Contents

Documentation

Issue settled

Europe moves to integrate restructuring into auction mechanism

A new proposal to integrate restructuring as a credit event into the auction mechanism for CDS settlement has been put forward by European dealers. However, given that cash settlement can be prone to squeezes, the move could potentially increase the risk of price manipulation.

"The European market is not prepared to drop restructuring as a credit event for cash settled CDS auctions because many jurisdictions don't offer the ability to restructure through bankruptcy like in the US under Chapter 11. Regulators still haven't provided any guidance around the associated capital relief issue, so the decision also reflects the market's cautiousness on this," confirms one London-based CDS trader.

There is currently no restructuring auction mechanism for contracts that include a maturity limitation for deliverable obligations because, as the set of deliverables depends on the maturity of the contract, multiple auctions would be necessary to establish the cash settlement prices for each maturity - thereby potentially negatively impacting liquidity. Consequently, in order to facilitate the move towards centralised CDS clearing in the Eurozone, the proposal aims to simplify these maturity limitations - while still reflecting the economics of the underlying contracts - to enable efficient auction settlement.

Under the present Modified-Modified Restructuring provisions, if a protection buyer triggers the CDS contract following a restructuring event, the maturity of obligations that may be delivered into the contract should not be after the later of: CDS contract maturity, 60 months following the restructuring date for any restructured obligation, and 30 months following the restructuring date for any other deliverables. If the protection seller triggers the contract, the only limitation on the maturity of deliverables is 30 years.

There had been some debate about whether to drop the Mod-Mod R clause, following the adoption of the standard North American corporate (SNAC) CDS contract at the beginning of April (SCI issue 132).

The proposed new solution creates five maturity buckets, four of which are applicable for buyer-triggered contracts. These include a 'blended' 2.5-year bucket for contracts with up to a 2.5-year maturity (for which deliverables with a maturity of up to five years for restructured obligations and up to 2.5 years for non-restructured obligations are eligible); a five-year bucket for contracts with a remaining maturity of 2.5-5 years (deliverables can have a maturity of up to five years); a 7.5-year bucket for a remaining maturity of 5-7.5 years (up to 7.5 years); and a 10-year bucket for contracts with a remaining maturity of more than 7.5 years (up to 10 years).

The fifth bucket is for seller-triggered contracts and so is not subject to maturity limitation. The maturity of deliverable obligations in this case may be up to 30 years.

The new mechanism entails separate auctions being conducted for each maturity bucket to determine a cash settlement price for the relevant range of contract maturities. However, no auction would be held for a bucket that contained no contracts within the maturity range, with ISDA's Determinations Committee then having the authority to combine buckets that share the same set of deliverable obligations.

Although the trader agrees that any move towards efficiency and transparency is a positive step for the market, he points out that cash settlement is prone to squeezes and so the integration of restructuring as a credit event in the settlement process could increase the risk of price manipulation. "The proposed framework does potentially add risk, but restructurings are rare in Europe. At the end of the day, it seems like we've spent lots of time agreeing new documentation terms that we'll hopefully only rarely have to use," he remarks.

It is hoped that the documentation will be formalised by the end of June, so that CDS central clearing in the Eurozone can begin in the second half of the year, as per the dealer community's commitment to the European Commission (see SCI issue 125). "The authorities are already complaining that Europe is lagging behind the US in this regard, but the market remains split between where the CCP should be based," the trader adds. "French and German supervisors are strongly arguing in favour of basing it in mainland Europe; however, the majority of European CDS is traded in London. If liquidity is split across two locations, we won't be able to net down to the smallest exposure - it's better to have a single product type concentrated around a single location."

CS

Monolines

New exposure

KBC's bailout puts spotlight on other MBIA policyholders

KBC's third bailout in eight months - following new CDO write-downs and revelations of substantial exposure to MBIA - focuses the spotlight not only on its management, but also on other banks that have significant monoline exposure. As legal challenges develop over MBIA's restructuring, analysts are calling for caution regarding those banks involved.

"The specific MBIA story has been developing for quite a while now, and this makes us wonder about the late emergence of these CDO problems," says Eleonore Lamberty, senior credit analyst at ING. "It also makes us wonder about management's communication on the matter, which was negligible to say the least: we would not be surprised to see lawsuits emerging and we would expect to see some form of accountability from the company's auditors, Ernst & Young."

"This is ugly, but it is absolutely going to put the spotlight on other heavy user monoline banks," adds Tom Jenkins, financials analyst at RBS. While monoline counterparty risk provisions have appeared in the first-quarter 2009 results that have been released to date, 'confessions' of the size of KBC's - post the February 2009 downgrades - are yet to be seen.

At the same time, a group of 19 banks have filed a suit in New York State Supreme Court alleging that MBIA's insurance subsidiary is grossly undercapitalised with no means of paying existing policyholders, following its restructuring in February (SCI passim). Dubbed the MBIA Policyholder Group, Bank of America Merrill Lynch, Barclays, BNP Paribas, CIBC, Citi, HSBC, JPMorgan, KBC, Morgan Stanley, Royal Bank of Canada, SG, UBS and Wachovia are some of the banks involved.

"Clearly these banks have their motivation and we call for caution - especially [around] those not benefiting from government-sponsored asset immunity schemes," says Lamberty.

MBIA says the challenge from the 19 banks is without merit (see Job Swaps for more). However, according to Zeshan Ashiq, founding partner of Shooters Hill Capital, while MBIA is in compliance with the regulators, from the policyholders' point of view, it is difficult to ascertain what argument MBIA has in its favour with regards to the splitting up of its business into two entities, as it clearly diminishes the claims paying resources available to non-muni policyholders.

"Even in the early stages of MBIA's plan to split the business, many people in the industry were amazed that it would even attempt such a move," he says.

The result of the lawsuit is expected to give a clearer indication to structured credit policyholders on the cash available to cover any payouts from their policies. Ashiq suggests that if MBIA wins, and the business is split up as planned, resources available to structured finance policyholders would be diminished from what they originally thought would be available in the event of a claim.

"Whether or not MBIA's action could lead to more write-downs at banks is difficult to say," he concludes. "It will depend on the health of the bank, how big its exposure is and the provisions it has already taken against monoline exposures."

AC

Regulation

Unclear thinking?

Mixed views on Geithner's initiative

US Treasury Secretary Tim Geithner last week released details of the Administration's proposed comprehensive regulatory framework for all OTC derivatives. The move has had a mixed reception, at best, from the CDS market.

The US Administration says the objectives of the reform are to: prevent activities within the OTC markets from posing risk to the financial system; promote efficiency and transparency within the OTC markets; prevent market manipulation, fraud and other market abuses; and ensure that OTC derivatives aren't marketed inappropriately to unsophisticated parties. Among other things, the framework envisages requiring clearing of all standardised OTC derivatives through regulated central counterparties, the movement of standardised trades onto regulated exchanges and electronic trade execution systems, and subjecting dealers to a robust regime of prudential supervision - including conservative capital, reporting and initial margin requirements (see News Round-up).

One New York-based hedge fund manager is sceptical about the focus on standardised products, particularly in the context of the CDS market. "Many of the players in the CDS market are SPVs, which obviously don't have the cash liquidity to meet daily margin calls. Equally, the AIG situation would not have been helped by a centralised clearing platform, because the trades were non-standard structured super seniors," he says.

"If you only trade with high-end credits, then there is less risk than putting everything on to one or two centralised clearing platforms and exchanges. So the market will be vulnerable to unilateral fee hikes, while concentration risk will be increased," argues the manager.

Instead, he says: "All the pieces are already there to resolve this problem. Existing players from the banks to the DTCC to the information providers, who - unlike the exchanges - fully understand the OTC market, can be linked together electronically to trade transparently and clear centrally."

However, law firm Ashurst takes a more positive view of Geithner's plans and released the following statement: "This will be enormously popular and no-one in the industry is likely to want to appear otherwise than being in tune with it. However, so much depends on the governments in other jurisdictions acting in concert with these proposals; otherwise, this will be the first step down the road of seeing financial service business and investment moving offshore. Politicians and policymakers in the US should not lose sight of the fact that the 2000 Commodities Futures Modernization Act was as much about levelling the playing field for US financial institutions as anything."

Nevertheless, there are some who argue that the only aspect of a level playing field in the proposals is the lack of appeal for the majority of participants. One structured credit investor observes: "Who will lose out? The big banks, whose bid-offer spreads will decline still further; FCMs, who will be disintermediated; ISDA, if documentation is standardised; and support firms - from Markit and TriOptima to any lawyers. That should mean it can't happen and should certainly exclude a full move to exchange-based trading - Geithner sees a seemingly obvious and easy solution, but in reality it is far from being so."

However, another market source says: "There appears to be a concerted regulatory-driven effort to engineer the market into what it 'should' look like rather than how it actually functions, which should be of great concern to those in London as well as the US. This plan feeds on the misapprehension that the CDS market is part of the problem, rather than simply one sector that kept functioning as the rest of the capital markets unravelled. The idea of centrally clearing standardised CDS also takes them out of the close-out netting equation, which is disadvantageous to anyone who trades both vanilla and structured credit."

For its part, the Wholesale Market Brokers Association (WMBA) reiterated its support for efforts to clear CDS through a CCP, as well as other financial products that are suitable for clearing. However, the Association also notes: "The implication being drawn by some market participants and commentators is that the only way of achieving regulators' ambitions is to coerce OTC products onto exchanges."

David Clark, chairman of WMBA, says: "The WMBA wishes to warn again that forcing OTC products onto exchanges would significantly reduce liquidity in financial markets, resulting in increased risks and costs for end users as their ability to hedge their exposures would be handicapped... The WMBA believes that European initiatives indicate a firmer grasp of the essential role of the clearing house, and understanding of the transparency and post-trade security inherent in the activities of banks, and WMBA members that use platforms that are MiFID compliant in an already regulated environment."

Whatever happens with standardised instruments, the granular side of the credit business will continue to exist, according to the hedge fund manager. "You will get firms specialising in non-cleared credit. It may even return to being a real service business, providing genuine solutions to genuine problems, rather than a trading-based business," he says.

MP

ABS

ABCMT tender 'too low'

Advanta Corp announced on 11 May that its securitisation trust (ABCMT) will go into early amortisation based on May's performance, although it will be officially determined on 10 June. Advanta is set to tender for the Class A senior notes of ABCMT at 65%-75% of face value in a modified Dutch Auction on 10 June 2009. In addition, bondholders tendering the senior notes before 27 May 2009 will receive an additional 2% of face for early participation.

ABCMT will not be allowed to fund new receivables once early amortisation is triggered and Advanta does not plan to fund the receivables on balance sheet. As such, it will shut down all credit cards after 10 June. These actions are part of the company's plan to maximise capital and limit credit loss exposure.

Advanta will continue to service its existing portfolio, both securitised and owned receivables.

According to securitisation analysts at JPMorgan, early amortisation and credit card shut down is a plausible scenario. They suggest that while the Class A senior notes will most likely be money-good, the tender offer of 65%-75% is too low.

"Bondholders will likely leave too much money on the table at those prices. At 75, it is possible to achieve a small positive yield on the senior note, even under very dire performance stresses," they explain. "Given that secondary bids for ABCMT Class As were seen in the mid/high US$70s area (after Advanta's tender announcement), we expect that investor participation in the auction may be low. We think the bonds offer value into the mid/high US$80s."

CS

CDS

ICE on track for European CDS launch

ICE has announced that it is working closely with the European CDS community to provide clearing services through ICE Clear Europe for iTraxx and European single name reference entities by the July 2009 deadline agreed upon by CDS industry participants and the European Commission. At the same time, the clearer says that it is currently expanding its services in the US to include buy-side clearing, which will provide for margin segregation and account portability to firms who are not direct clearing members.

Dirk Pruis, president of ICE Trust, comments: "ICE Trust was designed as an open platform, with membership available to qualified market participants who meet the clearing house's rigorous financial, operating and risk management criteria. We welcome RBS in our continued efforts to bring transparency and stability to the vital CDS markets, and we look forward to working with new dealer and buy-side participants." RBS has become the 11th CDS clearing member of ICE Trust.

For the week ended 15 May 2009, ICE Trust cleared US$223bn in notional value. Since launch, it has cleared 6,599 transactions, totaling US$586bn of notional value and resulting in open interest of US$103bn. During the last clearing cycle, ICE Trust added Series 8 and Series 9 CDX contracts, which accounted for approximately 76% of the week's cleared volume.

CS

CMBS

GGP ruling recognises 'integrity of SPE structure'

The judge ruling on the General Growth Properties (GGP) bankruptcy case said the REIT can use cashflows from the 166 malls - that also back numerous CMBS transactions - in the company's restructuring. However, the CMSA says it believes the bankruptcy court ruling recognises the integrity of the special purpose entity structure.

The CMSA submitted on 1 May an amicus brief to the court, expressing concern that the GGP proposal would disregard the core financing structure the commercial mortgage industry has relied upon for more than twenty years (see last week's issue). The Association emphasised that an adverse ruling might damage the CMBS market.

Last week an investment group led by Farallon Capital Management provided debtor-in-possession financing, which included concessions to the SPE subsidiaries of GGP.

"No second mortgage liens were placed on General Growth's SPE properties, and the Bankruptcy Court gave the secured creditors of each of the subsidiaries a superior lien on the cash collateral account to pay all obligations of each SPE," says Christopher Hoeffel, president, CMSA. "Judge Allan Gropper stated that the interests of the secured creditors would be respected."

While CMSA and its members consider this to be a generally positive ruling, it still doesn't completely abate the industry's concerns about putting SPEs into bankruptcy. "There is still a concern as to why these solvent SPE subsidiaries voluntarily entered bankruptcy proceedings in the first place," Hoeffel adds. "We feel the trusts that own these loans will incur greater costs and expenses due to the bankruptcy filings."

To be sure, CMSA, the commercial mortgage market and its bondholders are waiting to hear how the bankruptcy court addresses whether the SPE subsidiaries undertook a bad faith filing, but a hearing is scheduled to take place in the US Bankruptcy Court on 27 May to discuss this and other outstanding issues. "We are encouraged that Judge Gropper responded to the questions and concerns in our amicus brief and said that it wasn't a substantive consolidation," Hoeffel continues.

AC

Distressed assets

Second European 'bad bank' scheme proposed

Further details have emerged about Germany's 'bad bank' model, following the German Cabinet's approval on 13 May of a draft law that expands the country's financial markets stabilisation legislation. The move comes after Commerzbank revealed its plans to spin off its structured credit assets into a Portfolio Restructuring Unit (see last week's issue). However, there remains some disagreement as to whether the bad bank model is the best way to address financial institutions' 'toxic' asset issues.

The €200bn German bad bank proposal differs significantly from the Irish model, which consists of a single bad bank for the entire banking sector (see SCI issue 131 for more). Under the German model, financial holding companies, credit institutions and their subsidiaries have the option to offload their troubled structured credit assets into individual SPVs (one per each participating institution).

The transfer of assets to the SPV will incur a 10% haircut on the book value of the assets, as of end-March 2009, providing the Tier 1 ratio of the institution remains at least 7% (if not, there would be no haircut). In exchange, the institutions will receive SoFFin-guaranteed SPV-issued debt for the same amount as that of the transferred assets.

These guaranteed bonds can then be repoed with the central bank for liquidity purposes. Institutions will pay a 'market price' fee in exchange for the guarantee from SoFFin.

In addition, the institution will pay the SPV on a yearly basis and amortised over the period of the guarantee an 'equalisation amount', representing the difference between the 90% of book value and the then current 'fundamental value' (which is the fair value discounted for potential risks). At the end of the period, any benefit on the SPV is given to the shareholders. However, any deficit on the SPV would mean that the distribution is made to SoFFin until the deficit is made good.

Credit analysts at BNP Paribas suggest that a 10% haircut looks generous for participating institutions, so they expect the impact on bank capital to be limited - although it is still unclear how much the fee will be to participate. Equally, beyond the initial haircut, subsequent losses appear to be borne exclusively by shareholders and not creditors or taxpayers.

"The cost or loss is paid out of dividends, i.e. it does not appear in the P&L, and therefore would not impact regulatory capital. This should be good for creditors, including subordinated debt, and for public finances," the analysts point out.

However, as with other similar proposals, the familiar criticism of how fair valuation or market price will be assessed applies. "The fact that there's typically little disclosure about the assets being placed in the bad bank is also troubling - it would certainly provide more comfort to investors if the nominal amounts, at least, of underlying bonds were released," adds one structured credit investor. "It is also frustrating for some funds looking to invest in distressed assets that once these bonds are placed in the bad bank, they're locked up for ever."

He continues: "My general opinion is that bad banks are an indirect way of subsidising failing institutions - by taking away their bad debts at off-market prices - instead of nationalising them. As a shareholder in a participating bank, I'd be thrilled by the prospect, but as a taxpayer, it's unclear as to how much public money will be needed to continue supporting these institutions in the future."

The draft law will now go to the German Parliament for further discussion and approval.

CS

Regulation

VIEs/QSPEs subject to new FASB disclosures

The FASB has concluded its deliberations on two proposals that will be finalised as standards in June. One of the proposals relates to the consolidation of variable interest entities (VIEs) under FIN 46(R) and the other will amend existing guidance for when a company derecognises transfers of financial assets (Statement 140). Both new standards will require a number of new disclosures, the Board says.

FIN 46(R) amends existing consolidation guidance for VIEs, which are generally thinly-capitalised entities and include many SPEs. The primary amendment to FIN 46(R) relates to how a company determines if it must consolidate a variable interest entity.

Under GAAP, a company must consolidate any entity in which it has a 'controlling interest'. The new standard now requires a company to perform a qualitative analysis when determining whether it must consolidate a variable interest entity. Under the standard, if the company has an interest in a variable interest entity that provides it with control over the most significant activities of the entity (and the right to receive benefits or the obligation to absorb losses), the company must consolidate the variable interest entity.

Under the new standard, the quantitative analysis often used previously is no longer, by itself, determinative. The newly-approved standard requires ongoing reassessments to determine if a company must consolidate a VIE. This differs from existing guidance, which requires a company to determine if it consolidates a variable interest entity only when specific events occur.

Under existing guidance, as expected credit losses increased significantly due to unpredicted market events, some companies did not reconsider whether they should consolidate a variable interest entity. The new standard requires a company to update its consolidation analysis on an ongoing basis and to provide additional disclosures about its involvement with VIEs and any significant changes in risk exposure due to that involvement.

A company will now be required to disclose how its involvement with a VIE affects the company's financial statements. A company will also be required to disclose any significant judgments and assumptions made in determining whether it must consolidate a variable interest entity.

The second standard now headed for finalisation - Statement 140 - enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company's continuing involvement in transferred financial assets. It removes the concept of a qualifying SPE from US GAAP, changes the requirements for derecognising financial assets and requires additional disclosures about a transferor's continuing involvement in transferred financial assets.

QSPEs generally are off-balance sheet entities that are exempt from consolidation, but the new standard eliminates this exemption. Many QSPEs that currently are off-balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.

The standard on derecognition restricts when a company may transfer a portion of a financial asset and account for the transferred portion as being sold. Existing guidance permits companies to report many transfers of portions or components of financial assets as sales. Under the new standard, a transfer of a portion of a financial asset may be reported as a sale only when that transferred portion is a pro-rata portion of an entire financial asset, no portion is subordinate to another and other restrictive criteria are met.

This clarifies the legal isolation requirements to ensure that a company considers all of its involvements and the involvements of its consolidated entities to determine whether a transfer of financial assets may be accounted for as a sale. The newly approved standard also eliminates an exception that currently permits a company to derecognise certain transferred mortgage loans when the company has not surrendered control over those loans.

The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.

FASB expects the approved standards to be effective as of the beginning of 2010 and they will apply to existing entities, including existing qualifying special purpose entities. However, the amendments on how to account for transfers of financial assets will apply prospectively to transfers occurring on or after the effective date.

CS

CDS

Counterparty risk reduction

Michael Shapiro, director, and Andrew Scott, md at NetDelta answer SCI's questions

Andrew Scott

Q: How and when did you/your firm become involved in the credit derivative market?
MS: NetDelta was founded in 2008 to address the counterparty risk management challenges that have been present in the credit derivative market since its inception. We believe that there is a structural problem in the OTC CDS market, whereby individual transactions have been consistently layered on top of each other, creating a complex web of overlapping and unmanageable exposures. This resulted in large gross notionals - and therefore counterparty risk - which are many multiples of actual market risk.

NetDelta seeks to remove the excess counterparty exposure, while keeping participants' market exposure constant.                                     

Q: How has your service/offering developed since then?
AS: The CDS market has constantly evolved and so has NetDelta. Over the years much work has been done to increase transparency, processing and connectivity in the OTC markets.

NetDelta helps add to the work that has been done in the past, while resolving counterparty risk issues which have often been overlooked. NetDelta is a post-trade platform and makes use of industry protocols, straight-through processing and links to DTCC, so that all positions and transactions are stored in DTCC's Trade Information Warehouse.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
MS: NetDelta focuses primarily on sell-side institutions; however, there are definitely applications to the buy-side. In addition, the platform has been set up for OTC credit derivative contracts, but there is no reason why it cannot be extended to include other OTC instruments.

Q: How do you differentiate yourself from your competitors?
AS: NetDelta offers a superior solution in that it seeks to eliminate counterparty risk. Many of the existing solutions in the market, including central counterparties, either re-distribute or actually concentrate risk in a single entity rather than removing it.

Michael Shapiro

We believe that NetDelta's model, which has been built and tested over a period of over three years, will help participants and regulators understand the amount of risk in the system and who bares it. For example, if NetDelta had been in place during Lehman Brothers' failure, the losses in the market would have been significantly reduced. NetDelta allows the most experienced party to assess credit risk, rather than outsourcing the decision to a third party.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
MS: The challenges of the current financial environment have helped shine a light on risk management. Participants and regulators are focused on finding solutions that help reduce risk while allowing the markets to function in an orderly manner. There has been great interest in NetDelta due to the fact that the platform allows participants to maintain their bilateral relationships while mitigating the risks inherent in the market.

Q: What major developments do you need/expect from the market in the future?
AS: Given the failures of the past, we expect a greater regulatory presence going forward. We believe that central clearing for credit default swaps should not be mandated and that market participants will choose the methodology which works best for their business model.

If the recent financial crisis has taught us anything, it's to be aware of over concentrating risk in a single place or relying on a single model to calculate risk [see also separate News Analysis]. Certain products will undoubtedly gravitate towards central clearing and exchanges, while others are better suited to trade in the over-the-counter market. NetDelta will continue to exist as a solution in the OTC markets to help reduce counterparty risk.

About NetDelta
NetDelta is a post-trade platform that allows participants to minimise and diversify their counterparty exposure while continuing to trade bilaterally in the over-the-counter CDS market.

NetDelta addresses a primary concern of both regulators and market participants by reducing counterparty risk concentration through the use of pooled credit and standardised credit derivative contracts. The platform multi-laterally nets transactions and uses participants' credit lines to reallocate exposures so that participants' market exposure stays neutral but counterparty risk is minimised.

ABCP

ABCP conduit moved onto balance sheet

State Street is moving its ABCP conduits on-balance sheet. This follows results of the US stress tests which showed that, after consolidation of the conduits and under the assumptions and methodology required by SCAP, State Street had a sufficient capital buffer to withstand even the stress test's 'more adverse' scenario.

In connection with the consolidation of the conduits, State Street recorded for accounting purposes an after-tax loss of approximately US$3.7bn relating to the recognition of the unrealised mark-to-market losses on the conduit assets. From the conduits, assets with an aggregate book value of approximately US$22.7bn as of 15 May were consolidated onto the company's balance sheet at a fair value of approximately US$16.6bn as of that date.

Based on its credit assessment of these assets, State Street expects that a vast majority of the after-tax loss recorded upon consolidation will accrete as interest revenue over the lives of the assets into the consolidated income statement. Based upon management's current prepayment assumptions, State Street expects approximately US$475m pre-tax to accrete as interest revenue in 2009.

ABS

Eight hired for new ABS unit

Brokerage Miller Tabak Roberts Securities (MTR) has launched an MBS/ABS department with a founding team of eight structured product veterans. The department will initially focus on secondary sales and trading of non-agency prime, Alt-A and subprime RMBS, CMBS and consumer and industrial ABS, but expects to expand into ABS/MBS CDOs and agency RMBS.

The team is led by md Sachin Jhangiani. Jhangiani most recently led the West Coast-based structured products sales team at Banc of America Securities and prior to that was BofA's head of origination and servicing sales in New York.

Joining Jhangiani as department founding senior staff, all as svps, are traders Sean Grettum and Aaron Read, institutional salespeople Earl Rix, Matthew Kulekofsky and Mohammed Noorali, and RMBS credit strategist Stevan Stevanovic. Grettum, Kulekofsky and Noorali each most recently held similar roles at BofA.

Rix started his career in MBS and ABS at Salomon Brothers and was most recently at Piper Jaffray. Read comes from Blue Mountain Capital Management and before that was a portfolio manager at BlackRock.

Stevanovic was most recently an MBS and ABS research analyst at Credit Suisse. Charles Joyce, recently of Citigroup, also joins the new team as assistant vp for MBS/ABS trading and operations support.

CDO

Citi structured credit director appointed

Olivier Renault, former director of global structured credit products at Citi, has joined StormHarbour Securities. In his new role, Renault will be a structurer in the client solutions team and focus on structured credit and alternative assets.

CDPCs

CLO manager in CDPC move

Jerry Donohue is rumoured to have joined CDPC Channel Capital Advisors. Donohue was previously md at CLO manager Deerfield Capital. The appointment has not been confirmed by Channel Capital Advisors.

CDS

PTCo goes to court over Mahogany notes

Perpetual Trustee Company (PTCo) has commenced legal proceedings against BNY Corporate Trustee Services (BNYT) in the High Court of England and Wales on behalf of the more than 1000 retail investors from Australia, New Zealand and Papua New Guinea in CLNs issued by Mahogany Capital. Grange Securities, the Australian subsidiary of Lehman Brothers Holdings International, sold these notes valued at A$125m to retail investors.

The money raised from investors in Mahogany notes (Series I and II) was used by Mahogany to purchase CLNs issued by Saphir Finance, which was the source of funds for paying interest and principal on the Mahogany notes. Saphir in turn used the proceeds to purchase collateral to secure its obligations under CDS agreements with Lehman Brothers Special Finance (LBSF) under the CLNs sold to Mahogany.

BNYT acts as trustee for the Saphir noteholders. No payments have been made to Mahogany investors since Lehman's failure in September. In its claim, PTCo says that Mahogany investors are entitled to the proceeds of the collateral ultimately backing the Mahogany notes following LBSF's insolvency. But BNYT has yet to enforce the security held over such collateral and apply it for the benefit of Mahogany investors.

Chris Green, group executive at Perpetual Corporate Trust, says that the lack of action is due in part to pressure from the Lehman bankruptcy trustee.

CMBS

Advisory firm adds in CMBS

NewOak Capital has hired Malay Bansal, former head of CRE CDOs at Merrill Lynch, as an md in CMBS. At NewOak, Malay will focus on structured commercial real estate (CRE) capital markets and advisory.

The firm believes that a tremendous amount of capital market solutions will be needed in the CRE space as credit issues surface when refinancing and restructuring becomes unavoidable. NewOak is becoming a one-stop-shop for providing opinion on potential workout solutions, as well as capital market de-risking or restructuring. The upcoming downgrades mean that taking action by existing noteholders will become even more urgent.

Distressed assets

Belgium offers asset relief solution to KBC

KBC has reached an agreement with the Belgian government regarding an asset relief solution, following the publication of structured credit and monoline-wrapped debt losses amounting to €3.8bn. The announced arrangement for KBC relates to a notional amount of €20bn, of which €5.3bn was marked down against revenue, including €5.5bn notional value of super-senior CDO investments and €14.4bn notional value of counterparty risk on MBIA.

Against payment of a premium, KBC will buy a guarantee from the state covering 90% of the default risk beyond a set first loss. The first loss tranche is set at €3.2bn notional (all credit loss to be borne by KBC).

Losses incurred in a second layer of €2bn above the set first loss tranche are compensated by the State at 90% (10% risk retained) via the subscription to new KBC shares at market value. KBC has, however, the option to opt out of the equity guarantee.

All further losses (up to €14.8bn) are compensated by the state in cash to the level of 90% (10% risk retained by KBC). The remaining downside impact relates to the marking-to-market of the retained 10% risk tranche. If market values were to rise substantially, reversals of earlier markdowns would be booked.

The guarantee premium amounts to €1.2bn, fully provided for up front, and an additional commitment fee of €30m per quarter, pre-tax, is payable.

Investors

Eaton Vance moves into DIP loans

Eaton Vance is understood to be raising US$1bn in order to invest in DIP loans. The firm joins Aladdin Capital in this activity, which announced it would be setting up a DIP fund in February (see SCI issue 123).

Investors

CDO manager ousted by controlling class

Realty Finance has been given written notice from MBIA of its decision to terminate the existing collateral management agreement in respect of the company's US$1bn CDO 2007, and to remove Realty Finance as the collateral manager of CDO 2007 upon the appointment of a successor collateral manager. The breach of the overcollateralisation covenant in either of Realty's CDOs provided MBIA - the controlling class of CDO 2007 bondholders - the ability to terminate the existing collateral management agreement and to remove the company as the collateral manager of CDO 2007. Given the termination, Realty Finance will no longer be responsible for the management services of CDO 2007 and therefore, will not be entitled to receive senior and subordinate collateral management fees beyond fees already earned.

Listed products

Slight improvement for Volta ...

Volta Finance has published its April monthly report. As of the end of April 2009, the gross asset value (GAV) of Volta Finance Ltd was €51.6m, or €1.71 per share, an increase of €0.01 per share from €1.70 per share at the end of March 2009.

The April mark-to-market variations of Volta Finance's asset classes have been: 0.1% for ABS investments, 0.7% for CDO investments and 2.0% for corporate credit investments.

The permacap has appointed AXA Investment Managers Paris for the investment management of all its assets.

Listed products

... while another Permacap's NAV drops

Carador reports that, at the close of business on 30 April 2009, the unaudited NAV per share were €0.4196 and US$0.5375, down by 11.28% and 11.32% month-on-month respectively. The reduction in NAV in the period reflects the updated estimates of cashflows for underlying investments, which, for certain transactions, have been reduced to reflect the potential for cashflow diversion due to breaches in the overcollateralisation tests.

Monolines

MBIA refutes banks' challenge

MBIA has released a statement that says the litigation filed on 13 May 2009 by the MBIA Policyholder Group challenging its recent restructuring, like substantially similar complaints that were filed by other parties in recent weeks (SCI passim), is without merit (see also separate News Analysis). The restructuring was completed in order to establish a domestic municipal bond insurance company to increase bond insurance capacity in the US public finance market, the monoline stresses.

It says the restructuring will also facilitate the issuance of municipal bonds at lower rates, benefiting municipalities, universities, hospitals and other municipal issuers. "Taxpayers will also benefit, which is especially important at a time when they have already provided substantial assistance to some of the plaintiff banks," the statement continues.

All of MBIA's actions in regards to restructuring, including those challenged by the banks in their complaint, were approved by the New York State Insurance Department (NYSID) after a thorough examination - including an independent assessment by both the monoline's outside advisers and the NYSID of MBIA's ability to meet its obligations to all policyholders. In addition, the Illinois Division of Insurance approved all transactions entered into by MBIA Insurance Corp of Illinois (now named National Public Finance Guarantee Corporation) in connection with the restructuring.

Monolines

Wrapped RMBS purchased

The BCP Voyager Master Funds SPC, acting on behalf of and for the account of the Distressed Opportunities Master Segregated Portfolio, has bought 56 classes of RMBS insured by Syncora Guarantee (SCI passim).

Operations

Insurers get access to TARP

US insurers Prudential Financial, Hartford, Allstate, Principal Financial, Lincoln and Ameriprise look set to receive TARP money after the US government finally granted them access to the funds. So far Hatford is believed to have received preliminary approval for US$3.4bn under the programme.

Trading

New credit trading platform launched

FBR Capital Markets has expanded its institutional brokerage business by launching a new credit sales & trading platform. Joining the group is a team of veterans who will debut the firm's corporate bond and bank loan trading capability, focusing on crossover, high yield and distressed debt instruments.

The new recruits are: Vikram Natarajan, md and head of distressed trading in New York; Todd Dahlstrom, md, credit sales in Boston; Paul Deen, md, credit sales in New York; Jay Coyle, svp, credit sales in New York; Michael Cunningham, svp, credit sales in Boston; and Eric Vander Mel, svp and desk analyst, credit sales & trading in Boston. The team will report to Michael Lloyd, senior md, who has been appointed to the new position of head of credit, options & convertible securities in sales & trading at FBR Capital Markets and will lead the group from the firm's New York office.

Natarajan most recently headed the distressed trading team at UBS, while Dahlstrom most recently served as an executive director at Morgan Stanley and helped launch the firm's fixed income distribution office in Boston. Deen was previously an executive director within distressed sales at UBS and Coyle was a vp on the distressed credit sales team at Banc of America Securities (formerly Merrill Lynch). Cunningham was previously a member of Morgan Stanley's high yield loan sales group, while Vander Mel most recently served as executive director in the firm's special situations group, where he was responsible for research coverage on its par loan trading desk.

"We're delighted to be able to assemble such an accomplished team to launch our Credit Sales & Trading platform," comments Lloyd. "We intend to fully capitalise on the current market dislocation by investing in immediately accretive opportunities to grow our product suite. This team will reinforce our core strategic strengths in the small- to mid-cap space, up and down the capital structure, from our strong equities franchise, through hybrids and preferred, through convertibles and up to senior unsecured bonds and bank debt."

Trading

Lighthouse mints derivatives platform

Lighthouse Financial, a New York-based investment bank and institutional securities firm, is launching a derivatives platform. The new platform consists of 12 professionals that will be led by Tim Youssef and Nimit Savani, who will serve as mds and co-heads of derivatives, based in New York.

The platform will handle agency-only transactions. The team will cover all areas of derivatives, including single name CDS, index CDS and loan CDS.

Youssef has over 15 years of industry experience, most recently at Louis Capital Markets, where he was partner and head of US derivatives. Prior to joining Lighthouse Financial, Savani was the director of the equities derivatives group at Louis Capital Markets.

Presently, the 12-person team, which is still growing, has previous work experience at institutions including, Morgan Stanley, Merrill Lynch, Lehman Brothers, Societe Generale, Natixis, Bluefin Trading, Link/ICAP, Collins Stewart and Timber Hill/Interactive Brokers.

CDO

Negative outlook for synthetic CDOs

Continued deterioration in the corporate credit markets, declining recoveries and the related volatility of spreads on CDS are likely to present challenges to synthetic CDOs for the remainder of 2009 and into next year, according to a new report published by S&P.

"Corporate defaults are generally rising, and recent recoveries upon default have been well below historical levels," says S&P credit analyst John McCarthy. "We believe this trend could have a significant negative effect on rated corporate SCDO tranches, particularly those that don't benefit from excess subordination or other structural features to mitigate the impact."

Additionally, proposed revisions to S&P's methodologies for rating these transactions could lead to downgrades of outstanding SCDOs, and movement toward tighter regulation of swaps in some jurisdictions could hurt demand for new issuance of SCDOs.

"We believe the implications of proposed steps to introduce or increase regulation of the CDS market may further dampen demand for SCDO issuance," adds S&P credit analyst Belinda Ghetti. "However, the International Swaps and Derivatives Association's introduction of a standardised process for declaring credit events and establishing recoveries on reference obligations in CDS has had no rating impact thus far, and we expect it to continue to have a minimal impact on the ratings on SCDOs."

Arrangers on many SCDO desks have indicated that a significant reemergence of new issuance in the SCDO market isn't likely until the market sees a period of stable CDS spreads lasting two or three quarters - at least before real money investors spur any material new issuance. McCarthy notes: "The efficiency and liquidity that the CDS technology offers do, however, provide a solid anchor to the SCDO market, and we think issuance could eventually pick up, if only at a fraction of the levels seen in prior years."

CDO

... and US SROC figures in

S&P has taken the following rating actions on 228 US synthetic CDO transactions, following its April month-end review of synthetic CDO transactions. The agency has placed 241 ratings from 187 transactions on watch with negative implications; lowered 26 ratings from 17 transactions; and affirmed 33 ratings from 24 transactions and removed them from credit watch negative.

The watch negative placements reflect negative rating migration in the respective portfolios and SROC ratios that had fallen below 100%, as of the April month-end review. The reviews reflect recent credit events in the underlying reference portfolios, including Abitibi-Consolidated Inc, Idearc Inc and Syncora Guarantee Inc.

CDO

Cash/hybrid CDOs downgraded

S&P has lowered its ratings on 55 tranches from 20 US cashflow and hybrid CDO transactions. At the same time, it removed 11 of the lowered ratings from watch with negative implications. The ratings on 43 of the downgraded tranches are on watch with negative implications, 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 55 downgraded tranches have a total issuance amount of US$12.781bn. Seven of the 20 affected transactions are mezzanine structured finance (SF) ABS CDOs, which are collateralised in large part by mezzanine tranches of RMBS and other SF securities. Seven of the 20 are high grade SF ABS CDOs that were collateralised at origination primarily by triple-A through double-A rated tranches of RMBS and other SF securities. The other six are CDO-squareds that were collateralised at origination primarily by notes from other CDOs, as well as by tranches from RMBS and other SF transactions.

The downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US subprime RMBS.

CDS

GGP settled, other auctions called

LCDS on General Growth Properties were settled at 44.25 on 13 May, after 10 dealers participated in the credit event auction. Meanwhile, a further four credit events have been called, with settlement auctions to follow in due course.

Markit LCDX dealers have voted to hold auctions for LCDS transactions referencing HLI Operating Company Inc and Georgia Gulf Corporation (GGC). Hayes Lemmerz International, the US auto parts maker, and certain of its US subsidiaries filed voluntary petitions for relief under Chapter 11 of the US Bankruptcy Code in the District of Delaware on 11 May. GGC is a North American manufacturer and international marketer of commodity chemicals. It failed to make interest payments on certain of its bonds that were due on 15 April.

ISDA's Americas Credit Derivatives Determinations Committee has also resolved that a failure to pay credit event occurred in respect of R.H. Donnelley Corp, a company which provides local search solutions and services in the US. In addition, the EMEA Credit Derivatives Determinations Committee resolved that a failure to pay credit event occurred in respect of JSC Alliance Bank, a Kazakhstan bank. The Committees also voted to hold auctions for both names.

CDS

CDS notionals continue to contract

The BIS has released its semiannual statistics on positions in the global OTC derivatives market for end-December 2008. The statistics cover the notional amounts and gross market values outstanding of the worldwide consolidated OTC derivatives exposure of major banks and dealers in the G10 countries.

The total notional amount of OTC derivatives contracts outstanding was US$592trn at the end of December 2008, 13.4% lower than six months earlier. The decline is the first since collection of the data began in 1998. Credit market turmoil and the multilateral netting of contracts led to a contraction of 26.9% in outstanding CDS.

Despite the drop in amounts outstanding, movements of financial market prices in the second half of 2008 lifted gross market values by 66.5%, to US$33.9trn. Gross market values measure the cost of replacing all existing contracts and are thus a better measure of market risk than notional amounts outstanding.

CDS

Sovereign CDS continue liquidity streak

Fitch Solutions' latest global CDS liquidity scores commentary shows that CDS on Mexico continue to trade with the most liquidity as worries persist surrounding its exposure to the weakened US economy. Thailand is now the fourth most-liquid sovereign as political strife continues to put stress on its tourism sector, with its airports reporting a 42% fall in Q209 net profits.

Meanwhile, the financial sector continues to dominate liquidity in the US market, with General Electric Capital Corporation and Ford Motor Credit Company retaining the top two spots. GMAC remains in the top 10 amid uncertainty about the bank holding company's credit condition after stress tests revealed that it must raise US$11.5bn in capital. GMAC is expected to call upon the government for another bailout as General Motors Corp will be unable to come to its rescue.

Although telecoms companies continue to be prominent in the European top 10, German automotives now hold the top two liquid spots after auto industry troubles were further accentuated by a 3.8% plunge in Germany's GDP during Q109. The Royal Bank of Scotland plc has climbed up to the fourth most-liquid position, moving up 15 percentile points this year after posting a Q109 net loss of £857m and warning that 2009 and 2010 will continue to be difficult.

South Korean entities continue to dominate liquidity in Asia Pacific, with seven of the 10 most liquid names domiciled in South Korea.

CLOs

Euro CLOs at risk of undercollateralisation EODs

Fitch says that some European CLO transactions may be susceptible to undercollateralisation event of default (EOD) triggers if leveraged loan prices continue at depressed levels and cumulative defaults reach 25% over the next two years. The prospect of some EoD triggers being breached draws on a scenario analysis of the risk exposure of European CLOs to undercollateralisation EoD triggers.

"Fitch-rated transactions differ widely in their likelihood of striking an EoD trigger, as well as in their EoD trigger language," says Jan Bockelmann, associate director in Fitch's structured credit team. "While Fitch-rated CLOs generally exhibit a significant resilience against the risk of breaching undercollateralisation EoD triggers, potential trigger breaches could still materialise for some CLOs before the end of 2010. However, this risk is not imminent and subject to several moving parameters, such as recovery and default rates, market prices, the extent of triple-C rated assets and default timing."

Cashflow mechanisms add considerable benefit to senior notes and reduce the risk of EoD trigger breaches due to the diversion of excess spread and junior note interest. In the report, Fitch discusses the drivers for and the likelihood of European CLOs breaching undercollateralisation EoD triggers based on scenario analysis.

CLOs

Leveraged loan negative credit migration hits CLOs

Fitch says that the performance of European CLOs has recently suffered from a rapid negative credit migration in the leveraged loan market. In the first edition of a new quarterly European Leveraged Loan CLO Performance Tracker report, the agency notes that 14 obligors were reported as defaulted between December 2008 and March 2009.

"The performance of European CLOs is deteriorating due to the stress in the leveraged loan sector that has resulted from the economic downturn," says Jeffery Cromartie, senior director and head of Fitch's European structured credit performance analytics. "Between December 2008 and March 2009, a first wave of defaults in the leveraged loan sector occurred, resulting in a breach of overcollateralisation tests for most Fitch-rated European CLOs."

"With further leveraged loan defaults expected, Fitch expects that overcollateralisation (OC) tests currently not in compliance are likely to remain breached for an extended period of time," says Laurent Chane-Kon, director in Fitch's structured credit team. "This is to the detriment of the manager, which will not receive subordinated fees. In some cases, OC tests which are not in compliance could also be detrimental for junior and mezzanine noteholders."

Meanwhile, the concentration of triple-C and below rated obligors in CLO portfolios has increased sharply. An increasing number of CLOs are now marking down triple-C obligors at their market values for the calculation of OC ratios.

CMBS

TALF to accept legacy CMBS

The US Federal Reserve has announced that, starting in July, certain high-quality CMBS issued before 1 January 2009 will become eligible collateral under the TALF programme. The objective of expanding the scheme in such a way is to restart the market for legacy securities and, by doing so, stimulate the extension of new credit by helping to ease balance sheet pressures on banks and other financial institutions (see SCI issue 135).

The inclusion of legacy CMBS is intended to promote price discovery and liquidity for legacy CMBS, the Fed says. The resulting improvement in legacy CMBS markets should facilitate the issuance of newly issued CMBS, thereby helping borrowers finance new purchases of commercial properties or refinance existing commercial mortgages on better terms.

To be eligible as collateral for TALF loans, legacy CMBS must be senior in payment priority to all other interests in the underlying pool of commercial mortgages. Eligible newly-issued and legacy CMBS must have at least two triple-A ratings from DBRS, Fitch, Moody's, Realpoint or S&P, and must not have a rating below triple-A from any of these rating agencies.

The initial subscription date for TALF loans collateralised by newly issued CMBS will be 16 June 2009. The subsequent subscription dates for TALF loans collateralised by newly issued and legacy CMBS will be announced in advance.

CMBS

Euro ...

S&P has placed on credit watch negative 35 tranches in eight European CMBS transactions. At the same time, it kept on watch negative 14 tranches in three European CMBS transactions affected by this review and already on watch negative for other reasons.

The affected tranches have a principal balance of about €2.3bn (for euro-denominated transactions) and £2.9bn (for sterling-denominated transactions). The watch placements affect approximately 61% (by number) of the transactions that closed between 1 July 2007 and 1 July 2008.

These rating actions follow S&P's current review of all European CMBS transactions. Commercial real estate debt and capital markets have been under pressure over the past 18 months, with market value declines in many markets led by a sharp increase in capitalisation rates, S&P notes. The agency expects further downward pressure on values, with drops in net operating income and falls in market rents likely as economic activity contracts in Europe.

Even though S&P continues to believe that Class A notes will not suffer an eventual loss, all else being equal, the risks to these tranches have, in the agency's view, materially increased. It considers that downgrades, including of senior notes, could be possible in future.

CMBS

... and Japanese CMBS on review

Fitch has placed 20 classes in seven Japanese CMBS transactions on rating watch negative (RWN). These classes and transactions have been identified as having structures in place that rely, to some extent, on the liquidation of commercial property collateral during the loan term to deleverage the transaction prior to loan maturity.

While Fitch only gives limited credit to property dispositions in its analysis, current market circumstances have made the liquidation of commercial property assets more difficult. As a result, the prospects of liquidating assets on the schedule and at the prices originally contemplated are unlikely. Fitch has placed the transactions on RWN pending a review of the transactions on a loan-by-loan basis.

Fitch's review will primarily focus on updating the status of the liquidation-type loans included in the underlying asset portfolio, and will revise the liquidation assumptions to be applied in its analysis as necessary. In general, the revised liquidation assumptions will reflect the deterioration in value and liquidity as seen in the current market. The agency expects to revise its initial assumptions downwards significantly, and this will likely have negative rating implications.

Fitch says it will, wherever possible, review revised forecasts and updated disposition plans of asset managers. It will also seek to complete reviews of the transactions identified below and resolve the RWN status by end-June 2009.

"Fitch believes Japanese commercial property values have recently seen declines of up to 40%, depending on collateral type and location," comments Kohei Hashimoto, senior director in Fitch's Japanese CMBS team. "This has directly and indirectly impaired general liquidity in the market. In resolving the RWN, Fitch will reassess its initial liquidation assumptions and, in many transactions and rating scenarios, will assume no further property dispositions to occur before loan maturity unless recent sales activity suggests otherwise."

Emerging Markets

BTA deal to test DPR securitisations

The 24 April announcement by Kazakhstan's Bank TuranAlem (BTA) that it will cease principal repayments on its foreign currency debt will inevitably have ramifications for the bank's diversified payment rights (DPR) securitisation transaction. It will also likely trigger events that make the transaction a test case for this type of deal, Moody's says in its Weekly Credit Outlook. Aside from BTA, developments across other Kazakh banks also underscore the high correlation between the general state of the economy, the stability of the banking system and the level of DPR flows - raising questions about the effectiveness of certain structural protections in these transactions.

As the year has unfolded, news has spread rapidly of potential difficulties at both BTA and Kazkommertsbank (KKB), two leading originators of DPR flows in Kazakhstan. Amid the deterioration of BTA and KKB's financial condition, Moody's has observed a steep reduction in the level of flows across the DPR transactions they sponsor.

"It has become increasingly clear that any perceived weakening in the credit quality of the originators has an immediate and marked impact on flow levels," says Moody's. "In addition, the crude oil price crash has brought to the fore the importance of industry diversification of DPR flows. Historically, a significant portion of the DPR flows observed in Kazakhstan are related to export financing in areas such as oil and gas, and the plunge in commodity prices has had an adverse effect on these flows."

The agency adds that the degree and speed of the decline in flows observed in these two cases has been higher than originally anticipated. As a result, the effectiveness of certain structural protections is reduced; for example, the flow-based triggers in the DPR transactions.

"While we believe BTA's recent announcement to cease principal repayments on its foreign currency debt will most certainly have a negative impact on the level of DPR flows, the magnitude of any such decrease remains to be seen," Moody's says. "A default on required payments by BTA on any other debt would constitute a 'sale rescission event', and if such an event is declared by the controlling parties, BTA is contractually obliged to repurchase the assets from the issuer, which would use the proceeds of this repurchase to repay noteholders in full. This would serve as a test case to confirm our view of the legal enforcement of sale rescission events in emerging markets."

Indices

CDO EOD index launched

As part of S&P's efforts to provide CDO market participants with greater transparency with respect to performance, it is publishing a new US corporate CDO EOD index that tracks the performance of CLOs and other corporate CDOs originated between 2003 and 2008. In the agency's view, the index constituents have indenture provisions that include an overcollateralisation-based event of default (EOD) calculation which includes haircuts to the par value of triple-C rated assets to the extent they exceed the maximum proportion of triple-C assets specified in the indenture; and provisions that it believes might allow the senior-most noteholders or other controlling party to liquidate the transaction collateral and terminate the CLO transaction upon the event of an O/C-based EOD.

To date, S&P has identified 75 US corporate cashflow CDO transactions, including CLOs, CBOs and CLO-squared transactions originated between 2003 and 2008 that it believes meet both of the above-referenced conditions. The original issuance amount for the rated notes from the 75 CLOs tracked by the index is US$29.94bn. The index tracks the senior-most O/C ratio for these CDO transactions as reported by the trustee each month, and presents the information based on the year of origination.

General trends S&P has observed in the index in recent months include:

• The cohorts have a considerable cushion before they would trigger an O/C-based EOD; transactions originated in 2005 have the tightest cushion, at 13.02% in absolute terms.
• The cushion before triggering an O/C-based EOD has declined over the past year; 2004-vintage corporate CDOs have seen the most significant decline and 2006-vintage CDOs have seen the least.
• The senior O/C ratios for corporate CDOs originated in 2008 are considerably higher than those in other cohorts. However, the cohort for corporate CDOs originated in 2008 is small, and it has seen shifts in the first several months of 2009 as additional transactions that have started to issue reports for the first time are now being included in the index.

Investors

Trio of tender offers announced

Two European issuers announced a tender offer on their ABS debt last week. Greene King has offered to buy up to £100m of its UK pub WBS subordinated notes, while Rabobank International said it would buy the Class B down to the Class E notes of its CMBS Skyline 2007-1. Additionally, Italian real estate company Beni Stabili announced its intention to buy back some of the notes from the Imser 2 CMBS.

The Imser issue securitises a loan backed by 227 properties leased to Telecom Italia. The Class A2a, A2b, A3a, A3b, B1, B2, B3, B4 and B5 tranches will be subject to the tender, which will be financed primarily by a €100m seven-year loan. The purchase price for the notes is between 50%-70% of par.

Green King's tender offer for its Class A4, B1 and B2 notes has purchase price ranges of 62 to 67, 50 to 55 and 35 to 40 respectively, according to SG. The offer will close on 19 May.

Reserve prices for Skyline are 68% of par for the Class B notes, 62% for the Class Cs, 40% for the Class Ds and 26% for the Class Es. This offer closes on 20 May.

LCDS

Cancellable LCDS protocol released

ISDA has launched the 2009 European Cancellable Form Loan CDS Protocol. The purpose of the protocol is to update the settlement method provisions of single name and index CDS transactions confirmed on previously published cancellable forms, also known as covered legacy transactions. These legacy trades are based on previously published cancellable (non-ISDA) documentation and LevX Series 1 trades, including single name and LevX Series 1 trades on Edscha.

The protocol is open to ISDA members and non-members alike, and the adherence period runs until 22 May 2009.

Operations

Transactional administrative issues on the rise

Fitch notes that issues with respect to the discharge of administrative roles within certain structured finance transactions are growing. In some extreme instances, this can adversely impact the ratings of affected securities to a substantial degree. The agency says an increasing number of instances where the actions, or inaction, of the parties fulfilling such roles are leaving some transactions in a state of uncertainty.

This is often proving to be the case with transactions that are already facing some distress, either in the form of problems with counterparties or deterioration in collateral performance. Such transactions are likely to have already seen adverse rating action prior to the administrative problems arising, according to Fitch.

The agency says it has been informed of several examples of recent administrative party issues that have acted, or could potentially act, to the detriment of the transactions concerned. These include: trustees waiting to call events of default and thereby waiting to release collateral to noteholders, pending satisfactory indemnification from noteholders; the apparent omission of requests for renewal of 364-day liquidity facilities, causing these facilities to expire, with the result that the transaction parties are now in dispute and substantial downgrade rating action has ensued; calculation agents making decisions in situations where it is alleged that junior noteholders receive payments prior to senior noteholders in breach of the documentation, or where it is alleged there has been incorrect allocation of losses with a resulting impact on credit support; and servicers choosing not to test certain covenanted terms.

"In its rating analysis, Fitch assumes that such parties will perform their roles as documented. However, contingent events may present specific circumstances that had not been anticipated in the documents. These are beyond the scope of our rating," says Stuart Jennings, structured finance risk officer for the EMEA and APAC regions.

He adds: "Such events can create uncertainty and will influence the way administrative parties behave. This may result in adverse rating action if their actions or inaction cause material disruption to the transaction."

Recently, the jump-to-default of Lehman Brothers left a number of transactions suddenly without a party to fulfil certain roles previously held by Lehman, for example, calculation agent. Replacement parties have proved difficult to source in many instances. In such cases, documents may not specify precise responsibilities for action when a party has fallen away suddenly in this manner.

Noteholders might look to the trustee to step in to resolve issues in the interests of the noteholders. However, in many cases, trustees may not be willing to take action if the function is not explicitly within their remit according to transaction documentation.

Even if such functions are within their remit, the trustee might seek indemnification from noteholders prior to taking certain actions. It is typical in transaction documentation that trustees have the right to seek indemnification to their satisfaction; however, arriving at agreement with noteholders as to what might be reasonable may cause delay.

Ratings

RFC on changes to US RMBS methodology

S&P is requesting comments on proposed changes to its methodology and assumptions for rating US RMBS. Methodology changes will raise triple-A credit enhancement levels, particularly for prime jumbo and Alt-A loans, and to a lesser extent for sub-prime loans, the agency says.

The rating agency hopes to set an anchor point representing the triple-A level of loss and credit enhancement for a benchmark pool of mortgage loans at a level that it believes to be sufficient to endure under a set of market conditions commensurate with an extreme economic downturn. The key aspects of the proposed changes to S&P's criteria on which it is requesting market feedback are:

• Setting triple-A loss and credit enhancement levels as anchor points for archetypical pools at 7.5% for prime jumbo, 18% for Alt-A and 30% for sub-prime collateral;
• Defining archetypical pools of prime jumbo, Alt-A and sub-prime mortgage loans;
• Supplementing its models with qualitative factors, such as its view of the state of the housing and credit markets and the outlook for those markets to vary the expected loss and credit enhancement levels for ratings below triple-A;
• Revising the credit enhancement adjustment factors in S&P's LEVELS model to assess the risk in pools of mortgage loans based on loan and borrower characteristics relative to the archetypical pool;
• Enhancing the CPR and CDR surveillance scenarios and alternative loss curves to provide a range of projected losses on seasoned deals, and a measure of uncertainty around those projections; and
• Supplementing surveillance methodology by using loan-level data, when available after issuance, in LEVELS.

Ratings

Criteria released for optional call provisions

S&P has published its general criteria methodology for rating structured finance securities that have optional call provisions which could result in a redemption of the securities at less than their remaining outstanding face amount, or par value.

The agency's structured finance ratings generally address the timely payment of interest and the ultimate return of principal no later than the legal final maturity date, according to the transaction terms. Ultimate return of principal typically refers to the payment of the face amount of the rated securities on or before the legal final maturity date of the securitisation.

However, there are some transactions that under certain circumstances may pay a lesser amount, according to the transaction terms. The most common example of this is a zero coupon bond.

According to the criteria S&P has published, it rates securities that can be called at less than par the same as it rates securities without the call provisions, provided certain conditions outlined in the criteria article are satisfied. The agency's preliminary analysis indicates that it does not expect any ratings to be affected by the new criteria.

Ratings

Current-pay criteria updated for CDOs

S&P has updated its current-pay criteria to provide for corporate debt held by CDO transactions when a corporate issuer announces a distressed exchange or buyback.

"Corporate entities in distress may often attempt to restructure their obligations, offering less than the original promise," says S&P credit analyst Robert Radziul. "There has been a great deal of such activity recently, taking the form of exchange offers and buybacks, known as distressed exchanges. The alternative of a potential conventional default, in which the investor or counterparty may fare even worse, often at least partially motivates their acceptance of such an offer."

S&P in certain circumstances treats such offers and buybacks analytically as de facto restructuring and, accordingly, as equivalent to a default on the part of the issuer, Radziul adds. "We have expanded our definition of current-pay to provide for the use of quantitatively-derived rating estimates (QDRE) on certain corporate debt collateral held by cashflow CDOs when an issuer credit rating is temporarily lowered to double-C or SD while a distressed exchange offer is pending," he explains. "In addition, we are revising our criteria for treatment of debt instruments subject to buyback or exchange offers at less than par. This change in assumptions is in line with our current-pay criteria and is intended to address the increasing prevalence of distressed exchanges and buyback offers at less than par."

Ratings

V scores published for consumer ABS

Moody's has published a report showing how its supplemental risk measures for structured finance transactions will work in practice within the global consumer loan ABS sector. The report, 'V Scores and Parameter Sensitivities in the Global Consumer Loan ABS Sector', applies the measures to typical transactions across Italian consumer loan ABS, Spanish consumer loan ABS and Japanese credit card (cash advance) ABS.

In the report, Moody's says that it expects typical transactions in the global consumer loan ABS sector will likely be assessed V scores ranging from low/medium assumption variability for Italian consumer loan ABS and Japanese credit card (cash advance) ABS to medium assumption variability for Spanish consumer loan ABS.

V scores are a relative assessment of the quality of available credit information and the potential variability around the various inputs in determining the rating. V scores are intended to rank transactions by the potential for significant rating changes owing to uncertainty around the assumptions.

The second supplemental measure being applied by Moody's in this sector is a parameter sensitivity analysis, which provides a quantitative calculation of how the initial, model-indicated rating of a structured finance security could vary if key assumptions were changed.

Ratings

European ...

After running its month-end SROC figures, S&P has taken credit watch actions on 339 European synthetic CDO tranches. Specifically, ratings on: 258 tranches were placed on watch negative; 71 tranches were affirmed and removed from watch negative; and 10 tranches were placed on watch positive.

Of the 258 tranches placed on watch negative: 30 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. 228 have experienced corporate downgrades in their portfolios.

Ratings

Q109 Asia Pacific rating actions analysed

Fitch says that negative structured finance rating actions during Q109 in Asia Pacific were driven by the downgrade of Indian corporates and the continued deterioration in the Japanese commercial real estate sector. In total, 55 tranches (including public, private, international and national ratings) were downgraded, while five were upgraded. Additionally, 159 tranches were affirmed, accounting for approximately 13% of all outstanding tranches rated by Fitch in the region.

"Economic conditions in India resulted in the majority of structured finance rating downgrades in the first quarter of 2009, with the remainder being largely Japanese CMBS," notes Alison Ho, director and head of performance analytics within the agency's Asia Pacific structured finance team. "As in the previous two quarters, Japanese CMBS experienced downgrades in Q109, driven in part by the assumption that replacements will not be found for roles previously carried out by Lehman."

Indian single loan sell down transactions accounted for 32, or nearly 60%, of downgrades in Q109, following negative rating actions on Sobha Developers Limited, TV18, Unitech Limited and Wockhardt Ltd. The Japanese CMBS sector saw 16 downgrades (30%) during the same period, seven of which were related to the ongoing replacement procedures in one transaction for the advance provider in light of the bankruptcy of Lehman Brothers Group. The remainder reflected Fitch's concerns regarding expected recovery amounts in light of the current illiquid Japanese real estate market, as well as the quality of the underlying property portfolios.

The remaining 10 downgrades were split between Australian and New Zealand CMBS and RMBS, plus two ABCP transactions from Australia and Thailand. All Fitch-rated tranches in Asia Pacific that are currently on watch negative are either from Japanese CMBS or Indian ABS transactions.

Negative outlooks were assigned to around 30 structured finance tranches in Asia Pacific during Q109, more or less evenly distributed between Australia, New Zealand and Japan. In Australia and New Zealand, negative outlooks are currently assigned to a mixture of small balance CMBS transactions due to loss expectations, as well as prime and non-conforming RMBS due to both performance concerns and the continued negative outlook on mortgage insurers.

Negative outlooks were also assigned to one Korean tranche and one Singaporean residential receiveables transaction during the quarter. The latter was subsequently affirmed and the outlook revised to stable in April 2009.

Upgrades were seen in one Korean RMBS transaction where three tranches from one transaction were upgraded following a significant build up in credit enhancement and asset performance within expectations. One Japanese RMBS tranche was upgraded for the same reason.

Ratings

CMBS downgrades increase, ABS more stable

Deteriorating performance in US and European CMBS led to significant negative rating action in the first quarter of this year. However, senior ABS ratings in particular have continued to exhibit stable performance, says Fitch in a new report.

"Despite the economic backdrop, core consumer and commercial US ABS sectors, including auto and credit cards, demonstrated resistance in Q109 to the severe economic contraction. Losses in credit card and auto loan sectors are expected to push higher following declines in housing and employment, but Fitch expects that the senior notes in auto and credit card ABS transactions will generally be able to withstand these losses," says Glenn Costello, risk officer for US structured finance at Fitch. "The exception was the student loan sector, which continued to experience negative rating activity as Fitch reviewed student loan transactions with auction rate exposure."

In Europe, ABS downgrades were largely restricted to Spanish consumer loan transactions. Meanwhile, US CMBS experienced a 37% quarter-on-quarter increase in negative rating actions, reflecting a sharp increase in commercial mortgage delinquencies to a historical high and declining property values. A significant decline in commercial property values across Europe led to a quarterly high for negative CMBS rating actions in the region.

"Continued weakness in the US economy has begun to impact later vintage CMBS transactions and the 2006 and 2007 vintages comprise 44% of the downgrades in the first quarter, where loans were originated as commercial property values peaked," Costello adds.

Delinquencies in US CMBS rose to 1.53% in April 2009 from 0.88% as of year-end 2008. Fitch expects US CMBS delinquencies to reach 3.5%-4% by the end of 2009. In the UK, the ongoing yield movement has resulted in average value declines of 30% to 40% for commercial property since peak valuations in 2007, according to the rating agency.

CMBS is also experiencing stress in Japan and Japanese CMBS formed the vast majority of the negative rating actions in the Asia Pacific region during the first quarter. The rating actions reflected Fitch's concern regarding expected recovery amounts in light of the current illiquid Japanese real estate market and sharp decline in Japanese commercial property values, as well as the quality of the underlying property portfolios. Transactions originated by Lehman Brothers also saw downgrade actions due to the continuing failure to replace Lehman as advance provider in a number of transactions.

Ratings

LBSF-guaranteed CDOs downgraded

Moody's has downgraded or removed from review for possible downgrade its ratings of certain synthetic CDOs backed by a CDS referencing a pool of corporate debt. Lehman Brothers Special Financing (LBSF), whose obligations are guaranteed by Lehman Brothers Holdings Inc (LBHI), acts as a CDS counterparty in these CDOs. The initial collateral securing the obligation to make payments with respect to the notes in all these transactions is the shares of the Lehman Brothers ABS Enhanced Libor Fund.

The Fund is invested in a portfolio of ABS that were initially rated Aaa. Moody's placed under review most of the tranches of these CDOs in May 2008 when the Fund's performance started to deteriorate.

Moody's explains that following the bankruptcy of LBHI, an event of default under the CDS in the CDOs occurred and subsequently a notice of designation of an early termination date was released. Following an acceleration of the notes, the Fund's portfolio may be liquidated. The proceeds of such liquidation may not be sufficient to repay in full the amount due under the notes, however.

Moody's took rating actions on the tranches of these CDOS in September 2008. But following a downgrade of the fund rating and the market risk rating of the Fund in November 2008, Moody's took another series of rating actions on the tranches of these CDOs.

Based on further information received, the agency understands that LBSFI's counsel in bankruptcy challenged the designation of the early termination date of the CDS. The case is pending a decision by the bankruptcy court.

In the meantime, the CDS are not terminated, preventing the deals to be accelerated and the repayment of the CDOs' liabilities to be made. The defaulting CDS protection buyer is no longer paying premium and the protection against credit events provided by the CDOs are not deemed effective.

Finally, Moody's downgraded the fund rating and the market risk rating of the Fund on 31 March 2009 to Ca/MR5 from A/MR5, following the decision by the Fund's trustee - in consultation with the Fund's manager - to suspend subscriptions and redemptions. Shareholders have been notified of its intention to liquidate the ABS portfolio in an orderly manner.

In two CDOs - Airlie CDO I and Airlie LCDO II (Pebble CREEK 2007-1) - the Fund's shares that serve as collateral for the secured creditors of these CDOs have been redeemed. The proceeds were reinvested in Milestone Offshore Funds Daily Dollar Portfolio, a money market fund currently rated Aaa/MR1+.

The rating actions are primarily driven by the last events and the consideration of increased expected loss attributable to the notes as a result of the potential liquidation of the Fund and the Money Market Fund and, in the case of Aaa and Aa rated tranches that are generally not interest-deferrable, the missed payment or increased likelihood of a missed payment of interest (or commitment fee).

Real Estate

US CRE CDO delinquencies could exceed 15%

Over 20 newly-delinquent assets led to an increase in US CRE CDO delinquencies to 7.8% for April 2009, up from 6.5% in March 2009, according to the latest CRE CDO delinquency index (CREL DI) from Fitch. Fitch currently rates 35 CRE CDOs encompassing approximately 1,100 loans and 370 rated securities/assets with a balance of US$23.8bn.

The CREL DI has now surpassed 7%, with over 75% of all Fitch rated CRE CDOs containing at least one delinquent loan. "At this rate of increase, the delinquencies for CREL CDOs are likely to exceed 15% by the end of this year," says Fitch senior director Karen Trebach. Individual CDO delinquency rates ranged from 0% to approximately 24% of the CDO par balance in the April reporting period.

CRE CDO asset managers continue to trade impaired assets out of CDOs at a discount, including at least eleven credit-impaired interests from seven different CDOs. Ten of these assets were sold at prices ranging from 2% to 50% of par, while one mezzanine loan was written off as a total loss.

Three of these assets were included in last month's CREL DI. Fitch considers all losses to par in its evaluation of the credit enhancement available for each CDO tranche.

Meanwhile, 29 loans, including one matured balloon, were extended in the April reporting period. Many of these were short-term extensions to allow time to negotiate longer-term extensions, or pursue refinancing, which in most cases Fitch expects will be unobtainable.

While whole loans and A-notes comprise the highest percentage of asset type in the CREL DI at 73%, mezzanine debt is the next highest at 13.1%, up from 8% in March 2009. Due to the unsecured nature of mezzanine debt and generally high leverage on these positions, Fitch assumes little to no recoveries in its analysis of these delinquencies.

Loans backed by interests in land represent the highest percentage of assets in the CREL DI at approximately 27.7%. The next highest percentage is multifamily at 23.1%.

The CREL DI includes loans that are 60 days or longer delinquent, matured balloon loans and the current month's repurchased assets.

Regulation

OTC reform proposal unveiled

US Treasury Secretary Tim Geithner has released details of the Administration's proposed comprehensive regulatory framework for all OTC derivatives (see also separate News Analysis). The Administration will now work with Congress to implement this framework and bring greater transparency to these markets. It will also continue working with foreign authorities to promote the implementation of similar measures around the world.

The objectives of the reform are to: prevent activities within the OTC markets from posing risk to the financial system; promote efficiency and transparency within the OTC markets; prevent market manipulation, fraud and other market abuses; ensure that OTC derivatives aren't marketed inappropriately to unsophisticated parties.

"This proposal is an important step toward much-needed reform of financial industry regulation," comments Robert Pickel, executive director and ceo, ISDA. "ISDA welcomes the recognition of industry measures to safeguard smooth functioning of privately negotiated derivatives and looks forward to working with policymakers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools."

In terms of preventing activities within the OTC markets from posing risk to the financial system, the proposed framework stipulates that regulators must have the following authority to ensure that participants do not engage in practices that put the financial system at risk:

• The Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardised OTC derivatives through regulated central counterparties (CCPs)
• CCPs must impose robust margin requirements and other necessary risk controls and ensure that customised OTC derivatives are not used solely as a means to avoid using a CCP
• All OTC derivatives dealers and all other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation, which will include: conservative capital requirements; business conduct standards; reporting requirements; and initial margin requirements with respect to bilateral credit exposures on both standardised and customised contracts.

In terms of promoting efficiency and transparency within the OTC markets, regulators should have comprehensive and timely information about the positions of each and every participant in all OTC derivatives markets. Consequently, the new framework amends the CEA and securities laws to authorise the CFTC and the SEC to impose:

• Recordkeeping and reporting requirements (including audit trails)
• Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository
• CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public
• CCPs and trade repositories must make data on individual counterparties' trades and positions available to federal regulators
• The movement of standardised trades onto regulated exchanges and regulated transparent electronic trade execution systems
• The development of a system for the timely reporting of trades and prompt dissemination of prices and other trade information
• The encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives.

In terms of preventing market manipulation, fraud and other market abuses, the CEA and securities laws should be amended to ensure that the CFTC and the SEC have:

• Clear and unimpeded authority for market regulators to police fraud, market manipulation and other market abuses
• Authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to futures markets
• A complete picture of market information from CCPs, trade repositories and market participants to provide to market regulators.

Finally, with respect to ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties, the CFTC and SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.

Regulation

Loan mod effectiveness analysed

Analysts at Wachovia Capital Markets examine in a new report loan modifications, borrower credit trends thereafter and their potential effectiveness. Of the asset pool analysed, deals that had modified loans averaged 9% of the total amount. The maximum amount of modified loans in any one deal was calculated to be 49%.

In aggregate, however, these modified loans seem to have only a limited impact on deal performance, the Wachovia ABS analysts note. Historically, many borrowers have become delinquent or redefault, despite changes to their loan.

Four different types of loan modifications are identified in the study: rate reduction, principal balance reduction, capitalised delinquent balance and rate freeze. Rate reductions make up 60% of the total, and these modifications seem to perform best for borrowers.

Risk scores for each type are also calculated based on default rates. The report shows that cumulative default rates are at least 40% lower for rate reductions than in the other modification types.

According to a global survey of 334 financial services executives, only a third think the principles of risk management in financial services remain sound and are confident that policy-makers can formulate an effective response to the current economic crisis.

Regulation

Focus on interaction of market and credit risk

The Basel Committee on Banking Supervision has issued a working paper entitled 'Findings on the interaction of market and credit risk', which summarises the findings of the Interaction of Market and Credit Risk (IMCR) working group under the Committee's Research Task Force.

The distinction between market and credit risk has been blurred by the development of credit risk transfer markets and the broad move to mark-to-market accounting for a wide variety of financial instruments, the Committee says. This has raised questions regarding approaches that treat the two types of risks separately. The financial crisis has illustrated how the two risks may reinforce each other and that in such stress situations illiquidity can exacerbate losses.

From a supervisory perspective, these developments raise important questions related to how the two types of risks can be defined and what relationships exist between them, how they should be aggregated and how precisely their joint risk is measured, what role liquidity plays in their interaction and under what conditions securitisation - as one driver of the above developments - can work as a risk management approach.

Work undertaken by members of the IMCR group illustrates that widespread mis-pricing and distorted investments can occur if the incentives of underwriting banks and investors are improperly aligned. As a consequence, the markets for risk sharing and funding can become illiquid, exposing banks to significant risks. Insufficient knowledge about pricing parameters, such as credit correlations, further increase the risks associated with risk management strategies that rely on securitisation, the report concludes.

RMBS

UK non-conforming RMBS deterioration continues

Fitch says the performance of UK non-conforming RMBS continues to deteriorate, with higher loss levels being the key driver behind negative rating action on these deals. "The recession in the UK has resulted in falling house prices and growing unemployment, both of which have a direct effect on RMBS through loss severity levels and affordability. These are considered to be the two main drivers of worsening performance in UK non-conforming transactions," Fitch says.

In Q109, Fitch observed a significant increase in loans in arrears for more than three months. Along with affordability and unemployment, the drop in interest rates has been a driver by artificially increasing the reported arrears level due to the calculation method used by servicers. "A continued increase in repossessions activity, in combination with declining house prices, is driving up both the volume of realised losses and the loss severity," says Fitch.

"Prepayment rates continue to decline due to a lack of refinancing opportunities. This is limiting credit enhancement growth that could provide more protection," it adds.

RMBS

Irish RMBS delinquencies on the rise

Irish RMBS delinquencies increased in Q109, while prepayments declined, says Moody's in its latest index report for the sector. In the context of Ireland falling into a recession with no signs of early recovery, performance is likely to deteriorate further in the coming quarters.

In the report, Moody's says that the weighted average 90+ days delinquency trend (as the percentage of the current balance) reached 1.7% in Irish prime RMBS transactions in Q109, up from 1% in Q108. At the same time, the weighted average total redemption rate (TRR) fell from 13.4% in Q108 to 5.8% in Q109, the lowest level observed in this decade in Ireland.

"The decline in the total redemption rate is indicative of the tight credit conditions and weak economic expectations," says Georgij Ludmirskij, a Moody's senior associate and co-author of the report. "Some lagging indicators have not shown any substantial movement yet. Only one loan has been repossessed in an Irish Prime transaction. In addition, the weighted average 360+ days delinquency trend remained low at 0.3% of the current balance, albeit rising from 0.1% one year ago. Further deterioration should be expected as a result of rising unemployment and house price depreciation."

The rating agency notes that although prior strong house price growth has left equity cushions for mortgages originated a few years ago, the pace and the impact of the economic slowdown have been exceeding forecasts during the course of the past year. Thus the available equity cushions are shrinking, while the risk of borrowers becoming unemployed increases.

"The Irish economy is in a deep recession. GDP contracted by 7.4% year-on-year in 2008, and is expected to shrink by 8.4% in 2009 and 4.5% in 2010," says Nitesh Shah, a Moody's economist and co-author of the report.

Ireland's Aaa long-term government bond rating is on review for possible downgrade, reflecting the severe economic adjustment taking place in Ireland, which threatens to undermine the country's low tax, financial services-driven economic model. "A painful de-leveraging process will have to be endured as households reduce indebtedness in the new environment. This will continue to stifle growth in the medium term," Shah concludes.

Technology

Risk management reform to be far-reaching

The Economist Intelligence Unit undertook a survey in March focused on enterprise risk management strategies on behalf of business analytics software services provider SAS. The results indicate that risk management reform within institutions will be far-reaching. More than half of survey respondents say that they have conducted, or plan to conduct, a thorough overhaul of their risk management, including improvements to data quality and availability, strengthening risk governance, moving towards a firm-wide approach to risk and integration of risk within lines of business.

Tower Group senior research director Virginia Garcia says: "Although technology is not to blame for the financial crisis, rigid technology and business processes have undoubtedly made it difficult for many FSIs (financial services institutions) to respond effectively to the financial crisis. This situation reinforces the business case for a more agile and intelligent enterprise architecture to mitigate risk by helping FSIs adjust to volatile business dynamics."

Even though less than one-third of respondents felt regulators handled the financial crisis properly, respondents agreed that transparency needs to be heavily emphasised within proposed reforms. They pointed to greater disclosure of off-balance sheet vehicles, stronger regulation of credit rating agencies and central clearing for OTC derivatives as initiatives thought to be most beneficial to the financial services industry.

Survey respondents identified poor data quality, lack of expertise and a lack of risk culture among the broader business as barriers to improving risk management in their organisation. Data governance also continues to be a fundamental issue for risk management initiatives. Only 40% of respondents say that the importance of risk management is understood throughout their company, suggesting that more needs to be done to embed a culture of risk management in financial institutions.

Trading

Trading ideas: fill the tank

Dave Klein, senior research analyst at Credit Derivatives Research, looks at an equity outperform trade on Marathon Oil

Marathon Oil made our list of top equity long recommendations last week, primarily on the strength of our medium-term outlook for the company. Since then, the company's stock underperformed and presents an even better opportunity. With our short-term view of Marathon fair value also indicating an equity rally, we believe now is an excellent time to take a beta-hedged long position in the company's stock.

Our CSA model provides us with a short-term view on the relative value of a company's CDS compared to its equity and implied vol. Longer term, we believe the two securities will revert back to their classic inverted relationship (CDS widens/equity drops, CDS tightens/equity improves). That is, credit and equity improve and deteriorate together over the medium to long term.

Exhibit 1 charts market and fair value equity levels for Marathon. Additionally, we forecast an equity time series by combining our CSA and directional credit fair values.

Exhibit 1

Our CSA model points to equity trading too cheap and CDS trading too tight. Our directional credit model points to medium-term improvement in Marathon's CDS levels based on its leverage, accruals, equity-implied default probability and implied vol.

Credit improvement should also result in equity improvement. With our short-term and medium-term outlook for Marathon equity in agreement, we believe the best opportunity for the name is to go long equity with a beta hedge.

Exhibit 2 charts Marathon's five-year CDS against its equity. The red line indicates the fair value curve for five-year CDS given equity price.

Exhibit 2

The blue squares indicate historical market levels. The green circle shows the current market level and the red square indicates our expected levels in three months.

The yellow circle shows the current fair value levels when implied vol is also considered. Given that the current market levels are below the red line, we expect a combination of share rise and CDS widening to bring Marathon back to fair.

Our model-implied three-month fair value for Marathon shares is US$40. This is a bit too aggressive as a target, given Marathon's short-term fair value, but an equity target in the mid-30s is reasonable.

Since we recommend going long against a short SPY hedge, we would not place a specific stop on the trade. We will look to exit the trade when one of two events occurs.

First, we will exit if Marathon reverts to fair value and we no longer see further profit potential. Second, if Marathon continues to trade too cheap according to our model, then we must assume that the company is trading under a new CDS/equity/vol relationship and the trade will be reevaluated for potential exit. Overall, we view this as a short to medium-term trade.

Buy 10,000 shares Marathon Oil at US$28.64.

Sell 4,000 shares SPDR Trust Series 1 at 88.89.

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).