Contents

CMBS

Every little helps

Tesco CMBS marketed to European investors

Tesco Property Finance 1, a £415m CMBS for the UK supermarket chain, is being marketed to third-party investors this week. If successful, the Goldman Sachs-arranged and led transaction will be the first publicly-placed European CMBS since 2007.

The transaction is effectively a sale-and-leaseback deal involving 14 properties currently owned by Tesco. According to one investor, it is similar to the Delamare Finance CMBS from Tesco, issued in 2004.

The properties comprise 12 retail stores and two distribution centres leased to subsidiaries of the supermarket chain. It has received ratings of A3/A-/A- from Moody's, S&P and Fitch respectively.

The single-tranche deal is fixed rate, which, according to Conor Downey, partner at Paul Hastings in London, is a little unusual given that most UK CMBS have historically been floating rate. "Fixed rate has high early redemption penalties and, given the high rate of prepays on real estate loans, isn't suitable for many deals," he says. "The fixed rate nature of the deal may indicate Tesco is taking advantage of low interest rates and locking in. Also it might mean they are selling to UK pension and insurance companies, who historically were big buyers of long-dated sterling fixed rate bonds."

The single-A rating on the deal, which is credit-linked to the rating of Tesco, means that it would be unable to access the ECB's repo facility, given that the Bank's updated criteria states bonds must be rated triple-A. However, Downey points out that Tesco deals would be unsuitable for the ECB repo programme, even if they were rated triple-A.

"Tesco deals have historically been agency deals, where all the economics are kept by Tesco and not the arranging bank," he says. "This means there is no incentive for the arranging bank to retain the bonds and repo them with the ECB. This is because the bank would take default risk on the bonds and the ECB would provide at most about 76% of funding on only the triple-A bonds."

"Additionally, because the bonds are denominated in sterling, the funding would be even lower (the ECB has higher haircuts for non-euro bonds)," Downey continues. "Further, the ECB has problems settling non-euros and this makes it even more complex. In summary, ECB funding isn't attractive enough to make a bank want to do a deal for a third party with funding on this basis."

The transaction is structured so that the bond obligations are ultimately supported by the payment stream arising from the underlying occupational leases. To guarantee the rental payments during the life of the transaction, partnership and issuer level swaps will be entered into with Tesco as the ultimate swap counterparty.

The bonds will be fully amortising over the life of the transaction, which is expected to close by the end of this week.

AC

CMBS

Downgrade mitigation

CMBS investors seek new avenues as losses loom

A number of US insurance companies are aiming to get Realpoint - a subscription-based rating agency - approved by the National Association of Insurance Commissioners (NAIC) as an official rater of CMBS. Should this go ahead, it could mitigate potential losses and forced sales from certain insurance companies related to the asset class if S&P carries out the mass downgrades it is threatening.

"From a business standpoint this would not make a lot of difference to us, as so many of the insurance companies are already subscribers to our service," says Robert Dobilas, ceo and president of Realpoint. "It would, on the other hand, have an upside for the insurance companies that invest in CMBS, as our ratings would provide stability and potentially mitigate losses/forced selling that result from the S&P downgrades."

Under NAIC rules, if there are two ratings on a CMBS, insurance firms investing in the asset class must use the lower of the two. If the bond has three ratings, however, the middle of those three ratings can be used.

Dobilas does not envisage that downgrades will penetrate the super-senior or triple-A tranches of Realpoint-rated CMBS. Moody's and Fitch have also recently confirmed they expect the highest ratings on late-vintage CMBS to be relatively stable (see News Round Up). However, S&P's unexpected announcement at the end of May that late-vintage US CMBS transactions would face severe downgrades has been partially blamed for a reverse in the recent rally seen in the sector, with certain names trading wider now than they did before the rally took hold.

"US CMBS spreads have been on a rollercoaster ride in the past few of weeks," says one CMBS trader. "While the market remains fairly liquid, names are moving wider. The most widely quoted GG10 deal passed 1000bp over swaps earlier this week: in the rally following the TALF announcement for CMBS this name traded as tight as the low 600s," he comments.

"You can't say that this drift is purely down to the actions of S&P," the trader adds. "The results of a poll taken at the CMSA conference last week showed that 42% of investors expected to lose principle on triple-A bonds from 06-07 vintages: that has to say something about the real state of the market. S&P is just the first one to come out with this true sentiment."

But, according to Dobilas, having one of the 'big three' rating agencies come out with new rating standards that cannot, in many investors' opinion, be justified is delaying the recovery in this market.

"It's the stability of ratings that are most important to investors at the moment, so S&P's timing could not have been worse," adds Joe Petro, md of sales and marketing at Realpoint. "That is why the insurance companies are looking to push our ratings to become official, for example with the NAIC."

Meanwhile, loan requests for the first CMBS TALF operation were due in yesterday, 16 June. According to official data from the Federal Reserve, no loan requests were submitted.

"Rumours indicate that new-issue TALF deals are in the wings. But that is just speculation," concludes the CMBS trader.

AC

CDS

Internal affairs

Different agendas slowing US CDS clearing progress

Speculation has been growing about the details in the Obama administration's financial reform plan ahead of its announcement today. At the same time, however, issues at the two leading US CDS central counterparties could hold back progress.

"My impression is that ICE Trust is doing just enough to keep ahead of the CME in terms of the progress it's making on its own CDS central clearing platform - for example, by establishing segregated funds to hold buy-side collateral - without making too many concessions," says one CDS trader. "Nevertheless, the CME appears to be attracting tremendous interest from the buy-side as it already has well-defined segregated funds based on an FCM [futures commission merchant] model."

But, he adds: "While the exchange is looking to recruit both dealer-backed and independent FCMs for its CDS clearing solution, it appears to be embroiled in its own internal issues. Arguably, the CME's slow progress in coming to the market is related to its failure to tie in FCMs."

To act as an FCM on the CME, an organisation is required to have a certain liquid net worth, a contingency fund and the ability to demonstrate competence in clearing. Few clearing brokers have that sophistication in connection with CDS because it hasn't been done before, but it is certainly possible to create the appropriate infrastructure. However, the CME is said to have not yet made a good-faith attempt to talk to a number of FCMs, including some of the largest global organisations.

Equally, it has been suggested that a number of dealers are trying to hinder the CME's progress towards launching its CDS clearing platform. "But ultimately there is no law forcing dealer-backed FCMs to join up; they can make their own strategic decision about whether the CME platform is compatible with their own market-making activities. Banks aren't looking to slow the CME's progress, but you can't blame them for trying to protect the status quo either," the trader remarks.

ICE says it has surpassed US$1trn in cleared credit default swaps since operations began on 9 March 2009, with the total number of transactions cleared standing at 12,050. The clearer confirms that it is continuing to work closely with industry participants and regulators to expand clearing for buy-side participants, add clearing for single name instruments and deliver its European CDS clearing solution in the coming weeks.

The trader notes that a number of buy-siders are, however, insisting that their current trades with dealers are novated to the CME. "The success of a CCP will ultimately be decided by demand from the buy-side and institutions would be wise to listen to the customer or suffer the consequences."

For its part, the CME confirms that it is continuing to work with buy-side and sell-side customers before launching its CDS platform.

Meanwhile, one potential method of determining which CDS contracts should be centrally cleared under consideration by the Administration emerged last week - labelling contracts as customised or standardised based on their liquidity. But Jamie Cawley, ceo of IDX Capital, says that defining such a liquidity test would be problematic, given the nebulous nature of liquidity and that the market isn't yet fully commoditised.

"There are 450 North American names; some trade every hour, others once a month. But liquidity isn't only defined by bid/offer spread or trade frequency," he explains.

"Who will decide the metric?" Cawley goes on to ask. "The tests could be set up to fail from inception, depending on how rigid the rules are."

The industry accepts that the majority of index products and around half of single name trades can be cleared centrally, representing around 75% of the daily volume traded, according to Cawley. "I think that 25% of the market remaining customised and not centrally cleared is OK - it achieves the goals of transparency and fair dealing for end-users and the removal of systemic risk from the financial system. The industry appears to be doing a reasonable job of educating the authorities about their intention to clear trades to the best of their ability."

Ultimately, unless the market insists that clearing houses become utilities run by the government, it is fair to argue that the government can't wholly dictate what will be cleared. "Clearing is one thing, but forcing CDS to be traded on exchange is another," Cawley argues. "Exchanges prefer contracts to have hard dates, but this would destroy one of the greatest advantages of single name CDS - the ability to customise the trade. You've really got to question the political motives of the sponsor of such initiatives."

Away from credit derivatives, the Administration's financial reform plan is also set to introduce new rules for the securitisation market. The framework is expected to require ABS originators to retain 5% of their deals and issuers to make increased disclosures in public filings, including reporting loan-level data. Transactions are likely to have to be reported on TRACE.

CS

CDS

CDS premiums lagging interbank rebound?

S&P's market, credit and risk strategies (MCRS) group recently stated that "once stability and confidence return to the financial system, credit should resume flowing to high-quality creditworthy borrowers, while speculative-grade borrowers will once again be judged on the medium- to long-term viability of their individual business models". In a new report, the group notes that the relative degree of the decline in CDS premiums suggests that this process is unfolding, but is slightly lagging the rebound in confidence in the interbank lending market.

One question that remains unresolved is the extent that US policymakers are currently pushing on a string, according to the MCRS team. The bear market position on the economy is that public-sector support of the financial system may have stabilised the banks, but the improvement is not guaranteed to flow through the financial system to non-financial corporations. Going forward, this hypothesis can be monitored by tracking the degree of convergence or divergence between financial and non-financial CDS premiums as the US economic situation evolves.

"If liquidity continues to flow more freely through the financial system to creditworthy borrowers, we would expect financial and non-financial CDS premiums to decline in tandem as the financial system continues to reach equilibrium," the report notes. "If, on the other hand, policymakers continue to stabilise the financial system via the liberal application of government support programmes, but banks remain reluctant to extend credit to corporate clients (as occurred in Japan during its post-bubble experience), we would expect non-financial CDS premiums to increase despite the appearance of improvement in the Libor-Fed fund spread or financial CDS premiums."

Both financial and non-financial CDS premiums have declined in lockstep since the March/April highs in line with the overall trend of improving credit conditions. Furthermore, judging by the degree of recovery in the Libor-Fed fund spread, the report suggests that additional contraction in both financial and non-financial CDS premiums into the pre-credit crisis range of 150bp to 250bp is possible, should credit resume flowing freely through the US economy.

CS

CLO Managers

Manager criteria brought in line with new landscape

Fitch is updating its criteria for rating credit managers and funds. The review is a subset of a broader review being carried out by the rating agency, in which it will update its asset manager ratings methodology to reflect changing industry dynamics.

Under the new criteria for rating credit managers and funds, the scope of CDO asset manager ratings will be broadened beyond CDOs to assess the whole credit manager's platform. There will also be an increased focus on financial and business viability, credit selection and portfolio risk management.

Meanwhile, criteria is being updated for fixed income fund ratings to better capture credit risk concentrations as well as spread and interest rate risks, the agency says. The release of both criteria is expected in Q2/Q309.

"From a valuation perspective, we are moving from a distressed market to a stressed market," says Manuel Arrive, senior director of the fund and asset manager rating group at Fitch. "Risk appetite is returning for credit products. However, we are still in an illiquid market where headline risk and profit-taking risk remains."

As managers rebuild their credit franchises in the coming months, Fitch expects their strategy to focus on three key areas: retaining existing/developing relations with institutional client base; strengthening existing or developing new, unleveraged credit product offerings in key sub-credit asset classes; and maintaining profitability at lower AUM levels. "Fund investors also take on the business risk of a manager, so they should be comfortable with the manager's viability in the longer term, which involves retaining a stable institutional investor base," comments Arrive.

At the same time, Fitch expects that credit managers will be in the process of adapting their processes and infrastructure. Improvements will be seen in fundamental credit research, risk management will be revisited in the context of increased tail risk and failure of models, while lack of liquidity calls for enhanced access to primary and secondary markets and valuation practices as well as reviewed liquidity terms of investment vehicles, according to the rating agency.

"An institutionalisation of the credit platform is in progress," says Arrive. "Certain asset managers will become focused on a certain asset class. I also expect to see the emergence of opportunistic, boutique-type niche players with specific value propositions alongside the large players."

Meanwhile, the consolidation of CLO and CDO managers remains an ongoing theme. In recent weeks several US CLOs have been taken on by other managers, while the pace of consolidation in Europe remains slow (see Job Swaps for more).

"Until recently the performance of CLOs has been OK, so managers have been receiving their fees and investors have not seen any need to fire them as managers," notes Arrive. "However, as deals fail O/C tests and there are lower subordinated fees, many managers are reassessing their commitment to CLOs."

He adds: "Fundamentals will take over the technicals this year. We are already seeing loan defaults topping the highs of the last cycle and we estimate that loan default rates for European leveraged loans could reach 25%-30% in the coming year. This will give the market an opportunity to see a managers' credit selection."

Fitch has performed several simulations to assess the financial resilience of a theoretical CLO management platform. For instance, if subordinated fee income was reduced by an average of 33% as a result of O/C test breaches, a CLO management platform would need at least four CLOs of average size (ie around €1.5bn) under management to remain profitable. If subordinated fees are reduced by 50%, the breakeven point is six CLOs.

In the benign market conditions that prevailed until late 2007, two to three CLOs were sufficient for a European CLO manager platform to break even, according to Fitch. This resulted in 60% of CLO managers entering the market in 2006-2007.

About a quarter of those have more than four CLOs under management (and more than €1.5bn CLOs under management). This means that the viability of a CLO business model is being reassessed by a majority of managers, resulting in new strategic initiatives, potentially a reduction or reallocation of resources and possibly outright failure or consolidation.

In this context, Fitch expects over the next few months a higher number of European CLO manager replacements in Europe than has been observed so far.

AC

Regulation

Compensation guidelines released

SIFMA has released a set of guidelines for compensation, providing recommendations on how financial services firms can better tie compensation to long-term performance and appropriate risk management. The move comes at the same time as the US Treasury published its principles for compensation reform.

"Restoring trust and confidence in the financial system must include a responsible approach to executive compensation," says SIFMA president and ceo Timothy Ryan. "Today the industry is setting a new standard that supports long-term performance and effective risk management. Together, we can build a better system that aligns compensation with the interests of shareholders, safeguards the financial system and strengthens the economy."

SIFMA's guidelines reinforce the central role and ultimate responsibility of a firm's board of directors in compensation practices and oversight. Risk management staff also play a critical role, providing a vital link to the board or compensation committee to facilitate appropriate risk management.

The guidelines call for regulatory initiatives to be complementary - emphasising the board's central responsibility - and to preserve the industry's ability to operate dynamically and help drive economic growth. They also encourage transparency to assist shareholders and other investors in understanding a firm's compensation structure, risk control processes and business strategy, while respecting confidentiality to ensure competitive differentiation among firms.

The guidelines reflect these principles:

• Firms should establish compensation policies consistent with effective risk management;
• Compensation should be linked to sustainable performance;
• Risk management professionals should be appropriately independent; and
• Firms should communicate their compensation practices to shareholders.

The US Treasury's principles state that: compensation plans should properly measure and reward performance; compensation should be structured to account for the time horizon of risks; compensation practices should be aligned with sound risk management; and whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders should be reexamined. Finally, transparency and accountability in the process of setting compensation should be promoted.

The Treasury intends to work with Congress to pass legislation in two areas. First to support efforts in Congress to pass 'say on pay' legislation, giving the SEC authority to require companies to give shareholders a non-binding vote on executive compensation packages. Second, it will propose legislation giving the SEC the power to ensure that compensation committees are more independent, adhering to standards similar to those in place for audit committees as part of the Sarbanes-Oxley Act.

CS

ABS

Bank further expands ABS/MBS team

Jefferies has hired three senior professionals in the firm's MBS and ABS sales and trading group. Marc DeFife joins as an md to head Jefferies' MBS/ABS effort in Chicago. Additionally, Elizabeth Harper and John Koutoupis join as svps.

All will be based in Jefferies' Chicago office and focus on serving the firm's Midwest MBS/ABS clients. The firm's MBS/ABS group now includes more than 55 sales, trading and origination professionals in the US and London.

DeFife was most recently at Barclays Capital following the firm's acquisition of Lehman Brothers, where he spent nine years and was most recently an svp in MBS/ABS sales. Harper was also most recently at Barclays Capital, following the firm's acquisition of Lehman Brothers, where she was a vp in MBS/ABS sales. Koutoupis joins Jefferies from Sandler O'Neill, where he was an associate director and focused on MBS/ABS sales.

Alternative assets

Prisma hires six

Prisma Capital Partners has made six new hires in the areas of portfolio management, operational due diligence and marketing. The new members to Prisma's team include several hedge fund industry veterans as well as younger associates. The expansion of staff follows the relocation of the Prisma headquarters from Jersey City, New Jersey to larger offices in New York, and the opening of a London office last year.

The new senior members of the team include James Walsh as md, Daniel Lawee as portfolio manager within fixed income, volatility and reinsurance, and Queenie Chang as senior operational due diligence associate.

After serving as an institutional marketing consultant for the firm since 2004, Walsh joins Prisma to coordinate the marketing effort. He brings with him over three decades of experience in capital markets, investment management and private client services in the US, Asia and Europe. Prior to joining Prisma, he was co-founder of Walsh Advisors, an advisory firm marketing alternative investment solutions to institutions.

Lawee has over 13 years of experience in investment strategies including fixed income, currencies and mortgages. Prior to joining Prisma, he served as a portfolio manager at Northwater Capital Management where he was responsible for fixed income, structured credit volatility and reinsurance fund strategies.

Chang has over 15 years of experience in hedge fund due diligence and hedge fund accounting. Previously Queenie served as a vp at DB Advisors Fund of Funds and an avp at Julius Baer Investment Management, in both cases with responsibilities for global operational due diligence.

CDO

Managers seeking CDO amendments listed

S&P has published a list of the amendments to European CDO transactions for which it provided a rating confirmation letter between 1 January and 31 May. S&P says it has recently seen an increasing number of requests from European collateral managers, trustees, and their legal counsel to provide rating confirmations regarding amendments to CDO documentation.

Between 1 January and 31 May this year S&P issued a total of 734 CDO rating confirmation letters, of which 95 were rating confirmations for cash and hybrid CDOs and 639 were rating confirmations for synthetic CDOs. The most common reasons for S&P giving rating confirmations during the period covered in this report have been:

Cash and hybrid CDOs: (i) Modification of counterparty rating requirement (58), (ii) Repurchase of notes (five), and (iii) Effective date confirmation (five).

Synthetic CDOs: (i) Application of counterparty downgrade language (227), (ii) Modification of counterparty rating requirement (136), and (iii) Novation of agent, and/or custodian, and/or deposit bank functions (133).

CLO Managers

Fortress takes on two CDOs

Bernard Capital Funding has resigned as collateral manager on the Bernard National Loan Investors and Bernard Global Loan Investors transactions, to be replaced by Fortress Value Recovery CM (see SCI issue 135). The required consent of MBIA Insurance Corporation, as the credit enhancer on the deals, has been obtained.

Moody's has confirmed that the appointment of a successor collateral manager does not result at this time in a downgrade or withdrawal of the current ratings assigned to the deals.

The successor collateral manager is an affiliate of Fortress Investment Group. Under its hybrid funds platform, Fortress has originated and currently manages eight CDOs/CLOs and three warehouses, and currently employs over 60 asset managers across various industries.

Fortress says it will allocate over 20 additional investment professionals to manage assets of the portfolios held by the issuers, including resources in its compliance and operations groups. The portfolios will be managed utilising the same asset management strategy as other portfolios managed by the hybrid funds group.

CLO Managers

Manager replacement confirmed

Pangaea Asset Management has confirmed that it is replacing De Meer Asset Management, a division of Bank of America, as collateral manager on the De Meer Middle Market CLO 2006-1 (see SCI issue 136). No objections to the agreement have been received from noteholders and Moody's states that the move does not affect its ratings on the deal at this time.

Pangaea was formed in 2007 and is a registered investment advisor. Its management team was previously affiliated with Antares Capital Corporation, where it was responsible for the management of both middle-market and broadly syndicated collateral within CLO structures. It currently has two other CLOs under management.

CMBS

TALF CMBS mandate awarded

Trepp, a provider of information and analytic services to the CMBS and commercial mortgage finance industries, has been selected by the Federal Reserve Bank of New York as a collateral monitor for CMBS as part of the TALF programme.

As a collateral monitor for the newly issued and legacy CMBS assets, Trepp will assist the New York Fed by providing valuation, modeling, analytics and reporting, as well as advising on these matters. Trepp will not establish policies or make decisions for the New York Fed, including decisions whether to reject a CMBS as collateral for a TALF loan or exclude loans from mortgage pools. Trepp will utilise the analytics and forecasting services of its subcontractor and sister company, Boston-based Property and Portfolio Research (PPR). Trepp was awarded the contract after a competitive bidding process.

Emerging Markets

Law firm names three Moscow partners

Chadbourne & Parke has named Dmitry Gubarev, Olga Koniuhova and Julia Romanova international partners in connection with the firm's practice in the Russian Federation. The moves increases its Moscow resident partners to five, reflecting the depth of its senior level capability in Russia in the areas of corporate, project finance, litigation and restructuring, the firm says.

Gubarev specialises in issues relating to finance and banking law and capital markets transactions, including structured finance, project finance and derivatives. His work with Chadbourne has included advising multilateral lenders, as well as Russian and western banks and companies on various securitisations, syndicated loans, project finance transactions, credit-linked notes issues and other financings in Russia and other CIS countries.

Koniuhova specialises in cross-border transactions, with an emphasis on mergers and acquisitions, private equity, shareholder and joint venture arrangements, corporate restructuring and reorganisation, preparation of companies for listing or the raising of debt on Russian and international capital markets. Romanova focuses her practice on litigation, international and domestic arbitration and bankruptcy/restructuring matters.

Listed products

QWIL portfolio generates more cash than forecast

Queen's Walk Investment Limited has reported a net loss of €2.3m, or €0.08 per ordinary share, for the quarter ended 31 March 2009, compared to a net loss of €20.6m or €0.77 per ordinary share in the quarter ended 31 December 2008. The permacap says its investment portfolio continues to generate more cash than forecast.

Total cash proceeds for the quarter ended 31 March 2009 amounted to €12.4m versus an expectation of €6.8m. The company's cash position remains solid with €18.7m of cash on its balance sheet as at 31 March 2009, compared with €17.3m as at 31 December 2008.

Fair value write-downs of the company's portfolio for the quarter were €5.2m, down from €24.1m for the quarter ended 31 December 2008. Its net asset value at quarter end was €3.96 per share, compared to €4.12 per share in the previous quarter.

QWIL has declared a dividend of €0.08 per share for the quarter, unchanged from the previous quarter.

Monolines

Assured updates on FSA acquisition

Dexia and Assured Guaranty have confirmed that the primary closing conditions, including rating agency reviews and agreement on key transaction documents, that are required under Assured's agreement to acquire Financial Security Assurance Holdings have been met, as of 9 June 2009. The transaction is expected to close on 1 July 2009.

The purchase price to be paid by Assured is US$361m in cash and up to 44,567,000 common shares of Assured, with Assured having the option to reduce up to half of the shares otherwise deliverable in exchange for cash at a price of US$8.10 a share. Assured expects to finance the cash portion of the acquisition with the proceeds of a public offering of securities.

Operations

New sub-servicers for CLOs

Middle-market cashflow CLOs CoLTS 2005-1, CoLTS 2005-2 and CoLTS 2007-1 have executed sub-servicing and/or sub-management agreements with Ivy Hill Asset Management (an affiliate of Ares Capital Corporation) and Ares Management. Ivy Hill and Ares will each separately manage a subset of the loans contained in the three CoLTS transactions.

Together, the two entities have managed 14 CLOs with a total original issuance of over US$7.2bn. Fitch has determined that the managers' capabilities are consistent with the current ratings assigned to the transactions.

Wachovia Bank and Structured Asset Investors, as collateral managers to the transactions, will remain fully responsible for their respective duties and obligations under the transaction documents for the deals.

Operations

Kamakura gets OCC default probability mandate

The US department of the Treasury Office of the Comptroller of the Currency has announced that the OCC has subscribed to the Kamakura Risk Information Services Default Probability Service. Kamakura replaces another (unnamed) vendor who had been providing monthly default probabilities for many years.

Ratings

Realpoint to expand coverage

Realpoint, the only subscriber-based credit rating agency in the structured finance sector, is to expand its asset class coverage from next year. While at present Realpoint provides ratings and analysis for CMBS, REITs, CDOs and commercial mortgages, from 2010 the agency will cover RMBS and ABS. Both new issues and legacy assets will be covered.

The US SEC granted Realpoint Nationally Recognised Statistical Rating Organisation status (NRSRO) in June 2008. Last month the Federal Reserve approved Realpoint to participate in the TALF programme with regards to CMBS.

Regulation

Hong Kong SFC goes to court over minibonds

The Hong Kong Securities and Futures Commission (SFC) has applied to the High Court for an order directing Lehman Brothers Asia (in liquidation) to comply with an SFC notice to produce certain records in connection with its investigation of the offer and marketing of minibonds. The SFC notice required Lehman Brothers to produce to the SFC all documents relating to the assessment of minibonds by an internal Lehman Brothers committee called the New Product Review Committee. The SFC believes the Committee oversaw or approved products, including the minibonds, and that these documents are relevant to its investigation.

In response to the SFC notice, lawyers for Lehman Brothers produced certain documents, but objected to the production of 17 other documents on the grounds that these documents should not be produced because they were the subject of a claim of legal professional privilege. It appears the claim arises because a member of the New Product Review Committee was an in-house lawyer at Lehman Brothers, the SFC says.

"The SFC disputes that the entire contents of these documents are necessarily the subject of a valid claim of legal professional privilege and asserts that they should be produced to the SFC in compliance with the SFC notice. Discussions between the SFC and the liquidators of Lehman Brothers and their lawyers, since December 2008, have not resolved this claim of privilege. In bringing this proceeding before the court, the SFC wants to ensure there is an independent adjudication on the issue," the Commission adds.

The case has been scheduled before the Honourable Justice Barma for directions on 22 July 2009.

RMBS

New REIT formed to buy RMBS

Capitol Acquisition Corp, a public investment vehicle, Pine River Capital Management, a multi-strategy asset management firm, and Two Harbors Investment Corp, a newly-organised REIT, have signed an agreement and plan of merger whereby Capitol will be acquired by Two Harbors. Two Harbors intends to focus on RMBS and will be externally managed by PRCM Advisers, a subsidiary of Pine River Capital Management .The transaction is expected to be completed by the end of Q309.

Two Harbors' investment team will be led by co-chief investment officers Steve Kuhn and Bill Roth. Kuhn joined Pine River from Goldman Sachs Asset Management in January 2008. He has over 16 years of experience investing in and trading MBS and ABS at Goldman Sachs, Citadel and Cargill. Roth will join Pine River on 16 June after having worked at Citigroup Global Markets since 1981, most recently as an md in the firm's proprietary trading group managing MBS and ABS portfolios.

"We believe Two Harbors represents a compelling opportunity for investors to capitalise on historically unprecedented values in the US$11trn US mortgage market," says Mark Ein, chairman and ceo of Capitol who will become vice chairman of Two Harbors upon completion of the transaction. "We are excited to partner with Pine River and their veteran team with a proven track record of investing in RMBS. We believe that Two Harbors, as a newly-formed REIT, created at or near book value with no legacy assets, will be well positioned to generate attractive risk-adjusted returns," adds Ein.

Two Harbors intends to pursue a relative value strategy targeting all subsets of the RMBS market. This strategy seeks to capture inefficiencies created by the current dislocations in non-agency and agency securities, and longer-term opportunities in residential mortgage assets.

The management of Two Harbors will be led by ceo Tom Siering, who joined Pine River as a Partner in 2006 from EBF & Associates where he was head of the value investment group. Jeff Stolt, a Pine River Partner and cfo, will serve as Two Harbors' cfo.

RMBS

REIT pursues RMBS investment

Cypress Sharpridge Investments, a New York-based REIT, has raised over US$100m via an IPO. The proceeds of the offering will be used to invest in agency RMBS on a leveraged basis.

Structuring/Primary market

Restructuring/valuations firm adds md

Houlihan Smith has hired Bruce Lohman as an md in its corporate development group. Lohman has over twenty years of experience in global derivatives, structured products, corporate credit and bankruptcy workout transactions, having worked with a wide range of corporate institutions, financial institutions and special purpose vehicle end users.

He was previously at ABN AMRO, where he was an md on the global derivatives team. He has experience in special purpose counterparty risk, securitisation, derivatives accounting, ISDA documentation and bundled financing solutions.

In his new role at Houlihan Smith, Lohman will focus on providing fairness opinions, solvency opinions, valuations services, complex securities valuations, transaction services, structured finance advisory and financial restructuring services.

"We are extremely pleased that Bruce has joined our firm. His expertise in derivatives, structured finance and distressed financial workouts is a terrific complement to our existing services platform," says Andrew Smith, founder and president of Houlihan Smith. "His background, working with a wide range of financial institutions, fits directly with our capabilities to add value to hedge funds, private equity firms and financial services institutions."

Structuring/Primary market

Structured solutions pro recruited

NewOak Capital has appointed Shad Quraishi as vice chairman and head of business development and strategy for its integrated advisory, asset management and capital markets businesses. He will be responsible for coordinating all client development efforts, capital raising, strategic relationships, and distribution of risk on structured solutions and will be a member of the NewOak Capital executive committee.

Quraishi was previously joint head of UBS' distressed real estate workout group in 2008 and was responsible for the distribution and structured solutions for over US$80bn of distressed assets in subprime, ALT-A, CDOs and esoteric assets. He was instrumental in providing creative de-risking solutions such as the US$15bn Blackrock transaction and other structured trades to help the bank de-risk its assets.

Prior to his role in the workout group, he was the global head of asset backed finance and warehousing focused on mortgage and non-mortgage assets. He co-ran the US, European and Asian asset backed finance units managing over 100 person team.

Technology

Risk management centre of excellence launched

Technology solutions provider DST Global Solutions is set to establish a centre of excellence for risk management, following the company's re-launch and implementation of its new management structure. The centre of excellence will be run by Jill Douglas, global head of risk at the firm.

She predicts: "Institutions that do not undergo a cultural shift in their approach to risk management could suffer further losses and damage to their reputation. Senior management and third parties, such as investors, now require evaluation of business risks, asset allocation and broader stress testing - not only to quantify the impact of exceptional events, but also to uncover the firm's or portfolio's vulnerabilities." The centre of excellence for risk management is being established to help meet this need, with the aim of providing thought leadership in these areas.

Trading

Credit trading desk formed

Collins Stewart has appointed Mike Wojtowicz and Mike Murphy to form a fixed income credit trading desk in London. The team will work closely with Collins Stewart's longstanding preference share/PIBs team. Its activities will also complement those of Collins Stewart ISTC in Dublin, which specialises in bank capital, and the FIG practice of Hawkpoint.

Wojtowicz joins from Barclays Capital, and previous to that he was at ABN AMRO and Lehman Brothers. Murphy was previously at BNP Paribas and Lehman Brothers, where the two worked together. They both bring with them a wealth of expertise in various forms of credit trading and combined have over 25 years of experience.

Trading

Broker-dealer adds in credit

BTIG, an institutional broker-dealer that launched its fixed income arm earlier this year, has further expanded its global fixed income group with four new hires. George Chalhoub has joined BTIG from Deutsche Bank where he ran the high yield proprietary portfolio on the high yield desk. He will have a dual role as a high yield salesman and desk analyst based in New York. Chalhoub spent 15 years in high yield research at Deutsche Bank, Merrill Lynch and Citigroup covering various industries, with his most recent focus being on the consumer products sector.

Mychal Harrison and Todd Sycoff have been hired as high yield traders in New York. Harrison joins BTIG from Barclays where he last traded high yield cash and CDS. He began his career at Goldman Sachs in high yield syndicate before transitioning into high yield trading. Sycoff comes to BTIG from Bear Stearns where he was last on the buy side as the high yield portfolio manager in the asset management division. Prior to that, Sycoff spent 16 years on the trading desks of Bear Stearns and Merrill Lynch as the head high yield trader.

Chris LeVine comes to BTIG from UBS where he was an executive director in the fixed income sales group focusing on investment grade and high yield credit. He will be in fixed income sales in BTIG's New York office. Prior to UBS, LeVine worked at MarketAxess, Trading Edge and started his career at Morgan Stanley.

The global fixed income group was launched in February of this year by Jon Bass, formerly of UBS, and John Purcell, formerly of Citigroup. The group focuses on sales and trading of credit products, which will cover the full credit spectrum from investment grade to distressed debt.

ABCP

APF to be extended to ABCP

The Bank of England has published a consultative paper setting out proposed extensions to its Asset Purchase Facility (APF), which would see the introduction in the near future of a Secured Commercial Paper Facility to support the provision of working capital to a broad population of companies. The facility will be designed to contribute to the APF's objectives of improving liquidity in credit markets that are not functioning normally, the BoE says.

Under the proposals, the APF would purchase, at a minimum spread over risk-free rates, newly issued securities in the primary market via dealers and, after issuance, from other eligible counterparties in the secondary market. In line with its overall objective, the APF would only finance assets where the underlying borrower makes a material contribution to economic activity in the UK.

Specifically, the maximum proportion of a programme's outstanding securities considered eligible for the APF would be based on the proportion of the underlying assets in the programme providing credit to borrowers that met this criterion. For example, if 80% of the assets met the criterion, up to 80% of the securities issued by the programme would be eligible for purchase.

The Fund would purchase only sterling-denominated securities, with the following additional characteristics:

• a maturity of one week to nine months if sold to the Bank at issue via a dealer; or
• an original maturity of nine months or less if sold to the Bank by a secondary market holder; and
• a minimum initial short-term credit rating of A-1/P-1/F-1 from at least two of S&P, Moody's and Fitch. Programmes with split ratings where one rating is below the minimum would not be eligible. Programmes rated A-1/P-1/F-1 that are on negative watch would be eligible; and
• issued directly into Crest, Euroclear or Clearstream.

ABS

Originator insolvency in UK credit card MTs mulled

Moody's is assessing the possible credit impact of certain trust provisions that exist in UK credit card master trust (MT) transactions. The assessment focuses primarily on the following consequences on the master trust upon the occurrence of an originator insolvency event:

• The transaction documents of UK credit card master trusts currently provide that certain receivables that arise following the insolvency of an originator may no longer be assigned to the receivables trustee. In addition, regardless of this contractual restriction, Moody's is assessing the practical ability for receivables to be generated by an insolvent originator.
• Transaction documents of several UK credit card master trusts further provide that, following an originator insolvency event, the receivables trustee is obliged to dispose of the securitised assets and dissolve the master trust unless, within 60 days of such event, it is instructed not to do so by the relevant investor beneficiary.

Moody's is evaluating the extent to which these provisions may negatively affect credit card master trust transactions. In particular, the agency is seeking to establish whether these provisions may result in exposure of the noteholders to the risk that, regardless of whether new principal receivables are generated following the occurrence of the originator insolvency event, the master trust may be exposed to a fully declining pool on the basis that future receivables may no longer be assigned to the master trust. Another issue is exposure of the noteholders to the risk that the market value of the securitised assets may be insufficient to fully repay the notes.

The focus on the provisions has arisen in the context of greater rating pressures observed on bank originators recently and forms part of a more general assessment by Moody's of the possible credit impact on UK credit card master trust transactions of an insolvency event affecting an originator (including considerations of set-off, commingling and servicing/operational risk). The agency plans to engage in a dialogue with the relevant credit card originators to understand the manner in which these risks may be mitigated.

In addition, Moody's is assessing the possible impact of the UK Banking Act 2009 on the efficacy of such provisions in the event of a bank originator insolvency. It believes that, should the risks not be mitigated sufficiently, the rated notes may be negatively affected as a result.

CDS

Auction results in, more to come

The final prices for General Motors CDS and LCDS were determined at 12.5 and 97.5 on Friday, with 13 and 10 dealers participating in the auctions respectively. Other auctions last week saw R.H. Donnelley Corp CDS settle at 4.875 (with 11 dealers participating), and Georgia Gulf LCDS and JSC BTA Bank CDS settling at 83 (with 10 dealers participating) and 10.25 (13 dealers participating) respectively.

Meanwhile, ISDA's Americas Credit Derivatives Determinations Committee has resolved that a bankruptcy credit event occurred in respect of Six Flags Inc, one of the world's largest regional theme park companies. The Committee also voted to hold an auction for Six Flags, while LCDX dealers voted to hold an auction for LCDS transactions referencing Six Flags Theme Parks Inc.

On 13 June Six Flags and a number of its subsidiaries filed voluntary petitions for relief under Chapter 11 of the US Bankruptcy Code. The petitions were filed in the US Bankruptcy Court for the District of Delaware.

Separately, Bradford & Bingley's first non-coupon payment day was yesterday, 16 June, and a credit event is expected to be called by some in the European market. The question on some analysts' minds is what kind of credit event this may be and whether it would trigger both subordinate and senior CDS.

CDS

Largest CDS re-risking seen since March lows

CDS volumes fell last week by US$260bn or 0.9%, according to the latest DTCC data, with single names seeing a US$170bn/1.1% net re-risking. Analysts at Credit Derivatives Research note that this re-risking is the largest since the March lows.

They add that it appears shorts capitulated in consumer services, as the sector slipped from most de-risked since the March lows to an almost balanced net open interest. "Sovereigns were the only significant de-riskers as investors begin to recognise the systemic shift of risk from corporate balance sheets. The popularity of curve and roll trades was evident as shorter-maturities re-risked relative to longer-maturities, but autos risk and tranche management seems to have significant impact on index activity."

CDS

European sovereign CDS liquidity drops

Fitch Solutions says its European sovereign CDS liquidity index has experienced a sharp fall in the past month, closing at 9.10 on 12 June, down from 9.67 on 4 May. This contrasts with overall CDS liquidity trends in the Europe and Americas regions during the same period, which have remained fairly static, showing only a gradual improvement.

Thomas Aubrey, md at Fitch Solutions in London, says: "While countries in Central and South America, such as Brazil and Mexico, continue to have the most liquid sovereign CDS by some margin, this fall in Europe highlights that credit markets are expecting ongoing economic pressures across the region. Greece has been leading this trend, moving up 18 global percentile rankings in the last month, closing last Friday with a liquidity score of 8.41."

Turkey has remained the most liquid European sovereign CDS over recent weeks, with a CDS liquidity score of 6.58 on 12 June.

In general, the liquidity of a credit derivative asset increases when it is showing signs of financial stress in combination with a significant amount of debt outstanding and/or changes in its capital structure, including new issuance. The liquidity scores of assets have historically traded between four at the most liquid end, through to 29 at the least liquid end. Entities also tend to be more liquid when there is agreement about present value but disagreement about future value due to heightened uncertainty surrounding the entity, Fitch notes.

CLO Managers

CDO note repurchases unlikely to impact ratings

Fitch says the growing trend of portfolio managers repurchasing CDO notes at a discount is unlikely to have a rating impact, as potential drawbacks are mitigated by the benefits of de-leveraging. The repurchased notes are subsequently cancelled, effectively de-leveraging the CDO's capital structure.

"In Fitch's view the relative increase in asset coverage resulting from discounted repurchase will usually outweigh the increased concentration risk and reduction of excess spread," says Jeffery Cromartie, senior director in Fitch's EMEA structured credit group. "Therefore, Fitch would not typically expect downgrades or rating withdrawals to result from such repurchases."

To date Fitch has only witnessed the execution of one large discounted buy-back and one much smaller repurchase; however, three additional trades have been proposed.Historically, sequential de-leveraging is the primary driver of Fitch's decision to upgrade CDO transactions. As a transaction de-leverages the relative amount of assets to liabilities increase; all else equal, this improves the credit profile of the remaining CDO notes.

"Purchasing liabilities at significant discounts to par magnifies the standard 1:1 impact of de-leveraging at par," says Christiane Kuti, associate director in Fitch's structured credit team. "Fitch has observed investors exchanging significant positions of notes for proceeds approximating 50% of par."

However, despite the increased coverage, there are potential drawbacks for remaining noteholders, according to the rating agency. First, the transaction will likely be exposed to greater portfolio concentration risk. Second, any level of excess spread, which can be diverted to support the rated notes through an O/C test failure, will be less as the de-leveraging will naturally increase the average cost of capital for the CDO. Third, previously failing O/C test levels could be elevated to passing levels which would then open the flow of interest proceeds to notes lower in the capital structure. This would also reduce the level of excess spread which could have otherwise been directed to amortise the more senior notes.

Finally, remaining senior noteholders who do not wish to sell may have to wait longer than anticipated for principal distributions. If portfolio managers deploy all principal proceeds to purchase senior notes from select noteholders, then there would be nothing left to pass through the normal principal waterfall. While the coverage levels would be better for the remaining class A noteholders, they may have anticipated larger principal distributions, which would not happen due to the behaviour of other class A noteholders who decided to exit their positions at a price agreed with the portfolio manager. Granted, the principal distributions would also be reduced if the portfolio manager decided to reinvest the proceeds.

The motivation for such trades is also worth examination,  says Fitch. All of the portfolio managers which are proposing these actions are facing considerable performance pressures. All have suffered significant downgrades both from poor asset performance as well as Fitch's CDO criteria revisions. The portfolio managers have a clear incentive to build par so that OC test failures can be cured. While reinvestment is one option to build par, many managers are restricted by minimum purchase prices, which restrict giving full par credit for assets in the OC test calculations.

Meanwhile, regulated investors may be facing increased capital charges because the current ratings of structured finance CDO notes are significantly lower than at origination. Rather than posting additional reserves against risky assets investors may wish to crystallise a loss and deploy their capital elsewhere. It is notable that some transaction documentation may not require the portfolio manager to seek the remaining controlling noteholders' consent to such cancellations.

CLOs

Triple-C assets increase in Euro CLOs

The performance of European CLO transactions continued to deteriorate in April, according to S&P's first European CLO Performance Index Report, which provides aggregate performance statistics across the agency's rated European cashflow CLO transactions.

The report, which covers April 2009, divides the CLOs' performance information into four cohorts issued in a specific vintage year from 2004 through 2007. In April, all four of the CLO cohorts saw an increase in the percentage of assets rated in the triple-C category. All CLO cohorts have also experienced significant increases in the percentage of defaulted assets held in their collateral portfolios since the end of 2008.

All of the cohorts have experienced at least some deterioration in their overcollateralisation test results over the past several months due, in S&P's view, to the deteriorating credit quality of the assets within the collateral portfolios, which has resulted in the downward rating migration of those assets, and defaults of corporate loan issuers in CLO portfolios.

CMBS

CMBS delinquency index sees historic highs

Large loan defaults, coupled with declining performance on multifamily and retail properties resulted, in a 29bp climb to 2.07% for US CMBS delinquencies in May, according to the latest Fitch Ratings Loan Delinquency Index. This marks the highest percentage of delinquencies since Fitch began its index in 2001.

"Defaults on larger loans continue to drive delinquency increases because later vintage transactions have larger loans, many underwritten with now-unrealised proforma income, as well as now-depleted debt service reserves and high leverage," says Fitch md and US CMBS group head Susan Merrick.

In total, the Loan Delinquency Index now includes 19 loans or crossed portfolios with balances of US$50m or greater, of which eight are in excess of US$100m. By comparison, in May 2008 only two loans had a balance over US$50m.

Of the loans greater than US$50m, eight are retail properties, seven are multifamily and six are hotels. Two of the largest 10 delinquent loans were newly added in May: the US$160m Mansions Multifamily Portfolio consisting of four cross-collateralised and cross-defaulted loans and the US$86m Arizona Retail Portfolio, both of which are in 2007 vintage transactions.

Declining performance, particularly in oversupplied markets, as well as in secondary and tertiary markets, has pushed the multifamily delinquency rate to 4.55%, the highest of all property types. Multifamily properties have been highly susceptible to default in CMBS during the current economic downturn.

The 60 days or more delinquency rate for retail properties is slightly higher than the index at 2.24%. This number is expected to climb.

Loans backed by hotels have thus far withstood economic pressures and continue to slightly outperform the Index with a 1.91% delinquency rate. Possible reasons for the relative resilience include generally more sophisticated sponsorship and management teams; slightly lower leverage and shorter amortisation schedules at issuance; and a reporting lag whereby many year-end audited financials have not yet been finalised. Fitch maintains its expectation that, as occupancy rates and revenues per available room (RevPAR) continue to decline, putting additional stress on borrowers' operating margins, defaults could rise precipitously.

CMBS

Moody's-rated CMBS to remain 'broadly stable'

Moody's expects that most ratings of late vintage conduit/fusion and large loan CMBS deals will remain broadly stable based on a review of updated data. In a new paper updating its February ratings review of these outstanding securitisations, Moody's notes that the underlying assumptions for those ratings remain on track, as long as conditions in the commercial real estate market and the general economy do not significantly worsen.

"While the scope and pace of developments in commercial real estate certainly warrant continued vigilance and further rating actions cannot be ruled out, we expect the ratings of the securitisations that were part of the February sweep to hold up for the most part over the near term," says Nick Levidy, a Moody's md.

Super-duper triple-A rated classes for late vintage deals, with 30% credit enhancement and a 6x multiple of current expected loss, are unlikely to experience downgrades, according to the report. Current mezzanine triple-A classes, with credit support at 20% on average, while stable for now, are very sensitive to further increases in expected loss.

The current projected expected loss estimate of 5% on average for late vintage CMBS pools results in triple-A credit support in the high-teens when stressed to an appropriate multiple. "Further increases in our expected loss estimate could conceivably lead to broad-based downgrades of mezzanine triple-A bond classes, subject as always to significant variability from deal to deal," notes Levidy.

In February 2009 Moody's undertook an analysis of conduit/fusion transactions issued from 2006 through 2008 and all large loan deals, regardless of vintage. As a result, the agency downgraded senior investment grade bonds, including the junior triple-A rated classes, an average of four to five notches on average.

Low investment grade and speculative grade bonds were downgraded from five to six notches on average. No mezzanine or super-duper triple-A-rated CMBS securities were downgraded in connection with the sweep.

Distressed assets

Losses expected at European banks until end-2010

The ECB's latest Financial Stability Report forecasts that a further net US$283bn (gross US$649bn) of losses will emerge at European banks by end-2010 - of which, only US$61bn will be on US originated securities and US$157bn on European originated securities. Additionally, an estimated US$431bn of losses on households and corporates is expected.

Analysts suggest that US$100bn of these losses will likely be taken through bad banks or asset protection schemes, but the remainder presuppose that another slug of capital is needed and it's difficult to envisage this coming from retained earnings.

Investors

Barclays puts out tender offer for CLOs

Barclays Bank has announced a tender offer for two of its CLOs. It will offer prices between 50% and 70% for the Class AB, B, C and D notes of Gracechurch Corporate Loans (Lambda Finance) Series 2005-1, and prices ranging from 20% to 55% for the Class AB, B, C, D, E and F tranches of Gracechurch Corporate Loans Series 2007-1. The offers are not being made in respect of any notes issued under Rule 144A.

Meanwhile, the initial results of HSBC's second tender offer for the Metrix CLO programme indicate that the bank has bought back £184.8m-equivalent of notes so far, with a 2% bonus on the purchase price for bonds tendered by 8 June.

Clydesdale Bank has bought back £175m of its Lanark Master Issuer 2007-1, comprising US$98.99m of Class 3A1s and €85m of 3A2s at 87%, and £40m of Class 4A1s at 89.5%.

Ratings

Public issuance in Japan falls, private issuance rises

S&P says it assigned ratings to securitisation transactions worth ¥686.7bn in Japan in the first quarter of 2009 (January to March), marking a 38% year-on-year decrease. The transactions exclude credit derivative products without issuances of bonds or trust certificates. Also, the number of securitisation transactions rated by S&P in the same quarter fell to 23, down by about 34% from the previous year.

The total amount of rated issuance in 2008 fell by 55.6% on a year-on-year basis. Although the overall trend in the total amount of rated issuance is still declining, the extent of the fall in the first quarter of 2009 is not as great when compared with the decline in the whole of 2008. The first quarter of 2009 saw a decrease in ratings assigned to public-sector issuances, while a small increase was seen in ratings assigned to issuances by private-sector originators.

Specifically, in the public sector, the agency notes a material decrease in issuances by Japan Housing Agency (JHF) from the same quarter last year and no issuance of FILP Master Trust transactions. Meanwhile, private-sector originators issued securities backed by housing loans, monetary receivables and commercial real estate properties. Although there are few signs of recovery in the issuance environment for structured finance products in Japan so far, S&P believes that originators have continued to see a need for financing through securitisation.

Ratings

Korean ratings to remain stable

Credit ratings assigned to Korean RMBS and ABS transactions are expected to remain relatively stable compared to several years ago, S&P says in a new scenario analysis report. The report reviews the current performance and tests the possible rating implications of a potential deterioration in the asset performance of 13 Korean RMBS and ABS transactions rated by the agency.

"Standard & Poor's believes the Korean economy will contract in 2009 before resuming growth in 2010. Given the potentially deteriorating economy, we have examined the current status and stress case scenarios that may impact Korean ABS and RMBS rated by us," S&P credit analyst Jerry Fang says. "Based on our analysis, we consider that significant arrears levels need to occur before they would impact ratings negatively, due to the build-up of credit support to date."

Further, ratings on most transactions rated by S&P are supported by the structures of the transactions. In the agency's opinion, Korea's more conservative financial management practices after facing several challenges in its economy over the past 10 to 12 years should also underpin the performance of most transactions.

Ratings

SROC results in for the US ...

S&P has placed its ratings on 60 tranches from 54 US synthetic CDO transactions on watch negative. At the same time, it affirmed its ratings on 55 tranches from 38 US synthetic CDO transactions and removed them from watch negative. The agency also lowered its ratings on 21 tranches from 17 US synthetic CDO transactions.

The watch placements, affirmations and downgrades follow S&P's monthly review of US synthetic CDO transactions.

Ratings

Supplemental risk measures applied to SME CLOs

Moody's has published a report showing how its supplemental risk measures for structured finance transactions will work in practice within the EMEA SME CLO sector. The report, entitled 'V Scores and Parameter Sensitivities in the EMEA Small-to-Medium Enterprise ABS Sector', applies the measures to German and Spanish SME ABS.

The overall V score, as well as the scores of the components and subcomponents, are represented on a five-point scale, from low variability to high variability. In the report, Moody's concludes that it expects V scores for typical transactions in the German sector to reflect medium assumption variability, while transactions in the Spanish sector will likely be assessed scores of medium/high assumption variability.

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.

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. For example, if a mean default rate of 12% and recovery rate of 50% were used in determining the initial rating of a typical Spanish SME ABS transaction backed by a granular portfolio, and these were then changed to 14% and 40% respectively, the initial model-indicated rating for the senior certificates might change from Aaa to Aa3.

Ratings

... and Europe

After running its month-end SROC figures, S&P has taken credit watch actions on 119 European synthetic CDO tranches. Specifically, the agency: placed ratings on 72 tranches on watch negative; affirmed and removed from watch negative ratings on 45 tranches; and placed ratings on two tranches on watch positive.

Of the 72 tranches placed on watch negative: 19 reference US RMBS and US CDOs that are exposed to US RMBS, which have experienced recent negative rating actions. 53 have experienced corporate downgrades in their portfolios.

The two tranches on watch positive is due to an upward revision of their attachment points. S&P believes that the new attachment points may be sufficient to support a higher rating.

Ratings

Use of credit ratings examined

The Joint Forum has released the final version of its paper entitled 'Stocktaking on the use of credit ratings'. The paper was developed in response to a request from the Financial Stability Forum (FSF) to conduct a stocktaking of the uses of external credit ratings by its member regulatory authorities in the banking, securities and insurance sectors.

The Joint Forum prepared and circulated to member authorities a questionnaire on the use of credit ratings in their jurisdictions. The questionnaire was designed to elicit information regarding member authorities' use of credit ratings in legislation (statutes), regulations (rules) and/or supervisory policies (guidance) governing, generated by or affecting such authorities.

The report focuses on the responses concerning the usage of credit ratings. It also describes respondents' assessments regarding the impact of their use of credit ratings.

John Dugan, chair of the Joint Forum and Comptroller of the Currency in the US, says: "This paper provides valuable information on the regulatory use of credit ratings by a broad range of regulatory authorities, including banking, securities and insurance supervisors across 12 countries. Policymakers and others will find the report a useful reference when considering the extent to which credit ratings should be relied on in regulation and supervision going forward."

Real Estate

CRE CDO note repurchase planned

Fortress Investment Group is proposing to repurchase the Class A notes of Duncannon CRE CDO 1 via two separate trades - for €25m and €96.4m respectively - at a significantly discounted purchase price. Subsequently, a total of €121.4m Class A notes will be cancelled, thereby increasing available credit enhancement to all rated notes.

The repurchase will be funded by using cash available in the principal collection account. Due to funding the proposed repurchase of Class A notes, the amount of principal proceeds available for immediate distribution to the remaining noteholders will be lower. At the same time, noteholders will benefit from an increase in credit enhancement due to the relative increase of assets compared to liabilities in the structure.

In addition, the senior, second senior and mezzanine par value ratios - which are currently in breach of their limits - will improve as a result of the repurchase. Consequently, the amount of interest diverted to the senior notes to cure the par value tests will be reduced.

Fitch says the proposed repurchase of Duncannon CRE CDO I Class A notes will not in itself impact the rating of the notes.

Real Estate

CRE CDO delinquencies 'relatively stable' for now

Fitch has observed a larger number of asset managers removing credit-impaired assets at prices below par, which has resulted in realised losses to CDO collateral. Many CDOs have offset this collateral deterioration through par building: primarily through the purchase of rated securities at prices well below par. As a result of the removal of credit-impaired assets and despite eight new delinquent loans entering the commercial real estate loan (CREL) CDO delinquency index, Fitch's May delinquency index was relatively stable at 7.9% - representing a slight increase from the April 2009 level of 7.8%.

"Asset managers have been removing credit-impaired assets from CDOs, often in order to preserve overcollateralisation ratio tests, which has tempered this month's delinquencies," says Fitch senior director Karen Trebach. "However, Fitch anticipates that this reprieve will be short, with delinquencies continuing to rise measurably through year end and more CREL CDOs facing overcollateralisation test failures in the coming months." Currently, 11 of the 35 Fitch-rated CREL CDOs are failing at least one overcollateralisation test.

During the May reporting period, nine assets were removed from the CREL delinquency index, including five assets traded out at discounts and one discounted payoff. Prices ranged from 0.59% to 69% of par. Consistent with Fitch's assumption of little to no recoveries on distressed mezzanine and subordinate debt, trades included two mezzanine loans sold out of their CDOs at less than 1% of par.

Fitch considers all losses to par in its evaluation of the credit enhancement available for each CDO tranche. Realised losses to the collateral have been occurring in three different ways: trades of impaired assets, repurchases and discounted payoffs.

Two repurchases of delinquent assets occurred in May 2009. A CDO asset manager paid less than par for both of these loans. Removing these two assets from the transaction assisted the CDO in maintaining cushion to its overcollateralisation ratio tests.

Finally, at least two asset managers reported accepting discounted payoffs on two loans, including a matured balloon loan that appeared in last month's CREL delinquency index, which was allowed to be paid off at 56% of par.

Regulation

FAS 166/167 published

FASB has published Financial Accounting Statements No. 166, 'Accounting for Transfers of Financial Assets', and No. 167, 'Amendments to FASB Interpretation No. 46(R)', which change the way entities account for securitisations and special-purpose entities. The new standards will impact financial institution balance sheets beginning in 2010 and have been taken into account by regulators in the recent stress tests.

Statement 166 is a revision to Statement No. 140, 'Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities', and will require more information about transfers of financial assets, including securitisation transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a qualifying special-purpose entity, changes the requirements for derecognising financial assets and requires additional disclosures.

Statement 167 is a revision to FASB Interpretation No. 46(R), 'Consolidation of Variable Interest Entities', and changes how a company determines when an entity that is insufficiently capitalised or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based upon an entity's purpose and design, and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance.

Robert Herz, chairman of the FASB, says: "These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitisations and special-purpose entities, and enhance disclosure requirements. They'll provide better transparency for investors about a company's activities and risks in these areas."

Both new standards will require a number of new disclosures. Statement 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. Statement 166, on the other hand, 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.

Regulation

JSDA reporting standards implemented

The Japanese Securities Dealers Association's (JSDA) new regulations regarding the distribution of securitised products took effect on 14 June. The regulations seek to ensure the "traceability of securitised products by further enhancing and standardising" the information communicated to investors, and encourage - but do not require - the use of a newly drafted Standardised Information Reporting Package (SIRP) as a reference for information communication purposes.

The regulations require each JSDA member that engages in the distribution of securitised products to establish the necessary organisational systems in order to enable the: (1) collection and analysis of the risks of the underlying assets prior to distributions; (2) communication of such information directly to customers at the time of distribution; and (3) collection, analysis and communication of information subsequent to distribution. The SIRP outlines information items that should be communicated for four separate asset classes (RMBS, narrowly defined ABS, CLOs and CMBS) and assigns each a level of priority based on the following scale: Level 1 (items considered almost essential in most cases); Level 2 (useful items that should be considered for reporting in most cases); and Level 3 (useful information, but with lower priority than Level 2).

ABS analysts at Deutsche Bank note that specific securitised product attributes may render certain of the stipulated items under SIRP unnecessary or irrelevant and/or necessitate disclosure of additional information that is not specified in the SIRP. "In other words, decisions as to what types of information should be communicated to investors will need to be carefully weighed on a case-by-case basis," they add. "That said, investors in Japanese securitised products should welcome the attempt to bring some measure of standardisation to information disclosure practices, which until now have varied significantly from one transaction (or originator) to the next."

While securitised product liquidity may also be boosted to some extent by the JSDA initiative, investors would stand to benefit even more from the new framework if rating agencies were to write their presale reports and other press releases with the SIRP format firmly in mind, the analysts conclude.

According to the latest quarterly data from Japan's Financial Services Agency, the country's banks have seen their realised losses and valuation losses on securitised products decline over the year ended March 2009. Realised losses for all deposit-taking institutions fell from ¥1.453trn in full-year 2007 to ¥1.082trn in FY2008, while valuation losses fell from ¥983bn to ¥767bn over the same period.

Realised losses increased by ¥368bn in the final quarter of FY2008 (January to March 2009), but valuation losses declined by ¥304bn in an apparent reflection of previous accounting measures. The ratio of valuation losses to total exposure (prior to deduction of valuation losses) is relatively low at just 4%, but is significantly higher for overseas-originated securitised products than for domestic transactions at 6% versus 1.3% - with foreign CLO/CDO holdings accounting for most of the exposure and valuation losses.

Regulation

Swedish banks pass stress test

The Swedish financial regulator, Finansinspektionen (FI), has published the results and methodology of the stress tests it conducted on four major Swedish banks (Nordea, Swedbank, SvenskaHandelsbanken and SEB). The conclusion was that even under a very bearish scenario, the banks have sufficient regulatory capital. But the FI notes that banks rely on the market for a substantial part of their funding and that it is therefore essential to secure the latter's confidence, which might require the raising of additional capital.

The stress test involved dividing the loan books of the banks as of end Q109 into 30 different asset classes. Each asset class was then attributed a 'stressed' cumulative three-year credit loss (2009-2011 period) under three different scenarios - conservative base scenario, extreme stress in Eastern Europe and extreme stress in Eastern Europe and prolonged stress in Western Europe.

Credit strategists at BNP Paribas note that overall the stress test results seem to have given the market confidence that Swedish banks should be able to weather the storm. "Despite this, uncertainty regarding the Baltics remains and caution is warranted in our view," they suggest.

RMBS

Freddie buys back euro securities

Freddie Mac is to conduct cash tender offers for the purchase of a targeted group of its euro Reference Notes securities this week. The GSE is offering to purchase from investors the securities through Goldman Sachs International, the designated lead dealer manager for the offers, as well as Barclays Bank and Deutsche Bank - the designated dealer managers for the offers. Each series of securities will be purchased at a fixed spread over the applicable reference swap rate and will settle on 25 June 2009.

RMBS

Tender offer for Dutch RMBS

Rabobank is set to buy back all the outstanding tranches of Storm Series 2003, 2004, 2004-II, 2005, 2006-I, 2006-II and 2007-I. The purchase price for the Class A notes is expected to vary between 89.5% and 96.5% and for the Class B tranches between 75%-91%, for the Class C notes between 72%-90% and for the Class D tranches between 70%-88%. The price for the Series 2007-I's Class E notes will be 98.5%, with the older transactions having the higher reserve prices.

RMBS

Less pessimism on European mortgage performance

Participants in the European structured finance market appear significantly less pessimistic about the performance of underlying residential mortgages, according to a new S&P survey, despite predicting a further 10% decline in house prices over the next 12 months. 'Worst case' expectations for defaults on prime and non-conforming UK RMBS have also improved, although under 'base case' expectations predicted defaults on non-conforming UK RMBS have increased from those polled in Q1.

The latest quarterly survey undertaken by S&P's fixed income risk management services (FIRMS) of European Structured Finance market participants reveals that default rates for non-conforming RMBS are anticipated to average only 12.4% over the next year, whereas respondents forecast defaults at 21% when asked the same question at the end of Q1. The severity of losses expected on the underlying non-conforming loans in default under a base-case scenario has dropped down to 31.1% - from 46% polled in Q1 - reflecting improved confidence of a continued slow-down in house price declines.

Similarly, the aggregation of respondents' expectations of default on prime RMBS has improved. But severity of loss on these defaults has risen slightly to 31.9% under the base-case, remaining consistent with the overall market.

RMBS

Positive outlook for Italian RMBS performance

Italian RMBS transactions in Q1 showed a relative stabilisation in performance, according to a new report from S&P. Performance metrics are starting to incorporate the benign effects that lower short-term interest rates are having on affordability for consumers. The agency expects performance data to benefit even further from the current low interest rate environment over the next few quarters.

"As floating-rate mortgage loans included in Italian RMBS transactions typically reset every three months, we expect that the reduction in short-term interest rates should be more pronounced in the performance of Italian RMBS transactions in Q209, as the rate reset changes begin to feed through," explains S&P credit analyst Giorgio Frascella.

He adds: "In our view, the improved affordability conditions should stabilise performance over the course of the year. We think that economic activity and unemployment dynamics are likely to take over from affordability considerations as the primary drivers of performance in this market."

RMBS

Mortgage DTI ratios could lead to weaker performance

Fitch says that European market-standard mortgage underwriting policies, with respect to debt-to-income (DTI) ratios, could lead to a weaker performance of floating-rate loans originated in the current low interest rate environment.

Within its European RMBS and mortgage covered bond analysis Fitch pays particular attention to how a lender assesses affordability. Subject to the lender's approach to affordability assessment, the agency may assume higher default probabilities for floating-rate loans originated during periods of low interest rates.

The DTI ratio, which measures the financial commitments of the mortgage applicant, including the installment of the requested loan, against an applicant's net income, is one of the key drivers behind the mortgage underwriting policies of European banks. For floating-rate loans, the DTI ratio has some limitations as a tool in assessing loan affordability, as the applicant's debt service commitments on the requested loan will be subject to varying interest rate levels.

While this shortcoming can be addressed by factoring the potential increases in interest rates into the assigned ratio, Fitch's analysis of European mortgage lenders' underwriting policies shows that such a forward-looking approach to DTI calculations has rarely been employed. "In those countries where the bulk of mortgage originations consisted of floating-rate products, such as Italy, Spain, Portugal and Greece, the limited use of forward-looking DTI ratios was one of the main factors that contributed to the wave of delinquencies and defaults experienced in 2007 and 2008 by floating-rate loans originated between 2003 and 2005," says Michele Cuneo, senior director in Fitch's European structured finance team.

As an example, Euribor-linked loans originated between 2003 and 2005 had an initial DTI ratio based on interest rates of around 2%. As such, when Euribor moved to around 4% in 2007-2008, the affordability of these mortgages was significantly affected, especially for loans that were originally approved with high DTI ratios.

Fitch expects that floating-rate loans originated in the current low interest rate environment by banks whose underwriting policies do not rely on forward-looking DTI ratios will show a similar sensitivity to interest rate shifts as the 2003-2005 vintages. These loans are likely to be even more sensitive to interest rate movements, with respect to lenders who did not tighten their DTI thresholds during the financial crisis, as low interest rates resulted in more low-income borrowers becoming eligible for a loan.

RMBS

Low foreclosure proceeds for Germany

Fitch says that despite stable house prices in Germany, foreclosure proceeds are low due to steep discounts when disposing of a property through a forced sale. In a special report, the agency says the comparatively low foreclosure proceeds are a result of the German housing market's comparatively high degree of illiquidity, which is caused by different structural characteristics that distinguish the country's housing market from many other western European markets.

These characteristics are Germany's overall stable house price development over the last 20 years, traditionally low home ownership (currently 43%), a low number of re-sold residential units from both owner occupiers and private property investors, and a highly segmented housing market with respect to metropolitan versus rural areas and strong versus weak economic regions.

"Many people in Germany have never considered purchasing their own home," says Susanne Matern, senior director and head of Fitch's structured finance team in Frankfurt. "Additionally, owner-occupiers in Germany do not move up the 'property ladder' by buying and selling during their lifetimes."

As a result, demand for owner-occupied living is low, with high disparities in demand between the German regions. These disparities are mainly driven by differences in regional economic performance.

"Overall, low demand means lower transaction volumes that, in turn, lead to weak informational efficiency regarding sale prices and reference values," says Gabriele Herbst, director in Fitch's structured finance team in Frankfurt. "This results in a high uncertainty around the resale prices that can be achieved, especially in a distressed sale."

Technology

Software optimised for multi-core technology

Quantifi has optimised its software suite for Intel(r) multi-core technology. The firm says that this new development enables faster calculations and increased scalability without additional cost by leveraging the power of modern multi-core CPUs.

"We recognise that in today's environment, clients need robust analytics that can work faster, perform better and scale throughout the firm without dramatically increasing cost," says Rohan Douglas, ceo of Quantifi. "We are leveraging Intel(r) multi-core technology to ensure that we remain ahead of the curve in delivering the premier solution for market participants, built on the most cutting-edge technology available to us today. We are proud to be the first financial software vendor to apply multi-core technology to analytics and risk management."

Indices

Status quo

Barclays Capital MBS strategists Ajay Rajadhyaksha, Kumar Velayudham and Yan Cao discuss the implications of Fed MBS purchases remaining in the MBS Fixed-Rate Index

The Barclays Capital Index Team announced on 10 June that Fed purchases of agency MBS would remain part of the aggregate index. Over the past few months, the question of whether Fed purchases of agency MBS should be part of the aggregate index or not had gathered increasing importance.

There are strong arguments to be made on both sides. But, with this question now answered, comes the task of discussing the implications. We start by looking at the current composition of the index.

Fed buying has focused on conventional 30-year 4s and 4.5s. Currently, there is US$313bn (US$71.5bn in 4s and US$242.8bn in 4.5s) of these two coupons in the index, accounting for just 8% of the agency MBS fixed-rate index (Figure 1).

But as the index only includes issuance through to April, this understates the concentration of lower coupons. With May issuance and most of June issuance out, we know that this number will grow substantially.

We estimate conventional 4s and 4.5s will grow by US$340bn (reaching US$179bn in 4s and US$474bn in 4.5s) over the next three months (which would be pools issued in May, June and July). Hence, even if rates stay where they are, conventional 4s and 4.5s should form around 14% of the agency MBS fixed-rate MBS index.

Implications: down in coupon
We believe that lower coupons could benefit from their inclusion in the index. With a majority of 4s and 4.5s being owned by the Fed, demand-supply dynamics favour lower coupons.

Figure 2 compares Fed purchases through May settlement with pools issued through May. As can be seen, more than 80% of 4s and 65% of 4.5s are owned by the Fed.

With indexed money managers accounting for 20%-25% of the mortgage universe, there are barely enough 4s and 4.5s to go around. We do not think that indexed money managers currently own enough 4s and 4.5s to be in line with the index.

Given the increased mortgage volatility over the recent weeks, we believe that they will try and track the index more closely going forward. This, in our opinion, should benefit 4s and 4.5s, which have taken a beating over recent weeks.

The up-in-coupon trade has performed extremely well in recent weeks, driven by extension fears in 4s and 4.5s (Figure 4). But we believe the trade is overcrowded and overdone. And, as Figure 4 also shows, when that trade has turned over the past six months, it has done so quite sharply.

The 5/4.5 swap looks rich by historical standards (Figure 5). Hence we recommend going down in coupon, buying 4.5s against 5s on a duration-neutral basis.

Other implications: 4s rolling special?
In addition, 4s pose a bigger problem. As Figure 2 shows, as of the end of May, there was US$100bn of 4s, with the Fed having bought US$82bn of these.

More will show up, but as Figure 3 shows, the Fed has bought 4s forward as well, for a total of US$142bn. Given that we expect around US$179bn in 4s to be produced over the next three months, that leaves only US$35bn for everyone else. For 20%-25% of the total agency MBS investor base, a slice of US$35bn is very unlikely to be enough.

Compounding this problem is the likelihood that new 4s are not going to be produced going forward. The economy seems to have stabilised, and mortgage rates have risen by 125bp from the lows, which is where the 4s were created. The result is that, as index managers get used to the idea of 4s and 4.5s in the index, 4s might roll special for a while.

The one point against this argument is that the Fed might eventually offer up some of its 4s to the roll market. But the likelihood of 4s rolling special for a while is quite high, in our opinion.

As far as the basis goes, we would still stay underweight. The two coupons at the heart of the issue - 4s and 4.5s - have very little influence on the nominal basis, given their dollar prices.

In fact, if some investors move out of 5s into lower coupons, it could add widening pressure. We would stay short the basis here.

© 2009 Barclays Capital. This Research Note was first published by Barclays Capital on 10 June 2009.

Trading

Trading ideas: dropped call

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

Verizon Communication's CDS is enjoying a good run this year and trades well off its early year wides. Its stock has had a rougher go of things, vastly underperforming the broader equity market and its CDS over the past two months. Perhaps this is a case of equity doing a better job of setting expectations.

However, our directional credit model points towards deterioration and we find the company's CDS trading far tighter than its equity-implied fair value. Even if Verizon's equity is the better indicator, we expect its CDS to fall into line and believe a relative value trade - buying CDS protection and buying stock - is a great way to take advantage of the current credit-equity disconnect.

Exhibit 1 charts Verizon's market and equity-implied fair value CDS over time. The company's CDS and equity crossed between trading rich and cheap multiple times over the past six months.

Since April, Verizon's CDS far outperformed its equity and now trades almost 20bp tight to fair value. Verizon CDS now trades at levels not seen since last August, while its stock trades lower than at the time of its Alltel acquisition in early January.

Exhibit 2 charts Verizon's market and fair CDS levels (y-axis) versus equity share price (x-axis). The green circle shows current market levels. The yellow square indicates current fair values when vol is also considered. The red square indicates expected three-month levels with our directional credit model factored in.

Our directional credit model points to CDS widening based on weak earnings, accruals and leverage. With CDS too tight compared to equity, we expect a combination of equity rallying and CDS widening.

Risk analysis
The main trade risk is that the name begins trading under a different regime and the current vol-equity-CDS relationship no longer holds. Each CDS-equity position does carry a number of very specific risks.

Recovery and 'default' stock price assumption: In the default scenario the cheapest-to-deliver CDS obligation may have a different than expected market value and the stock price might not fall as assumed.

CDS present value (PV): The CDS PV is an expected value, but not necessarily a realised outcome. In practice, the CDS may trade on an up-front or running basis.

Corporate actions: Spin-offs and private equity buyouts, for instance, could radically change the equity-CDS relationship, leaving investors with a mishedged position.

Government actions: Bailouts, stimulus packages and other governmental interventions have distorted the credit/equity relationship among certain names.

Mark-to-market: Relative mispricing may persist and even further increase, which could lead to substantial return fluctuations.

Position
Buy 20,000 shares Verizon Comm. at US$29.90.

Buy US$10m notional Verizon Comm. 5Y CDS at 65bp.

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).