadpoint Capital has hired Brian Zucker as an md in the debt capital markets division. He joins Broadpoint with 14 years of experience trading high yield/distressed securities, most recently at Deutsche Bank where he was head of high yield cash trading. Prior to Deutsche Bank, he was a vp of high yield trading at Goldman Sachs from 2002 until 2005.

RBS hires head of credit portfolio analytics
RBS has appointed Scott Aguais as head of credit portfolio analytics for the credit risk executive team for global banking and markets. His responsibilities include developing, implementing and managing a suite of credit risk models and methodologies end-to-end in support of active credit risk and capital management.

Prior to joining RBS, Aguais was global head of credit risk methodology at Barclays Capital, where he led the bank's credit risk modelling effort in support of the attainment of their Basel 2 AIRB waiver. This work included developing a suite of 40 credit models and a solution for PIT and TTC ratings that utilised systematic credit risk cycles. In this role he also led the design, development and implementation of Barclays Capital's Phoenix solution, which is the firm's Basel 2 system and architectural solution.

CRE veteran appointed
Grubb & Ellis Company, a real estate services and investment firm, has appointed Ken Page as svp. Page will be a member and director of Grubb & Ellis' institutional capital markets group. Page, a 25-year veteran of the commercial real estate industry, joins Grubb & Ellis from Cushman & Wakefield, where for 14 years he was a member of the capital markets group, ultimately serving as the group's executive director in Houston.

CMA and Pricing Partners team up
CMA and Pricing Partners have announced a strategic partnership to provide a powerful combination of credit market pricing data and analytics to OTC credit market participants. The deal will integrate CDS price data from CMA's buy-side consensus-based CDS pricing service, DataVision, with Price-it Excel, a multi-asset class pricing platform from Pricing Partners.

Eric Benhamou, ceo of Pricing Partners, says: "We are delighted to partner with CMA. The accuracy of pricing models is dependent on the quality of the underlying data and DataVision is widely known and respected for its precision and timeliness. We see it as premium fuel for the high-performance machine our clients use to quickly and confidently value their credit derivative positions in Price-it Excel."

Laurent Paulhac, ceo of CMA, adds: "CMA is committed to providing greater transparency and operational efficiency in the OTC credit markets. It is important for us that our clients can consume the data they need via the platform of their choice. Combining data from CMA's buy-side consortium with Pricing Partners' technology enables market participants to apply the most reliable CDS data to a wide variety of trading, analytic and risk management functions."

GCM expands in aviation capital markets
Guggenheim Capital Markets (GCM) has hired James Palen as an md. Palen will help grow and expand the scope of GCM's aviation capital markets capabilities in sales, trading and investment banking and help develop other areas of the transportation sector for the firm. He will be based in the firm's New York office.

Palen brings extensive experience in the secured asset financing area, specialising in the structuring, restructuring and trading of airline, railroad and leasing company debt securities. Prior to joining GCM, Palen was a director at Credit Suisse, where he was responsible for the execution of secured capital market transactions for the firm's transportation clients.

MBIA faces new law suit
Three mutual funds managed by Third Avenue Management have commenced litigation in Delaware Chancery Court against MBIA Insurance Corporation and MBIA Insurance Corporation of Illinois, subsidiaries of MBIA Inc. The monoline is already being sued by a consortium of hedge funds led by Aurelius Capital (see SCI issue 128).

The latest complaint alleges, among other things, that the recent corporate 'transformation' announced by MBIA was illegal and was accomplished without due consideration in an attempt to defraud holders of MBIA Insurance Corporation's debt. The complaint describes how the Third Avenue Funds purchased notes issued by MBIA Insurance Corporation in February 2008 based upon the balance sheet of that entity and representations that this and other capital raises would be conducted to recapitalise and revitalise MBIA Insurance Corporation, following losses in its structured finance insurance business.

Martin Whitman, chairman of the Third Avenue Funds, says: "We are now being improperly denied the benefit of our investment - namely, a well-capitalised insurance company that is able to conduct a profitable business insuring municipal bonds. MBIA has stripped that business away from us and left us with a run-off portfolio that is likely worthless."

"Ironically, MBIA is now in the marketplace attempting to raise capital for the new entity, despite Third Avenue's bad experience with MBIA's last capital raise, which has given rise to this litigation," he adds.

UBS takes hit on 'bad bank' assets
UBS will book a US$300m charge in Q109 for the US$22.2bn of assets it transferred to the 'bad bank' scheme set up with the Swiss National Bank. The assets have fallen in value by US$700m since UBS' initial valuation in September 2008. It took US$400m as part of 2008 numbers and will be taking the balance in Q1.

TCC acquisition costs revealed
Consistent with new accounting standard SFAS No. 141(R), which requires transaction costs to be expensed, ICE will recognise transaction costs related to The Clearing Corporation (TCC) acquisition of approximately US$6m, as well as start-up expenses related to the launch of ICE Trust of approximately US$2m during Q109. The revenues and expenses associated with TCC and ICE Trust are not expected to be material to ICE's Q109 financial results, however.

Determinations committees adjusted
ISDA has announced the final composition of the credit derivatives determinations committees, following an adjustment by the DTCC in its classification of firms for the Asian regions. The adjusted data has resulted in an amendment to the regional non-voting representatives in Asia Ex-Japan and Australia/New Zealand (Nomura International), and the regional voting and regional non-voting representatives in the Japan (Mizuho Securities and RBS respectively) committee. The buy-side representation on these committees has not changed.

Formal membership of the committees will be confirmed once firms have signed a standard form of agreement with ISDA and (if they have not done so already) adhered to the 'big bang' CDS Protocol.

AC & CS

Fair value accounting 'relaxed'

A round-up of this week's structured credit news

In response to comment letters and additional feedback received, the FASB last week revealed significant revisions to the proposed FSP FAS 157-e, 'Determining Whether a Market Is Not Active and a Transaction Is Not Distressed' (see also separate News Analysis).

The Board decided that the final FSP would:

• Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).
• Clarify and include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
• Eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP will instead require an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
• Include an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
• Require an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
• Apply to all fair value measurements when appropriate.

The Board also affirmed its previous decision that the FSP would be applied prospectively and that retrospective application would not be permitted. The FSP is effective for interim and annual periods ending after 15 June 2009, with early adoption permitted for periods ending after 15 March 2009.

However, an entity early adopting this FSP must also early adopt FSP FAS 115-2, FAS 124-2 and EITF 99-20-2, 'Recognition and Presentation of Other-Than-Temporary Impairments'. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, 'Interim Disclosures about Fair Value of Financial Instruments', it must also elect to early adopt this FSP and FSP FAS 115-2, FAS 124-2 and EITF 99-20-2.

The Board also discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a and EITF 99-20-b, 'Recognition and Presentation of Other-Than-Temporary Impairments'. The Board made the following decisions in response to comment letters and additional feedback received:

• Scope
• The change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities.

• Recognition
• To replace the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery, with a requirement that management assert: a) it does not have the intent to sell the security; and b) it is more likely than not it will not have to sell the security before recovery of its costs basis.
• The guidance will incorporate examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired and how those factors interact with the requirement to assert that the entity does not intend to sell the security.
• When an entity does not intend to sell the security, it will recognise the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
• An entity will be required to recognise non-credit losses on held-to-maturity debt securities in other comprehensive income and amortise that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset, unless the security is subsequently sold or there are additional credit losses.
• The FSP will include guidance stipulating that credit losses should be measured on the basis of an entity's estimate of the decrease in expected cashflows, including those that result from an increase in expected prepayments.
• The guidance will clarify that existing premiums or discounts and subsequent changes in estimated cashflows or fair value should continue to be accounted for in accordance with existing guidance.

• Presentation
• An entity will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognised in other comprehensive income.
• An entity will be required to present separately in the financial statement where the components of other comprehensive income are reported, amounts recognised in accumulated other comprehensive income related to the non-credit portion of other-than-temporary impairments recognised for available-for-sale and held-to-maturity debt securities.

• Disclosures
• The disclosure requirements of FASB Statement No. 115, 'Accounting for Certain Investments in Debt and Equity Securities', and FSP FAS 115-1 and FAS 124-1, 'The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments', will be modified to require an entity to provide the following: a) the cost basis of available-for-sale and held-to maturity debt securities by major security type; b) the methodology and key inputs used to measure the portion of an other-than-temporary impairment related to credit losses by major security type; and c) a roll-forward of amounts recognised in earnings for debt securities for which an other-than-temporary impairment has been recognised and the non-credit portion of the other-than-temporary impairment that has been recognised in other comprehensive income.
• Statement 115 and FSP FAS 115-1 and FAS 124-1 will also be modified to require that major security classes be based on the nature and risks of the security and additional types of securities will be included in the list of major security types listed in Statement 115.

When adopting the new guidance, an entity will be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the non-credit component of a previously recognised other-temporary impairment from retained earnings to accumulated other comprehensive income, if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery. The cost basis used to calculate accretable yield will also be adjusted to reflect this adjustment.

Finally, FASB also re-deliberated proposed FSP FAS 107-b and APB 28-a, 'Interim Disclosures about Fair Value of Financial Instruments', in light of comments received and decided to proceed to a final FSP. The final FSP will amend FASB Statement No. 107, 'Disclosures about Fair Value of Financial Instruments', to require an entity to provide disclosures about fair value of financial instruments in interim financial information.

Next steps for improving OTC infrastructure
The Federal Reserve Bank of New York hosted a meeting on 1 April of major market participants and their domestic and international supervisors to discuss ongoing efforts to improve the infrastructure supporting the OTC derivatives market. Participants outlined their next steps to strengthen market infrastructure and enhance risk management practices, consistent with the priorities of the President's Working Group on Financial Markets and the US Treasury's framework for regulatory reform.

"Recent events underscore the need for more progress in reducing risk in the OTC derivatives market. Collective international efforts have increased operational efficiency and created greater transparency. But banks and buy-side firms still need to make considerable improvements to both risk management and the design of the OTC derivatives markets," comments William Dudley, president of the FRBNY.

Since the previous meeting with regulators in June 2008, industry participants have taken a number of steps to improve the OTC derivatives market infrastructure, including: establishing CDS central counterparties (CCP), increasing market transparency and reducing the size of CDS portfolios. The group has now agreed to pursue further improvements, including: completing 'hardwiring' the auction-based settlement mechanism for CDS, expanding operational performance targets and the use of CDS CCPs and trade repositories (see separate News Analysis), and supporting broad-based market governance and decision making processes. The next steps for addressing these priorities will be detailed in a letter to regulators by 29 May.

The New York Fed will continue to work with domestic and international industry supervisors to monitor progress and encourage further efforts to improve the OTC derivatives infrastructure.

Idearc LCDS auction approved
Markit LCDX index dealers have voted to run a credit event auction to facilitate settlement of LCDS trades referencing telephone directory publishing company Idearc - a constituent of Series 8, 9 and 10 of the index. The auction terms, including the auction date, will be determined according to LCDS auction rules published on the ISDA website.

Idearc is the fifth largest obligor in US CLOs, according to structured credit analysts at JPMorgan, with 0.9% average concentration among 399 sampled US CLOs. Year-to-date high yield defaults have pushed the CLO default rate to around 4.5% and the broader high yield loan default rate to over 8.3%, the analysts note.

CDS gross notionals rise
DTCC data for the week ending 3 April indicates that gross CDS notionals rose by US$779bn (or 2.87%) to US$27.95trn. After a significant drop of over 11% in gross notional the prior week, indices rebounded to be the largest gainer on the week with almost 7% growth in gross notionals to US$9.15trn.

Single names saw minimal growth in gross notionals (less than 1%), but remain the largest segment of the market at US$15.15trn. Index tranches picked back up after two weeks of stagnation with a 1.7% rise to US$3.6trn gross notional (although volumes remain low in absolute terms and focused on off-the-run).

While the CDX Series 12 and iTraxx Series 11 indices are not included in the data yet, the trend remains positive growth for the CDS market in terms of gross notional, according to analysts at Credit Derivatives Research. However, they note, with the roll holding appetite down and investors waiting for the 'big bang', activity in general was quiet.

FSF pro-cyclicality recommendations released
The Financial Stability Forum has released a report detailing its recommendations for addressing pro-cyclicality in the financial system. They encompass a mix of quantitative/rules-based and discretionary measures that are interrelated and reinforce one another. They will be implemented over time once conditions in financial markets return to normal, the FSF says.

The recommendations are in the following three areas:

• The bank capital framework. These recommendations were developed with the Basel Committee on Banking Supervision and are intended to mitigate the risk that the regulatory capital framework amplifies the transmission of shocks between the financial and real sectors. They include the development of countercyclical capital buffers and a supplementary non-risk based measure to contain bank leverage. An integrated package of measures covering the recommendations will be issued for consultation before the end of 2009.
• Bank loan loss provisions. These recommendations reflect the view that earlier recognition of loan losses could have dampened cyclical moves in the current crisis and that earlier identification of and provisioning for credit losses are consistent both with financial statement users' needs for transparency regarding changes in credit trends and with prudential objectives of safety and soundness. Recommended accounting and capital measures seek to achieve these objectives while encouraging sound provisioning practices and enhancing their transparency.
• Leverage and valuation. These recommendations, which were developed with the Committee on the Global Financial System (CGFS), are intended to reduce pro-cyclicality that has arisen from the interaction of leverage, funding mismatches and fair value accounting. They call on regulators and supervisors to obtain a clear and comprehensive picture of aggregate leverage and liquidity, and to use quantitative indicators and/or constraints on leverage and margins as macro-prudential tools for supervisory purposes. Accounting standard setters are encouraged to improve approaches to valuation and financial instruments, in cooperation with prudential supervisors, so as to dampen adverse dynamics potentially associated with fair value accounting.

The FSF will monitor the implementation of these recommendations and continue to examine aspects of pro-cyclicality in the system.

Separately, the FSF has issued principles for sound compensation practices and for cross-border cooperation on crisis management. Compensation practices in the financial industry are required to align employees' incentives with the long-term profitability of the firm. The principles call for effective governance of compensation and for compensation to be adjusted for all types of risk, to be symmetric with risk outcomes, and to be sensitive to the time horizon of risks.

Authorities expect evidence of material progress in the implementation of the principles by the 2009 remuneration round.

Meanwhile, the crisis management principles call for authorities to commit to cooperate both in making advanced preparations for dealing with financial crises and in managing them. The principles also commit national authorities from relevant countries to meet regularly alongside core supervisory colleges to consider together the specific issues and barriers to coordinated action that may arise in handling severe stress at specific firms, to share information where necessary and possible, and to ensure that firms develop adequate contingency plans. The FSF will act as a clearinghouse for experiences in information sharing and contingency planning for the benefit of all its members.

CLO spreads widen on downgrade risk
Indicative CLO spreads have moved for the first time since mid-February. According to structured credit analysts at JPMorgan, US CLO triple-As widened by 50bp to 600bp and double-Bs dropped by three points to US$5, largely on the back of imminent downgrade risk and a rising outlook for losses in the underlying collateral markets.

"Currently, we observe the secondary market is paying clear attention to each individual deal's EOD language, with resulting price bifurcation," they note.

Based on JPMorgan's loan-level analytics platform and current leveraged loan market prices, the analysts estimate cumulative two-year default rates ranging from 30% to as high as 50% for the base case to stress/market re-rating cases.
Assuming baseline recoveries of 55% for first lien and 20% for second lien names, the corresponding losses range from mid-teens to close to 20%.

The analysts highlight the 'sharp cliff' centered around 2013 in terms of loans needing to refinance, indicating that CLO (or broader market) ability to absorb refinancing needs is thus a serious question. "Of course, 2013 is a long way off and PPIP/TALF intervention could easily have changed the landscape by that time," they add.

More TALF-eligible deals completed ...
Two US credit card ABS and two US auto loan ABS were being marketed earlier this week as the subscriptions for the second round of TALF financing opened. Bank of America and JPMorgan were marketing the US$735m CarMax Auto Owner Trust 2009-1 transaction, while the US$750m World Omni Auto Receivables Trust 2009-A was being led by Bank of America and Barclays Capital.

Barclays Capital and JPMorgan were in the market with World Financial Network 2009-A's US$709m credit card transaction, and JPMorgan and Wachovia marketed the US$486m Cabela Credit Card Master Note Trust 2009-1 deal.

... while second TALF facility requests revealed
A total of US$1.71bn worth of loans were requested at the 7 April TALF facility, split between auto ABS (US$811m) and credit card ABS (US$896.8m), to be settled on 14 April. The rates for the facility were set at 2.8725 (fixed) and 1.46933 (floating).

US$7trn CDS compressed in Q109
TriOptima's multilateral compression service, triReduce, eliminated US$5.5trn in notional principal in the first three months of 2009 (out of the approximately US$7trn in notional reduction reported to the New York Fed for the period). In a series of 12 compression cycles for US and European indices, tranches, ABX and emerging markets transactions, participants reduced even further the notional amounts outstanding. During 2008 TriOptima offered 50 compression cycles in various CDS transaction types in US dollars, euros and Japanese yen, which reduced outstandings by US$30.2trn.

SF CDO assumptions updated
S&P has updated its assumptions for assessing the default probability of structured finance (SF) assets with ratings on credit watch negative held within global CDO transactions. Following a recent review of rating transitions for SF securities, the agency has modified the assumptions it uses when rating cashflow, hybrid and synthetic CDO transactions with exposure to such SF assets. These changes are intended to provide our CDO analysis with a forward-looking view of the likely default probability of the underlying SF collateral, S&P notes.

Across S&P's rated SF securities globally in 2007 through year-to-date 2009, the agency has observed an increase in the average notches per downgrade to a level that is almost twice the historical average seen in the years before 2007. As the overall economy and housing markets continue to exhibit volatility, S&P anticipates that this increased severity will continue through the current economic cycle.

Going forward, in assessing the credit quality of SF assets held as collateral within CDO transactions, the agency will lower the current rating on any SF asset with its rating on credit watch negative by three notches (up from our prior assumption of one notch) for purposes of running CDO Evaluator. Additionally, for certain vintages of US RMBS transactions with ratings currently on credit watch negative, it will apply an additional adjustment of three to six notches on top of the standard three notches.

Specifically, for prime jumbo RMBS and Alt-A RMBS originated in the second half of 2005, S&P will lower ratings on watch negative an additional three notches for purposes of generating the CDO analysis; and for prime jumbo RMBS and Alt-A RMBS originated in 2006 and 2007, it will lower ratings on watch negative an additional six notches for purposes of generating the CDO analysis.

Card delinquencies reach historical high
Fitch says that delinquency levels reported on UK credit card trusts increased further in February 2009, reaching a new historically high level after showing a month-on-month increase for each of the last six months. The agency expects this deterioration to continue throughout 2009, with the rise in delinquencies supporting its view that the UK economic downturn will continue to impact customers' ability to service their credit card debts.

In its 'Credit Card Movers & Shaker (UK) - February 2009' report Fitch details the increase in 60-180 day delinquencies that occurred for each of the trusts included in the index in February 2009. The Fitch Delinquency Index recorded a month-on-month increase of 30bp, to 4.8%, from 4.5% in January.

In line with the rise in delinquencies, the Fitch Charge-off Index (Fitch CI) recorded a month-on-month increase of 60bp in February to 7.4% from 6.8%. The rise in the Fitch CI was partially driven by a 140bp increase in charge-offs for the Sherwood trust, driven by the impact of day count in February and an increase in the roll through of delinquencies to charge-offs.

Following a slight increase in January, the Fitch Monthly Payment Rate Index (Fitch MPRI) fell again in February, by 130bp to 15.1%. The decline occurred as a result of a drop in MPR by each of the trusts included in the index, with the exception of the CARDS I trust, which remained unchanged from its January value. Although the Pillar trust reported one of the largest month-on-month drops in MPR in February, of 220bp, the size of the fall can be partially explained by an overstatement of the trust's MPR in January due to the buy-back of delinquent receivables.

The Fitch Yield Index (Fitch YI) also fell in February to 19% from 19.5% in January, driven by a reported drop in yield for half of the trusts included in the agency's index. On a positive note, following an increase in January, the Fitch Excess Spread Index (Fitch ESI) increased again in February, rising 20bp, to 7.2% from 7%.

New index series' risk profiles analysed
Moody's Analytics has released a report on the impact of the iTraxx and CDX index rolls on the risk profiles of their constituents. The indices rolled into Series 12 and 11 on 20 and 27 March respectively.

Despite the tightening of spreads on the indices on their roll dates, the risk profiles of the indices were unchanged to marginally better. Reference entities that were removed from the indices, due to widened spreads or credit events, were replaced by higher quality (i.e. higher-rated) names on average.

Nevertheless, the added names traded cheaply for their ratings, indicating greater credit risk than implied by their credit ratings, Moody's notes. This is also consistent with the practice of selecting cheap names for the indices.

Many of the reference entities that were removed from the benchmark CDS indices experienced spread widening in line with the market. Conversely, some names that were retained had large negative ratings gaps compared to those that were dropped, meaning that they experienced relatively more spread widening than the broad market. At least for this roll, the report indicates that the practice of adding and removing names to the index based on spread levels may not, in fact, help improve the overall credit quality or liquidity of the indices.

The CDX.NA Series 11 indices experienced a total of six credit events compared to one credit event in the iTraxx Series 10/11 indices. The relatively higher number of credit events in the North American CDS indices highlights the fact that the deterioration of credit quality of primarily US-domiciled entities began sooner and has run higher than their European counterparts, the report says. The outlook for European credit quality is, however, shifting to the negative.

The iTraxx Europe HiVol and Crossover indices may be particularly exposed to the expected increase in credit risk. The majority of the names added to each of these two indices on the last roll exhibit negative CDS-implied ratings gaps, contributing to the overall negative gap of each portfolio. Moody's Analytics research has shown that negative CDS-implied gaps have historically been strong signals of higher relative default risk.

High hopes for TALF
In a new report, Moody's says that TALF will have an uneven and modest impact on the credit markets in its early stage. However, the rating agency expects the programme to gain significant momentum as it unfolds and as its terms are adjusted to cover more securities and more vintages.

TALF currently targets a number of triple-A rated consumer finance-related securities issued in 2009, while upcoming expansions will cover a broader range of securities and older vintages, such as pre-2009 triple-A rated ABS and CMBS, as well as RMBS that were originally rated triple-A (SCI passim).

"TALF is structured to provide stop-loss protection to investors via non-recourse loans, while requiring participants to have 'skin in the game' with haircuts that force borrowers to retain a share of the risk," comments Moody's vp Jean-Francois Tremblay, the report's lead author. "Once future expansions are phased in and the programme gains momentum, TALF could help stimulate a market-based price-discovery process for less liquid securities and, through arbitrage, the yields on other instruments should fall - which would gradually help all forms of debt."

"Judging from the size of TALF, the government appears to be signaling its ambition to boost the issuance volume of eligible securities to pre-crisis levels," continues Tremblay. He comments that TALF roughly matches the size of recent issuance volumes of the eligible securities, noting that the government allocated US$200bn to TALF in its first phase, targeting assets whose issuance volume had reached US$214bn in 2007.

In the report, Moody's says that TALF 1.0 should be beneficial to prime retail auto loan lenders, while the benefits to lenders of non-prime retail auto loans, retail auto leases and auto dealer-floorplan loans will likely be limited.

Moody's also says the credit card ABS market should benefit from TALF 1.0. "Scheduled maturities in 2009 are about US$80bn, thus forming the largest single asset class that is presently eligible," the analyst notes.

The agency remains cautious, however, about new issuances. "Whether the securities are prime loan ABS, RMBS or CMBS, perhaps the biggest challenge that originators will face is to fund the riskier subordinated tranches (mezzanine and equity) that are required to support the securitisation process." In the current risk-averse environment, originators may have to keep these subordinated tranches on their balance sheets, which may contribute to fewer new originations.

TALF 1.0 appeared to be initially designed to provide support to leveraged investors, like hedge funds, as opposed to cash buyers such as insurers, because of a number of accounting and risk management considerations, which are examined in detail in Moody's report. "However, we have come to the view that TALF's non-recourse loans may also attract some cash buyers, such as life insurance companies, because of the low liquidity risk," says Tremblay.

In the worst case, Moody's points out, at the end of the loan term (three years), the investor simply surrenders the ABS to the government, regardless of the market price or the rating of the pledged asset, in order to pay off the loan. An investor is not required to pledge additional liquid assets as collateral if the ABS loses value in the market, unlike some alternative investment options.

On the other hand, Tremblay points out that a significant limitation to the potential success of the programme - at least in the short run - is the lack of flexibility with respect to the term of the loans, which are currently granted on a standard three-year maturity, regardless of the maturity of the securities being financed (see SCI issue 129). "Investors purchasing an instrument that has a maturity over three years through TALF will face refinancing and market risks, which are both significant rating factors," he says.

Moody's is, however, significantly more positive regarding the potential credit implications of future TALF expansions, which will cover a broader range of securities that are currently burdening many banks' balance sheets. In the report, it explains that an expanded TALF has the potential to help banks in three ways: as originators of asset-backed securitisations; as broker-dealers; and, perhaps most significantly, as investors.

Banks may obtain greater benefit from TALF than investors - in part because of more favourable accounting implications - than they would as issuers. "Easing the fall in the value of securities would already be a major achievement and potentially the beginning of a new virtuous circle that would be supportive of lending," the agency says.

"Because the securities that banks currently hold for investment and trading have been marked down to current market prices, their sale at a higher price would result in profits," explains Tremblay, adding that this situation would in turn boost earnings and possibly capital levels.

"From a credit rating perspective any significant impact of TALF on investors' confidence and on economic conditions might cause our loss assumptions to be reduced, which may in turn have a positive credit impact on our calculations of banks' capital ratios and, potentially, on their broader credit profiles and ratings," concludes Tremblay.

Primus...
S&P has lowered its issuer credit, senior debt and senior subordinated debt ratings on Primus Financial Products. At the same time, the agency affirmed its rating on Primus' preferred shares. Its outlook on Primus remains negative.

The lowered ratings reflect further deterioration in the ratings on the reference entities on which Primus sold credit protection through CDS, and the fact that one of those reference entities recently experienced a new credit event. Based on the 1 April 2009 report that S&P received from Primus, the reference entities' negative rating migration has outpaced the benefits of a shrinking maturity profile and Idearc Inc, a reference entity in Primus' credit default swap portfolio, has experienced a credit event. The CDPC has failed the capital model tests that it is required to pass in order to maintain its current ratings.

S&P says it is lowering its issuer credit rating on Primus to triple-B plus to reflect the impact of Idearc's credit event on Primus' capital, as well as the impact of other lowered ratings on the reference entities in Primus' derivatives portfolio. The agency's outlook on the CDPC remains negative because it believes that the fundamental economic and business condition for Primus has deteriorated significantly.

...and Athilon downgraded
S&P has lowered its issuer credit, senior subordinated, subordinated and junior subordinated note ratings on Athilon and removed the ratings from credit watch with negative implications, where they were placed 31 October 2008. At the same time, S&P has assigned a negative outlook to Athilon.

The lowered ratings reflect: the further credit deterioration of the reference entities in Athilon's corporate tranche CDS portfolio; the updated lifetime loss projection on Athilon's exposure to senior tranches of ABS CDOs (transaction B); and the possibility of a credit event cash settlement payment on the CDS on transaction B's senior tranches occurring after 4 October 2014 and S&P's projected losses associated with that scenario.

Bank shifts SIV from balance sheet
Baltimore-based Legg Mason announced that it has repaid debt and amended its debt agreements with its lenders, allowing the company to sell the US$49m in carrying value of SIV assets that had remained on its balance sheet after the removal of all SIVs from its money market funds on 5 March. The company sold its remaining SIV exposure for approximately US$49mn in proceeds. Together with the expected tax benefit from the previous sales of SIV securities, the company expects to receive a combined tax benefit of approximately US$520m.

SF CDOs impacted
Moody's has lowered the ratings of 40 notes issued by 11 structured finance CDO transactions and confirmed the ratings of 10 notes issued by two other deals. The agency explains that the rating actions reflect certain updates and projections and recent rating actions on underlying assets on these asset classes.

Moody's has also downgraded its ratings of eight notes issued by three CDOs that have ratings that are primarily based on the long-term rating of the put counterparty (Wachovia Bank). The put counterparty was downgraded to Aa2 on 25 March 2009.

Fitch comments on distressed German mezz CLOs
Fitch has published a new report discussing the recent performance of German mezzanine CLOs, the agency's surveillance approach to such transactions and the rating action it has taken in the sector since the launch of its corporate CDO methodology in April 2008.

Of the 11 transactions rated by Fitch - belonging to five different programmes - have experienced considerable negative credit quality migration. With the exception of PRIME 2006-1, all the transactions have experienced credit events and in some cases, credit events were amplified through being referenced in more than one mezzanine programme.

Due to concentration risks, past performance and negative portfolio migration, Fitch believes that the credit quality of the downgraded classes of notes was no longer commensurate with an investment grade rating. The typical magnitude of downgrade saw the triple-A rated classes downgraded to a double-B rating category.

Japanese ABS/CDO issuance declines
According to provisional totals compiled by Deutsche Bank's securitisation products research team, issuance of Japanese ABS for March 2009 fell by 39.4% from March 2008 to ¥687.6bn - thereby marking the first time in six years that March issuance has come in below the ¥1trn level. The figures indicate that securitised product issuance for full-year 2008 (April 2008 to March 2009) totaled some ¥4.77trn, down 39% from full-year 2007.

Specifically, the CMBS and CDO sectors saw declines of 78% and 52% respectively relative to full-year 2007, while narrowly defined ABS issuance increased - with origination up by 57% for credit receivables (including auto loans), by 48% for consumer loans and by 2% for equipment lease receivables. However, RMBS issuance was down 37% from full-year 2007.

According to the Deutsche analysts, the CDO sector saw a significant decline in CLO/CBO origination in line with the deterioration in creditworthiness of SMEs. "The biggest factor behind this sharp contraction of the market would appear to be the performance of CBO 'All Japan Tokutei Mokuteki Kaisha', a product backed by SME-issued private placement bonds," they explain. "It has long been clear that only investors in the super-senior Class A notes will be able to recoup their entire investment, and on 26 March CBO All Japan announced that upon scheduled maturity (in April) it will be redeeming just ¥83.95 per ¥100 face value to investors in the Class B notes (which were initially rated triple-A by S&P) and zero to investors in Class C (initially rated double-A) and Class D (initially rated single-A). As expected, investors in the Class A notes will be repaid in full."

Within the ABS sector, origination of products backed by credit receivables (including auto loans) was up 87% from 1Q08 in January-March 2009, while issuance of products backed by equipment lease receivables was up 21%. "This is perhaps an indication that non-banking financial institutions have turned to the securitisation market for a portion of their fundraising needs as a worsening of the financial crisis since autumn 2008 has increasingly restricted their access to funds in the corporate bond and commercial paper markets. We expect this trend to continue into the new fiscal year," the analysts add.

The increase in consumer loan ABS origination was in large part attributable to the GE Consumer Finance issue, after the firm was purchased in its entirety by Shinsei Bank. Outstanding consumer loan principal continues to decline, however, as a consequence of legislative changes and the continued need for lenders to reimburse overpaid 'grey zonei interest, and so the analysts expect to see only limited consumer loan ABS origination in the near to medium term.

Meanwhile, the steep decline in CMBS origination reflects a rapid downturn in the property market and the scaling-back of operations by some of the sector's major players. Moreover, a number of originators are now finding it difficult to refinance maturing CMBS issues due to reluctance or caution on the part of lenders, Deutsche notes.

'Downward spiral' for EMEA RMBS
EMEA RMBS markets have followed a clear downward spiral in 2008, according to Moody's latest EMEA RMBS index report. The strongest deterioration was witnessed in those countries where the real estate sector represented a large portion of the economy.

Nevertheless, despite the virtual disappearance of investor interest and deteriorating performance, the amount of outstanding transactions has grown strongly during the course of 2008. This is mainly due to interventions by central banks and governments to inject liquidity into the markets.

"The countries whose RMBS sectors were surveyed in the report remain in recession, driven by a fall in private consumption and fixed investment, which in turn is exacerbated by the scaling-back of the real estate sector," says Nitesh Shah, a Moody's economist and co-author of the report.

Rising unemployment and a further decline in house prices remain the main concern in all European economies. "The common thread among countries with fast-rising unemployment - Ireland, Spain and the UK - is the role played by the real estate sector during the upswing: countries that had attracted more employment in the real estate sector suffered greater job losses in the downturn," adds Shah.

Moody's report notes that house prices across Europe declined sharply in Q408. Indeed, the fall in house prices for the whole of 2008 reached unprecedented levels not previously seen in commonly used price indices.

"UK prime and Spanish transactions experienced the steepest increase in 60+ days delinquencies, reaching 2.24% and 1.73% respectively in Q408. Compared to Q407, delinquencies in the UK more than doubled while those in Spain tripled," says Georgij Ludmirskij, a Moody's senior associate and co-author of the report.

On the other hand, the majority of French, German and Dutch prime transactions continued to show stable levels of delinquencies, defaults and losses. Moreover, a decline in prepayment rates was recorded in UK prime, buy-to-let and UK non-conforming markets, where refinancing mortgages was a common practice.

"Rising house prices have played a role in increasing household leverage in many countries, prompting most consumers to seek to rebuild savings after a considerable period of rising debt. In the UK, the household savings ratio turned negative in Q108, but recovered to 1.8% by Q308 and is trending higher as consumers engage in more cautionary saving," concludes Shah.

Indian microfinance CLO completed
SKS Microfinance and Yes Bank have completed a Rs1bn securitisation deal, which will allow Yes Bank to purchase around 140,000 micro loans extended to priority sector borrowers. Rating agency Crisil has assigned a rating of P1+SO to the transaction, with Unitus Capital acting as advisor. SKS Microfinance has completed a number of securitisations of microfinance loans, the last one being a Rs2bn deal with ICICI bank in February (see SCI issue 125).

Harbourmaster triple-As hit in review
Fitch has put three triple-A tranches from two Harbourmaster CLOs on rating watch negative, following shortfalls in interest payments incurred last month. The affected tranches are Class A2E and A2F of Harbourmaster CLO 5 (HM5) and Class A2 of Harbourmaster CLO 8 (HM8).

These notes are rated for timely interest payment, but Fitch expects the interest shortfall to be temporary. However, the notes will remain on rating watch negative until the missed interest is paid and timely payments resume - which the agency anticipates will occur on the next quarterly payment date. The non-payment of interest on these notes, under their terms and conditions, does not constitute an event of default for the transactions.

The notes suffering shortfalls received approximately 50%-60% of the due interest, caused by the management of the liquidity facility. The transactions have a liquidity facility that can be drawn by the manager prior to the CLO payment date to borrow portfolio accrued interest owed to the transaction, but not yet received by a due payment date.

The drawn amount can be used to pay interest on all classes, including the equity holders. On the December 2008 previous payment date for HM5 and HM8, up to 60% of the interest proceeds distributed to the noteholders consisted of cash borrowed from the liquidity facility.

The portfolio manager could continue to use the liquidity facility as long as the overcollateralisation (OC) tests were in compliance. Since December, the portfolios of the affected transactions have suffered defaults.

As a result, the junior OC tests have breached. Under the terms of the liquidity facility agreement, the liquidity facility could no longer be drawn.

On the March 2009 payment date, the liquidity facility for HM5 and HM8 had to be fully repaid from the previous period's drawing. However, no future drawing on the facilities was possible due to the failure of the OC tests. Consequently, the interest proceeds available for the noteholders were reduced by as much as 70% compared to the previous payment date.

These remaining proceeds were insufficient to pay the due interest on the Class A2E and A2F of HM5 and Class A2 of HM8. Although principal proceeds can be used to pay interest shortfall on these classes, the principal cash available was also insufficient to ensure the full interest payment of these classes.

Given that the liquidity facilities have now been fully repaid for HM5 and HM8, interest proceeds projected for the next payment date in June 2009 are expected to be significantly higher. Harbourmaster Capital, the manager of these transactions, anticipates that sufficient interest proceeds will be available to pay the due interest, the March 2009 interest shortfall and the interest on the interest shortfall of the affected tranches.

Protracted commercial mortgage workouts likely
Fitch says that workouts of defaulted commercial mortgage loans are likely to be protracted as servicers contend with balloon risk.

"Such is the level of uncertainty surrounding commercial property sales prices, especially those achieved by forced sellers, liquidation is being viewed very much as a last resort. This is encouraged by the fact that funding costs may fall after the expiry of hedging arrangements," says Euan Gatfield, senior director in Fitch's CMBS team.

Whereas European CMBS provides floating-rate property finance, the underlying contractual rental income used to service the bonds tends to be much more stable in nature. This creates a mismatch that is hedged via the use of swaps or caps. After loan maturity such hedging arrangements will typically fall away, which might create new servicing opportunities, particularly given the low interest rate environment in Europe.

"Servicers may attempt to lock in lower swap rates as a means of improving the affordability of CMBS debt service. This may allow for principal amortisation to take place, albeit only after loan maturity and until the deadline of bond final maturity," adds Gatfield. "The possibility of improved interest coverage over an extended 'tail period' might enhance the recovery prospects for some classes of note that would likely incur losses if a property fire-sale was attempted in current market conditions."

Yet servicers face several potential pitfalls along the way. With the real economy coming under renewed stress, declines in rental income could scupper the scope for enhanced amortisation.

However, one mitigating factor is that many loans do benefit from rental income contracted for several years after loan maturity. Even so, the length of tail period for loans might in practice be insufficient to produce significant amortisation; or worse, it may expose noteholders to the full depths of the property downturn.

In this respect, the timing of European CMBS legal maturities happens to be quite benign. In general, the riskier loans are those that were originated in 2006 and 2007, although they typically have at least four years left until bond maturity. Furthermore, in multi-borrower CMBS the effective tail period for loans on shorter terms is longer because bond maturity lags that of the longest-dated loan in the pool.

Nevertheless, by the time loans finally mature, a lower all-in cost of funding might no longer be accessible. Swap rates could have reverted back to their long-term averages sooner than expected (although forward-starting hedging contracts entered into pre-emptively could minimise this risk).

The imposition of senior special servicing/workout fees would reduce interest coverage. Rolling forward the coupon on a fixed-rate loan or imposing penalty interest might boost income at the issuer level (benefiting Class X notes), but not at the borrower level where it is needed if amortisation is to be enhanced.

At the peak of the property market the level of rental yields in the UK became the constraining factor for the affordability of new loans, which meant that providing long-dated swaps with lower rates gave some lenders a competitive edge. Falling swap rates create a challenge for investors in certain Eclipse and Epic CMBS that have this feature because not only are servicers prevented from exploiting falling swap rates (by the term of existing contracts), they also run the risk of incurring breakage costs upon liquidating loan security.

Without the prospect of enhanced CMBS amortisation, delaying liquidation could heighten noteholders' exposure to further declines in property value - a risk that cannot be ruled out, especially in areas of mainland Europe where the downturn is lagging that experienced in the UK.

"Given the number of moving parts, whatever course of action a servicer elects to take will likely prove contentious to some or other party [SCI passim]. In particular, holders of senior bonds bought in the primary market who are being paid only a fraction of the prevailing market-implied risk premiums might well balk at the idea of receiving principal back with greater arrears," says Andrew Currie, md in Fitch's CMBS team. "However, servicers ought to be able to pursue whatever tactics they see fit, and the alternative of a fire-sale is probably even less appealing."

Calypso releases SNAC update
Calypso Technology has released a software update to support the new standard North American corporate (SNAC) CDS contract, scheduled to launch today (8 April).

"This is a monumental change in the world of credit derivatives, when you consider that credit default swaps are the building blocks for all synthetic credit trading. As a result, the new convention has a wide-ranging impact on organisational trading business and workflow and consequently on any trading system," states Shailendra Methi, senior product manager at Calypso Technology. "The creation of fungible CDS trades is a crucial step toward efforts to standardise the CDS market, institute central counterparty clearing for credit derivatives and help clean up systemic risk."

The software update encompasses all areas of credit trading, including trade capture, pricing, market data, risk analysis, settlement and clearing. The enhancements include: trade capture using SNAC conventions; calculation of upfront fees using the ISDA standard model; yield curve (interface with Markit to automatically update this curve on a daily basis); termination (unwind by specifying conventional spread or upfront; risk analysis (convert all the names to conventional spread and upfront to compare; credit event processing (enhanced to take care of rolling credit event date).

CDS liquidity diverges in the UK/US
Fitch Solutions' latest global liquidity scores commentary shows that liquidity in the US market for CDS fell significantly on 3 April, with the Fitch Americas CDS Liquidity Index closing at 9.81 after having improved over the previous two weeks. This is in stark contrast to liquidity in the European market, which closed at 10.11 on the same day after continuing to drift over the last two weeks.

Looking ahead, the market will shift its focus to the upcoming changes to the CDS market in North America, which will improve standardisation across the trade and settlement process, Fitch says. In theory this should help the North American market become more liquid, although only time will tell what impact this is truly going to have.

At the same time, Latin America continues to dominate liquidity in the sovereign CDS market, with Brazil taking top spot over Mexico. The entry of Thailand into the top five for the first time highlights increasing market concerns about its current border dispute with Cambodia.

The financial sector continues to dominate liquidity in the US market, with General Electric Capital Corporation retaining the top spot, closely followed by Citigroup and Bank of America Corporation. Companhia Vale do Rio Doce, the Brazilian mining company, has entered the top five for the first time against a backdrop of declines in the price and volume of its iron ore exports.

Meanwhile, telecoms companies are back in the driving seat in Europe from a liquidity standpoint, with Portugal Telecom International Finance now joining British Telecom and Telecom Italia in the top five, due to ongoing M&A speculation in the market. AXA, the insurance company, is now the third most liquid credit in Europe - this appears to be the result of investor activity to buy protection on AXA CDS after recent ratings downgrades for a number of insurers across the insurance sector, Fitch suggests.

Finally, the Korean banks' dominance of liquidity in the Asia-Pacific market is finally being broken with POSCO, PCCW-HKT Telephone and Samsung Electronics moving into the top five. POSCO, the Korean steel manufacturer, has seen volumes and revenues decline due to the impact of the global economic slowdown and is looking to further extend the output reduction it made in December 2008. PCCW-HKT Telephone has been subject to a potential buyout by Richard Li, a PCCW shareholder.

Risk monitoring framework developed
Aleri, a provider of enterprise-class complex event processing (CEP) technology and CEP-based solutions, has announced the development of a real-time (RT) risk monitoring solution framework. The framework provides a template for rapid implementation of a customised, comprehensive solution for consolidating and managing credit and market risk.

Aleri's RT Risk Monitoring solution provides consolidation and analysis of positions in real-time, which can help a firm identify unacceptable levels of exposure along a number of configurable dimensions, including counterparty, trader, asset class, region and industry sector. The solution gives users the unique ability to determine the underlying cause of the concentration, right down to individual trades.

Additionally, Aleri's event-driven architecture allows for non-intrusive integration with existing systems, making it easy for firms to quickly move from end-of-day monitoring to immediate insight.

"Market volatility and the increased focus on counterparty risk have prompted trading firms to look for better tools to manage their exposure," comments Jeff Wootton, vp of product strategy at Aleri. "The current tools many firms are using can't provide consolidated information on a timely enough basis across their trading operation. Aleri's RT Risk Monitoring solution can quickly provide firms with this capability."

Hardwiring to have 'limited impact' on rating assessments
S&P says that ISDA's hardwiring process will have only a limited impact on its rating assessments and will likely not lead to any changes in its default or recovery assumptions.

"Because loan-only transactions and CDS on ABS generally are not protocol-covered transactions and not modified by the protocol, the changes are limited to bespoke and index-based corporate and sovereign portfolios and single name corporate and sovereign portfolios," notes S&P. "The auction process is already well established for these protocol-covered transactions and S&P believes that the protocol will have a limited effect on our rated transactions. In addition, none of the proposed changes is expected to affect our review of recoveries under a swap that adheres to the protocol because the changes do not affect the swap's sizing of defaults and recoveries."

The rating agency also confirms that adherence to the protocol pursuant to the form adherence letter is not expected to, in and of itself, lead it to lower or withdraw the ratings it assigned to US synthetic CDO and US cashflow CDO securities supported by CDS that meet the definition in the protocol of a protocol-covered transaction and any of the following definitions in the protocol: covered CDX tranched transaction; covered CDX untranched transaction; covered iTraxx tranched transaction; covered iTraxx untranched transaction; single name CDS transaction; or bespoke portfolio transaction.

Prime brokerage covered for docGenix
docGenix has expanded its inSight documentation risk management service to cover prime brokerage agreements. The offering aims to enable participants in the OTC derivatives markets to manage mission-critical risks inherent in portfolios of ISDA legal agreements, meeting the increased regulatory and best practice standards of the new age.

Launched in April 2008, inSight's initial coverage included ISDA Master Agreements, Credit Support Agreements and associated amendment agreements. This new enhancement gives market participants the ability to access and search prime brokerage agreements, as well as related ISDA legal agreements through a single online platform.

General Counsel John Berry comments: "This is an enhancement that buy-side clients have requested. It shows that we are responsive to the needs of our clients and is evidence of how our flexible approach permits inSight to be expanded into new areas."

CS & AC

Trading

Trading ideas: pressure bow

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Pitney Bowes Inc

With unemployment looking to shoot past 10% in the US and commercial property values falling like a stone, clearly the business sector is hurting. We find the capital goods sector and more specifically its industry subset, business services & supplies, to be trading rich relative to other non-financials. As a cheap short, we recommend taking a look at Pitney Bowes.

Its credit spread trades at an extremely tight 81bp. Though we are confident that the issuer will not have any serious liquidity or actual default concerns, its spread should be trading wider, given its relative risk levels. We currently have an open long equity/short credit capital structure arbitrage trade on Pitney; however, due to its recent spread tightening, we also believe an outright short is prudent.

Pitney Bowes runs a stable and cashflow-generating business; however, it also maintains a substantial debt load. The weight of its debt is evident when looking at its interest coverage levels relative to similar issuers.

Exhibit 1 shows a histogram of the interest coverage levels for all capital goods issuers. Pitney Bowes has US$4bn in long-term debt coupled with US$600m in commercial paper issuance.

The company's interest expense is approximately US$240m per year, resulting in an interest coverage (EBITDA to interest expense) close to 7x. This puts its coverage level in relatively the bottom of the capital goods range.

Exhibit 1

Again, we do not envision the company defaulting on its debt; we just find 80bp to be too tight, given its inherent credit risk and the state of the economy. Also, the equity market values its market capitalisation at almost US$5bn. It would be hard to find many companies trading at 81bp with leverage (total debt-to-market capitalisation) close to 1x.

We see a 'fair spread' of 160bp for PBI based upon our quantitative credit model, due to its leverage, change in leverage and interest coverage levels. The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit).

After trading tight to fair value throughout most of 2008, Pitney's spread widened to fair right after the Lehman Brothers bankruptcy (Exhibit 2). However, since then its expected spread level continued to climb, reaching a level above 300bp at one point.

Exhibit 2

Though its spread did trade above 150bp late in December, it has since rallied to a level 50% below its wides. We believe this is overdone and recommend buying protection on Pitney Bowes.

Buy US$10m notional Pitney Bowes Inc 5 Year CDS protection at 81bp.

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).