Contents

CMBS

TALF extended

But news fails to reverse weakening trend in secondary CMBS

The US Federal Reserve and Treasury's decision to extend TALF for newly-issued CMBS to June 2010 was welcomed by the CMBS community, but the news failed to reverse the spread weakening that has characterised the secondary US CMBS market for the past week. It is unclear whether technical reasons have temporarily put a stop to spread tightening in the sector or whether the CMBS rally has simply run out of steam.

"The TALF extension is an overall positive for the market," says Elton Wells, head of structured products at SecondMarket. "We've seen a lot more investors interested in CMBS as a result. Of the 700-800 investors that we have for structured products, 400 of those look at RMBS. However, due to the extension of TALF, a lot of those are switching to looking at CMBS."

US CMBS spreads have been widening since early last week, however - with the delay of the PPIP programme, a large CDO liquidation and news that several Maguire/Moinian properties are due to be foreclosed cited as reasons. "Even though Maguire's default was not a complete surprise, as with any event like this, it makes people pause a little and look at what other potential landmines may be out there," notes Manus Clancy, md at Trepp.

"With each trade that brings spreads tighter on CMBS, levered returns also contract: the market will eventually reach a certain threshold where investors start finding other alternatives with equal or better potential returns. Whether the weaker tone is an indication of that threshold being reached will only be seen in hindsight," he adds.

One CMBS investor, meanwhile, was surprised that the TALF extension announcement didn't spur activity on the CMBX. He notes that CMBX triple-As have dropped by 10 points over the last two weeks and so the fact that it didn't move could be due to a technical squeeze in the index market or a reflection that the rally in CMBS has run out of steam.

"Fundamentals in the commercial real estate sector remain poor and losses/delinquencies continue to rise - albeit from a low base. Prices nonetheless imply that every loan referenced in the index will default," he says.

The investor continues: "While I expect volatility in the CMBS sector to continue, the market is hoping to see a couple of new issue CMBS transactions in September. I expect these new issues to have simpler structures than before: there is no demand for mezzanine paper, so the capital stack will consist of wide equity and triple-A tranches only. Investors want to see originators retaining a significant portion of the risk."

It remains to be seen whether the June 2010 TALF deadline for new issue CMBS will provide issuers with the time they need to put deals together, however. Certainly Craig Lieberman, md co-head of commercial real estate at NewOak Capital, is unsure that the extension allows enough time for multi-borrower fusion transactions to be created, which would give the market the liquidity it needs.

"Substantial lead time is needed to first re-staff a conduit platform, then to originate and underwrite the loans, and finally to structure and place the bonds, all within the context of untested TALF guidelines and a volatile market. However, the extension is a good start and shows the government has a commitment to restarting this part of the market," he says.

"There's still a lot of uncertainty in the market, especially with respect to the start of the PPIP programme. There needs to be more clarity around how much investor appetite there really is before the market gets back on track," Lieberman adds.

For now, however, a bifurcation has become evident between those bonds that are considered eligible for the government programes and those that are not. "Investors don't want to accumulate assets only to find that they can't finance them. The market seems to be making its own risk assessment on which bonds are most likely eligible and which are not," confirms Clancy.

The US Federal Reserve and Treasury announced on 17 August that TALF loans against newly issued ABS and legacy CMBS would be extended to 31 March 2010 (see also separate News Round-up story). The programme for newly-issued CMBS has also been extended to 30 June 2010.

AC

Documentation

Thomson tests small bang

Concern mounts over potential short maturity bucket squeeze

The Thomson SA restructuring credit event comes hot on the heels of the introduction of ISDA's restructuring supplement, published on 27 July and implemented via the 'small bang' protocol (SCI passim). Together with broader concerns over testing the documentation for the first time, one issue troubling the market is the apparent lack of deliverable obligations for the auction's shorter maturity bucket.

The restructuring credit event was triggered by a deferral of principal on Thomson's 6.05% Series A bond, which was agreed by bondholders in June 2009. ISDA's EMEA Determinations Committee resolved on 12 August that one or more auctions may be held in respect of outstanding CDS transactions of varying maturity buckets.

The Association says it will publish the initial list of deliverable obligations for each maturity bucket in due course. Following publication, participants will have five business days to trigger their contracts, after which triggering is not permitted for this credit event.

But one CDS trader confirms his concern about the apparent lack of deliverable obligations for the 2.5-year maturity bucket. "It's unclear at this stage what will happen to the auction if no deliverables can be identified," he notes.

The Determinations Committee agreed that the Thomson restructuring credit event occurred on 15 June 2009. Based on this date, Barclays Capital credit derivatives strategist Matthew Leeming suggests that three maturity bucket end dates can nonetheless be determined - 20 December 2011 for the 2.5-year bucket, 20 June 2014 for the five-year bucket and 20 December 2016 for the 7.5-year bucket.

Although a significant portion of Thomson's debt is via private placements and so much of the relevant information is not public knowledge, a reasonable estimate of the important dates for determining bucket assignments can also be made. Namely, a portion of debt matures on 21 June 2012, but no debt matures between 20 December 2011 and 21 June 2012. Similarly, a portion of debt matures in October 2014, with no debt maturing between 20 June 2014 and October 2014.

"The first assumption is useful because it tells us that March 2012 and June 2012 contracts will be rounded down to the 2.5-year (ie. the Mod Mod five-year) bucket," Leeming explains. "The second assumption is useful because it tells us that September 2014 contracts will be rounded down to the five-year bucket. As the longest debt matures in 2016, all contracts longer than 7.5 years will be rounded down to the 7.5 maturity bucket." All other contracts are unlikely to be rounded down.

Although uncertainty remains about whether creditors will ultimately agree to the Thomson restructuring plan, BarCap has used the four components of this proposal as the foundation for its Thomson CDS recovery valuation. If the agreement is approved, senior creditors holding €2.839bn of debt will be offered new senior debt (nominal value of €1.55bn), Disposal Proceeds Note (€300m), Obligations Remboursables en Actions (€639m) and equity issuance (€350m).

"Post a present value discount of 10% to reflect the likely timeframe of working through the 'Restructuring Agreement', we believe that the current 'Restructuring Agreement' is worth around 74% of face value if implemented," Leeming notes.

However, given that some creditors may disagree with that the restructuring plan, a 'sauve-garde' process or bankruptcy filing remain possible. BarCap has therefore assigned a 30% probability of the agreement failing, which could lead to a lower recovery - of 40% in the case of a sauve-garde.

This provides a weighted average recovery of 64%, with the recovery range being between 60% and 70%. But, as Thomson's private placements and bank loans are not actively traded, a possible shortage of deliverable obligations could create technical demand in the auction process, which could push the recovery rate above what is considered to be fundamental fair value.

Philip Gisdakis, director and senior strategist at UniCredit, notes that the decision to trigger a CDS contract on Thomson ultimately depends on whether the investor is a protection buyer or a protection seller. "Outright protection sellers will - in most cases - prefer not to trigger the contract, unless they really fear that another credit event is imminent," he explains.

He adds: "First, when triggering, they will move into the less favourable longest maturity bracket for the settlement and, second, by not triggering the contract there is still the hope that this contract will never be triggered and that the seller can continue to earn the premium (assuming that it was not triggered by the counterparty)." If, however, the restructuring agreement isn't approved by debtholders, a subsequent failure-to-pay/bankruptcy credit event could lead to larger losses in the settlement for protection sellers.

On the other hand, protection buyers are incentivised to trigger the contract, as not triggering might lead to the loss of a beneficial settlement payment. This is particularly the case if the protection buyer has a short-dated CDS contract. But Gisdakis concedes that a protection buyer with a contract with a longer time to maturity and with a low coupon might have an incentive not to trigger, given the potential to participate in a future credit event and that carrying forward the protection is not prohibitively expensive.

Thomson is referenced in many series of iTraxx indices (Main Series 1-7, HiVol Series 4-7 and Crossover Series 8-11) and the restructuring credit event is also the first example of a default on an on-the-run index. Any position in affected iTraxx indices will consequently be split into an iTraxx contract that excludes Thomson and a single name CDS contract on Thomson. The Thomson CDS contract will have the same maturity date and deal spread as the underlying iTraxx index, but the holder now has a single name CDS position in a Thomson CDS - which involves them in the auction settlement procedures.

A further implication of the removal of the name from the indices is that the average spread should drop, causing the indices to tighten. The theoretical change can be calculated by comparing the intrinsic spread before and after Thomson is removed. Theoretically, the Crossover index, for example, should tighten by around 29bp, according to Citi estimates.

Meanwhile, investors in iTraxx tranches on older series will also have to decide whether to trigger a credit event (see also separate News story). But Gisdakis indicates that not triggering will likely mean that the investor has a position in a bespoke CDO, rather than a tradable security.

He says that the Thomson restructuring highlights that, even with increasing standardisation, CDS contracts involve economic risks, as well as operational risks due to a complex legal framework. "Moreover, the probability that Thomson will only be the beginning of a series of similar events should not be underestimated," he warns.

Gisdakis adds: "Large multinationals, with a significant portion of bank debt, typically go the restructuring way, as banks will seek to avoid real credit events by providing a restructuring solution. The associated 'frictional' costs in case of a real insolvency procedure is simply too high to push restructurable companies down the bankruptcy road."

Criticism already appears to be building about the operational difficulties inherent in the revised restructuring credit event documentation, with some traders reportedly considering boycotting the Thomson restructuring auctions. But Gisdakis argues that trying to solve this problem by pushing Thomson into a real default could be counterproductive.

"Just imagine the response that such a (unnecessary) forced bankruptcy only because the CDS settlement procedures are too complicated would have on the regulatory side. A derivatives framework that provides incentives to involved banks to pull the trigger on companies that can be restructured will apparently not be welcomed by regulators," he concludes.

CS

Secondary markets

Extension risk rising

Views diverge over non-agency RMBS fundamental value

Slowing prepayment rates are raising the spectre of extension risk in the US non-agency RMBS market. At the same time, a divergence in views about fundamental value in the sector appears to be emerging.

The non-agency RMBS market is at present distorted by the influx of cash into the sector from private equity and distressed debt hedge funds, according to one ABS trader. He says: "Some investors have too favourable a view on prepayment rates, for example, which are likely to slow even further going forward. Around 90% of mortgage origination in the US is currently accounted for by the GSEs and, as soon as the government ends its support for them, borrowers will have difficulty remortgaging - and hence prepayments will be impacted."

However, the trader points out that interest rates remain low and therefore payment shock in the ARM sector is low.

Another factor that is complicating US RMBS performance analysis is the activities of mortgage servicers. "It remains unclear whether mortgage servicers are renting repossessed properties out rather than selling them, for example. Furthermore, differences in loan modification programmes between servicers mean that it is difficult to identify specific trends in the sector," the trader explains. Added to this is the fact that a high risk of government intervention in the market remains and so any consequent upside/downside is hard to price in.

Amherst Securities Group is one firm that reckons, with the recent improvement in prices in the sector, many non-agency securities are now looking fully valued. By contrast, it says that much of the market believes these securities remain attractively priced.

"Prices were too cheap in March; however, now the pricing on many securities seems full to us," the firm explains in a recent note to clients. "In contrast, most market participants we talk to believe that prices are still attractive across the board - they contend the assets remain fundamentally undervalued. The divergence in views is a result of the differences in methodology used by Amherst versus many other market participants in looking at the 'value' of these assets."

The client note goes on to outline the firm's evaluation approach to non-agency RMBS securities. Amherst says it focuses on three areas that are typically overlooked by most investors: default rates are being calibrated from loans that are liquidating rather than from loans entering the non-performing bucket; the time necessary to liquidate the non-performing pipeline is being underestimated; and that it is important to analyse different groups of collateral separately.

"Loans with positive equity are less likely to default and more likely to prepay than their negative equity counterparts. These differences can often produce yields that are lower than those many market participants believe they are receiving," the note explains.

The first divergence in approach is that Amherst looks at the transition rate rather than the liquidation rate. While most investors look at the rate at which loans are being liquidated, Amherst says it looks at the rate at which loans are moving into the non-performing bucket. Since the market is deteriorating, transition rates - which provide a forecast for future liquidations - will be much higher than the current liquidation rates.

Second, Amherst says it pays close attention to the liquidation pipeline, recognising that loans are spending longer periods in foreclosure/liquidation (simply looking at how long the liquidated loans are spending in the liquidation pipeline contains a selection bias). To the extent cashflows on a discount security are received later than anticipated, the yield on the security drops. In addition, greater advancing of principal and interest, fees and insurance will increase severities, according to the firm.

Finally, Amherst divides every deal into loan buckets according to performance. Loans with better credit characteristics tend to prepay more quickly and default more slowly than their counterparts. In contrast, investors who assume that all performing loans in a pool behave identically will overstate the yield on most securities.

The client note goes on to say that there is potential for these securities to increase further in price on technical grounds, but their upside is limited. Consequently, Amherst believes that this is a good time for investors to do their homework and sell securities that are being fundamentally mis-valued by the marketplace.

The trader suggests that even though non-agency RMBS prices may have improved by around 10c recently, at 30c these assets still represent fundamentally good value. However, he adds: "Most holders still can't afford to sell their positions in any case - they're either unwilling to take the loss or they recognise that they might be able to realise a higher price at a later date."

CS

Documentation

Restructuring creates tranche operational challenges

The Thomson SA restructuring will not only test ISDA's 'small bang' protocol (see also separate News Analysis), but it also marks the first time that such a credit event is applied to index tranches. The move is expected to create operational challenges in the correlation market due to the potential for recoveries to differ across maturities, as well as the fact that it does not lead to a mandatory CDS trigger.

According to credit derivatives strategists at Banc of America Securities-Merrill Lynch, the event is likely to result in tranches with different attachment and detachment points depending on both the tenor and whether buyer/seller/neither triggered the contract first. Further, it introduces market concerns around liquidity, fungibility and information value.

In light of these concerns, ISDA has formed a working group to look at the settlement of tranches under a restructuring credit event. A spokesperson for the Association confirms that at the time of the small bang protocol there was discussion about the need to work out a permanent tranche solution and, while the intention is for this group to look at long-term solutions, naturally the current focus is on Thomson.

The group is understood to have come up with two separate proposals that attempt to keep tranche attachment/detachment points identical at the same maturity and, if possible, over the term structure. These proposals are also said to seek the removal of Thomson from the portfolio in a similar manner to which index CDS transactions have been dealt with.

However, the BAS-ML strategists note that splitting a non-linear instrument such as a tranche into a combination of new non-linear (tranche without Thomson) and linear (Thomson single name CDS) securities is not straightforward. "Hence, although the proposals were put forward with the correct intentions, they both inevitably fail to replicate the economics of trades that undergo the normal settlement procedure. Given the requirement to reach agreement within the group and from legal advisors, we think it unlikely that a solution will be found before the list of TMMFP deliverables is published (from when CDS can be triggered)."

The eventual outcome is not expected to be as disastrous for liquidity and fungibility as perhaps initially feared though. As there is generally an incentive for either buyer or seller of tranche protection (or neither) to trigger the restructuring event, assuming market participants act rationally, this should lead to one of a limited number of tranche outcomes to dominate for a particular maturity/series. Liquidity is thus likely to converge on this dominant set of tranches, since it will reflect the majority of open interest in the market, the BAS-ML strategists explain.

But one bespoke CDO investor says that he's inclined to wait for a possible failure to pay credit event to be called on Thomson, should the company's creditors not agree to the proposed restructuring. He indicates that this would allow his positions to be settled in a more straightforward manner than they would be through a restructuring auction.

Barclays Capital credit derivatives strategist Matthew Leeming adds that there may be demand from correlation desks to acquire Thomson debt as a hedge for anticipated settlement of synthetic CDOs in a few months' time, with pressure being greatest for shorter buckets where there is less outstanding debt. "Although the auction procedure is in part designed to reduce the risk of a squeeze, for issuers with little available deliverable debt and which were also CDO-efficient names, the risk mitigation can be less effective," he explains.

Leeming continues: "Often holders of basis packages provide a balance by triggering their CDS and delivering bonds into the auction; however, in this instance, it is likely that demand from CDO desks will exceed supply from basis holders. Additionally, basis package holders may prefer to hold out for more profitable, subsequent credit events, such as a failure to pay."

A strong argument for retaining restructuring as a credit event in European CDS documentation was to keep regulators happy, according to the bespoke CDO investor. "Whether the consequent operational difficulties will cause the regulators to revisit this is a moot point, but dropping the clause would obviously help standardise CDS documentation even further," he concludes.

CS

Legislation and litigation

Lehman CDO case has broader rating implications

Ratings on global structured finance transactions with material derivative exposure to US-based counterparties may be adversely affected by pending litigation related to the Lehman Brothers bankruptcy filing. Related cases are being heard in both the UK courts and the US bankruptcy courts, specifically involving provisions that subordinate swap termination payments to the rated noteholders as a mitigant to counterparty default risk in synthetic CDOs.

A current dispute involves the validity of the priority of payments in the Dante CDO (SCI passim). In this case, the waterfall provides for an early termination payment to appear in two different places: above the payment to noteholders in the case that an SPV has experienced an event of default or has been affected by a termination event; or at the bottom of the waterfall in cases where the counterparty has actually defaulted.

The UK courts upheld the provisions of the documents. However, the case was bounced back the US courts and a trial date has been set for September.

As reported in Moody's Weekly Credit Outlook, attorneys for the Lehman entity in question, Lehman Brothers Special Financing (LBSF), have argued that a deprivation clause would preclude a debtor from contractually giving preference to one creditor at the expense of others. Lehman's argument was that giving payment priority to noteholders as a result of the firm filing for bankruptcy would, in effect, deprive other creditors of assets that should be available to them, invoking the "anti-deprivation clause".

In addition, Lehman petitioned the court to grant a temporary stay, pending the resolution of bankruptcy proceedings in the US. The court has upheld the provisions of the waterfall and adjourned the application for stay.

Moody's notes that in reaching its conclusion, the court stated that it was necessary to consider the structure of the note programme as a whole, rather than looking at one provision of the waterfall in isolation and that the court should not interpret commercial transactions based on the general principles of law, particularly if doing so can bring into question many other similar transactions. Moreover, the presiding judge pointed out that the intention of the parties was to give payment priority to LBSF only prior to the default and that priority was never intended to continue after the default due to LBSF's bankruptcy.

Analysts at Moody's point out that part of the discussion also focused on the fact that the anti-deprivation clause could only be invoked in the proceedings under English insolvency laws, while Lehman has filed for bankruptcy in the US. "Although this decision is a victory for noteholders and a relief for many securitisation professionals, many questions remain unanswered; for instance, how will similar cases be decided in US courts? And if the decision is contrary to UK court decision on substantive issues, will the US decision trump the UK ruling? The UK ruling is also being appealed by Lehman," the analysts note.

A consultant familiar with the Lehman case explains: "In staying the effect of his ruling, the judge both permitted Lehman to pursue its appeals in the English courts and, more importantly, recognised that the application of US bankruptcy law could compel a different result. He specifically granted the stay to give the US Bankruptcy Court time to deliberate on the issues."

He adds: "We believe that the fundamental arguments we have made are still valid and that a final resolution of these issues will involve considerable additional legal argument."

According to Fitch, a final outcome favourable to the Lehman bankruptcy estate could have implications not only for synthetic CDOs, but also for global SF transactions more generally due to the widespread use of the subordination provisions within securitisation structures. However, the ultimate outcome and timing for resolution of the court cases remains uncertain at this stage, thus any potential rating action is not inevitable or imminent.

Fitch md Kevin Kendra says that the outcomes of the court cases in favour of Lehman will have clear rating implications for synthetic CDOs and other similar securitisations. He adds that if the rulings are ultimately in favour of Lehman and no other counterparty risk mitigants are present in the transactions, then Fitch will cap the credit ratings of notes in synthetic SF transactions to the credit rating of the CDS counterparty where the counterparty may be subject to US bankruptcy proceedings.

While the potential impact on Fitch's ratings is most pronounced in SF transactions where the termination of the derivative contract triggers a termination of the securitisation (usually synthetic transactions), this feature is also prevalent in other SF transactions where the role of the derivative is mainly for hedging purposes within the structure. In these instances, the termination of the derivative contract does not trigger a termination of the securitisation, but may also result in termination payments being due to the counterparty at a senior level in the priority of payments.

However, other factors such as the size of the derivative position in the context of the SF transaction overall and the potential appointment of a possible replacement counterparty may provide some mitigants. Consequently, the potential rating implication of the pending cases will depend on the specifics of each transaction, as well as the ruling by the respective courts.

AC & CS

Operations

TALF gains momentum

Two positive developments in TALF-land this month underscore the growing success of the programme, amid increasing issuance and tightening spreads in the ABS market. The US Federal Reserve and Treasury announced on 17 August that they will extend TALF loans against newly issued ABS and legacy CMBS to 31 March 2010 and the programme for newly-issued CMBS to 30 June 2010 (see also separate News Analysis). At the same time, demand for non-CMBS TALF loans is expanding into new asset classes.

The extension of TALF into 2010 has been welcomed by market participants, in particular in connection with CMBS. "By extending this important programme for six months for newly issued CMBS and three months for so-called legacy CMBS, this action sends a clear signal to markets that the Fed and the Treasury understand the gravity of the problem in commercial real estate credit markets," says Jeffrey DeBoer, president and ceo of The Real Estate Roundtable.

"Due to the long lead time necessary to assemble TALF-eligible CMBS transactions, it was important to extend the programme's remaining term to address the massive credit shortfall to the sector," he adds. "With this extension, we are optimistic that an increased number of CMBS securitisations will take place under TALF and the programme will not end before it has a chance to make a difference. TALF's extended runway gives it an opportunity to achieve a desired, positive effect on price discovery and facilitate the return of an active securitisation market."

Meanwhile, the New York Fed awarded US$6.9bn in non-CMBS TALF loans for the 6 August facility. The TALF-related primary market this month moved away from retail auto and bank credit card ABS to floorplan, fleet lease and retail credit card ABS - marking the first time in 2009 that floorplan (auto, as well as farm and recreational equipment) transactions have been issued. By the August TALF loan subscription date, 11 transactions (five credit card, three floorplan, two student loan and one fleet lease) had priced, for a total of US$8.2bn in TALF-eligible issuance.

According to ABS analysts at Barclays Capital, leveraged yields remained at 8%-10% for retail credit card ABS (compared to 6.5% for bank card ABS) and 6.5%-7.25% for dealer floorplan transactions. TALF yields were not estimable for the fleet lease and student loan transactions, as these deals were privately placed.

While issuance this month is ahead of that from last year (US$8.2bn versus US$3bn), year-to-date volume is well behind last year's, the analysts note. Through to 10 August, consumer ABS issuance totalled US$85.3bn (US$59.5bn TALF-eligible, US$25.8bn non-TALF-eligible), compared to US$111.4bn for the same period last year - a 23% decline. However, if the primary market remains robust during the rest of the year - as is expected - this gap is likely to close, given that consumer ABS new issues ground to a halt in Q408.

S&P credit analyst David Hoberman notes: "Investors' initial feedback seemed to indicate that market participants were receptive to the TALF programme, as ABS issuance has continued to increase from its near-frozen state at the beginning of 2009 and spreads in the secondary market have narrowed. We believe the success of the programme has also been somewhat augmented by other factors, such as investors' increased demand for high credit quality returns paying interest greater than US Treasuries."

The agency's latest report on the programme confirms that the TALF facility has increased investors' interest in investing in ABS (SCI passim). This interest, rather than the actual usage of the facility, ultimately benefits the markets and consumers, as evidenced by the steep decline in ABS risk premiums.

In addition, the oversubscription of some TALF deals has resulted in increased demand for trading non-TALF deals in the secondary market. This led to higher prices and lower yields, S&P says.

Such spread tightening has also made securitisation a more desirable capital source for issuers, thereby fostering an increase in ABS issuance. S&P believes a reduction in TALF participation and increased issuance in the cash market points to the programme's success.

In the report, S&P also reviewed its rated ABS transactions that were used as collateral for TALF loans during each of the first six rounds of TALF funding, including auto loan and lease, credit card, student loan and equipment ABS, as well as CMBS.

Meanwhile, further expansion of the types of collateral eligible for the TALF facility has been put on hold. However, the US Treasury says it is prepared to reconsider this decision if financial or economic developments indicate that providing TALF financing for investors' acquisitions of additional types of securities is warranted.

JA, AC & CS

Regulation

Draft OTC derivatives regulation welcomed

Draft legislation proposed by the US Congress on regulation of privately negotiated derivatives has been welcomed by the industry.

Under the proposed legislation, the OTC derivative markets will be comprehensively regulated for the first time. The plan calls for strong prudential and business conduct regulation of all OTC derivative dealers and other major participants in the markets (SCI passim). In addition, it calls for improved regulatory and enforcement tools to prevent manipulation, fraud and other abuses that pose excessive risk to both the financial system and unsophisticated parties.

Tradeweb is one online marketplace that has voiced its support of the objectives of the Treasury's draft OTC derivatives legislation. In particular, the firm notes the clear mandate that standardised swaps must be traded electronically, either on a "designated contract market" or an "alternative swap execution facility".

Tradeweb believes that electronic trading in the OTC markets will drive increased efficiency and transparency for institutional clients. The company says it looks forward to ongoing discussion on the draft bill, including greater clarity on what is required to become an alternative swap execution facility and the ongoing obligations of such facilities.

"The message from Treasury is clear. It is looking for a more streamlined and transparent derivatives industry. Electronic trading clearly answers these concerns and Tradeweb looks forward to playing a major role in helping the market adopt these important measures," comments Lee Olesky, ceo of Tradeweb. "In addition, we welcome the opportunity to link to, and partner with, clearinghouses to ensure that the overall marketplace operates efficiently."

The firm adds that it is important that central counterparty/clearing organisations offer equal access to multiple trading platforms. This strikes the right balance between fixing systemic problems and encouraging market innovation that broadens access to credit, Tradeweb notes.
 
Under the plans, the Administration will require standardised OTC derivatives to be centrally cleared by a derivatives clearing organisation regulated by the CFTC or a securities clearing agency regulated by the SEC. All non-standardised derivatives will require both higher capital requirements and higher margin requirements.

In terms of promoting transparency, the proposal requires that all relevant federal financial regulatory agencies will have access on a confidential basis to the OTC derivative transactions and related open positions of individual market participants. In addition, the public will have access to aggregated data on open positions and trading volumes.

OTC derivative dealers and major market participants that are banks will also be regulated by the federal banking agencies. OTC derivative dealers and major market participants that are not banks will be regulated by the CFTC or SEC.

The CFTC and SEC will be required to issue and enforce strong business conduct, reporting and recordkeeping - including audit trail - rules for all OTC derivative dealers and major market participants. The legislation gives the CFTC and SEC clear, unimpeded authority to deter market manipulation, fraud, insider trading and other abuses in the OTC derivative markets.

In addition, the legislation will tighten the definition of eligible investors that are able to engage in OTC derivative transactions to better protect individuals and small municipalities.

Robert Pickel, executive director and ceo of ISDA, says: "ISDA is appreciative of the recognition by Congress and the Administration that reform of the US financial system is an important part of ensuring a healthy economy."

He concludes: "We are examining the details of the draft legislation, being especially mindful of the need to preserve the availability and flexibility of privately negotiated derivatives for American companies. Privately negotiated derivatives are important both in order for American companies to manage risk as well as to compete on a global basis. We look forward to working with Congress and with regulators to address these important matters."

JA & CS

ABS

Fixed income team expands

MF Global has expanded its fixed income business, adding more than 20 professionals to its fixed income group in New York and London, and introduced a new institutional sales group.

Among the hires made in New York is James McHugh, who has joined as the head of credit trading and sales. He joins MF Global from RBC Capital Markets Corporation, where he served as md and head of US investment grade credit sales. Paul Gallagher has also joined the credit team from RBC Capital Markets Corporation.

Additionally, Scott Princer and Joe Scellato have joined the credit team from Jeffries & Co. Meanwhile, Kristi DeBriyn and Frank Bruzese have joined the firm's ABS/MBS sales and trading team from Merrill Lynch & Co and Banc of America Securities respectively.

Among the key talent added to MF Global's fixed income team in London are James-Scott Wong and Christiane Schuster, who will head the high yield and distressed loans desk. Wong joins the firm from Calyon London, where he built the crossover & high yield trading platform. Schuster previously served as md and head of European loan sales at Lehman Brothers International Europe, where she was responsible for establishing the loan sales team.

ABS

Jeffries bolsters MBS/ABS group

Jefferies has made eight appointments within its MBS/ABS group.

Steven Hulett joins as an md and co-head of Jefferies' European MBS/ABS group. He joins from RBS, where he was an md and co-head of the structured product & solutions credit group. Previously, Hulett was an md at Lehman Brothers, where he worked for 14 years.

Craig Tipping also joins as an md and co-head of Jefferies' European MBS/ABS group. He joins from Nomura, where he was an executive director and head of ABS trading. He previously worked at Lehman Brothers.

Marc Allison joins the bank as an svp for MBS/ABS sales. He joins from RBS, where he was a director in the structured product & solutions credit group. He is based in London.

Marion Guilbert has also been named an svp for MBS/ABS sales. She was most recently at Lehman Brothers, where she was an svp for the securitised product sales group.

Dennis Hollands joins her as an svp for MBS/ABS sales. He joins from RBS, where he was a director in the structured product & solutions credit group.

Jason O'Brien also joins as an svp for MBS/ABS sales. He was a director in RBS' structured product & solutions credit group.

Edward Tunstall joins as an svp for MBS/ABS sales. He joins from Nomura, where he was an svp for the securitised product sales group, and previously worked at Lehman Brothers.

Meanwhile, Hitoshi Masumizu joins as an md and head of Jefferies' Asia MBS/ABS group. He joins from Potomac Capital, where he was head of investment banking. He previously worked at Countrywide Capital Markets Asia, where he headed the financial product division for the Asia Pacific region.

All the appointments are London-based, with the exception of Masumizu who is based in Tokyo.

In July Jefferies announced the addition of Lisa Pendergast as head of CMBS strategy and risk, and added US sales teams in Boston and Chicago.

ABS

Bank appoints ABS strategies head

RBS has hired Brian Lancaster to its global banking & markets (GBM) Americas division as head of MBS, CMBS and ABS strategies. He reports to John Richards, head of strategy, GBM Americas. Lancaster is the latest of several senior level additions to the GBM sales, trading and strategy teams in the US.

In his new role, Lancaster will be responsible for developing investment strategies for clients in MBS, CMBS and ABS. In the coming months, RBS will be beefing up his team significantly with the hire of additional strategists.

Lancaster has more than 20 years' experience in finance. He joins RBS from Wachovia Capital Markets, where he served as chief investment officer in its real estate division, responsible for capital allocation, business and lending strategies. Prior to this, he was head of structured products research at Wachovia. Before joining Wachovia, he was an md principal at Bear Stearns, where he developed MBS/CMBS/CMO strategies for clients.

Lancaster will be based in RBS' Americas headquarters in Stamford.

Advisory

Derivatives solutions practice launched

Navigant Consulting has launched a new structured products and derivatives solutions (SPDS) practice in the UK designed to address the problems raised by market volatility. The new team includes former heads of business from both Barclays Capital and the RBS.

The SPDS practice will have several disciplines, encompassing valuation, counterparty risk management in derivatives transactions, restructuring services and asset management. The new practice will count a variety of funds among its clients, including hedge, pension and private equity funds. It will also service both commercial and investment banks, as well as insurance companies.

Pawan Malik, the former global head of derivative counterparty risk solutions at Barclays Capital, will head up the SPDS practice. The team also includes Rizwan Hussain, who is a founding principal of Navigant Capital Markets Advisers, a subsidiary of Navigant Consulting, and is the former head of portfolio trading and management at RBS and ABN AMRO. The practice is four-strong, with plans for further recruitment this year.

Advisory

Advisory names vice-chair

Byron Wien has been appointed vice-chairman of Blackstone Advisory Services. Wien was previously chief investment strategist for Pequot Capital and prior to this served for 21 years as chief (later senior) US investment strategist for Morgan Stanley. He will act as a senior adviser both to Blackstone and its clients in analysing economic, social and political trends in order to determine the direction of financial markets and thus help guide investment and strategic decisions.

Stephen Schwarzman, chairman and ceo of Blackstone, says: "Byron brings to the firm unparalleled experience, wisdom and judgment formed over many years of deep involvement in the financial markets. At a time when Blackstone stands ready to deploy the largest amount of investment capital in its history and our clients are faced with unprecedented economic turmoil and uncertainty, Byron will play a central and invaluable role in providing direction and guidance."

Wien adds: "Blackstone is the largest independent alternative asset manager and advisor in the world, whose businesses and clients touch almost every major market and economy. I am looking forward to working with the firm and its clients to help capitalise on the opportunities to invest and grow businesses that the current economic dislocations will produce."

Advisory

Firms team up to manage impaired asset exposures

Technology and agency brokerage services provider ConvergEx is collaborating with Standish Asset Management Company's global workout solutions group to provide clients access to a fiduciary advisory business designed to manage exposures related to distressed, illiquid and hard-to-value assets.

"Given the ongoing market dislocation in certain asset classes, our clients appreciate the extensive knowledge and highly customised services that Standish's global workout solutions group is able to provide," says Kal Bassily, md at ConvergEx. "By working together with Standish, we are offering our clients a solution to some of the very real challenges they still face with specific fixed income products."

Through the agreement, ConvergEx will be able to offer its plan sponsor and pension fund clients access to Standish's expertise in assessing the risk and value of mortgage- and asset-backed securities, CDOs, SIVs and other structured and corporate finance investments. "We are very pleased to have the opportunity to work alongside ConvergEx," comments Desmond Mac Intyre, president and ceo of Standish. "Plan sponsors remain concerned about the risks involved with certain impaired assets. Our investment professionals are well-equipped to formulate a strategy and provide solutions, within a client's specific framework."

CDO

KBC marks up CDO portfolio

KBC has substantially marked up its CDO portfolio in Q209. This comes just three months after it sought an asset relief solution from the Belgian government, following the announcement of structured credit and monoline-wrapped debt losses amounting to €3.8bn (SCI passim). In January, the bank wrote down in full the value of its mezzanine CDO investments, retaining only the super-senior tranches.

The positive impact on earnings from the CDO revaluation in Q209 amounted to €1.3bn. This mark-up includes the positive impact from the acquired guarantee (from the Belgian state) and the negative impact from the increase in the coverage of the CDO-linked counterparty risk against MBIA, from 60% to 70%.

KBC has also set aside €200m, which the bank says is related to CDOs sold to customers.

CDO

CRE CDO servicing agreements amended, transferred

GKK Manager (GKKM), the collateral manager for Gramercy Real Estate CDO 2005-1 and Gramercy Real Estate CDO 2007-1, has substantively modified the 2005 primary servicing agreement and transferred it from Capmark Finance to SitusServ. In addition, the 2007 primary servicing agreement with Situs has been substantively modified, while the 2005 and 2007 special servicing agreements have been substantively modified and transferred from Green Loan Services to both Situs and Green on a bifurcated basis.

Green has a CMBS large loan special servicer rating of CLLSS2- and Situs has a CMBS primary servicer rating of CPS3 and a CMBS special servicer rating of CSS3. Since both servicers are Fitch-rated and neither servicer is rated below the Level 3 servicer rating category, the servicers are considered by the agency to have appropriate capabilities for commercial mortgage servicing. The assignments of and modifications to the servicing agreements therefore would not prompt a review of or adversely impact Fitch's CDO ratings because the CDO manager continues to have adequate commercial mortgage servicing capabilities in place.

CDPCs

CDPC tests new credit protection vehicle

Primus Guaranty has been testing a new credit protection vehicle that it hopes will replace its CDPC Primus Financial. The new company's strategy would be to sell protection via credit default swaps on single name corporate and sovereign reference entities. This would be similar in concept to Primus Financial, with the major difference being that the new company will post collateral.

Over the course of the year, Primus has tested the concept by constructing and managing a US$1bn notional test portfolio. "We believe that a new credit protection seller can capture a solid market niche and generate attractive return," said Tom Jasper, ceo of Primus in a Q209 results call. "We're discussing our strategy with potential investors and counterparties and are encouraged by the dialogue to-date. This is obviously a longer-term initiative and much depends on the state of credit markets, financial systems and global economy."

CDS

Critical mass for negative basis fund

Assenagon Asset Management reports that its negative basis fund - Assenagon Credit Basis - has raised more than €350m from institutional investors in only three months. This makes it the biggest fund of its asset class in Europe, according to the manager.

At the same time, Assenagon has temporarily suspended the issuance of new shares in the fund due to decreasing investment opportunities caused by current market conditions. The manager intends to counter profit dilution in the fund through this action.

The investment portfolio placed in the market was invested sustainably at a negative basis above the fund's target return of 300bp-350bp over three-month Euribor, according to Assenagon. This is reflected in the performance of the fund since its inception on 22 April 2009, with 5.5% in share class I and 5.3% in share class G.

"We still see very good opportunities in the market, which we are pursuing with our active management approach," notes Jochen Felsenheimer, fund manager at the firm. "This implies exchanging basis packages which become less attractive over time for significantly more attractive ones, thereby consistently exploiting the still existing distortions in the credit market. We feel very comfortable with being able to employ heretofore not yet used repo transactions and to cover different segments of credit quality."

The UCITS III fund invests worldwide in corporate bonds and their corresponding CDS, representing its key earnings component. In this segment the capital markets are presently pricing in a default rate of nearly 10%. A similar rate of return can only be achieved by traditional corporate bond funds if enormous default risks are accepted, the manager says.

Counterparty risk is mitigated by having collateralise the CDS contracts with cash and first-rate government bonds (collateralised CDS).

CDS

Fund improves liquidity terms

Tiden Capital has improved the liquidity terms for the Tiden Core Fund, which returned +5.7% in July and +23.5% year to date. The firm, launched in September last year, invests in single name CDS as well as baskets and tranches of structured credit portfolios.

"We continue to find excellent risk-adjusted relative value trading opportunities in the credit markets," the manager confirms.

Effective from 1 September, the fund's terms change such that liquidity will be available quarterly with 45 days' notice (previously 90 days) and the lock-up period becomes one-year soft, with a 2.5% redemption fee (previously one-year hard).

CDS

Derivatives trade processing venture launched

Markit and the DTCC will launch MarkitSERV on 1 September. The venture was first announced in July 2008 (see SCI issue 98) and involves combining both parties' trade confirmation platforms to provide OTC derivative trade processing.

MarkitSERV will cover credit, interest rate, equity and commodity derivatives. It will also connect multiple market participants and execution venues, as well as connect to various central counterparty platforms for interest rate swaps and CDS.

CDS

CDS market website launched

ISDA has launched a website to aide the CDS market. Dubbed 'ISDA CDS Marketplace', the website brings together information, data and statistics on CDS business in four main sections. There is an overview of the CDS market, a daily prices section, a weekly section regarding exposures and trading activity, and market statistics.

ISDA CDS Marketplace was developed with the support of DTCC Deriv/SERV, Markit and Moody's Analytics.

Clearing

BClear contracts suspended

CDS index contracts on BClear - the CDS clearing service launched by Liffe and LCH.Clearnet (SCI passim) - have been suspended. No trades have been processed since the service launched last December. A spokesperson for Liffe stresses that the contracts have been suspended, not delisted, and says that the exchange is still interested in CDS clearing activities.

Clearing

New clearing member for European clearer

RBS has been approved as the 11th CDS clearing member of ICE Clear Europe and began operations with the clearinghouse last week. In its first three weeks of operation, the clearer says it processed 1,574 transactions totalling €88.7bn of notional value.

CLO Managers

MBIA Capital Management takes on CRE CDO

MBIA Capital Management is expected to replace Vertical Capital as collateral manager for Vertical CRE CDO 2006-1, a revolving US CRE CDO issued in May 2006. MBIA Capital currently manages 11 CDOs issued since February 1997- on four of which it acts as replacement manager, totaling US$6.2bn. Vertical is the first CRE CDO to be managed by MBIA Capital.

As of the July 2009 trustee report for Vertical CRE CDO 2006-1, the CDO was substantially invested in CMBS (73.8%), CRE CDOs (19.9%), commercial mortgage B-notes (3.9%) and CRE mezzanine loans (2.4%). The transaction has a five-year reinvestment period, ending April 2011, during which principal proceeds may be used to invest in substitute collateral. Fitch notes that as of July 2009, the CDO was failing all of its interest coverage and overcollateralisation tests as a result of six defaulted assets (14%), as well as overcollateralisation haircuts associated with below-investment grade collateral.

As long as these tests are failing, interest and principal proceeds are redirected to pay down the senior-most notes and the asset manger's ability to reinvest is therefore constrained. As a result of the asset credit deterioration, resultant coverage test failures and portfolio concentration by industry and vintage, Fitch downgraded all classes of the transaction to below investment grade on 5 March 2009.

CLO Managers

CLO deconsolidation ups manager's profits

Deerfield Capital has reported a gain of US$29.6m net income during Q209 due to the deconsolidation of the Market Square CLO. Net income attributable to the firm for the quarter totaled US$52.9m in total, or US$7.85 per diluted common share

Meanwhile, the firm reports that investment advisory fees totaled US$4m in Q2, a decline of US$0.7m as compared to US$4.7m in Q109. The decrease in investment advisory fees was primarily the result of the breach of certain overcollateralisation tests on CLOs that the company manages.

Subordinated investment advisory fees declined by US$0.9m during Q2, as compared to the first quarter of 2009. The company expects its subordinated investment advisory fees to continue to be deferred in the near term.

However, over time and with improvement in market conditions, Deerfield expects the CLOs to regain compliance with the overcollateralisation tests and - subject to the satisfaction of certain other conditions - it expects to recoup at least a portion and potentially substantially all of the deferred subordinated management fees and to receive future CLO subordinated management fees on a current basis.

CLOs

Avoca participation agreements novated

The selling institutions in certain participation agreements entered into with the issuers of the Avoca Credit Opportunities and Avoca CLO III, IV, V and IX transactions have been replaced by a newly constituted SPV - dubbed Avoca Participation - incorporated in the Netherlands. Avoca Capital Holdings, as manager of the deals, requested that Moody's provide its opinion as to whether the ratings on the affected securities be downgraded or withdrawn as a result of the transfer, by novation, to the new participant. The agency has confirmed that such a transfer does not have an adverse effect on the deals' ratings.

CMBS

NY Fed cuts two agency MBS managers

The New York Fed has cut from four to two the external investment managers mandated for its agency MBS purchase programme. Wellington Management Company has been retained for trading, settlement and as a secondary provider of risk and analytics support, while BlackRock remains as the primary provider of risk and analytics support. Goldman Sachs Asset Management and PIMCO were the other two managers initially appointed to help implement the agency MBS purchase programme.

The Fed says it has now gained more experience with the programme and that the change in the number of external investment managers was not performance-related.

The Fed has been purchasing agency MBS since November 2008. In March of this year, the FOMC announced the expansion of the Federal Reserve's programme to purchase agency MBS up to a total of US$1.25trn by the end of the year.

Investors

Insight Investment acquired

The Bank of New York Mellon has acquired Insight Investment Management from Lloyds Banking Group for £235m. Insight Investment will join the other investment boutiques at BNY Mellon Asset Management.

With this acquisition, The Bank of New York Mellon will have more than US$1trn in assets under management. The acquisition is expected to close in the fourth quarter of 2009.

Based in London, Insight Investment specialises in liability-driven investment (LDI) solutions, active fixed income and alternatives. Insight Investment's assets under management, net of identified internal assets that will be retained by another part of the Lloyds Banking Group, are approximately £80bn.

Ronald O'Hanley, president and ceo of BNY Mellon asset management, says: "Two equity downturns in 10 years and rapidly growing liabilities have left many retirement plans at a crisis level and have created an urgent need to overhaul many aspects of the current funding system. LDI is a critical tool for meeting the needs of current and future retirees, while improving the stability of plan sponsors. Moreover, LDI has great potential to assist life insurance companies with similar liability issues."

Legislation and litigation

Litigation weighs on US CLO managers

A survey of 134 US CLO managers undertaken by S&P shows that 28.4% of the managers are currently subject to litigation. The agency issued a questionnaire that included 58 questions covering a variety of areas it considers significant to the rating process. These areas included portfolio management, as well as the economic, organisational, staffing, transactional, structural and revenue sufficiency needed to meet operating expenses.

However, none of the managers who classified themselves as a structured CLO manager/standalone manager indicated that they were subject to any litigation issues. Several managers that responded 'yes' to this question further clarified their responses with comments indicating that their firm is: (a) typically subject to litigation as a normal course of business or (b) that the pending litigation is not material to the firm's operations or financial condition as a whole.

Other key findings from the survey show that: 61.4% of US CLO managers classify themselves as an asset management firm, 39.4% indicated that their firm's total corporate fixed income assets under management (AUM) were greater than US$7bn, and 32.8% indicated that their firm's total corporate fixed income AUM amounted to US$2.5bn or less.

Meanwhile, 4.4% of respondents stated that they anticipate their corporate fixed income asset management fee income (and other income) will not be sufficient to absorb their operating expenses in 2009, 54.5% replied that they had made staff reductions in the last twelve months and 7.5% indicated that they are an acquisition target.

Listed products

Permacap profits from new investment policy

Carador has announced that, as of 31 July, the unaudited net asset values per share were €0.4131 for euro shares and US$0.5317 for US dollar-denominated shares, down by 1.77% and 1.88% respectively. The decrease in the month includes the payment of the interim dividend of 0.0149 per euro share or US$0.0208 per US dollar share declared by the board on 13 July 2009. This month's calculations include an estimated €1.48m of net cashflow interest received in the month (to be allocated between capital and income), which equates to €0.0112 or US$0.0159 per share.

Following the July month-end, Carador sold its investment in the senior notes of GELCT 06-2 - a 2006 vintage CLO - realising profits of US$1.63m. This investment was the first by Carador in a senior CLO security, following the change in the investment policy approved by shareholders on 9 March 2009 (SCI passim).

Carador initially invested US$4.04m in April 2009 and received aggregate proceeds of US$5.67m (including US$2.1m of principal repayments), representing a total cash on cash return of 1.4 times the initial investment over the four-month holding period.

This investment was included in the July NAV at the sales price of 92.5% of face value. This compares to the June NAV valuation of 65% of face value.

Listed products

Permacap continues share buyback

Queen's Walk Investment Ltd (QWIL) has entered into an irrevocable, non-discretionary arrangement with Citigroup Global Markets and JPMorgan Cazenove to repurchase on its behalf ordinary shares in the company for cancellation during the close period commencing on 14 August 2009 and ending on 15 September 2009. The maximum price to be paid shall be not more than 105% of the average of the middle market quotations for the company's shares for the five business days before the day on which the purchase is made. The permacap can repurchase up to 14.99% of its issued share capital as of 4 September 2008.

QWIL has also reported that, as at 31 March 2009, its NAV was €3.96 per share down from a NAV of €4.12 per share as at 31 December 2008. The decrease in NAV reflects the increase in discount margin applied to its SME and continental European mortgage portfolios, the permacap says.

In the quarter ended 31 March 2009, estimated cashflows for the June quarter were €5.5m (using 30 June 2009 FX rates). Actual cashflows recorded in the quarter ended 30 June 2009 were €5.2m million.

The company had a net cash balance of €9.6m as at 13 August 2009, following payment in July 2009 of €2.1m for the March 2009 dividend and payment of €1.5m to reduce the principal of its financing facility. The current outstanding amount for the facility of €22m is already significantly lower than the agreed target loan amount at 31 March 2010 of €25m.

Ratings

Asia Pacific SF surveillance team strengthened

Fitch has expanded its Asia Pacific structured finance (SF) surveillance team with the addition of another director. Helen Wong previously gained experience with the agency through rating transactions across a variety of asset classes and countries within non-Japan Asia and India.

Wong will now report to Alison Ho, director and head of Fitch's Asia Pacific SF performance analytics team, assisting in the region's continued focus to improve the agency's surveillance work. Both are based in Hong Kong.

Ben McCarthy, md and head of Asia Pacific structured finance at Fitch, says: "Alison and Helen have a wealth of experience between them in different asset classes and jurisdictions. The bolstering of the team with Helen's new appointment reflects the importance Fitch places on surveillance and the continual monitoring of outstanding ratings."

Real Estate

US expansion for Canadian CRE services firm

Avison Young, an independently-owned commercial real estate services company based in Canada, has appointed Earl Webb as president of its US operations, effective as of 8 September 2009. Webb will be responsible for leading geographic and service line expansion efforts in the US for the firm, as well as heading all Avison Young US operations.

"Avison Young's global vision is one of the most compelling in the industry," says Webb. "The company has developed a new client service model that recognises the inadequacy of traditional service line structures. Avison Young understands the key to success is the alignment of interests between its principals and the changing needs of clients in the new economic environment. I look forward to the opportunity to help build both the company's presence and its capabilities in the world's dominant real estate market."

Webb becomes a principal and a member of the company's board of directors and executive committee. He will be based in Avison Young's Illinois office.

Webb previously spent 24 years in senior positions with Jones Lang LaSalle. For the last seven years he served as ceo of the capital markets group, responsible for strategic direction and management of all capital markets activities and oversight of personnel and transaction activities in investment sales, corporate finance, debt and structured finance, and real estate investment banking for the firm's clients.

Real Estate

Distressed debt manager absorbs ResCap staff

Mountain Funding, a real estate investment company specialising in distressed real estate debt portfolios, has absorbed the 14 senior management and real estate professionals from the REO asset management group of GMAC-ResCap's Business Capital Group. Mountain Funding completed this transaction through its asset management affiliate, Mountain Special Servicing.

As part of the transaction, GMAC-ResCap has engaged Mountain to provide asset servicing and other consulting services for ResCap-BCG's residential development real estate owned (REO) and non-performing loan (NPL) assets nationally. This servicing arrangement covers a portion of the portfolio of ResCap's Business Capital Group, including residential housing development REO properties.

Peter Fioretti, ceo of Mountain Funding, says: "We have been pursuing this expansion for several months and are very excited to have completed it. Mountain Special Servicing has become one of the leading asset managers of residential development REO and NPL assets for institutional lenders in the country. As importantly, Mountain Funding will be able to utilise its asset management staff to efficiently underwrite and bid on distressed debt portfolios, an area in which we expect to be a major player for the next three years."

Joining Mountain Special Servicing as md will be GMAC-ResCap's former head of ResCap-BCG REO management, Joel Kaul. He will head up the company's residential asset management group.

Fioretti adds: "I was very impressed with Joel and he was an important factor in us acquiring this group. He has tremendous real estate experience and has led this group to be extremely successful in managing and disposing of BCG's REO and NPL assets nationwide."

The commercial asset and fractured condo management group continues to be led by Mountain's Brett Peterson.

Combined with its existing portfolio, Mountain Special Servicing now has approximately 90 assets under management, totalling over US$1bn in unpaid principal balance. The assets are diversified over 20 states and include the following property types: residential land development, residential lot development/sale, housing construction/sale, commercial land development, sub-performing retail centers, fractured condos, apartments and resort development. Mountain Special Servicing intends to pursue additional asset management business for portfolios of distressed assets owned by REITs, hedge funds and other institutional lenders.

In addition to its capability to provide asset management services for third-party lenders with distressed assets, Mountain Funding is capitalised to invest US$1bn over the next few years in distressed debt and property for its own account.

Real Estate

Consortium to invest in under-performing real estate

Brookfield Asset Management and Brookfield Properties Corporation have established a US$4bn investor consortium dedicated to investing in under-performing real estate. The consortium will invest in equity and debt in undervalued real estate companies or real estate portfolios where value can be created for stakeholders in a variety of ways, including financial and operational restructuring, strategic direction or sponsorship, portfolio repositioning, redevelopment or other active asset management. Investments will be targeted at corporate property restructurings with a minimum US$500m equity commitment and pursued on a global basis, but with a focus on North America, Europe and Australasia.

In addition to Brookfield, the participants in the consortium consist of a number of institutional real estate investors that have each allocated between US$300m and US$1bn to the consortium. Brookfield has allocated US$1bn to the consortium, with opportunities in the office sector being funded by Brookfield Properties, at its option, and opportunities in other sectors being funded by Brookfield Asset Management.

The consortium participants have expertise in investing across different geographies and property types, and this expertise will be pooled together to maximum advantage in individual investment opportunities.

Cyrus Madon, senior managing partner of restructurings at Brookfield, says: "We believe that the current distressed economic environment and the dislocation both in real estate values and financing availability creates a compelling opportunity to pursue transactions on a global basis where we can utilise our restructuring and operating capabilities. We look forward to creating value for all stakeholders."

RMBS

Moody's launches RMBS newsletter

Moody's has launched a newsletter to provide investors with information and analysis about key credit issues affecting the US RMBS market. Each issue of ResiLandscape will feature commentary about the underlying housing market, news on the government support and modification programmes and their credit impact, summarise ratings activity, keep an eye on regulation affecting securitisations and provide views on the performance of the collateral underlying RMBS.

The newsletter will feature articles written by Moody's analysts that rate RMBS, mortgage servicers, banks and the GSEs, as well as housing and macroeconomic commentary from Moody's Economy.com.

Structuring/Primary market

Structured credit mandate awarded

Babson Capital is said to have been awarded a US$40m structured credit mandate by TWU Super, Australia's superannuation fund for the transport workers' union. This follows the US$150m mandate that the manager received from REST, the Retail Employees Superannuation Trust (see SCI issue 144).

Technology

Distressed mortgage trading platform launched

A proprietary US mortgage trading platform has been launched by The Carlton Group. The Carlton Exchange (CEX) has been created in response to the increasing demand from institutional buyers and sellers of loan and REO assets and notes for a more efficient, transparent marketplace.

CEX operates as a secure online interface and provides buyers and sellers with a bidding process designed to produce multiple, non-contingent final bids accompanied by pre-negotiated asset sale agreements. The platform will also provide initial investor screening and asset due diligence.

CEX is currently marketing over US$500m in performing and non-performing commercial and residential real estate and land development loans located throughout the US. In addition, Carlton has marketed over US$2bn of performing and non-performing residential and commercial loans for some of the country's largest investment banks and financial institutions, regional banks and other distressed sellers of assets since the beginning of the credit dislocation in 2007.

Trading

Bank hires in credit trading

UBS has made a number of credit hires within its FICC (fixed income, currencies and commodities) department.

Anatoly Nakum has been appointed head of investment grade trading. He previously worked at Barclays Capital, where he was md and head of high grade and crossover flow trading in its US fixed income division.

Dan Brereton has moved from BNP Paribas to head up high yield trading, while Nahil Bayrasli has moved over from Barclays Capital and will work on flow CDS. Todd Corsair, who previously worked at Bear Stearns, joins as credit analyst. The new recruits will be based in the US.

Meanwhile, Rajeev Misra - who joined UBS as head of its global credit business earlier this year - has been appointed co-head of emerging markets along with Ritesh Dutta, as UBS underlines its commitment to grow that part of the business.

Trading

Credit team expanded

Carmine Urciouli and Martin Teevan have been promoted to co-heads of global credit at Cantor Fitzgerald, and have announced a number of new hires within their team.

Mike Brennan will become head of high yield sales. Brennan is a veteran of the high yield markets, having 15 years of experience at UBS and Credit Suisse, and will be responsible for coordination of account coverage across Cantor Fitzgerald's client base.

Brian Devaney is now product manager of capital markets. Devaney will be the point person in coordinating dialogue between the company's high yield and distressed sales and trading and its leveraged finance banking team.

Jeremy Goldman has become head of distressed sales. Goldman will now be responsible for coordinating the marketing of the company's ideas and product among the distressed and special situations client base.

Adam Vengrow becomes cross asset trading product manager. Vengrow was previously a senior high yield debt trader at Cantor and will now continue to coordinate communication and cross-selling within the firm.

Finally, John Hanauer has been promoted to head of US investment grade trading. Prior to joining Cantor, Hanauer was md at UBS, where he traded credits across the curve.

Trading

Cohen tapped for ABS trading head

Amherst Securities has hired Jim Regan as head of ABS trading. Regan is a 19-year veteran of the ABS market, having most recently served as the head of ABS trading at Cohen and Company.

In addition to spearheading Amherst's efforts in traditional consumer-related ABS products, Regan will also be working to further develop Amherst's expertise in distressed ABS markets, such as lease-backed ABS, aircraft and insurance products. He will be based in Amherst's New York City office.

Prior to working at Cohen and Company, Regan was the head of structured trading at ABN AMRO, where he focused on subprime RMBS, autos, credit cards and student loans. He also previously served as a senior trader on the ABS desk at Credit Suisse, where he focused on subprime and other asset classes, such as aircraft, timeshare receivables, business loans and railcars. Before joining Credit Suisse, Regan worked for ten years as a senior ABS trader at Prudential Securities, where he was responsible for all the various major classes of the ABS markets.

ABCP

BoE's ABCP purchases likely to have limited impact

The Bank of England's Secured Commercial Paper Facility (SCPF) is unlikely to ignite the European ABCP market, according to a new report from Moody's. The programme's aim is to improve market liquidity for ABCP by purchasing eligible sterling-denominated ABCP directly from issuers and secondary market investors (see last issue). However, despite the continued liquidity shortage in the European ABCP market, restrictive eligibility criteria are likely to mean take-up of the facility is low, limiting its impact on the UK economy and the European ABCP market.

The amount of SCPF funding for each programme will be limited based on the proportion of the programme's assets that "make a material contribution to economic activity in the UK" - a criterion that Moody's expects will be interpreted broadly. However, other criteria are significantly more restrictive.

They include limits on the term and type of assets in a programme, since the facility is intended to provide support to short-term assets, such as trade receivables, equipment leases and short-term consumer credit (such as loans and credit cards). A programme will be ineligible if the weighted-average life of its assets exceeds nine months or if any asset has a maturity of over 18 months. Any term ABS bonds, emerging market transactions or synthetic assets that a programme holds may also render it ineligible.

Many European multi-seller and hybrid ABCP programmes contain a mix of short- and longer-term assets (such as mortgages, auto loans/leases and some equipment leases), while around half hold rated term ABS and emerging market transactions. The discretionary nature of some of the SCPF eligibility criteria means that precise figures are unavailable, but Moody's believes that a significant number of European conduits will not qualify for SCPF funding.

ABS

California future flow programme prepped

The structure, timing and application details of California's proposed Proposition 1A securitisation programme are currently being determined.

On 28 July 2009 Governor Arnold Schwarzenegger signed the 2009-2010 California State Budget, pursuant to which cities, counties and special districts (local governments) will be required to lend property tax revenues to the State of California, with the promise of repayment in three years. As part of the budget package, local governments have the opportunity to receive the monies being borrowed by the State upfront through a securitisation financing offered by California Communities, a joint powers authority sponsored by the League of California Cities and California State Association of Counties.

Under the proposal, California Communities will issue bonds backed by the future payments by the State and remit the proceeds of the bonds to the local governments that opt to participate in the securitisation programme. The State will then repay the bondholders in order to pay off the outstanding bonds, including interest costs.

ABS

'Cash for clunkers' impact on auto ABS examined

Recent analysis of the US Car Allowance Rebate System (CARS) scheme suggests that auto ABS issuance could increase by approximately US$8bn to US$11bn, according to securitisation analysts at Wells Fargo. Based on recent deal sizes, this would translate into an additional 10 deals.

CARS is a US$1bn government programme - popularly referred to as the 'cash for clunkers' scheme - to help consumers buy or lease new vehicles when they trade in a less fuel-efficient one. The motivation for the programme is to boost auto sales, stimulate the economy and add fuel-efficient vehicles to those already on the road.

The increased turnover of new vehicles could provide a short-run boost to voluntary prepayment rates on auto ABS deals, which have slowed, the analysts note. However, one element of the programme could constrain the subprime auto ABS market in the short term. A key provision of the programme is that the trade-in vehicles be scrapped.

Trade-ins must be taken off the road and destroyed rather than being turned over to the used car market. A reduced supply of used cars could thus pose an additional hurdle to the subprime auto ABS market.

The programme is believed to have received around 184,000 dealer applications for funds worth about US$775m through to early August, with the original funding appropriated for the programme expected to run out shortly.

US auto sales in July rose to 11.2 million units on an annualised basis from 9.7 million units in June. Wells Fargo Securities estimates that CARS is responsible for about two-thirds of the increase. An increase in the scale of the programme will likely keep demand elevated in August as well.

Congress has passed legislation to extend the original CARS programme by injecting an additional US$2bn that would be transferred from another economic stimulus programme.

CDO

CRE CDO losses continue apace

Realised losses continue to rise for US CRE CDOs as delinquencies declined to 7.6% from 8.2% in June, according to the latest CREL CDO Delinquency Index (CREL DI) results from Fitch. On average, 2.7% of the CDO par balance has been lost to date due to distressed asset sales and discounted payoffs. Had the loans - which were resolved at a loss over the past three months (1.5%) - remained in the transactions, the index would have exceeded 9% this month.

Fitch senior director Karen Trebach says: "Though the number of distressed sales to third parties and discounted payoffs for troubled CDO assets is on the rise, many of these losses have been masked as managers often use the proceeds to purchase new assets at an even deeper discount, which builds par. Par building can preserve equity distributions as overcollateralisation tests are either cured or maintained."

Because preferred shares are not written down for CDOs, collateral losses are not always apparent to investors. Fitch determined that 21 of the 35 rated CREL CDOs had realised losses totalling over US$600m, or approximately 2.7% of the fully ramped CDO balances. Individual CDO loss rates range from 0.4% to as high as 20% for one CDO, which had a high percentage of losses attributed to subprime RMBS asset sales.

In the July reporting period, 12 troubled assets were disposed of through either third-party sales or discounted payoffs. The average recovery on these loans was approximately 46%, resulting in realised losses to five different CREL CDOs totalling US$95.3m.

Over the same one-month period, CDO managers reported approximately US$97m of par building from discounted asset purchases. Although the total dollar amount is similar to the total realised losses for the month, the par building has not necessarily occurred in the same CDOs as the realised losses. In addition, a couple of issuers purchased assets at par.

Currently, a total of 10 of the 35 Fitch-rated CREL CDOs are failing at least one OC test. At least seven additional CDOs are within 1.5% of breaching an OC test.

As assets continue to near maturity, the pace of impaired assets in individual CDOs is expected to increase, placing additional pressures on OC ratios. Failure of OC tests leads to the cut-off of interest payments to subordinate classes, including preferred shares, which are typically held by the CDO asset managers.

Faced with limited options, some managers are also managing OC ratios by extending and/or restructuring loans. In the July 2009 reporting period, asset managers reported 48 loan extensions (4.2% of loans), which is nearly double the prior month's total of 26.

These extensions are reducing the number of matured balloon loans. However, many of these extensions and modifications merely have the effect of postponing inevitable losses.

Fitch anticipates high default rates within CREL CDOs as these loans mature into the trough of the current commercial real estate cycle. As such, the agency is currently finalising review methodology and anticipates significant downgrades to all CREL CDOs that it rates in the coming months.

CDS

Dresdner succession event determined

ISDA's EMEA Determinations Committee has determined that a succession event has occurred with respect to Dresdner Bank, following a request submitted by JPMorgan. Commerzbank was determined to be the sole successor and the succession event was agreed to have occurred on 11 May 2009.

CDS

Q2 results ease Euro CDS liquidity stresses

CDS liquidity stresses for the European sector have eased in the past two weeks due to most European banks recently reporting a Q2 positive turnaround in overall profits, according to Fitch Solutions. As a result, the European financial sector CDS liquidity score is now rapidly converging towards the Americas region score, sharply reversing the previous divergence seen between the regions in the past three months (SCI passim). As of 10 August, Fitch's European financial CDS liquidity index closed at 10.52 versus 10.55 for the Americas.

Overall Macy's, TelMex and Harrah's Operating Company are the most liquid corporate names in the Americas, according to Fitch Solutions, while OAO Gazprom, Ineos Group Holdings and Codere Finance (Luxembourg) display the greatest liquidity in Europe.

CLOs

Overweight on AA/A CLOs recommended

Structured credit analysts at JPMorgan have upgraded to overweight on double-A and single-A CLOs. They cite as reasons the technical picture, as well as what appears to be an improving fundamental outlook (better-than-expected payrolls, unemployment and other economic figures). The analysts have moved their yield targets down from 15% area to the 10%-12% area for double-A tranches and from the 20% area to the 15% area for single-As.

"For CLOs, as with our broader securitised products view, we face the unavoidable (and increasingly uncomfortable) position of becoming even more bullish, despite spread tightening and as investors are forced to chase ever-fleeting yields," the analysts note. "Technical conditions remain supportive: CLOs still price below the underlying leveraged loan market and yield compression in CMBS, subprime and related markets bodes well for risk-taking, especially against the backdrop of negative net supply of many credit products. While at this point credit markets may generally offer more questionable value for the risk, given the exceptional spread tightening, CLOs remain in the pantheon of higher-yielding sectors and will benefit to the extent yields in CMBX, ABX (etc) compress."

Meanwhile, CLO pricing extended its tightening trend last week (to 14 August) , with triple-As 75bp tighter to 500bp, double-As up US$5 to US$65, single-As up US$10 to US$45, triple-Bs up US$10 to US$30, and double-Bs up US$10 to US$20 - even amidst heavy BWIC volumes. Longer term, the JPMorgan analysts believe triple-A CLO yields should narrow along with CMBS, credit card ABS and other spread products.

"We are targeting a triple-A CLO spread in the 300 basis points area, attainable over the next 3-6 months."

CLOs

Euro CLO triple-C exposure still rising

S&P's latest European CLO performance index report shows that three of its four CLO cohorts have continued an upward trend in the percentage of assets rated in the triple-C category, with only the 2004 cohort seeing a slight decrease. In addition, all cohorts have seen increases in the level of defaulted assets.

The index provides aggregate performance statistics across the European cashflow CLO transactions that S&P rates. It divides the CLOs' performance information into four cohorts issued in a specific vintage year, from 2004 through 2007.

As of June 2009, the assets held by European cashflow CLOs rated in the triple-C category, as a percentage of total collateral, were as follows:

• 2004 vintage CLOs: 9.97% of total assets (down from 10.08% in May 2009);
• 2005 vintage CLOs: 10.04% of total assets (up from 8.78% in May 2009);
• 2006 vintage CLOs: 8.94% of total assets (up from 7.98% in May 2009); and
• 2007 vintage CLOs: 8.79% of total assets (up from 8.19% in May 2009).

CLOs

Westchester CLO retranched

Preliminary triple-A ratings have been assigned to Blue Wing Asset Vehicle Series 2009-1's US$96.05m Class A1 and A2 notes by S&P. The transaction repackages Westchester CLO's US$570.5m Class A1-A floating-rate senior secured extendable notes due 2022.

Westchester CLO is a cashflow CLO backed by corporate loans and is managed by Highland Capital Management. It was issued in May 2007.

CLOs

Greek CLO rated

Details have emerged on Synergatis, a new €2.3bn Greek balance sheet CLO for Marfin Egnatia Bank. The deal is backed by loans to large businesses and SME loans, with industry concentrations in finance (20%), construction and real estate (14%).

BNP Paribas and Morgan Stanley are said to be involved with the deal. The senior of two tranches has been rated triple-A by Moody's and comes with a 2.25% fixed coupon.

CLOs

SME CLO tranches on review

Fitch has placed 262 tranches of European SME CLOs on rating watch negative (RWN) and affirmed 102 tranches. All tranches affirmed at single-B and above have stable outlooks.

The rating actions cover all 86 publicly-rated European SME CLOs and follow the release of Fitch's revised criteria for rating CLOs of granular pools of small corporate loans on 23 July 2009. The rating actions are based on the agency's initial analysis that considered the level of delinquencies and defaults, obligor and industry concentrations, and the level of credit protection currently offered by each rated note. Fitch plans to start resolving the RWNs immediately.

Ratings that have been placed on RWN can be classified into the following general categories: (a) transactions with low credit enhancement levels and that have suffered performance deterioration; (b) transactions that have performed well but do not have sufficient credit enhancement under the revised criteria; and (c) junior notes from older vintage transactions that have benefited from deleveraging but are exposed to obligor concentration risk.

In contrast, the ratings that have been affirmed fall into two general categories. The first category includes transactions that are recently rated and have thus incorporated much of the revised criteria assumptions. 10 out of 11 transactions rated in 2008 and so far in 2009 are affirmed.

The second category includes the more senior notes within a transaction that has been de-leveraged. These notes tend to have increased credit enhancement levels that are sufficient to cover increased obligor concentration and low or moderate levels of delinquencies.

Tranches that have not been affirmed or placed on RWN remain under analysis.

CMBS

B-note buybacks may benefit Euro CMBS

Buybacks of B-notes by borrowers, generally at a noticeable discount over face value, may prove beneficial to noteholders of European CMBS transactions if certain conditions are met within the purchase strategies, according to Fitch.

Over the last 18 months, Fitch says it has seen eight buyback proposals involving B-notes totalling €146m. The corresponding A-notes spread across three European CMBS transactions total approximately €1.05bn. In most instances Fitch found the buybacks to have a positive impact on the corresponding A-notes, as well as for the securitisation containing the senior debt.

"The buyback proposals are usually accompanied with a waiver of certain, if not all, rights previously granted to the B-note holder, some limited amortisation towards the senior debt and/or full diversion of interest otherwise due to the B-note lender towards unscheduled amortisation of the senior debt, with no leakage of income. Therefore, these restructurings can generally be seen as positive for CMBS noteholders," says Alessandro Pighi, associate director in Fitch's European structured finance team.

The agency believes the buyback process may become more popular over time, given the deteriorating market conditions within European commercial real estate and as servicers increase the range of workout strategies at their disposal.

CMBS

GGP creditors' plea denied

The US judge presiding over the GGP bankruptcy proceeding has denied motions to dismiss as bad faith filings the bankruptcy cases of 20 GGP property-level subsidiaries. In denying the motions, the court stated that the fundamental creditor protections negotiated in the special purpose entity (SPE) structures at the property level are in place and will remain in place during the pendency of the Chapter 11 cases.

As outlined in a client note from Cadwalader, Wickersham & Taft, those protections include adequate protection of the lenders' interest in their collateral and protection against the substantive consolidation of the project-level debtors with any other entities (SCI passim).

CMBS

US CMBS delinquency rates increase

Moody's latest CMBS Delinquency Tracker (DQT) has recorded the aggregate rate of delinquencies among US CMBS conduit and fusion loans at 3.02%, based on data through to the end of July. This represents a 35bp increase from the prior month's 2.67% rate.

Moody's continues to expect the aggregate rate to reach 5% to 6% by the end of the year. By comparison, the DQT was 0.48% a year ago and is now 280bp above the low of 0.22% measured in July 2007.

Once again, hotels saw the greatest month-to-month increase in delinquencies, with the rate rising 143bp during July to 4.69% from 3.26%. Moody's says the hotel sector is quickly gaining ground on multi-family, which is the worst performing sector so far during this downturn. Delinquencies for multi-family rose by 43bp during the month to 5%.

Of the five core property types tracked by Moody's, the office sector has so far been the best performer in terms of delinquencies during the current downturn. During July, the delinquency rate for offices increased by 20bp to end at 1.80%. Because this property type typically has longer leases, it may be several months before delinquencies in this sector see large increases, the agency says.

Industrial and retail loans both experienced a 28bp increase in delinquency in July. The retail delinquency rate now stands at 3.20%, a nearly four-fold increase since the end of last year. Delinquencies for loans backed by industrial properties now stand at 2.25%.

By US region, Moody's DQT shows the South as the worst performer, with delinquencies rising by 42bp during July to 4.32%. The Midwest region saw an increase of 17bp - the smallest for any region - but ended the month with a second-highest 4.12% delinquency rate.

Delinquencies in the West are in line with those of the nation as a whole, with an increase of 38bp lifting the rate to 3.09%. The East is the only region with delinquency rates below the 3.02% national average, with a rate of 1.74%. It had a minimal 17bp increase during the month.

During July, Nevada passed Michigan to become the state with the highest rate of delinquencies. Nevada now has a delinquency rate of 7.71%, up 78bp, while Michigan has a rate of 7.65%.

Distressed assets

Recovery ratings revisited

Fitch and S&P have moved to improve their approaches to recovery ratings (RRs) for structured finance transactions. The former has released an updated RR methodology, while the latter is requesting comments on its proposed stressed recovery ratings for all senior tranches of US prime, alt-A and subprime RMBS that it originally rated at triple-A but has downgraded to double-B plus or below.

Fitch says its structured finance RRs enhance transparency in the sector by providing investors and other market participants with an easy to understand indicator of its expected recovery on distressed or defaulted RMBS, CMBS, CDO and ABS securities. Initially launched as 'distressed recovery' ratings in April 2006, they have been re-launched as 'recovery ratings' as part of a ratings definition update by Fitch in February of this year. The agency now has in excess of 19,000 RRs, which operate on a RR1 (highest recovery) to RR6 (lowest recovery) scale and are a relative indicator of creditor recovery prospects on a given obligation within an issuers' capital structure in the event of a default.

Fitch group md and US MBS group head Huxley Somerville says: "Investors recognise that while a structured finance bond may have a higher degree of default risk due to collateral deterioration, ongoing principal and interest payments can be valuable, particularly for senior bonds."

He continues: "Fitch's recovery ratings are a vital enhancement to original ratings that have historically opined solely on the probability of first dollar loss, providing investors with the additional level of transparency they are seeking in quantifying and comparing those recoveries."

The significant stress within the structured finance market, most notably in the US RMBS sector, has resulted in Fitch downgrading a large number of senior and subordinate securities to triple-C and below, reflecting a high probability of default. However, despite the high likelihood of a dollar loss, ongoing principal and interest payments can result in a substantial recovery. RRs indicate the expected level of recovery on a bond by comparing the present value of Fitch's expected future cashflows from the bond to the bond's outstanding principal balance.

Fitch plans to publish group-specific RR criteria for ABS, CMBS, RMBS and structured credit in the coming weeks to ensure more granular recovery analysis for investors. In addition, the agency is currently looking into enhancing its web-based surveillance tools with respect to RRs to enable users to manipulate assumptions and run their own recovery analysis.

Meanwhile, S&P's proposed stressed recovery rating would represent its assessment of the total amount of principal likely to be recovered in the event of default under a single-A stress scenario. The proposed recovery rating would complement a security's current credit rating, indicating the agency's opinion of the projected principal recovery on a security if it defaults. This additional metric would be expressed as a percentage of the security's initial par amount.

S&P is seeking responses to the following questions:

• Should S&P use the single-A stress scenario for the stressed recovery rating or should it consider another scenario?
• Should S&P express stressed recovery ratings in terms other than percentages of securities' initial par amounts?
• Are the intervals S&P is proposing to use in the stressed recovery rating scale suitable?

The agency introduced corporate recovery ratings to the market in 2003 to discern differences among numerous and varied debt instruments. These ratings are its estimates of ultimate recovery of principal and pre-petition interest on specific issues in the event of a potential payment default.

Documentation

Thomson to have limited impact on IG CDOs

The restructuring credit event called on Thomson SA will have a minimal impact on the investment grade ratings of Fitch-rated synthetic CDOs, according to Fitch. The company is directly referenced in 77 Fitch-rated synthetic CDO transactions, or 167 tranches of debt, out of a total global universe of 277 corporate synthetic CDOs.

Potential losses resulting from this credit event are already reflected in the agency's investment grade CDO ratings. The majority of the exposed transactions are European CDOs, with 11 US CDOs, 13 Asian CDOs and 53 European.

Fitch comments that its recently completed sensitivity analysis shows that a total loss of any single widely-referenced corporate reference entity would not result in any losses to tranches rated above triple-C. However, tranches currently rated in the triple-B and double-B rating categories do face downgrade risk resulting from diminished credit enhancement from potential corporate losses.

Meanwhile, 261 tranches from 183 S&P-rated US synthetic CDOs have exposure to Thomson SA. The agency says it will continue to monitor the CDO transactions it rates and take rating actions, including credit watch placements, when appropriate.

Emerging Markets

REATs under pressure

Fitch notes that Taiwan's real estate asset trust (REAT) transactions are highly sensitive to net property income (NPI) and refinance rates, and that NPI may have a bigger impact on ratings as compared to refinance rates. As a result, the rising vacancy rates and decreasing average rental levels of Taipei's office leasing market since Q308 have brought downward pressure to the NPI of the collateral backing Taiwan's REAT transactions, which are mainly entrusted with office buildings located in Taipei.

The agency says it has observed downward pressure on the actual NPI of Taiwan's REAT transactions due to the deterioration of the global and Taiwanese economies. Some properties backing the REAT transactions are experiencing higher-than-expected vacancy rates and/or facing the pressure of offering rental discounts or longer rent-free periods when renewing existing leases or signing new leases.

Nonetheless, most transactions are still generating healthy net cashflows exceeding Fitch's stabilised assumptions. Should the cashflows generated by the underlying properties continue to deteriorate, negative rating actions may be warranted.

Investors

European credit investors polled

The majority of senior credit investors in Europe believe that the markets are past the worst of their disruption, according to a new report from Fitch. Fitch's Q209 survey of credit investors found that 72% believe this, compared to just 29% in Q109.

The report also found that 54% of respondents believe that banks have not been subjected to sufficient regulatory stress testing; however, the fear of a major bank collapse has fallen dramatically. 57% now score the chance of this happening as low, against 29% three months ago.

"European investors' estimates of the length of the recession have shortened considerably since the end of the first quarter, in particular for emerging Europe," says Trevor Pitman, regional credit officer at Fitch for EMEA and Asia Pacific.

Just 18% of respondents believe that the recession will last in excess of 24 months in emerging Europe, compared to 55% at the end of the first quarter. 65% believe that the recession's duration will be 12-24 months against 39% in Q1.

Views have similarly eased regarding the developed economies. For the US, a stable proportion quarter-on-quarter (44%-45%) believe the recession will last 12-24 months, but those believing it will last less than 12 months has jumped to 44% from 32%. There is a similar reduction in the percentage of investors believing it will be of more than 24 months' duration.

Pitman adds: "The availability of global liquidity remains the primary area of investor concern, although less convincingly so than in the previous quarter."

27% of respondents score the risk of liquidity shortages as being high, while 23% see the risk of housing market disruption as high. This compares to 40% and 29% respectively at end-Q109. Of the other risks Fitch asked investors about, over half regarded the risk of hedge fund collapse, geopolitical events, housing market disruption and global liquidity disruptions as having moderate probability.

The report - entitled 'European Senior Credit Investor Survey, June 2009' - featured 62 responses from 100 of the top investing institutions in Europe. The majority are traditional asset management companies investing in corporate debt. Structured and sovereign debt investors also responded.

The majority of respondents have over US$100bn of fixed income investments under management.

Overall, European investor sentiment is consistent with the sentiment of US investors expressed in Fitch's recent US investor survey (see SCI issue 147), which was conducted in conjunction with the Fixed Income Forum.

Ratings

Lloyds prepares RSL securitisation

Ratings have been assigned to Chepstow Blue - a securitisation of senior secured loans made to registered social landlords (RSL) in the UK. The portfolio is managed by Lloyds TSB.

The deal comprises three tranches: Class A1, sized at £2.4bn, has been rated triple-A by Fitch and S&P; Class A2, sized at US$600m, has also been awarded a triple-A rating by Fitch and S&P; the Class S notes, sized at £1.05bn, has not been rated. The ratings reflect the significant support by the UK government for RSLs and therefore the ratings are also credit-linked to the sovereign rating of the UK.

The loans in the portfolio are senior secured debt obligations of UK RSLs, which are housing associations registered with the government regulatory body, the Tenant Services Authority (TSA). RSLs must abide by TSA regulations and receive public support in the form of housing benefit and grants.

Lloyds TSB, as originator, will declare a trust over the portfolio of RSL loans for the benefit of the issuer. The issuer holds a 99% share of the trust and Lloyds TSB (the originator beneficiary) holds a 1% share. The net proceeds from the note issuance will be used to purchase interests in the trust for the issuer and originator beneficiary in accordance with their respective shares.

At closing date, the current portfolio size is approximately £3.7bn. A further £1.2bn may be drawn under the terms of the underlying RSL loans and a corresponding further £1.2bn of Class A2 notes may be issued.

Lloyds TSB acts as counterparty to the transaction in several forms, including swap counterparty, loan trustee, collateral administrator, account bank and servicer.

Ratings

A-REIT results impacted by declining asset values

Fitch believes that the Australian REIT (A-REIT) reporting season, which is just commencing, will see continued property capitalisation rate expansion and consequential price declines impacting profitability. In addition to declines in property values, the agency expects continued weakening carrying values of offshore asset management businesses purchased in recent years by some market participants in more expansionary times. Current accounting standards, which require changes in asset values to flow through the profit & loss statement, are also anticipated to reflect negatively on A-REIT results.

Most A-REITs have re-valued a significant proportion of, if not all, properties within their portfolios, undertaken by either independent valuations or by directors' valuations and usually a combination of both. Those vehicles that have recently reported property valuation changes are seeing continued value declines for the half-year reporting period to June 2009 in the order of 10%-15% on a portfolio basis and could potentially be much higher on an individual basis, on top of previous value declines in the order of 10%. Property values generally peaked in the December 2007 reporting season and have been declining at a faster rate with each additional reporting season.

Falling property values have affected the credit metrics of many A-REITs, particularly gearing levels, leading to concerns around the ability of some trusts to meet covenant requirements. In order to protect their credit metrics, many of the larger A-REITs have over recent months raised additional equity capital to around A$15bn.

This has allowed some A-REITs to reduce overall debt levels and meet immediate debt maturities, thereby reducing liquidity risk and generally taking pressure off debt covenants. This is not the case for all A-REITs and these two risks continue to remain significant for many market participants, however.

David Carroll, director in Fitch's REIT team, says: "Fitch does not expect the current reporting season to see a bottoming of property values, given the continuing lack of liquidity in property financing markets that is affecting the ability of purchasers to fund transactions. Book values are still lagging behind reality due to a lack of transactional evidence, allowing A-REITs to smooth the downward trend of values."

He continues: "The agency expects a higher level of transaction volume as A-REITs continue to restructure their property holdings and to downsize balance sheets to protect their credit metrics and manage liquidity. This process will continue to affect values, as transactional evidence allows valuers to become more confident in assigning independent valuations. Fitch expects Australian property values to trough in H110 with a peak-to-trough value decline in the order of 30%."

Ratings

Uncertain direction for Turkish DPR ratings

Moody's has placed the ratings of certain Turkish diversified payment rights (DPR) transactions under review, direction uncertain. This rating action is prompted by two opposing rating drivers.

First, Moody's announced on 3 August that it has placed the global local currency (GLC) deposit ratings of certain Turkish banks on review for possible downgrade. This may negatively impact the rating of some DPR transactions as such ratings are typically capped and retain linkage to the GLC rating of the originating banks.

Second, Moody's has lowered its assessment of the risk that the Turkish government would divert the DPR payments away from the issuer. As a result of this positive reassessment, a Turkish DPR transaction, in the absence of any transaction specific concerns, can now achieve a rating equal to the GLC rating of the originator. As all the DPR notes are currently rated Baa2, which is lower than the GLC rating of some of the originating banks, this could positively impact some of the DPR ratings.

A DPR transaction is a securitisation of receivables arising from future money-order payment contracts and is therefore intrinsically linked to the originator's future ability to originate these contracts. As such, under Moody's approach to rating future flow transactions backed by DPRs, the GLC rating of the originator generally acts as a cap on the ratings assigned to the issued notes.

The direction of the rating review of the DPR notes is uncertain because, at the end of the review period, and in the absence of any transaction specific concerns, Moody's expects that the ratings of the DPR notes will be aligned to the GLC ratings of the respective originators.

Regulation

Good bank/bad bank to disrupt agency MBS sector?

There is speculation that the Obama administration's proposed good bank/bad bank programme (see SCI issue 148) will encompass the GSEs. MBS analysts at Barclays Capital suggest that the move is a good catalyst to position for a basis widener.

The plan - should it materialise - has several implications, the analysts note. First, any privatisation presumably refers to the guarantee business going forward, but agency MBS buyers are likely to be unhappy about the prospect of new agency MBS that is not backed by the US government.

"While we are not sure that the administration is thinking of a mortgage world without government backing, the mere possibility should make some MBS investors nervous," the analysts explain.

The second implication of the plan could be that if the GSEs are spun off, the portfolio will be wound down. Hence, the chances of the portfolio ever being used as a countercyclical force dwindle - another negative for the basis.

Finally, if the plan progresses quickly, it would increase the chances of the GSEs cleaning up the delinquency pipeline by buying out delinquent loans, which would then be put into a federally-backed entity. This again would be disruptive to the agency MBS market, according to BarCap. Taking all these factors into account, the analysts indicate that the stage seems set for a spread-widening episode.

Regulation

Regulator seeks more time for Lehman investigation

The UK's FSA has asked the Financial Ombudsman Service for more time to continue its work on the Lehman Brothers-backed structured products review that it commenced shortly after the bank collapsed in September 2008. Since the collapse, the regulator and the ombudsman have been looking at the potential detriment this has caused for investors in the UK structured products market.

The FSA's review of the marketing literature for Lehman-backed structured products is now complete and it is in the process of evaluating the findings. A further priority, which the regulator aims to conclude as quickly as possible, is to prepare for an assessment of the quality of advice for these products. Third, it is conducting an analysis of the wider market for structured products in the UK, which will feed into the overall review.

In the aftermath of Lehman's default, the Financial Ombudsman Service has received a number of complaints from investors and other parties involved in the sale of linked products. It has been investigating some cases, but the number of these is comparatively small in relation to the total numbers affected.

In the course of the regular liaison between the FSA and the ombudsman service, it was agreed that implementing the regulator's 'Wider Implications' process may have greater potential to remedy any consumer detriment, as well as potentially being able to deal with the concerns of more consumers than those who have referred cases to the ombudsman service.

Regulation

FASB considers fair value disclosure changes

FASB has made tentative decisions about how an entity should present financial instruments in basic financial statements. The Board decided that financial instruments whose fair value changes are recognised in net income should be separately presented on the balance sheet from those financial instruments whose fair value changes are recognised in other comprehensive income.

The board made the following additional decisions:

1. For financial instruments whose fair value changes are recognised in net income: entities would be required to present on the balance sheet the 'fair value amount'. Entities would not be prohibited from presenting on the balance sheet or disclosing in the notes the amortised cost amount and the fair value adjustment amount related to the instruments in addition to the fair value amount.

In addition, entities would be required to present the amortised cost amount for own debt on the balance sheet. Finally, entities would be required, at a minimum, to present separately on the income statement an aggregate amount for unrealised and realised gains or losses. Entities would not be prohibited from reporting interest accruals or credit losses as separate line items on the income statement.

2. For financial instruments whose fair value changes are recognised in other comprehensive income: entities would be required to present the cumulative credit losses as a separate line item on the face of the balance sheet for financial assets. The cumulative credit losses amount would be presented separately from the remainder of the fair value adjustment to reconcile the amortised cost amount to the fair value of the financial instrument.

Entities would also not be required to report foreign currency transaction gains or losses on a foreign currency-denominated financial instrument as a separate line item on the income statement. Those changes in fair value would be required to be reported in other comprehensive income with other changes in fair value when the financial instrument is reported in the fair value through other comprehensive income category.

Finally, entities would not be required to provide additional information on further disaggregation of changes in fair value beyond credit impairment, interest accruals and the remainder (other residual changes in fair value). For an entity's own debt for which the amortised cost option is elected, entities would be required to present separately on the income statement the interest accruals and any realised gains or losses.

Regulation

German bondholder law a 'missed opportunity'

A new German law has been passed giving bondholders more rights and flexibility to adjust the terms and conditions of their bonds. However, according to research conducted by Barclays Capital securitisation analysts, the rules offered to multi-tranched ABS transactions present a missed opportunity to provide clarity on future securitisations.

The law became effective on 5 August 2009 and applies to all new bonds issued henceforth governed by German law. Bondholders in existing transactions can decide by a 75% majority vote to have the new rules apply to their transaction as well. The law applies to structured finance bonds, but does not cover pfandbriefe and German government bonds.

The new law does not provide any specific rules for securitisations with multiple-bond tranches, according to the analysts. They point out that the treatment of each bond tranche in the same transaction as a separate bond does not help settle the possible conflicts between junior and senior tranches. It is likely that any changes to the terms and conditions in the securitisation deal will require a 75% majority resolution from each individual tranche.

However, Barclays agrees that the possibility of having one common representative per bond tranche is likely to simplify any potential modifications of T&Cs. Similarly, the appeal - which has a time limit of one month - provides more certainty to bondholders than under the old law, where no time limit was stated.

Regulation

FSA reviews mortgage regulation

The UK Financial Services Authority (FSA) is currently conducting a wide-ranging review of all aspects of its mortgage regulation and will be publishing proposals this autumn. The review will cover everything from securitisation to arrears and is based on establishing the problems in the mortgage market that have contributed to the current economic situation and fixing those problems. Through this report the Authority hopes to ensure that there is a sustainable market for the long term.

The FSA is expected to take a robust position with firms once it has evidence of wrong doing and also ensure that borrowers are treated fairly throughout the lifetime of their mortgage. With sale and rent back, and any new areas of scope, the FSA will bring its sanctions to bear against firms that break the rules, as well as tackling unauthorised business.

The FSA says it will respond in full to the Treasury Select Committee's report in due course.

RMBS

Servicing advance transactions on the rise

Servicing advance transactions, in which mortgage servicers securitise their rights to reimbursement for advances made to US RMBS trusts, are becoming a more common financing type within the RMBS sector, according to a new report from DBRS. The rating agency believes that their increased use partly reflects the financial strain advancing responsibilities are placing on servicers as a greater portion of residential mortgages have become delinquent. While servicers are obligated to advance missed payments to RMBS trusts monthly, full reimbursement of these advances may take months or - in some cases - years, depending on reimbursement method.

Advances arise because mortgage servicers are responsible for making certain payments to RMBS trusts when borrowers fail to make loan and other payments. Advance types include principal and interest (P&I), tax and insurance (T&I, also known as escrow advances) and corporate payments (which are costs associated with foreclosing on and liquidating mortgage collateral). The servicer remits P&I advances monthly to RMBS trustees and makes T&I and corporate payments as needed to secure and preserve the mortgage collateral.

RMBS transaction documents specify which collections (pool-wide or loan-specific) are used to reimburse servicers for each advance type. The obligation to reimburse servicers for advances from designated collections generally falls ahead of payments to RMBS security holders and other transaction participants.

This enables servicers to securitise their rights to advance reimbursements at high investment grade rating levels. High investment grade ratings can be achieved as long as certain conditions, legal and structural features and overcollateralisation levels are in place.

DBRS notes that although servicers are reimbursed for advances before RMBS security holders are paid, servicing advance transactions are not without risk. Important credit considerations include which collections are designated to pay servicing advance noteholders and whether they are subject to delays, reductions or interruptions.

Such risks can materialise from a servicer's financial condition and operational procedures, as well as from poor RMBS pool performance or nuances in the RMBS transactions that generate the advance receivables pledged to the servicing advance trust, explains the rating agency. Servicing advance transactions also contain liquidity exposure.

Liquidity risks are two-fold. First, reimbursements of servicing advances are non-interest bearing, while servicing advance securities do carry interest. Second, a timing mismatch exists between expected remittances to the servicing advance trustee and noteholder payment obligations.

Servicing advance notes are often issued under master trusts and enable issuance of additional series with equal payment priority. Typically, interest is due monthly and, absent an event of default, principal amortisation commences after a revolving period in which new receivables are added to the trust. Once amortisation begins, funds that would have been used to buy new receivables prior to amortisation are instead redirected to pay note principal.

Due to the revolving nature of the receivables, minimum overcollateralisation tests are established for each advance reimbursement type. This dampens the effect of dramatic shifts toward delayed recovery advances following note issuance.

Principal is due upon the stated final maturity, generally five to ten years after issuance, though some note maturities are even longer. The ultimate principal repayment feature is important, given the potential for cashflow interruptions due to servicer-related risks, and reduces the likelihood of liquidity events.

While notes often accelerate only upon consent of the majority (or other threshold) of holders or servicer bankruptcy, the trustee may also have the ability to liquidate the collateral to pay off the notes in full. The longer final maturity helps alleviate risks that the receivables' liquidation value plummets and/or recoveries are significantly delayed during a servicer event and allows for extra time to resolve a servicing transfer or insolvency event.

DBRS believes a servicing transfer on a small portion of the RMBS trusts is a surmountable risk to the servicing advance transaction if the servicer has ample other RMBS trusts from which to generate receivables in order to sufficiently overcollateralise the notes. This may arise if a nominal percentage of the servicer's deals contain performance triggers and the triggers are breached.

On the other hand, transfer of servicing rights to the bulk or all of the servicer's mortgages pledged to the servicing advance trust is a potentially severe situation. Under this scenario, the risk of lengthy cashflow interruption to the servicing advance transaction escalates.

RMBS

Loan modifications reported

The US Treasury and the FHFA have released their reports on the rate of loan modifications. FHFA reports that completed loan modifications totalled 10,400.

For an agency loan modification to be completed, the borrower must demonstrate the ability and willingness to pay for three months. FHFA does not report loan modifications started, so determining loan modification success via its report is not possible.

The top three reasons for delinquency are reported as: curtailment of income (accounting for 40% of delinquencies), excessive obligations (24%) and unemployment (18%).

RMBS

Results in for EBS buyback

EBS' tender offer for the Emerald Mortgages 4 Class A tranche has resulted in the repurchase of €78.1m of notes at a price of 80%. The original tender offer was for up to €100m of notes with a suggested price range of 77%-81%.

RMBS

Non-performing US prime mortgages jump

Between March and June this year non-performing dollar-value balances in prime US mortgages increased by 13.8% - the largest rise shown among the three RMBS categories of prime, subprime and Alt-A - according to a new report from S&P's market, credit & risk strategies (MCRS) group. Non-performing balances of Alt-A mortgages have risen by 3.2%, while subprime structures have surprisingly decreased by 4.2%.

"The mortgage bubble popped with the stresses first seen in the subprime loans, but these may be close to the end of being the main problem for banks. Instead, attention is now shifting to prime loans," the report explains. "The loans with the most suspect creditors in the subprime structures have by now defaulted, moving these RMBS structures past the peak for defaults."

According to MCRS, prime loans now have less than half the originally securitised loan balance outstanding and the lowest amount of nonperforming loans. However, prime securitised structures were not designed to expect the defaults currently being seen and which are expected to continue to rise.

RMBS

UK RMBS master trust ratings resilient

Moody's has concluded its sector review of UK RMBS master trusts and has taken no rating actions. There are currently 13 UK RMBS master trusts, which have issued a total of £345bn of notes between April 2000 and June 2009 and currently contain approximately £244bn of mortgage assets, representing around 20% of total UK mortgage debt.

In a new report Moody's compares the current asset quality and performance of each trust to that seen in the early 1990s recession and illustrates the level of losses that would be required to sustain a loss on the notes issued by each trust, as well as the rating stability of the notes issued by the trusts.

"If the number of repossessions is in line with that observed in the early 1990s and the loss severities remain at the levels seen so far this year, the result would be a weighted-average loss of 1.24% across the Master Trust sector," says Jonathan Livingstone, a Moody's avp/analyst and co-author of the report. "However, this varies significantly from 0.65% for the Gracechurch Master Trust containing mortgages originated by Barclays to 2.02% for the Granite Master Trust, which contains Northern Rock mortgages."

RMBS

BTL RMBS delinquencies stabilise

Delinquencies on UK buy-to-let (BTL) mortgages backing UK RMBS showed signs of stabilisation in Q209, according to a report from S&P, with early-stage delinquencies falling compared with the previous quarter. However, severe delinquencies continued to rise.

S&P reports that in Q209, average total delinquencies for UK prime BTL RMBS fell for the first time in two years, to 6.1% from 6.2% in Q109, while in UK non-conforming BTL RMBS they fell to 17.1% from 18.6% over the same period. Average 90+ day delinquencies increased to 2.9% from 2.5% for UK prime BTL transactions and to 9.5% from 8.7% for UK non-conforming BTL transactions over the quarter. The stock of repossession and receiver of rent cases in both UK prime and non-conforming BTL markets has also stabilised, with suggestions that lenders are appointing receivers of rent for longer periods.

Prepayment rates have declined significantly and S&P's UK prime BTL prepayment index is currently 4.5%, down from 15.1% in Q208, likely due to more constrained credit availability. Since the beginning of 2009, the agency lowered the ratings on tranches in four UK non-conforming BTL transactions.

UK house prices may be stabilising, with seasonally-adjusted month-on-month data recently beginning to show price increases. However, S&P estimates that the number of borrowers in negative equity would rise significantly even for comparatively small further falls in house prices.

RMBS

Australian RMBS impacted by Genworth downgrade

Fitch has made numerous downgrades within the Australian RMBS sector following its internal assessment on Genworth Financial Mortgage Insurance (Genworth Australia), which is maintained for the purposes of reviewing Australian RMBS ratings. The agency withdrew Genworth Australia's double-A minus insurer financial strength (IFS) rating on 20 November 2008 and no longer publicly provides ratings or analytical coverage of the company.

As a result, Fitch has downgraded 53 subordinated tranches of Australian RMBS to single-A plus from double-A minus and revised the outlook for four senior tranches of Australian RMBS to negative from stable. The outlook remains negative for all subordinated tranches.

At the same time, the agency has affirmed the long-term ratings of 118 tranches of Australian RMBS with stable outlooks, as well as affirmed the short-term ratings of four other such tranches.

Regulation

Replacing IAS 39

Phil Adams, securitisation strategist at RBS, finds that the new IASB and FASB proposals are likely to increase the volatility of banks' P&Ls in the near term

The IASB on 14 July published an exposure draft (ED) for a replacement of IAS 39. It is a bid to simplify the current fair value (FV) accounting rules but, contrary to early indications, it will not mean wholesale forbearance and a paradigm shift back in time to book value accounting.

The process for replacement of IAS 39 is going to be split into three stages: classification and measurement (current proposals), to be followed by impairment methodology (draft expected October 2009) and hedge accounting (draft expected December 2009). Any feedback and comments on the current proposals should be submitted to the IASB by 14 September 2009. The remaining two stages are expected to be finalised in 2010, with the new methodology to be compulsory from 1 January 2012.

The plan is for the current proposals to be finalised in time to be usable for 2009 year-end accounts on a voluntary basis.

Importantly, our strong understanding at this stage is that it will replace all prior iterations of financial instrument accounting, namely IAS 39 and modifications thereto, including last year's one-time moratorium allowing financial institutions to transfer asset from AFS and trading books to banking books. The proposals would allow banks to account for 'basic' loans with contractual cash flows on an amortised cost (AC) basis. Indeed, the basic loan features and the 'predictability of cash flows' appear to be the lynchpin for the ED.

It appears to us that the senior notes in securitisation transactions would be eligible for AC accounting under these proposals because the proposals allow for variations in the timing of the cash flows. However, mezzanine and junior tranches in securitisations would be deemed to violate the 'basic' loan features test because of their role in providing credit support to senior classes.

As a result, all subordinated tranches of securitisations would need to be carried under FV accounting, with changes passing through the P&L. All securities held would have to be categorised individually as either AC or FV assets, which would supersede any previous classification as 'loans & receivables', 'held-to-maturity', 'available for sale' or 'held for trading'.

Another objective of this process is to reduce the differences between IFRS and US GAAP, to improve consistency of treatment of companies and aid international comparisons, so these proposals may be altered in light of US proposals. The FASB announced an initial summary of changes that it is proposing, which would move many assets to fair value accounting with changes recognised either in net income or other comprehensive income. The FASB expects to publish an exposure draft in Q409 on its proposals, including changes to the impairment methodology, but it is possible that it will be published earlier.

The IASB proposals envisage two measurement categories: AC and FV. Assets or liabilities that have 'basic loan features' and are managed on a contractual yield basis would qualify for AC accounting and all other assets would have to be measured at FV.

Gains and losses on assets measured at fair value would under most circumstances have to be presented in the P&L. In contrast, gains or losses on assets held at amortised cost would be recognised in the P&L only on sale or amortisation of the asset. There would be no recognition of the market value of the asset through the equity account (revaluation reserves).

The term 'basic loan features' is defined as contractual terms that give rise to principal payments and interest on the principal outstanding. It allows for certain other features that are found in loans, such as interest rates that reset on a pre-specified basis or in response to changes in credit quality of the borrower.

Interest rates may be fixed rate, floating rate or a combination of the two resulting in rates with caps, floors or collars. Prepayment penalties would be allowed, provided "the compensation substantially reflects the change in creditor's economic position".

A security that has become impaired and bought at a discount reflecting expected credit losses would not qualify for amortised cost accounting because the return on such an asset will be highly dependent on the recovery rate, rather than simply an interest rate. However, if the discount was due to an increase in prevailing market interest rates or a result of extension of the expected maturity date and not credit losses, we believe the security should still qualify.

Subordinate tranches in securitisations would not qualify because they provide credit protection to the senior notes, which is not a 'basic loan feature', could amplify the variability of cash flows and the security would therefore have to be accounted for at fair value. Senior tranches would qualify and this would not depend on achieving any specified minimum rating.

Outside of securitisations, many debt instruments are subordinated by virtue of the ranking of creditors. The proposals suggest that any security ranking equal to or above general creditors would qualify for amortised cost, but any securities ranking below general creditors would have to be held at fair value.

The second component of the qualification tests for amortised cost treatment is that the assets are managed on a contractual yield basis; i.e. are held in order to receive the net interest margin between the return on the asset and the entity's funding cost. The test refers to the business model rather than management intentions, which can change over time and vary between individual assets.

However, the proposals do therefore allow assets to be sold prior to maturity, provided this reflects management of the cash flows rather than realising changes in fair value, and removes the tainting provision currently in place for held-to-maturity assets. The held-to-maturity category would be abolished under the current proposals.

An asset that qualifies for amortised cost accounting would be allowed to be held under the fair value option, if this would reduce (or eliminate) an accounting mismatch - such as where there is a natural hedge with another fair value asset. The company would have to make a one-off decision for each asset at purchase or the introduction of the proposed changes and no subsequent reclassifications would be allowed.

Under the current proposals, all equity investments would have to be measured at fair value on the basis that there are no contractual cash flows and in almost all cases any changes in fair value would be reported in the P&L. The changes would remove the exemption under IAS 39 for assets that "do not have a quoted price in an actively traded market and whose value cannot be reliably measured".

What's the difference from old IAS 39?
Trading book: mark-to-market moves captured by corresponding gain/loss in the P&L. The equivalent movement also therefore is directly captured in core capital via the impact to retained earnings.

Available for sale (AFS): mark-to-market moves captured by corresponding gain/loss in the revaluation reserve in equity. This equivalent movement does not impact core capital as the revaluation reserve is deducted from regulatory calculations for T1/core capital. The new rules will not impact regulatory capital accounting treatment whereby equity instruments losses impact T1 but gains impact UT2.

Held to maturity (HTM): held at book value but may not be actively traded and must be held to final maturity. Gain/loss only recorded via P&L if the asset is sold. Direct hit thus to core T1. Some impairments (OTTI - other than temporary impairments) may be recorded via P&L on HTM securities if book value can be demonstrated to be permanently weakened. This is very unlikely to be the mark to-market price.

Loans & receivables (L&R): aka banking book, aka loan book: held at book value. Securities sitting on the loan book are treated as loans in that there is a high degree of discretion for the bank's management/auditors to ascertain how much or if a (loan loss) provision should be recorded against the asset. Any impact is taken through the P&L as a loan loss provision.

In H2 last year, IASB allowed banks a one-time transfer of assets from trading, AFS or HTM books to their L&R books in order for them to curtail further negative mark-to-market moves. Most banks undertook this in varying size.

The transfer though had to go across at the then mark-to-market price or price at which they were being carried, not at par. Many of these assets were also being treated as Level 3-style assets, so had questionable FV accounting marks on transfer to the L&R book.

Impact
Anything at all presently on the trading book will continue to have to be treated with current mark-to-market, FV accounting practices - so no change there. But it looks like IAS will have effectively done away with the difference between all the different 'books' above.

Being too simplistic (but to make a point), a bank will hold an asset and it will have to be held at FV or AC depending on what the asset is and where it is held on the bank's balance sheet (i.e. if the asset meets the criteria to be held at AC it can be held at AC; if not it will be held at FV either through P&L or OCI if it is a strategic equity investment). It means, for example, that trading restrictions in HTM portfolios disappear.

For securitisations:
For securitisations, the proposals seem to represent an attempt to protect investor balance sheets against a large part of any liquidity-driven mark-to-market volatility by allowing the senior tranches to be held at AC, while ensuring that any changes in value of the junior tranches (which are more credit-driven) are included in the P&L. Overall the senior tranches account for the majority of the value of the issued securities, so the new regulations would still provide considerable protection compared to full mark-to-market treatment.

There may be an increased incentive to sell junior notes from securitisations - full mark-to-market volatility would have to be reflected in the P&L and balance sheet. The impact on individual institutions would therefore depend on the split between senior and subordinated assets held in L&R, although it is worth remembering that the new rules would not be compulsory for 2.5 years.

It is, however, not fully clear how these proposals will work in practice until any changes to the regime for recognising impairments have been published.

For banks at large:
Our belief is that the bulk of assets which were transferred to L&R were whole tranched assets or tranches/vertical slices thereof. There were some 'vanilla' assets/tradable loans/bank hybrids, doubtless or other non-tranched securities but we'd suggest this was a lower figure.

All these assets will have to be treated under the new rule. This would mean only the most senior note in any whole structure or vertical slice would qualify for AC; all other tranches would have to be transferred at FV.

Bank hybrids, so long as there is no equity-linked embedded call/put/collar/cap, will be able to be carried at AC. This means convertibles will not qualify, but one would not expect this to translate to hybrids with a stock settlement feature. This treatment obviously does not qualify for hybrids on the trading book.

Equity investments which are not held for active trading, i.e. strategic investments, have typically been held as AFS equity investments. Now they may be allowed to be accounted for as effectively old-style AFS, i.e. no FV gains through P&L, no impairments through P&L, no dividend income through P&L, but all movement registered through non-core capital on the balance sheet, even if the equity position is sold.

For Treasury portfolios, IASB admitted more guidance is needed on how to treat the middle ground of assets that are held on a contractual yield basis but which in all honestly may be sold - for example a liquidity portfolio. In the interim, though, it appears that these will be allowed to be accounted at AC.

Capital treatment
These accounting changes will make no material difference to capital treatment under Bas1e 1 or 2. The expected rating downgrades will continue to come and banks will continue to have to engage in capital arbitrage trades or sell in order to reduce the charge.

The fact that, for some, fungibility of assets across the balance sheet looks to have been made easier may actually smooth the mark-to-market hits, which would otherwise have to be taken on the one-time unwind of positions. That said, taking the hits earlier is rarely a good thing.

FASB proposals
The FASB has announced a summary of its own initial proposals, which suggest that many more assets will need to be recognised at fair value on the balance sheet. Its exposure draft is due to be released in Q4, but will include proposals on changes to the recognition of impairments (around the same time as the IASB and we expect there to be much co-operation).

Changes in fair value would be recognised in net income for trading assets or in other comprehensive income for non-trading assets. Similarly to the IASB, classification of financial assets would be set at initial determination and no reclassification would be allowed.

Credit impairments, realised gains or losses, interest and dividends would be recognised in net income, as would derivatives, equities and hybrid instruments that contain embedded derivatives requiring bifurcation under FAS 133.

Conclusion
All these proposals are subject to revision as a result of feedback and further discussions, but the changes look likely to result in a near-term increase in the volatility of banks' P&Ls, perhaps contrary to what was intended. The move last year was designed to create a blanket of forbearance and it worked, particularly for FY08 and Q109 data. A rapid unwind of that, in these markets, will not do anything to improve liquidity and pricing, as sellers - most particularly in the most junior notes of structured finance and structured credit - may be inclined to rush for the exit against the backdrop of ever-worsening ratings migration.

It must be remembered that this is just an exposure draft, a request for comment. There is a strong school of thought that many of our continental European brothers, which have perhaps not taken the most aggressive mark-to-market hits on many portfolios, may find this to be an extremely painful one-time adjustment process and that, just perhaps, the corridors of power in Paris and Berlin will be fizzing their most charming lobbyists 'super-schnell' towards the IASB offices.

© 2009 The Royal Bank of Scotland. All rights reserved. This Research Note was first published by RBS on 23 July 2009.

Trading

Trading ideas: anti-conspiracy theory

Tim Backshall, chief strategist at Credit Derivatives Research, looks at a pairs trade on The Goldman Sachs Group versus USA

Goldman Sachs has been at the top of the hit-list for conspiracy theorists for a while now and, given the recent collapse in risk premia on its credit assets, we suggest irrational exuberance peaked in this highly levered systemic risk name. Recent weeks have seen an aberrant rise in derisking and spread underperformance in GS risk and, while its relatively low spread level may be appealing, we prefer to play it against the cost of USA protection to bet against the GS halo. We look for weakness in financials to be realised in GS rather than further systemic risk transfer to the USA.

Financial risk has fallen dramatically relative to sovereign risk. The relative shifts in CDR's Counterparty Risk Index and Government Risk Index show financials appear to have overshot and DTCC data from the week before last shows capitulation in financials from the March lows (although Exhibit 3 indicates an unusual shift to derisking in GS versus all other major financials).

GS balance sheet transparency remains minimal at best, with Exhibit 2 showing asset valuations remaining suspiciously stable through this period (despite some growing losses hidden in the bank's recent 10Q from Level 3 derivatives exposure). VaR remains extremely high (but with special dispensation) and swap exposure huge relative to peers.

The low level of risk premia priced into GS spreads is clearly a reflection of its 'too big to fail' status, but a look at the CDS curve shows five-year to be nudging up (perhaps a reflection of terming out TLGP and government sponsorship). GS' status as a bank holding company is laughable with deposits minimal (and hence its ability to earn its way out via lending). But this is not a bet on GS default, more that GS will be more reflective of systemic risk than USA protection if/when the next leg of stress hits the market.

Potential catalysts for GS underperformance, after the recent hope-driven rally, include FASB toughening its stance on mark to market (finally), end to Flash/HFT trading advantages, gap risk in credit and equity market hedges, and the conspiracy theories themselves - meaning that GS 'is' the systemic risk hedge. Fears of a USA protection gap up, as a systemic risk hedge, are reduced as we see catastrophe hedges appear more based in out-of-the-money VIX/SPY options and super-seniors recently. USA protection is also received in euros, so if we see further recovery on the back of a weaker dollar, there will be some cushion to the differential.

GS is a highly levered trading vehicle, not a deposit-backed bank (otherwise we may have chosen JPMorgan as the systemic short). Now that it is de-TARPed, we suspect it will be hard to raise capital (if necessary) when the next wave of losses from CMBS/RMBS hits.

Our view is that the systemic dislocations post-Lehman are much less likely than a return to more normal risk relative value (albeit at higher spread levels). This is reflected in the left portion of Exhibit 1 and shows a 100bp-plus differential between GS and 5x USA protection (with potential for upward spikes on counterparty risk fears reappearing).

Position
Buy US$10m notional The Goldman Sachs Group Inc 5 Year CDS at 135bp.

Sell US$50m (€35m) notional United States of America 5Y protection at 25bp.

For more information and regular updates on this trade idea go to: 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).