Contents

ABS

Consolidation call

Protectionism and political risk threaten Euro ABS recovery

The recovery of the European ABS sector visibly lags that of the US, as signified by the disparity in public issuance and in the fast-paced tightening of benchmark spreads. A growing number of market participants believe that an approach similar to the US' TALF and PPIP programmes is necessary for the re-opening of the European primary market - with issues over political risk and protectionism hindering any progress.

Numerous programmes have been set up across Europe in the form of country- or bank-specific 'bad banks' or SPVs, asset protection schemes and government guarantees for triple-A rated ABS paper (SCI passim). However, the failure to consolidate such programmes could ultimately be detrimental to the revival of European ABS.

"Political risk and protectionism is delaying recovery in the European ABS markets," says Douglas Long, evp business strategy at structured finance software firm Principia. "Until there is greater clarity and more unity across the European initiatives, investors will be wary of making a wholesale return."

He continues: "Industry bodies like the ESF have helped overcome some of these issues, with recommendations for standard RMBS issuer reports across Europe, for example. This is now a requirement in the UK asset guarantee scheme and demonstrates how a more unified approach can help build investor confidence."

According to one UK-based ABS investor, preliminary discussions concerning the debut UK government-guaranteed RMBS issues are underway, with the first deals likely to come to market after the ESF-IMN Global ABS conference next week. But, at the same time, issues over price discovery and the availability of funds for investors remain problematic.

Long says that while the UK guarantee system for RMBS is great in principle, in reality it only addresses one aspect of the problem. "The inability to raise cash to purchase these assets in the first place still remains. US investors are being offered leverage to do this. In Europe, countries have adopted individual programmes to support local ABS and MBS markets, but a more consolidated approach is needed to encourage the European securitisation market as a whole."

According to Conor O'Toole of Deutsche Bank Research, the European market continues to face the twin challenges of a lack of substantial depth in bid-side liquidity and an unwillingness to sell down at distressed levels. "Indeed it could be argued that the absence of government-provided leverage via a TALF/PPIP-like programme is inhibiting a more orderly US-style asset unwind - one where buyers' return hurdles can more easily be matched with acceptable seller write-downs," he says.

After a cautious start, TALF appears to be gaining momentum and is driving continued tightening across asset classes and increased investor appetite down the capital structure, as investors seek greater yields. For example, US auto ABS issuance volume in May stands at US$15.9bn, according to Glenn Schultz, md and head of ABS and mortgage research at Wachovia Capital Markets.

While this figure is less than the US$27.7bn seen for the same period in 2008, it is a substantial increase from Q208 when the credit crunch took hold and issuance fell to only US$6bn, he notes. It is also US$15.9bn more auto ABS issuance than that seen in the public European ABS market during the same period.

"Many regular issuers have returned to the ABS market, though these have mainly been lenders to prime borrowers," Schultz adds. However, he concludes that companies that primarily service subprime borrowers have still not accessed the market, even with the support of TALF.

AC

CMBS

Turning point?

Inclusion of legacy CMBS in TALF boosts market

The US Administration's u-turn last week on the inclusion of legacy CMBS bonds in TALF has been warmly welcomed by the industry. CMBS spreads have continued their rapid tightening - by around 75bp over the week - with further tightening expected. It is believed that this latest move by the US Fed will instill confidence in the CMBS market and put it on the path to recovery.

"The affirmation of the higher-ranking priority of the senior debt in the SPE in the GGP ruling, together with the acceptance of legacy CMBS under TALF [see last week's issue] are the first two steps that have real material bearing on the CMBS market," says Adam Margolin, managing partner of Structured Finance Solutions. "I believe they mark the beginning of the recovery in the CMBS market."

He adds: "There has been a dysfunctional psychology in the capital markets regarding CMBS over the past eighteen months or so, but I believe these two recent events have not only validated the structure, but provided a rational starting point to regain market liquidity. Given that the TALF will accept super-senior classes suggests that the Administration is on the correct path to re-establish confidence and liquidity in the most senior CMBS tranches. It will be interesting to watch if the TALF administrators add the credit support triple-A classes, AM and AJ, to the programme."

While the decision by the US Fed to include legacy CMBS bonds did not come as a complete surprise to the market (see SCI issue 135), there are still several points that need clarification. For example, it is not immediately clear how legacy CMBS will be valued on the date on which the TALF loan is made, in order to determine the amount of the TALF loan.

According to lawyers at Schulte Roth & Zabel, the Fed may choose to use an outside valuation agent to review each CMBS proposed as collateral. The Fed will also require that the CMBS have been sold in a recent secondary market transaction between unaffiliated parties on arms' length terms.

The Fed is also considering whether to limit the volume of TALF loans secured by legacy CMBS and, if so, whether to allocate that volume via an auction or other procedure. In a client note, partners at Cadwalader say that the form any such auction would take is unknown. However, they point out that the New York Fed utilises a Dutch auction format in selling US Treasury Bills.

"A Dutch auction format for TALF loans might require prospective borrowers to bid on the interest rate they are willing to pay for a particular principal amount of TALF loans, with the prospective borrowers who are willing to pay the highest margin over the corresponding Libor swap rate winning the auction," they suggest. "This format would be inconsistent, however, with the published interest rates in the release."

One of the main issues that the CMBS market needs to work out before it can truly get back on track, however, is what constitutes a triple-A rated bond - in terms of credit quality, credit enhancement and also pricing. According to Margolin, the problem over the past year has been that nobody could determine the price in the secondary market for triple-A tranches.

"Until you know what that is, the market can't restart. TALF has provided that direction," he says.

"The challenges faced by the CMBS market are very real," Margolin concludes. "But we're now seeing the beginnings of a rational recovery. I don't believe the CMBS market will have a linear recovery. Collateral performance will remain the primary concern. But, given the historically robust structure in CMBS, collateral concerns are manageable. In order for the market to fully reboot, however, investors need to have confidence that the market has corrected its mistakes."

AC

Operations

CDS auctions 'served their purpose'

A new Federal Reserve Bank of New York staff report examines all of the CDS auctions conducted to date and evaluates their efficacy by comparing the auction outcomes to prices of the underlying bonds in the secondary market. Based on auction results for 43 credit events since 2005, the research finds that the auctions generally served their purpose, as they appear to have allowed participants to settle their positions efficiently, with high participation and low levels of open interest.

The report notes that one piece of evidence of the auctions' success comes from a survey of auction participants by the G7 Senior Supervisors Group. Respondents to this survey indicated satisfaction with the auctions' mechanism.

Participation in the auctions was high, according to the survey, representing 95% of eligible parties. Those few who chose to settle outside the auctions process did so either because they wanted to close out positions earlier or because they had too small a number of affected CDS trades to invest resources in participation. The majority of participants elected to cash-settle.

The research goes on to explore whether the auctions establish a fair recovery price for the underlying debt. The authors say they interpret negative open interest in the first round as indicative of an excess supply of bonds that should tend to make the final price lower than the initial (first-stage) price. Conversely, a positive open interest should result in a final recovery price higher than the initial estimate.

"This appears to have been the case: the correlation between the open interest and the difference between the final and initial prices is 0.29 for senior bond auctions and 0.71 for loan auctions. Thus the first stage process played an informative role in determining the final recovery price," they explain.

But the authors point out that in situations of extreme uncertainty the two-stage process may lead to strange results in the second stage, mainly if the participants revise their initial beliefs strongly. An example is the Fannie Mae auction, where the demand for Fannie subordinated debt in the first stage was strong, as indicated by the positive open interest of more than US$6bn. This resulted in the final recovery rate of Fannie's secondary debt being more than 4% higher than initial estimates; so high, in fact, that the resulting recovery rate of the subordinated debt was, perversely, higher than that of Fannie senior debt (SCI passim).

In contrast to Fannie, the volume of open interest has been moderate for a majority of the auctions so far, resulting in final recoveries being close to initial estimates. The final minus initial recovery estimates has averaged -2% for the entire sample of senior bond auctions, following corporate bankruptcies, according to the report.

"We find that implied recoveries from CDS auctions and recoveries implicit in bond market transaction prices are generally close. The bond price either the day before the auction or the day of the auction is essentially the same as the final recovery price in the CDS auction," it continues.

Moreover, the bond price on the day of default is shown to be a fairly accurate predictor of the CDS auction price, with the important exceptions of Lehman Brothers and Washington Mutual. The authors conclude that these results suggest that effective price discovery occurred in the bond market.

CS

Regulation

ISDA, SIFMA slam NCOIL proposal

SIFMA and ISDA have commented on the National Conference of Insurance Legislators (NCOIL)'s proposed model legislation to regulate CDS under provisions patterned on New York's current regulation of financial guaranty insurance. In a letter to NCOIL the two associations write that, while they appreciate NCOIL's concern about the regulation of financial products, they believe NCOIL's proposal - if enacted into law by one or more states in its present form - would adversely affect commercial, industrial and other companies that benefit from CDS, as well as banks and other financial firms that act as CDS dealers, and might cause financial institutions to move their CDS businesses out of state or offshore.

In addition, the associations point out that the promulgation of the model legislation threatens to undermine the Obama Administration's new approach to the regulation of OTC derivatives. The letter notes that Treasury's proposal addresses the concerns raised by NCOIL and also provides a framework for effective use of CDS.

"In contrast, the NCOIL model legislation risks effectively eliminating the domestic CDS market or, at best, creating a patchwork of legislation with state-based variations. These competing approaches to derivatives regulation could well lead to regulatory turf battles at a time when cooperation between state and federal regulators is essential," the letter explains.

ISDA and SIFMA say that they also question the wisdom of replacing a market where CDS are actively traded with a non-transparent, illiquid market limited to insurance companies as sellers of protection. "These insurance companies could amass large CDS positions, which would not be marked to market," the letter continues. "They would not post collateral to their counterparties, and a decline in their CDS positions would likely be highly correlated with declines in their investment portfolios."

Moreover, given the market's adverse experience with this model in purchasing CDS from the monolines, the two associations believe it unlikely that market participants will be willing to purchase protection from these newly created insurers.

SIFMA and ISDA also stress that they disagree with a fundamental premise of the NCOIL model legislation, specifically that credit default swaps constitute insurance. Whereas insurance requires an insurable interest, they explain, CDS are often purchased by protection buyers that are not hedging a specific underlying risk. Insurance contracts generally are also purchased and held by the buyer, whereas CDS are frequently bought and sold.

And finally, insurance contracts only pay out when the insured party actually incurs a loss. But CDS provide for payments to protection buyers upon the occurrence of a credit event, which frequently occurs before any loss is incurred.

"SIFMA and ISDA agree it is important to bring increased regulatory oversight to the CDS market to reduce systemic risk in the financial system and increase transparency and liquidity of the markets," the letter concludes. "But applying the capital regimes, concentration limits and the other specific requirements borrowed from the New York financial guaranty insurance law would create regulatory ambiguity and inconsistency with respect to other state and federal regulatory regimes, such as banking regulation, already applicable to CDS providers. Broadly drafted legislation such as this also might have unintended consequences, such as applying to financial instruments or transactions that were not meant to be captured."

CS

RMBS

Freddie offers new multifamily programme

Freddie Mac has launched the Series K-003 Structured Pass-Through Certificates - multifamily MBS that provide a new vehicle for the company to provide liquidity, stability and affordability to the US multifamily housing market. The K Certificates - which are backed by approximately US$1bn in multifamily mortgage loans originated through Freddie Mac's capital markets execution (CME) programme - will be offered to the market by a network of dealers led by Deutsche Bank Securities.

The certificates, which are expected to settle in June 2009, are backed by 62 recently originated multifamily mortgages and are guaranteed by Freddie Mac. Traditionally, multifamily loans have been held solely in Freddie Mac's mortgage-related investments portfolio. But the certificates provide Freddie Mac with a new vehicle to securitise those loans and offer structured guaranteed securities to the market tailored to meet investors' needs.

"Freddie Mac is responding to difficult conditions in the multifamily housing financing market by finding innovative ways to link affordable rental housing to the capital markets," explains Mike May, Freddie Mac svp of multifamily. "By offering multifamily loan securitisation through our K Certificates, we're providing critically needed support to the multifamily housing market during these difficult economic times."

David Brickman, vp of multifamily and CMBS capital markets for Freddie Mac, adds that K Certificates provide the market with a new investment option fuelled by the GSE's growing pipeline of multifamily CME product. "K Certificates offer a simple and transparent structure for investors," he says. "The securities offer investors credit protection in the form of both Freddie Mac's guarantee and principal subordination, and they are structured to provide stable, reliable cashflows due to the large, diversified pool of call-protected multifamily mortgages underlying the certificates. And most important of all, our K Certificates provide another way for Freddie Mac to provide liquidity to the multifamily housing finance market."

CS

Investors

Seeking beta

Scott Johnston, managing partner, and Simina Farcasiu, partner at Belstar Group answer SCI's questions

Scott Johnston

Q: How and when did Belstar Group become involved in the structured credit market?
SJ: Belstar was founded in 2005 with a unique perspective: we believe that diversification is paramount in risk management and so we didn't want to offer cookie-cutter products. Our business has evolved into four different product lines: TALF credit funds; a fund that invests in hard assets, such as timberland; a fund of funds (FoF) on Société Générale's Lyxor platform, around which principal protected notes are structured; and a fund of hedge funds.

The fund of funds was developed specifically to correct what we saw as major inefficiencies in the fund of fund industry. It employs a reduced fee structure, it focuses on smaller hedge funds - which tend to have a statistical advantage worth around 300bp-400bp over larger hedge funds - and captures alternative sources of beta, such as insurance exposure in property/casualty and diversified life, special purpose acquisition companies and short-term asset-based lending. We take a sceptical view of pure arbitrage strategies.

The idea is to identify 'frontier beta', which relies less on manager expertise than on the structure of the investment idea itself. We prefer to have alpha as a bonus on top of a unique beta source.

Many tail risks have become aligned over the last few years, but we're still looking for tail risks that aren't. If you don't do that, we think it's impossible to identify where the correlation risks come from.

The Lyxor platform enables a near-infinite variety of note structures around a fund of funds serving as the engine; for example, a five- or seven-year double-A rated note where the coupon is driven by the return of the underlying FoF portfolio. It's been shown to be a good way for investors to access decent returns - the portfolio lost only 3% last year and, as of this interview, we're up 1.5%.

The platform also offers investors weekly liquidity and the risk control/capital preservation aspects are transparent. We've seen an up-tick in calls coming in about it recently.

Simina Farcasiu

Q: What, in your opinion, has been the most significant development in the fund of funds area in recent years?
SJ: The larger fund of funds typically buy big-name hedge funds, but the liquidity crisis demonstrated that 'size equals safety' isn't always true. In addition, large size acts as a constraint because it means that potentially interesting exposures, ones that are often the province of smaller funds, are often missed. These exposures are often hard to characterise as well, which confounds box-checking consultants.

Q: How has this affected your business?
SJ: The last six to eight months have validated what we've been a proponent of all along. The market has been presented with a unique opportunity to strip everything down and re-evaluate the lazy assumptions of the last cycle.

Q: What are your key areas of focus today?
SF: We launched two new funds in April - the Belstar Credit Fund and the Belstar Altair Credit Fund - with the aim of participating in the ongoing TALF funding rounds [see SCI issue 133]. There are significantly positive policy aspects associated with the TALF programme.

TALF recognises the importance of securitisation technology. The essence of the capital markets is to aggregate and redistribute risk and reduce the costs of intermediation.

The beauty of securitisation is that it enables different risks to be distributed across different appetites through the use of senior and subordinated tranches. In a well-structured securitisation, senior tranches get paid for providing liquidity and subordinated tranches get paid for taking credit risk. But to work properly there has to be a diverse and understandable set of risks backing the bonds, as well as a way for investors and their agents to understand the correlation of the underlying portfolios.

To take a negative example, securitisation technology became perverted by applying it to non-diversifiable asset classes (namely, subordinated tranches of subprime mortgage pools) and the misperception of risk ended up damaging an entire class of investors. Investors did not understand that those particular pools were essentially 100% correlated, and hence that those senior tranches were not protected by risk diversification.

The TALF programme targets traditional ABS structures, which are based on diversifiable risk. These ABS classes offer liquidity alpha to capital providers.

The current TALF opportunities derive from policymakers' attempts to attract capital to senior tranches of diversifiable asset pools. Providers of senior capital are supposed to get paid primarily for taking liquidity risk rather than credit risks. This class of investors is essential to the operation of modern capital markets.

The programme does seem to be working and is helping to unfreeze credit markets. In this respect, we're seeing the beginning of a virtuous cycle.

Attractive returns for providing liquidity will continue for a while, but opportunities will shift as spreads begin tightening and the market's attention will move from one asset class to another as the TALF dollars are redeployed to other liquidity bottlenecks. Consequently, it is necessary to have an approach that is broadly flexible from a top-down perspective, yet specifically analytical from a bottom-up perspective.

Our new TALF-enabled funds are traditional hedge fund structures but corrected to have longer lock-ups and lower fees. Both funds have broadly similar objectives: the critical factor is to be flexible and responsive to the sources of capital that fit the character of the alpha opportunity.

One such important source of capital is investors with high savings rates and comparatively high risk aversion, and whose profile suits them to acting as short-term liquidity providers. Such investors were spooked by the events of the last two years, but are now being gradually attracted back into certain asset classes.

Q: What is your strategy going forward?
SJ: As a boutique, we can come to market with flexibility and speed. When we began, credit didn't hold much interest for us - there was too much complexity risk relative to the available returns. This changed quite rapidly and we have been able to respond.

Transparency is vital and ultimately helps us to be nimble. But generally we'll always be adaptive to what's going on in the market - we've created a platform that can bring new and creative products online swiftly.

SF: We have expanded our core team of experienced individuals, as we identify partners with a common vision and complementary skill-sets to address a broader set of opportunities.

Q: What major developments do you need/expect from the market in the future?
SJ: The next few years will be a great time to be in the alternatives area. Volatility is high, which is highly advantageous.

In volatile environments people inevitably make sub-optimal decisions driven by emotion rather than objectivity. This is a gift to the hedge fund industry.

Borrowing costs are low, which helps, even though leverage levels will be far lower. But, most importantly, much of the competition has been vaporised, particularly if you take into account bank prop desks.

As a result, I expect certain hedge funds to enjoy at least two or three years where they make returns of around 20%, while stocks - for example - continue to go sideways.

SF: However, the market eventually needs to see a reduction in uncertainty if it is to get back on track. Hedge fund alpha is coming at the cost of market beta in a high-uncertainty environment.

About Belstar Group
Belstar Group is a private investment firm providing alternative and real asset investment vehicles to financial institutions and high net-worth individuals globally. The firm's investment strategies seek to maximise returns by leveraging its seasoned management team's knowledge, experience and industry relationships. Founded in 2005 by ceo Daniel Yun, Belstar Group has offices in New York, Dallas, Thailand and South Korea.

CS

ABS

Portfolio manager moves to advisory role

Krishna Prasad is believed to be joining BlackRock, where he will work in the financial markets advisory group, a team headed up by Craig Phillips, former global head of the securitised products group at Morgan Stanley. Prasad, who headed up securitised products research at Lehman Brothers before moving to PIMCO as senior ABS portfolio manager a year ago, will work on the European side of the BlackRock advisory group, according to sources.

ABS

Rescue fund prepped

SRA Management, an affiliate of Stamford Restructuring Advisors (SRA), is in the process of creating investment funds that it says will assist in the thawing of the credit markets. In particular, it is prepping a vehicle dubbed America's Triple-A Rescue Securities (ATARS) Fund that will participate in borrowings from the TALF programme and acquire newly issued AAA/Aaa rated ABS. SRA believes this is a unique opportunity in the US structured finance market for the ATARS Fund and other higher risk/higher return funds that will be arranged by SRA Management to "significantly jump-start" the economy while delivering strong returns to investors.

CDS

Misra heads to UBS

Rajeev Misra is understood to be joining UBS as head of its global credit business. Misra was global head of credit and commodities at Deutsche Bank, before leaving in June 2008 to establish a credit opportunity fund called Clarent Capital Management.

CDS

HSBC approved as ICE clearing member

HSBC Bank USA has been approved as a clearing member by the board of ICE Trust. HSBC, the twelfth clearing member to sign up to the CCP, became operational with ICE Trust as of 25 May.

For the week ended 22 May, ICE Trust cleared US$60bn in notional value of CDX indexes. Since launch, the clearer says it has cleared 7,478 transactions, totalling US$646bn of notional value and resulting in open interest of US$106bn.

CLO Managers

New manager takes on distressed CDOs

Dock Street Capital Management (DSCM), a newly-formed asset manager specialising in distressed CDO management and other advisory services related to the structured credit market, is being tipped as replacement CDO manager for Robeco High Grade CDO 1. The asset manager is also in the process of being assigned two further distressed CDOs with an aggregate balance of US$2.195bn.

DSCM's staff members were formerly part of KBC Structured Investment Management (KBC SIM), a wholly owned subsidiary of KBC Financial Products (KBC FP). DSCM has, for the most part, retained its previous systems and analytic tools and organisational structure, with experience in transaction structuring, asset valuation, cashflow analysis, documentation and credit analysis. While at KBC FP the team was the core part of a group that managed a structured credit asset portfolio of over US$13bn.

DSCM also serves as a liquidation agent for trustees and other parties liquidating CDOs and portfolios of structured credit assets, and advises large institutional clients on disposition and remediation strategies.

Fitch has reviewed Dock Street Capital Management (DSCM) as a potential CDO replacement asset manager for Robeco High Grade CDO I and determined that the manager's capabilities are consistent with the current ratings assigned to the transaction.

Robeco High Grade CDO I is a high grade cashflow CDO that closed in June 2007. The collateral portfolio consists of approximately 43.6% US subprime RMBS, 32.3% US prime RMBS and 24.1% US structured finance CDOs, as of the trustee report dated 1 May 2009.

The asset manager maintains the ability to sell defaulted or otherwise distressed securities, along with credit-improved securities at any time. In addition, the asset manager may perform discretionary sales up to 15% per annum and reinvest amortisation and credit risk sale proceeds from fixed rate collateral through to July 2015.

Technology

Valuations firm hires for structured credit push

Prime Source, the independent valuation service launched by NYSE Euronext last year, has hired Arvind Balakrishnan as part of its drive to ramp up specialist structured credit valuations.

Balakrishnan, who takes on the role of senior products specialist in the structured credit group at Prime Source, has six years' experience in the industry. Most recently he was a structurer in the structured credit group at Citi, having previously worked as a credit structurer at ABN AMRO. He reports to Nicholas Stewart, head of structured credit products at Prime Source.

Technology

Alternative investment administrator expands

Butterfield Fulcrum, an independent administrator for the alternative investment industry, has opened a Chicago office to focus on client relationship management and US business development. Headquartered in Bermuda, Butterfield Fulcrum now has 11 offices in nine countries.

Jim Gabriele, previously of Caledonian Fund Services USA, will run the office and serve as md and head of strategy. He is joined by John Peterson, also previously of Caledonian Fund Services USA, who will serve as md of business development.

Trading

Credit trading head appointed

Standard Chartered Bank has appointed Brent Eastburg as its new global head of credit trading. Eastburg is based in Singapore and will report directly to Remy Klammers, global head of fixed income trading.

Eastburg is responsible for Standard Chartered's global credit trading operations, where he will lead and manage the credit trading team in executing the bank's business strategies. He will also support and develop collaborations between the credit trading business and the other business entities within Standard Chartered.

Eastburg joins Standard Chartered from Ravenscourt Capital Partners in London, where he was a managing partner, managing the credit hedge fund portfolio. Prior to that, he headed the trading team under the capital markets business at RBS.

Trading

Trading head exits

Greg Branch, head of ABS trading at Deutsche Bank, has left the bank. A spokesperson for Deutsche Bank declined to comment on the move. Mark Tanase, a European financials CDS trader at Deutsche Bank in London, is also understood to have left the firm.

ABS

Severe stress scenario expected for Spanish SME ABS

The real estate market downturn and its impact on unemployment, delinquencies and default rates mean that a severe stress scenario is materialising for Spanish SME ABS, says Moody's in its latest index report for the sector.

"The Spanish economic climate deteriorated further over Q109. The weakening real estate sector has already driven companies to bankruptcy, led to higher unemployment and lowered domestic demand in general," says Nitesh Shah, a Moody's economist and co-author of the report. "This has severe implications for the SME sector. To a large extent, it is responsible for the spike in delinquencies, which are now resulting in an increasing number of reserve fund draws."

Moody's says in the report that tough economic conditions will continue to adversely affect asset performance in Spanish SME ABS. The rating agency notes that an update in methodology or bad performance prompted 40 Spanish SME transactions to be placed on review for downgrade in Q109.

"All of the transactions from the 2006 and 2007 vintages have been placed on review for downgrade or have already been downgraded," says Ludovic Thebault, a Moody's senior associate and co-author of the report.

The report reveals the extent to which key performance indicators deteriorated over Q109. Weighted-average 90-360 days delinquencies represented 2.42% of the outstanding balance of Spanish SME transactions during the period, compared with 1.73% in Q408 and 0.55% in Q108.

Delinquency ratios (90-360 days/current balance) exceeded 1% in 50 transactions in Q109, up from 40 in Q408. In addition, 23 transactions experienced reserve fund draws over the quarter, up from 12 in Q408.

Moody's maintains a negative outlook on Spanish SMEs.

ABS

UK credit card ABS deterioration continues

The UK credit card ABS sector continued to deteriorate in Q109, a trend which is expected to persist through to 2010, says Moody's in its latest index report for the sector. The charge-off index reached 7.39% in March 2009, which is its highest point since April 2007. Meanwhile, the credit card delinquency index, an indicator of the expected increase in charge-offs, surged to an all-time high of 8.08% in Q109.

"As a base case, we expect an increase in charge-offs of 25%-50% from the current levels by the end of 2010," says Elise Lucotte, a Moody's vp - senior analyst and co-author of the report. "Charge-off deterioration may put pressure on existing ratings across the sector, although this would also depend on the speed of deterioration and other performance variables, such as delinquency levels, payment rates, yields and the economic climate at the time."

Moody's notes in the report that the aggregate payment rate index has remained broadly stable over the past 18 months between 16% and 18%. However, the rating agency expects a decline in payment rates over the coming months as re-financing options remain limited and more borrowers are expected to make the minimum contractual payments each month, given the increased financial difficulties they are facing.

Moody's continues to have a negative outlook for the UK credit card sector.

CDS

Bradbi credit event imminent?

Bradford & Bingley has announced that it won't be paying coupons (due in June and July) on three sterling-denominated LT2/UT2 notes. The lender managed to avoid a trigger event on subordinated CDS in February over its restructuring of LT2s (see SCI issue 125), but it's difficult to see how this case won't become a trigger event. ISDA warned Bradford & Bingley in February that the next time it does not pay and it's considered because of credit deterioration, it could be a trigger event under the restructuring clause.

CDS

DTCC data shows light volumes

The latest DTCC CDS data shows that volumes were extremely light in the week ended 15 May, with only a US$68.5bn (0.24%) rise in notional outstanding compared to the significant increase of the previous week. Single names saw net re-risking of US$5.8bn (compared to US$141bn de-risking the prior week), analysts at Credit Derivatives Research note. Indices dominated activity, with the Markit CDX de-risking in general, while iTraxx indices saw re-risking and off-the-run indices generally saw re-risking versus on-the-run as gross notional risk steepened.

CDS

UK sovereign CDS react to rating action

UK sovereign five-year CDS spreads widened to 80bp last Thursday, following S&P's placement of the UK's long-term sovereign credit rating on negative outlook. The 80bp level was 8bp wider than Wednesday's close. 80bp is still some way off the 165bp level that was seen in February, however.

CLO Managers

CLO O/C breach avoidance tactics scrutinised

As more managers adjust their strategies to avoid breaching CLO overcollateralisation (O/C) tests, there may be reason to believe that some could be seeking to preserve their management fees in the near term to the potential detriment of asset quality over the life of the CLO, says S&P in a new report.

"The prospect of an O/C test breach may pose a dilemma for managers, particularly for smaller asset management firms that depend heavily on subordinated management fees to cover their infrastructure costs," notes the agency. "In a benign credit environment, managers' two objectives - preserving management fees and protecting asset quality - generally don't conflict. But in a deteriorating credit environment, strategies for avoiding an O/C test breach can potentially lead to weaker overall credit quality."

The rating agency explains that from a credit perspective, an O/C test breach may improve the likelihood of ultimate repayment for all CLO debt classes by shutting off the release of excess cashflow to the manager and the equity investors. In certain cases, however, some managers may engage in certain trading practices to avoid an O/C test breach by taking advantage of potential ambiguities in the bond indenture terms that govern trading activities.

Additionally, following an O/C test breach and the related loss of management fees, a manager may decide to cut back on staff and infrastructure, which could, in some cases, leave them with insufficient resources for managing the portfolio.

"We believe that now more than ever, the impact of managers' actions on CLO ratings has the potential to be significant," continues S&P. "However, it's difficult to generalise about likely outcomes because they'll vary depending on the manager's chosen strategy and the specifics of a CLO's structure and asset pool."

CLOs

CLO spreads retrench

Increasing confidence and participation in the CLO sector have resulted in spreads on senior and mezzanine tranches tightening by a significant margin over the past week. According to structured credit strategists at JPMorgan, generic triple-A spreads now stand at 750bp - 50bp tighter than one week previously.

Spreads on double-A tranches, meanwhile, are up 10 points to US$35 and single-As up five points to US$15. Triple-Bs and double-Bs remain unchanged, however. A number of CLO/CDO bid lists are due today (27 May) and will provide indications of whether last week's strength carries over.

CLOs

Second Metrix tender announced

HSBC has announced a second tender to buy back the outstanding notes from its Metrix CLO programmes (see SCI issue 134). The tender is scheduled to close on 22 June, with an increase in the purchase price of 2 per 100 principal amount for bonds tendered by 8 June. The bids are across the capital structure and prices are set at the same levels as the first tender offer.

CLOs

Alpha Bank brings CLO

Definitive ratings have been assigned to Epihiro, a replenishable cashflow CLO originated by Alpha Bank. The transaction has a senior tranche of €1.6bn, rated triple-A by Moody's, and an unrated sub note of €1.6bn.

This cash transaction is the first securitisation of Greek corporate loans originated by Alpha Bank. The major sectors referenced by the deal are beverage, food and tobacco (14.9%), construction and building (14.7%), hotel, gaming and leisure (12.6%), consumer goods (10.3%) and automotive (10.2%).

CLOs

Euro SME CLO performance stable, except Spain

The performance of pan-European balance sheet SME CLOs, excluding Spain, remained largely stable with low default rates and stable recovery rates during Q109, says Fitch.

"While delinquency rates in Spain remain a concern, the performance in other SME jurisdictions continues to show signs of stability. Despite the current economic downturn, current default rates of SMEs remain low and recoveries appear to be stable, achieving 75% on average," notes Jeffery Cromartie, senior director and head of Fitch's EMEA structured credit performance analytics group. "Over the past year this has meant that European balance sheet deals outside of Spain have been the best-performing cohort captured by the tracker."

Approximately half of Fitch's Spanish SME CLOs have experienced negative rating actions since December 2008; 70 classes from 29 transactions were downgraded, 92 classes from 32 transactions are on negative outlook and five classes from one transaction are on rating watch negative.

"Spanish SME CLOs exhibiting stable performance fall into two general groups: highly deleveraged transactions with limited concentration risk, and recent transactions where the rated notes benefit from robust levels of subordination," adds Cromartie.

Meanwhile, the level of defaults has continued to rise with varying recovery rates for capital market German schuldschein CLO transactions. Fitch continues to monitor the transactions closely.

CMBS

RFC issued on US conduit CMBS assumptions

S&P has published a request for comment article, in which it is seeking market feedback on proposed changes regarding the methodologies and assumptions it uses to rate US conduit or conduit/fusion CMBS transactions. While the agency will leave its property evaluation criteria unchanged, the migration to determining credit enhancement levels represents a significant update to its methodologies and assumptions, and hinges on establishing an enhancement for triple-A ratings that is sufficient to enable tranches rated at that level to withstand market conditions commensurate with an extreme economic downturn without defaulting.

The key aspects of the proposal on which S&P has requested market feedback are:

• Establishing triple-A credit enhancement levels that it expects will be sufficient to withstand a pre-set level of commercial property income declines. By extension, the triple-A credit enhancement levels will also be sufficient to withstand severe declines in property values.
• Refining its capitalisation rates to provide greater specificity and consistency from one pool to another.
• Introducing a standardised method to assess geographic concentration.
• Using a forward-looking commercial real estate forecast for the term of the transaction to determine its expected loss of each transaction it rates.
• Revising its surveillance methodology for projecting losses.

S&P says the goal of the proposed framework is to provide the market with a more transparent and straightforward approach to assessing the creditworthiness of CMBS securities. Defining its average stress for triple-A, triple-B and single-B credit enhancement would provide the market with clearer benchmarks against which all pools are measured, both in terms of credit support provided and the particular risk characteristics of each transaction, the agency says.

S&P also proposes to make the criteria more responsive to changing conditions by placing greater emphasis on how macroeconomic factors affect property-level credit risk factors (such as income and valuation), its outlook on the commercial real estate sector and the state of the economy.

CMBS

GGP bankruptcy concerns 'overstated'

Concerns may be overstated that the bankruptcy filings by General Growth Property's (GGP) SPEs will have broad negative implications for US structured finance as a whole, according to Fitch (SCI passim). With respect to CMBS transactions, however, junior subordinated tranches may be more susceptible to higher losses, depending on how the issues surrounding GGP's SPEs are resolved.

While the relationship between the SPEs and GGP presents some challenges for CMBS, implications for ABS, RMBS and structured credit securitisations are limited due to the differences at the asset level between CMBS and other areas of structured finance.

Fitch believes that SPEs that are part of CMBS create clear lines of separation among assets pledged to particular lenders (i.e. securitisations), but the bankruptcy remoteness the structure affords is not, as has been widely noted, bankruptcy-proof. In analysing all securitisation trusts, bankruptcy concerns generally focus on the sale of financial assets (loans) that are deposited into passive trusts, which in turn issue notes or certificates. This sale is intended to isolate the loans from a potential bankruptcy of the originators of the loans.

Once the sale is completed, the originator retains no direct interest in the loans, although they may retain an interest in the trust. These securitisation structures are not called into question by the issues surrounding the GGP SPC bankruptcies, says Fitch.

Documentation

US CLO O/C EOD provisions a growing concern

According to a new report published by S&P, the credit quality of many US CLO transactions has deteriorated over the last year because their underlying assets have faced significant downgrade activity. As a result, most US CLO portfolios now contain more assets from triple-C rated obligors than their portfolio guidelines specify - a trend that eventually affects their overcollateralisation ratios.

Given the increase in defaults among speculative-grade obligors, market participants are increasingly considering the ramifications that decreasing overcollateralisation ratios will have on their CLOs, S&P notes. "In particular, participants appear to be focused on overcollateralisation provisions that trigger an event of default (EOD) if the par value, after any applicable haircuts, of the collateral held by the CLO drops below a predetermined threshold relative to the balance of senior CLO notes outstanding," explains credit analyst Steve Anderberg, analytical manager for surveillance in the US structured credit group at S&P.

The agency has reviewed documents for more than 600 of its rated US corporate CDO transactions originated from 2003 through to 2008, to aggregate information on US CDO par-based EODs and provide greater transparency to market participants on this subject. To date, it has identified 149 outstanding transactions that contain par-based EOD provisions and voting requirements that it believes could allow the senior-most noteholder to attain sufficient votes to liquidate the portfolio collateral once a par-based EOD has occurred. Of these transactions, 71 include haircuts to the par value of excess triple-C assets (and in some cases other haircuts as well) when calculating their par-based EOD test.

Indices

ABX rallies on policy actions ...

JPMorgan data indicates that most Markit ABX index LCFAAAs and PENAAAs are up two to three points this month, with the 06-2 PENAAA the biggest gainer at 5.4 points. ABS analysts at the bank note that overall ABX triple-As have been correlated with CMBX recently, even rising with CMBX on the back of the CMBS TALF announcement (see separate News Analysis). Indeed, the one-month moving correlation between various ABX and CMBX tranches has been ranging around 80% and higher.

Policy actions have been the catalyst for recent rallies in the indices and the JPMorgan analysts believe that the overall impact will be positive for RMBS. "We continue to recommend a neutral weight on ABX (and subprime RMBS in general) due to our adverse intervention concerns, and hence continued uncertainty in subprime cashflows, but also recognise that prices are biased to the upside as market technicals and the search for yield (increased risk appetite) continue to dominate."

Their analysis of H4H (Hope For Homeowners), in conjunction with Obama Administration modifications, indicates that even modest refinancing success can improve the returns of subprime cash bonds. "In particular, assuming just 10% of subprime ends up being refinanced through H4H, the benefits of accelerating the return of principal and substantially lowering the loss severities can be significant. However, modifications still pose duration extension risks," they conclude.

Indices

... while early-stage delinquencies improve

ABX remittance reports for the May distribution date show improved early-stage delinquencies, slower liquidation speeds and higher loss severities, according to ABS analysts at Barclays Capital.

CDRs are currently standing at 21.3, 23.7, 19.7 and 19.3 for the 06-1 through to the 07-2 indices respectively, an absolute decrease of 340bp, 240bp, 190bp and 80bp from last month. However, given that the spring housing season has started, the decline in CDRs is expected to be temporary. The BarCap analysts note that most deals in the indices serviced by American Home Mortgage and RFC Homecomings posted significantly lower CDRs this month.

Aggregate 60+ day delinquencies climbed by 53bp, 60bp, 101bp and 130bp for the 06-1 through to the 07-2 indices, compared with changes of -4bp, 55bp, 70bp and 102bp last month. The REO bucket also fell by 8% for the 06 series and 6% for the 07 series on a relative basis as a result of elevated liquidation speeds; however, foreclosures and 90+ delinquencies rose across indices.

Meanwhile, several new non-ABX constituents have begun taking losses at the single-A level, suggesting that during the next three months there will be a wave of single-A write-downs. ABS analysts at JPMorgan expect the MSAC 06-WMC2 M-2 to be the first double-A ABX reference entity to take a hit.

Indices

Counterparty risk hits lowest level since January

Counterparty risk has fallen by more than half since the early March equity lows and spread highs, according to Credit Derivatives Research. CDR's Counterparty Risk Index (CRI) stood at 149bp on 20 May, which is its lowest level since the first week of January.

"A small drop from here and we are around the levels not seen since before the September/October AIG/Lehman debacles," note analysts at the firm.

Citigroup is the only bank that still trades wider than its pre-capital injection levels, as all other institutions are now considerably tighter. US banks rallied by 228bp (risk fell by 54%), compared to 108bp (45%) for European members of the CRI. Citi remains the riskiest (widest trading) credit, at 375bp, among the CRI members, with BNP Paribas the least risky at only 64bp.

"The CRI indicates that the market's perception of counterparty risk has fallen dramatically as a combination of government-enhanced balance sheet efforts and the Treasury's OTC derivative regulatory plans have raised confidence in the global financial system. We remain sceptical of the former as sustainable, but feel the latter is a good step forward (especially in the CDS market)," the analysts conclude.

Ratings

Loss severities assigned to CSOs

Fitch has assigned loss severity (LS) ratings to 310 tranches (affecting 239 public ratings and 71 private ratings) from 161 global synthetic corporate CDO transactions. The agency recently introduced the concept of assigning LS ratings to structured finance securities.

LS ratings are meant to complement the existing long-term credit (LTC) ratings for structured finance securities, which exclusively address the probability of default of a security. They provide an indication of the relative degree of risk that a security might suffer a high loss severity in the event that the security defaults, Fitch explains. It will always be necessary to consider loss severity (as indicated by the LS rating) in conjunction with probability of default (as indicated by the LTC rating).

The LS rating scale consists of five rating categories from LS-1 to LS-5. LS ratings are only assigned to securities that have corresponding LTC ratings in rating categories triple-A through to single-B.

The LS rating category to be assigned will be determined through a calculation that measures the size of the tranche (tranche thickness) relative to the base expected loss determined for the asset portfolio underlying the CDO transaction. The base expected losses for these global synthetic corporate CDOs were derived from the portfolio credit models for the respective transactions.

Additional consideration was given to transactions with obligor concentrations. Portfolios with significant obligor concentration were also subjected to additional overlays which analysed the number of obligor defaults a tranche's thickness could withstand in the event it experienced a default.

The majority (76%) of public and private LS ratings assigned by Fitch to these synthetic corporate CDO tranches were LS-4 or LS-5, indicating a relatively severe risk of loss severity given default. This reflects the increased loss expectations on the underlying asset pools.

Ratings

DBRS enhances ABCP conduit disclosure

As part of its ongoing efforts to promote improved transparency in the Canadian ABCP market, DBRS is releasing updated rating reports in a new format for all Canadian bank-sponsored ABCP conduits that it rates. The revised format is the latest in the ongoing reporting improvements being introduced by the agency and is expected to provide enhanced disclosure for market participants. Key points of the detailed analysis provided in the rating reports include the underlying structure of each conduit, the transactions into which it enters, the asset pool composition and a description of and requirements for the various parties that support the conduit.

Ratings

Euro ABS downgrades far outnumber upgrades

During Q109, downgrades outnumbered upgrades among European structured finance transactions by more than 17 to 1, according to S&P. Generally, many downgrades were due to poor collateral performance, given challenging economic and financial market conditions. Other rating actions followed the deterioration in the creditworthiness of supporting parties.

CDOs accounted for 76% of all downgrades, mainly due to negative rating migration among global corporates and US RMBS. In European RMBS, there were only 44 upgrades in eight deals, while there were 160 downgrades in 50 transactions.

For ABS, there were 48 downgrades in 28 deals, including SME CLOs, auto ABS and consumer loan ABS. There were only eight upgrades in five transactions, mostly backed by SMEs.

For CMBS, there were 38 downgrades in 18 transactions during the quarter and three upgrades in two transactions. Collateral performance was the main driver of CMBS downgrades during Q1, with the remainder related to supporting party rating actions.

S&P believes that macroeconomic deterioration will continue to be the main determinant of European structured finance credit performance over the coming months. It believes that various expansive policy initiatives may only partially mitigate the macroeconomic strains.

Ratings

Asian CDOs hit by SROC results

S&P has lowered the ratings on 24 Asia Pacific (excluding Japan) synthetic CDOs, nine of which remain on credit watch with negative implications. In addition, the ratings on 10 other CDOs were raised and on one other CDO affirmed.

The downgrades reflect the increased credit risk of underlying portfolios in the respective transactions, the agency says. The SROC levels for tranches that have been downgraded fell below 100% at their current rating levels during the SROC analysis for the month of May. This indicates that the available credit enhancement for each of the tranches is lower than the level required to maintain its current rating.

Ratings

Japanese CDOs impacted

S&P has lowered its ratings on 29 tranches relating to 21 Japanese synthetic CDO transactions. At the same time, the agency removed its ratings on 20 of the 29 tranches from credit watch, while keeping the ratings on the other nine on watch with negative implications. In addition, it affirmed its ratings on four tranches and removed the ratings from watch with negative implications.

The rating actions are part of S&P's regular monthly review of synthetic CDOs whose ratings have been placed on watch with positive or negative implications.

Regulation

Basel issues stress-test guidelines

The Basel Committee on Banking Supervision has released a report entitled, 'Principles for sound stress testing practices and supervision', which sets out a comprehensive set of principles for the sound governance, design and implementation of stress-testing programmes at banks. The principles address the weaknesses in banks' stress tests that were highlighted by the financial crisis.

Stress testing is a key component of the supervisory assessment process to identify vulnerabilities and assess the capital adequacy of banks. The Committee says that the principles establish expectations for the role and responsibilities of supervisors when evaluating banks' stress-testing practices.

"The current crisis underscores the importance of stress testing as an essential risk management and capital planning tool," notes Nout Wellink, chairman of the Basel Committee on Banking Supervision and president of the Netherlands Bank. He adds that "stress testing programmes should be fully integrated in banks' governance frameworks, and the Basel Committee will follow up to ensure that these principles are implemented".

Klaas Knot, chairman of the Basel Committee's Risk Management and Modelling Group and division director of supervision policy at the Netherlands Bank, adds: "Stress testing plays an important role in strengthening not only bank corporate governance, but also the resilience of individual banks and the financial system."

He explains that the Basel Committee's principles were developed with the long-term objective of deepening and strengthening banks' stress testing practices and supervisory assessment of those practices. In developing the principles, the Basel Committee reviewed industry stress testing practices before and during the crisis.

Regulation

US committee suggests plan for regulatory reform

The Committee on Capital Markets Regulation, an independent and non-partisan research organisation dedicated to improving the regulation and transparency of US capital markets, has released a report entitled 'The Global Financial Crisis: A Plan for Regulatory Reform' that provides a path forward for making the US financial regulatory structure more integrated, more effective and more protective of investors, it says. The 57 recommendations contained in the plan address these shortcomings, with proposals to reform capital requirements, create resolution procedures and other regulation for non-bank financial institutions, increase transparency and supervision around sophisticated financial instruments, and improve accounting standards.

The Committee believes that an effective system must achieve four critical objectives:

• Reduced systemic risk through more sensible and effective regulation
• Increased disclosure to protect investors and stabilise the market
• A unified regulatory system where lines of accountability are clear and transparency is improved
• International regulatory harmonisation and cooperation.

The Committee found that the financial system failed on all four fronts, with regulation applied inconsistently across products and services, insufficient transparency to protect investors and support market discipline, fragmented supervision and a lack of coordination on basic global rules. "The financial crisis came about because there were too many gaps in our regulatory system where products and markets operated in the shadows. There was too much fragmentation and not enough daylight," says John Thornton, chairman of the Brookings Institution and co-chairman of the Committee. "Taken together, our recommendations derive from the goals of a unified regulatory system and a more transparent market."

RMBS

Alt-A neg-am RMBS default risk 'may be dissipating'

In its latest research report, S&P's market, credit & risk strategies (MCRS) group focuses on the delinquency and default rates associated with the Alt-A negative amortising ARM-based structure to investigate the different ways that constant default rates (CDRs) are either disclosed or can be calculated when valuing associated tranches in the current market. The group also examines the wide gaps that can exist among reported CDRs, calculated CDRs and reported delinquencies for clues regarding the appropriate assumptions for valuing Alt-A neg-am backed structures.

Among the report's key findings is that measures of CDR based on disclosed liquidated loans are both backward-looking and misleading in terms of reaching intrinsic valuations of RMBS. Using data for the latest disclosed monthly new collateral pool default balance should be the preferred basis for calculating current CDRs.

Balanced against current CDR intelligence, total delinquencies as a percentage of the performing collateral pool balance can be monitored as a basis for making future CDR assumptions. Current calculated CDRs for US Alt-A neg-am RMBS turned lower in March, possibly suggesting that previously concentrated default risk for the asset class may be dissipating, the MCRS analysts indicate.

RMBS

Subprime RMBS delinquencies decline

Total delinquencies among US subprime RMBS transactions originally rated in 2005, 2006 and 2007 declined for each vintage for the first time in two years, as of the April 2009 distribution date, according to a report published by S&P. Total delinquencies were 42.17%, 50.11% and 46.90% of the current aggregate pool balances for the 2005, 2006 and 2007 vintages respectively. When compared with the March 2009 distribution date, delinquencies decreased by approximately 0.45% for the 2005 vintage, 0.34% for 2006 and 0.57% for 2007.

Serious delinquencies (90-plus days, foreclosures and real estate owned), however, continued to increase - but at a slower rate than in previous months. As of the most recent reporting period, serious delinquencies for the 2005, 2006 and 2007 vintages were approximately 33.44%, 40.83% and 36.69% of the current aggregate pool balances respectively. Compared with the prior distribution date, serious delinquencies have increased by approximately 0.45% for the 2005 vintage, 1.04% for 2006 and 1.24% for 2007.

Cumulative losses also increased for all three vintages. As of the April 2009 distribution date, cumulative losses totaled 5.63%, 10.56% and 7.11% of the original aggregate pool balances for the 2005, 2006 and 2007 vintages respectively. Compared with the previous distribution date, losses were up by approximately 6.43% for 2005, 12.22% for 2006 and 13.40% for 2007.

RMBS

Increased data required for South African RMBS

Fitch has outlined increased interim data requirements for rating RMBS transactions backed by South African residential mortgages. The agency will now request loan-by-loan loss severity and foreclosure data, plus static pool performance information by origination vintage from the issuing institution.

The data would be requested for loans that are in the pool and also for other representative loans, which the issuing institution is holding on its balance sheet but not securitising. This policy is effective immediately, in advance of the agency's update of its South African RMBS criteria, expected in the third quarter of 2009. In the absence of this data, the ability of Fitch to rate a transaction and/or a rating cap will be considered on a case-by-case basis, it says.

If observed data regarding loan performance or loss severities is out of line with Fitch's expectation in the current South African housing market environment, case-by-case adjustments will be made to the expected defaults and loss severities when rating transactions. Any adjustments will be disclosed in the new issue report for the transaction.

"Since the criteria were introduced in 2003, the South African economy and the South African residential property market have changed substantially and the risks within it have also changed. It is therefore necessary to look at lender- specific data in greater detail," comments Alfons Ideler, director in Fitch's Johannesburg-based structured finance group.

Technology

Aire Valley cashflow model released

Bradford & Bingley has developed a cashflow model for the notes issued under its Aire Valley Master Trust, which is available on request to investors. The move comes as concern rises more generally about slowing prepayment rates. The model is designed to enable estimation of the payment and maturity profile of each series of notes under different prepayment assumptions.

Technology

Non-agency MBS surveillance tool launched

ABS data provider Lewtan Technologies has unveiled a new product called ABSNet Loan. The platform provides valuable key performance metrics and predictive variables on the mortgages and home equity loans that back US non-agency MBS and home equity transactions.

"Our decision to build ABSNet Loan came in response to overwhelming market demand," says Ned Myers, chief marketing officer of Lewtan. "Obviously, the continued deterioration of loans backing non-agency securitised pools necessitates a loan-by-loan review of credit risk. Coupled with the lack of consistent, normalised, timely and transparent data otherwise available in the market, ABSNet Loan became a logical extension to Lewtan's market-leading surveillance data and analysis tools."

He adds: "We have found that investors have taken greater ownership of the credit analysis of their holdings in this credit downturn. As a result, the additional transparency provided by ABSNet Loan is long overdue."

ABSNet loan is available in two different forms: via a direct download or a flexible on-line web application. The information is updated in a timely fashion and undergoes rigorous data normalisation and quality control checks. Since Lewtan augments publicly available data with proprietary data, a more comprehensive picture of potential exposure on each loan is possible, the firm says.

Trading

Trading ideas: spring forward

Dave Klein, senior research analyst at Credit Derivatives Research, looks at a pairs trade on CDX NA IG 12 versus SPDR Trust Series 1

Both credit and equity enjoyed a pleasant spring, powering forward after reaching an early-March nadir. Since the beginning of April, just after the CDX IG 12 began trading, credit outperformed equity in the names we follow. Single name CDS in North America trades well tight of equity-implied fair value.

When stepping back and looking at CDS levels against market cap, we find that the past month marks new territory for the CDS-equity relationship as spread levels tightened more dramatically than shares rallied. With an expectation that equity will outperform credit in the short to medium term, we recommend buying protection on the CDX and buying SPY shares.

Delving into the data
We start by looking at CDS against equity from the bottom up. Exhibit 1 charts the average five-year CDS market and modelled mids of North American credits, for which we find a strong relationship between CDS, equity and implied vol.

Exhibit 1

Since the beginning of April, credit outperformed equity and we look for a return to fair value with equity outperforming credit. We note, however, that over the past six months, credit has disconnected even further from equity multiple times before reverting back to fair value.

Exhibit 2 takes a longer view of the CDS-equity relationship. We pulled North American CDS and market cap data going back to August 2005. We normalised market caps and, for each trading day, calculated average market cap and average DV01-weighted five-year CDS spread.

Exhibit 2

The blue diamonds range from August 2005 through to February 2009. The green triangles chart from March 2009 through to the present. Since the beginning of April, CDS rallied much more dramatically than equity.

Caution is required when looking at this chart. Clearly, multiple trading relationships, or regimes, are visible in the data.

The chart also does not factor in the role of implied volatility on CDS spreads as done in our CSA model. We include the trend line in our chart for use as a comparison between now and the past, but we do not view it as useful for trading purposes.

Still, from two different bottom-up views, credit trades too tight to equity. If credit continues to improve, equity should outperform. If credit deteriorates, the pain will be felt more acutely in credit-land.

We may be at the beginning of a new stage of the credit cycle and credit outperformance could last for a number of months. If true, equity will eventually catch up with credit and make this trade profitable.

The challenge is to implement this view efficiently and we believe that buying CDX 12 protection and buying SPY shares makes sense. Exhibit 3 charts SPY share value (x-axis) against CDX 12 spread (y-axis) since late March.

Exhibit 3

Not surprisingly, the CDX is trading tight to its trend line. Over this period, the CDX moved 4bp for every US$1 move in SPY.

We would prefer to have more history before judging CDX sensitivity to SPY, but the hedge ratio is in line with single name CDS trading in the 130bp-160bp range. We therefore recommend buying 19,000 SPY shares against US$10m notional CDX protection.

Looking for exits
This is a short- to medium-term trade. If our bottom-up analysis points to credit trading wide of fair value and the CDX trades flat to wide of its intrinsics, we will exit the trade.

The main motivation for the trade is our bottom-up perspective that credit trades too tight and that will be the driver for exits. However, if the CDX moves wide of fair value against SPY (according to the short historical relationship we have available), we will consider an exit but will most likely look for CDX to come back in line with intrinsics and for credit to trade close to equity-implied fair value as well.

Buy US$10m notional CDX NA IG Series 12 at 147bp.

Buy 19,000 shares SPDR Trust Series 1 shares at US$89.80.

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).