Contents

Trading

Rally drivers

Can the high yield rally keep going?

The high yield market is enjoying a rally that is notable for its magnitude and duration in a generally bearish environment. The Markit iTraxx Crossover index correspondingly tightened to 774.58bp (as of 12 May) from its highs of over 1000bp at the beginning of March, but some warn that the rally may have gone too far.

"We feel that credit offers fundamentally good value for long-term investors, but downside potential remains and the recent rally may limit the asset class's appeal for short-term investors/speculators," says Mark Pearce, fixed income and alternative investment specialist at Threadneedle. "It's not yet the right time to be aggressive, so we're using relative value strategies to enhance performance."

For example, Threadneedle's new Credit Opportunities Fund (see Job Swaps for more) comprises two segments. The first is a directionally long 'core portfolio', whereby the investment manager identifies shorter-dated opportunities displaying sound fundamentals, yet whose debt has suffered significant price declines. Overlaying this is an alpha portfolio, consisting of relative value strategies involving directional long and short positions, pair trades, capital structure arbitrage trades and basis trades.

Approximately US$7.6bn across 13 new issues was snapped up in high yield during April, with ratings ranging from double-B plus to single-B and the yield-to-maturity ranging from 8.5% to 12.6%. S&P's speculative grade composite index finished the month at 1200bp, the lowest level since 16 October 2008. The rally in high yield extended across all rating classes, according to the agency, with spreads for double-B credits tightening by 178bp during the month and single-B and triple-C spreads tightening by 328bp and 703bp respectively.

However, Pearce says that Threadneedle is underweight double-Bs at present because many of these names have already been downgraded due to their cyclical nature. "High yield returned 9.5% in April, but our high yield portfolio underperformed because it was these fallen angels that did well and our current strategy is to avoid companies at risk of (further) downgrade," he explains. "There is no need to be a hero in this environment: you're amply rewarded for not taking much risk. On the flip-side, if you pick the wrong name and it defaults, the downside can be very significant."

Meanwhile, the Crossover index is currently identified as the richest asset in SG's top-down investment universe, according to its risk factor model. Fair value is shown as 895bp, 17% wider than the market spread.

Quantitative strategists at the bank suggest that the index was quick to react to Lehman Brother's collapse and traded with a premium to fair value through to March 2009 and is now leading the rally, as the return of risk takers favours high yield assets first. According to SG's model, the XO is a leading indicator that trades more than 10 days in advance of its fair value.

But Andrea Cicione, senior credit strategist at BNP Paribas, indicates that the rally in XO appears to have gone too far, at least over the one-year horizon. The latest Moody's forecasts in terms of European default rates indicate that XO investors are being compensated for about half the expected default losses over twelve months - although they should still be able to break even over the entire life of the contract. According to the rating agency, this is because the default cycle will be front-loaded, with defaults expected to peak in December this year and then drop sharply - leaving the five-year cumulative default rate well below its historical levels.

Cicione sees two risks with XO spreads at current levels. The more obvious one is that Moody's forecasts over the five-year horizon prove to be too optimistic and default rates will match - or exceed - those seen in the latest cycle, leaving investors under-compensated by the carry. Investors may thus have to close their long-risk positions earlier, with the carry earned over the holding period insufficient to offset the losses caused by a surge in default rates. The second risk is that a 'long-squeeze' could occur as default losses mount, with investors forced to buy back protection, leading to a rise in XO spreads.

Threadneedle's key market view for the medium to long term is an increase in defaults throughout 2009, with a default rate of around 15%. "Consequently, we want to be certain that the credits we invest in are financially sound on a relative basis, which requires a back-to-basics approach in terms of scrutinising company reports and balance sheets," explains Pearce.

He adds: "We're focusing on credits with strong fundamentals and building a book that is less driven by sectoral/technical factors than fundamental views. Sectoral and technical factors are what drove markets in 2008 and the earlier stages of this year; looking forward, we believe investors will increasingly focus on company-specific risks. In such an environment, those companies with the best fundamentals will outperform."

Under this scenario, given that finance is difficult and expensive for many companies to access, a good credit will have few short-term funding requirements, low relative levels of debt to their industry peers and/or strong/stable cashflows. Companies in the utility and telecoms sectors typically exhibit these characteristics because consumers will always need these services. On the other hand, cyclical sectors - such as industrial, capital goods and consumer credits - as well as financials should be avoided.

High yield strategists at Barclays Capital note that after the recent rally, further gains in the sector are likely to be choppy and difficult to obtain. In addition to rising default rates, there are also a number of other hurdles for the market to clear, such as policy risk, long-term sub-par growth and the leveraged loan refinancing wall. "These concerns, however, are generally longer term in nature and should not affect near-term performance," the strategists conclude.

CS

Operations

Under pressure

Surge in troubled loans puts servicers to the test

Mortgage servicers, both residential and commercial, are facing increasing pressure as the volume of troubled assets continues to rise sharply. There are concerns over whether primary and special servicers are adequately prepared and that - in certain cases - the infrastructure is not capable of dealing with the expected surge in delinquencies.

According to Alan Cleary, md of soon-to-launch UK mortgage servicer Exact, there is clear evidence that mortgage loans in the UK are deteriorating (SCI passim). "For example, in the past year there has been an eight-fold increase in troubled mortgage loans," he says. "As this sort of problem has not existed in the UK for the past 15 years or so, the UK's market infrastructure does not have the capacity to cope with the rise."

Cleary adds: "I therefore believe a systematic risk exists in the UK mortgage market because of this. There are large amounts of non-conforming mortgage loans being held by a small number of UK mortgage servicers that could face difficulties, given the huge rise in troubled mortgage loans."

Commercial mortgage servicers are also under increased pressure. A core group of 26 ranked CMBS special servicers analysed recently by S&P received nearly 3000 new problem loans in the second half of 2008 - a 50% increase compared with the prior six-month period.

Between July and December 2008, they also completed 95 discounted payoffs (DPOs)/note sales and 890 loan restructures, obtained full payoffs on another 426 loans and converted 174 loans to real estate owned (REO) status. This left 3,966 unresolved loans and 664 unsold REO assets at year-end 2008, compared with 2,254 loans and 268 unsold REO assets at year-end 2007 - a nearly 46% increase.

Servicers have been preparing for the increased workload by hiring more staff. But, according to S&P, special servicers may be better prepared than primary servicers at the moment.

S&P data indicates that the ratio of non-performing assets per asset manager increased only moderately in the second half of 2008 compared with the first half. For primary and master servicers, however, a review of staffing allocations among a sample of selected servicers showed a significant jump in their ratios of loans to portfolio management staff between mid-2008 and year-end 2008.

"This calculation, while only an approximation, could be an indication that servicers may have less than the optimal amount of staff to cover their credit monitoring, asset management and non-administrative servicing duties," says Michael Merriam, a director at S&P. "Especially in light of current commercial real estate market conditions, the ability for servicers to exercise sound judgment as to whether and when a loan will truly become non-performing has, in our opinion, become critical for primary and special servicers alike - particularly because both sides must contend with their respective pressures to contain costs while acting as proactively and prudently as possible."

Meanwhile, Cleary believes that the way in which mortgage loans are serviced in the future will have to change. He suggests that a single servicer that can cope with both the primary and the special servicing of loans is the way forward for the market.
"I believe that servicing of troubled mortgage loans, as it exists now, doesn't necessarily make sense in that a defaulted loan stays with the primary servicer for one or two months before being transferred to the special servicer," he explains. "The Exact servicing platform will be a servicer for both markets - it will do whatever our clients want, depending on the status of the mortgage loan."

AC

Correlation

Mezzanine play

But systemic risk concerns remain

The recent rally in corporate credit has driven junior tranches tighter relative to index delta, while senior tranches have widened. However, the 3%-7% tranche still looks expensive given that systemic risk concerns remain.

The rally in both equity risk and the 7%-10% tranche makes sense, given the option-like characteristics of the former and the higher subordination of the latter. But Sivan Mahadevan, global head of credit derivatives and structured credit strategy at Morgan Stanley, says a perplexing theme is the recent move in the 3%-7% tranche - which is most akin to distressed bespoke mezzanine risk.

One driver could be from investors looking for levered plays on an improving economic climate. But it is difficult to argue that 3%-7% is cheap just yet, given concerns about default risk or systemic risk, Mahadevan notes.

"We have been negative on CDX IG 3%-7% for several years now, given that we felt investors were not compensated enough in the healthy market and we expected tremendous negative convexity in an unhealthy one," he says. "As the economic cycle ultimately turns, we expect to warm up to this tranche as it has the potential to be a great recovery trade. But for now, we believe it is a bit too early for 3%-7% risk and our preference for distressed mezzanine instead of index junior mezzanine is really about price and limited downside on the bespoke opportunities."

If the 3%-7% rally holds, it could be a leading indicator for the distressed mezzanine world, however. Bespoke mezzanine prices improved by about five points in April, while price improvements in 3%-7% almost doubled that figure. As tail names start to recover or are restructured out, bespoke mezzanine is nevertheless expected to catch up with its index counterpart in the future.

But Banc of America Securities-Merrill Lynch credit derivatives strategist Santhosh Bandreddi warns that, during significant market moves, portfolio dispersion changes substantially and could lead to different moves in different tranches. In a new report, credit derivatives strategists at the bank examine IG9 tranche performance relative to single name delta hedges as an indicator of the change in the risk premium for junior tranches. Delta-adjusted tranche moves can be used as a future risk metric and to identify relative value across the capital structure.

The 0%-15% tranche has clearly outperformed the index in the current rally, with the 3%-7% and 7%-10% tranches exhibiting the biggest outperformance because they are at-the-money tranches and hence the adjustment in risk premium is most prominent here, Bandreddi explains. By comparing the p&l from a long tranche position to that of a long position in single name delta-hedges from 9 March to 4 May, the outperformance of junior tranches relative to single name deltas is shown to be an indication of a reduction in the risk premium.

However, the reduction in risk premium is not necessarily uniform across all tranches, as the risk premium is the highest where volatility/uncertainty is the highest. For example, senior tranches (15%-30%) may underperform single names as the junior tranches outperform, ensuring the total p&l across the capital structure is in line with that of the index.

"10%-15% underperformance could also be viewed along the same lines as it becomes more and more senior as the index rallies. However, the underperformance of 7%-10% relative to single names is surprising, given its effective attachment point is 6.7% (the index expected loss is around that level, which doesn't make it a clear senior tranche) and that it tends to be more equity-like at these levels of index," adds Bandreddi.

Given that the 7%-10% is expected to tighten relative to single names going forward to ensure consistent pricing of risk, Bandreddi suggests that going long 7%-10% in five-year IG9 delta-hedged is appropriate in the current environment. At first glance, this trade might seem market-directional, but the index reference on 7 May was 192bp and 7%-10% trades at 4.5 points mid.

On 15 September 2008, the index ref was 195bp and 7%-10% was trading at -0.18%. Since that day, the 7%-10% has traded wider by over five points.

"As the market thinks that the crisis has been averted and we are back to pre-Lehman collapse levels, the trade still makes sense, even delta-hedging with the index. If 7%-10% were to outperform the single names as well going forward, it will be an added bonus," Bandreddi concludes.

CS

CDPCs

CDPC aquires manager, details new strategies

Primus Guaranty has announced a trio of strategies that it hopes will align the company with the new financial landscape. It confirmed its plan to tap new opportunities in structured credit asset management, initially with the acquisition of CypressTree Investment Management, and gave further details of a new company it intends to launch that will write credit protection (see SCI issue 123). Furthermore, the CDPC announced that it is keen to invest in TALF.

Founded in 1995, CypressTree manages leveraged loans and high yield bonds in a variety of investment products, including CLOs, CSOs, off-shore funds and separately managed accounts. Its assets under management total approximately US$2.4bn.

Following its acquisition, CypressTree will operate as a wholly-owned subsidiary of Primus Asset Management (PAM), which will have over US$25bn in assets under management in structured credit vehicles. This includes the US$21bn notional CDS portfolio of Primus Financial Products, as well as two existing Primus CLOs with US$800m in assets and three existing Primus CSOs totaling US$800m.

Martha Hadeler and Robert Weeden, CypressTree partners and portfolio managers, will join Primus as senior portfolio managers and will assume responsibility for managing its loan and high yield platform, including its CLOs. They will report to Thomas Jasper, Primus Guaranty's ceo.

"The acquisition of CypressTree marks a solid step forward in our strategy to leverage our platform and increase the scale and scope of our credit asset management business," Jasper comments. "It also significantly strengthens our investment capabilities, as Martha and Bob bring excellent track records and five decades of combined experience to Primus. I'm delighted to welcome the CypressTree team to our company."

Weeden adds: "In joining forces with Primus, we are bringing together two fundamental credit investors who share a common investment approach to build a robust loan and high yield platform with the size and skills to succeed in today's market."

Fusion Advisory Partners acted as advisor to PAM on the acquisition. Fusion provides third-party independent advice to participants in the fixed income structured product market.

In Primus' Q1 results presentation, Jasper described the acquisition as a "major step forward in our plan to gain the size and scale that we need to thrive in the credit markets".

He added that there will be other opportunities to acquire companies, asset management contracts and structured credit assets because of the consolidation taking place within the structured credit markets this year. "We are seeing good interest so far," he noted.

Jasper also confirmed that Primus is working in other ways to position PAM for the longer-term reopening of the structured credit markets where an experienced manager with an established track record should be able to originate new transactions. "Given the disruptions in the financial and credit markets, there are currently very few, if any, sellers of credit protection whose strategy is to be an end risk taker. The reality is that the markets want and need this capacity. We believe this could present us with an attractive opportunity to create a new company that leverages our fundamental credit platform, a company that's actively managed with a relative value orientation - and that's generally long credit," he explained.

The new company's strategy would be to sell protection via credit default swaps on single name corporate and sovereign reference entities. This would be similar in concept to Primus Financial, with the major difference being that the new company would post collateral.

"We believe Primus Asset Management is one of the few managers that has the credit platform and track record to execute on this type of strategy. Over the last few months, we have built and are managing a US$1bn test portfolio that will help us prepare for the prospective launch of this new credit protection seller. So far, we've seen good performance, although we continue to refine and enhance our approach to managing this new test portfolio," said Jasper.

He also confirmed that Primus will be signing up to participate in the TALF programme and that the company is in the process of deciding how much cash it should allocate to these assets. "We expect at this point that it would be a modest amount and are treating this as an additional opportunity for us under our enhanced investment guidelines," Jasper concluded.

AC & CS

CLOs

CLO managers chase DIP-financed names

CLO managers are choosing to remove defaulted names from their portfolios or reduce exposure partially, while buying activity has focused mostly on names that have been able to obtain DIP financing (for example, Aleris and Lyondell), according to structured credit strategists at Barclays Capital. They note that for names that did not secure DIPs, CLOs have been net sellers of loans. Their research also shows that sellers have outnumbered buyers, but the average notional bought by buyers has been significantly greater than that sold by sellers.

"Our analysis suggests that in the absence of a DIP, CLOs have so far been reluctant to hold on to defaulted loans to final recovery," the strategists explain. "This, of course, might change as more CLOs breach their OC cushions and managers are encouraged to hold on to defaulted assets rather than deleverage their structures."

BarCap focuses on ten out of forty defaulted names since October, which have more than US$100m exposure in CLO deals. For these ten names, BarCap found that managers preferred to reduce their exposure partially or completely in 70% of the CLO deals.

Lyondell is the only name for which the number of deals increasing their exposure is larger than those decreasing. The strategists suggest that this might be a result of some managers adding term loan exposure to participate in the Lyondell DIP loan, which should be attractive for CLO deals, given its attractive coupon and short duration.

From a dollar-notional exposure standpoint, the action managers took is less severe. Besides Lyondell and Charter, which had exposure changes of +21% and -29% since October respectively, the changes for the rest of the names are roughly in a ±10% range, according to BarCap. For Aleris, although the number of deals that reduced their exposure is greater than those that increased, the dollar notional actually increased because a few managers increased their exposure in significant size.

AC

Emerging Markets

Indonesia reopens sovereign sukuk market

The Republic of Indonesia has issued a US$650m Shariah-compliant ijara sukuk - the first such deal from the region and also the first sovereign sukuk to be launched since Bahrain sold a US$350m transaction in March 2008. The deal was launched out of Perusahaan Penerbit SBSN Indonesia I (PPSI-I), an SPV holding beneficial rights over approximately 66 properties used for government purposes, including buildings, improvements and fixtures thereon, located in Bandung and Jakarta.

The deal is also notable for being the largest sukuk since Dubai Ports in June 2007 and the first from a country outside the Gulf Cooperation Council (GCC) since Pakistan's issue in 2005.

Ijara is a sale and lease-back arrangement, whereby an asset is bought by a bank (or investor) and then rented to a client for a fee that includes the purchase price and the profit earned during the rental period. The ijara principle is increasingly being preferred over alternative types of structure, such as mudaraba and musharaka, which contain profit-sharing components and hence greater exposure to market turbulence.

Ijara sukuk are also said to be more widely endorsed by Shariah scholars. S&P estimates that ijara structures made up more than 45% of sukuk issued in 2008.

The Bank of New York Mellon will act as delegate trustee, principal paying agent, transfer agent and registrar. "The sukuk comes as Indonesian markets are enjoying one of their rosiest periods in months, thanks to market relief at the legislative election passing off smoothly, the strong prospect of President Susilo Bambang Yudhoyono being re-elected in July and positive regional sentiment. Indonesia is in better economic shape than most places in the region and, while its economy is slowing, prices of its key soft commodities like palm oil are rising strongly," says Gary Lew, head of Asia Pacific, corporate trust at The Bank of New York Mellon.

AC

Indices

Positive run continues for hedge fund index

Both gross and net monthly returns for March 2009 in the Palomar Structured Credit Hedge Fund (SC HF) Index have continued their positive run.

The latest figures for the index were published this week and show a gross return of 0.92% and a net return of 0.72% for the month of March (compared to 0.57% and 0.4% respectively in February). However, the gross and net indices still show negative annualised returns since outset of -9.11% and -10.89%. For more Index data click here.

The objective of the Palomar SC HF Index is to produce an index that represents the risk and return of investable hedge fund investments in the structured credit area. It currently tracks 15 funds and represents over US$7.5bn of assets under management.

The index aims to provide a monthly measure of the performance of the universe of open, investable structured credit hedge funds. The Palomar SC HF Index is calculated in two formats - as gross asset value and as net asset value.

The Palomar SC HF Index is calculated by the Centre of Alternative Investments of the Zurich University of Applied Sciences and run by Palomar Capital Advisors. It is published exclusively by Structured Credit Investor.

Palomar Capital Advisors is a financial advisory firm specialising in structuring, managing and placing alternative investment products, specifically credit-related securities. It is an independent firm based in Zurich, Switzerland, owned and controlled by its investment professionals.

Investors

SCI '09 London initial line-up announced

The initial line up of panellists for SCI '09, the third annual Structured Credit Investor conference, has been announced. The conference will take place on 2 July at One Great George Street, Westminster.

Experts speaking at SCI '09 include representatives from: Alcentra, Assenagon, Capstone Investment Advisors, Chenavari Credit Partners, Citi, GSO Capital, IKB Fund Management, Incisive Capital Management, ISDA, Pearl Diver Capital, Principia Partners, Prytania, Shooters Hill Capital, S&P, StormHarbour Securities, Threadneedle, TwentyFour Asset Management and UniCredit.

This year the conference will dig deeper into strategies for opportunistic investors and offer discussions regarding pricing and valuations of ABS, CDO and CDS instruments. Investor strategies across asset classes and explanations of how regulatory reform is shaping the future of the market will also be highlighted.

Buy-side investors are invited to attend the conference free of charge. For more information on the event, regular updates and reservations please click here.

Operations

Stress test results in, but strictness questioned

The US stress test (Supervisory Capital Assessment Program/SCAP) results were published last Thursday (7 May) and indicate that 10 US banks will be required to raise another US$75bn of new capital. However, at least 15 of the 19 banks that have undergone federal stress tests would fail a stricter test based on more objective economic assumptions and stricter evaluation procedures, according to Weiss Research president Martin Weiss.

A review of the US Federal Reserve's white paper, 'The Supervisory Capital Assessment Program Design and Implementation', indicates three major differences between the federal stress tests and Weiss' analysis. First, the federal stress tests consider strictly a one-year further decline in GDP, in contrast to prior government stress tests that assumed a 10-year decline. The Weiss analysis does not include macro-economic projections, but it generally assumes the possibility of a deeper and more prolonged economic decline.

Second, systemic risk is not specifically discussed and does not appear to be a significant consideration in the stress tests. Weiss considers systemic risk by evaluating the OCC's measures of total credit exposure to derivatives.

Third, the Federal Reserve states that the stress tests are based, to a large extent, on each bank's self-evaluation - not only for loan loss estimates that can be derived from past data, but also for the future performance of trading accounts, which can be far more subjective. Moreover, each institution can appeal the final results and it has been widely reported that several are strenuously negotiating for more favourable grades. In contrast, Weiss does not permit the institutions to directly or indirectly influence its evaluation process or results.

Under the Weiss analysis, seven institutions - JPMorgan, Citi, Wells Fargo, Goldman Sachs, GMAC, SunTrust Banks and Fifth Third Bancorp - are at risk of failure with a continuation of current economic and financial conditions. Eight institutions - Bank of America, Morgan Stanley, PNC Financial Services Group, US Bankcorp, BB&T Corp, Regions Financial Corp, American Express and Keycorp - are borderline, meaning they could be at risk of failure with worsening economic or financial conditions. According to Weiss Research, only four institutions - MetLife, Bank of NY Mellon, Capital One and State Street - appear to have adequate capital to withstand worsening conditions.

"Our analysis directly contradicts the overall conclusion by the banking authorities that most bank holding companies are well capitalised," says Weiss. Moreover, of the US$11.6trn in assets held by the 19 institutions, those considered at risk of failure represent US$6.56trn, or 56.5%, of the assets.

The top five institutions with capital needs under the SCAP are Bank of America (with US$33.9bn needed), Wells Fargo (US$13.7bn), GMAC (US$11.5bn), Citigroup (US$5.5bn) and Regions Financial (US$2.5bn).

According to credit strategists at UniCredit, the official stress test results are better than expected in terms of capital and loss projections for the US banking system. "Total capital needs were initially estimated much higher and previously rumoured to be even up to US$200bn," they comment. "While the loss projection of the stress test (US$599bn) and of the IMF (US$550bn) are in line, the respective conclusions about capital requirements differ, as the IMF sees a requirement of another US$275bn-US$500bn in fresh capital to bolster losses until 2010."

The strategists add: "As the results are on the one hand very comforting, they might be criticised as being 'too good to be true' by less optimistic players. Moreover, even if the stress test results prove realistic, the European banking system is still not out of the woods."

Credit Derivative Research's Counterparty Risk Index (CRI) rallied on Friday to 165.9bp (tightening by 15.5bp on the day and 71.1bp on the week), a level not seen since the first week of January. All fourteen members traded tighter (less risky), with Citigroup and Bank of America being the biggest stress-test winners, tightening last week by 40% and 37% respectively. Other names tightening in the index included Morgan Stanley (which tightened by 40bp on the day), Merrill Lynch & Co (30bp) and Goldman Sachs Group Inc (22.5bp).

Credit strategists at BNP Paribas note that what matters is not whether the sums ultimately prove to be right or wrong, but whether the results of the tests reassure the market. "So far, the leaked conclusions seem to be doing the trick, so we cannot complain," they say. But they suggest that the ultimate test will be whether the results of the tests and banks' response to them reassure the market sufficiently to enable banks that need to raise private capital to do so.

"Overall, we feel they are a bit of a fudge designed to fit into the political realities of the day. The tests therefore put off the problem until later - like suspending mark to market. If they keep the show on the road, is that worse than a tougher result that causes a convulsion? Probably not. In the market's current mood the stress tests look like a glass half full rather than one half empty," the BNP Paribas strategists add.

According to the US Federal Reserve, the results of the SCAP suggest that if the economy were to track the more adverse scenario, losses at the 19 firms during 2009 and 2010 could be US$600bn. The bulk of the estimated losses - approximately US$455bn - come from losses on the banks' accrual loan portfolios, particularly from residential mortgages and other consumer-related loans. The estimated two-year cumulative losses on total loans under the more adverse scenario is 9.1% at the 19 participating banks; for comparison, this two-year rate is higher than during the historical peak loss years of the 1930s.

Estimated possible losses from trading-related exposures and securities held in investment portfolios totaled US$135bn. In combination with the losses already recognised by these firms since mid-2007 - largely from charge-offs and write-downs on the values of securities - the SCAP results indicate that financial crisis-related losses at these firms, if the economy were to follow the more adverse scenario, could total nearly US$950bn by the end of 2010.

National supervisors in Europe are now reportedly preparing stress tests for European banks, following common guidelines and methodologies. Unlike those for the US, they are likely to be undertaken at an aggregate level rather than for the individual banks.

If this approach is confirmed, credit strategists at BNP Paribas believe that the exercise will have limited usefulness. "The most valuable information that the US stress test provided investors with is a peek into the individual banks' balance sheets, assets quality and loss potential. A decision by European supervisors not to disclose this information - or, worse, not even look at it - would defy the whole purpose of a stress test," they conclude.

AC & CS

Investors

New balance of power

Jerome Booth, head of research at Ashmore Investment Management, answers SCI's questions

Jerome Booth

Q: How and when did Ashmore Investment Management become involved in the structured credit market?
A: Ashmore Investment Management was formed out of Grindlays Bank (which was bought in 1984 by ANZ), whose London unit made markets in emerging market debt. We then began taking on simple corporate restructurings in Latin America, then government-to-government restructurings and ended up building an investment bank around this focusing on emerging markets. We were also a founding member of EMTA (the trade association for the emerging markets).

We're a specialist emerging market asset manager, highly experienced in restructuring and managing sovereign debt, local currencies, derivatives, government paper, infrastructure loans and private equity. Our special situations experience has given us a strong ability to work with local participants. We've invested in many deals and countries and consequently have a strong reputation.

We launched our first fund, the Emerging Markets Liquid Investment Portfolio (EMLIP) in 1992. It outperformed through the severe stresses during the 1990s, with a pattern of underperforming on the way down as we bought value in falling markets, followed by strong outperformance on the way up. Our assets under management totalled US$37bn in June 2008, but subsequently fell to US$24.5bn in December and US$23.5bn in March - the downturn is due to performance as well as redemptions.

Additionally, we listed on the FTSE 250 in 2006 primarily for the profile it gave us. Central banks and finance ministries like the accessible governance structure of an exchange.

Q: What, in your opinion, has been the most significant development in the credit market in recent years?
A: The credit crunch has turned the world upside down, but within this there are opportunities to take advantage of the growth in emerging markets as an investment destination. Equally, the fastest growing investment pools are in emerging market countries, thanks to the huge reserves that central banks have built up over the last few years and large domestic populations and savings bases.

Q: How has this affected your business?
A: The potential for growing our business has been accelerated by the credit crunch, especially since the competition has reduced in number. Our conservative approach and stable investor base has certainly helped us vis-à-vis our peers. Our investor base, 90% of which is institutional investors, has been built up organically and many accounts have seen such a down-turn before.

We had one of seven or eight external Russian debt funds by early 1998 (we launched ours in 1996), but by the end of 1998 ours was the only fund remaining. The current crisis is therefore familiar territory to us, whereas many funds in developed countries have never experienced such a downturn.

For instance, the competitors that failed weren't defensive enough in their investments and messed up the recovery of the assets or had damaged portfolios. The key is to manage the portfolio as a whole in line with the most negative scenarios and then add returns within this constraint.

Emerging market assets require a different skill-set to managing typical fixed income assets in Europe or the US - it is necessary to understand the political and technical dynamics across the different jurisdictions and have good local relationships. This is very different to the 'straw man' characterisation of developed world private equity deals, which is as follows: find an asset that is, say, 5% undervalued, leverage it up to the hilt, shout about it and this then attracts an exit opportunity.

This is a bit of an unfair description, but makes a huge contrast with EM, where we do not employ the leverage approach and do not publicise what are often sensitive problems for companies in need of capital and restructuring. They are often family-run businesses that need restructuring or simply a capital injection on a discreet basis, and we are often not competing against others for this business in any public auctions.

Our reputation is one of effectiveness and constructiveness: we've helped countries develop their capital markets, for example by offering free policy advice. It takes time to develop relationships and this is one barrier to entry - the other is critical mass. We're the only institutionally-sized fund manager that is dedicated to emerging markets and across a full range of EM asset classes.

Q: What are your key areas of focus today?
A: Illiquid markets have created high spreads because few participants want to put risk on and there has been a huge flight to liabilities in the US, which has created a downdraught. However, EM has largely been on the road to recovery since October.

Nonetheless, we've been more careful about liquidity and have adopted our normal barbell approach in EMLIP, consisting of liquid sovereign bonds and illiquid assets. Around 70% of NAV is invested in high beta assets and the rest is in high return, less liquid paper.

Additionally, we went into the credit crunch with a defensive position and cash in the portfolio, though we are now more bullish. Ashmore does not manage any highly levered or hedge funds, but we do alter our exposure through cash and/or some moderate leverage - clients in effect delegate some of the tactical asset allocation to us, so they can think more strategically.

Corporate high yield and special situations are highly attractive right now, and local currency is a good insurance against dollar weakness as well as offering good medium-term appreciation. We are just starting to be more cautiously bullish on equities, having been at zero since September in our multi-strategy fund.

We also recently launched the Ashmore Global Consolidation and Recovery Fund (see SCI issue 134 for more), which involves banks swapping their distressed emerging market exposures for units in the fund, thereby enabling those banks to retain the upside associated with a recovery in asset prices.

Q: What is your strategy going forward?
A: There is scope for pension funds to have as much as a 50% allocation to emerging markets, if they begin considering asset allocation at a strategic level. We are ready to help investors get to much higher allocations by continuing to grow organically, build out more local operations and offer more products in more EM asset classes to cater for this growth.

Q: What major developments do you need/expect from the market in the future?
A: Emerging markets are in a good position and in this interconnected world will be the next engine of growth. The emerging countries and their numerous asset classes stand to benefit significantly from the changed global balance.

The average non-weighted reserve-to-GDP ratio in the emerging world is 30%, meaning that EM countries are large net creditors and exporters of capital. Central banks alone have US$5.5bn that could be pulled back from developed economies and the danger is that they may behave in a similar way at the same time - this is why the G20 has become so powerful.

It also explains the switch in economic bargaining power from developed to developing countries. There'll be some short-term stress in terms of exports, but it should be replaced by domestic consumption.

The reality is that there is now a higher ten-year risk of sovereign default in some developed countries than in many EM countries, for example. Compared to the last crisis, the risk of sovereign default in EM is minimal - there's no sense of the financial contagion of the 1990s.

This is because, for the most part, EM countries do not have credit crunch disease - a process of deleveraging after years of developed market excess leverage - but rather have collateral damage in the forms of reduced cross-border flows and reduced exports (neither exclusively or even dominantly EM problems). Eastern Europe is the exception because it has some credit crunch disease. The last few years have seen huge fighting for market share among Western European banks in countries that were becoming 'developed'.

Russia has always had a dysfunctional banking system. The trade shock resulted in a devaluation of the currency, but sovereign credit risk is fine - the central bank has US$400bn in reserves, for example.

The behaviour of central bank reserve managers will impact markets going forward in terms of stabilising currencies. Lower reserves may lead to domestic investment booms, thereby impacting the level of foreign investment in US Treasuries. The net effect will be increased economic growth in developing countries.

About Ashmore Investment Management
Ashmore Investment Management Limited is one of the world's leading investment managers dedicated to emerging markets, with a history of consistently outperforming the market. Ashmore focuses on a number of investment themes, including external debt, local currency, special situations (incorporating distressed debt and private equity), corporate high yield and equity.

CS

ABS

Structured credit head recruited

Jefferies & Co has hired Andrew Peisch as an md and co-head of MBS and ABS banking and origination. He has more than 25 years of industry experience and was most recently head of structured credit products banking and origination for the Americas at Deutsche Bank, where he worked for six years.

Peisch will co-head the firm's MBS/ABS banking and origination group along with Adam Smith, who joined Jefferies in April 2008. Together, Peisch and Smith will lead the firm's underwriting and structuring effort for MBS/ABS transactions, including the incorporation of related government programmes. They will jointly report to Johan Eveland and William Jennings, co-heads of Jefferies' MBS and ABS group.

The addition of Peisch marks the next step in Jefferies' plan to build its structured finance business. Jefferies' MBS/ABS group now includes more than 50 sales, trading and execution professionals in the US and London.

CDO

More CDO write-downs for KBC?

KBC Group has requested to have its shares suspended today, 13 May, following rumours that have been circulated in the market. There is speculation that the Belgian government is working on a new rescue plan for KBC, as the group is set to write down a further €1bn in CDOs.

CLO Managers

CLO manager fees plummet

Deerfield Capital Management noted a 30% drop in its investment advisory fees in its Q109 results. The fees totalled US$4.7m in the quarter, compared to US$6.7m in Q408. The decrease in investment advisory fees was primarily the result of the breach of certain OC tests contained in a number of the CLOs that the company manages.

Deerfield expects its CLO subordinated investment advisory fees to further decline and be subject to deferral in the near term. However, over time and with improved market conditions, the company expects the CLOs to regain compliance with the OC tests and, subject to the satisfaction of certain other conditions, it expects to recoup at least a portion of the deferred subordinated management fees and to receive future CLO subordinated management fees on a current basis.

The remaining decline in investment advisory fees primarily related to the company's fixed income arbitrage investment fund, which was liquidated during Q408 and provided US$0.6m of fees for that period.

CLOs

New manager for middle market CLO

Pangaea Asset Management is being tipped to become replacement CLO manager for De Meer Middle Market CLO 2006-1. In March 2009, it was proposed that the CDO asset management responsibilities for De Meer 2006-1 be transferred to Pangaea from Bank of America - Bank of America having assumed management responsibilities from De Meer Asset Management. The firm was the initial asset manager on the deal and a division of LaSalle Financial Services, which was acquired by BofA in October 2007.

Fitch has reviewed Pangaea as a potential replacement CLO asset manager for De Meer 2006-1 and has determined that Pangaea meets Fitch's minimum criteria to qualify as collateral manager for the transaction. Pangaea, formed in 2007, is a specialised asset management firm focused primarily on managing leveraged loan collateral with a significant allocation to middle-market loans. It currently employs 15 professionals and manages approximately US$1bn of assets underlying three middle-market loan CDOs.

De Meer 2006-1 is a cashflow CLO that closed in August 2006. The transaction's initial note balance has amortised from US$409.5m at closing to US$334.5m, as of the latest trustee report dated 6 April 2009.

The current collateral portfolio is composed of floating-rate senior secured loans, primarily invested in broadly syndicated (45%), traditional middle-market (42%) and larger middle-market (13%) borrowers. While De Meer 2006-1 is a static transaction, the deal allows for the substitution of loans that have prepaid. The substitution period ends in October 2009.

Distressed assets

Distressed credit analysts hired

Broker-dealer Broadpoint Capital has hired Matthew Swope and Bradley Bennett for its debt capital markets division as vps and fixed income analysts, as the firm looks to expand the types of credit it brokers.

Swope joins Broadpoint with nine years of experience in the high yield bond, leveraged loan and distressed debt markets. Most recently, he was a research analyst, portfolio manager and partner at Washington Corner Capital Management, a distressed and credit-based investment firm.

Bennett most recently spent eight years at Goldman Sachs, where he was a vp in the high yield distressed investing group. He joined Goldman in 2001 and initially worked in the bank loan distressed investing group.

Distressed assets

Commerzbank confirms structured credit spin-off

Commerzbank confirmed its plans to ring-fence its structured credit products and spin them off into a new unit called the Portfolio Restructuring Unit (PRU - see SCI issue 130 for more). A portfolio of €38bn of assets, including ABS, MBS, CDOs, conduits, exotic credit derivatives, bonds, loans trading and indices, will be moved into the unit. Not included are government-wrapped student loans and leveraged acquisition financing client-driven conduits.

Investors

Investment manager attracts strategic capital

SkyBridge Capital, a provider of strategic capital to new and early-stage hedge funds, has committed to invest in WyeTree Asset Management, a London-based investment management firm focused on the residential mortgage markets.

WyeTree invests globally in assets with highly predictable cashflows linked to residential mortgages and residential real estate. Supported by a proprietary database and analytical tools, the WyeTree team seeks to identify distressed assets that derive their principal risk and return from residential mortgages or residential real estate, and which are oversold due to market technical factors.

WyeTree is currently investing in US sub-prime MBS and sub-prime mortgages, but it is expected to eventually invest in mortgages outside the US, as well as in securities backed by home loans rated higher than sub-prime. The vehicle may also invest in other distressed assets.

In addition to providing WyeTree with long-term strategic capital, SkyBridge Capital will seek to enhance its investment in WyeTree by providing business-building support. SkyBridge Capital's investment is being made from its SkyBridge Capital II Fund. In aggregate, SkyBridge Capital and its underlying managers currently have approximately US$1.5bn under management.

WyeTree was founded in 2007 by two securitisation specialists: Michael Chacos, ceo, and Judith Sciamma, portfolio manager. Sciamma, who has 15 years of portfolio management and asset analysis experience, previously served as portfolio manager and head of the ABS team at London-based Solent Capital, where she oversaw US$4.7bn in four CDO funds.

Prior to that, she was a senior analyst and trader in the ABS area of IXIS CIB. She previously served as a fund manager at ODDO Asset Management in Paris.

Chacos, who has 23 years of structuring, asset analysis and trading experience, previously oversaw the credit strategy group at TD Securities (London). He has also worked in structured credit and interest rate derivatives structuring areas of Bank of America in London, Chicago and New York.

Scott Prince, managing partner of SkyBridge Capital, comments: "Judith Sciamma and Mike Chacos are proven investors in the residential mortgage markets arena, and we are pleased to back the firm. WyeTree is currently investing in US sub-prime mortgage-backed securities and sub-prime mortgages, a significant opportunity in itself, but the team also will have the ability to invest in mortgages outside the US and in other assets."

Chacos adds: "As we focus on the substantial market opportunities that exist within the residential mortgage markets arena, we are pleased to partner with SkyBridge Capital, the premier strategic investor in new hedge fund managers. SkyBridge possesses unmatched business-building and investment-support capabilities, including an exceptional risk management capability and a growing distribution platform - all of which will benefit WyeTree as we continue to build the firm."

Investors

Threadneedle launches credit opportunity fund

Threadneedle has expanded its Absolute Return range, with the launch of the Threadneedle Credit Opportunities Fund. It will be to be managed by head of high yield, Barrie Whitman, who will be joined by high yield fund manager Roman Gaiser and investment grade credit fund manager Alasdair Ross. The new fund is authorised for distribution in the UK and will be registered in the coming months for distribution in Europe.

The Threadneedle Credit Opportunities Fund will focus on opportunities within the high yield and investment grade markets, but can also exploit opportunities that arise within other areas of the credit market. Investments will include corporate bonds and derivative contracts. In terms of primary investment strategies, the fund can hold outright long and short positions, as well as pair trades, basis trades and capital structure arbitrage trades (see also separate News Analysis story).

Mark Pearce, fixed income and alternative investment specialist at Threadneedle, says the launch is in response to demand from investors for products that can deliver more consistent performance than traditional long-only funds. "There are significant opportunities within the credit space for managers that have experience managing absolute return strategies, as well as the ability to exploit the flexibility that UCITS III provides," he explains. "We have developed the necessary skills from managing our existing absolute and hedge fund strategies. It is important to realise that the ability to successfully implement short and credit derivative strategies is not common."

The fund will aim for a performance of one-month Euro deposit rate plus 350bp - gross of charges and tax - per annum over the medium term, but will be creating alpha primarily through the team's bottom-up credit views.

"The current weak economic environment and the high degree of risk aversion prevalent across financial markets have created a wealth of opportunities," says Whitman. "We are able to add value via both traditional and alternative means, or more specifically via both long and short positions in the credit markets. Whilst we expect the market to be subject to ongoing volatility in the near term, there can be no denying that valuations appear cheap and the opportunities to add value are plentiful. "

Threadneedle says the fund is likely to appeal to investors who are seeking the potential for positive medium-term (circa 18 months) returns. The multiple sources of alpha incorporated within the fund and its usage of long and short investing means that the fund's returns are likely to be lowly correlated with those of traditional fixed income portfolios and with other asset classes.

As such, the fund should prove to be a useful diversification tool, allowing investors to reduce overall portfolio risk. With a similar performance target but different sources of alpha compared to Threadneedle's other absolute return funds, the Credit Opportunities Fund could also potentially be used in conjunction with its existing products to diversify risk further in a broader absolute return portfolio.

Ratings

Fitch names Asia Pacific head

Fitch has appointed Ben McCarthy as md and head of the structured finance group in Asia Pacific. He replaces Marjan Van Der Weijden, who is returning to Fitch's London office following five years in Asia Pacific.

Having joined Fitch in 1998, McCarthy has substantial structured finance rating experience. He was head of Fitch's non-Japan Asia structured finance group between 2001 and 2005, and head of Australia and New Zealand structured finance from 2006 to the present. He is replaced as head of Australia and New Zealand structured finance by Natasha Vojvodic.

Regulation

ICFR appoints Prada

The International Centre for Financial Regulation (ICFR) has appointed Michel Prada as non-executive director to its board of directors with immediate effect.

Lord Currie, chairman of the board of the ICFR, says: "Michel's experience with securities regulation in France and on an international scale through his active participation in International Organization of Securities Commissions will be instrumental in advancing the ICFR's global agenda."

Prada is the former chairman of the Autorité des Marchés Financiers (AMF), France, as well as a member of the Financial Crisis Advisory Group set up by IASB and FASB to consider financial reporting issues arising from the global financial crisis. He is also chairman of the board of trustees of the International Valuation Standards Council.

Trading

FSA bans prop trader for mismarkings

The FSA has fined Morgan Stanley £1.4m for systems and controls failings in relation to trader mis-marking which led the firm to make a US$120m negative adjustment in June 2008. The FSA has also banned Matthew Sebastian Piper, a former proprietary trader at the firm, from performing any function in relation to any regulated activity on the grounds that he is not a fit and proper person. Piper, who is understood to have traded European CDS at the bank, was also fined £105,000.

"In breach of FSA Principles, the firm failed to effectively use the controls it had in place for dealing in illiquid financial products. It failed to ensure adequate supervision of Piper's books and as a result, did not price certain positions accurately. Further, the firm failed to prevent or detect the mis-marking in a timely manner," says the FSA in a statement.

The regulator also says the firm further failed to respond quickly enough to changing conditions in the credit markets (namely an increase in volatility and a decrease in liquidity) by making adjustments to its existing systems and controls which would have enabled it to detect the mis-marking of the illiquid products in a timely manner.

Piper deliberately mis-marked the positions he traded on behalf of Morgan Stanley and sought to hide losses by manipulating the processes the firm had in place to monitor trading activity, the FSA says.

Margaret Cole, FSA director of enforcement, comments: "Piper has been banned because his misconduct was deliberate, frequent and repeated over a six-month period. He was a senior and experienced trader, who held a position of trust at the firm. This was clearly a serious breach of the standards of behaviour we expect of approved persons."

Morgan Stanley cooperated fully with the FSA and agreed to settle at an early stage of the FSA's investigation. The firm qualified for a Stage 1 discount under the FSA's settlement discount scheme. Without the discount the fine would have been £2m.

The FSA took into account Piper's early admission of misconduct and his cooperation with both the FSA and Morgan Stanley. He agreed to settle early and also qualified for a 30% reduction to his fine. Without the discount the fine would have been £150,000.

On discovery of the mis-marking, the firm suspended Piper and senior management commissioned a review into the marking of his positions. The review identified serious weaknesses in the implementation, operation and management of Morgan Stanley's systems and controls.

ABS

Texan collateral value in auto ABS monitored

S&P is monitoring developments following a November 2008 US federal bankruptcy court case in Texas that has created some uncertainty regarding the value of the Texas collateral in auto loan securitisations. In the case, Clark Contracting Services Inc. vs. Wells Fargo Equipment Finance, the US bankruptcy court held that, under Texas law, the assignee of a motor vehicle loan must be named as lienholder on the certificate of title in order to enforce its rights in the vehicle underlying the loan if the borrower files for bankruptcy.

The ruling, which is not binding on Texas state courts, effectively requires the title of a motor vehicle to be amended when the related loan is transferred. The decision conflicts with a long-standing practice in auto loan securitisations whereby the originator generally remains on the title as lienholder and titles are not amended to name the seller, the trust or the indenture trustee as lienholder.

As a result of the ruling in the Clark Contracting case, there is now significant uncertainty regarding whether the outstanding auto loan trusts would be able to realise recoveries on collateral for the loans if an obligor located in Texas defaults. This uncertainty presents a potential risk to new and outstanding transactions that have exposure to loans to obligors in Texas.

As a result of this court decision, some originators have chosen to exclude Texas receivables from their proposed securitised pools. In the Ford Credit Auto Owner Trust 2009-A transaction, which closed on 15 March 2009, Ford elected to include receivables from Texas to maintain consistency for potential investors. When S&P analysed this transaction, it assumed that the trustee would not be able to realise any recoveries on vehicles for defaulted Texas receivables.

Recently, Senate Bill 1592 (SB 1592) and House Bill 3077 (HB 3077) have been proposed to address this issue. The Texas legislature has reviewed both bills: the Senate has passed SB 1592 and is now with the House, and HB 3077 has yet to be voted on. These bills include provisions that amend the Texas Certificate of Title Act and clarify that an assignee may amend the certificate of title, but that such action is not required to perfect an assigned lien. S&P is closely monitoring the status of these proposed bills, since their passage into Texas law would most likely nullify the issues created by the Clark Contracting decision.

Although S&P has not taken any rating actions thus far solely as a result of this issue, there is a possibility that some negative rating actions will result in the near term after it completes its review, particularly if the uncertainties created by the Clark Contracting decision are not resolved.

CDPCs

CDPC downgraded, ratings withdrawn for another

Moody's has downgraded the counterparty ratings of Athilon Asset Acceptance Corp and Athilon Capital Corp from Baa1 to Ba1, as well as the CDPC's senior debt ratings. The agency explains that the key driver behind the downgrades was the application of revised and updated key modeling parameter assumptions that it uses to rate and monitor ratings of corporate synthetic CDOs and CDPCs. The revisions in modeling assumptions affect key parameters in Moody's model for rating CDPCs: default probability, asset correlation and other credit indicators such as ratings reviews and outlooks.

Separately, S&P has withdrawn its counterparty and debt issue ratings on Cournot Financial Products at the issuer's request.

CDS

CDS beta-neutral strategies suggested

The rally in single name CDS has served to stabilise the basis, with the skew having flattened after starting the year at the most negative level ever witnessed in the Markit iTraxx Main index's life (at -60bp).

"During the course of the past few days, the skew has been hovering around 0bp and, in our view, it will remain range-bound between -5bp and 0bp for the time being as single names and the index tighten in sync," confirm quantitative strategists at SG. "The basis was also stable around the -60bp level throughout [last] week, as cash bonds tightened at a similar speed to single name CDS. In our view, the basis will slowly recover some ground in the coming weeks as we expect cash to slightly outperform CDS."

However, analysts at Credit Derivatives Research (CDR) warn that the rally in credit spreads defies what they describe as "the pull towards fundamentals". Though the analysts expect a repricing of credit risk in the future, the timing aspect of the forecast is unclear.

Consequently, CDR advocates remaining beta-neutral through pairs trades to pick up alpha. Investment grade credits from the energy, utilities, technology and telecom sectors are recommended.

CDS

CDS notionals reach 2009 high

CDS volumes were heavy in the week ended 8 May, according to the latest DTCC data, with a significant US$541bn rise in notionals (the highest increase of 2009). Indices dominated activity, as on-the-runs saw significant derisking and HY rerisking relative to IG.

Analysts at Credit Derivatives Research note that single names had their largest week of net derisking in over six weeks, with consumer and industrial names seeing the worst of it and technology and telecoms the best. "Covering of off-the-run risk or curve trades seems to be climactic and we suspect roll markets will see less compression," they add. "Curve derisking and single name activity implies a lower demand for new issues in the bond market."

CLOs

Triple-A CLO overweight recommended

Indicative secondary triple-A CLO spreads widened to 800bp last week, according to JPMorgan structured credit research. The levels follow observed bid levels around the Whistlejacket liquidation in the previous week (see last week's issue).

"At these levels, we recommend an overweight of triple-A," say JPMorgan strategists. "Whether these levels hold or are short-term liquidation levels that will ultimately retighten remains to be seen. Triple-A CLOs are demonstrably cheaper than even CMBS and could well fall victim to the 'squeeze' we observed this week as the ABS market tightened."

A number of CLO mezzanine OWICs circulated last week, thought to be driven by the view that CLOs are cheap as loans rally. However, the lists are said to have received a muted response from sellers.

"It appears little is trading as few holders are motivated to sell anywhere near the context of where CLO mezz has been trading," comment the strategists. "We observe some is being sold in the single-digit price area. It will be interesting to see how this stalemate evolves between buyers and sellers over the next few weeks, but from a relative value perspective CLO valuations continue to languish while leveraged loan, high yield, ABS, CMBS and broader credit and equities markets improve."

CLOs

Greek CLO closed

Piraeus Bank has closed a €900m CLO. Axia II Finance has a €459m senior note, rated triple-A by Moody's, and an unrated subordinated note sized at €441m.

The underlying portfolio consists of bond and term loans advanced by Piraeus Bank to SMEs located in Greece. This cash transaction is the second securitisation of Greek corporate loans originated by Piraeus Bank. The deal has a two-year revolving period.

Piraeus Bank has retained the transaction. See SCI Database for more.

CMBS

Singapore CMBS highly sensitive to NPI

Fitch says that Singapore CMBS transactions are highly sensitive to net property income (NPI) and refinance rate, and that the NPI may have more impact on the ratings compared to the refinance rate. NPI is a key element in the agency's ratings approach, as it determines Fitch's stabilised cashflow, which is defined as the free cashflow available for the CMBS debt service under the agency's assumptions.

Assuming a CMBS transaction is fully hedged for its interest rate and currency risk exposure, refinance rate is another integral factor in assessing the credit risk of the transaction. It is due to the fact that Singapore CMBS transactions are typically issued under a bullet structure, with full principal repayment by the expected maturity date and no amortisation in the interim.

NPI is calculated by deducting operating expenses and property management fee from annual property revenue. Fitch reviews the historical financial performance of the underlying collateral and arrives at the stabilised occupancy level, rental rate and operating expenses. As a result, its stabilised cash flow, which reflects the volatility in historical cashflow as well as management quality and competition, will be derived to reflect the expected cashflow performance from the collateral over the tenor of a CMBS transaction.

The refinance rate is affected by various factors, including interest rate movement, spread for secured real estate lending and volatility of property sector cashflow. An increase in the volatility of the market interest rate and spread will potentially increase the refinance rate assumption. Besides, more volatile property sectors, such as hotel and office sectors, are assumed to have higher refinance rates.

Fitch has observed that the actual NPI of the portfolio properties in rated Singapore CMBS transactions have been increasing over the past few years. However, downward pressure is expected due to the deterioration of the global and Singapore economy. Nevertheless, Fitch believes the ratings of outstanding Singapore CMBS transactions will remain largely stable due to steady property cashflows which consistently exceed the agency's stabilised cashflow assumptions made at the outset of the transactions.

Correlation

CSO restructured

Nomura International has restructured the AphexCapital MOTIVE Series 2005-D1 Trust by amending the portfolio of reference entities, decreasing subordination and permitting an enhanced number of substitutions of reference entities. Moody's has determined that the changes will not result in an immediate reduction or withdrawal of the current rating it has assigned to the CSO. The agency upgraded the deal from B3 to Ba3, reflecting the improvement in the credit quality of the transaction's underlying reference portfolio which more than offsets the credit risk associated with the reduction in credit enhancement.

Documentation

Bowater settled, other credit events determined

The final price for CDS referencing Bowater Inc is 15, after 11 dealers participated in yesterday's credit event auction. LCDS on General Growth Properties Inc are scheduled to be determined today.

Separately, Markit iTraxx LevX index dealers have voted for a credit event auction to facilitate settlement of LCDS trades referencing McCarthy & Stone, which is a constituent of the LevX Senior Series 2 index. At the same time, the ISDA Determinations Committee has determined that while no succession event occurred with respect to MBIA Insurance Corp (see SCI issue 134), succession events did occur on National City Corporation, Wachovia Corporation and The Bear Stearns Companies.

Credit Suisse requested the latter three determinations (relating to events on 27 February 2009 and 31 December 2008). The sole successor in each case is JPMorgan, Wells Fargo and PNC Financial Services Group respectively.

Meanwhile, voting in connection with JPMorgan's request to determine whether a succession event occurred in connection with Energy East Corporation has been deferred until 27 May.

Documentation

CDS big bang challenged

In what it describes as an open challenge to the financial industry, TABB Group has released a report that asks whether the CDS big bang is "setting [the industry] up for another big bust". In the commentary, Kevin McPartland, a TABB Group senior analyst focused on CDS, warns that the main goal of ISDA's Determinations Committee is to "uniformly agree when a credit event has occurred to prevent any litigation or market uncertainty".

He adds: "Not only does the big bang create this group, but it also modifies standard CDS documentation for new trades to recognise its omnipotence for all things credit events. More standardisation equals less guesswork, which will result in a much clearer market structure, right? In theory, this is true, but the devil is in the details."

McPartland suggests that these developments could in effect be a license for a bank to make loans, buy more CDS protection than the loan is worth, call the loan during a turbulent time where the company or bank can't pay the loan back and can't refinance, thereby forcing the company into default and triggering a CDS credit event (which the banks control) where the banks lose money on the loan but make back several times more on the CDS. "As with most of the regulatory changes implemented or proposed during the credit crisis, the big bang's goals were noble, but a chain is only as strong as its weakest link and the creation of the Determinations Committee brings the CDS chain close to a breaking point."

Documentation

More evaluation needed in financial statements

Fitch says the proposed overhaul to financial statements offered by accounting standard setters contains several good points, although some of the specific suggestions will need further evaluation to determine their workability and usefulness.

In October 2009, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) published a joint discussion paper which was open to public comments until 14 April 2009. The proposal, in its current form, would significantly change the current presentation of the balance sheet, income statement and the cash flow statement.

The discussion paper's objectives were created in response to criticism from investors and analysts that current financial statements were too summarised and inconsistently presented. Final standards are not expected to be published until 2011.

In Fitch's view, the three overall objectives set forth in the discussion paper - cohesiveness of financial statements, 'disaggregation' of line items and more clarity on liquidity/financial flexibility - should improve the usefulness of financial statements to users and enhance analysis. However, the agency believes that further clarity and/or revision is needed on some of the more specific points offered in the proposal.

For example, the rating agency says cohesiveness should serve to address some of the inconsistencies present in reconciling key balance sheet, income statement and cash flow items and making flows from period to period more understandable. While Fitch supports cohesiveness as an objective, applying this principle too rigidly in practice by hard-wiring cohesive application line-by-line through all financial statements would result in cumbersome, unhelpful reporting, it says.

"The discussion paper is a good start, although it is unclear whether the benefits of the changes, if enacted in the current form, would outweigh the added costs for users as well as preparers," says Olu Sonola, director at Fitch.

Monolines

FSA downgraded

Fitch has lowered its ratings on FSA from triple-A to double-A plus and on FSA Holdings from double-A to single-A plus. The ratings remain on rating watch negative.

The rating action primarily reflects Fitch's view of the residual risks retained by FSA, following the transfer of its financial products (FP) business to parent Dexia. As part of its sale of FSA to Assured Guaranty, Dexia agreed to retain FSA's FP business and to protect FSA/Assured from the credit and liquidity risks associated with this business line through various liquidity lines, guarantees and collateral posting mechanisms. In addition, certain of Dexia's obligations will be guaranteed on a several basis by the governments of Belgium (rated double-A plus) and France (rated triple-A).

Consequently, Fitch believes the risk to FSA of the FP business is consistent with a double-A plus rating while the financial products portfolio runs off. The agency says it recognises that FSA remains well-capitalised at its current ratings level, and the transaction is expected to be capital accretive for the merger with Assured.

Robert Cochran, chairman and ceo of FSA Holdings and FSA, says: "We want to underscore that Fitch's downgrade of FSA to double-A plus results from its capping FSA's rating at a level consistent with the Belgium sovereign guarantee provided in the structure for transferring the FP business to Dexia. Once the planned acquisition of FSA is complete, FSA will be well capitalised and strongly protected from the financial products exposure, which is now approximately US$13bn and will diminish substantially over the next several years."

Fitch says it will resolve the rating watch status once the acquisition of FSA is completed and that, if FSA were to be downgraded in the future, FSA's IFS rating would be unlikely to fall below double-A.

Operations

Servicer safe harbour provision passed

Senate bill S.896, 'Helping Families Save Their Homes Act of 2009', was passed last week by a 91-5 margin. The most relevant provision of this bill to the securitisation market is the servicer safe harbour provision, which insulates servicers from investor lawsuits for carrying out modifications as outlined in the Emergency Economic Stabilization Act of 2008. The only requirement of the servicer is to perform a good faith NPV test on loans that are in default or at imminent risk of default.

Once the final bill is passed after reconciliation with the House, securitisation analysts at Barclays Capital believe that the move will provide a strong boost to loan modifications, as there are significant incentives for the servicer to modify loans.

While the bankruptcy cramdown provision was voted out of the Senate version, the bill contains other important provisions, including changes to the H4H programme that reduce the upfront and running annual mortgage insurance premiums from being equal to 3%/1.5% respectively to not more than 3%/1.5%. The bill also provides some general guidance on foreclosure moratoriums.

Congress expects lenders and servicers not to initiate foreclosure proceedings on any homeowner until mitigation provisions - such as HAMP or H4H - have been implemented.

Operations

TALF performance analysed

In an effort to bring greater transparency and insight to the market, S&P has published its first Quarterly Term Asset-Backed Securities Loan Facility (TALF) Report. "The report is designed to provide updates and insights to market participants in light of the TALF programme's importance to the credit markets' recovery, including the availability of credit to US consumers and small businesses," says S&P credit analyst David Hoberman. "The report will also track the ABS purchased under the TALF programme, together with the performance measures for those securities."

In the first Quarterly TALF Report, S&P reviewed its rated ABS transactions that were used as collateral for TALF loans during each of the first three rounds of TALF funding, including auto loan and lease, credit card, student loan and equipment. The report also discusses the TALF programme's new and evolving features, and includes a breakdown of its mechanics and an example of S&P's sensitivity analysis.

Ratings

Senior ABS ratings show resilience

Fitch says that globally ABS ratings showed greater stability than other asset classes in 2008. Senior ABS ratings, in particular, have continued to demonstrate resilience to global economic conditions in early 2009. However, the increasing stresses faced by consumers are feeding through to negative rating action on lower-rated consumer ABS categories, the agency says.

"Inevitably, given contracting markets globally, the 2009 outlook for the global consumer and commercial ABS sectors is negative," notes Rodney Pelletier, md in Fitch's structured finance group. "However, due to sufficient credit enhancement levels and good structural features, negative rating activity will be concentrated in lower rating categories; ratings of higher classes are expected be affected by transaction-specific issues rather than widespread industry problems."

In 2008, the ABS sector reported a low number of impairments (13), resulting in a 0.6% impairment rate. No impairments were recorded in any investment grade category.

Most observations were US-based; however, Asia Pacific ABS accounted for three impairments. No impairments were recorded in Europe last year.

Ratings transitions in the ABS sector remained positive for the year, as upgrades outnumbered downgrades by 1.3 to one. However, global downgrades increased relative to 2007.

Despite the forecasts for a substantial increase in losses, both credit card and auto ABS in the US are expected to continue to demonstrate their resistance to significant negative rating actions, as indicated by the stable to negative and stable rating outlooks assigned to those asset classes respectively. In particular, ratings for credit card-backed senior notes are expected to remain stable.

The picture is similar in Europe and the consumer asset sector has a negative outlook across a number of EMEA jurisdictions, notably Spain and the UK, with all countries likely to be affected to some degree by the global economic downturn. Although ratings for many of these sectors are also turning negative, the impact in terms of rating actions is still expected to be largely confined to the junior and, in some cases, mezzanine tranches.

Meanwhile, in Asia the rating outlook is stable for Japanese, Korean and Australian ABS, despite the negative outlook on asset performance, due to sufficient credit enhancement and robust transaction structures.

Ratings

ABS CDO OC tests breached

S&P has placed on credit watch negative its credit ratings on 13 tranches issued by four CDO transactions - Stanton MBS I, FAB CBO 05-1, FAB UK 04-1 and Cairn Euro ABS CDO I - backed by structured finance securities. The ratings on the other classes of notes issued in these CDO transactions are unaffected at this time.

These rating actions are the result of deterioration in the credit quality of the underlying portfolios. This deterioration is shown in the fall of overcollateralisation test ratios, which in most cases now breach their respective trigger levels as set out in the transaction documents. Overcollateralisation test ratios have fallen mainly as a consequence of various haircuts applied to low rated assets.

According to S&P's analysis, all the transactions are exposed predominantly to European structured finance securities, with the largest country exposure in each case being to the UK.

Ratings

More CLOs on watch

S&P has put 199 tranches from 126 US cashflow CDOs on credit watch negative and three tranches on credit watch positive, following its monthly review of US cashflow CDO performance. The credit watch negative placements largely affect corporate loan CLO transactions, many of which have seen a decrease in collateral credit quality in recent months due to speculative grade corporate downgrades and defaults. The credit watch positive placements affect older vintage transactions that are benefiting from pay-downs to their senior note balances.

Ratings

Cash/hybrid ...

S&P has lowered its ratings on 18 tranches from five US cashflow and hybrid CDO transactions. At the same time, it removed five of the lowered ratings from credit watch with negative implications.

The ratings on nine of the downgraded tranches are on watch negative, indicating a significant likelihood of further downgrades. The watch 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.

The 18 downgraded US cashflow and hybrid tranches have a total issuance amount of US$1.565bn. All five affected transactions are mezzanine structured finance (SF) ABS CDOs, which are collateralised in large part by mezzanine tranches of RMBS and other SF securities. The CDO downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US sub-prime RMBS.

Ratings

... and synthetic CDOs downgraded

S&P has lowered its ratings on six US synthetic CDO tranches and one retranched CDO that reference tranches of CDOs of RMBS that have defaulted. These referenced CDOs of RMBS tranches were among the list of 87 ABS CDOs that had their ratings withdrawn on 1 May 2009. S&P subsequently withdrew its ratings on these seven CDOs, along with four other US synthetic CDO tranches that also referenced CDOs that were part of the 1 May action.

Separately, the agency lowered: 391 ratings from 252 US synthetic CDO transactions - 207 of which remain on watch negative, while another was placed on watch negative; and two ratings from one transaction were placed on watch with negative implications. These downgrades reflect negative rating migration in the underlying reference portfolios and the fact that the SROC ratios for the affected transactions had fallen below 100%, as of S&P's current review and at a 90-day forward run.

Real Estate

CRE refinancing problem quantified

Deutsche Bank has published an analysis that attempts to quantify the scale of the refinancing problem in commercial real estate. In particular, by making conservative assumptions, ABS analysts at the bank attempt to determine the minimum size of the problem.

The quantitative analysis is carried out on commercial mortgages in CMBS because only here do the analysts have extremely detailed and complete data about every individual loan, including exact cashflow models. It is then possible, however, to extrapolate the findings on CMBS to the broader commercial real estate debt market, they note.

The analysis finds that at least two-thirds of the commercial mortgage loans maturing between 2009 and 2018 (US$410bn) are unlikely to qualify for refinancing at maturity without significant equity infusions from borrowers. For the 2007 vintage, well in excess of 80% of the loans are unlikely to qualify. The aggregate equity deficiency (i.e. the additional amount of equity that borrowers would have to put up in order to qualify to refinance) is at least in the order of US$100bn.

The Deutsche Bank analysts' conservative estimate of maturity default-related losses for fixed rate CMBS is US$50bn - or 6.5% of the aggregate outstanding balance. Further, they forecast that maturity default-related losses will be at least 4.6% for the 2005 vintage, 5.8% for the 2006 vintage and 12.5% for the 2007 vintage.

However, the analysts stress that the report considers the likely percentage of CMBS loans that would not qualify for refinancing and the associated maturity default-related losses, assuming that loans do not default prior to maturity. "In reality, a large percentage of these loans are likely to default prior to maturity. Thus, a significant part of what we calculate as maturity default-related losses will actually end up as term default losses," they conclude.

Regulation

UK set to strengthen insolvency regime

UK Financial Services Secretary Paul Myners has published a report setting out the government's initial thinking on reforms to strengthen the country's ability to deal with the failure of an investment bank. Like other financial centres, London was affected by the collapse of Lehman Brothers in September 2008 and the events that followed. The government says it is committed to implementing reforms that will enable an easier resolution of a failing investment bank, should any such event happen again.

The report outlines the UK government's thinking on the changes to market practice, regulation and insolvency law that might be needed to deal with any future failure of a major investment bank. The treatment of investment banking clients after default, the future of their assets and the treatment of their open or unreconciled trading positions are considered in the report. It also examines what can be done to make the process of insolvency more effective and to limit the damage that may be done by a failing investment bank.

These reforms are part of a package of steps aimed at renewing the financial services sector, other aspects of which will be laid out in the government's forthcoming paper on financial regulation. The reforms which are considered in this report demonstrate the government's commitment both to financial stability and to the future of London as a global investment banking hub, it states.

Myners comments: "The UK's insolvency regime is an important aspect of its attractiveness as an international centre for investment banking. The government is committed to maintaining these advantages and strengthening the existing solvency regime."

Regulation

AIFM directive 'onerous' for ABS

A recent Paul Hastings client briefing says that the draft EU Directive on Alternative Investment Fund Managers (AIFMs) - if implemented in its current form - will not only have an immediate impact on hedge funds but also on the ABS market. The new requirements will be particularly onerous for the CMBS and RMBS markets, according to the note.

The draft is designed to regulate the acquisition by AIFMs of loan securitisations, such as CMBS and RMBS (and presumably CLOs), by establishing: requirements to be met by originators of such issuances in order for an AIFM to be permitted to invest in these securities after 1 January 2011 (such as the requirement that such originators retain a 5% net economic interest in the issuance); and qualitative requirements to be met by the AIFMs that invest in these securities on behalf of one or more AIFMs. As a result of this, non-EU loan securitisations seeking to access the European investor market will need to comply with these rules.

Any AIFM that does not comply with these requirements may have its authorisation to carryon business within the EU withdrawn and may face criminal sanctions at a national level. "It is notable that this is a relatively cumbersome enforcement mechanism compared to the proposed changes to the Capital Requirements Directive," the Paul Hastings briefing notes.

It concludes: "At a time when many are commenting on the need to increase the availability of credit to boost economic activity, it seems contradictory for regulators to restrict the availability of ABS, which is one of the principal mechanisms for banks and other lenders to finance their lending activities. It is also difficult to see the policy underlying restricting the ABS investment activities of private vehicles backed by wealthy and sophisticated investors."

Regulation

Octaviar clarification would benefit Australian ABS

S&P continues to monitor developments following the March 2009 Queensland Supreme Court decision in connection with Re Octaviar that has created some uncertainty regarding variations to transactions secured by registrable charges, including charges providing security for Australian securitisations. Although the decision appears not to impact on 'all moneys' charges, where charges are referable to transaction documents, the agency continues to assess the impact of the decision when it assigns ratings to new issuances of securitised pools and consider the impact of amendments relating to existing issuances.

The court's decision resulted from a claim in relation to security given by Octaviar to a lender. The trustee for certain noteholders of Octaviar claimed that there had been an increase in the liabilities secured by the lender's charge due to the introduction of a guarantee that was specified as a transaction document under the loan facility.

The court found that the effect was that there had been a variation in the terms of the charge, increasing the amount of the debt or increasing the liabilities secured by the charge, requiring notice to be lodged with the Australian Securities and Investments Commission (ASIC) within 45 days. As no such notice was lodged, the charge was void to the extent that it purported to secure the amount of the increase in debt or liability.

As a result of the Octaviar decision, an amendment to a transaction document may potentially be deemed an amendment to the charge, requiring notice to be lodged with ASIC and potentially creating uncertainty in relation to stamp duty. The court's decision conflicts with long-standing market practice in securitisations, whereby the trustee generally does not lodge amendments to transaction documents with ASIC.

The result of the decision has the potential to affect securitisations for which the original documentation contains a charge referable to transaction documents, and the parties seek to amend transaction documents in a way that may result in increasing the debt or liabilities secured by the charge. Mitigating the decision's impact on securitisations is the fact that counterparties usually provide representations and undertakings that require the counterparties to ensure that the charge is effective security and has the first-ranking priority contemplated by the transaction structure. S&P's criteria also anticipate that the SPV would be insolvency/bankruptcy-remote, mitigating the potential for third-party creditors to challenge the priority of the charge.

As a result of the decision, some originators have chosen to lodge documentation with ASIC reflecting any amendment to transaction documents that may have the effect of increasing the debt or liability secured by the charge. For new issuance, some originators are choosing to include 'all moneys' charges, so that the transaction does not fall within the parties' understanding of the Octaviar decision.

The appeal of the Octaviar decision is likely to be heard in Q309 and it is possible that the decision may not stand. If the uncertainties are not clarified by the appeal court, it is S&P's view that Australia's securitisation markets would benefit from the clarification of the issues raised by Octaviar through legislative changes.

Regulation

Retention requirement improves alignment of interests, Fitch

Fitch says that the amendment to the Capital Requirements Directive regulation passed by the European Parliament will help to improve alignment of interests in the European securitisation market and is unlikely to impede the return of a fully functioning structured finance market. The agency also notes that the minimum 5% retention requirement is unlikely to disrupt market dynamics when the public market ultimately revives, due to likely investor appetite.

"Traditionally, the equity tranche was retained by the originating bank," says Stuart Jennings, Fitch's structured finance risk officer for EMEA and Asia Pacific. "At the peak of the market in 2006 and 2007, investor appetite for these positions emerged such that some were sold on to investors and some originators sold down the entire capital structure. However, investor appetite for structured finance risk post-revival is unlikely to extend to the 'first loss' or equity tranche and the originating bank would likely therefore need to retain it anyway, and potentially other parts of the capital structure, regardless of this amendment."

The stated intention of the amendment is to improve alignment of interests and mitigate previous limitations seen in the risk assessment of structured finance investments. The core principle of the amendment legislation stipulates that originating banks (or transaction sponsor) retain a 5% position in the transactions they sell to European banks to promote alignment of interests with investors.

The final amendment that was voted through also contains some extra options, which offer more flexibility than the earliest drafts of the proposal. These options include retaining a minimum 5% proportion of the exposures targeted for securitisation (rather than 5% of the securitised tranches themselves).

In the case of revolving exposures, retaining a minimum 5% seller share of the securitised exposures is also an acceptable alternative. Since credit card master trusts frequently already hold seller shares of this proportion or greater, the existing status quo may remain for such structures.

However, Fitch notes that one clause presenting an alternative option in recent drafts appears to have been dropped from the final amendment. This option would have allowed the originator, lender or sponsor to offer warranties that the securitised exposures and the obligors meet the asset and obligor criteria in the transaction documentation, and that due diligence was carried out by the originator, sponsor or original lender as appropriate on the assets. This option would have worked as an alternative to the 5% retention limit, to satisfy the condition of retaining an economic interest by the originator or sponsor.

"Fitch believes that, subject to the interpretation of this alternative clause, its inclusion would have minimised the impact of the overall amendment on structured finance as such warranties and due diligence provisions are largely already standard practice with respect to structured finance transactions. Nevertheless, the alternative options that remain do offer some extra flexibility to originators and sponsors," says Jennings.

RMBS

Improving trend for HPA data

One-month annualised non-seasonally adjusted LoanPerformance HPA came in at -7.13% for March. Accounting for seasonality and estimated revisions, ABS analysts at JPMorgan consequently expect the one-month annualised seasonally-adjusted HPA to reach -18.43% for March, -19.44% for February and -15.62% for January. The peak-to-current declines now stand at -32.84%, they note.

The year-over-year home price decline was -16.60% in March, -17.46% in February and -17.75% in January. These figures indicate that annual declines are stabilising, with early signs of a slowly improving trend, according to JPMorgan.

"The year-over-year price declines seem to have bottomed for all the major home price indices - LoanPerformance, Case-Shiller and FHFA - albeit at slightly different times, and are now slowly recovering," the analysts say.

They expect close to another 20% decline in home prices, as measured by the LoanPerformance index, and an eventual bottom in the first half of 2010. "Distressed sales will continue to put downward pressure on prices, but the strong government support of the housing market - both in terms of quantitative easing and different modification/refinancing programmes - will buoy prices and eventually drive a stabilisation of the US housing market."

RMBS

Sharp rise in UK BTL RMBS delinquencies

Key performance measures indicate that UK buy-to-let (BTL) delinquencies increased significantly during Q109, says Moody's in its latest index report for the UK BTL RMBS sector. The agency notes that outstanding repossessions and the cumulative loss trend also increased during the quarter, albeit at a lower scale.

Moody's BTL index for 90+ delinquencies increased to 3.55% of current balance in Q109 from 2.42% in Q408. However, if the Aire Valley Master Trust is excluded, the index was 1.71% this quarter. Meanwhile, the outstanding repossession index increased to 0.18% of current balance from 0.15% recorded in Q408 and cumulative losses in the BTL market were 8.2bp as a percentage of original balance.

Moody's cautions in the report that, with the economy in recession and unemployment rising, tenant demand and tenant's ability to make timely payments will be tested over the coming quarters. UK house prices continued to fall in Q109 and rental price inflation stayed flat over the past year.

"Whilst the UK BTL sector has historically maintained a strong performance, this is the first time the sector has experienced a recession with falling house prices and rising unemployment," says Nitesh Shah, a Moody's economist and co-author of the report. "However, although the level of arrears is rising, it remains within expected levels. Given that BTL properties are not primary residences of the owners, there may be a rise in prepayments as BTL investors decide to cash in their investment and lock into the capital gain. However, the total redemption trend does not yet show any signs of BTL borrowers exiting the market."

During Q109, Moody's did not take any performance-related rating actions on outstanding UK BTL RMBS transactions. No new UK BTL RMBS transactions closed.

Structuring/Primary market

ELCF I restructured

European Loan Credit Fund I (ECLF I) noteholders have agreed to a number of amendments to the transaction, as requested by the issuer, investment manager and trustee. S&P has subsequently confirmed that the double-A credit rating on the outstanding notes issued by ELCF I remains unchanged.

The restructuring involved amendments being made to the portfolio profile tests, as well as the target par amount being reduced from €1.1bn to €900m. Additionally, on 5 May the issuer redeemed €150m of the senior notes, leaving an outstanding senior notes balance of €600m. The effective date in the transaction documents was also amended to 22 April 2009; at closing, the effective date was noted as 12 December 2008.

Technology

Pricing analytics vendors evaluated

Firms and solution providers should re-examine their piecemeal approach to implementing pricing analytics and models in order to reduce weak links in the overall process, according to a new report from Celent entitled 'Pricing Solutions for OTC Derivatives and Structured Products'.

Financial reform is bringing unprecedented levels of scrutiny and requirements for firms to show procedural consistency in their complex deal pricing and portfolio valuation activities. Regulators, investor groups, quasigovernmental organisations and government agencies are driving towards an emphasis on having well-defined processes and ensuring that these processes are repeatable.

The report uses Celent's ABCD Vendor View to examine the relative market position of eight vendors (Andrew Kalotay, FINCAD, Numerix, Pricing Partners, Quantifi, SciComp, SunGard Reech and UnRisk) delivering pricing solutions that can underpin firms' efforts towards such reform. Vendors are evaluated across four categories: advanced technology, breadth of features and usability, customer base and depth of financial institution services.

In terms of advanced features and technology, Numerix, Quantifi and FINCAD stand out as leading vendors, according to the report. In particular, Numerix and Quantifi have demonstrated a strong track record of staying at the cutting-edge of pricing complex securities and building out scalable valuation applications.

In terms of functional breadth and asset coverage, vendors that fare well have a mixed asset class approach and other mechanisms to distribute their analytics - with Numerix, FINCAD, Pricing Partners and SunGard Reech falling into this category. Numerix and FINCAD particularly stand out in the analysis, not only in terms of having a broad asset class coverage for their pricing libraries, but also significant ISV partners that embed their models and tools in their applications - thereby enabling clients to gain more consistent access to their models in third-party applications.

Overall, FINCAD and Numerix have the highest number of clients in their portfolio compared to peers, each with more than 300 clients. Indirectly. FINCAD and Numerix have demonstrated a sustained vigour to partner with vendors in the different parts of the value chain - securing formalised relationships with market data, portfolio risk management, order management systems (OMS) and trading vendors.

In addition to FinCAD and Numerix, Quantifi and SunGard Reech have demonstrated a good track record in terms of volume of clients, client tiers and quality of clients. For this category, although Pricing Partners and UnRisk have momentum in terms of client wins, their successes have still primarily been in their respective home countries, France and Austria (and German speaking jurisdictions), and not yet beyond.

In the depth of client services dimension, Numerix has not only expanded product functionality and services footprint into various parts of the structuring and OTC lifecycle, but has also customised its product offerings to cater to users within asset class groups. Since the mid-2007, Numerix has been actively engaged in a higher degree of advisory-type services around alternative valuation techniques, implementation of its position-keeping application and participation in industry dialogues with regard to pricing/valuation practices, according to the Celent report.

ABS

Credit dulls, spreads sharpen

Ron Thompson, global head of ABS strategy at RBS, expects credit card ABS spreads to remain range-bound in the intermediate term

Over the last several months, consumer ABS spreads, especially in the credit card sector, have marched tighter as a result of TALF and the follow-on Public-Private Investment Program (PPIP) for legacy assets (see Figure 1). Simultaneously, credit card-backed trusts have seen charge-offs and delinquencies rise, and rating agencies have threatened or downgraded notes as a result.

In response to investor and rating agency concerns over credit deterioration in master trusts, a number of US issuers have chosen to issue additional credit enhancement - either through additions of Class D tranches or by discounting receivables into trusts. The Class D tranche route was popular several years ago and discounting occurs with some frequency in retail trusts. Thus far, of the major bank issuers, Bank of America and Citibank have incorporated the structuring technique as well as discounting receivables.

Spread tiering finally has become a feature in the sector (see Figure 2). The difference between well-regarded bank card paper and less so issues can be as much as 175bp in triple A rated notes and 250bp in triple-B rated tranches.

Intriguingly, the market appears somewhat sceptical of American Express's ability to fix its trust in the same way as Bank of America or Citibank have, so indicative offering levels remain relatively cheap to those programmes. On the other hand, investors appear to give full credit to JPMorgan to fix its Chase trusts in light of S&P's negative watch.

Though spreads have shown a great deal of strength thus far, we expect for risk assets to remain relatively range-bound in the intermediate term. The technical pressures driving spreads in likely will be offset by declining credit fundamentals, potentially creating a floor on discount margins. We expect to see further spread tiering within the market, as we do not believe that the current tiering reflects the full credit differences amongst the trusts, where we do expect to see less absolute spread difference as discount margins tighten further.

To a certain degree, credit card spreads have mimicked recently those in unsecured bank CDS. For a while, these markets seemed divergent, and the asymmetry in spread movements gave pause for thought.

As this point, it is time to reflect on how much tighter card spreads can go. Credit spreads in Citibank, Bank of America and American Express credit card trusts have especially moved tighter, but their respective sponsors' unsecured CDS have continued to move wider as there is uncertainty over how much capital commitment will be needed (see Figure 3).

ABS spreads likely will remain in a trading range, similar to other risk assets for the short term. However, range-bound spreads can offer opportunities for nimble traders, and certainly selected value can be found, especially for investors less concerned about mark-to-market risk.

With unemployment climbing rapidly and the prospects for the economy worsening, it is hard to make the case that risk assets should continue to see discount margins tighten, especially those likely to be sensitive to more negative performance. Therefore, shortening duration appears to make sense given the environment. As unemployment and other credit support factors begin to stabilise, more directional bias will likely re-enter the market.

Despite a view that favours a short spread duration strategy, several idiosyncratic opportunities likely will appear, in our view. Spread duration trades may make sense, such as in Advanta's credit card bonds.

Advanta's credit card senior tranche on its remaining public deal sells at a significant discount. With an increasing probability of early amortisation, an acceleration in principal repayment would greatly enhance the yield on the bonds and, with a reasonably fast payment rate, we believe that little credit exposure exists in the senior bonds.

Card lenders and credit fixes
Thus far, several institutions have made aggressive moves to help out ailing trusts, with bank issuers Citibank and Bank of America among the most prominent (see Figure 4). These banks used both a Class D note structure and announced that they would discount receivables into the trust. These actions will benefit the trust by a) increasing credit support and b) increasing the yield in the trust and therefore excess spread.

Following a negative watch warning from Moody's last October and S&P in January, Bank of America said that it would create a subordinated, non-interest bearing Class D interest sized at 8% of the aggregate principal amount of outstanding notes to facilitate additional excess spread for the benefit of the entire trust. Bank of America also plans to enhance the yield on the card pool by discounting up to 6% of its Master Trust II receivables from 1 March to 30 September 2009.

Following Bank of America's lead on providing a Class D note to its BA credit cards trusts and discounting receivables, Citibank's credit card master trust will issue additional credit enhancement and discount receivables into the trust.

The credit card lender expects that the amount of additional credit enhancement will equate to 3.75% of the aggregate principal amount of the outstanding term notes of the issuance trust and approximately 2% of the outstanding principal amount of CP notes of the issuance trust.

The enhancement is expected to be in place on or about 1 May 2009. Citibank also intends to discount credit card principal collections from receivables beginning in the March 2009 monthly due period.

Initially, Citibank will discount 1% of principal receivables collected in any monthly due period. The bank reckons that this action could add 1.8% in yield for a given monthly due period, assuming a principal payment rate of 15% and all other revenue components (interest, fees, interchange) remain the same. As an indicator (though hardly perfect), Citibank's monthly payment rate averaged 19.2% over the trailing 12 months.

For future periods, Citibank will incorporate a dynamic discounting methodology based on excess spread. It will increase the discount by 1% increments if the three-month average excess spread hits 3.50% or lower, up to a maximum total discount of 3%.

If the three-month moving average excess spread exceeds 7% for three consecutive months, then the discount will decrease in 1% increments each month that the test is maintained until the discount reaches zero. That test will adhere until the dynamic discount percentage reaches zero or the first monthly due period in 2010, whichever occurs later.

Clearly, these actions will benefit all noteholders in the trust, but they will be of most benefit to Class C notes. All notes will have to be affirmed as a condition of executing the amendments. The bank intends to issue subordinated notes in the master trust or, in a new twist, possibly subordinate the seller's interest in the master trust.

With Citibank providing the second, recent support action, other large bank lenders likely will follow, leaving some uncertainty around less well-capitalised retail and private label credit card lenders - though we would note that Target and Nordstrom have recently taken actions.

At this point, it appears to us that the credit card originators may have to take more steps to support their securitisations. Recent actions by Bank of America and Citibank likely will be followed by others. Global economies are expected to worsen and, as unemployment rises, charge-offs and delinquencies are likely to increase and yields, excess spread and payment rates likely to fall.

More rating actions (or fixes) loom
In mid-February, S&P commented on a series of 'what-if' scenarios. In the analysis, the rating agency posted their expectations for first-half loss expectations for a full range of issuers.

Of the eight bank card master trusts, five issuers saw March charge-off rates above the top end of the bands (American Express by 97bp, National City by 34bp, Capital One by 21bp, First National by 3bp and Chase by 38bp), but the rest were within or close to expectations (see Figure 5). None were below. In private-label and retail card sectors, the story was more displaced (see Figure 6).

Three street retail card issuers ranged above loss expectations for March and four were below, and in some cases significantly. GE Master Note Trust's charge-off rate has been extremely volatile, and March's figure was nearly half of February's.

Loss rates cannot necessarily predict when rating agencies will move on ratings of credit card trusts, but they are worth watching. Excess spread levels appear sufficient for most trusts for the time being and, with a number of issuers taking action to support their deals, there is good value, especially in the front end of the curve. For weaker trusts, senior tranches of discounted credit card ABS paper looks attractive, with a strong prospect of an early amortisation event.

Moody's has a negative outlook on the credit cards asset class in general and believes that the retail sector in particular has more uncertainty. This mindset led the agency to downgrade a number of issues in the sector, though collateral performance was not the primary factor in its downgrade actions in all of the cases. Rather, the agency cited susceptibility to a downturn in the retail sector, with borrowers likely putting other loans ahead of retail-provided credit.

Retail credit card paper has been under pressure for far longer, and a number of programmes have been downgraded as a result of a poor outlook for retail as well as certain idiosyncratic pressures faced by a number of the retailers and specialty card issuers.

In mid-February, Moody's downgraded notes in five issuers' trusts, comprising Advanta Business Card Master Trust, Cabela's Credit Card Master Note Trust, Charming Shoppes Master Trust, three of CompuCredit's trusts (CompuCredit Credit Card Master Note Business Trust, CompuCredit Credit Acquired Portfolio Voltage Master Business Trust and CompuCredit Acquired Portfolio Business Trust) and World Financial Network Credit Card Master Trust. In the case of Advanta, for example, Moody's did cite deteriorating collateral performance that was likely to continue for the foreseeable future, but also access to securitisation markets. As Advanta pursues small business and individuals who depend on access to credit for purchases but also borrowing, the economic downturn presents additional stress if cardholders can no longer make purchases, especially where Advanta has concentrations in California and Florida.

March's investor report showed that Advanta's gross charge-offs jumped by 80bp to 17.31% (net of recoveries, charge-offs were 16.54% - over February's gross charge-off figure of 16.50%) and 90+ day delinquencies climbed by another 51bp month-on-month to 5.96%, suggesting more write-offs were to come sooner rather than later. Monthly payment rates slowed, though not as far off the pace as many of the other programmes. Excess spread dropped to 1.34% last month, bringing the three-month average to 2.23%, fully requiring the spread account to trap cash.

The company indicated there is still excess subordination for the Class A through to Class C notes, but that protection could wear thin with higher losses. The company said in its first-quarter earnings call that it had sold written-off receivables and was considering other actions to stabilise the trust, but the company faces growing shareholder dissatisfaction and a constrained balance sheet that will make staving off an early amortisation event more difficult.

In the bank card sector, rating actions have been more warnings than cuts. Moody's placed American Express Credit Account master trust's Class B and C notes on watch negative in mid-March. This action followed S&P's rating watch negative on the Class C tranches earlier in the month.

American Express has seen a rapid climb in its charge-offs to 9.72% for March, which represented a further deterioration from February's 9.32% and well over double the 4.36% seen last March. Too, the trust's monthly payment rate has slowly fallen over the last couple of years, though it remains higher than other trusts due in part to higher transactor volume within the trust.

In late March, S&P put all of National City Credit Card Master Trust ABS on credit watch with negative implications. The action reflected the agency's concern over deterioration in credit performance around losses and delinquencies, as well as a declining payment rate and a decrease in portfolio yield.

Clearly, monthly payment rates slowed considerably, dropping to less than 14.5% in February, while loss rates have climbed to nearly 8%. We saw less of an impact in portfolio yield, which jumped to 17.03% in February after averaging 16.7% over the prior 12 months.

Even the venerable Chase Issuance Trust was not immune. S&P placed the Class C tranches on watch negative in early April, as the rating agency had raised its loss forecast for the trust and general concerns about the acceleration of charge-offs and delinquency rates. Though the trust remains above its 4.5% reserve trapping level and its net losses remain low relative to similar programmes, the rate of increase caused the rating agency concern over credit deterioration within the trust, given its relatively low portfolio yield compared with others.

In early April, S&P placed all of the Class C tranches of Chase's two credit card master trusts on watch with negative implications. The rating agency cited an accelerating rise in the trusts' charge-offs since 2008. We suspect that Chase will follow in the footsteps of Bank of America and Citibank in issuing a Class D note and possibly discounting receivables into the trust.

With the announcement that Capital One's credit card subordinate tranches were put on review for a possible downgrade by Moody's, tranches of the master trusts for the major six bank card lenders have been put on watch for possible downgrade within the last several months. Collateral performance continued to deteriorate in the month across the sector, with charge-offs accelerating in many cases alongside.

On the positive front, Bank of America/MBNA's Class B and subordinated notes were actually upgraded by S&P after being placed on watch negative prior to the announcement of its trust credit enhancement additions.

US legislative changes
Meanwhile, the US Senate Banking Committee approved the credit card bill of various rights that limit card companies from making significant changes to terms and conditions and prohibit applying rate increases retroactively to existing balances and to increase disclosures around the time to pay off balances. The bill as drafted is broader than the Federal Reserve rules that come into effect in July 2010, limiting further certain over-limit fees and interest charges, as well as new requirements for card issuers looking to extend credit to holders under the age of 21.

The bill is competing with a similar, but less onerous one that has passed in a House subcommittee. That bill goes to the House for a vote, and the Senate version too will go to that chamber for a full vote.

The House bill passed in that chamber last week, and we expect swift movement on the Senate version. These two bills will take some time to reconcile, but the pressure will be on the lenders to visibly respond ahead of the Federal Reserve and Congress in order to get any leverage later.

President Obama has promised to follow the legislation closely and, more recently, discussion has surfaced around caps on interest rate increases ahead of the Federal Reserve's implementation of its regulations. The two, if both pass, will ultimately get reconciled in a joint committee, then go to both chambers for a vote and then signed by the President. Clearly, the President retains a right to veto the bill.

Both bills offer some poor timing for a card market that has finally seen some life from TALF and other programmes, despite the Fed rules already scheduled to be put in place. The ultimate impact of the reconciled Bill likely will be less onerous than appears now, despite the populist appeal.

The issue has been a perennial one for Congress, but has generally died a quiet death. This time probably will end with a different outcome.

The imposition of even stricter rules likely will increase pressure on yields and could push charge-offs higher, even without substantial (and likely) increases in unemployment. Lenders face a Hobson's choice in some ways: to respond places stress on the business models, but to not respond risks the imposition of even more draconian legislative and regulatory measures.

© 2009 The Royal Bank of Scotland. This Research Note is an extract from 'Master Trusts in Focus', first published by RBS on 1 May 2009.

Trading

Trading ideas: exposed negative

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Eastman Kodak Co

The seemingly perpetual rally in credit spreads has washed through the good and the bad, creating a once-in-a-cycle opportunity to buy protection on markedly weak companies at tight spreads. Burning cash, collapsing revenues, compressed margins. What's not to like about Eastman Kodak's present situation?

The company released first-quarter earnings two weeks ago and they were nothing short of miserable; however, its credit spread trades at a multi-month low of 22% upfront. We view its credit risk to be one of the greatest amongst all non-financials and recommend taking an opportunistic short position.

The ever-touted up-tick of the second derivative of negative growth, or rather the slowing of the collapse of the economy, cannot be applied to Eastman Kodak. A look into its first-quarter numbers paints a picture of a company on its way out.

Revenues declined by 29% relative to the first quarter of 2008 (which saw zero growth from 2007 numbers). At US$1.477bn in total sales, this marks the absolute worst quarter in all of the 21st century for Eastman Kodak (Exhibit 1).

Exhibit 1

One bright spot the company does highlight is its cash balance of US$1.3bn. Interesting that management does not spend an inordinate amount of time discussing where that number once was.

The company burned through more than US$800m in cash during the first quarter of the year due to negative cash generation from operations. This sucked out around 40% of its cash balance from the previous quarter.

Keep in mind, at the end of the fiscal year 2007 the company held nearly US$3bn in cash (Exhibit 2). With revenues and cash plunging as fast as this, we do not need to worry about second derivatives.

Exhibit 2

We see a 'fair spread' well above 2000bp for Eastman Kodak based upon our quantitative credit model due to its equity-implied factors, liquidity, leverage, change in leverage, free cashflow and interest coverage. The model ranks each issuer on a scale of 1 to 10 using eight factors (1 = poor credit, 10 = good credit).

The recent earnings announcement had a dramatic impact on Eastman Kodak's expected spread. Its spread shot up well above 2000bp as each and every factor (except for liquidity and accruals) receives a ranking of one. The single name credit rally, however, pushed the company's traded spread tighter - presenting a solid trading opportunity to buy protection (Exhibit 3).

Exhibit 3

Buy US$10m notional Eastman Kodak Co 5 Year CDS protection at 22.5% upfront.

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).