Contents

Emerging Markets

Primed for growth

Recovery fund to target emerging market exposures

Emerging markets look set to fuel the next stage of global growth and the latest recovery fund is expected to benefit from this environment - as well as help banks address some of their balance sheet issues. But whether such a solution could be tailored to tackle the broader problem of 'toxic' asset overhang is debatable.

The traditional emerging markets 'core versus periphery' model is erroneous, according to Jerome Booth, head of research at Ashmore Investment Management. "As the credit crunch is the problem with the core, the brain is hardwired to think that the same problem is affecting the periphery - but it isn't," he says.

He adds: "Brazil and China, for example, are good examples of countries impacted by the two principal forms of collateral damage - cross-border flow issues and the disappearance of the export market respectively. But we expect a full recovery in EM within five years, which is totally different to the current uncertainty in US mortgages."

The recently-launched Ashmore Global Consolidation and Recovery Fund (AGCRF) involves banks swapping their distressed assets for units in the fund at a price negotiated with Ashmore, thereby enabling those banks to retain the upside associated with the recovery in asset prices (see SCI issue 132). Once the assets are in the fund, they're valued by a third party. UBS is the seed investor in the fund, accounting for US$100m.

Together with lightening the bank's balance sheet, the benefit of swapping hard-to-value assets into a diversified fund is that more reliable marks can be achieved, notes Booth. "Additionally, banks can demonstrate shareholder value by having the assets managed professionally or there may be other situations where investors in gated funds can transfer the assets in-specie. We can also offer advisory services on portfolios, where necessary."

AGCRF has a five-year tenor, with a penalty for redemption in years three and four. The swapped assets are expected to amortise eventually and so the fund will invest in replacement assets, providing a cash payout to investors at maturity.

Booth says that the potential for the fund to grow is significant. "UBS participated as seed investor in a recovery fund that Ashmore launched after Russia defaulted in 1998. In that case capital controls were implemented in the country, meaning that investors with assets in the jurisdiction were caught by the moratorium. It proved to be more convenient for us to manage these assets and the fund ended up returning 104% over three years on an average annualised basis," he explains.

He adds: "We thought we could use the same idea but in a different global environment: emerging markets have seen collateral damage rather than the financial rout experienced in developed markets and there are many European and North American banks that have become distressed sellers of EM assets, who - as market liquidity has reduced - want to concentrate on core assets. There is wide recognition that while EM assets are problematic, they do have an upside - consequently, there is a reluctance to sell at the bottom, yet banks are keen to resolve their problems."

There is no typical way of managing the distressed assets being swapped into the fund because they will come from many different asset classes and regions, and EM deals are typically highly complex. Ashmore has a menu of options it uses to manage the assets, but in many cases this will involve restructuring them or finding an appropriate buyer.

Booth says that whether a similar structure would work for non-EM asset classes is an intriguing idea, especially given the growing need for private sector solutions to the current overhang of 'toxic' assets. "My feeling is that it wouldn't necessarily work: such a solution requires relative expertise outside of banks, yet it would have to add value to the banks. Also, if the upside for the assets is limited, the banks will likely be incentivised to sell rather than swap the assets," he concludes.

CS

Regulation

Countercyclical capital

Moves are afoot to address ratings migration within Basel 2

The eight-notch downgrade of Zions Bancorp last week sparked concern about the potential incompatibility of Basel 2 being predicated on ratings and the consequences for bank capital. However, the countercyclical approach towards capital currently being considered by the Basel Committee could help to ameliorate such pressure.

Moody's last week lowered its senior unsecured credit rating on Zions Bancorp from A3 to B2 (negative outlook), while S&P downgraded the company to triple-B minus from triple-B plus. Moody's indicates that Zions' capital position is likely to "come under significant pressure" in the short term because of its large commercial real estate lending concentration and CDO portfolio, consisting primarily of bank trust preferreds.

One structured credit consultant says it is intriguing that there has been such a significant loss of confidence in 'ratings', ostensibly due to troubles in the structured finance sector, but no visible decoupling of ratings in terms of Basel 2 or the central bank liquidity schemes. "To remove ratings from Basel 2 would require some very painful adjustments and it would be enormously political," he argues. "And, as yet, there are no obvious alternatives. Therefore, I think the powers that be don't really know what else to do but leave ratings embedded as they currently are, despite there being less than full understanding of what they are or even what they should mean."

The consultant points out that rating agencies probably believe that it may be better to be criticised as being overly conservative in order to balance out the criticism of being too lax in the past. "While I don't believe that all the criticisms levied against ratings have been justified, neither do I see any of the recent developments being as rational as they should be," he adds.

Peter Green, capital markets partner at Morrison & Foerster, suggests that because Basel 2 is predicated on ratings difficulties could arise where there is significant bank downgrade activity. "Rating downgrades have material consequences for bank capital/risk weightings, depending on what basis obligations are being held (i.e. the standardised or internal ratings based approach), but this does appear to be on the Basel Committee's radar screen. The Committee is looking at capital from a macro level: it is aware that downgrades involve banks posting increased capital reserves, so one potential solution is to take a countercyclical approach, whereby banks hold more capital in good times and relax that level in bad times," he says.

"The static capital approach through cycles has been proved to have significant drawbacks and so I don't think there'd be too much objection, in principle, to working towards these objectives," confirms Jeremy Jennings-Mares, capital markets partner at Morrison & Foerster. "However, ultimately that might depend to a large extent on whether cyclicality is determined on a formulaic basis, or by a bank's prudential supervisor. In other words, who decides at what point in the cycle we are at any given time and what capital levels are appropriate for that point?"

Indeed, a move is emerging towards changing the Basel 2 rules to reflect this. It is still early days in the consultation period and the impact probably won't be felt until the next upswing, but at least there'll be some lead time for the market to prepare for any changes.

"The general theme is that banks are considered to have been undercapitalised and so regulators feel that they should begin holding more core capital in the form of ordinary shares and reserves. This goes hand in glove with increased liquidity support facilities being put in place and the different asset purchase schemes being established by governments," adds Green.

In the meantime, because current credit spread levels mean that it is disproportionately expensive to hedge an entire portfolio, some banks are said to be exploring more dynamic ways of achieving capital relief. Conceptually, protection could be bought on the first-loss piece that is structured to resemble a reserve over a defined period, whereby gains on the amount at risk from good years are used to smooth any losses.

CS

Operations

Stress-test nerves drive market sentiment

Mixed economic data and earnings announcements last week could not overcome the market's nervousness about the forthcoming bank stress-test results. The initial results of the stress tests were communicated to banks on Friday (24 April), with final results scheduled to be released publicly on 4 May. Leaked information to the US press suggests that Bank of America and Citi may be required to raise billions of dollars of extra capital as a result of the tests.

According to reports, other banks among the 19 under scrutiny are expected to fail the stress test and require more capital, particularly regional institutions with large exposure to commercial real estate loans. However, the stress-test process is aimed at instilling confidence in the banks rather than undermining it, FDIC chair Sheila Bair notes.

Leading up to the release of the results, structured credit analysts at Barclays Capital expect a deluge of commentary, analyses and estimates around the stress tests to be the key driver of near-term market sentiment. "With respect to potential stress test results, we believe that the money centre banks can generate additional TCE through exchanges of subordinated and Tier 1/Tier 2 paper to address any potential capital requirements determined by the stress tests," they note. "We thus remain constructive on the money centre banks ahead of the stress test results." However, the caveat is that the proposed base- and stress-case macroeconomic assumptions do not seem particularly onerous, the analysts say.

Meanwhile, structured credit strategists at Citi do not expect any major banks to fail on the basis of US Treasury Secretary Tim Geithner's recent comments. "On the other hand, as the IMF's latest reports have made blatantly clear, the US banking system (and the European even more so) needs more capital still," they explain. "Banks found wanting will no doubt be in for a rough ride unless any news of a shortfall is accompanied by clear, credible and swift remedies. We can only hope that one will not be released without the other."

The US Federal Reserve also published on Friday a white paper describing the process and methodologies employed by the federal banking supervisory agencies during the stress-test process. All US bank holding companies (BHCs) with year-end 2008 assets exceeding US$100bn were required to participate in the assessment. These institutions collectively hold two-thirds of the assets and more than half the loans in the US banking system, the Fed points out.

More than 150 examiners, supervisors and economists from the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation participated in this supervisory process. Starting from two economic scenarios - a consensus estimate of private-sector forecasters and an economic situation more severe than is generally anticipated - they developed a range of loss estimates and conducted an in-depth review of the banks' lending portfolios, investment portfolios and trading-related exposures, as well as revenue opportunities.

In doing so, the supervisors examined bank data and loss projections, compared loss projections across firms and developed independent benchmarks against which to evaluate the banks' estimates. From this analysis, they determined the capital buffer needed to ensure that the firms would remain appropriately capitalised at the end of 2010 if the economy proves weaker than expected.

The process involved firms submitting their projections to the agencies, which included significant amounts of detailed data. Supervisory teams - organised by specific asset classes, revenues and reserves - then evaluated the substance and quality of the initial submissions and, where appropriate, requested additional data or evaluation of the sensitivity of projections to alternative assumptions.

The supervisors also developed independent benchmarks based on firm‐specific portfolio characteristics, against which they evaluated the appropriateness of the firms' projections for losses and resources that would be available to absorb losses. Results for each firm were also evaluated to assess the sensitivity of the firm to changes in the economy based on projections under the baseline and the more adverse scenarios.

While the SCAP is conceptually similar to stress tests that firms undertake as part of their ongoing risk management, the objective of this programme was to conduct a comprehensive and consistent assessment simultaneously across the 19 largest BHCs using a common set of macroeconomic scenarios and a common forward‐looking conceptual framework, the Fed notes. The US Treasury has committed to make capital available to eligible BHCs through the Capital Assistance Programme. BHCs can also apply to the Treasury to exchange their existing Capital Purchase Programme preferred stock to help meet their buffer requirement.

CS & AC

Operations

UK guarantee to spark new lending?

Further details were released about the UK government's RMBS guarantee programme (see last week's issue), following Chancellor Alistair Darling's budget announcements. Fitch suggests that the two guarantees offered under the proposed UK government's ABS guarantee scheme will likely provide additional comfort for investors from a credit and liquidity perspective. However, the degree to which the scheme will spark new lending by improving funding conditions remains unclear, as other schemes - such as the Credit Guarantee Scheme - currently offered by the UK government might result in competing funding options for eligible financial institutions.

The first type of guarantee (credit guarantee) will be an unconditional and irrevocable guarantee of the timely payment of all amounts contractually due from the relevant issuer in respect of the eligible instruments. The second type (the liquidity guarantee) will apply to: (i) the failure of an issuer to exercise a call right in respect of the eligible instruments in accordance with the terms of the relevant documentation; or (ii) the failure of an issuer to purchase eligible instruments at the option of the holders of those eligible instruments in accordance with the terms of the relevant documentation.

The scheme will therefore effectively cover credit risk above the triple-A level, given the underlying rating requirement. Fitch says it has received feedback from investors indicating that they are generally willing to take on good quality credit risk of UK prime RMBS.

"This is perhaps, in part, due to the high level of loss coverage on outstanding triple-A UK prime RMBS," says Gregg Kohansky, head of EMEA RMBS. "Our recent analysis showed that existing triple-A tranches have, on average, an expected 9x loss coverage assuming our current 30% peak-to-trough expectation for UK house prices."

Participating institutions will be required to undertake to the issuer to put the issuer in funds to meet the call or the purchase obligation, as the case may be, on the due date. In each case, the guarantor will irrevocably undertake that, if the issuer fails to pay the relevant price to the holder of such eligible instruments on the due date, the guarantor will purchase such eligible instruments from the holder at the relevant price. The relevant price will be the principal amount outstanding of the eligible instruments as at the due date, adjusted to include any accrued but unpaid interest, but reduced to take into account any losses which may have been incurred on the portfolio of mortgage loans backing the eligible instruments prior to the due date and which are allocable to the eligible instruments.

The obligations of the guarantor under the liquidity guarantee will be conditional upon the holder of the eligible instruments transferring their ownership of the instruments to HM Treasury against payment under the liquidity guarantee. An eligible instrument can have the benefit of a credit guarantee or a liquidity guarantee, but not both.

The government will issue guarantees (of both types) in respect of eligible instruments issued during a six-month period from the commencement of the 2009 scheme, subject to any extension at the discretion of HM Treasury. The guarantee in respect of an eligible instrument will have a maximum term of either up to three years or up to five years. Up to one-third of the guarantees (based on the total amount of guaranteed eligible instruments) may have up to the five year term.

A guarantee may be applied to instruments issued under stand-alone transactions or to instruments issued under established or newly established master trusts, in each case approved by HM Treasury at its sole discretion.

The eligible instruments must be single currency-denominated in sterling, euro, US dollars, yen, Australian dollars, Canadian dollars or Swiss francs or such other currency as may be approved by HM Treasury. The instruments must be rated triple-A (or the equivalent) at the time of issue by at least two international credit rating agencies, on the basis that the eligible instruments do not carry the applicable guarantee.

The mortgage loans which are sold into the mortgage pool backing the eligible instruments must be of a high quality. Any mortgage loans which are sold into the a pool after the date the participating institution joins the 2009 scheme must meet additional specified criteria, including the following:

• each mortgage loan must be made not earlier than 1 January 2008,
• each mortgage loan must be secured by a valid first ranking mortgage or (in Scotland) standard security over a residential property located in the UK,
• the loan-to-value ratio of each mortgage loan at its origination must not have exceeded 90% of the lower of the purchase price or the then most recent valuation of the mortgaged property,
• immediately following the date of each sale referred to above, the weighted average LTV ratio of all the mortgage loans in the pool which backs the eligible instruments must not, by reference to the mortgage loans at their respective origination, exceed 75% of the lower of the respective purchase prices of the mortgaged properties or the most recent valuations as at the time of origination, and
• the borrower of each mortgage loan must not have an adverse credit history.

Issuers will be required to procure the issue of periodic reports, at least quarterly, to investors and the guarantor in line with international best practice. SIFMA and its affiliate ESF welcomed the move.

"The criteria for tapping into the guarantee scheme draw on the industry RMBS Issuer Principles for Transparency and Disclosure, Version 1, issued in February 2009. Importantly, this plan will improve transparency and consistency for pre- and post-issuance disclosure," says Rick Watson, md of SIFMA and ESF.

The guarantor will be entitled to be indemnified for any amount that it pays out under the credit guarantee from both the participating institution and from the issuer of the eligible instruments. In the first case, the indemnity will be contained in an unsecured counter-indemnity from the eligible institution. In the second case, the indemnity will be contained in a counter-indemnity granted by the issuer under which the guarantor will have a claim against the issuer equivalent to the claim had by the holder of the eligible instrument, secured over the relevant mortgage pool.

The guarantor will be entitled to be indemnified for any amount which it pays out under the liquidity guarantee from the participating institution under an unsecured counter-indemnity. Following any payment being made by the guarantor under the liquidity guarantee, the guarantor will, as holder of the relevant eligible instruments, have all the rights of such a holder.

The guarantor will be entitled to hold or sell the relevant eligible instruments at its discretion at any time. The guarantor will also be entitled to require the participating institution to purchase the eligible instruments.

The fee payable to HM Treasury on guaranteed issues will be based on a per annum rate of 25bp plus 100% of the participating institution's median five-year CDS spread during the period from 2 July 2007 to 1 July 2008, as determined by HM Treasury. HM Treasury may apply its own estimate of an appropriate CDS spread if public data is unavailable.

The fee will be applied to the principal amount outstanding from time to time of the eligible instruments and will be payable on the interest payment dates of the eligible instruments until the earlier of the expiry of the applicable term of the guarantee and the date the eligible instruments have been redeemed. In addition, HM Treasury may charge an incremental fee to any applicable guarantee being applied to non-sterling denominated eligible instruments.

In order to assign triple-A ratings to government-guaranteed RMBS, Fitch says it would pay attention to transaction documentation details - in particular the price at which notes would be called that might be reduced by certain principal losses on the underlying portfolio. "The terms on which the government guarantee is offered and, perhaps more importantly, what it will cost will also be at the forefront of investors' considerations," concludes Alastair Bigley, head of UK RMBS at Fitch.

AC

Ratings

MEPs endorse strict rules for CRAs

Strict rules to improve transparency and independence of European credit rating agencies (CRAs) were endorsed by the European Parliament last week when MEPs adopted a legislative report with 569 votes in favour, 47 against and four abstentions. Of particular relevance to the structured finance market is the ruling that CRAs should either use different rating categories when rating structured finance instruments or provide additional information on the different risk characteristics of these products (see last week's issue).

According to MEPs, credit rating agencies failed to detect the worsening of the financial market conditions and to adapt their ratings in time. They also failed to adapt to the new risks of the credit market, such as structured credit products and hedge funds.

The main objectives of the approved regulation are: to ensure that CRAs avoid conflicts of interest; to increase transparency by setting disclosure obligations; to ensure an efficient registration and supervision framework at EU level; and to improve the quality of the methodologies and the quality of ratings.

According to Morrison & Foerster (MoFo) capital markets partners Jeremy Jennings-Mares and Peter Green, there is a danger that if CRA regulation isn't globally coordinated, regulatory arbitrage opportunities will be created. "The EU has opted for fairly prescriptive rules, which are more detailed and inflexible than the principles-based approach set out in the revised IOSCO code of practice and recommended by CESR," they explain. "In particular, rating agencies will be required to comply with detailed corporate governance requirements. Ultimately, this may have a detrimental impact on the region's competitive position."

Avoiding existing or potential conflict of interest between the agency issuing the rating and the rated organisation is a key aim of the legislation. Long-lasting relationships with the same rated entities may compromise the independence of analysts and those in charge of approving credit ratings. Therefore, the agreed text proposes that those analysts and persons approving credit ratings should be subject to a rotation mechanism.

At Parliament representatives' request, the rotation will take place on an individual basis rather than changing the entire team of the company. The aim is to avoid negative consequences on CRA performance.

The compromise reached provides for a greater role for the Committee of European Securities Regulators (CESR), which will be in charge of registering CRAs, according to the new rules. This would provide a single point of entry for the submission of applications and thus cost reduction for agencies.

CESR should receive applications for registration and inform competent authorities in all Member States. CESR will also make this information available to the public.

National authorities will take the decision on CRAs' registration and compliance with the rules and on the possibility of withdrawing an agency's registration, should the rules be breached. Moreover, a college of supervisors - representing the 27 Member State authorities - will also be established to provide a platform for an exchange of supervisory information among national authorities and to improve coordination of their activities.

"The enhanced role of CESR and the college of supervisors should help ensure a more consistent approach between member states and national regulators, although there will be concerns as to how smoothly these arrangements will work in practice," the MoFo partners note.

They add: "The new EU regulation contains an express provision that prohibits member states or national regulators from interfering with the ratings process and methodology which is of course welcome. However, there remains scope for political pressure to be applied to rating agencies, in particular the provisions giving national supervisors the power to issue a temporary prohibition of a rating agency issuing a rating. Requirements requiring consultation with the college of supervisors in such circumstances may do little to mitigate such concerns."

The agreement is nevertheless regarded as a first step forward and the Commission is asked to report on its application by July 2010 with a view to possible new proposals for further streamlining.

Non-European ratings will have to be endorsed by an EU agency, established according to this new regulation. This agency will be responsible for determining and monitoring on an ongoing basis whether rating activities of non-EU CRAs comply with the requirements.

For smaller non-EU agencies, which have no presence in the EU, a specific certification regime will be established. The Commission will decide, on a case-by-case basis, on the equivalence of the legal framework of the third country with EU rules and therefore on the possible use of that rating within the Community.

Under the proposed regulation, each CRA would have to disclose to the public the methodologies used to adopt their ratings. The company would also need to ensure that the issued ratings are based on all available information, as well as adopting all necessary measures to ensure all used information is of sufficient quality and from reliable sources.

Finally, a CRA would have to publish annually a transparency report, including information on ownership, the outcome of the annual internal review of the independence compliance, and a description of the management and analyst rotation policy.

The MoFo partners agree that it is sensible to seek to restrict rating agencies' activities to their core rating business and to exclude consulting and advisory services with a view to limiting the potential for conflicts of interest. However, the prohibition on rating agencies making recommendations regarding the design of a structured finance instrument may give rise to potential difficulties, the note.

"Providing an indication of the changes needed to a product to achieve a particular rating has been part and parcel of the ratings process, particularly for structured debt," the partners conclude. "It's in investors' interests that products are designed well - and input from the rating agencies is fundamental to their development."

AC & CS

Regulation

Concerns mount over 'forum shopping'

Following an ECB workshop on its new Financial Vehicle Corporations (FVCs) Regulation, there is growing concern that inconsistent implementation of the regulation could lead to securitisation arrangers 'forum shopping' for jurisdictions for their deals that have implemented the rules in the most favourable way. The regulation imposes quarterly reporting of the statistics on the assets and liabilities of financial vehicle corporations engaged in securitisation transactions.

A Paul Hastings client note says that the ECB's view at this time is that the regulation is in its final form and no changes will be made to it. As such, the next step is for each of the Eurozone national central banks (NCBs) to publish their own guidelines implementing the regulation in their respective countries.

The ECB reportedly indicated at the workshop that it expected different countries to take different approaches to implementing the regulation and accepted that this could lead to regulatory arbitrage. Further discussion with the NCBs present showed that radically different approaches to implementation are being contemplated, according to Paul Hastings, with some countries looking to the legal form of entities and others looking at the nature of the transactions in which entities may be engaged.

For example, Spain and France intend to apply the regulation only to the very narrow range of companies formed under local specific securitisation laws and not to other types of entities, even if they are engaged in securitisation transactions. The Netherlands and Germany, on the other hand - which do not have securitisation laws allowing for the formation of specific entities - plan to apply the regulation to entities of any form engaged in transactions that fall within the definition of securitisation in the regulation.

"It is difficult to see how such radically differing approaches can meet the objective of the regulation to provide consistent statistical information for Eurozone financial transactions," the client note continues. "By way of example, under this approach certain countries will report many billions of euros of transactions involving local FVCs acting as intermediate financing companies in ABCP funded trade receivables securitisations, while other countries will report nothing on such transactions."

Some NCBs have already begun consultation exercises with local industry participants about implementing the regulation. According to Paul Hastings, it seems possible that at least some practical concessions may be won in this process - although where these do not comply with the strict letter of the regulation, reporting FVCs may be left with at least some risk of liability.

However, once reporting has commenced it is hoped that the ECB will come to realise that the information it will receive is not what it intended it to be. Consequently, this could lead to a more practical and pragmatic version of the regulation being issued. But in the meantime, the client note concludes, it would seem that securitisation professionals will be kept very busy trying to comply with the regulation and investors may face shortfalls and possibly even ratings downgrades due to the resulting costs.

CS

Negative basis fund launched

The latest company and people moves

Assenagon has launched a UCITS III fund - dubbed Assenagon Credit Basis - whose central earnings component is based on exploiting the negative basis between corporate bonds and CDS. The fund, which is authorised by the Luxembourg Financial Supervisory Agency, targets an outperformance, after fees, of 300bp-350bp over Euribor. Such a yield could only be achieved with a traditional corporate bond fund if it invested primarily at the lower end of the investment grade universe, according to Assenagon.

At present, financial markets assess the probability of default in this segment at more than 10%. In contrast, the investment strategy of the Assenagon Credit Basis fund precludes default risk, as each corporate bond position is hedged by a credit default swap that protects the bond against payment default.

In addition, interest and currency risks are minimised by hedge transactions. The management eliminates the counterparty risk of the CDS by either trading the CDS via a clearing house or has it collateralised by the swap partner by cash or first-rate government bonds.

Assenagon notes that during the duration of the bonds there may be temporary price declines when the negative basis expands, but such basis risk will be eliminated by holding the bonds and the associated CDS until maturity. "The Assenagon Credit Basis is therefore primarily suited for investors who pursue a long-term buy-and-hold strategy," explains Jochen Felsenheimer, co-head of credit at Assenagon.

"As the creation of central clearing houses will markedly reduce the price anomalies in the CDS market, the present time to invest is as good as ever," adds Wolfgang Klopfer, co-head of credit at Assenagon.

Normally, hedge funds and investment bank prop desks would be expected to benefit from such negative basis opportunities, the firm says. Both market agents have dropped out, however, due to the enormous reduction of banks' risk capital - meaning that outstanding profit opportunities remain for investors with liquidity, as well as free risk budgets.

UK broker prepares CDS platform
UK-based agency broker Mint is preparing to launch a CDS platform and has hired a team of six for the move, headed up by Mark Harris, fomer md of MIS Brokers. According to Mint co-founder Tim Bullman, the firm is likely to make more hires for the platform, which is expected to launch in Q209.

"It was never intended that Mint would be focused on just one product," says Bullman. "We already have a fixed income branch to the business and believe that there is a natural synergy between fixed income products and CDS."

Mint is also looking at the possibility of expanding into other asset classes in the coming month, including ABS, high yield and FX. "Any growth in our business is likely to be organic," he continues. "We will grow the business and expand into new products if it suits the trading floor. I believe that in this environment you don't have to be a big institutional firm to provide an institutional service. It's the quality of the service that matters."

Global CDO head recruited
Keith Grimaldi has joined Cantor Fitzgerald's debt capital markets team as senior md of CDO and structured products trading. He will be responsible for building the trading and distribution of all CDOs and other structured credit products. This will include identifying secondary trading opportunities for clients, providing liquidity in secondary markets for these products, helping clients value their portfolios, and analysing and helping to repackage securities for holders or potential buyers.

Grimaldi will report to Shawn Matthews, ceo of Cantor Fitzgerald. He was previously md and global head of the CDO group at UBS, where he was responsible for overseeing the origination and trading of CDOs.

He left UBS in February this year. Prior to joining UBS, Grimaldi was an executive director at CIBC, where he was in charge of the syndication, trading and distribution of CDOs and other esoteric securitised transactions in the public and private placement markets.

FSA bans and fines credit trader over mismarkings
The UK Financial Services Authority (FSA) has banned and fined Loic Montserret, a former portfolio manager at BlueCrest Capital Management, £35,000 for deliberately mismarking his positions in an attempt to avoid losing his job over losses he made on his trading book. This is the first time that the FSA has both banned and fined an individual for mismarking trading positions.

From November 2007 to May 2008, Montserret was responsible for managing US$60m of the capital in the BlueCrest Multi Strategy Credit Fund. During April 2008, changing market conditions resulted in a significant fall in the value of his trading book, which he knew would put his job at risk.

To disguise the extent of his losses, Montserret mismarked four equity index options by valuing them at nearly two to three times their actual market price. The mismarking went on for ten days and resulted, at its maximum, in the fund being overvalued by US$8.6m. On the tenth day, he admitted the overvaluation to the head of his trading desk.

Montserret's actions also prevented BlueCrest from properly monitoring his trading book. This meant that customers were put at the risk of making investment decisions based on incorrect information.

In determining the appropriate action to take, the FSA took into account that Montserret admitted his misconduct at an early stage of its investigation. He also qualified for a 30% discount on the fine by agreeing to settle early. Otherwise, the fine would have been £50,000.

Alternatives firm hires credit hedge fund manager
BLM Partners, an alternative asset management firm based in London and founded in March 2009, has appointed Jason Carley to the partnership. Carley was most recently the senior portfolio manager for the BlueMountain Global Value Fund, a credit-focused special situations hedge fund.

Prior to BlueMountain, he was an md at Merrill Lynch, where he was the head of European corporate credit research. At BLM, he will continue to focus on credit private financing-related investment opportunities.

Firm adds CSO restructuring expert
Alejandro Videla has joined NewOak Capital as md. Videla has 12 years of experience, having previously worked at Wachovia, Fortis, Société Générale, Nomura and Goldman Sachs. At Wachovia he led the execution and restructuring of hybrid and synthetic resecuritisations and risk-transfer strategies, managed warehouse risk and over US$1bn of ABS and short-term securities.

Credit sales co-head on the move
Henrik Raber is understood to have left UBS, where he was co-head of flow credit sales and trading in Europe, in order to take up a new role at Standard Chartered. It is rumoured that his new position will be head of European and US capital markets operations. A spokesperson for Standard Chartered declined to confirm or deny the move.

Sales head exits bank
Tarek Islam, head of UK credit derivative sales at UBS, is rumoured to be joining Goldman Sachs to head up its credit hedge fund sales unit. A spokesperson for Goldman Sachs was unable to confirm or deny the hire.

Meanwhile, a number of other credit derivative sales directors from UBS are said to be moving to Libertas, the Knight Capital subsidiary.

Bank hires three for alternative investments
The Bank of New York Mellon has appointed Julian Poodhun, Huw Rees and Kelly Wilson to its alternative investment and broker-dealer global client management division. They will be based in London and report to David Aldrich, md, Europe, global client management financial institutions division.

Rees and Wilson have both joined the broker-dealer client management division from Lehman Brothers. Rees is head of the client executive team for the investment banking sector in Europe and will be responsible for delivering the full range of the company's solutions to broker dealers. He previously spent eight years at Lehman, where he was head of European creditor relations and more recently head of treasury operations for Lehman Brothers International (Europe) in administration.

Wilson joins as a client executive for broker dealers and works closely with Rees. She spent seven years at Lehman Brothers in both London and New York, where she held a number of positions including relationship manager in creditor relations covering Nordic and French banks, structured credit and ABS sales, and European debt and equity investor relations. Most recently, she worked with PricewaterhouseCoopers on the Lehman administration.

Poodhun joins the bank as the lead client executive for the alternative investment sector. He is responsible for providing the full range of the company's solutions to alternative investment fund managers. He previously spent nine years at Merrill Lynch, where he was responsible for running the prime brokerage sales group in Boston as well as the international prime brokerage client services team in New York.

SF CDOs see most manager replacements
CDO asset managers will continue to be replaced at a steady pace in the US and in increasing numbers in Europe, as the sector faces ongoing financial pressure from collateral credit deterioration, reduced liquidity, a diminishing fee base and performance-driven franchise impairments, according to Fitch.

Fitch has observed an increase in the number of CDOs undergoing asset manager replacement over the past year and a half, albeit at a much slower pace than originally anticipated. Replacement activity has been largely concentrated in the US and has related primarily to structured finance CDOs. To date, 35 Fitch-rated CDOs have experienced a CDO asset manager replacement.

"Further institutional departures from the CDO asset management space are likely as companies face increasing pressures on fees, resources and staffing," explains senior director at the agency Nathan Flanders.

Universal identification system created
CUSIP Global Services (CGS), managed by S&P on behalf of the American Bankers Association, has formed an alliance with Avox to create a universal identification system for global business entities. The new standard code, to be known as a 'CABRE' (CUSIP Avox Business Reference Entity identifier), will be generated and maintained for issuers, obligors and counterparties on a global basis.

The CABRE has been designed as a ten-character code that will be made available immediately to existing Avox and S&P/CUSIP customers as an adjunct to existing services. The structure will also be made available to global market participants in a variety of distribution options, including portfolio, bulk-file and web-based applications. A directory containing CABRE's and basic data for over 250,000 entities from around the world and across all industry classes will be made available in Q209.

"With so much emphasis on global counterparty risk and the need for certainty in identifying issuers, counterparties and obligors, we feel CUSIP Global Services is uniquely positioned to assist the industry in this endeavour," says Scott Preiss, vp for CUSIP Global Services in New York. "Given their client-driven system of maintaining global entity data, Avox is an ideal partner to augment our time-tested system of unique issuer and obligor identification."

Weak SF market dents S&P's profits
The McGraw-Hill Companies, parent group of S&P, has seen profits drop in earnings partly because of continued weakness in the structured finance market. The company has reported earnings per diluted share of US$0.20 for the first quarter of 2009, compared to US$0.25 for the same period last year.

Net income for the first quarter was US$63m versus US$81.1m for the first quarter of 2008. Revenue declined 5.7% in the first quarter to US$1.1bn.

Revenue for Standard & Poor's Credit Market Services declined by 8.4% to US$391.4m in the first quarter, compared to the same period last year. Non-transaction revenue at S&P Credit Market Services decreased by 3.8% to US$279.8m in the first quarter primarily due to a reduction in fees earned for work performed on cancelled transactions.

Non-transaction revenue also includes surveillance fees, annual contracts and subscriptions. In the first quarter of 2009, non-transaction revenue accounted for 71.5% of S&P Credit Market Services' revenue compared to 68.0% for the same period last year.

Business development head named
Butterfield Fulcrum, an independent administrator for the alternative investment industry, has appointed industry veteran Andrew Smith as its global head of business development and marketing. In this position, he will lead the firm's global sales, business development and marketing efforts as it expands its services to alternative asset managers and their clients. He will be based in the company's New York office and will oversee Butterfield Fulcrum's teams in Europe, Asia and North America.

Smith brings nearly 20 years of institutional sales, business development and client service experience in securities, global fund services, plan sponsor services and global investor services to Butterfield Fulcrum. He most recently served as an md and head of North America in global transaction services at Citi, overseeing a US$1bn securities and fund services region.

'Ratings Quick Check' launched
Moody's has launched a new weekly research report, entitled 'Structured Finance Ratings Quick Check', accessible without charge to any registered user of its public website. This MS Excel workbook is intended to provide a summary view and intuitive means of navigating the agency's current ratings, rating changes, other monitoring activity and credit research for all sectors of structured finance globally. The tool is designed to organise and summarise the high volume of Moody's global structured finance rating and research activity in a way that improves its usability and provides some additional context and perspective.

AC & CS

CLO manager mitigates counterparty risk

A round up of this week's structured credit news

Harbourmaster Capital Management is proposing to implement a credit support annex (CSA) on six of its CLOs. According to Fitch, the amendments are a positive structural feature as they reduce counterparty risk.

The amendments will affect Harbourmaster Pro Rata CLO 3 and 4, and Harbourmaster CLO 6, 7, 8 and 9. In these transactions, non-euro denominated assets may be purchased, provided these assets are asset-swapped with an FX hedging counterparty that meets the counterparty rating requirements as outlined in the transaction documents.

Asset swaps simultaneously help mitigate FX risk and basis mismatch between the non-euro assets and the liabilities. The default of the FX hedge counterparty would terminate the asset swaps and leave the transaction exposed to FX rate and index fluctuations, which may result in reduced cashflows to the notes.

In addition to asset swaps, certain Harbourmaster transactions use FX options (Harbourmaster Pro-Rata CLO 2), an interest rate cap (Harbourmaster CLO 7) or both (Harbourmaster CLO 6) to further mitigate residual FX risk and/or interest rate risk remaining in the transaction.

The inclusion of the CSAs allows these counterparties to post collateral, should its rating fall below a predefined first or second rating trigger. The CSAs also outline the type of collateral used as eligible credit support and applicable valuation percentages for the collateral. Independent third-party verification of both mark-to-market calculations and the correct and timely posting of collateral are introduced if the counterparty chooses to post collateral after downgrade below the second rating trigger.

Fitch says it views the amendment of the CSAs to the transactions as a benefit to the structure, particularly in the instance where collateral is posted as a result of falling through the second rating trigger. Previously, the only available remedies were for the counterparty to replace itself or find a guarantor that meets the counterparty rating requirements within 30 calendar days.

With the CSAs, if the counterparty wishes to find a replacement/guarantor upon falling through the second rating trigger, the posting of collateral provides additional security while allowing the counterparty time to pursue a replacement/guarantor that meets the counterparty rating requirements as defined in the transaction documents. Additionally, the transaction will continue to benefit from the asset swaps, FX options or interest rate caps in place while the counterparty pursues remedies after falling below the second rating trigger.

Decision on MBIA succession event delayed
The ISDA Determinations Committee is understood to have referred a determinations request from Aurelius Capital regarding a possible MBIA succession event to a legal sub-committee. The request argues that the reinsurance of FGIC should be succeeded to the MBIA Illinois unit and - since it makes up more than 25% of MBIA opco obligations - that the CDS should transfer to MBIA Illinois as a reference entity. Analysts at Credit Derivatives Research indicate that, if this were the case, then MBIA opco will likely rally as a major part of its obligations have disappeared.

The determinations request is in light of MBIA Corp's 17 assignment and assumption agreement with MBIA Illinois, pursuant to which MBIA Illinois succeeded to MBIA Corp's obligations under the reinsurance agreement between Financial Guaranty Insurance Company and MBIA Corp, dated as of 30 September 2008 (SCI passim), and MBIA Corp was released of all obligations. A vote on the matter is scheduled for 12 May.

CLO/leveraged loan disconnect widens
CLOs are lagging broader credit and leveraged loan markets, as a growing pricing differential emerges between loans (US$80 for flow names, US$73 according to the LSTA index) and CLOs (US$77 for triple-As, US$57 weighted average). This disconnect speaks to the lack of liquidity, rating downgrade pressures and supply fears in CLOs, according to structured credit analysts at JPMorgan.

"A telling comparison is between triple-As and loans, as for the first time in months triple-As price below flow loans, which doesn't make sense given the subordination, excess spread and event of default control rights afforded to the triple-A holder," the analysts note.

One explanation could be that the relative sensitivity to ratings and downgrade risk for triple-A CLO investors may be weighing more heavily on CLO prices than rating issues at the loan-level, the analysts suggest. "Given the trend in CMBX though, it's not clear triple-A CLO prices end up actually suffering as much from downgrades, and the fundamental cheapness to loans more than compensates for the downgrade risk, in our view," they add.

While perhaps not representing an arbitrage opportunity between loans and CLOs, CLOs are starting to look more attractive. Away from this disconnect, the analysts suggest that higher loan prices should translate to improved CLO O/C ratios, all else being equal. But the effect is limited to the extent that valuations in excess of triple-C and defaulted asset buckets improve.

"We stand by our 25bp-50bp forecast for maximum near-term O/C improvement, which could nevertheless help some CLOs that are on the edge of failure temporarily preserve (or restore) equity/subordinate bond cashflow," they conclude.

Progress for European standardised CDS contract
European CDS contracts are expected to move to standardised contract terms at the 20 June index roll in line with dealers' February agreement to implement EU-based central clearing by 31 July (see SCI issue 132). European trades are likely to have fixed strikes of 25bp, 100bp, 500bp and 1000bp. In addition, strikes of 300bp and 750bp have been proposed for the historical trade population, whereas the US market opted for 100bp and 500bp strikes.

The advantage of using 100bp and 500bp strikes is that It is easier to net trades. However, using more strikes is more efficient from a cash management perspective.

Monoline suspends claims payments
Pursuant to the New York State Insurance Department's (NYID) order under Section 1310 of the New York Insurance Law, Syncora Guarantee has suspended payment of all claims and is operating only in the ordinary course and as necessary to complete a successful comprehensive restructuring. The monoline confirms that its Board of Directors will continue to monitor the situation on a daily basis and, in the absence of a successful restructuring, may - in the exercise of its fiduciary duties - request the NYID to seek court appointment of a rehabilitator or liquidator.

The NYID issued an order to Syncora Guarantee on 10 April requiring the monoline to suspend paying any and all claims as of 26 April until such time as it has restored its surplus to policyholders to the minimum amount required by New York State Insurance Law. Syncora has not restored its surplus to policyholders to this minimum amount and is therefore prohibited from paying all claims.

Syncora warns that there can be no assurance that the NYID, or other regulators, will not take regulatory action at any time.

Manager signals PPIP intent
The deadline for US institutions to register their interest in participating in the Public Private Investment Programme (PPIP) was last Friday (24 April). Since then Invesco and its WL Ross affiliate have said they have committed US$1bn to the programme, joining a number of other asset managers that are said to be getting involved, such as PIMCO and BlackRock.

The LeFrak Organization, Assured Guaranty, and American Home Mortgage Servicing have joined Invesco to provide insights to the investment team. Furthermore, strategic partnerships have been created with a leading woman-owned securities firm, Muriel Siebert and Co., and with two minority-owned firms, investment banking and investment advisory firm Williams Capital Group and the Jackson Securities affiliate of 103-year old Atlanta Life Financial Group.

Results indicating which parties have been successful in their applications to take part in the programme are unlikely to be made public until May or June and the first transaction is unlikely to be launched before July or August, according to market sources.

According to market participants, the level of clarity for the PPIP remained very unclear on the days running up to the cut-off date. However, according to Hiram Matthews, senior md and head of structured products at CastleOak Securities, the government is moving in the right direction with the plan.

"It's clear that we have to take substantial action to improve prices in the securitised markets," he says. "PPIP may not be a perfect solution to the problem, but it has the potential to improve prices significantly. While it may not be perfect I think we need to get on with it because any problems in the plan can be tweaked over time."

ISDA launches protocol for Edscha ...
ISDA is to launch a CDS auction protocol to facilitate the settlement of cancellable European loan-only CDS (ELCDS) trades referencing certain loan obligations of Edscha, the automobile parts supplier. Cancellable ELCDS transactions refer to reference obligations rather than reference entities, as is the case in regular CDS and North American LCDS.

Markit iTraxx LevX market-makers have determined that the reference entity (Edscha) has become insolvent and have voted to hold an auction for cancellable ELCDS transactions referencing certain reference obligations. The auction terms, including the auction date, will be determined by the market-makers.

ISDA will also publish a protocol to update the settlement method of legacy trades based on certain previously published cancellable (non-ISDA) documentation and LevX Series 1 trades, including single name and LevX Series 1 trades on Edscha, which will be open to ISDA members and non-members alike.

... while two auctions are settled
The price of CDS and LCDS trades referencing Idearc were determined to be 1.75 and 38.5 respectively. 12 dealers participated in the settlement auction on 23 April.

Meanwhile, the final price for CDS trades referencing Capmark was determined to be 23.375, following the auction on 22 April, in which 10 dealers participated.

Rapid rise in default rates for March remits
After showing signs of stabilisation over the last six to eight months, Markit ABX default rates rose rapidly in March, increasing by 4.52%, 5.52%, 2.95% and 3.47% for the 06-1 through 07-2 indices respectively. CDRs have been see-sawing for a while and, given that foreclosure moratorium programmes have been in effect, structured credit analysts at JPMorgan suggest that this spike likely reflects a pent-up liquidation flush.

"As loan modification programmes gain momentum, we think that default rates will stabilise once the current foreclosure and REO pipelines have been cleared," they note.

Voluntary CPRs rose unexpectedly this month, increasing by 0.8% for the 06-2 and 07-1 indices, and by 1.40% for the 06-1 to raise them to the 2%-3% CPR range; the 07-1 was unchanged at 2.6%. 60+ day delinquencies remained on trend this month, increasing by 57bp for the 06-1 and by 93bp-115bp for the remaining indices; 60+ delinquencies are now at 41.38% for the 06-1 and in the 44%-46% range for the rest.

The foreclosure bucket also increased by 140bp-170bp, while the REO bucket decreased by 50bp-100bp. The 60-89 and 90+ buckets were relatively unchanged and the 30-59 bucket decreased by 20bp for the 06-1 and 60-80bp for the other indices. Cumulative losses continue to accelerate, increasing by 76bp, 80bp, 88bp and 99bp in March to reach 7.73%, 9.99%, 9.60% and 9.09% for the 06-1 through to the 07-2 indices respectively.

This month, 11 new ABX constituents began experiencing write-downs: three in the 06-1 index, three in 07-1 and five in 07-2.

Whistlejacket auction results imminent
The results of the auction of assets from Standard Chartered's SIV, Whistlejacket, are due imminently. Bid lists have been circulated to market participants, which consists of 47 line items, including a dozen triple-A CLOs and a few middle-market triple-A CLOs.

The auction process, administered by Deloitte, follows a similar formula to that seen for the Cheyne SIV. A portion of the assets will be auctioned off to gauge market pricing, with the remaining assets sold into a new SPV. Existing senior SIV investors from Whistlejacket will be invited to invest in the new structure, dubbed New Co.

Repo-eligible Russian ABS rated
Fitch has assigned ratings to a Russian securitisation that is due to be repoed with the Russian Central Bank: GPB Credit Risk Management's Series 2 US$600m Gazprom Compartment notes. A triple-B rating has been assigned, with a negative outlook.

This issuance repackages a senior unsecured loan granted from GPB Credit Risk Management (a multi-issuance securitisation vehicle formed under Luxembourg law) to OAO Gazprom. The notes have been issued to finance the loan disbursement to OAO Gazprom. The loan is to finance part of OAO Gazprom's acquisition of about 20% of OJSC Gazprom Neft.

The structure is a simple pass-through transaction under which all collections from the loan will be advanced to the notes. The notes mirror the profile of the loan, including the amortisation profile and the interest component. The transaction will amortise semi-annually from March 2010 onwards.

As such, the rating of the notes is fully linked to OAO Gazprom's issuer default rating. Any rating action on OAO Gazprom will trigger the same action on the notes issued under this compartment.

Several other Russian banks are in the process of preparing RMBS that they hope to repo with the Russian Central Bank (see SCI issue 132).

CDS CCP plan is "flawed"
Darrell Duffie, professor of finance at the Stanford Graduate School of Business (GSB), has published a report indicating that global financial regulators' plan to fix the credit default swap market is "flawed". In a preliminary research paper, Duffie and GSB doctoral student Haoxiang Zhu, conclude that CDS central clearing houses will not remove nearly as much risk as regulators might hope. What's more, despite a mistaken belief by some commentators, the clearing houses are unlikely to bring transparency to CDS trades, says Duffie.

Although the worldwide market for CDS is huge at US$27trn, it has shrunk by more than 50% in the past year and is too small - and the number of participating institutions is too small - for a clearing house that deals only in CDS to efficiently reduce counterparty risk, he adds. Instead, Duffie and Zhu suggest that the clearing house should clear a much larger fraction of trades made in the US$500trn market for OTC derivatives.

"Our results make it clear that regulators and dealers should carefully consider the trade-offs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing," the research paper states.

Banks reduce risk by trading across various classes of options, derivatives and other financial instruments. Ultimately, positions between two counterparties tend to have offsetting exposures, which have a netting effect - that is, only the net amount of market value is at risk in a default by one of the counterparties. The researchers' model reveals that clearing only credit default swaps can actually increase the risk to the counterparties because the benefits of bilateral netting across asset classes is reduced in this case.

Their report finds that a dedicated central clearing counterparty improves netting efficiency for these dealers only if the fraction of a typical dealer's expected exposure attributable to CDS is the majority of the total expected exposures of all remaining bilaterally netted classes of derivatives. In fact, the CDS market is now too small to reach that threshold.

Making matters somewhat worse was the decision to establish multiple clearing houses. Having more than one reduces the netting effect even more, says Duffie, adding that each additional clearing house exacerbates the problem.

It has been suggested that establishing new CCPs would at least add transparency to the CDS market. But, according to the paper, the same level of information about CDS trades that would be available to regulators in a clearing house is already available through the DTCC. With or without a clearing house, there is no plan to reveal trades to the public, so the stories of improved transparency are a "red herring".

Six months to IAS 39 replacement proposal
The IASB has released a detailed six-month timetable for publishing a proposal to replace its existing financial instruments standard, 'IAS 39 Financial Instruments: Recognition and Measurement'.

David Tweedie, IASB chairman, comments: "We have heard a clear and consistent message on financial instruments accounting - fix this once, fix it comprehensively, and fix it in an urgent and responsible manner. The IASB is committed to do just that by developing proposals within six months for public comment."

The IASB's comprehensive project on financial instruments responds directly to and is consistent with the recommendations and timetable set out by the G20 at their meeting earlier this month, the Board says. The Group called for standard-setters "to reduce the complexity of accounting standards for financial instruments" and to address issues arising from the financial crisis, such as loan-loss provisioning. Consequently, the IASB will work jointly with the FASB to pursue the objective of a globally accepted replacement of the requirements on accounting for financial instruments.

Meanwhile, the IASB has also reviewed the FASB FSPs on fair value measurement and impairment (SCI passim) and considered comments received from its consultation on the FSPs, as well as advice received from the Financial Crisis Advisory Group (FCAG), the Standards Advisory Council (SAC) and participants at the three joint IASB-FASB public round tables held in November and December 2008. The IASB concluded that the guidance on fair value measurement issued by the FASB is consistent with existing guidance on IFRS, contained in the IASB's Expert Advisory Panel report, 'Measuring and disclosing the fair value of financial instruments in markets that are no longer active'.

Therefore, a level playing field exists in this area, the IASB notes. To ensure ongoing consistency in the application of IFRS and US GAAP, the Board will include relevant guidance from the FSP in its exposure draft on fair value measurement, which will be published in May.

On the question of impairment, the IASB agrees with the widespread view amongst commentators that the Board should improve its impairment requirements. It will consequently take up the broad issue of impairment as part of its comprehensive and urgent review of IAS 39. The Board believes that an immediate response to the recent FSP on impairment is unnecessary, but it will work with the FASB as part of its comprehensive project to ensure global consistency in impairment approaches.

Royal Park Investments financing agreed
Fortis holding, BNP Paribas, Fortis Bank and the Belgian state have reached an agreement on the financing structure for the SPV Royal Park Investments (RPI). In line with the parties' agreement of 12 March 2009, RPI will acquire a portion of the structured credit portfolio of Fortis Bank at an estimated cost of approximately €11.4bn, corresponding to a nominal amount of €19.3bn.

The financing of RPI consists of €1.7bn of equity and €9.7bn of debt. The debt component comprises a super-senior tranche and a senior tranche.

The super-senior tranche of €4.85bn consists of a revolving loan provided by Fortis Bank, which will carry an interest rate of IBOR plus a mark-up of 0.20%. All cash receipts from the assets in the portfolio will, after consideration for interest and costs, be applied as a first priority to the redemption of the super-senior loan.

It is anticipated that the super-senior loan will be redeemed in full within a period of four years. As a result, the average duration of the loan is expected to be less than two years.

To mitigate any currency risk the loan will be divided into sub-loans denominated in US dollars, euros, sterling and Australian dollars, allocated on the basis of assets and expected cashflows in each of these currencies.

The senior tranche of €4.85bn will consist of a loan from BNP Paribas (10%) and a commercial paper programme (90%), through which RPI will place commercial paper with institutional investors. The programme will benefit from a guarantee from the Belgian State and a firm underwriting commitment from Fortis Bank at a rate of IBOR.

This means that in the event that the commercial paper programme fails to attract sufficient support from investors, firstly Fortis Bank and ultimately the Belgian State will step in. The BNP Paribas portion of the senior loan will carry an interest rate of IBOR plus a margin equal to the guarantee fee charged by the Belgian State.

The fee charged by the Belgian State to RPI for providing a guarantee on the commercial paper programme is still subject to approval by the European Commission, but is expected to be 70bp.

Credit event for Primus ABS CDS ...
Two ABS CDS written by Primus Financial Products have been downgraded below Caa2 by Moody's. The notional principal on these CDS with counterparties is US$15m. Under the terms of the ISDA master agreement governing ABS CDS, a downgrade of the underlying security to triple-C (S&P) or Caa2 (Moody's), or below, is considered to be a credit event.

Primus says it will make a provision for the credit event in the first quarter. In accordance with the ISDA master agreement, until the referenced ABS is presented to the company, the credit swaps remain outstanding and premiums are required to be paid by the counterparty. The CDPC does not expect any immediate capital impact from these events.

As of 31 March 2009, Primus Financial's portfolio of ABS CDS that have not technically defaulted was US$5m.

... while NewLands notes/loan on review
Moody's has placed the Aaa rating of the floating rate notes due 2022 and the Class A loan of NewLands Financial Products on review for possible downgrade. The agency explains that the review was prompted by the application of revised and updated key modeling parameter assumptions that its uses to rate and monitor ratings of corporate synthetic CDOs. The revisions affect key parameters in Moody's model for rating corporate synthetic CDOs and CDPCs: default probability, asset correlation and other credit indicators, such as ratings reviews and outlooks.

Carrera downgraded ...
Moody's has downgraded its long-term senior debt ratings of Carrera Capital Finance, a SIV sponsored and backed by HSH Nordbank. Carrera is managed by HSH Nordbank Securities, a subsidiary of HSH. The rating action does not affect the short term Prime-1 ratings of the Euro and US commercial paper programmes.

The rating action on Carrera's Euro and US MTN programmes follows the downgrade on 23 April 2009 of HSH's long-term rating to A2 from A1. The direct linkage between the senior debt ratings of Carrera and those of HSH is based on HSH's commitment to support the SIV's senior debt through a note purchase and liquidity facility, and a committed repo facility.

... as restructured SIV notes are placed on watch
S&P has placed on credit watch negative its ratings on various notes issued by three HSBC Bank-sponsored SIVs: Barion Funding (junior senior MTNs and Tier 1 income notes), Malachite Funding (junior senior MTNs, and Tier 1 and Tier 2 income notes) and Mazarin Funding (junior senior MTNs and Tier 1 income notes). The actions follow deterioration in the credit quality of the portfolios due to their exposure to assets that have recently been downgraded or placed on watch negative. In S&P's opinion, this migration of credit quality places downward pressure on the ratings on the notes.

In addition, the agency has revised its treatment of structured finance assets held by SIVs. Previously, for the purposes of its analysis, S&P would assume these to be rated one notch lower. Now, the agency assumes a lowered rating of a minimum of three notches.

S&P says it has taken no rating actions on the CP and senior MTNs issued by Mazarin Funding because, in its opinion, the liquidity facility is sized appropriately to maintain the current ratings.

Resolution of the watch placements will follow further analysis, including a cashflow analysis of the ability of the notes to meet their obligations, given the decline in the credit quality of the portfolio.

HSBC discloses payments in CLO buyback
HSBC is to buy back £315.3m-equivalent of senior notes and £167.8m-equivalent of junior notes from its CLOs Metrix Funding 1 and Metrix Securities. Earlier this month the bank announced an invitation to holders of the Metrix notes to tender their notes for cash (see last week's issue).

Of Metrix Funding 1, HSBC purchased the Class A1, A2 and A3 notes at 91% and the B2s at 83.4%, C1s and C2s at 74.07%, D1s and D2s at 50% and E1s and E2s at 30%. Prices paid for Metrix Securities were lower, at 84.5% for the Class A2 and A3 notes, 64.5% for Class B2s, 61.59% for C2s, 45% for D1s and D2s, and 25% for E1s and E2s.

AIMA criticises draft EC regulation
The draft Alternative Investment Fund Managers Directive published by the European Commission is not a proportionate regulatory response to any of the identified causes of the current crisis, according to the Alternative Investment Management Association (AIMA).

Florence Lombard, AIMA executive director, comments: "This directive is not a proportionate regulatory response to any of the identified causes of the current crisis. All of the major reports which analysed the crisis in-depth, including the de Larosiere report and the Turner Review, concluded that hedge funds neither caused nor played a significant role in the crisis. This directive undermines the findings of these reports and the vast amount of work that is currently being undertaken by the G20, IOSCO and the Financial Stability Board. It also conflicts with the G20's global plan for recovery and reform which calls for regulators and supervisors to 'reduce the scope for regulatory arbitrage' and to 'resist protectionism'."

Hastily prepared and without consultation, the directive contains many ill-considered provisions which are impractical and may prove unworkable, AIMA says. The unintended consequences of these measures may put thousands of jobs in several major European industries under threat and slow down any economic recovery. Additionally, many of the provisions will disadvantage European hedge fund managers against those outside of Europe, which could prove an incentive for them to move business elsewhere - negatively impacting badly-needed tax revenues for Member States.

Lombard concludes: "We understand the great deal of political pressure facing the Commission; however, it is the Commission's role to propose necessary, unbiased and effective legislation. This directive is punitive and falls far short of this goal. It also does not recognise or take into account the existing progressive and effective regulatory framework in some EU states."

RFC released on SME CLO approach
Fitch has released its exposure draft on the rating methodology and process for CLOs of granular pools of smaller corporate loans, often called SME CLOs. The agency says that investors have been in regular contact about its approach amid significant demand for new SME CLOs for funding purposes.

The exposure draft captures the agency's latest thinking and rating approach, which has evolved since late-2007 and sets out the key tenets for comment. Fitch does not expect recently rated transactions to be affected by any methodology revisions.

"Based on Fitch's new research and analysis of default data from this sector in Europe, Fitch believes it is highly unlikely that any pool of SME loans will behave as well as investment grade debt," says Matthias Neugebauer, senior director in Fitch's risk analytic solutions team. "While default data differ between European countries and there are often some deficiencies in data quality, it seems clear that on average, and over the long term, in all the European countries Fitch has studied default behaviour in this sector has most closely resembled corporates in the double-B range and the average is clearly not investment grade."

Previously, Fitch had assumed that a diversified pool of SMEs could behave similarly to low investment grade corporates. However, this does not mean that all SME loans in Europe are in the double-B range.

The exposure draft for granular smaller corporate CLOs also contains a version of the obligor concentration uplift introduced last year (SCI passim). In addition, Fitch highlights rating sensitivity to specific scenarios, such as increased defaults and lower recoveries, to help investors and lenders to see clearly where the concentration risks lie, as well as examples of what the ratings will be sensitive to going forward.

Fitch believes that default correlation in this segment is likely to be lower than for larger corporates, but that losses in the event of default are likely to be higher unless loans are well secured on residential or commercial mortgages. Fitch has placed all 86 of its SME CDOs under analysis and expects that the seven recently rated transactions which benefit from stronger credit enhancement and the 15 older, de-leveraged SME CLOs will be affirmed at their current ratings. However, 30 Spanish SME CLOs - the majority of which have already been downgraded across the capital structure in 2008/2009 due to poor performance and outsized concentration risk - are expected to be most affected and may fall to low investment grade and high non-investment grade range.

HVB brings new Geldilux CLO
HVB has issued and retained the €994m Geldilux TS 2009. This is the ninth securitisation of loans extended under the Euro-loan programme of HVB Banque Luxembourg. See the SCI Database for more details.

Last Month Moody's and S&P placed a number of the existing Geldilux transactions on review for possible downgrade (see SCI issue 130).

Provisional BIS data released
The BIS has released its provisional international banking statistics for Q408. The figures show that, at current exchange rates, the consolidated international claims of BIS reporting banks on an immediate borrower basis contracted by US$2.2trn during the quarter, to US$20.5trn. On an ultimate risk basis (i.e. after taking into account net risk transfers related to credit derivatives, guarantees and collateral), banks' exposures dropped by US$2.8trn.

Brisk activity, predominantly in swaps and interest rate products, as well as large movements in credit derivatives, led derivative contracts with positive market value to rise by almost 52%, to US$6.5trn. Final data will be published in the forthcoming BIS Quarterly Review on 8 June 2009.

Derivatives use among large companies continues growing, ISDA
ISDA has announced the results of a survey of derivatives usage by the world's 500 largest companies. According to the survey, 94% of these companies use derivative instruments to manage and hedge their business and financial risks.

This is the second such survey conducted by ISDA: the first was in 2003. The results of this most recent survey show that derivatives use among large corporations continues to grow. The survey found that usage of credit derivatives is concentrated in the financials sector (to the tune of 76%), due to credit risk being an inherent business risk for the segment.

"The survey demonstrates that derivatives continue to be an integral risk management tool among the world's leading companies," comments Eraj Shirvani, ISDA chairman and head of fixed income for EMEA at Credit Suisse. "Across various geographic regions and industry sectors, the vast majority of these corporations rely on derivatives to hedge a range of financial risks to which they are exposed in the normal course of business."

SF CDOs hit
Moody's has downgraded its ratings on 928 notes issued by 272 US CDOs and confirmed the ratings of six notes issued by three other transactions that consist of significant exposure to Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. At the same time, the agency has downgraded its ratings of 188 notes and confirmed the ratings of 27 notes issued by 91 European CDOs that have significant exposure to US and European RMBS and other ABS.

Moody's explains that the rating actions reflect certain updates and projections and recent rating actions on underlying assets on these asset classes. Some of the deals have also experienced an event of default.

Japanese CMBS loan default rate doubles
The underlying loan default rate on Fitch-rated Japanese CMBS transactions more than doubled in the three months to end-March 2009, and the agency expects it to deteriorate further on the back of significant near-term refinancing requirements, limited availability of commercial property financing and a deteriorating property market. As at end-March 2009, 15 loans totalling Y55.9bn (3.4% of the total outstanding balance) were in default as compared to eight loans totalling Y23.8bn (1.4% of the total outstanding balance) at the end of 2008.

The causes of underlying loan defaults observed to date can be classified into two types: the first type being the failure to pay the full loan principal amount on or prior to the maturity date (a maturity default); and the second is the result of a breach of covenants regarding the default of a transaction entity, such as borrower's sponsor.

"In Fitch-rated CMBS transactions in Japan, 15.5% of all underlying loans mature in 2009 and another 24% mature in 2010. Given the current severe environment, in which property prices have fallen significantly and in which funds available to borrowers or prospective buyers of collateral properties are extremely depleted, a significant increase in loan defaults in the near term is likely to result. Fitch's rating analysis, reflecting current market conditions, continues to focus on recovery expectations under collateral disposition scenarios for underlying loans with relatively shorter periods to maturity," notes Masaaki Kudo, md and head of Japanese structured finance at the agency.

Of the 48 (Y1.64trn/US$16.7bn) CMBS currently rated by Fitch, 16 transactions have experienced a rating downgrade or a placement on rating watch negative of at least one class in the past 12 months. These rating actions were mainly due to the agency's concerns on expectations of underlying loan principal recoveries and ultimately CMBS note principal recoveries following defaults of underlying loans. Recoveries are being negatively affected by the recent severe downturn in the Japanese real estate market.

"There have been 42 collateral sales observed in Fitch-rated CMBS since September 2008. Sales prices range from those sold at above Fitch's original estimates (11 cases), to cases where prices were below our original expectation by more than 30% (nine cases). Actual sales prices reflect specific seller and buyer circumstances, but in general sale transactions will increasingly be exposed to downward pressure in prices," says Naoki Saito, director in Fitch Japan's CMBS group.

Of the Fitch-rated CMBS transactions in Japan, underlying loans maturing in 2009 amount to Y254.6bn and Y394.5bn in 2010.

CDS efficiency praised by City of London Corp
The Wholesale Market Brokers Association (WMBA) welcomes and endorses the conclusions drawn in the City of London Corporation's paper entitled 'Current issues affecting the Over-the-Counter (OTC) Derivatives Market and its Importance to London', prepared by Bourse Consult.

In particular, the WMBA agrees that evidence suggests the extreme losses suffered by financial institutions during the credit crisis arose from investment activities in CDOs, ABS and similar structured credit products, rather than in the CDS market itself. The CDS market has price and transparency characteristics that do not apply to the structured product markets, and is well supported by widely accepted legal documentation, the Association points out.

It adds that the Corporation is also right to draw attention to the efficient way in which CDS contracts were closed out after the Lehman default, which represented an extreme stress test in a live situation. "All participants in OTC markets seek greater safety and security, and the experience of the way in which the CDS market has been managed during the crisis gives comfort in that respect," WMBA states.

David Clark, chairman, WMBA, comments: "The WMBA strongly supports the paper's conclusion that any attempt to move OTC products onto exchanges would result in a diminution of liquidity in both OTC and exchange-traded markets. This, in turn, would have potentially severe consequences in the real economy as end-users of OTC markets - such as governments, corporates and pension funds - would experience difficulty in hedging their risks and obtaining the financial products necessary to achieve their investment and financial targets."

He adds: "Moreover, OTC markets are truly global in nature and are essential to the generation of wholesale financial market products used widely in both developed and emerging economies."

US CLO issuance to remain low, S&P
New issuance of US CLOs is likely to remain low and existing CLOs could perform worse than in previous recessions, according to a report published by S&P.

"Given the state of the economy and financial markets, we expect new issuance of US CLOs to remain subdued in the coming quarters," says S&P credit analyst Robert Radziul. "Although US credit markets have opened up slightly since the beginning of the year, liquidity remains scarce and we expect the cost of financing to remain high."

He adds that there is also a lack of confidence in the credit and structured credit markets, increasing regulatory uncertainty and anticipated ratings downgrades on the underlying loans and existing CLO tranches.

"New CLO issuance appears unlikely to increase significantly until these uncertainties are addressed," Radziul notes.

The picture for the performance of outstanding US CLOs is also uncertain. "The magnitude of the current recession is greater than any experienced since we first rated CLOs," he explains. "As such, we don't believe that existing CLOs will perform as well as they did during previous recessionary periods, including the downturn earlier this decade that severely affected many collateralised bond obligations."

European office occupational markets hit
The economic downturn continued to affect the European office occupational markets that support CMBS in H208, says Moody's in its latest special report on the sector. Since the start of the downturn, the effects have become clearly visible and the decline seems to have also spread across the Continental European markets, the agency says.

Moody's Red-Yellow-Green report is based on actual data and 12-month forecasts of market supply-and-demand movements. The analysis covers 24 major European office markets, including London, Paris, Barcelona and Munich.

Depending on the degree of stress on rental markets in the short term, markets are scored on a scale of zero (weak) to 100 (strong). Scores of 0-33 are identified as red, 34-66 as yellow and 67-100 as green. The objective of the analysis is to offer transparency to investors and issuers by providing a tool for assessing the impact of supply and demand on the occupational market performance of European office markets over time.

"Between year-end 2007 and year-end 2008, the weighted-average composite score for the European office markets covered by Moody's analysis decreased to 39 from 61," says Jeroen Heijdeman, a Moody's analyst and co-author of the report. "This score indicates an overall weak yellow market. The movement in the composite score was mainly caused by negative reclassifications of 14 of the 24 markets analysed. In addition, the number of red markets increased from five to 13 over the 12-month period."

In the report, Moody's notes that there are now 13 red markets, eight yellow markets and three green markets. Over the period covered, only three markets showed positive changes in their overall scores, while in 20 markets the market situation deteriorated and one market score remained stable.

With the exception of Manchester, the remaining six UK markets showed further signs of deterioration and are currently all classified as red markets. "This is mainly due to a decline in projected take-up and increased vacancy in some markets," Heijdeman adds. "Specifically, also the Scottish office market showed a significant deterioration in the occupational market, with the largest decline shown in Glasgow (reclassified from a green to a weak red market) followed by Edinburgh (reclassified from a green to a weak yellow market)."

Although the majority of the 24 markets affected are located in the UK, the Continental European markets now also show clear signs of weakening. Spain was severely affected as the Madrid performance declined from a green to a red score (mainly as a result of reduced demand) and Barcelona reached the bottom score of zero.

"Meanwhile, the most improved occupational market conditions over the 12-month period were observed in Paris - La Defense, which now has the highest score of any market mainly due the slight decrease in expected completions and the low vacancy level which further decreased to currently approximately 3% (compared to 4% year-end 2007)", explains Oliver Moldenhauer, a Moody's avp and co-author of the report.

The rating agency further notes that the German office occupational markets showed the first clear signs of decline at year-end 2008, with all markets showing declining scores. "The Düsseldorf and Frankfurt markets were most affected; reclassified from yellow to red markets. The Munich and Berlin market changed from a green to a yellow market," Moldenhauer adds. "The main reason for these reclassifications is the deteriorating demand-supply ratio, which is affected by the reduced forecast net take-up reflecting a decline on the demand side."

Moody's cautions in the report that a continuation of the turmoil in the capital markets and the knock-on effects on the real economy will most likely result in a further deterioration of the European office occupational markets, while a meaningful recovery is not expected before 2011/2012.

German auto ABS to remain stable
Fitch says that German auto ABS transactions are expected to remain stable through 2009, despite increasing unemployment and pressure on used car prices.

"Although the credit fundamentals for German auto ABS transactions have turned increasingly negative, the performance of these transactions is expected to remain stable through 2009, given the increased credit enhancement levels of most existing transactions based on semi-sequential pay-down, their strong performance to date and their limited direct exposure to residual value risk," says Susanne Matern, senior director in Fitch's structured finance team in Frankfurt.

To date, the performance of German auto ABS transactions has been robust. Fitch's cumulative net loss ratio, which incorporates both default amounts and recoveries applied to those, has remained well below the agency's base case assumptions set at closing for most transactions.

Furthermore, credit enhancement levels have increased as a result of semi-sequential amortisation. These factors make the transactions less vulnerable to an increase in potential delinquencies and defaults.

"Moreover, the transactions are generally not exposed to direct residual value risk through the used car market," says Uli Maute, associate director in Fitch's structured finance team in Frankfurt. "For auto loan transactions that contain balloon loans, the balloon payment obligation is transferred to the supplying dealer, if the borrower returns the car, and in case of dealer default, the obligation is retained by the borrower. This means that the transactions are only exposed to used car prices if both the dealer and borrower default. For German leasing transactions, the residual value component of the leasing contracts is typically not financed through the securitisation transaction."

Fitch nonetheless expects an increase, albeit moderate, in delinquencies and defaults of German auto ABS transactions in the second half of 2009, with a potential acceleration in 2010 based on the expected macroeconomic development in Germany. With regard to recovery rates (sale proceeds obtained for cars following a borrower default), the agency expects rates to come under pressure in line with the observed deterioration in used car prices. The price deterioration is driven by decreasing demand for used cars and by government (auto scrapping premium) and manufacturer subsidies being granted for new cars and cars aged up to one year.

Microfinance CLO hit
Fitch has downgraded VG Microfinance-Invest Nr. 1's senior CDO notes to double-B plus from triple-B, and assigned the notes a negative outlook. The transaction consists of subordinated credit exposure against 20 (initially 21) microfinance institutions (MFIs) globally distributed across 15 jurisdictions.

The portfolio's largest geographical exposures are Azerbaijan (21.7%), Kenya (17.1%) and Ecuador (12.3%). The institutions were selected by Deutsche Bank in its role as seller and protection buyer.

The downgrade of the senior notes reflects Fitch's concerns about developments regarding ACODEP, a Nicaraguan MFI which represents 8.8% of the portfolio. Sharp asset deterioration in the MFI's loan book and political uncertainty have contributed to Fitch's assessment that default risks have materially increased regarding this institution. A further concern is that MFIs located in Eastern Europe and Asia may suffer from foreign exchange exposure as their local currencies have lost value against the US dollar.

While individual institutions have come under increased pressure, the credit risk associated with the majority of the portfolio has remained stable or in some cases has even improved slightly. In addition, the senior notes benefit from subordination of 40% provided by unrated junior and mezzanine notes, and excess spread is available to provide credit protection if the portfolio experiences defaults.

Given the available credit enhancement, Fitch expects the CDO notes to be able to withstand the default of 5-6 names without incurring a loss. In its analysis, primarily due to the subordinated nature of the loan obligations, the agency assumed that no recoveries would be obtained following a default of an MFI.

Despite the structural credit support, Fitch views approximately 60% of the portfolio as commensurate with triple-C or below risk. This portfolio credit risk is compounded by concentration risk, as the portfolio is comprised of only 20 positions.

Given these risks, as well as the performance concerns in selected positions, Fitch has downgraded the CDO notes by two notches to double-B plus. The agency notes that this is the highest possible non-investment grade rating, reflecting the significant structural protection within the transaction.

South African ABS market now hit by credit crisis
The South African securitisation market is caught up in the global credit market malaise, according to a new report from S&P. "We have seen a big fall in publicly placed structured finance issuance in South Africa since the record levels of 2007, due to the ongoing global credit crunch and an apparent fall-off in investor demand," says S&P credit analyst Irina Penkina. "This year has also started slowly with no new public issuances in the first quarter, so it's likely that the subdued market conditions will continue for some time yet."

Penkina adds that, despite some originators and arrangers expressing interest in new transactions, there is uncertainty about the economic viability of debt refinancing, including securitisations. The report states that against a backdrop of more sluggish economic conditions, the collateral performance in outstanding South African securitisations rated by S&P worsened last year.

"Delinquency rates have risen since early in 2008 and haven't recovered, and current expectations are for continued pressure on collateral for the foreseeable future," Penkina says. "This has, though, not resulted in rating actions on any South African securitisations we rate, as this level of performance is still relatively low and we believe our ratings are still appropriate."

Dutch mortgage lending tightening could harm RMBS
The Dutch Financial Markets Authority's (AFM) plans to tighten mortgage lending regulation in the Netherlands have the potential to reduce default risk on new loans, according to Fitch. However, the proposed measures may lead to further downward pressure on house prices and as a result aggravate loan-level loss severities in existing Dutch RMBS transactions and covered bonds secured on Dutch residential mortgage loans.

"The intended rules, which introduce mandatory underwriting criteria for mortgage lenders to follow, mark a major change in the AFM's regulatory approach," says Lara Patrignani, senior director in Fitch's RMBS team. "The plans for loan-to-value restrictions would also represent another breakthrough, as they are not part of the current code of conduct."

The proposed rules envisage in particular setting a maximum loan-to-market value (LTMV) ratio of 100% and a limit on the maximum loan amount of 4.5-5 times the borrower's income. The current mortgage code of conduct, to which most Dutch mortgage lenders are contractually committed, sets certain affordability standards for calculating the maximum loan amount; but originators are allowed to deviate from these recommendations, provided that clients are properly informed of these deviations.

LTMVs can be very high in the Netherlands, partly due to fiscal incentives that encourage households to take on a larger mortgage loan. Lenders often grant loans up to 110% to 115% of the property market value, which is considerably higher than in other European jurisdictions. This exposes Dutch households to significant housing price risks.

"The proposal is a positive step towards setting clearer mortgage regulation in the Netherlands. However, the sudden introduction of an LTMV ceiling in the current weak economic environment without addressing either the slowdown in new lending, or how existing loans at or above the 100% LTMV threshold will be treated, may well add further strain on house prices and reduce market liquidity," says Patrignani. "For example, borrowers who are unable to refinance an existing mortgage due to the proposed new LTMV requirement will either have to accept the new mortgage reset rate from their current mortgage lender or may have to sell their homes, and given the current market conditions may be forced to sell at a loss. This could in turn reduce the level of mortgage prepayments on the higher LTMV loans. Prepayment rates on Dutch RMBS have been relatively stable over the last year at around 12%. First-time buyers will also be increasingly forced out of the housing market, unless they are able to pay upfront for the costs associated with the house purchase."

This may in turn undermine further the resale value of properties and lead to higher loss severities in Dutch RMBS and covered bonds secured on Dutch residential mortgage loans, especially on more recent origination vintages. The extent of additional losses would depend on the future evolution of mortgage defaults, which are still low and relatively stable at the moment, according to Fitch.

SF CDOs downgraded
S&P has lowered its ratings on 67 tranches from 19 US cashflow and hybrid CDO transactions with a total issuance amount of US$5.3bn. At the same time, it removed 17 of the lowered ratings from watch with negative implications.

The ratings on 45 of the downgraded tranches are on watch with negative implications, indicating a significant likelihood of further downgrades. In addition, we placed the ratings on two tranches from two transactions on watch with negative implications. The placements primarily affect transactions for which a significant portion of the collateral assets currently have ratings on watch with negative implications or have significant exposure to assets rated in the triple-C category.

Fourteen of the 19 affected transactions are mezzanine structured finance (SF) CDOs, three are CDO-squareds and two are retranchings from another CDO transaction that is part of the same rating action. The downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US sub-prime RMBS.

CS & AC

CDS

Charting a course through the CDS Big Bang

Damiano Brigo, md of the quantitative team of Fitch Solutions in London, warns that the proposed standardisation of the upfront conversion method for CDS could cause confusion if it isn't used carefully

Barclays, Goldman Sachs, JPMorgan and Markit (BGJM) (2009), seconded by ISDA, have recently proposed an imminent change in the convention for quoting CDS. In a traditional running CDS contract a spread is paid throughout the life of the deal, with this spread being set so that the premium and default legs match at inception. In the new proposal the running spread will be fixed at Sc, equal to 100bp or 500bp depending on the quality of the credit.

Individual CDS will vary in the required upfront payment (an amount to be exchanged immediately upon entering the contract). The recovery is also standardised to two possible values, again depending on the credit quality: 20% or 40%.

In this paper we briefly review a widely accepted CDS model and show how it can be used to convert between running spreads and upfronts. We contrast this with the proposed 'flat hazard rate' (FHR) convention method in BGJM/ISDA (2009) and show that there is a material difference which could lead to significant inconsistencies and arbitrage opportunities, should the converted spread be taken as the spread of a real running CDS product.

The FHR methodology, however, works and avoids inconsistencies provided that:

• It is applied, as is meant, to a universe where each CDS name has just one quoted maturity. As this does not happen in reality, having more maturities on the same name, this will work only if traded CDS prices will be upfront ones, so that running spreads of CDS will not appear directly in trading in the way they used to appear in the earlier running market.
• It is used only as a quoting mechanism in that FHR is a method to go from traded upfront quotes to a semblance of fair-spread quantities and back again without losing information. The semblance of fair spread is not the actual fair spread that one would have computed in a real running CDS contract that used to appear in the market.
• The FHR converted running spreads for CDS with different maturities are not used to strip hazard rates or to calibrate models across term.

For highly distressed names with high upfront paid by the protection buyer, the conversion to running spread fails if the upfront plus 20% recovery is larger than one. That is why we suggest that if one is to limit the possible recovery scenarios as in the proposal, adding the 0% recovery case to the proposed 20% and 40% guarantees the existence of the converted running spread.

Conversion between running and upfront spreads
For converting upfront CDS spread quotes into running or vice versa there are essentially two possibilities. The first one is consistent with the whole term structure of hazard rates and allows also for hedging portfolios with several positions. The second one is merely a quoting mechanism that has to be used very carefully and only at a single deal basis, in order to avoid possible dangers.

Running to upfront with a consistent term structure of hazard rates
The upfront is just the amount that makes the contract fair, in that the upfront added to the value of the premium leg with the contractual spread S_c (100bp or 500bp) matches the protection leg value. It is therefore straightforward to convert the running spread into an upfront and a new given fixed contractual spread.

The upfront is simply the present value of the payer CDS contract having the new contractual (100bp or 500bp) spread in the premium leg. Given the hazard rate curve h(.) calibrated to the running CDS spreads for several maturities, the market running spread S_0,n and the contractual spread S_c, the upfront for a maturity T_n is simply

Upfr_0,n = ProtecLeg_0,n (LGD;D(0,.),H(.)) - S_cDV01_0,n(D(0,.),H(.)).

or, equivalently,

Upfr_0,n = (S_0,n - S_c) DV01_0,n(D(0,.),H(.))

Upfront to running with a consistent term structure of hazard rates
If we have the upfront for several maturities and we wish to move to running spread taking into account the term structure of CDS consistently, we need first to strip hazard rates from the spanning upfront quotes and then use the hazard rates to obtain the runnings. This is done as follows: Solve in h(.) with

the equations

If we are given

for different maturities Tn, we can assume as before a piecewise constant h, and invert prices in an iterative way as T_n increases, deriving at each time the new part of h that is consistent with the Upfr for the new increased maturity.

Once this is done, the running spread can be readily obtained as

Besides being useful for a consistent conversion across term, this tool allows us to derive a model consistent with several upfront quantities on different maturities at the same time, so that we are able to properly handle a portfolio of CDS across several maturities.

Conversion using a flat hazard rate (FHR)
In order to standardise the conversion from running fair spreads (par spreads) to upfronts, BGJM/ISDA (2009) suggests a conversion method, which is reasonably robust. C++ code is provided so that market participants are able to adopt this method.

However, this method suffers from two important drawbacks: first, it is inconsistent across maturities; and second, it leads to different results, even when converting single CDS deals between running and upfront when compared to the consistent method.

As a result of this, the method works as a rule-of-thumb metric to uniquely if inconsistently convert traded upfront prices into a semblance of running spreads that are not meant to be spreads of actually traded running CDS. This method works for translating upfront to running spread for a single maturity.

The 'model' is not intended to price CDS for any other maturity or a portfolio of CDS and thus we are not dealing with a CDS model, as mentioned before. In the proposal, the 'model' is calibrated to a single upfront CDS quote for a specific maturity (eg Upfr_0,5Y).

It can only be seen as consistent in the absence of any other quotes for earlier maturities. If other such quotes exist (eg Upfr_0,3Y), then they give information about the default probability of the reference entity for an overlapping period of time and this information should be accounted for consistently, which is not possible under the flat hazard rate paradigm.

Example 1: inconsistency of the flat hazard rate framework when used for more than one maturity
The Upfront Upfr_0,5Y gives information about default over zero to five years and Upfr_0,3Y gives information over zero to three years. Suppose there is not a 2y upfront CDS quoted but that we need to price a 2y running CDS. The proposed methodology is powerless and should not be used since it works only on a single deal level and there is no 2y upfront deal.

However, if one tries to force the methodology, one could first use the 3y upfront to get a flat hazard rate translating into a 3y running and then use that hazard rate to compute the 2y running. Or one could do exactly the same thing with the 5y upfront, getting a flat hazard rate for the 5y running calculation and then use this to compute the 2y running.

This would lead to two different running spreads for the 2y: one based on the 3y flat hazard rate and one based on the 5y one. Other examples are possible: suppose the market quotes the 3y and 5y upfront, but we need the 4y running. What to do?

The only possible reasonable method is to strip a term structure of hazard rates consistent with the 3y and 5y at the same time and then price the 2y (or 4y) running CDS. This would be consistent.

However, if some not-too-careful investor applies the above FHR methodology, this can lead to ambiguous results. Furthermore, for hedging a portfolio of upfront CDS, the methodology is also quite powerless.

To phrase the flat hazard rate method in terms of our set-up, let

be the maturity for which we transform the upfront U with a fixed spread S_c into a fair spread S.

The major assumption is that we are using a flat hazard rate h for the time interval

So we are looking for h > 0 which satisfies H(T) = hT for all T and such that

This can be calculated by an ordinary root searcher. After obtaining h we get the running S by

This, however, leads to differences with the consistent framework above. In other words, even at single deal level the fair running CDS spread calculated with the rough and CDS-term-inconsistent flat hazard rate is different from the running CDS spread calculated with the CDS-term-consistent hazard rate curve.

The difference can be considerable in presence of strong patterns of the term structure of upfront CDS quotes by maturity. It is therefore clear that this does not involve a problem as long as running CDS are not traded, but if they were, the potential confusion this can create in the market would certainly be a concern. An example of confusion is the following.

Example 2: investor with existing pre-upfront CDS libraries based on running spreads
We consider a hypothetical investor who has developed libraries to strip a term structure of hazard rates from running spreads across maturities. These hazard rates are used as basic modeling tools in pricing other credit derivatives, counterparty risk and other products involving credit features.

With the market switching to upfront CDS and with input becoming upfront quotes, this investor would now have two choices:

• The first choice would be to strip hazard rates directly from the upfront CDS of a name from several maturities.
• The second choice would be to use the proposed FHR methodology to convert upfront CDS into running and then put the FHR converted running spread into the old libraries based on running CDS inputs.

The two procedures would not produce the same result. The only consistent procedure would be the first one, whereas the second procedure would produce a term structure of hazard rates that are inconsistent with the originally traded upfront CDS. This would be a problem when pricing other products.

The role of recovery and problems with the 20% and 40% choices
In the proposed conversion method one is not free to choose the recovery. Instead, it is fixed at 40% for senior and 20% for subordinated.

In case the contract to be converted featured a different recovery, part of the difference would be absorbed by the flat hazard rate. That is, if the market consensus recovery was 50%, but 40% was used in the conversion, then the hazard rate (and hence the default probability) must move down to balance the larger loss incurred on default. This change in modeling quantities will, of course, affect the conversion.

A potential problem with the conversion method is when the upfront is very high. In some such cases the conversion method would fail to produce a corresponding positive running spread. For example, if the upfront to be paid by the protection buyer is 81%, then converting with the proposed fixed recovery rate of 20% will not work.

The only way of achieving a positive flat hazard rate to do the conversion is to lower the recovery rate. Highly distressed names were recently observed for American automobile producers (March 2009).

For cases when the conversion method fails, we suggest using a third possible value of 0% for the recovery rate R, if we have to stick to a limited set of recovery scenarios. Since in the conversion we are calculating the hazard rate at one maturity only, a realistic case of a failing conversion method is when Upr+ R >1, which can be fixed for

by setting R = 0.

In fact, a sufficient condition for the upfront paid by the protection buyer not to be convertible into a running spread with the proposed methodology is Upr+ R >1. This stems from the default or protection leg of a CDS being bounded from above by 1− R .

This is why the adoption of a third recovery value, 0%, would ease matters in this respect. Indeed, one can show that Upr+ R <1 is a sufficient condition to guarantee existence of a flat hazard rate for the upfront paid by the protection buyer.

© 2009 Fitch Solutions. All rights reserved. This Research Note is an extract from 'Charting a Course Through the CDS Big Bang', first published by Fitch Solutions on 8 April 2009.

Trading

Trading ideas: house party

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

We consider a trade on KB Home (KBH), a name with CDS trading at levels not seen since July 2007. KB Home's equity has not kept pace with its CDS and our directional credit model points to significant credit deterioration.

With credit and equity so far apart, we choose a short credit/long equity trade to bet on convergence. While it is possible that the CDS rally is reflecting a market bet on a takeover, we like the economics of a relative value trade rather than taking an outright bet on either KBH's credit or equity.

Delving into the data
Exhibit 1 charts KBH's market and equity-implied fair value CDS over time. Since the beginning of the year, KBH's CDS handily outperformed its equity and now trades almost 100bp tight to fair.

Exhibit 2 charts KBH's market and fair CDS levels (y-axis) versus equity share price (x-axis). The green circle shows current market levels. The yellow square indicates current fair values when vol is also considered, and the red square indicates expected values in three months taking our directional credit model into account.

With CDS too tight compared to equity, we expect a combination of equity rally and CDS widening. Even if one views our equity targets as too aggressive, we still see more upside in KBH equity than in its CDS. In the case of a sell-off, we believe CDS will be harder hit than equity, given the extent to which it has rallied this month.

Exhibit 1

Our directional credit model indicates significant widening of CDS based on weak market factors, earnings and interest coverage. Although the company's credit and equity now appear to be trading under a different relationship from the past, we believe the tight CDS level is unwarranted unless the market is anticipating a KBH takeover by a better-rated company à la the Pulte-Centex deal.

Exhibit 2

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 upfront 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. A KBH takeover by a better-rated company could radically alter the credit/equity relationship, as we saw with Pulte's proposed acquisition of Centex.

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 KBH. KBH has good liquidity in the CDS market and bid-offer spreads are around 15bp.

Buy US$10m notional KB Home 5-Year CDS at 285bp.

Buy 75,000 shares KB Home at US$18.07.

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).