Contents

CDS

Uncertain direction

Hesitation over sovereign CDS pricing remains

Sovereign CDS have tightened significantly since the beginning of the year, following the credit market rally and a diminishing need for further government intervention in the financial system. Yet, overall, sovereign risk levels are still significantly higher than where they were a year ago. Increased liquidity and cases of unpredictable spread movements imply that market participants are struggling to determine the right price for a trade.

Scott Pagano, emerging markets CDS broker at GFI, confirms that sovereign CDS spreads have tightened since the beginning of the year in general, but adds that the spreads are fluctuating on a regular basis. "Mexico was in the 400s at year-end, and trading around 205 today [30 June]. The market is unpredictable and a gap in any price with little trading in-between is not uncommon in today's market," he says.

Liquidity has also increased over the past quarter, as reflected in Fitch's sovereign CDS liquidity index. "While the volatility in spreads has lessened since the autumn or winter just passed, the increased liquidity suggests that there is still a lot of uncertainty in the market, and buyers and sellers of the CDS are still looking for the right price for certain names," says Jon Di Giambattista, senior director, risk & performance analytics at Fitch Solutions.

In many countries, it is the state of the banks - not the governments - that are reflected in the CDS pricing, according to Giambattista. "In the US, for example, we've seen banks repaying TARP money. We have therefore seen a robust tightening in US spreads in line with the rest of the market," he says.

"The market is still trying to figure out the degree of government interventions and the economic health of countries," he adds. "The degree of debt issuance is also likely contributing to some technical movements in sovereign spread levels."

However, in some cases spreads on sovereigns are fluctuating with little or no correlation to political or financial news from the region.

Based on GFI data, the most liquid names trading today are Brazil and Mexico. "Mexico has seen the most liquidity as of late, and general opinion is that this fact is not based on news/politics coming from these regions," notes Pagano. "The day of the earthquake in Mexico the CDS widened out quite a bit, but came back in a few days later. Markets can shift spreads and with no news/events to justify the move in price."

Venezuela and Argentina are the least liquid credits, according to GFI data. Currently, the price of their CDS is widening.

"The uncertainty of their credit has drastically reduced the amount of trading with these two sovereign credits. There are still a few dealers actively trading Venezuela and Argentina CDS, but most trades are in minimal size of US$5m, with US$10m being the largest trade in the current market," adds Pagano. "The spreads can shift rather quickly and that has kept many dealers from actively quoting to clients."

However, Dave Klein, manager of CDR Credit Indices, notes that its Government Risk Index (GRI) - an index of the CDS of seven major debt-issuing nations - dropped significantly across most of the major constituents this week. As of 30 June, CDR GRI was down by 11.1bp (-17%) to 56bp from 67.1bp recorded in the previous week.

The GRI now sits roughly halfway between its recent highs of 68.2bp reached on 18 June and recent 8 May lows of 46.5bp. "With the continued strength shown by financials, we would not be surprised to see the GRI drop, or at least hold steady, as the need for further sovereign intervention in the financial system recedes or at least is delayed," says Klein.

However, Diana Berezina, research director at Fitch Solutions, concludes that sovereign CDS spreads have not returned to pre-crisis levels. "They may have moved in substantially, but going on a benchmark portfolio of sovereign CDS names, spreads are 192% wider than this time last year - this puts things into perspective."

Meanwhile, a new family of sovereign CDS indices is being prepped by Markit - see separate 'News' story.

AC

CMBS

Kicking the habit

US ABS market's TALF dependence diminishing?

The Federal Reserve has decided not to extend TALF past the end of the year, despite extending a number of other liquidity programmes. While current market sentiment suggests that by December 2009 the ABS market should have recovered to a point where a 'real' primary market could take over, some are calling for an extension of the programme for certain problematic assets, such as CMBS.

The Federal Reserve last week announced extensions of and modifications to a number of its liquidity programmes. Specifically, it approved the extension until 1 February 2010 of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF). However, the expiration date for TALF has not changed: it remains set at 31 December 2009.

"There are concerns in the structured finance industry as to what happens at the end of the year when the TALF programme finishes," says Marjorie Hogan, senior portfolio manager at Capstone Credit Advisors in New York. "However, I'm not sure the programme is necessarily needed any more. It's a matter of confidence - and confidence is growing. A number of investors are now happy to put their own money towards new deals."

Several non-TALF deals have emerged in recent months. Just last week Chase Issuance Trust marketed and placed a US$1.8bn non-TALF-eligible credit card ABS with third-party investors. The US$1.825bn transaction - CHAIT 2009-A5 - was issued at a price of 80bp over one-month Libor for a WAL of one year.

One ABS trader suggests that the US Treasury is unlikely to want to extend the TALF programme any longer than it has to. "Besides, the market is now seeing new issue ABS - credit card, auto and even student loan deals - being snapped up outside of TALF by unlevered investors," he notes.

Improved secondary market liquidity may also be a sign that the structured finance market is gradually weaning itself off the US government's support. "Trading in CDOs and RMBS has picked up substantially in the past couple of months. It feels almost like business as usual," says Hogan. "The Armageddon risk in these securities has been taken off the table. Underlying credits are still at risk though - especially in corporate CDOs."

The ABS trader adds that it is a little early to say that the TALF programme is redundant, given that the CMBS and RMBS sectors are yet to feel its benefit and start opening up. "It would be helpful to extend the programme beyond the end of the year for CMBS in particular because of the significant refinancing issues the sector faces going forward," he notes.

According to Aaron Bryson, CMBS strategist and vp at Barclays Capital in New York, the most pressing question with regards to CMBS remains how the Fed will respond to potential super-senior downgrades by S&P (see News Round-up for more).

He indicates that the Fed should pursue the following strategy in connection with TALF: include super-seniors originally rated triple-A with higher haircuts for any such bonds that are downgraded and not rejected by the collateral monitor; maintain current haircuts for senior triple-A bonds that are not downgraded; and allow senior pieces of re-REMICS (simplified structures only).

"We believe this would have the greatest impact toward its stated goal of stabilising the commercial real estate market and reviving CMBS, while also balancing risks," he says.

Bryson also suggests expanding the programme beyond its scheduled maturity at the end of 2009, as 'unusual and exigent' conditions in the CMBS market will likely persist. "We see growing pressure emanating from the shutdown of the CMBS market," he adds.

The importance of reviving CMBS is magnified beyond the end of this year, given rising maturities and weaker collateral characteristics. In 2009, Barclays Capital CMBS research analysts estimate that only 29% of remaining maturing loans have an exit debt yield of less than 10%; by 2017 this jumps to 87%, or US$118bn by current balance, using most recent cashflow figures.

"This is simplistic, as you could argue for upside and downside risk to most recent cashflow figures. But it signals significant, prolonged stress and uncertainty around principal recovery, consistent with our conservative stance on recent vintage LCF triple-As," they note.

"A legacy TALF programme will certainly not 'save' all of these loans, but increasing credit availability and reducing required debt yields would enable a greater percentage of such loans to find refinancing," they conclude.

AC

CLOs

Short-term gains

Loan amend-to-extend negotiations gather pace

Negotiations between issuers and investors over loan amend-to-extend restructurings are expected to become more prevalent as both sides increasingly jockey for more favourable deal terms. But concern is growing about whether the extra yield sought in the short term will compensate for potential ratings downgrades and the impact of defaults on the CLO market in the long term.

"Amend-to-extend restructurings are always going to be a theme any time that there is stress in the market and at present we're seeing the end of a cycle in using leveraged loans as prolifically as we did in the past," notes Jason Pratt, md at Peritus I Asset Management.

He says that the recent Georgia-Pacific restructuring is a good example of the powerful role securitisation played as a buyer base in developing the breadth of the asset class. Without the ability to utilise securitisation, there is a question about how useful leveraged loans are in more traditional portfolios.

"Looking back to mid-2007, securitisation created additional demand for risk by using a vehicle which could be bought easier than the loans themselves," he adds. "Now that excess demand has evaporated. It's easy to look back now and note the time needed by banks in working out their pipelines as securitisation shut down. That supply and demand ratio needed to get worked out."

Georgia-Pacific has three term loans - A, B and C - and has extended the maturity of the C loan under the restructuring to December 2014, with a provision that will see the coupons (currently set at 200bp over Libor) on the A and B loans step up by 100bp if the leverage of the C loan extends beyond 4.5x. The firm was initially seeking a US$1bn-US$1.5bn deal, but the size was cut to US$750m-US$1bn with increased pricing set at 325bp over Libor.

Favourable EBITDA definition changes, covenant amendments and a second-lien debt issuance basket were also dropped in order to get the deal away. High yield strategists at Barclays Capital suggest that the company had to revise the terms of its proposal after receiving pushback from investors, who considered it below market. "We expect such back-and-forth to become more prevalent as firms and investors jockey for a better deal," they note.

Georgia-Pacific also has a US$2bn revolving facility. But if it's using some of the proceeds of the loan extension to pay down the A and B loans and the interest is being used to repay the debt, it leaves questions about refinancing debt the market generally doesn't see - like the revolving facilities.

"Issuers have seen over the past six months a willing participation and have taken advantage of this demand, while investors are looking for Libor floors and leverage safety in the pricing," explains Pratt. "There is capitulation on both sides: companies are agreeing to terms that they wouldn't normally prefer; investors are focused on the short term at the expense of the long term. A step-up of the magnitude of Georgia-Pacific's on a breach of leverage will inevitably impact a company's free cashflow, for example."

The high yield market remains concerned about defaults and recoveries, yet there is little focus currently on the sustainability of these companies, according to Pratt. "The amend-to-extend process is enabling the right companies to circumvent the need to refinance in 2010/2011, but many others will be forced to fail. Such companies can survive for a little while longer in current conditions, but what's the motive for investors? They can, for example, charge issuers more if the leverage increases, but if the company is going to fail anyway, what is the point?" he asks.

A significant issue in terms of debt maturity is that there's no more clarity about the market today than there was six months ago. As such, Pratt suggests that the closer the market gets to 2011 without a material improvement in the economy and the performance of the issuers, the more defaults are likely to hit the market.

"In cases where there's some stress, investors holding a TLA could still get paid - given that adjustments to terms, such as coupon step-ups, may boost spreads. But it's a question of whether that extra yield will compensate for potential ratings downgrades and the impact of defaults on the CLO market more broadly," he concludes.

CS

CMBS

CMBS re-REMIC-induced rally 'unsustainable'

Additional CMBS re-REMICs were marketed in the US last week (see SCI issue 142). While the rise in the number of deals has contributed to the tightening of CMBS prices, analysts at Barclays Capital do not expect a further short-term rally purely as a result of re-REMIC activity.

At least three more CMBS re-REMIC deals were marketed in the US last week, backed mostly by 2007 vintage collateral of average to below-average quality. The expected pricing range for the senior tranches, with 50% credit enhancement, remained in the 500bp over swaps range for most deals.

"This is roughly in line to slightly tighter than where we think underlying top-tier 2007 vintage LCF triple-As trade," note CMBS analysts at Barclays Capital. They add that on the triple-A rated mezzanine re-REMIC classes, typically with 30%-50% enhancement, price guidance has been in the 15%-16% yield range, which is roughly 50bp-200bp tighter than where they believe top-tier 2007 vintage AMs trade.

"We believe the re-REMIC activity has helped reverse most of the late May/early June spread widening fuelled by downgrade concerns," the analysts add. "It has generated incremental demand for triple-A CMBS, primarily from ratings-constrained investors or investors extremely sensitive to any principal impairment (as opposed to extension risk)."

From 22 May - the day before the S&P RFC addressed triple-A credit support levels (SCI passim) - until 15 June, BarCap estimates that recent vintage LCF triple-A spreads widened by 295bp. From 15 June until late last week, BarCap recorded a 215bp tightening in spreads.

"At this point, we do not expect a further short-term rally in triple-A spreads purely from re-REMIC activity, as the price difference between the underlying collateral and re-REMIC execution has narrowed sharply," the BarCap analysts conclude.

AC

Indices

New sovereign CDS index prepped

Markit is set to launch a family of sovereign CDS indices in July. Dubbed Markit iTraxx SovX, they will track investor perceptions of the credit risk of a range of countries around the world.

Niall Cameron, evp of commodities, indices, equities and risk management at Markit, explains: "The financial crisis and the effects of governments' financial guarantee schemes on the perceived credit quality of their debt have put sovereign CDS under the spotlight. We have therefore designed the Markit iTraxx SovX indices to provide investors with greater insight into the credit risk of a group of countries and an ability to gain exposure to the sovereign CDS asset class."

The trading of sovereign CDS has historically been limited to emerging markets, reflecting the credit risk associated with the government debt of these countries. However, an actively traded CDS market in industrialised sovereigns has now emerged as a result of the financial crisis and growing investor concerns relating to the solvency of developed economies.

Markit says that the family of indices has been designed to meet investor demand for a transparent and standardised tool to monitor the sovereign CDS market and gain access to the asset class on both a regional and global basis. The creation of this alternative investment tool is expected to bring more investor demand for sovereign credit, the firm adds.

The SovX family of indices will initially comprise a SovX G7 index, which tracks the credit risk of the most industrialised countries in the world; a SovX Global Liquid IG index, tracking the credit risk of countries in Asia Pacific, Eastern Europe, Latin America, Middle East & Africa, North America and Western Europe; a SovX Western Europe index, tracking the credit risk of 15 countries in Western Europe; and a SovX CEEMEA index, which tracks the credit risk of 15 countries in the CEEMEA region.

Credit Derivatives Research was the first to enter this space when it launched an index designed to track the credit risk of leading industrial nations' sovereign debt in April (see SCI issue 130). Dubbed the CDR Government Risk Index (GRI), it tracks the CDS spreads of the US, the UK, Germany, France, Italy, Spain and Japan.

CS

Indices

ABX stabilises, but constituents continue to be hit

ABS analysts at Wachovia Securities have updated their 'loss-timing' and 'unrealised factor' models to estimate the expected cumulative net losses in subprime mortgages. The results of this update for the June 2009 remittance report data show that average cumulative net losses for the ABX index cohorts would be in the range of 12.5%-18.7% for the 2006-1 index, 20.3%-28.3% for the 2006-2 index, 26.6%-36.2% for the 2007-1index and 38.2%-42.2% for the 2007-2 index.

The analysts attribute the differences between the two models to the higher loss severity assumptions built into the unrealised factor model, as well as the timing of defaults and net losses. However, they point out that while credit performance is still weak in the subprime mortgage sector, credit does continue to show signs of stabilising at current levels.

Indeed, the latest ABX remits show that default rates were relatively stable in May, decreasing by 63bp for the 06-1 index and increasing by 20bp-110bp for the rest of the indices. This follows a period of high volatility in which CDRs jumped and dropped sharply in alternate months, according to structured credit analysts at JPMorgan.

Voluntary CPRs fell by 106bp for the 07-2 index, while increasing modestly by 19bp-27bp for the other three indices. However, losses continued to increase at a steady pace in May; cumulative losses are now at 8.39% for the 06-1 and approximately 11% for the others. The JPM analysts point out that the ACE 07-HE4 (07-2 constituent) and MSAC 06-WMC2 (06-2 constituent) are the worst performing deals in the indices, with losses currently at 19%.

60+ delinquencies increased by 70bp-80bp for the 06-1 through 07-1 indices and by approximately 109bp for the 07-2 index; 60+ delinquencies are now at 41.95% for the 06-1 and in the 46%-47% range for the others and have been increasing at a steady rate. "The rising foreclosure and 90+ buckets and falling REO inventory suggest that servicers are waiting for more progress on the loan modification and H4H refinancing front, and hence they have been slow to move loans into REO while continuing to liquidate loans that are already in REO," the analysts add.

In total 98 ABX constituents have been fully written down, according to JPM, with the 06-2 index contributing the most (33 bonds) and an additional 15 are currently being hit. "Given how thin most of these tranches are, it generally only takes two to three months for them to get wiped out, which will result in almost 115 out of 480 reference entities being fully written down by the end of 3Q09."

CS

Structuring/Primary market

Northern Rock to spin mortgage book off

Further details have emerged in connection with the restructuring of Northern Rock (SCI passim). The proposal is expected to be completed in the second half of the year and will split the firm into two separate entities - a 'BankCo' and an 'AssetCo'.

The BankCo is to be authorised by the FSA as a deposit taker and will undertake new lending. It will hold the retail deposit book, some wholesale deposits and a proportion of Northern Rock's unencumbered mortgage assets, together with the firm's branches and mortgage origination capability.

The AssetCo, on the other hand, will hold the balance of the existing residential mortgage book, the vast majority of which is performing, including the firm's interest in those mortgages allocated to the Granite securitisation and covered bond programmes. AssetCo is to also hold the existing government loan to Northern Rock, plus the firm's wholesale funding instruments. It is proposed that AssetCo will not hold any retail deposits and, subject to FSA approval, will be regulated as a mortgage lender with a lower regulatory capital requirement.

The proposed structure offers the most capital efficient solution, according to Northern Rock, with an additional capital requirement - for BankCo and AssetCo combined - of no more than £3bn. However, implementation of the proposed restructuring is conditional on European Commission approval and on any necessary consents and approvals under foreign law.

The asset-backed strategy team at RBS expects the changes to have little impact on investors in Granite RMBS, at least in the short to medium term, as the master trust is in wind-down and the assets are ring-fenced. However, they point to two key concerns: that servicing/collections quality is maintained to a good standard; and that the incentives are changed to call/restructure the Granite transactions in the longer term.

"In practice all the functions carried out by Northern Rock for Granite would be very likely to stay with BankCo and continue to have reputation risk, and the securitisation would have the ability to move contract to another party if the functions were not carried out to required standards," the RBS strategists explain. "Given that the seller share in Granite would form a significant portion of the assets of the bad bank, there would still be incentive for the government to ensure AssetCo maximised its recoveries from the trust."

They suggest that in the short term extension risks will depend on the interest rate setting process for the mortgages and any influence that has on CPR, and whether lending by the good bank targets previous customers. "Ultimately the tail redemption risk will depend on whether the trust is wound-up to release the assets in the seller share. If the assets perform reasonably well, this should become an increasingly attractive option as the trust shrinks in size."

CS

Trading

Driving democratisation

Farooq Jaffrey, founder, chief executive and head broker of Traccr, answers SCI's questions

Q: How and when did Traccr become involved in the structured credit market?
A: We got UK FSA approval this month (June) and are now operating as the first retail CDS broker to market. Traditionally, the CDS markets have been available exclusively to volume players. However, the growing liquidity, ease of use and transparency of credit derivatives has drawn the attention of retail traders. Many people wish they'd had an opportunity to short the iTraxx, for example, a year ago, but the infrastructure wasn't there.

Q: What is your strategy?
A: Traditionally, most CDS products were pushed through dealers' private client networks and were pre-constructed as opposed to being customised for retail investors, so often re-distributors did not know what they were selling and accounts didn't really know what they were buying, besides the headline marketing information. But through our dealing relationships, we can create customised products with the appropriate education and disclosure.

There is demand for credit derivatives for risk management purposes too. Retail investors typically have a 25% allocation to corporate bonds and so have a need to hedge their positions with CDS. They couldn't do this before Traccr launched.

Private banks in particular have suffered recently because their portfolios were mostly long-only. We're working with clients to mitigate that risk; for example, by providing an index hedge using CDS indices or buying protection on certain names if there is a large concentration.

The Traccr service is also perfect for managed account platforms because it enables fund managers to do one trade but divide it into lots of US$10,000-sized buckets via a CLN, so that each investor on the platform has an allocation. Historically, it was impossible to break a CDS trade into retail sizes, but this way it's easier for the fund manager to allocate gains and losses on the position for each managed account.

Q: Which market constituent is your main client base?
A: Our clients are professional traders within the FSA definition of professional client; in other words, someone who understands CDS and has a minimum net-worth. This encompasses high net-worth individuals up to institutions, such as private banks and stock brokers. The idea is to enable them to trade on their own account.

Private banks have historically been significant issuers of CLNs, although they aren't typically specialists in credit derivatives. They are relationship managers that assist in finding the appropriate trading strategies for their clients, and thereafter source execution either in-house or through the market. They often do not have accessibility to CDS, however.

We're working with private bank clients in particular to explain how the product works. Given all the changes happening in credit derivatives at the moment, such as the move to trading upfront plus coupons and the big/small bang protocols, there is still a lot for people to understand about the market. Education is an important aspect of the business and so we provide trading simulations and will supplement the infrastructure with more tools over time as the market develops.

This also serves to supplement the efforts of dealers, who obviously want to maintain these client channels but are also aware of the compliance issues and so want to be sure that the counterparty understands what they're getting into (in light of the minibond scandal and so on). The retail channel is very important for banks: it's a mass market where they can do interesting and different trades around the world. Although these trades are usually in the form of CLNs, they can take customised forms and have different underlyings.

Q: How do you differentiate yourself from your competitors?
A: We have first-mover advantage. As central clearing of CDS picks up, it will naturally make the product more transparent and then real money should enter the market. Consequently, we expect some competition in the future, but we'll differentiate ourselves by our knowledge of CDS and broking.

I was previously head of structured credit trading at CreditTrade and my partners are an ex-CDS trader and CDS compliance professional. We believe that ultimately the quality of service we provide is the most important differentiator. Given our target market, this service needs to be client-led.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
A: Our challenge is to get people familiar with the Traccr platform. We believe that once customers understand the service, they'll get the concept straight away.

At the moment participants aren't necessarily sure where the market is heading. CDS sold off last year, which created lots of volatility, which has since disappeared now that people are waiting to see what happens. Volatility is good for the credit derivatives business, but there are still opportunities for investors to put on one- to three-year mezz iTraxx index tranche trades or first-to-default baskets on reference credits they are comfortable with. Investors are happy to take on this risk because they want yield, know the reference names and are comfortable with the risk.

When volatility returns to the market, a good trade to put on would be options on CDS. There are so many different structures on offer; the key is to provide the products that clients need.

Q: What major developments do you need/expect from the market in the future?
A: As soon as CDS begin to be widely cleared with via central counterparties, we'll start seeing a democratisation of the product. Anyone can trade FX or equity options, for example, and in some ways CDS are less risky than these asset classes because you can't lose more money than the notional you bet. CDS may have got a bad name due to the fallout from the subprime debacle, but a need to transfer credit risk will remain - and the need to educate the market will continue.

The current industry initiatives that are underway - central clearing, big/small bang protocols and so on - are positive for the market. There is a general impetus from dealers to improve the transparency of the CDS market and educate investors, as well as the public, about the usefulness of the product.

CS

ABS

Packman heads to Aladdin

Alan Packman has joined Aladdin Capital Management UK as an md, where he will focus on ABS, CDOs, CLOs and MBS. Packman was previously head of ABS at Hoare Capital Management - a role he held for four months.

Aladdin is hiring a number of ABS specialists for its new structured sales and trading platform. See last week's issue for more.

Advisory

Joint venture builds out advisory platform

VCAP Solutions is set to offer independent valuation and strategic advisory services across all fixed income securities, loans and securitised products. The platform was created by combining Vertical Capital's technology and analytics with Kensington Blake Capital's advisory platform, which has deep experience in structured products valuation, advisory, risk management and the trading of complex loans and securities.

VCAP Solutions has been formed in response to the unprecedented changes in the financial markets that have created demand for independent advice, valuation and analysis, the two firms say. The platform's services are focused in three main areas: valuation and financial reporting, risk assessment and strategic advisory. Its range of capabilities include delivering independent valuations on large portfolios, providing granular cashflow and stress analysis, and assisting in portfolio management and trade execution on individual assets and portfolios.

The effort is led by Charles McLendon, who will join as managing partner. He was formerly the president and cio of Primus Asset Management and was the global head of the investment grade credit group at Bank of America. Ricardo Diaz and Brian Zwerner, former partners at Kensington Blake Capital, will join as founding partners in VCAP Solutions.

McLendon says: "Our clients need access to unbiased advice supported by granular information, market perspective and robust analytics capabilities. The combination of an experienced team of structured products professionals with access to market-leading tools developed over the last six years at Vertical Capital will allow VCAP Solutions to be an immediate leader in the market for providing valuation and risk management services."

CDS

FINRA fines ICAP, fines and suspends CDS broker

FINRA has fined ICAP US$2.8m and sanctioned a former broker for numerous improper communications with other interdealer brokerage firms about customers' proposed brokerage rate reductions in the wholesale CDS market. FINRA's investigation into misconduct by the other interdealer brokerage firms and individuals involved is continuing.

Jennifer Joan James, a former ICAP broker and manager of ICAP's CDS desk, was fined US$350,000 and suspended from working in the securities industry in all capacities for six months for attempting to improperly influence other interdealer brokerage firms and their employees. ICAP was fined US$1.8m for its supervisory failures - specifically, failing to detect and prevent improper inter-firm communications - and US$1m for engaging in conduct through its CDS desk manager that was designed to improperly influence other firms and their employees.

FINRA found that James engaged in repeated improper communications with personnel at other interdealer brokerage firms that improperly attempted to influence those firms and individuals. These communications generally occurred after individual customer firms sought to renegotiate their CDS brokerage fees, sending schedules of proposed rate reductions separately to a number of individual interdealer brokers. James's communications with personnel at other interdealer brokers included reactions to customers' proposed rate reductions, statements concerning actual or contemplated interdealer broker responses or counter-positions to the customers' proposed rate reductions, and discussions about the interdealer brokers creating identical or similar individual counter proposals to rate reduction requests.

FINRA also found that while James's communications typically involved one-to-one discussions with personnel from one other CDS interdealer brokerage firm, the communications frequently referred to similar discussions about the proposed fee-reduction schedules with additional interdealer brokerage firms.

ICAP and James settled these matters without admitting or denying the allegations, but consented to the entry of FINRA's findings.

CLOs

Dispute arises over CLO manager replacement

The controlling class of Hudson CLO 1 is trying to remove Aladdin Capital Management UK as collateral manager on the deal. According to a regulatory news filing, the trustee (BNY Corporate Trustee Services) and the issuer have received requests from certain Class A-1 noteholders to convene a meeting of the controlling class for the purpose of directing the removal of Aladdin as collateral manager for 'cause' pursuant to clauses 5.4 and 5.12 of the collateral management agreement.

 However, according to the trustee, Aladdin disputes the right of the controlling class to take steps to effect its removal, and has requested a meeting of the controlling class and of the holders of the Class C notes in order to discuss the replacement of a key person (as defined in the Collateral Management Agreement) proposed by Aladdin.

In the circumstances the trustee is considering the position, including the above-mentioned requests, and the action it should properly take, which may include seeking the directions of the court. In the meantime the trustee has not acted on any of the said requests.

Distressed assets

Drum hires two

Distressed investment manager Drum Capital Management has named David Marcus associate director and Colin Wilson-Murphy associate of the firm.

Marcus will focus on global markets, with particular emphasis on Europe and developing Asia. He joins Drum Capital after six years with Bassini Playfair Wright, a diversified investment management firm focused on emerging markets, where as a private equity analyst he tracked global portfolio companies, fund investments and managers, in addition to evaluating acquisition candidates.

Wilson-Murphy was previously an investment banking analyst with Capstone Partners, where he specialised in middle market mergers & acquisitions and corporate recapitalisations.

"Dave and Colin are both top performers and core components of the firm's robust growth as we expand our domestic expertise and global reach, particularly in the pan-Asia markets," comments Scott Vollmer, ceo of Drum Capital. "We are consistently adding to our industry-leading roster of over 340 global distressed and turnaround specialists actively tracked and managed, and look forward to the immediate contributions of these key additions."

Distressed assets

Distressed debt manager wins Alaskan mandate

The Alaska Permanent Fund Corporation Board of Trustees has hired Oaktree Capital Management to manage a portion of its distressed debt allocation. The Board says it has committed US$250m to Oaktree's Opportunities Fund VIII, which focuses on distressed debt opportunities. This new commitment is part of the Fund's 1% allocation to distressed debt.

In a related action, the Board has approved the transfer of US$200m of existing debt-based absolute return strategies from Crestline`s distressed opportunity mandate to Crestline`s absolute return mandate. This transfer of exposure will better align the investments of Crestline's two portfolios with the Fund`s new asset allocation, the Board notes.

Investors

Hedge fund divests its structured credit portfolio

Basis Pac-Rim Opportunity Fund is to begin selling off its structured credit securities and paying back capital to investors. The move comes in light of the continued global market deterioration and volatility.

In a letter to investors explaining the proposed sale the hedge fund explains that the value of the securities has been almost exhausted after crystallising losses of almost 40% since 1 June 2007.

Basis Pac-Rim says: "In the circumstances, the value of the structured credit portfolio has now been practically exhausted and, given that the ongoing costs of holding the securities may shortly exceed future anticipated cashflows from those securities, it is the investment advisor's view that there is little continued benefit to investors in continuing to hold the structured credit assets."

90% of the remaining participating shares have been compulsorily redeemed and investors will receive a corresponding cash payment this month.

Investors

Middle market platform launched

Steve Shenfeld has joined the newly formed Mid-Ocean Credit Partners unit as president. Shenfeld will be responsible for building out a credit investment platform focused on middle market opportunities.

Prior to joining MidOcean, Shenfeld managed a private equity fund for MD Sass, a US$6bn investment management organisation, and previously was a general partner with Avenue Capital Group where he invested in a range of high yield and distressed debt strategies. Shenfeld has also worked at BancBoston Robertson Stephens as an md and group head for high yield capital markets and trading and was a partner at Bankers Trust where he worked with Ted Virtue, MidOcean's ceo, and several other members of the MidOcean team.

Virtue says: "We believe that the dislocation in the credit markets will continue to bring great opportunities to deliver strong risk-adjusted returns to our investors. I am delighted to partner with this world class team of debt professionals on this initiative. I have had a long relationship with Steve and his team and hold each of them in such high regard."

Joining Shenfeld at MidOcean are Mike Apfel as an md and Jim Wiant as principal, who previously worked together at Deerfield Capital where they were responsible for building and managing Deerfield's middle market debt business. Apfel has over 18 years of credit market experience and previously worked with Virtue at Bankers Trust. Apfel also worked at Bank of America and Chemical Bank.

Also joining the MidOcean team is Scott O'Callaghan, md, who previously worked with Virtue and Shenfeld at Bankers Trust and most recently was global head of leveraged sales at Bank of America. O'Callaghan has 20 years of wide-ranging experience in credit markets, including senior positions at Drexel Burnham Lambert, Bankers Trust and Deutsche Bank.

Virtue adds: "Information flow is the key to successful investing and by leveraging MidOcean's focused relationships in the middle market, this should be a very complementary network for our investors."

Investors

Hedge fund vet joins asset manager

Coast Asset Management has appointed hedge fund industry veteran Roy Callahan as a portfolio manager and member of the firm's investment committee. He joins the firm from Stratos Advisers, a southern California-based hedge fund of funds manager. Previously, Callahan worked at Financial Risk Management (FRM), where his responsibilities included serving on the investment and portfolio management committees, as well as training and mentoring FRM investment analyst groups.

Investors

Listed REIT to invest in MBS

Invesco Mortgage Capital, a REIT managed by Invesco Ltd that plans to invest in agency and non-agency MBS, has raised US$170m by offering 8.5 million shares at US$20 each. The company had originally planned to sell 20 million shares before cutting the deal size last Thursday, immediately prior to its IPO. Credit Suisse and Morgan Stanley were the lead underwriters on the deal, with the REIT listed on the NYSE.

LCDS

Boutique adds in high yield

Pali Capital has continued the expansion of its high yield sales and trading team with the hiring of Matt Goldfarb and Peter Levine from Tradition (North America) Inc, and William Tillinghast from SMH Capital in New York.

While at Tradition, Goldfarb was co-manager of the loan trading desk that handled institutional accounts, including hedge funds, mutual funds, CLOs, insurance companies and private equity firms. Prior to Tradition, he was a director at The Blackstone Group/GSO Capital Partners, where he was a senior member of that firm's credit team.

Levine was most recently an assistant trader and loan closer at Tradition, where he gained extensive experience ensuring the closing process for levered loan trades. While at the firm, Levine brokered both high yield bonds and gained exposure to distressed and par bank debt contracts and credit agreements. He came to Tradition from LM Isis Capital Partners, where he was a trading associate handling CDS, LCDS, various indices and bank debt.

William Tillinghast was most recently a member of the investment banking and private capital group at SMH Capital. He brings to Pali knowledge of private placements focusing on PIPEs, debt, private equity and venture capital.

LCDS

Jefferies takes on two loan specialists

Jefferies has hired two for its leveraged loan sales and trading effort. Anthony LoGrippo joins as an md and head of par loan trading, while John Gally joins as an svp for par loan trading.

LoGrippo joins Jefferies from Deutsche Bank, where he worked for eleven years and was most recently an md and head of par loan trading within that firm's senior debt capital markets effort. Previously, he was a director in the leveraged portfolio group at Bankers Trust. Gally also joins Jefferies from Deutsche Bank, where he worked for nine years and was most recently a vp and trader of bank debt and LCDS.

"With the addition of these new partners, we continue to expand Jefferies' high yield and distressed debt platform and strengthen our presence in par loan trading," comments Richard Handler, chairman and ceo of Jefferies.

Ratings

Fitch expands and promotes in structured credit

Fitch has hired Melissa Tessier as a senior director for structured credit business development. She will report to Karen Skinner, md and head of structured finance business development for EMEA at the agency.

Skinner says: "Melissa's extensive structured credit syndicate and marketing experience, coupled with her CDO structuring background will enhance Fitch's strong investor focus in the structured credit market."

Prior to joining Fitch, Tessier worked on the structured credit syndicate desk at Bank of America from 2006, where she was responsible for distribution and pricing of global structured credit products. Before that, she spent six years at Axa Investment Managers in Paris, initially in high yield fund management and later within the CDO structuring/marketing division.

Meanwhile, Jeremy Carter has been promoted to become the new head of European and Asian structured credit at Fitch. He replaces Phil McDuell and will report to Ian Linnell, group md and head of structured finance for EMEA.

Linnell says: "Jeremy has been heavily involved in the recent enhancements to our structured credit operations and is therefore extremely well placed to take the group forward."

McDuell is believed to have left the agency for a new role at RBS.

Real Estate

Real estate specialist adds new role

GE Capital Real Estate has expanded its global investment management team with the appointment of real estate veteran Skip Wells as fund manager for senior secured debt investments. In this newly created role, he will be responsible for the implementation of investment strategies and general fund supervision.

Wells moves over from GE Capital Real Estate's strategic capital group, where he was md of originations. He began his GE career in 1989 with the GE Capital financial management programme, before holding roles at GE Capital Real Estate as a finance operations analyst, asset manager, underwriter and relationship manager.

Real Estate

Real estate fund to target Europe

The Blackstone Group has closed its latest real estate fund, Blackstone Real Estate Partners Europe III (BREP Europe III). The closing brings to the fund total equity capital commitments of over €3.1bn.

The fund will target property investments throughout Europe and is composed of commitments from a diversified group of limited partners from around the world. Its investment portfolio is expected to consist of a variety of real estate-related securities, including mezzanine debt, publicly traded debt securities, whole loans, preferred equity, bridge equity, publicly traded equity securities and joint venture equity.

Chad Pike, senior md and co-head of Blackstone Real Estate, says: "We are very pleased to have received this further vote of confidence from both existing and new Blackstone investors. BREP Europe III is well positioned to take advantage of the inevitable recapitalisation of the property sector. Given the continued deterioration in the global economy and the lagging nature of the real estate market, we will remain disciplined and cautious in deploying this capital over the coming years."

Since The Blackstone Group started its real estate investment business in 1997, the firm has raised a total of over US$28bn. Its alternative asset management businesses include the management of corporate private equity funds, real estate funds, funds of hedge funds, credit-oriented funds, CLOs and closed-end mutual funds.

Real Estate

CRE manager appoints new ceo

JE Robert Companies (JER) has appointed Barden Gale as ceo. He joins JER from Starwood Capital Group, where he served as vice chairman of real estate.

Joseph Robert, founder of JER and its chairman and ceo since 1981, will become executive chairman. In this role, Robert will work with Gale to add value in setting corporate strategy and structure, as well as in building relationships with investors and business partners.

As ceo, Gale is responsible for leading the company's strategic growth and managing its daily business operations globally. He will begin in mid-July and will be based in McLean, Virginia.

Regulation

EIWG to set regulatory agenda

The European Investors Working Group (EIWG) met yesterday, 30 June, for the first time in Brussels to set the agenda for its active contribution towards creating an efficient, effective and globally competitive European regulatory model. The EIWG has been established as an independent, non-political body to evaluate both the strengths and weaknesses of the existing regulatory model of the financial markets and proposed solutions to the current crisis. The primary objective is to represent the interests of professional investors, and through them the many thousands of investors they serve, the Group says.

The EIWG's initial agenda will focus on MiFID; market abuse and the prospectus directives; the Lamfalussy and the de Larosière framework on the supervisory side; funds and investment products, including the Alternative Investment Fund Manager Directive (AIFM); and corporate governance and transparency issues.

The co-sponsors of the EIWG are the CFA Institute Centre for Financial Market Integrity and the European Capital Markets Institute (ECMI). The group is chaired by Fabrice Demarigny, head of capital markets activities at Mazars and former secretary general of CESR. Members of the Group are leading investor organisations, industry observers and investment practitioners with deep knowledge of the European framework for financial regulation and oversight.

Charles Cronin, head CFA Institute Centre for EMEA, says: "Policy making is now progressing at a pace rarely seen before. The scope for major regulatory reform has never been greater. In this context, it is important that the collective voice of investors and users of financial information is given the weight it merits. It is critical that the coming reforms be measured and modern in their design and application, and that their framework must offer protection to investors that is both adequate and effective.

RMBS

Two Harbors SPAC financing completed

Thomas Siering, a partner of Pine River Capital Management and the president and a director of Two Harbors Investment Corp, has entered into a written plan to purchase up to an aggregate of 100,000 shares of common stock of Capitol Acquisition Corp, pursuant to Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934. Capitol and Two Harbors, a company wholly-owned by Pine River, have entered into a merger agreement pursuant to which Capitol will become a wholly-owned subsidiary of Two Harbors following approval of the merger by Capitol's stockholders (see SCI issue 141).

Capitol Acquisition Corp is a Washington D.C. specified purpose acquisition company (SPAC) formed for the purpose of acquiring through a merger capital stock exchange, asset acquisition, stock purchase, reorganisation or similar business combination with one or more operating businesses or assets. Two Harbors is a newly-formed Maryland corporation focused on investing in, financing and managing RMBS. The firm was formed solely to complete the business combination with Capitol and has no material assets or liabilities.

Trading

Trading and advisory capability for credit manager

The Chenavari group has established an advisory and broker-dealer company called Chenavari Financial Advisors (CFA) focused on fixed income credit markets. The firm, which is independently regulated by the UK FSA, is headed up by Frederic Couderc.

CFA says it is actively advising on and trading credit instruments, including ABS, CLOs, leveraged loans, CSOs, CFOs and high-yield cash bonds. The firm brings together a team of experienced bankers and credit products specialists that provide value-added solutions to issues such as regulatory capital, mark-to-market volatility and financing.

The team has already led the restructuring process of over €2bn of CSOs and intermediated over €400m of European mezzanine ABS and CLO tranches. It is currently focused on the launch of several new products: a new monthly liquidity fund focused on European corporate credit opportunities; a dedicated Luxembourg vehicle focused on European mezzanine ABS opportunities called Toro Capital Fund I (see separate News Analysis); and a closed-end private bank product with a one-year maturity.

Trading

Global credit trading head appointed

Stephen Lane has joined Calyon as head of global credit trading for Europe and Asia in the debt and credit markets team. Lane most recently worked at ABN AMRO, where he held various trading and managerial positions in the government and SSA  (sovereign, supranational and agency) market, and most recently ran the global flow credit trading platform.

Based in London, Lane reports to Philippe Rakotovao, Calyon's head of global credit sales & trading.

ABCP

European ABCP surveillance report released

S&P has published its first monthly European ABCP surveillance snapshot, containing portfolio data on all the European conduits that it rates.

S&P surveillance credit analyst Benjamin Benbouzid says: "The report provides monthly information on outstandings, programme-wide credit enhancement, supporting counterparties, and our key rating and collateral considerations for all of the European-based conduits that we rate."

S&P plans to establish greater minimum portfolio disclosure standards for all rated ABCP conduits. The snapshot will be published monthly to update the market with data that the conduit administrators provide as part of the agency's surveillance process.

Benbouzid adds: "We believe investors are searching for additional insight to evaluate the various ABCP conduits in which they invest. As such, we are publishing this new monthly snapshot within a suite of publications to promote greater European ABCP market transparency. The report also allows market participants to compare in one place all of the conduits that we rate."

ABS

Credit card charge-offs rise to record level ...

Charge-offs on US credit cards, as measured by Moody's credit card index, broke through the 10% level in May, for the first time in the 20-plus-year history of the index.

"We expect the charge-off rate index to continue to rise in the coming months but at a slower pace, as it peaks at around 12% in the second quarter of 2010," says Moody's svp William Black.

The charge-off rate measures those credit card account balances written off as uncollectible as an annualised percentage of total outstanding principal balance. It is the sixth consecutive month the charge-off rate has attained a record high.

The index also shows the delinquency rate (monthly payments more than 30 days late) declining for the second month in a row in May, to 5.97%. Moody's views the improvement as an expected seasonal phenomenon arising from it being the tax refund season and expects delinquencies to resume their upward trend.

The May index also shows payment rates slipping for the second consecutive month, to 16.01%. A key factor, along with charge offs, in assessing the credit quality of credit card securitisations, the payment rate is the average amount of principal that cardholders pay each month as a percentage of the total outstanding principal balance

"We expect industry-wide payment rates to remain soft due, in part, to lower purchase volumes among those cardholders who use their credit cards for convenience - those who pay off their entire balances each month," says Black.

Moody's yield index rebounded from last month's sharp decline, returning above the 18% level and reflecting discounting initiatives by Citibank and Bank of America. However, the increase was not enough to keep excess spread levels from falling below the 5% level for the first time since 1998.

ABS

... while new credit card ABS issuance increases

Issuance of credit card ABS increased again in June to US$11.4bn, including US$5.6bn of non-TALF-eligible bonds issued by CHAIT, CCCIT and COMET, according to Wachovia Capital Markets research. "Spreads finally met some resistance toward month-end as investors took profits or acted to redeploy cash into sectors with wider spreads," ABS analysts at the bank report.

Charge-off rates climbed in June to 10.08% in the Wachovia Capital Markets credit card index. Excess spread dipped to a new low in this cycle, falling to 4.36% from 4.65% in May. Portfolio yield remained relatively stable as trust sponsors continued to find ways to support finance charge collections.

The Advanta Business Card Master Trust (ABCMT) began its early amortisation in June as excess spread fell to -6.09% and the three-month moving average hit the trigger at -1.74%. "The senior notes received a principal payment of US$326.3m," note the analysts. "At this rate, it would take about eight months to repay the remaining US$2.47bn of senior notes in full."

ABS

Survey highlights trustee importance

A recent survey undertaken by The Bank of New York Mellon of over 200 participants of IMN/ESF's Annual Global ABS conference reveals that the role of the trustee has become more relevant to 83% of the respondents. The survey, which was conducted in London in early June 2009, focused on the future and outlook for the securitisation markets, as well as the factors for future success of the market.

One market participant comments in the survey: "The role of the trustee has become far more relevant in terms of the involvement in deal structures."

Another says: "The issue of data integrity and transparency has become much more relevant in this market."

Regarding the important issue of investor confidence, investors voted for independent price verification of assets as being most important. Paradoxically, most structurers and issuers approach this issue from the perspective of either an independent trustee, or the production of independent reports and analysis. These results showed the investor base continuing to ask for better price discovery from the market.

Head of international corporate trust at The Bank of New York Mellon, James Maitland, comments: "Investors do not want to step in while secondary markets are dysfunctional and they cannot accurately assess the value of their portfolios. We know structurers and issuers absolutely understand that the role of the trustee has become ever more important and relevant in today's market, and as a key participant we need to ensure we can provide our input at an early stage of structuring transactions. Our survey confirmed what we have been increasingly hearing from our clients."

When asked about the securitisation market, over 90% of participants believe that arbitrage cashflow CLOs will return in a meaningful way, albeit not until at least 12 months' time. Most delegates agreed that corporate default rates will peak in the next 6-12 months and see a slow improvement in the market in 2010.

The majority - 53% of respondents - also stressed that the provider of outsourcing of operational functions must have proven stability as an organisation. In a related question, participants were asked what factors precipitated the success of government stabilisation programmes. The widely-held view was that a suitable infrastructure was needed to launch and exit these programmes.

CDS

Europe overtakes US in CDS liquidity

Fitch Solutions reports that liquidity in the European CDS market has overtaken the Americas region in the past two weeks, closing on 26 June at 9.96 compared to 9.99 for the Americas.

"This liquidity increase in Europe has been largely driven by uncertainty in financials and technology during the second half of June, in combination with an uncertain European economic outlook with exports down, unemployment high and credit markets still not fully functional," says Thomas Aubrey, md at Fitch Solutions in London.

Across the other sectors covered by Fitch's fortnightly global CDS liquidity scores commentary, British Airways has been one of the biggest movers, jumping from 31st to the second most liquid European corporate CDS over the course of June, amid market concerns over the company's financial profile.

CDS

CDS roll spurs large single name re-risking

The latest DTCC data shows that CDS notionals rose last week by US$140bn or 0.5%, despite single names seeing a US$199bn/1.3% net re-risking - one of the largest since the March lows, according to analysts at Credit Derivatives Research - as the CDS roll took centre stage.

The apparent re-risking was, however, offset completely by the maturing of over US$300bn of protection, leaving a net of around US$100bn de-risking for the week. Indices saw a small net de-risking of only US$15bn (0.17%), with off-the-run names more active than on-the-runs, as confirmed by the major de-risking in the tranche markets.

"An 11.2% rise (US$323bn) is the most significant in three months and helps explain the high beta underperformance and HVOL skew decompression we have seen in the last week," the CDR analysts explain.

CLOs

... while second Metrix buy-back sees limited interest

The second tender for notes from HSBC's Metrix CLO issues has expired with no further bonds tendered beyond those that were offered to the bank in time for the early deadline (and the higher prices) on 8 June. For Metrix Securities 06-1, HSBC bought €14.3m A1 notes, €57m of the A2s and US$40.58m A3s at 84.50%. It also bought £1m C1 notes at 61.69% and €7m E2s at 25%.

For Metrix Funding, HSBC bought €4m A2s at 91%, US$78.1m A3s at 91%, €19.94m B2s at 83.39%, £1m C1s and £1m C2s at 74.07% each, £15m D2s at 50% and £6m E2s at 30%.

CMBS

US conduit/fusion CMBS criteria updated

S&P has updated its criteria for rating US CMBS conduit and fusion transactions. As a result, 3,563 ratings on 217 transactions will be affected, with 1,584 ratings being placed on credit watch negative. The remaining 1,979 ratings were on credit watch negative before the criteria update and remain on credit watch.

The criteria changes represent a significant update to S&P's methodologies and assumptions for determining credit enhancement levels and ratings for conduit and fusion CMBS.

CMBS analysts at Barclays Capital note that the changes S&P has made since the initial RFC was announced are "a step in the right direction", however. The new criteria partially address the analysts' two biggest disagreements with the original analysis: the treatment of seasoned triple-As and an insufficient emphasis on structure. "We argue that even further emphasis on structure is warranted," they point out.

The analysts suggest that the major implications of the new criteria are that the TALF-eligible universe shrinks, but not as much as originally expected. Equally, re-REMIC trades are likely to continue (see last week's issue), while value remains in seasoned triple-As and recent-vintage second- and third-pay triple-As - given their greater TALF eligibility.

S&P's analysis found that the projected impact is most significant on recent-vintage (2005-2008) CMBS. The percentages of triple-A classes - including 30%-enhanced classes (super-dupers), 20%-enhanced classes (AMs) and junior triple-A classes (AJs) - from these vintages that will likely be downgraded are 30% for 2005, 45% for 2006, 65% for 2007 and 60% for 2008. These levels are significantly higher than those for pre-2005 vintages, which will likely experience significantly fewer triple-A downgrades.

Transactions from the 2007 vintage will likely experience the most significant rating changes. Approximately 50% of super-duper triple-A tranches may experience downgrades. The weighted average rating of the downgraded classes would fall to single-A minus.

10% of 2005 vintage super-duper classes would likely be downgraded to a weighted average rating of double-A, while 25% of 2006 vintage super-duper classes would likely be downgraded to a weighted average rating of double-A minus. 10-year super-duper classes have a higher potential for downgrades than those with a shorter weighted average life. 20% (for 2005), 60% (2006) and 95% (2007) of the 10-year classes are at risk of downgrades; these percentages far exceed the percentage of shorter-life classes susceptible to downgrades in their respective vintages.

The weighted average rating for the AM classes from the 2005-2008 vintages generally would likely be lowered to the single-A and triple-B categories, S&P notes, and approximately 50% of the AJ classes would retain investment-grade ratings.

Some well-seasoned transactions may experience upgrades under the new methodology in the future. These transactions, however, have other offsetting credit considerations, such as high concentrations of maturing loans over the next few years and volatile property types (such as lodging) in their collateral pools, which precluded their placement on credit watch positive at this time.

CMBS

US CMBS deals to face in-depth review

46 US CMBS deals have been placed under analysis by Fitch, which is expected to issue a rating action in connection with the transactions within 30 days. The agency says its ongoing monthly surveillance process, SMARTView, will perform an in-depth review of the deals over the next month.

CMBS

CMBS A/B loan structures scrutinised

Securitisation analysts at Barclays Capital have in a new report attempted to answer a number of key questions on A/B loan structures in European CMBS transactions.

The inter-creditor agreement (ICA) covers the legal rights of the A and B loans. But, since the ICA is not publicly disclosed, investors cannot be entirely certain of their position in every possible circumstance, the analysts note. Also, the covenants can be structured and/or reported on a senior or whole loan level, creating additional confusion.

"Possible conflicts of interest might exist if the (special) servicer owns or has an indirect interest in the B loan," the analysts note. "This is especially the case, since neither the B loan investor's name nor the servicing agreement are made publicly available."

Other conclusions from the analysis indicate that:

• A/B loans account for about 10% of the outstanding CMBS loan pool.
• 80% of servicing standards refer to whole loan and 63% prescribe NPV approach.
• The average whole loan LTV has increased from 83% at cut-off to 88% currently.
• The top five banks accounted for nearly 80% of A/B loan origination.
• Hatfield Philips, Capmark and Morgan Stanley service over 80% of A/B loans.
• 34% of A/B loans are in special servicing (11%) or on servicer's watchlists (23%).

CMBS

CMBS hit by declining commercial property values

The swathe of downgrades of UK CMBS in recent months is due to the decline in UK commercial property values, says Fitch in a recent report. Payment arrears have increased in the last 12 months following tenant defaults, which have led to specific negative rating actions being taken. However, the majority of downgrades were driven by the severity of declines in capital values, which is not often communicated in conventional investor reporting.

Mario Schmidt, associate director in Fitch's EMEA CMBS performance analytics team, says: "Approximately 15% of UK loans are in breach of a covenant or in outright payment default and, although at a historical high, this figure understates the full impact of falling capital values on UK CMBS leverage."

Leverage is not consistently being tracked by servicers and so the introduction of Fitch's loan-to-value (LTV) ratio is in part an effort to redress this and highlight the true state of UK CMBS, the agency says. In the absence of revaluations on the majority of loans, the ratio combines Fitch's assessment of property quality with quoted rental value and yield indices to estimate the likely current market value of the collateral.

Gioia Dominedo, director in Fitch's EMEA CMBS team, adds: "Although less than 10% of loans report an LTV above 100%, Fitch estimates almost 30% to be in negative equity. Over four-fifths of loans have Fitch LTVs over 80% and, given the scarcity of debt available at the moment, this leads us to believe that few of these borrowers would succeed in refinancing today. It may currently be of some comfort that few loans are set to mature in the short term; nevertheless, without an improvement in lending market conditions the risk of default at maturity remains."

As rating actions were primarily driven by capital value declines, it is unsurprising that the transactions on which the most severe and extensive negative actions were taken are those that were originated at or close to the peak of the market. The focus on transactions exposed to refinance risk is also evident in the magnitude of rating actions taken on short-dated single- and multi-borrower (and, to a lesser extent, granular) transactions, compared to long-dated transactions. Whereas the latter tend to incorporate substantial scheduled amortisation that reduces bondholders' reliance on property value, the former incorporate significant bullet repayments and, consequently, balloon risk.

Euan Gatfield, senior director in Fitch's EMEA CMBS team, explains: "While leverage has increased across rating categories, prompting downgrades at all rating levels, the effect is most pronounced for junior bonds, which are exposed to loans with LTVs approaching - or even exceeding - 100%. As these bonds are in many cases exposed to negative equity, it is hardly surprising that they have been downgraded to a greater extent."

Despite the magnitude of the rating actions taken, Fitch's view on the UK commercial property market continues to be negative and, consequently, most tranches remain on negative outlook.

CMBS

WaMu leases pose risks for CMBS

Based on information recently made available by the FDIC on a significant number of Washington Mutual leases that it plans to terminate, Realpoint has identified 52 such leases on more than 800,000 square feet securing properties in CMBS deals. The properties have an allocated property loan balance of about US$733m and serve as collateral for 51 loans in 50 CMBS transactions totaling more than US$105bn.

Realpoint also found another seven leases on properties that have similar but not identical addresses as those at which the FDIC plans on rejecting leases. These have an allocated property balance of about US$75m.

"We note that in rejecting the Washington Mutual Irvine Campus lease, the FDIC was not obligated to pay any rent or other compensation in connection with the lease termination," the agency comments. "As such, the greatest risk in our view is with 30 loans, or 69% of the allocated property loan balance, where collateral occupancy will fall to less than 80%."

In addition, the largest such loan is the US$175m Second & Seneca loan. Washington Mutual occupies 14% of the Seattle office property that secures the loan. Without Washington Mutual, Realpoint projects that occupancy will drop to 79%.

The agency's loan-level review of the portfolio found the following additional characteristics:

• Six collateral properties (representing 6% of the total allocated loan balance) are already less than 80% occupied. Seventeen loans (41%) have DSCRs less than 1.25, including six loans (29%) with DSCRs less than 1.
• Seven loans (4%) are specially-serviced, of which four loans (3%) are delinquent. We project about US$13m in losses on five loans.
• Nine additional loans (46%) are on the Realpoint Watchlist, including seven loans (45%) that have value deficiencies noted.

WaMu occupies 245 total properties in CMBS, with exposure to around US$2.4bn in allocated property balance across 169 transactions worth about US$339bn.

CMBS

Australian CMBS sector remains stable, despite risks

Although the performance of Australian CMBS transactions has been stable in the face of the broader economic slowdown, S&P believes that key significant risks for the sector remain. CMBS transactions remain supported by steady collateral performance to date, including income growth and modest falls in underlying property values. However, refinancing conditions, continued liquidity pressure in real estate markets and potential for further value adjustments could pose a challenge, the agency says.

S&P credit analyst Narelle Coneybeare says: "We believe that the stable collateral performance of Australian CMBS portfolios is due in part to the commercial property sector traditionally experiencing a lagged impact from factors affecting the economy. If challenging economic conditions were to continue, including lower retail spending and production, we expect that CMBS portfolios may experience reduced occupancy rates and ultimately lower property cashflows."

CMBS

Red Roof Inn defaults

Red Roof Inn, the discount hotel chain, has defaulted on four loans totalling US$361.4m backed by 131 of its locations, due to decreasing revenue. According to information from Realpoint, three of the four loans were transferred to the special servicer, while the fourth loan (currently 30 days delinquent) is likely to be transferred shortly.

"Our initial estimate for potential losses total about US$99m on the defaulted loans," says Realpoint. "We also found four additional smaller loans totalling about US$12.5m that remain current, bringing the total Red Roof Inn exposure to eight loans totalling about US$374m backed by 135 properties."

Altogether, the hotel chain owns 210 hotels, while its franchisees own 130 additional hotels. In 2007, Red Roof was acquired from Accor for US$1.3bn by a group led by Citigroup Global Special Situations Unit and including hotel manager Westmont Hospitality Group. Red Roof's properties in CMBS carry US$939m in debt, including mortgages, mezzanine loans and other notes.

Emerging Markets

Blue Granite notes repurchased

The issuer of Blue Granite 2007-1- the first South African RMBS to be placed internationally - has purchased €23m of the notes for cancellation. Backed by loans originated by Standard Bank, the international notes were placed jointly by RBS and Standard Bank with investors in Europe in 2007. The original transaction was sized at €233m.

Emerging Markets

DPR programme terminated

Kazkommertsbank will terminate its diversified payment rights (DPR) securitisation programme after its final repayment. The principal amount of US$850.4m was redeemed by the SPC on 11 June 2009; US$99.6m had already been repaid on 16 March 2009.

Acting in its capacity as originator, Kazkommertsbank requested that the programme's controlling parties - which include Ambac, MBIA, Financial Guaranty Insurance Company, the Asian Development Bank and WestLB - to terminate the programme. The DPR programme was initiated in 2005.

Indices

CDO EOD Index shows cushion remains for most deals

The latest report released by S&P on its US Corporate CDO EOD Index shows that the cohorts continue to have a considerable cushion before they would trigger an O/C-based EOD. Transactions originated in 2005 have the tightest cushion, at 15.17 percent in absolute terms, according to the agency.

The cushion before triggering an O/C-based EOD has declined over the past year, however. 2004-vintage corporate CDOs have seen the most significant decline and 2006-vintage CDOs have seen the least.

In the past month, the senior O/C ratios for all of the cohorts have stayed flat with marginal changes. This implies that the rating-based haircut, due to lower rated assets in the underlying pools, has not changed much in the last month, S&P notes.

A majority of the transactions from the 2008 cohort have redeemed. Since there are too few active transactions, the agency has not included data from this cohort in the current report.

Indices

Shariah-compliant index launched

Russell Investments and Jadwa Investments have teamed up to create a Shariah-compliant index, which is set to launch by mid-summer. The Russell-Jadwa Shariah Index family is expected to contain approximately 2,700 securities from over 60 countries. The new index family will be divisible by region, country, developed and emerging markets, capitalisation size, sector, industry and style to provide fully modular benchmarks representing the comprehensive opportunity set within each segment.

Jadwa chairman Andrew Doman says: "The indexes we have built with Jadwa include securities from 62 countries, offering investors the most complete country coverage currently available. At the same time, we believe our screen offers strict Shariah compliance. Our methodology will filter out many more financial companies than our competitors, for example."

He adds: "Our clients have been demanding this robust approach and we expect US$1bn in assets to follow the new index family."

Jadwa head of asset management and cio Fadi Tabbara adds: "As managers of Shariah-compliant funds and discretionary accounts, we have often struggled to find benchmarks that would provide an appropriate comparison with peers and an accurate measurement of our performance. The Russell-Jadwa Shariah Index fills that void with its comprehensive universe, transparent methodology and its modular design offering unlimited divisibility."

Investors

T2 begins CLO buyback ...

The T2 Income Fund has purchased approximately US$1.1m of face value Class B second priority senior notes due 2019 - issued by T2 Income Fund CLO I - at 43.5% of par. But the firm says it can give no assurances that its continuing negotiations with various noteholders will result in further purchase of those notes. The firm recognises that the CLO loan notes acquired to date are only a small portion of the total CLO loan notes outstanding.

LCDS

LCDS auction results published

Results for three LCDS auctions were published on 24 June: R.H. Donnelley LCDS were settled at 78.125 (with 10 dealers taking part); Dex Media East trades were settled at 77.25 (10 dealers); and Dex Media West LCDS were settled at 82.875 (10 dealers).

Monolines

Ambac ...

S&P has downgraded Ambac from single-A to triple-B and placed its ratings on credit watch negative. The agency has taken this action because it believes that the monoline is effectively in run-off and is likely to require regulatory intervention. At the same time, S&P also lowered the ratings on related entities and placed all of the ratings on watch with negative implications.

S&P has found that as Ambac's book of business runs off, it could become concentrated and lack sufficient sector diversity. In addition, the company's 2005-2007 vintage direct RMBS and ABS CDO exposures are subject to continued adverse loss development that could erode capital adequacy. Supporting the holding company's debt-service needs might also place pressure on capital adequacy.

S&P has warned that ratings could be lowered again upon review of the insured portfolio.

Monolines

... and MBIA downgraded

Moody's has downgraded MBIA's senior debt rating from Ba1 to Ba3 and placed the rating on a negative outlook. In addition, the rating agency confirmed the Baa1 rating of National Public Finance Guarantee Corporation (National) with a developing outlook, after a review for possible upgrade initiated on 18 February 2009.

These rating actions reflect the continuing deterioration of insured portfolios at MBIA Insurance Corporation and the uncertainty stemming from ongoing litigation challenging MBIA's recent restructuring (SCI passim). Creditors and counterparties have sued MBIA, requesting that the 17 February 2009 restructuring of the group - that led to National's capitalisation with some of MBIA Insurance Corp's resources - be reversed.

Ratings

Rating agency actions

CRE CDOs/re-REMICs hit by CMBS criteria change
S&P has lowered its ratings on 384 classes from 50 CRE CDOs and re-REMIC transactions with an aggregate outstanding balance of US$17.1bn. In addition, the agency has placed 35 classes from two re-REMIC transactions on watch negative, totalling US$837.4m. The transactions affected by these rating actions are collateralised entirely or partially by rated CMBS.

The rating actions on the CRE CDO and re-REMIC transactions primarily reflect their exposure to CMBS ratings on watch negative, including CMBS ratings placed on watch negative following S&P's revised conduit/fusion pool CMBS criteria. The downgrades also reflect the agency's application of revised criteria for assessing the probability of default for structured finance (SF) assets with ratings on watch negative held within CDO transactions.

CDO liquidated
S&P has lowered to single-D and withdrawn seven classes of notes issued by IXIS ABS CDO 3 (a hybrid CDO) following the liquidation of the collateral in the portfolio. The transaction did not have sufficient proceeds to pay back par payments to the noteholders after making the termination payments on the CDS contract. The deal had triggered an event of default, after which the controlling noteholders voted to accelerate the maturity of the notes and liquidate the collateral assets.

S&P's rating actions follow notice from the trustee that the liquidation of the portfolio assets is complete and that the available proceeds have been distributed to the noteholders.

European synthetic CDOs impacted
S&P has taken credit rating actions on 174 European synthetic CDO tranches. Specifically, the ratings on: 107 tranches were lowered and removed from watch negative; 61 tranches were lowered and remain on watch negative; three tranches were raised and removed from watch positive; two tranches were placed on watch negative; and one tranche was removed from atch negative.

Of the 170 tranches lowered and/or placed on watch negative, 27 references US RMBS and US CDOs that are exposed to US RMBS, which have experienced negative rating actions; and 143 have experienced corporate downgrades in their portfolio.

Cash/hybrid CDOs downgraded
S&P has lowered its ratings on 105 tranches from 29 US cashflow and hybrid CDO transactions. At the same time, the agency removed 51 of the lowered ratings from watch with negative implications. The ratings on 31 of the downgraded tranches are on watch with negative implications, indicating a significant likelihood of further downgrades.

These downgrades reflect a number of factors, including credit deterioration and recent negative rating actions on US subprime RMBS. The watch placements primarily affect transactions for which a significant portion of the collateral assets currently have ratings on watch with negative implications or have significant exposure to assets rated in the triple-C category.

The 105 downgraded tranches have a total issuance amount of US$21.178bn. Eighteen of the 29 affected transactions are mezzanine structured finance (SF) ABS CDOs, which are collateralised in large part by mezzanine tranches of RMBS and other SF securities. The other eleven transactions are high-grade SF ABS CDOs that were collateralised at origination primarily by triple-A through to single-A rated tranches of RMBS and other SF securities.

Regulation

IOSCO consults on ABS disclosure

The IOSCO Technical Committee has published a consultation paper entitled 'Disclosure Principles for Public Offerings and Listings of Asset-Backed Securities'. The principles have been developed to provide guidance to securities regulators who are developing or reviewing their regulatory disclosure regimes for public offerings and listings of ABS. This will in turn contribute to enhancing investor protection by facilitating a better understanding of the issues that should be considered by regulators, IOSCO says.

The principles were developed following a recommendation in the Technical Committee's 'Report on the Subprime Crisis', published in May 2008, that IOSCO develop international principles regarding the disclosure requirements for public offerings of ABS if it was found that its existing disclosure standards and principles did not apply to such offerings.

The principles are based on the premise that the issuing entity will prepare a document used for a public offering or listing of ABS that will contain all material information, clearly presented, that is necessary for full and fair disclosure of the character of the securities being offered or listed in order to assist investors in making their investment decision. These would not apply to securities backed by asset pools that are actively managed, such as securities issued by investment companies or CDOs, or that contain assets that do not by their terms convert to cash.

The disclosure topics highlighted in the ABS Disclosure Principles are intended as a starting point for consideration and analysis by securities regulators. Their principles-based format allows for a wide range of application and adaptation by securities regulators, IOSCO notes.

The proposed ABS Disclosure Principles for regulatory regimes outline the information which should be included in any offer document, such as: parties responsible for the document; identity and functions/responsibilities of parties involved in the transaction; static pool information; significant obligors of pool assets; and credit enhancement and other support.

Regulation

BIS calls for government/private sector cooperation

The BIS' 79th Annual Report underlines the need to focus clearly on the medium term and on sustainability when designing both macroeconomic and financial policy responses. It points out that the crisis had both macroeconomic and microeconomic causes: large global imbalances; a protracted period of low real interest rates; distorted incentives; and an underappreciation of risk. There were market failures, and regulation failed to prevent the build-up of excessive leverage, the BIS notes.

In September and October 2008, the financial crisis intensified, forcing monetary, fiscal and regulatory authorities both to expand their fight to restore the health of the financial system and to counter the threats to the real economy. The scale and scope of the monetary and fiscal policy measures are unprecedented.

Nevertheless, the balance sheets of many financial institutions have still not been repaired. Further steps are needed to address this, the BIS says.

A healthy financial system is a precondition for the effectiveness of expansionary policies and for stable long-term real growth. But financial protectionism, sometimes an unintended consequence of national support for the financial sector, should be avoided as this would moderate growth and development.

"Implementing the rescue is a complex task that is fraught with risks," the BIS comments. "Policies should aid, not hinder, orderly adjustment. They need to strike a balance between short-term stimulus and well articulated exit strategies that ensure long-term sustainability. They need to allow the financial sector to shrink as borrowers reduce their leverage. And they need to promote a shift in production patterns away from export- and leverage-led growth models towards more balanced ones."

This requires governments and the private sector to work together to build a more resilient financial system, according to the report. Addressing the broad failures revealed by the crisis means that systemic risk in all its guises must be identified and mitigated, adopting a macroprudential perspective.

The BIS Annual Report argues that financial instruments, markets and institutions all require reform if a truly robust system is to emerge. For instruments, this means a mechanism that rates their safety, limits their availability and provides warnings about their suitability and risks.

For markets, it means encouraging trading and clearing through central counterparties and exchanges. For institutions, it means the comprehensive application of enhanced prudential standards that integrate a system-wide perspective.

Macroeconomic policies must also play a role in promoting financial stability. For monetary policy, this means taking better account of asset prices and credit booms; for fiscal policy, it means putting a premium on medium-term fiscal discipline and long-term sustainability.

RMBS

Spanish RMBS publicly placed

Europe's second publicly-placed ABS deal of 2009 priced last week. The deal in question was a guaranteed tranche of a Spanish VPO (subsidised housing) RMBS transaction sold to domestic accounts. The new notes carry a 30bp coupon, but were priced at a discount to 150bp DM.

RMBS

Deutsche Postbank completes synthetic RMBS

Deutsche Postbank is securitising a portfolio of housing loans through KfW's PROVIDE securitisation platform for the second time. It is the first deal conducted on the KfW platform since the financial crisis took hold.

The portfolio comprises around 25,000 individual German housing loans held by the Deutsche Postbank Group, which amount to a total volume of roughly €1.5bn. The transaction has been rated by Moody's and S&P, and is said to have high granularity, broad diversification and a good credit quality. In addition, the loans underlying the portfolio have a low loan-to-value ratio.

The transaction structure complies with the established standards of the KfW securitisation platform. The platform enables default risks contained in the portfolio to be securitised synthetically via a CDS with KfW. Postbank remains the owner of the loans, so as not to impair the relationship between the institution and its borrowers.

RMBS

Non-conforming servicer strategies set to evolve

Fitch says that the servicing strategies of UK non-conforming lenders have developed rapidly since the onset of recession and continue to evolve to reflect the changing economic landscape.

Robbie Sargent, director of Fitch's European structured finance team, says: "Fitch rates a number of residential primary and special servicers across the UK and has noted that the increased focus on 'Treating Customers Fairly' and other regulatory and government initiatives over the past 12-18 months has led specialist lenders and servicers to amend their arrears and foreclosure strategies."

The timeline of a typical UK residential mortgage foreclosure process has extended compared to 12 months ago. In early 2008, on average, 9-12 months elapsed between the initial default and possession, but this period is now approaching 12-15 months. Prior to 2008, a number of specialist lenders started possession proceedings immediately following a missed second mortgage payment. However, Fitch analysis shows that loans within non-conforming UK RMBS now typically see the foreclosure process start at three to four months of missed payments.

The agency believes the increased forbearance shown by lenders and servicers is a key driver behind the Council of Mortgage Lenders recently reducing its forecast for 2009 possessions by 10,000 to 65,000.

In contrast, the UK FSA recently announced an investigation into four firms in relation to their arrears handling techniques, citing an approach focused too strongly on arrears recovery without reference to the borrower's individual circumstances. It is unclear whether these firms are third-party administrators (TPAs) or specialist lenders who originated the loans and are now acting as the named servicer on RMBS transactions.

Fitch is aware that where RMBS legal documents allow, some special servicers have instigated loan modification programmes that address this very issue. These programmes are seeking to prevent borrowers falling into default and losing their properties, while at the same time maintaining the maximum cashflow possible into any RMBS. The process requires discussion with the borrower and a thorough understanding of their finances in order to agree the most appropriate loan modification.

Typically, this can include an extension of loan maturities, changing the repayment method, capitalisation of arrears and/or deferral of payments. These measures have only become more widespread in the UK non-conforming sector since early 2008 and, although still in the early stages of implementation, a number of successful modifications have enabled borrowers to remain in their homes.

It is too early to have re-default rates for modified UK loans, but the high level of re-defaults in the US - which is up to 70% - shows the difficulty of successfully implementing such schemes. This highlights another problem surrounding the loan modification programme: if the borrower (or servicer) is only delaying the inevitability of possession by agreeing to a loan modification that is unrealistic, in the current declining house price environment, the loss on the sale could be larger and only add to the borrower's long-term debt.

Sargent adds: "Clearly, mortgage defaults will continue to be prevalent during the recession. However, servicers are more geared up than before to tackle rising arrears. A continued investment in staffing and training, along with more emphasis on 'Treating Customers Fairly' should help to mitigate increasing possessions."

Alastair Bigley, director of Fitch's European Structured Finance team, says: "It is wrong to assume that because a loan has been securitised it is more likely to be pushed through to possession in the event that it falls into arrears. It is in the interests of investors in RMBS that servicers adopt strategies that minimise ultimate losses. Servicers are in the best position to judge whether loan modification is the best means of achieving this. Certainly, with interest rates at their current low levels, a servicer's flexibility to make this decision is greater than in the early 1990s recession."

The UK FSA is scheduled to publish a Mortgage Market Review discussion paper in September 2009, including its findings on arrears handling.

RMBS

Credit enhancement drives UK NC RMBS rating transitions

The rating transitions of UK nonconforming RMBS have to date differed strongly by transaction vintage and appear to be correspondingly linked to the evolution in credit enhancement that different vintages have experienced, according to new research published by S&P.

"In our view, rising delinquencies and repossessions, higher realised losses and increasing loss severities are placing greater pressure on the available credit enhancement in UK nonconforming RMBS transactions and therefore continue to put downward pressure on ratings. This is having a more profound effect on recent vintage transactions, which have not benefited from the same degree of deleveraging as some earlier vintage transactions," explains S&P credit analyst Kate Livesey.

Lower credit enhancement means that there is less cushion available for the tranche to absorb any future losses in the underlying loan portfolio, or to deal with other cashflow problems, such as a significant drop in collection rates. However, in its report S&P found that the overall rating experience to date has differed significantly by transaction vintage. Early vintages have seen a more positive rating transition than later vintages.

Correspondingly, earlier vintage transactions have seen a much greater growth in relative credit enhancement since closing due to historically high prepayment rates. Later vintages are showing significantly slower growth.

Credit enhancement growth in RMBS transactions is most significantly affected by prepayments and reserve fund draws. Prepayment rates, in turn, in UK nonconforming RMBS have now fallen significantly; on an annual basis S&P's prepayment index has halved.

Reserve fund draws have become common among such transactions over the past 24 months. Of the 93 outstanding transactions that have a reserve fund, in 48 the fund's balance is now lower than the required amount. Nine transactions have drawn down their entire reserve fund.

"We expect the combination of lower prepayment rates and further reserve fund draws to continue to suppress positive rating actions and cause further negative rating actions for some transactions," Livesey concludes.

RMBS

Spanish RMBS delinquencies deteriorate further

Spanish RMBS delinquency rates deteriorated further during Q109, according to Moody's. Weighted-average delinquencies greater than 60 days past due represented 3.32% of the outstanding pool balance, up from 1.06% in Q108, while weighted-average delinquencies greater than 90 days past due represented 2.20% of the outstanding pool balance, up from 0.49% from Q108, the rating agency says in a new report.

Cumulative artificial write-offs increased further as well, from 0.11% in Q108 to 0.63% in Q109. This increase is mainly driven by mortgage loans with high LTVs greater than 70%, where delinquencies of 60-90 days increased from 0.87% to 1.72% within the last quarter.

The total outstanding portfolio balance of Spanish RMBS increased to €151.4bn in Q109. During this period, seven new Spanish RMBS transactions were rated by Moody's with a total issuance of €6.98bn.

In its current index report, Moody's notes further that default and loss data remain very limited at this stage. The weighted-average annualised total redemption rate stood at 10.81% in Q109 compared to 11.06% in Q108, it reports.

"The number of individuals facing difficulties meeting their loan obligations has increased, as evidenced in the rise in the doubtful loans ratio and personal bankruptcy filings. House prices will continue to fall in Spain (in Q109, they fell 6.8% year-on-year), resulting in a continued reduction in homeowners' equity," Moody's adds.

Secondary markets

Disconnect between RMBS price and intrinsic value

There is a disconnect between how the market prices US RMBS and the bonds' intrinsic value, according to a recent study conducted by Fitch Solutions to gauge the factors driving the valuations of RMBS tranches. Among the key findings is that on average, the market expectation regarding future losses is approximately 32%, which can be decomposed into a pool default rate of 40%, with 80% loss severity. Vintage and performance are key determinants, the firm says.

"With structural features clearly having an impact on price sensitivity, it is now more important than ever to understand slight nuances from deal-to-deal through in-depth cashflow modelling," says the report's author Richard Hrvatin, an md for Fitch Solutions, who lead the study.

The case study compared observed valuations of RMBS bonds in the market with internally derived discounted cashflow valuations based on a range of default and loss assumptions. One goal of the study was to find the loss assumptions that would cause the modelled price to converge with the market price. In the analysis, collateral information was obtained and analysed using Deal View, a desktop application launched by Fitch Solutions in partnership with Portsmouth Financial Systems that provides loan-level analytics for the US structured finance market (see last week's issue).

Structuring/Primary market

AIG liability structure simplified, MTM losses continue

The US Fed has entered into a senior secured debt for preferred swap with AIG, which converts US$25bn of senior secured Fed credit line for US$25bn of fixed coupon preferreds across two SPVs. One SPV will house American Insurance Association (AIA) with US$16bn Fed preferreds and the other will house American Life Insurance Company (ALICO) with US$9bn Fed preferreds.

AIG is providing the equity layer, but expects to benefit from the mark-to-market upside in AIA and ALICO. It remains unclear whether the Fed has any charge on the assets of the SPVs to protect its principal. Nonetheless, analysts suggest that the new structure should ease the sale of AIA and ALICO by simplifying the liability structure.

Meanwhile, the insurer reported in a regulatory filing that its exposure to mark-to-market losses on the super-senior CDS it sold to European banks could continue for longer than anticipated, and could have materially adverse effects on its results. Earnings are expected to be announced on 6 August, with such losses potentially triggering a downgrade from S&P and Moody's (which currently rate the company A-/A3, outlook negative). Both agencies lag Fitch, which has AIG at triple-B with developing outlook.

AIG says it does not expect that it will be required to make payments on the CDS it sold, but credit analysts at BNP Paribas point out that a lower rating may trigger further collateral posting to its swap counterparties, placing further strain on the insurer's finances. "However, with several US banks having returned their share of TARP funds, the US government should be in a position to step in with further support to stem a possible escalation of systemic risk," they note.

Trading

Trading revenues up, but CDS notionals down

US commercial banks reported record trading revenues of US$9.8bn in the first quarter of 2009, compared to losses of US$9.2bn in the fourth quarter of 2008, according to the Office of the Comptroller of the Currency in its 'Quarterly Report on Bank Trading and Derivatives Activities'. However, credit derivative notionals fell by 8% to US$15trn during the quarter.

"Banks continued to benefit from solid client demand and wide intermediation spreads in the first quarter, and from lower write-downs on legacy assets," says OCC deputy comptroller for credit and market risk Kathryn Dick. "Bank trading revenues have a definite seasonal pattern, with the first quarter of each year often the strongest due to increased risk management activity by bank clients."

Dick notes that increases in banks' own credit spreads led to increased trading revenues due to declining values of bank trading liabilities. While trading results were very strong even without considering the impact of liability value changes, it is important to recognise that such changes did contribute meaningfully to first quarter performance, she adds.

However, the impact from changes in bank credit spreads can be very volatile. "Some of the positive impact on bank trading results in the first quarter has reversed in the second quarter, due to improving perceptions of bank credit health," Dick continues. "That's a very positive development, but the increase in the value of trading liabilities from lower bank credit spreads means bank trading revenues will face strong headwinds in the second quarter."

The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$2trn (nearly 1%) in the first quarter to US$202trn. The increase resulted from the continued migration of investment bank derivatives activity into the commercial banking system.

The OCC also reports that net current credit exposure, the primary metric that it uses to measure credit risk in derivatives activities, decreased by US$105bn or 13% to US$695bn. "Credit exposure from derivatives remains very high," Dick continues. "However, concerns about counterparty credit risk have led to increased regulatory pressure to reduce bilateral credit risk by moving transactions with standardised terms on to regulated clearinghouses."

The OCC report also notes that:

• Derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 96% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%.
• Credit default swaps are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.
• The number of commercial banks holding derivatives increased by 53 in the quarter to 1,063.

Trading

Further healthy CLO BWIC activity

Structured credit analysts at JPMorgan report that around six BWICs traded last week, mostly in US CLOs but also European CLOs, US CBOs and a few US ABS CDOs. Compared to the previous week, less triple-A paper was listed, with the assets mostly comprised double-As and mezzanine paper. Total size traded was about US$400m, down from the staggering US$1.1bn in the previous week.

The analysts also observed trading outside lists, mostly in CLOs. "In general, the depth of the bid seemed slightly weaker, but what traded was at similar levels to the week before," they note.

Documentation

Europe follows suit

Tim Brunne, senior credit strategist at UniCredit, discusses the practicalities of Europe's 'small bang'

Since the Big Bang Protocol became effective, European dealers have been discussing several alternatives to improve European market conventions. The adoption of the new conventions was scheduled for 22 June - the maturity-roll date of single name CDS.

As of that date, standard single name CDS referencing European corporates adopted similar market conventions as the standard corporate CDS referencing North American entities adopted back in April. Contrary to North American CDS, however, mod-mod restructuring will remain a CDS credit event by default in Europe.

The new conventions will see European corporate and sovereign single name CDS trading with fixed coupons and a full first coupon payment (similar to the existing convention for iTraxx CDS). The current format of par spread CDS will no longer be offered as a standard contract.

That implies that CDS trading always requires an upfront fee. This CDS cash settlement amount, similar to current conventions for iTraxx CDS, comprises not only the combined present value of the CDS fixed and floating payment legs ('clean price') but also the accrued coupon (yielding the 'dirty price') as the first coupon is paid in full to protection sellers - contrary to previous European conventions for distressed-level CDS. CDS will be quoted in spread-terms and translate into upfront amounts by means of the ISDA standard model already in use in North America and implemented in Bloomberg's CDSW pricing sheet.

But why four coupons?
While the new North American standard, since April of this year, offers two possible coupons -100bp and 500bp, tailored for investment- and speculative-grade credits - in Europe now a wider range of coupons is offered: 25bp, 100bp, 500bp and 1000bp. Despite some disadvantages, the additional coupon levels were chosen mainly for two reasons.

First, the additional coupons potentially diminish the magnitude of the upfront payments and thereby liquidity requirements, making it more attractive for investors to use CDS as investment and hedging instruments respectively. Second, the replication of existing par coupon CDS trades by a pair of fixed-coupon trades is facilitated, in particular in the context of the proposed solution for the restructuring credit event in the framework of the 'small bang'. In order to replicate a par coupon contract, the notional volumes of a pair of fixed coupon CDS is determined in such a way that the risky cashflows of the par coupon CDS are exactly matched (except for the full first coupon).

A long protection trade can be replicated by a pair of 100bp and 500bp long protection CDS if, and only if, the par spread is in the range between 100bp and 500bp. If the par coupon CDS spread is smaller than 100bp (or greater than 500bp), a long protection replication requires a long-short (short-long) combination of the 100bp-500bp fixed-coupon CDS pair.

That should be avoided, as the position may then be split among different recovery auctions in a CDS credit event settlement after counterparties adhered to the 'small bang' protocol. If the proposed four different coupons are available for replication, then the long-short (or short-long) combination can be avoided for par coupon CDS with spreads ranging from 25bp to 1000bp.

Re-couponing without replication
For re-couponing existing trades, CDS with fixed coupons of 300bp and 750bp will be offered. In order to re-coupon existing trades, an alternative to replication is the simple adjustment of the CDS coupon for a fee that reflects the present value of the risky annuity that is added to or subtracted from the CDS fixed leg (plus the accrued spread). The additional coupons of 300bp and 750bp facilitate such an approach, as the liquidity demand for such a re-couponing is reduced.

Finally, we emphasise that re-couponing is a matter that must be negotiated among the counterparties that stepped into the original trade. The adoption of new market conventions does not require that old trades are re-couponed.

Restructuring is not dropped in Europe
A crucial ingredient of the European market convention, in contrast to the CDS on North American corporate names, is that mod-mod restructuring remains one of the possible credit events by default. The economic importance of the restructuring event is greater in Europe than in the US as there is no equivalent to the Chapter 11-based debt restructuring on this side of the Atlantic.

But when the small bang protocol takes effect at the end of July, the settlement of a restructuring credit event will change as well. That step is, however, in principle independent of the market convention improvements that were applied on 22 June.

Hardwiring the restructuring event
The restructuring credit event, which is part of the 2003 ISDA Credit Derivatives Definitions, has been excluded from standard auction-based cash settlement set forth in the ISDA 2009 Supplement. According to the Supplement, the Credit Derivatives Determinations Committee would in principle decide whether such a credit event occurred.

But triggering a CDS contract leading to a credit event settlement remains at the discretion of the bilateral counterparties, which limits the decision of the respective local Determinations Committee to setting the event determination date. There is currently no recovery auction in case of a restructuring event.

In order to incorporate the auction method into the standard settlement of the European mod-mod-R credit event, the ISDA CDS legal documents need to be amended once more. The aim of the imminent legal changes is to simplify the conditions on deliverable obligations in order to facilitate recovery auctions for restructuring events.

The legal changes required to incorporate restructuring in the new standard credit event settlement procedure (Committee decisions and recovery auction) are due to be finalised imminently. The initial plan was to release a first draft of the associated documents, in particular the ISDA 'Small Bang' Protocol, by mid-June to allow for a discussion period prior to the formal adherence period. On 23 June, ISDA published on its website a comprehensive term sheet, entitled 'Implementation of Auction Settlement Following a Restructuring Credit Event', which specifies many details of the upcoming ISDA 2009 Restructuring Supplement. The final draft of this Supplement and the 'Small Bang' Protocol will be available only shortly before the small bang adherence period, which is expected to commence on 13 July.

Optional triggering and restrictions on deliverable obligations
After the small bang takes effect on 27 July (date not yet officially confirmed), the local EMEA Credit Derivatives Determinations Committee will look at all possible restructuring events, make a decision, set the so-called restructuring date andcompile lists of deliverable obligations for the recovery auctions within two weeks after the event. In contrast to failure-to-pay and bankruptcy credit events, this does not immediately imply that a CDS is triggered for a credit event settlement.

The latter must still be done on a bilateral basis and both counterparties have the option to trigger the respective CDS by delivering a valid credit event notice. If a CDS contract is triggered, the deliverable obligation depends on the maturity of the contract and on the counterparty that triggered (protection buyer or seller). These two peculiarities lead to a series of complications for: a) carrying out recovery auctions; and b) central clearing of CDS.

Discussions about how to remedy these peculiarities have been ongoing for months already and for many aspects final solutions were determined by ISDA and its members. These are presented in the publicly available term sheet mentioned above.

Maturity bucketing
For a CDS recovery auction, the respective local Determinations Committee needs to decide on the deliverable obligations that can be sold in the course of the auction. For non-restructuring credit events, these obligations are independent of the individual CDS maturity. However, in the case of a restructuring event, current maturity limitations for deliverable obligations make it virtually impossible to hold a single recovery auction.

Depending on the maturity of outstanding CDS (with quarterly maturity rolls) and on the outstanding debt of the reference entity, a whole variety of different subsets of deliverable obligations emerges. In order to conduct recovery auctions, maturity restrictions on deliverable obligations will be simplified such that the maximum number of necessary obligations will be eight (for EMEA). This is achieved by a bucketing approach for CDS maturities.

If the protection seller triggers, there is no bucketing and obligations with maturities up to 30 years are allowed. If the protection buyer triggers the credit event settlement, in EMEA, the deliverable obligations (that were not restructured) have a maximum maturity of 2.5 years, five years, 7.5 years, 10 years, 12.5 years, 15 years, 20 years and 30 years if the CDS has a maturity that is smaller than the respective term. Auctions will be held for each maturity bucket.

The exact details of the bucketing approach and other aspects of the upcoming settlement of restructuring credit events are complicated. They are extensively described in the term sheet, which is open for comments until 2 July.

The final offering of European CDS central counterparties depends on the details of the new ISDA legal documents. Thus the timeline is tight and investors should anticipate that there will only be a small period of time to adhere to the Small Bang Protocol.

The signing of the Small Bang Protocol will imply adherence to the Big Bang Protocol and therefore provides an opportunity for investors who missed the adherence deadline to the latter Protocol to join in June.

The European CDS clearing house
In a letter to the European Commission, major CDS dealers committed to establishing CDS central clearing in Europe by 31 July 2009. In the US, CDS central clearing began on 9 March and more than US$1trn of index trades have already been processed by the respective clearinghouse, ICE US Trust.

A first attempt in Europe to introduce CDS clearing was not successful when NYSE/Euronext Liffe started offering iTraxx CDS last December. Although market acceptance has apparently been one obstacle, an additional difficulty existed - namely the incorporation of the restructuring credit event in the new legal framework, which entails the establishment of the Determinations Committee and the hardwiring of the recovery auction.

Why the US was faster
One of the reasons why ISDA created the 2009 Supplement to amend the CDS contract is that a CDS clearing house requires a body that determines whether credit or succession events happened. Also the credit event settlement of CDS contracts by physical settlement unnecessarily complicates the operations and flexibility of a clearing house. Liffe dealt with these issues by forming its own 'credit determinations committee' in December 2008.

In order to assess the progress the North American market has made towards transferring the major fraction of outstanding CDS trades to a central clearinghouse, ICE US data must be compared to global CDX.NA CDS volume data. The global gross volume in such index CDS and corresponding tranches was US$3.7trn as of 19 June 2009 (US$3.8trn as of 3 April 2009), according to the DTCC. This means that the total volume of CDX.NA index CDS that have been centrally cleared (almost USD1.2trn as of 22 June) already captures a significant fraction of the global market.

Since almost 14,000 trades were centrally cleared by ICE Trust US until 22 June also, in terms of number of contracts, the market share is substantial (see Exhibit 1). In Exhibit 2, the total global gross notional of CDX.NA.IG Series 12 index CDS and index tranches is compared to the ICE Trust cumulative total cleared volume and open interest in contracts referencing that index. Although outstanding gross notional and cumulative cleared volume have a slightly different meaning, this chart suggests that the majority of on-the-run CDX.NA deals are already processed via the central clearinghouse.

Exhibit 1

Exhibit 2

While it seems that ICE US Trust has a clear competitive advantage to emerge as the dominant CDS clearer in North America, the race is still open in Europe. There are several companies that are currently preparing to offer CDS clearing in Europe in the near future (see Exhibit 3). These entities presented the details of their prospective offerings to officials of the European Commission and have been discussing these proposals and their implementation on an ongoing basis with them.

Exhibit 3

European financial regulators have asked for a CDS central counterparty that is regulated by European authorities. Only Eurex, Liffe and ICE Clear Europe seem to be operationally ready to process CDS business (at least for iTraxx indices) before or by the end of July, when the European Commission's deadline for the CDS dealer community to start central clearing in Europe ends.

DTCC's Trade Information Warehouse (TIW) plays a pivotal role for all CCP offerings as a trade matching platform and for global credit event management. In addition, TIW will provide CDS market transparency as required by European and North American regulatory authorities.

Apart from the regulatory approval by the principal regulators of the respective jurisdiction provided in Exhibit 3, other European regulators will also have to review the business set-up. Also, all vendors will be required to obtain SEC regulatory approval such that US firms are eligible to use the European CCPs as well.

We anticipate that European CDS dealers will rapidly start to novate their CDS portfolios to one of the clearinghouses, similar to in the US. This concerns in particular inter-dealer trades. We have the impression that ICE Clear Europe and Eurex have a pole position to become dominant players in the CDS market on this side of the Atlantic.

Issues that still require a final solution comprise the following:

• Mechanism that will be in place to ensure that the CCPs' books are balanced when restructuring credit events are only partially triggered.
• Account segregation: only Eurex will provide a means to separate customer CDS portfolios from the respective dealer's CDS positions, as of 31 July 2009.

However, an important piece of the puzzle for the European-style CDS market, namely the fully-automated process for triggering restructuring credit events, will be available through the DTCC only at the end of this year.

© 2009 UniCredit. This Research Note is an updated extract from 'Credit Derivatives - Europe Follows Suit', first published by UniCredit Credit Research on 18 June 2009.

Trading

Trading ideas: no clear plan

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

We've had Entergy as a long in our model equity portfolio since early May and the stock performed well during that time. Although event risk surrounds the name in the form of a potential spin-off of the company's non-utility nuclear assets, we find the company's equity trading cheap to both our short- and medium-term expectations. We recommend taking a beta-hedged long position in Entergy's stock to capitalise on this view.

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

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

Our CSA model points to equity trading too cheap and CDS trading too tight. Our directional credit model points to medium-term improvement in Entergy's CDS levels based on its margins, accruals, interest coverage and implied vol.

The company's CDS has consistently traded wider than our MFCI model implies. After making adjustments to the model, we still find Entergy's CDS trading wide of fair value and expect continued improvement.

When considering an 'event-risky' name like Entergy, extra caution is warranted and quantitative models must be used carefully. Without a clear plan from the company on how it will fund or structure the spin-off (as well as the potential impact of cap and trade legislation winding its way through Congress), uncertainty surrounds the company's capital structure.

Exhibit 2 charts Entergy's five-year CDS against its equity. The red line indicates the fair value curve for five-year CDS given equity price. The blue squares indicate historical market levels.

The green circle shows the current market level and the red square indicates our expected levels in three months. The yellow circle shows the current fair value levels when implied vol is also considered. Given that the current market levels are below the red line, we expect a combination of share rise and CDS widening to bring Entergy back to fair.

Our model-implied three-month target for Entergy shares is US$115. We believe this is aggressive, but an equity target in the high-80s is reasonable.

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

First, we will exit if Entergy reverts to fair value and we no longer see further profit potential. Second, if Entergy continues to trade too cheap according to our model over the next six months, then we must assume that the company is trading under a new CDS/equity/vol relationship and the trade will be reevaluated for potential exit.

Third, if the company's planned spin-off is approved, we will reevaluate the capital structure trading relationship, as well as our fundamental outlook for the company's equity. Overall, we view this as a short- to medium-term trade.

Position
Buy 20,000 shares Entergy Corp at US$77.26.
Sell 11,700 shares SPDR Trust Series 1 at US$91.72.

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).