Contents

Secondary markets

Valuation question

Pricing still causing investor concern

Despite improving market conditions, structured credit investors continue to report serious valuation issues. Now, these problems appear to be prohibiting fundamental business opportunities.

As one European asset manager says: "It's all about knowing where things are and at the moment they're all over the place. You can get two valuations more than 15 points apart - you might expect that kind of pricing volatility for an equity piece, but not a triple-A."

Another London-based fund manager says: "If you receive a valuation almost 10 points below where similar bonds just traded, you have to wonder if the trader is marking his book there too. Equally, you have to try to explain to administrators and auditors that the market is higher, but the only real alternative is to sell all or part of the position to be able to show a transactional price."

The European asset manager adds: "We need to find someone capable of doing proper valuations - someone who sees bid lists, can take an informed view and say this good double-A is a better proxy to this weaker triple-A than a good triple-A that have both just traded, for example. Or they are able to differentiate between, say, a good triple-B - which might be worth 40 - and a poor one that's only worth five. In principle that should be the dealer's role, but the service and understanding you get from different banks now varies so much - some are good, but an awful lot aren't."

A New York-based hedge fund manager concurs: "Our problem has been that the traders we did the deal with and the structurers who structured it have all been fired. Who we're left with can't make unilateral or informed decisions and are hidebound by compliance, so valuations are stunningly low."

A European CLO manager adds that low valuations are not the only challenge. "We have tried to buy assets at the offer price quoted by dealers without success. Despite offering higher than the market price, we have been unable to buy; however, the quoted price has not changed because there has been no trade. Similarly, you can forget about selling at the quoted bid price," he says.

This, the CLO manager argues, is a direct result of the overreliance that CLOs have on market pricing - which is not up to the mark in this environment. "At the top end of the market, i.e. with good assets, pricing is based on very thin supply, so values are flying around all over the place. The top 30 or 40 names should now be in the 90s, but no-one wants to sell, so they're stuck at pre-rally prices."

At the bottom end, with triple-C and defaulted tranches, there has been almost no trading at all. Here, the CLO manager says: "Sometimes stuff is valued on a single quote or an implied price, or failing that the rating agency recovery rate. This means a lot of tranches are marked at 60 until there's a real trade price quoted, which accounts for a lot of volatility."

In any event, the European asset manager says: "We're not asking for any favours; we just want to be confident that a dealer has spent five minutes doing something properly. I really don't want to be in a position where I have to go down the lower quality third-party valuations route and I certainly don't want to be marking to model for triple-A paper. That's just ridiculous."

He continues: "There are good opportunities out there, but being sure you've got the right one and then being able to show that to investors is a problem. These valuation issues are preventing us from doing things - for example, you cannot launch a fund in this environment without spending an inordinate amount of time defining a subscription/redemption structure that doesn't penalise current or prospective investors."

MP

Operations

Motivation shift

Repo-driven CLO issuance drops as banks refocus priorities

The once-popular funding method whereby banks structured balance sheet CLOs and CDOs to repo with the European Central Bank (ECB) has seen a sharp drop in demand. Several-billion-euros worth of transactions were completed in 2008 (see SCI database), but lingering uncertainty over further changes to the central bank's eligibility criteria, a shift in the motivation for the creation of deals and a lack of suitable assets to securitise all appear to be behind the lack of such new issuance.

According to Thorsten Klotz, md at Moody's, banks have typically used the ECB repo facility for liquidity management. "When the ECB's collateral eligibility changes came into effect in March and the amount of required subordination on a deal changed from, say, 18% for a single-A tranche to 46% on a triple-A tranche, there was a significant drop in what could be raised through the trade," he says.

The Governing Council of the ECB ruled that, as of 1 March 2009, securitised issuance to be used as collateral for repo purposes must be rated triple-A (SCI passim). The previous minimum rating for repo-eligible ABS was single-A minus.

"Certain banks did a large number of ECB CLO trades, but the number of deals has slowed given that the amount of assets that can be financed through the programme have run out," Klotz adds. "In certain cases, banks have tried to assemble other pools to back a new CLO with varying different assets - leveraged loans, SME loans, project finance loans and in some cases even muni bonds. These pools are very complex and the ECB might be more reluctant to accept them."

Klotz is unsure how many ECB CLOs will be seen during the remainder of the year, but notes that such deals usually come to Moody's in the anticipation that they will be turned over quickly. "So, while there are relatively few deals around now, by September or October the situation could be different again," he says. "Also, it is difficult to anticipate what the ECB might do next: the changes to deal eligibility in January came rather as a surprise."

Recent ECB CLO activity has nonetheless come from Greek banks, with Piraeus Bank and Marfin Egnatia Bank both structuring SME CLOs of around €2bn last month, with the senior tranches expected to be ECB-eligible. However, the motivation of banks to bring deals has also shifted, with a focus now on regulatory capital trades rather than funding (SCI passim).

"This is why retranched CLOs are taking centre stage," says Klotz. "At the moment, there is a lot of talk about these sorts of deals, but it is unclear how many of the deals will actually go ahead. The summer holidays may explain the lack of activity."

A European-based lawyer comments that some clients have approached him with retranched CLOs that they hope will be accepted by the ECB as collateral. "ECB funding is not necessarily driving the retranching of CLOs and CDOs, but some clients have approached us to work on deals that would be done in the hope that the senior portion would be accepted through the repo facility," he says. "In other cases, they are hopeful that the higher-rated portion would be bought by a real-money investor."

Meanwhile, the debate surrounding government support packages and their effect on the reopening of the primary structured finance market continues. In a recent report from Barclays Capital, securitisation analysts discuss how long European support packages will remain in place - and what the impact on European ABS will be once the support programmes conclude.

"The government-sponsored rescue programmes must all come to an end at some point, as European governments will not want to support their banks indefinitely," the analysts say. "If all form of support terminated simultaneously, regardless of circumstances, the result could indeed be renewed turmoil in the banking system and the fear of large ABS fire-sales from banks could yet become reality."

However, they add: "Precisely because of the consequences such an approach would entail, we consider it highly unlikely. Instead, central banks and governments are far more likely to take a gradual approach to unwinding their support. The ECB may tighten its eligibility criteria for ABS further in the coming months, but only by tightening up the existing requirements in small steps."

AC

Documentation

Solution needed for CDS triggering complexity

TriOptima's portfolio compression cycle following the restructuring event under the ISDA small bang protocol for Thomson CDS has been described as a remarkable achievement, but not the ultimate solution to the complexity of triggering credit derivative contracts. The trade volume compression run, announced last week, targeted outstanding Thomson single name corporate CDS. With 28 dealers participating, some 6850 trades with a notional volume of US$16bn were eliminated on a net basis.

"The reduction of outstanding single name CDS volume by 28% (DTCC volumes only) and of the number of outstanding trades by 34% (to about 13,000 trades in the DTCC Trade Information Warehouse) is a remarkable achievement," says Tim Brunne, senior credit strategist at UniCredit. "In our view, it was clear that the compression cycle could not be the ultimate solution to the complexity of triggering, which large institutions are faced with. To what extent the compression run was able to achieve such a goal is difficult to asses, as clearly none of the portfolios of the many different CDS counterparties is public."

According to Ulf Andersson, global business manager for triReduce: "There were a significant number of European iTraxx index contracts affected by Thomson's restructuring, which resulted in increased operational risk due to the volume of new single name contracts created. We worked in close consultation with the industry to ensure the maximum reduction in both ticket count and gross notional in advance of the auction settlement process to reduce this risk."

In anticipation of the Thomson restructuring credit event, TriOptima had completed a portfolio compression cycle on 14 August in European index tranches including the Thomson name, eliminating 2515 tranche trades with a notional value of US$113bn. "Eliminating tranche trades prior to the auction settlement also achieves significant risk reduction," adds Henrik Nilson, head of business development at TriOptima. "The industry is pursuing all opportunities to ensure the smooth operation of the new settlement process."

However, Brunne says: "The remaining gross CDS volume for Thomson single name CDS (according to the DTCC) of about €28bn in comparison to the remaining corresponding net notional of €1.5bn shows that the portfolio compression attempt has not fundamentally changed the situation. Still most (major) counterparties should have Thomson CDS portfolios with gross CDS volumes by far exceeding their respective (theoretical) net risk exposure due to hedging. But exactly such a situation creates the triggering headache."

On 12 August ISDA's EMEA Credit Derivatives Determinations Committee ruled that the decision of Paris-based electronics company Thomson to defer payments on privately placed debt constitutes a restructuring credit event (see last issue). This decision does not automatically trigger the credit event settlement of CDS referencing Thomson, as triggering the settlement is optional.

"Being at the discretion of CDS buyers and sellers whether to trigger some individual CDS trade or not, counterparties are now faced with considerable operational challenges," explains Brunne. "The principle difference between the restructuring credit event and other types of such CDS events is the asymmetry of the CDS recovery, depending on whether the seller or the buyer of protection triggered the settlement of the respective CDS contract."

According to the ISDA small bang protocol, the significant outstanding volume of iTraxx CDS that referenced Thomson had to be split into two separate contracts - a new version iTraxx CDS not referencing Thomson and a single name CDS on Thomson. Primarily single name CDS are subject to optional triggering.

The split was implemented during the two weeks before 21 August, subsequent to ISDA's credit event decision. It led to a significant increase in single name CDS gross volumes from €26.5bn to €39.5bn, reported by the DTCC. Also, the number of trades increased fourfold from 4,932 to about 19,966.

"At the same time, the net notional volume - which represents the maximum value of outstanding CDS - remained essentially constant," concludes Brunne."This fact indicates that there was substantial netting between index and single name CDS in the CDS portfolios of many counterparties."

AC

Investors

European primary issuance rumours intensify

Rumours about the imminent launch of a new publicly-distributed European ABS or RMBS are mounting, but few investors appear to have been presented with concrete marketing material.  Potential issuers are said to be either testing market appetite, or marketing the deals to very select accounts.

One such rumour circulating is that Barclays Capital is preparing a UK RMBS that incorporates a UK government guarantee and that VW is readying a new auto ABS. "I've heard that BarCap has sounded out one or two people as to their appetite for a new deal, but when we spoke to our sales coverage there they knew nothing about it," says one UK-based investor. "The sounding out may have been very targeted to just a handful of clients, but we think that they are probably just gathering market information at this stage and nothing is actually imminent."

However, he suggests that a bank could move fairly quickly to launch a deal if it wanted to. "If anything, we think that the most likely candidate for a UK RMBS deal would be HBOS. I haven't heard anything directly, but the bank has definitely been touted as looking at a deal in the autumn," the investor adds.

Another UK-based investor's opinion is that BarCap does not have anything going on. "However, spreads are tighter, so issuers might be tempted and investors seem to be keen to add in more here," he says. "I reckon any new issue would still need a big discount to secondary spreads; hence, this could be the stumbling block. I think right now people are just flying kites across a range of issues." According to investors, spreads of around 170bp to 180bp for a new UK RMBS are being touted.

A mainland Europe-based ABS investor confirms that he has heard rumours about incoming new issues. "However, nobody has shown us documents or any other information that may help us evaluate any investment opportunity," he comments.

Meanwhile, the ability to execute market dislocation trades among senior European ABS bonds is diminishing by the day. According to new research from Deutsche Bank, as spreads grind ever tighter and paper in any discernable size becomes difficult to source, investors are faced with the prospect of either seeking cuspier (lower down the capital structure, longer maturity, off-the-run) assets or accepting lower returns.

"With the psychological barrier of 200bp for triple-A paper well and truly broken compared with just a few short weeks ago, a willingness to sacrifice returns now appears to have the upper hand," note securitisation analysts at Deutsche Bank. "Benchmark prime UK RMBS paper currently trades at 160bp-180bp, with further tightening and the continued scarcity of paper likely to be supportive of any re-opening of the primary market."

In the meantime, an alternative to cash securities may be on its way in the form of a new CDS index referencing prime RMBS. Dealers are once again believed to be discussing whether to launch the proposed Markit ERMBX index, which was first mooted in January 2008 (see SCI issue 72).

AC

Operations

TALF could be extended again

ABS analysts at Wells Fargo are not surprised by the Fed's decision to extend the TALF programme to 31 March 2010 for new issue ABS (see last issue) and suggest that it could be extended again, depending on developments in credit market conditions over the coming months.

"This was not a surprise, in our opinion, since the Fed supports 51% of the 2009 new issue ABS market," the ABS analysts note in a recently published report. "Our expectation is that it could be extended again, depending on developments in credit market conditions as we move into 2010."

The analysts expect the Fed to extend TALF based on the programme's success in reviving the ABS market for issuers in need of capital, as well as the amount of private demand for ABS that still appears to be subdued compared with pre-credit crisis levels.

Total TALF loans made by the Fed stand at about US$40.8bn against ABS collateral so far, accounting for 51% of the total amount of ABS issued since March. The amount of TALF lending has varied widely from month to month, depending on the amount of new issue volume and the ABS sectors represented, note the analysts.

"For example, subscription periods with more credit card issuance have tended to be funded with more TALF loans, while periods with more auto ABS have been funded with relatively fewer loans," they explain. "This seems to be related to the soft-bullet nature of credit cards, which allow for a closer maturity match between the loan and the collateral. As a result, approximately 65% of the credit card ABS issuance in 2009 has been funded by TALF. In addition, shorter average life auto ABS tends to be less well suited to the Fed's lending, given the cost of TALF loans at +100bp."

The distribution of TALF loans across ABS sectors supports this analysis as well. The analysts report that credit card ABS accounts for 48% of the TALF loans in 2009 through the August subscription period.

Auto ABS and student loans follow, with 28% and 15% shares respectively. Other sectors represent only small shares of the TALF programme, though the Fed's loans have been quite effective at bringing demand back to ABS and helping to bring down capital markets funding costs, the analysts conclude.

Meanwhile, US$2.3bn in legacy CMBS TALF loans were requested for the 20 August facility (although only US$2.15bn worth were settled), according to the New York Fed. This amount exceeds the US$669m in legacy CMBS TALF loans requested for the 16 July facility.

In the latest round, three legacy CMBS bonds were rejected. The Fed says those deals were rejected on the basis of either the explicit requirements of the terms and conditions or its own risk assessment.

AC

Secondary markets

Real money leads CLO bid

Based on public BWIC data, structured credit analysts at JPMorgan estimate that approximately US$6bn-US$7bn of cash CLO paper traded during the May-August period. The majority of demand was for US dollar-denominated triple-A and double-A tranches, but some paper also traded down the capital structure and in euros.

"In measuring buying activity for YTD 2009 period, we note the so-called 'real money' accounts (e.g. asset managers, insurance, pensions) emerged as the single-largest client type at 40.5%, leading banks at 38.6% and hedge funds at 20.9%," the analysts report. "This stands in contrast to our 2008 data set, which placed banks as the largest CLO buyer at 52% and real money far behind at 27.6%, and suggests the CLO investor base is broadening with the market recovery over the last few months."

While it appears that real money has eclipsed banks by only a small margin in 2009 so far, the data understates the extent to which banks have left the market, the JPM analysts note. Because banks were generally buying triple-As while real money was buying across the capital structure, the aggregate dollar volume for banks is inflated by the larger triple-A bond sizes bought by a few institutions.

"This trend makes sense; the rebuilding of bank capital, retreat to more bread-and-butter businesses and balance sheet uncertainty with respect to structured products ratings volatility has led to more opportunistic buying by fewer banking institutions. Finally, we note the proportion of 'fast money' or hedge funds has stayed relatively constant, at about a fifth of the market," the analysts explain.

Anecdotally, JPMorgan believes that funds raised so far this year for CLOs total around US$2bn-US$3bn, or roughly 10% of the broader increase in buying power allocated to sub-investment grade corporates. This figure does not include dry powder left over from 2008 fundraisings, which is understood to remain only partially invested.

CS

Alternative assets

Canadian DIP fund launched

Brookfield Asset Management has established a C$1bn fund with the backing of Export Development Canada (EDC) to provide debtor-in-possession (DIP) loans and other specialty finance solutions to Canadian companies undergoing a restructuring or reorganisation. Brookfield has committed to provide 10% of the fund's capital and will manage the fund, identifying and evaluating investment opportunities. EDC played a lead role in structuring the fund and is the largest investor, with an initial participation of C$450m that could grow to C$1bn.

"Brookfield's history of specialty bridge lending and expertise in corporate restructuring positions us well to provide tailored solutions to support companies through the restructuring process. We believe that providing financing for companies undertaking a restructuring will help viable enterprises emerge from the current recession in a strong competitive position," says Joe Freedman, the senior managing partner responsible for the fund at Brookfield.

DIP financing provides companies seeking protection from creditors with capital to continue to operate their business while they complete a plan of reorganisation. The fund will target mid-market and larger scale opportunities where at least C$20m of financing is required.

"This fund will help Canadian companies gain access to credit during restructuring, when it's most needed," comments Eric Siegel, president and ceo of EDC. "This new partnership with Brookfield enables us to further assist even more Canadian companies during the current downturn."

Fund investors also include CIBC and Sun Life Financial. "CIBC is pleased to be a part of this initiative, which will help support Canadian companies in these uncertain economic times," adds Laura Dottori-Attanasio, global head of corporate credit products at CIBC.

CDO

Swap counterparty replaced on two CDOs

Merrill Lynch Derivative Products (MLDP) has replaced AIG Financial Products as interest rate swap counterparty for two structured finance CDO transactions, Davis Square Funding II and South Coast Funding VII. According to Fitch, this is not expected to affect the current ratings; however, it could do so in the future.

The novation of the interest rate swap counterparty will not impair the ratings of the notes because MLDP's rating meets Fitch's current minimum counterparty rating threshold of A/F1. However, Fitch says this does not address whether the novation of the interest rate swap counterparty with respect to the transactions is permitted by the terms of their respective documents. Nor does it address whether the swap counterparty change is in the best interests of, or prejudicial to, some or all of the holders of each of the two CDOs.

Fitch therefore emphasises that while the criteria is satisfied today, it may not necessarily be satisfied in the future if the criteria change. Furthermore, the agency notes that the criteria referred to is currently under review.

CDPCs

CDPC eyes increased management fee caps

Channel Capital is set to amend its investment management agreement (IMA), operating guidelines and periodic agreed-upon-procedures (AUP) in order to increase its pre-suspension senior management fee caps. The CDPC is permitted to invest in a diversified portfolio of eligible corporate credits and sovereigns using bespoke tranched synthetics and single name CDS.

Moody's has confirmed that the proposal would not result at this time in the counterparty rating assigned to Channel or ratings of the notes issued by the CDPC being reduced or withdrawn solely as a result of the implementation of the amendments. The agency says its ratings analysis is indifferent to pre-suspension senior management fee caps, providing no such discretionary payment would cause a capital adequacy shortfall that would be inconsistent with the current ratings.

Channel will also perform a new capital shortfall test prior to making payment of a senior management fee to determine whether each fee payment would cause a capital adequacy shortfall and, if such a test fails, will not make such payment to the extent it can be voided, postponed or deferred by the manager (deferral being at the discretion of the manager in accordance with the terms of the IMA). Compliance with such tests is further monitored by the AUP provider.

As a result, Moody's believes that no such capital adequacy shortfall due to a senior management fee payment should occur. In turn, the agency does not believe the amendments would introduce sufficient additional risk so as to negatively affect Channel's ratings.

Clearing

CMA ceo appointed to CME management team

CME Group has appointed Laurent Paulhac, an executive with more than 17 years of derivatives industry experience, to its management team as md, OTC products & services. He will report to Rick Redding, md, products & services at the exchange.

Paulhac previously served as ceo of CMA, a provider of credit derivatives market data that was acquired by CME Group in 2008. He will continue leading the CMA organisation for a transition period until a new ceo is named.

In his new role, Paulhac will be responsible for leading the development, execution and management of CME Group's global OTC business strategy. He will be based in New York.

"CME ClearPort has grown into a US$220m business over the past seven years and we are committed to helping market participants around the world to mitigate their counterparty risk and access neutral valuations for OTC products across multiple asset classes," comments CME Group ceo Craig Donohue. "With more than 700 products currently available for clearing in energy, metals and agricultural commodities, average daily volumes of 500,000 contracts per day and more than 10,000 registered users globally, we look forward to developing CME ClearPort to serve credit, equities, foreign exchange and interest rate markets as well."

"Both buy-side and sell-side clients have indicated their need for open clearing alternatives in OTC derivatives markets, particularly in financial products," adds Redding. "Laurent's experience in credit and interest rate products will be a tremendous asset to CME Group as we broaden our OTC offerings and focus on delivering cleared-only solutions to our OTC clients around the world through CME ClearPort."

CLO Managers

MBIA Capital takes on another CDO

MBIA Capital Management intends to assume the collateral management duties for Acacia CDO 6. This comes after the recent announcement that MBIA Capital will also replace Vertical Capital as collateral manager for Vertical CRE CDO 2006-1 (see last issue).

Fitch views MBIA Capital's administrative and operational capabilities as sufficient relative to the transaction's outstanding ratings and the distressed nature of the underlying collateral.

Acacia CDO 6 is a diversified structured finance CDO originally managed by RWT Holdings, a subsidiary of Redwood Trust, and issued on 9 November 2004. On 8 June 2009 holders of a majority of the controlling class directed the acceleration of the maturity of the notes as a remedy to the event of default (EOD) that occurred on 14 May 2009, when the class A/B overcollateralisation (OC) ratio fell below 100%.

As a result of the note acceleration, all interest and principal proceeds remaining after the payment of fees and the interest rate swap payment are being used to pay down the notes, beginning with the senior-most notes outstanding, until paid in full. As a condition of the EOD, active trading for the CDO is prohibited and any firm assuming management duties is effectively taking on a passive, administrative role focused on reconciliation of asset and note payments with the Acacia CDO 6 trustee.

On 31 July 2009 Fitch was notified of a proposed change to the Acacia CDO 6 collateral management agreement in which the CDO asset management responsibilities for the transaction would be assumed by MBIA Capital from RWT. RWT was removed by the trustee, Wells Fargo, at the direction of a two-thirds majority of the controlling class of the Acacia CDO 6 noteholders on 21 July 2009.

Acacia 6 has a portfolio currently comprised of approximately 56.1% prime RMBS, 23.9% subprime RMBS, 11.6% CDO and 8.3% CMBS. The transaction had a limited reinvestment period that ended in November 2007 and the manager had the ability to sell credit risk and defaulted portfolio assets up until the EOD occurred this past May. As of the latest trustee report dated 6 August 2009, all interest coverage tests are passing; however, all OC tests are failing, with the class A/B OC ratio at 84.7% versus its threshold of 107.6%.

CLO Managers

CSO rating unaffected by collateral change

Ratings on Amura II - issuance made under Shakespeare Managed CSO Series 1, 2 and 3 - have not been affected as a result of the reinvestment in senior unsecured debt issued by Rabobank Nederland as new charged assets, according to Moody's. Banco Santander requested that the agency provide its opinion as to whether the ratings on the Moody's-rated notes would be downgraded or withdrawn as a result of the collateral change.

CLOs

Two Swiss asset managers merge

Alpstar Capital has replaced Mignon Genève as investment adviser to the Alpstar funds and investment vehicles, including Alpstar CLO 1 and 2. This follows the merger of Mignon Genève and Alpstar in July.

Mignon Genève - a Swiss-regulated asset management company established in 1996 - was previously advisor to private and institutional clients, including the Alpstar Management Companies, a group of companies specialising in hedge funds, funds of funds and CLOs.

CMBS

Asset manager adds CMBS/CRE specialists

CWCapital Asset Management (CWCAM) has made six appointmets aimed at strengthening its expertise in commercial real estate and CMBS.

Burr Ault, vp and senior asset manager at the firm, will be responsible for the management, stabilisation and disposition of retail properties. Most recently, he served as president of Ault Real Estate Group, specialising in REO workouts and real estate advisement for financial institutions, specifically designing and implementing stabilisation strategies for challenged commercial real estate assets.

Daniel Balkam, also a vp and senior asset manager, is a former executive with Bridger Commercial Funding, where he previously served as head of underwriting and closing of new CMBS loans for the eastern US. He joins CWCAM with over 20 years of experience in asset management, underwriting CMBS loans, workout and financing of commercial and multifamily real estate assets, and will strengthen the firm's expertise in the handling of FHA-financed assets.

Patrick Connell, vp and senior REO asset manager, will be responsible for the management and disposition of a portfolio of single-asset REO paper. Connell's experience includes designing leasing and asset repositioning and redevelopment strategies, as well as financial reporting for institutional and private equity clients. Most recently, he served as vp and regional asset manager for New Boston Fund, where he was responsible for value creation efforts over a portfolio of office, industrial, multifamily and condominium development projects from Florida to Pennsylvania.

David Smith, vp and senior asset manager, joins CWCAM with 20 years of experience in the hospitality industry and will focus on overseeing the operations, leasing and disposition of assets in a portfolio of CMBS loans, primarily hotels. Smith has experience in creating and executing strategic plans for special serviced assets and REO. Most recently, he served as vp of portfolio management for General Electric's Healthcare Financial Services.

Sam Stern, vp and senior asset manager, has over 30 years of experience in the commercial real estate industry, directing a full range of asset management services. Most recently, he served as principal of SBS Associates in New York.

Geoffrey Wood, vp and senior asset manager, has 25 years of experience in the commercial real estate industry, including lending, REO, investment sales, joint ventures and loan workouts. Wood joins CWCAM from Opus East, where he handled all construction financing, joint ventures and investment sales for the commercial real estate development firm.

In addition, CWCAM has expanded operations to Baltimore, Dallas and Boston, in order to broaden its reach in specific markets and depth of expertise in insurance, hospitality, multifamily and office property management and disposition.

CMBS

SBS bankruptcy impact monitored

S&P is monitoring the impact that Successor Borrower Services' (SBS) 29 July voluntary petition for relief under Chapter 11 of the US Bankruptcy Code may have on the US CMBS it rates. SBS is the sponsor of various successor borrowers created to complete certain defeasance transactions for loans in CMBS transactions. The successor borrowers are generally intended to be SPEs.

"It is our understanding after reviewing the petition that the bankruptcy filing is limited to SBS and that the individual successor borrowers are not included in the filing," says S&P.

The agency has identified 20 rated CMBS with a current total outstanding balance of US$176.8m for which SBS is the sponsor of the successor borrowers. Of these 20 transactions, only one has a total exposure to SBS that exceeds 2% of the respective trust amount. Because the bankruptcy filing contains only the names of the trusts and does not identify the defeased loans by either the loan or the property names, S&P's ratings of transactions with exposure to SBS may change as it receives additional information.

It remains uncertain what, if any, actions the respective master servicers may take as a result of the bankruptcy filing. Because the bankruptcy filing is limited to the principal/sponsor of the SPEs and does not include the individual SPEs, S&P believes it is unlikely that the defeased loans will be transferred to special servicing. However, any such actions will be dependent on the loan documents for the individual defeased loans, as well as the proceedings in the bankruptcy court.

Distressed assets

Distressed credit fund launched

Third Avenue Management has launched the Third Avenue Focused Credit Fund, which aims to capitalise on the firm's 23-year heritage of successful credit, distressed and value equity investing. The fund seeks long-term total return from capital appreciation and interest income by investing in the team's highest-conviction ideas across the credit spectrum, including high yield bonds, bank loans and distressed securities.

David Barse, ceo of Third Avenue Management, says: "The current market environment provides attractive opportunities for experienced credit pickers like Third Avenue Management to generate meaningful returns. Third Avenue Focused Credit Fund is a natural extension of our investment heritage and a complement to our existing product offerings."

Jeff Gary has been named portfolio manager for the new fund, while Thomas Lapointe will act as senior research analyst.

Gary will be responsible for portfolio construction and for identifying credit opportunities. He has more than 20 years of investment experience in high yield, bank loan and distressed investment strategies, including the last 12 years as a senior portfolio manager.

Prior to joining Third Avenue, Gary was at BlackRock Financial, which he joined in 2003 as the portfolio manager and head of the high yield and distressed investment team that managed approximately US$17bn in assets in various mutual funds and institutional accounts. Previously, he was a senior high yield and distressed portfolio manager at AIG/American General and Koch Industries.

Lapointe will focus on identifying and researching opportunities in high yield and bank loan investments. He has over 17 years of investment experience and was previously responsible for managing approximately US$6bn in high yield assets as co-head of high yield investments for Columbia Management. Earlier in his career, Lapointe was a convertible bond credit analyst at CIBC World Markets and a high yield analyst at AIG Global Investment Corp.

Gary and Lapointe will be supported by a dedicated credit team, comprised of investment professionals with an average of 13 years of experience in distressed and high yield credit investing, as well as in financial restructuring. They will also capitalise on the expertise of the additional 21 investment professionals on Third Avenue's broader investment team, many of whom have extensive credit experience.

Gary states: "Third Avenue's style emphasises credit selection, total return and a deep value approach. Our opportunistic mandate allows us to invest in a wide range of credit securities - including bank loans, high yield and convertible securities - that have the best risk-adjusted return potential, which distinguishes the fund from typical high yield funds. Very few funds have the flexibility and expertise necessary to capitalise on opportunities, including distressed investments, throughout many different periods of economic uncertainty and high levels of default."

The fund will offer two classes of shares: the Third Avenue Focused Credit Fund Investor Class and the Third Avenue Focused Credit Fund Institutional Class.

Distressed assets

Structured credit guarantee provided

BPCE, a bank formed through the merger of Banque Populaire and the Caisse d'Epargne groups and 72% shareholder in Natixis, is to guarantee against losses approximately €35bn of the bank's structured credit assets. According to a statement from Natixis, the effect of this guarantee is to cut risk-weighted assets by approximately €16bn, while leaving part of the portfolios' upside potential intact. It also allows the bank's staff to refocus on the implementation of a new strategic direction.

In conjunction with the guarantee, Natixis carried out a full audit of its structured credit portfolios with the help of external advisers, including Blackrock.

Investors

Fund hires four in credit research

BlueMountain Capital Management has expanded its fundamental credit research team with the hire of four seasoned credit research analysts - Agata Andrevski, Michael Kass, Omar Vaishnavi and Vincent Cooper. Led by the firm's head of research Scott Lessing, the team will utilise a disciplined approach to fundamental analysis to uncover relative value throughout the capital structure.

"BlueMountain aspires to build the leading, fundamentally-driven, cross-capital structure research team among credit-focused asset managers," says Lessing. "We relentlessly pursue distinctive insight through collaboration among analysts with deep expertise, who focus in specific industry sectors, particular research disciplines and geographies."

With these additions, the fundamental credit research team has now reached 17 members. The firm says it plans to continue expanding in both London and New York.

Of the new hires, Andrevski will lead European distressed research and joins BlueMountain after a period of leave from Camulos Capital, where she served as senior credit analyst, focused on European distressed, high yield and leveraged loans. Prior to joining Camulos, she was a credit analyst with Soros Fund Management.

Kass, who joins BlueMountain in New York from 3-Sigma Value Management, brings experience both in restructuring investing and advisory - skills which he honed during previous positions at Lehman Brothers, Miller Buckfire & Co and McKinsey & Co. Vaishnavi, a US distressed company specialist, joins the firm from SilverPoint Capital, where he focused primarily on healthcare after beginning his career with UBS.

Finally, Cooper - who rejoins BlueMountain out of London - will cover financials. Earlier in his career, he co-authored highly-regarded research reports on bank Tier 1 capital instruments while at Barclays Capital, where he was a sell-side analyst covering Southern-European banks and insurance companies.

Lessing adds: "We measure the performance and accuracy of every call the research team makes. Our high confidence calls have been accurate this year, by a ratio of nearly two to one. This is a testament to the talent and hard work of our team."

Operations

Non-primary dealers named as TALF agents

The Federal Reserve Bank of New York has named four non-primary dealer broker-dealers as agents for the Term Asset-Backed Securities Loan Facility (TALF) - CastleOak Securities, Loop Capital Markets, Wells Fargo Securities and The Williams Capital Group. These agents will represent borrowers in accessing the facility, serving the TALF programme in the same capacity as the existing primary dealers.

"Establishing a wider network of TALF agents as a distribution mechanism for TALF financing is an important step that should enable a broader range of investors to access the facility, leading to a further improvement in the securitisation market," comments New York Fed president William Dudley.

The appointment of these agents is also expected to enhance opportunities for non-primary dealers previously active in the primary distribution of ABS underwritings to participate in the issuance of TALF-eligible securities.

Regulation

AIFM directive impact assessment welcomed

AIMA has welcomed the impact assessment of the European Commission's draft directive on Alternative Investment Fund Managers commissioned by the UK's Financial Services Authority. The FSA has commissioned CRA International to undertake a cost/benefit analysis of the proposed directive. Some of the main themes of the brief include: impact on investment portfolios, impact on costs to firms and investors, impact on functioning of markets and the question of systemic risk, and the effect on small company financing and European competitiveness.

The Association is campaigning for the draft directive in its current form to be revised. Although the association welcomes the parts of the directive that relate to the G20 process, such as the reporting of systemically relevant data by managers to their national supervisors and the registration and authorisation of managers, AIMA has argued that there are other elements of the directive (such as the sections relating to leverage, depositaries and marketing) that have been poorly drafted and which will have unintended consequences.

AIMA has sought an impact assessment of the directive by the European Commission, suggesting that it could impose major costs on a large part of Europe's financial services industry, reduce Europe's competitiveness in financial services and as a destination for international investment, and impact Europe's citizens through its effect on pensions, savings, jobs and real estate.

Andrew Baker, AIMA ceo, says: "We're very glad that the FSA has commissioned this impact assessment for the UK and we hope that the European Commission will now follow suit at a pan-EU level. It would be extraordinary if there were no proper assessment at a European level of the impact of a directive that could have extremely wide-ranging consequences."

Structuring/Primary market

Law firm adds two in restructuring

Chadbourne & Parke has named Alper Deniz as a partner in its bankruptcy and financial restructuring practice in the London office. Deniz was previously a partner in the finance and restructuring group of Paul Hastings Janofsky & Walker (Europe) in London and, before that, he was an associate with Orrick, Herrington & Sutcliffe and Jones Day - both in London.

"Having Alper join us is strategically important for the bankruptcy and financial restructuring group in Chadbourne & Parke's London office as we help clients with cross-border issues in today's economy," comments Claude Serfilippi, managing partner of the firm's London office. "He will work closely with European restructuring head Adrian Harris and be part of our integrated global insolvency practice chaired by Howard Seife in New York."

Also joining the practice will be Nuala Casey, an associate who has been with Kirkland & Ellis International in London and, before that, Cadwalader Wickersham & Taft. She has worked on cross-border restructurings, advising both debtors and creditors, and on acquisitions, disposals and reorganisations of distressed businesses.

Chadbourne & Parke says its bankruptcy and financial restructuring group in the London office has been at the forefront of a range of issues relating to the collapse of Lehman Brothers, from advising fund clients on the recovery of assets under their prime brokerage and custody arrangements to the provisions of the forthcoming Scheme of Arrangement. The group also continues to be heavily involved in the restructuring of the Golden Key SIV-lite.

Technology

LBHI asset servicing mandate awarded

Citadel Solutions has been selected by Lehman Brothers Holdings International to provide administration services, including the creation of an asset servicing platform. Citadel Solutions will leverage its proprietary technology and team of experts to support LBHI in managing middle- and back-office processing for its derivative, corporate bank loan, commodity and principal investment portfolios.

The implementation of the Citadel Solutions platform is anticipated to begin in September 2009 and to be fully operational in 2010. In addition to providing ongoing services for Lehman's asset classes, the firm will supply technology and middle-office support during the wind-down of the Lehman estate over an anticipated three- to four-year period.

Technology

Vendors form valuation partnership

Pricing Partners and ActiveEon have formed a partnership that is aimed at improving the Price-it Excel derivative and structured product valuation solution. Under the initiative, ActiveEon's distributed computing technology will enable increased computing power and a reduction in the amount of time required for the valuation of complex products, the two firms say.

Eric Benhamou, ceo of Pricing Partners, comments: "Pricing Partners' valuation models are highly accurate; however, they can take time in calculation. This partnership with ActiveEon enables us now to provide our clients a solution that could reduce dramatically the computing time, and hence responds to a more obvious need in terms of computing power."

Denis Caromel, founder of ActiveEon, explains: "Partnering with Pricing Partners positions us in the financial grid computing field as a key grid computing actor with a robust, powerful and recognised solution. This fully integrated solution should be very valuable to Pricing Partners' existing and future clients for sizing the computing power effectively and rapidly."

Trading

French bank hires ABS trader

Colm Corcoran joined Société Générale in late July as an ABS trader in London. Corcoran most recently worked at HSH Nordbank, having previously spent five years trading ABS at Dresdner Kleinwort.

Two ABS traders left SG earlier this year: Alexander Lazanas - formerly head of ABS trading at SG, and Rajan Dosanjh - formerly vp of ABS trading at the bank, moved to Evolution Securities in April in order to launch Evolution's ABS trading desk.

Trading

European credit sales and trading head hired

Jefferies has hired Jon Pliner as an md and head of European credit sales and trading, based in London. Pliner will be responsible for managing the firm's European credit trading platform, which includes the sales and trading of investment grade and high yield bonds and loans. He will also work with Jefferies' credit trading business in the US to accelerate the development of its global credit trading activity.

Pliner previously worked at Merrill Lynch, where he spent 15 years within the credit trading group, including the positions of head of flow credit trading, and head of European emerging markets. He will report to Tim Cronin, Jefferies' global head of fixed income, and Robert Harteveldt, chairman of Jefferies' fixed income group.

Trading

Asia-Pacific trading and sales team expanded

Credit Suisse has expanded its Asia-Pacific fixed income franchise with several new credit trading and sales hires.

In sales, the bank has appointed Vishal Sodha as director and head of credit sales, non-Japan Asia. He will be based in Hong Kong and joins from Citigroup, where he worked for 11 years - most recently as director of fixed income investor sales in Hong Kong.

Theresa Wong will join as a director and head of fixed income sales, based in Hong Kong. Previously, she worked at UBS, where she was executive director of fixed income distribution.

Hong Nam Yeoh will join CS as a director to cover both financial institutions and corporates in Malaysia. He will be based in Singapore. Yeoh joins Credit Suisse from JPMorgan, where he was an executive director for derivatives sales in Malaysia.

Finally, Regina Tan will join as a director and generalist country salesperson for Singapore. She was most recently at UBS as an executive director, responsible for fixed income and credit sales and distribution. Prior to that, Tan was with JPMorgan.

In fixed income trading, Credit Suisse has hired Richard Cohen, who will join as a director and head of credit trading for Asia Pacific, based in Hong Kong. He joins from Morgan Stanley, where he worked for seven years and was mostly recently head of Asia and Japan credit and convertible trading. Cohen has more than 12 years of Asian credit experience, having worked in Hong Kong, Tokyo and Australia.

Trading

Bank adds in credit index trading

Mohit Gover has joined Bank of America-Merrill Lynch's credit index trading team as a director, reporting into Mayur Jewtha, as the bank beefs up its capabilities in this area. He was previously a member of the financials credit trading team at Deutsche Bank in London.

ECB pushes for CDS market improvements

The European Central Bank's Banking Supervision Committee (BSC) has issued a report on the CDS market, which discusses the role of credit derivatives in the current economic crisis. While emphasising the international nature of the market, the report focuses on the market at an EU level.

Assessing the risk factors involved, the report identifies four main features of the CDS market that should be improved upon, in the BSC's opinion. First, the Committee notes that the CDS market remains highly concentrated in the hands of a small group of dealers, with the top-ten counterparties of each surveyed large bank accounting for 62%-72% of exposures. In addition, the concentration of the CDS market is now higher than it was before the crisis, since some major players or counterparties that used to be sellers of protection have recently exited the market.

The BSC believes that this concentration has increased the liquidity risk in the event of another dealer failure. Market participants have also indicated concerns regarding the relative scarcity of protection sellers, the report notes.

Second, the BSC says that the interconnected nature of the CDS market through chains of OTC derivative contracts results in increased contagion risk. In practice, the Committee has found that the transfer of risk through CDS trades has proven to be limited, as the major players in the CDS market trade among themselves and increasingly guarantee risks for financial reference entities.

Another finding suggests that European banks are currently net sellers of CDS, although the net amount of protection sold is relatively small. This contrasts with the traditional net buyer position indicated by BIS data. The "risk circularity" within the CDS market may be a concern for financial stability, as banks may be replacing credit risk with counterparty risk, the report says.

Third, it is noted by the BSC that CDS are playing a broader role in the determination of prices, as they are widely used as price indicators for other markets, including loan, credit and equity markets. The report has found that a trading strategy commonly employed by banks and other market participants consists of selling a CDS on a reference entity and hedging the resulting credit exposure by shorting the stock. While linkages and circular feedback effects on the underlying reference entities cannot be ruled out, studies have not yet been undertaken to determine the strength or otherwise of those links.

Although the CDS market may be a useful source of price information in normal market conditions, its reliability for pricing purposes in times of distress has recently been questioned, according to the BSC. Given its properties as an OTC market, it is particularly difficult to conclusively assess liquidity in the various CDS market segments.

Finally, the report highlights the risk factors related to the significant widening observed in sovereign CDS spreads in mid-March 2009. Given that sovereign CDS spreads are also viewed as lower limits for the corporations of those countries, further research is warranted to assess the causes of these developments, the report adds. The BSC concludes that the impact that these exceptional CDS spreads could have on the credit ratings of sovereign governments in illiquid environments and the possibility of negative feedback loops warrant further research with regards to potential policy implications.

The report also provides an overview of a number of regulatory and market initiatives that are underway with a view to addressing these weaknesses, including details of the latest EU consultation for OTC derivatives and reviews of the various initiatives to establish CCPs for CDS.

Downgrade hits restructured monoline

Moody's has downgraded to Caa2 from Ba3 the insurance financial strength ratings of CIFG Guaranty, CIFG Europe and CIFG Assurance North America, and is to review those ratings for possible further downgrade. The rating action was prompted by significant deterioration in the monoline's remaining insured portfolio since January 2009, when CIFG initiated a broad restructuring (see SCI issue 121).

In its second quarter regulatory financial statements, CIFG Assurance reported a large statutory deficit, driven by significant deterioration in its insured portfolio, particularly the RMBS and CDO sectors. Moody's loss expectation for CIFG's portfolio has similarly increased since the January restructuring, noting that RMBS and CDOs account for over 70% of the monoline's portfolio and therefore adverse performance trends in these segments have a significant impact on its capital adequacy position.

The agency also notes that the company has meaningful single risk concentrations in the pooled corporate and international infrastructure segments such that meaningful deterioration in a few large credits could affect portfolio loss estimates substantially. Moody's believes that losses for CIFG's insured portfolio will exceed the monoline's claims paying resources.

CIFG's capital position is now below the minimum statutory capital required under New York law, which also heightens the risk of regulatory intervention. With the heightened likelihood of ultimate policyholder claims exceeding CIFG's resources, Moody's believes there will be increased pressure on the insurer's counterparties to commute outstanding exposures on terms that could imply a distressed exchange.

During the review, Moody's will refine its assessment of CIFG's insured exposures, with particular emphasis on future performance of the monoline's mortgage-related and pooled corporate exposures relative to expectations and the resulting capital adequacy levels. The agency will also monitor other developments at the monoline, including possible regulatory action and additional commutations of risk.

ABS

EMEA ABS revival remains uncertain

The performance of the consumer loan ABS sector in EMEA continued to deteriorate in Q209, says Moody's in its latest index report for the sector. Moody's net default index reached 1.30%, which is its highest level so far, while the delinquency index - an indicator of the expected increase in defaults - has surged to 0.99% from 0.75% in the past year. The agency's outlook for the EMEA consumer loan sector is negative.

The rating agency notes that the total outstanding pool balance in the EMEA consumer loan market remained stable in Q209 at €35.4bn with 47 underlying pools of receivables. Olimpia da Silva, a Moody's associate analyst and author of the report, says: "The performance of the EMEA consumer loan sector has been strongly impacted by the adverse effects of the recession on labour markets, which are expected to deepen given the time lag that labour markets have to economic cycles. Worsening labour markets increase pressure on consumer loan pools and point to an increase in delinquencies and defaults."

In the report, Moody's also notes that the recession is showing some signs of slowing. In particular, improved industrial output points to a deceleration in the pace of GDP decline. Moody's economist Nitesh Shah explains: "In the Eurozone economy, industrial production showed its first increase in May, driven by the improvement in the automobile sector in Germany and France. However, risks remain significant."

He continues: "For one, the credit markets need to return to normal functioning to guarantee liquidity supply beyond central banks, which is essential to firms' ability to invest. In addition, rebuilding inventory could provide an initial spur to production. Furthermore, the capability of recent economic policies to halt unemployment, boost demand and aid recovery needs to prove tangible in the upcoming months."

At present, despite some positive signs emerging, the timing and pace of economic revival in Europe remain uncertain.

ABS

Mortgage underwriting trends stabilise

ABS analysts at Wells Fargo Securities note that the latest Loan Officer Opinion Survey indicates a stabilisation of underwriting trends in the residential lending sector. "In aggregate, lenders have continued to tighten their standards since the April survey," they say. "However, the percentage of respondents reporting tighter underwriting standards has declined. This suggests to us that most lenders have tightened their underwriting standards to a degree that they can tighten no more."

In the prime sector, 78.4% of lenders reported unchanged underwriting standards, while the balance (21.5%) reported that they had tightened somewhat or tightened considerably. In the non-traditional sector - including Alt-A limited documentation and investor occupancy, option ARMs, interest-only and common hybrid ARMs - underwriting standards continued to tighten.

The percentage of respondents reporting considerably and somewhat tighter underwriting standards was 12.5% and 33.3% respectively. The balance (54.2%) reported unchanged underwriting standards. Respondents reporting tighter underwriting in the non-traditional mortgage sector outnumbered prime lenders responding likewise by a margin of 2:1, according to the analysts.

Specific breakdowns are not available for subprime lenders due to a lack of responses (three or less).

Meanwhile, the decline in demand for all residential loans hit a low in Q406 (-60.4%). Since then, recovery in demand has been somewhat anaemic, the analysts add.

Of those responding in the prime lending sector, 37.3% reported that demand had remained the same since April 2009 and 39.2% reported moderately or substantially stronger demand. The balance (23.5%) reported that demand had eased moderately or substantially.

However, demand for non-traditional mortgages appears to be somewhat weaker. More than half (58.3%) of the respondents reported that demand for non-traditional mortgages remained unchanged, while 29.2% responded moderately weaker or substantially weaker demand.

ABS

Reserve fund depletions to hit Spanish SME ABS

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

"The Spanish economic climate deteriorated further over Q209. The weakening real estate sector has already driven companies to bankruptcy, led to higher unemployment and lowered domestic demand in general," says Nitesh Shah, a Moody's economist and co-author of the report. "This has severe implications for the SME sector. To a large extent, it is responsible for the spike in delinquencies, which are now resulting in an increasing number of reserve fund draws."

Moody's says in the report that tough economic conditions will continue to adversely affect asset performance in Spanish SME ABS. It also reveals the extent to which key performance indicators deteriorated over Q209.

Weighted-average 90-360 days delinquencies represented 2.83% of the outstanding balance of Spanish SME transactions in the period, compared with 2.28% in Q109 and 0.73% in Q208. Delinquency ratios (90-360 days/current balance) exceeded 2% in 44 transactions in Q209, up from 38 in Q109.

Furthermore, the spike in delinquencies which emerged in Q208 is now resulting in defaults and more frequent cases of reserve fund draws. 30 transactions experienced reserve fund draws over the quarter, up from 23 in Q109. The first cases of full reserve fund depletion could be seen as soon as Q309 for some transactions, Moody's warns.

ABS

Deterioration in Italian leasing ABS continues

The performance of the Italian leasing ABS sector continued to deteriorate in Q209, according to the recent Moody's report entitled 'Italian Leasing Q209 Indices'. Moody's net default index reached 1.68%, which is its highest level so far.

Moody's delinquency index, an indicator of the expected increase in defaults, has also increased to 5.28% from 3.18% in the past year. The agency's outlook for the Italian leasing sector is negative.

Olimpia da Silva, a Moody's associate analyst and author of the report, says: "The total outstanding pool balance in the Italian leasing market remained stable in Q209 with €18.7bn and 27 underlying pools of receivables."

In the report, Moody's notes that Italy is in recession, which is weighing on the financial health of Italian businesses, putting pressure on margins and liquidity and pointing to an increase in delinquencies and defaults. Da Silva explains: "Declining revenues narrow profit margins and, combined with relatively tight credit conditions, make it difficult for enterprises to retain earnings, fund fixed investments or even to maintain adequate cashflow levels to operate. This effect is catalysed for SMEs, the majority of lessees in this market. With generally low equity-to-debt ratios and long payment periods, as well as the biggest payment delays in Europe, Italian businesses are especially susceptible to the economic downturn and insolvencies are expected to rise by 30% in 2009."

The rating agency further notes that according to preliminary GDP estimates for Q209, a deceleration in the pace of GDP decline is anticipated. However, the timing and pace of economic revival remains uncertain.

CDO

US$351.6bn in CDOs suffer EODs

S&P received notification of 369 events of default (EODs) on cashflow and hybrid mezzanine ABS CDOs, high grade ABS CDOs, CRE CDOs and CDO-squareds as of 18 August. The list includes global cashflow and hybrid CDO transactions originated since 2001 that have experienced an EOD as a result of credit deterioration of recent-vintage ABS, either by directly holding notes from the ABS transactions or by holding notes from other CDO transactions that are in turn collateralised by ABS.

The 369 transactions for which S&P has received EOD notifications to date represent an aggregate issuance amount of US$351.6bn.

These transactions include: 226 mezzanine ABS CDO, which were collateralised at origination primarily by single-A through to double-B rated tranches of RMBS and other structured finance transactions; 106 high grade ABS CDOs, which were collateralised at origination primarily by triple-A through to single-A rated tranches of RMBS and other structured finance transactions; 36 CDO-squareds, which were collateralised primarily by notes from other CDOs, as well as tranches from RMBS and other structured finance transactions; and one CRE CDO collateralised primarily by tranches of CMBS and other structured finance transactions.

CDS

CDS concentration risk remains

Corporate single name and index CDS remained resilient in 2008 and so far in 2009 in the face of numerous credit events and the auction/settlement process has generally worked as expected, with no material disruptions, according to Fitch's sixth global credit derivatives survey. However, the agency notes that concentration risk remains a feature of the market and the steps taken to mitigate the failure of a major counterparty by putting in place a central clearinghouse is a necessary first step in reducing the overall risk.

The survey highlights that recent changes and those being contemplated to further standardise the CDS market are generally expected to make the derivatives market less susceptible to credit market events. These changes include the standardisation of coupons, cash settlement and the auction settlement process, and the determination of credit and succession events (SCI passim). An important change, also cited in the survey as one of the major challenges, is the clearing of single name contracts and indices through a central counterparty.

Although the total notional amount of CDS contracts outstanding have fallen for the first time, the 26 banks which participated in this year's survey continued to report an increase in market share. This is perhaps not surprising, given the consolidation in the sector.

At end-2008, total sold and bought positions reported by those banks surveyed were US$13.8trn and US$13.9trn respectively. The decline in the total amount outstanding reflects, to a great extent, the collective efforts of market participants and regulators to compress offsetting trades, as well as the virtual absence of new structured credit deals after years of strong growth.

As the buying and selling of CDS contracts tend to be relatively well-balanced at these 26 institutions - in particular the largest institutions, given their role as financial intermediaries - it is difficult to establish whether they have been using credit derivatives as a tool to mitigate default risk, as net CDS exposures are still not a significant percentage of their loan books.

Single name CDS and indices continue to dominate the market, with both products contributing 88% of the total CDS market surveyed. Notable is the decline in outstanding CDOs, CDO-squared and other complex and highly leveraged structures, including those referencing structured finance instruments.

CDS

Materials/healthcare sectors drive Euro CDS liquidity

Market uncertainty over the future direction of the European basic materials and healthcare sectors has ensured that the European CDS market remains more liquid than the Americas market, according to Fitch Solutions.

Thomas Aubrey, md of Fitch Solutions, says: "Question marks over future demand levels across Europe for basic materials, coupled with uncertainty over underlying commodity prices are pressuring CDS liquidity for the sector. In healthcare, companies are facing potential government healthcare budget curtailments as a result of the downturn, whilst pending patent expiry on certain drugs also begins to kick in from next year."

As of 24 August, Fitch's European CDS liquidity index closed at 9.74 versus 10.05 for the Americas.

The European financial sector CDS liquidity has notably decreased in the last two months, suggesting that the market is now clearer on its future direction after recent Q209 earnings announcements, which saw a turnaround in overall profits for most European banks.

According to Fitch Solutions, OJSC Gazprom, Ineos Group Holdings and Kabel Deutscheland remain the most liquid contracts in Europe, while Vale SA, Citigroup and Macy's are trading with the most liquidity in the Americas.

Clearing

EC given derivatives industry feedback

ISDA, along with SIFMA and the London Investment Banking Association, has welcomed further improvements in market infrastructure and strongly supports several initiatives outlined by the European Commission in its communication aimed at ensuring efficient, safe and robust derivatives markets. The associations say that they are especially pleased that the EC acknowledges "the clear value played by OTC derivatives markets", which have remained open and resilient throughout the financial crisis.

"We have a simple message from all those that use these vital risk management products," comments Robert Pickel, executive director and ceo of ISDA. "The real economy faces diverse risks and depends on privately negotiated derivatives to address them effectively. As long as risk itself is not standardised, then tailored instruments will remain important."

He adds: "Close global cooperation is essential to ensure a harmonious approach among different regulatory regimes and to foster appropriate standards for infrastructure solutions. We also encourage the Commission to recognise that robust market infrastructure takes time to build and that hastily implemented solutions, whether voluntary or imposed, could be counter-productive."

Many new OTC market infrastructure initiatives have been completed in recent months and the associations strongly support further efforts aimed at increasing process, as well as documentation and legal uniformity in order to reduce systemic risk. "We believe the regulatory focus should be on process uniformity, not product uniformity," continues Pickel. "Exchange trading is not required to achieve this and it certainly would not insulate our financial system from risk or reduce losses in a challenging environment."

ISDA, SIFMA and LIBA strongly encourage the EC to coordinate closely with regulators in the US and Asia. They also support the recommendations made by ESCB/CESR and call for adherence to them in order to establish a legal framework for CCPs.

However, the associations are not in favour of additional new penalties for contracts that are not centrally cleared. They point out that existing capital charges are already a significant incentive for market participants to use a central clearinghouse. Additionally, while there are benefits from having CCPs in privately negotiated derivative markets, the associations believe that there are also strong reasons for not clearing all trades.

Finally, ISDA, SIFMA and LIBA believe that central data repositories are in principle relevant for systemic participants in all asset classes, though it is also critical that their usage does not curtail the flow of new products to the market and fully respects the global basis on which these products trade. Access to data repositories should be granted to all relevant major financial regulatory bodies, the associations note.

Clearing

Debut single name CDS cleared

Eurex Credit Clear has successfully cleared a single name CDS contract. The cleared transaction had a notional value of €5m and references RWE. The clearer says it is the first and only CCP worldwide to offer clearing of single name credit derivatives, as well as index contracts, and has also been offering access for both sell-side and buy-side market participants in Europe from launch.

CLOs

Rating actions for cancelled KKR CLO notes

Moody's has taken a number of rating actions on the KKR Financial CLO 2005-1, 2005-2 and 2006-1 transactions, following the cancellation by the manager of some of the mezzanine notes (see SCI issue 148). Prior to this move, the overcollateralisation ratios of the tranches had been failing.

If these test failures had continued, on the next payment date the junior notes would be deferring interest and excess interest would be used to delever the senior notes, according to Moody's. The cancellation of some the notes consequently improves the overcollateralisation ratios.

Prior to the note cancellation, KKR had owned, directly or indirectly, the majority of the mezzanine notes and junior subordinated notes issued by the transactions.

Moody's has upgraded the ratings of the Class D and E deferrable mezzanine floating rate notes issued by KKR Financial CLO 2005-1 to Caa2 from Caa3 and to Caa3 from Ca respectively. Based on the trustee report dated 16 July 2009, the Class C and D overcollateralisation ratio was 109.53% versus a test level of 106%, and the Class E overcollateralisation ratio was 107.72% versus a test level of 106.2%. Both tests are now passing with cushion over their respective trigger levels.

The agency has also upgraded the ratings of KKR Financial CLO 2006-1's Class C and E deferrable mezzanine secured floating rate notes to Ba1 from Ba2 and to Ba3 from Ca, as well as withdrawing the ratings of the Class D and F cancelled notes. Based on the trustee report dated 15 July 2009, the Class C/D overcollateralisation ratio was 128.874% versus a test level of 118.9% and the Class E overcollateralisation ratio was 123.188% versus a test level of 114%. Both overcollateralisation tests are now passing with substantial cushion over their respective trigger levels.

Finally, Moody's has downgraded the ratings of KKR Financial 2005-2's Class A-1 and A-2 senior secured floating rate notes to Aa2 from Aa1, and upgraded the ratings on the Class E and F notes to B2 from Ca and to Caa1 from Ca. Additionally, it has withdrawn the rating of the Class D cancelled note.

Based on the trustee report dated 16 July 2009, the Class C/D overcollateralisation ratio was 118.79% versus a test level of 108.6%, and the Class E overcollateralisation ratio was 114.53% versus a test level of 106.9%. Both tests are now passing with substantial cushion over their respective trigger levels.

These rating actions considered the impact of this cash flow re-diversion on the entire capital structure of the three transactions. Moody's determined that although the senior notes were negatively impacted in the case of the first two deals, the overall effect on their ratings was not material.

CLOs

112 Euro CLO tranches on review

Fitch has placed 112 mezzanine tranches from 23 European CLO transactions on rating watch negative. The tranches involved are currently rated between single-A and single-B. The rating action reflects a recent clustering of defaults that has been compounded by continued negative rating migration in the European leveraged loan market, the agency says.

Fitch has noted 15 defaults within its European CLO rating universe since its February 2009 review. These recent defaults affected 26 CLO transactions, with some transactions being exposed to up to five defaulted obligors.

The average cumulative default exposure per CLO has doubled to 5.8% from 2.9% in March 2009. Excluding defaults, the average exposure to assets rated triple-C and below increased to 10.1% from 9.1% at that time. Overall negative rating migration in the underlying leveraged loans has been significant since March, with an average of 3.9% of assets rated single-B minus and higher migrating to triple-C or lower.

Fitch's analysis considered the level of defaults and exposure to assets rated triple-C and below, in addition to failed overcollateralisation tests and current credit enhancement levels.

CMBS

Rare Australian CMBS rated

S&P has assigned preliminary triple-A ratings to the two classes of Series 3 CMBS to be issued by Macquarie CountryWide Finance. Sized at A$265m, this will be the second CMBS programme for Macquarie CountryWide, with proceeds to be applied to refinance the existing 2006-1 notes. This is the first issue of CMBS in the Australian market since 2007.

This transaction is a single borrower, secured loan CMBS ultimately secured by first ranking, real property mortgages over 44 sub-regional shopping centres, neighbourhood shopping centres and freestanding supermarkets throughout Australia. The loan is advanced by MCWF to the borrower, Macquarie CountryWide Trust, a REIT listed on the Australian Stock Exchange.

CMBS

EMEA CMBS performance deteriorates further

The performance of CMBS and multifamily transactions in EMEA exhibited further deterioration during Q209, according to Moody's latest surveillance report for the sector. Many transactions experienced multiple notch downgrades, driven mostly by loan performance-related concerns.

In the report, Moody's comments on various performance-related and transaction counterparty-linked events that impacted the transactions it monitors in Q209. The rating agency highlights that there were no signs of a slowdown in the pace of performance deterioration in the EMEA commercial real estate loan universe over the quarter.

Property values decreased further, driven by further increasing property yields and weaker occupational markets. Although Moody's notes that towards the end of Q209 the yield widening for prime UK commercial properties with beneficial lease profiles slowed down to some extent, the negative commercial property market environment combined with the still limited amount of capital in the market available for commercial real estate investments is putting increasing pressure on securitised loans.

Lifang Chen, a Moody's senior associate and co-author of the report, says: "The number of transactions that experienced adverse events continued to rise during Q209. The cumulative number of loans on the respective servicer's watchlists, in default and/or in special servicing continued to increase at a fast pace during the quarter. Meanwhile, the performance of loans was negatively impacted by both the sustained pressure on property values and declining property cashflows as more tenants had difficulties in making rental payments, especially in the retail sector. In addition, the occupational markets showed further signs of weakening as rental values fell and vacancy levels increased in many markets."

Moody's expects the deterioration in EMEA CMBS loan performance to accelerate further over the coming months. Deniz Yegenaga, a Moody's associate analyst and co-author of the report, explains: "In Moody's view, the prevalent factor in performance deterioration will be the failure of borrowers to refinance loans with upcoming maturity amid the significant property value declines experienced and the current lack of available financing in most commercial real estate markets. Even if commercial real estate lending and investment markets recover from their current state, most loans will be highly levered at maturity unless property values recover substantially, which Moody's does not expect to happen in the near- to medium-term."

In addition to increased refinancing risk, Moody's cautions that weaker occupational markets and adverse tenant performance will also result in more loans suffering payment defaults during their term, resulting in further increasing delinquency rates throughout EMEA CMBS transactions over the coming quarters. However, the agency expects that first losses will be allocated to certain transactions over the course of the next few quarters.

Chen adds: "These losses will relate to defaulted loans for which the servicer and other relevant parties see limited scope for property management and will instead pursue an immediate sale of the mortgaged properties."

CMBS

US CMBS delinquencies fall

The delinquent unpaid balance for US CMBS transactions decreased in July for the first time since August 2008, according to new research from Realpoint. The drop comes after ten straight monthly increases, but is down to only US$25.68bn from US$28.65bn a month previously.

Delinquencies in June 2009 increased by a substantial US$9.87bn from May, up to a trailing 12-month high of US$28.65bn. The decline through July, however, came after nearly US$4.8bn of GGP-sponsored loans were returned to current payment status following a 30-day delinquent status in June.

"While the ultimate resolution of these GGP-sponsored specially-serviced loans has yet to be determined, many were reported as current in July 2009 after multiple master servicers made modifications to their systems to account for the non-default rate interest-only payments being made on previously amortising (principal and interest required) loans," says Realpoint. "On the other hand, not all master servicers are accounting for the GGP payments and cash-collateral order in the same fashion, and these loans remain on our Realpoint Watchlists for potential future delinquency and/or workout via liquidation."

Despite the decline, the delinquent unpaid balance through July 2009 remains up some 511% from one-year ago - when only US$4.2bn of delinquent balance was reported for July 2008 - and is now almost 12 times the low point of US$2.21bn in March 2007, notes Realpoint.

Outside of the 30-day delinquency decline, an increase in the remaining four delinquent loan categories was noted in July. More notably, the distressed 90+ day, foreclosure and REO categories grew in aggregate for the twentieth straight month - up by US$2.15bn (15%) from the previous month and over US$13.63bn (377%) in the past year.

The total unpaid balance for all CMBS pools under review by Realpoint was US$819.2bn in July 2009.

Constant Proportion technology

Spread tightening positive for CPDOs

Moody's has confirmed its ratings on five series of CPDO notes, consisting of both static and managed transactions. The action affects approximately €137m of debt securities across the Cairn CPDO I, Castle Finance II - SURF CPDO Series 2 and SEA CDO - R-Evolution Transaction vehicles.

The significant tightening of spreads over the past few months - since March 2009, the Globoxx spread dropped from its peak of 250bp to the 100bp range, according to Moody's - has allowed the transactions to stabilise their net asset value and move further away from the risk of heavy market value loss crystallisation. The agency also notes that the reduction in spread volatility in the market leaves the deals less sensitive to the current environment.

Emerging Markets

Stabilisation for Asian RMBS markets

Moody's says that the RMBS markets in Korea, Hong Kong and Taiwan largely stabilised in the second quarter of 2009 against the backdrop of the ongoing global financial crisis. At the same time, the agency notes that - according to its analysis of loans with auctioned properties - high recovery levels were evident for the Korean market.

"In the Korean market, the deteriorating trend in the quarter improved a bit and delinquency levels are still very low," confirms Kan Leung, a Moody's analyst.

He adds: "In June 2009, the over 60 days delinquency - as a percentage of the outstanding pool balance - was 0.45% for Moody's-rated Korean RMBS transactions, up a bit from 0.41% in April. In addition, in our analysis on loans sent to auction, recovery rates from auctioned properties were very high with an average of over 99%."

Meanwhile, in Hong Kong the performance of mortgage loans in RMBS transactions has not been significantly affected by the financial crisis, as they were seasoned and have accumulated sufficient equity. "And in Taiwan, Hsinchu International Mortgage Loan 1 Limited (Hsinchu1) - whose LTV ratio is lower than Hsinchu International Mortgage Loan 2 Limited (Hsinchu 2) - continued to outperform Hsinchu 2, with its over 60 days delinquency - as a percentage of outstanding pool balance - almost one-third of that of Hsinchu 2," says Leung.

Indices

Stable collateral performance for ABX

Markit ABX remittance reports for the August distribution date indicate that collateral performance stabilised relative to the previous month, according to ABS analysts at Barclays Capital, as evidenced by slightly lower early delinquencies and moderating default rates across most series. Severities were also flat or lower across the indices, except for the 07-2 series.

After increasing from June to July, default rates fell across most indices in August. However, the BarCap analysts expect seasonals to carry CDRs higher this month.

Moderating CDRs in August suggest that a declining REO bucket may be restricting aggregate liquidations. CDRs are currently 19.3, 22.4, 19.1 and 21.3 for the 06-1 through to the 07-2 indices - an absolute change of -3.3, -2.7, -1.9 and 1.2 points from last month.

Meanwhile, total 60+ delinquencies generally grew in line with last month. Aggregate 60+ day delinquencies climbed by 39bp, 38bp, 76bp and 61bp for the 06-1 through 07-2 indices, compared with changes of 13bp, 48bp, 86bp and 8bp last month.

Early stage delinquencies (30-59 day) came in flat to lower across indices. The changes in the 30-day bucket were 2bp, -14bp, -14bp and 3bp for the 06-1 through 07-2 series.

Indices

Sovereign risk to outperform financial risk

Counterparty and sovereign credit risks have increased to near one-month highs as summer exuberance has given way to concern, with CRE loan losses, FASB accounting changes and macro-economic factors weighing on systemic risks. The ratio (and differential) between sovereign and financial risk has reached a turning point and any systemic risk concerns will be felt more aggressively in bank spreads than sovereigns going forward, according to Credit Derivatives Research (CDR).

There has been considerable risk transfer in and across the financial and government entities in Europe and the US over the past nine months or so, the firm notes. The first week of August 2009 saw the CDR Counterparty Risk Index (CRI) reach levels not seen since June 2008 (below 110bp), dramatically lower in risk than its peak in March 2009 (at around 305bp). Since that low, the CRI has increased by 22% to over 130bp this week as subordinated bank debt spreads significantly underperformed senior debt, with both widening amid legacy broker/dealers (GS and MS) underperforming the traditional banks.

In the past two weeks, the CDR Government Risk Index (GRI) has also risen - by 26% - off its August lows as sovereign risk reached a nadir not seen since early October 2008. Interestingly, the improvement in financial risk was far more aggressive than the drop in sovereign risk, as systemic risk has been transferred permanently from bank balance sheets to government borrowings.

The initial spike higher in spreads around the Lehman period and pre-CCP were dramatically felt within financials. But once the US and European governing bodies stepped in to provide support, sovereign risk among the major countries rose significantly.

Critically, the CRI has hovered well below half its 'Lehman' levels of risk in the last few weeks, while the GRI remains almost double its levels from September 2008. "We feel that, with the US government cutting its budget on the back of 'lesser' needs for financial aid, the deTARPing we have seen, the rising stigma of TLGP issuance and the public outcry at bank bailouts, government support will be less easily maintained," notes Tim Backshall, chief strategist at CDR.

He suggests that as financial system risk flairs up once again, the market will see financial risk (CRI) underperform sovereign risk (GRI).

Indices

Improvement continues for troubled companies index

The Kamakura index of troubled public companies made its fifth consecutive dramatic improvement in August after reaching a peak of 24.3% in March. The month-on-month rate of recovery has accelerated, dropping by 2.3 percentage points to 12.4% of the public company universe in August compared to a 1.7 percentage point drop to 14.7% in July.

Credit conditions are now better than credit conditions in over half of the months since the index's initiation in January 1990 and 1.3 percentage points better than the index's historical average of 13.7%. In March, by contrast, credit conditions were better than only 3.6% of the monthly periods since 1990. The absolute number of companies in the 'over 20%' default probability category declined by 38 to 258.

Kamakura president Warren Sherman says: "The index's return to its historical average levels is an excellent sign. However, there are still many individual credits that deteriorated during the month of August. The rated public companies showing the sharpest rise in short-term default risk in August were Princeton Consulting and Services (USA), Ambrilia Biopharma Inc (Canada), Open Interface Inc (Japan) and MDR Limited (Singapore)."

Indices

Index rolls confirmed

Markit has confirmed that the roll process for the Markit iTraxx Europe, iTraxx Asia Pacific (Series 12) and CDX indices (Series 13) will go ahead next month. Provisional index membership details will be published by Markit in early September.

Investors

Euro ABS buybacks to optimise funding profiles

Fitch says the increased numbers of European banks and other originators making tender offers to buy back their structured finance issues primarily reflects originators taking advantage of opportunities to optimise their funding profiles and capital structure (SCI passim). Further evidence of this trend emerged last week, with Banco Santander's tender offer for 27 series of structured finance transactions, worth a nominal value of €16.5bn.

To the extent that these liabilities are recorded at their amortised cost in the originators' consolidated financial statements, originators may also be able to report a profit on any tender offer once it is executed. The rating agency also notes that, even though tender offers are made at a discount to their face value, this does not necessarily indicate credit problems with the securities concerned. In many instances, the discounted price may primarily reflect the continuing liquidity squeeze in the market and other investor concerns, such as extension risk.

"Several originators have conducted tender offers to buy back their securitisation issues at discounted purchase prices. In many prior cases, the securities concerned performed within Fitch's rating expectations and had stable ratings," says Stuart Jennings, Fitch's structured finance risk officer for Europe.

"Given that originators have the most direct access to information on underlying collateral performance, a tender offer could be construed as the originator demonstrating confidence in the credit quality of their transactions, given they are prepared to set a price to take those assets back onto their balance sheet," Jennings adds.

Fitch notes that Santander's tender offer is the largest to date in Europe and consists of various RMBS, consumer ABS and SME CDO securities. The agency rates 14 of the 27 securities that are the subject of the tender offer - seven RMBS, two consumer ABS and five SME CDOs. All of these securities were originally rated triple-A; however, most of these have since seen adverse rating action.

All of the seven RMBS have seen downgrades for performance reasons and all remain on outlook negative. One of the SME CDO securities has been downgraded for performance reasons. The remaining four securities' ratings remain triple-A; three of these are on rating watch negative - together with the previously downgraded transaction - pending further analysis under Fitch's recently revised rating criteria for SME CDOs (SCI passim).

The two consumer ABS securities currently remain at triple-A with a stable outlook. Fitch notes that those securities that have been downgraded or remain on RWN generally have a lower tender offer price, reflecting the greater degree of perceived credit risk inherent with these securities.

Santander says the tender offer and subsequent liquidation of the bonds will improve the efficiency of the group's capital structure and strengthen the bank's balance sheet. The deadline for the tender offer is 7 September and the date for the liquidation of the tender offers currently stands at 14 September.

Investors

Fed may not spend full agency MBS quota

The US Federal Reserve may not purchase the full US$1.25trn of agency MBS it was authorised to do so under the agency MBS programme, according to comments made by Richmond Fed chief Jeffery Lacker last week during a speech. Wells Fargo MBS analysts believe that this is due to foreign investors continuing to increase their net purchases of agency debt, including MBS, and that as foreign central bank purchases increase, the Federal Reserve has decreased its purchases.

"Although Lacker did not specifically mention foreign purchases of MBS, we believe that the Fed's mortgage purchase programme was serving, in part, to fill the demand gap created when foreign investors scaled back their MBS exposure," the analysts note.

"We do not view a decline in the activity of the mortgage purchase programme as a negative for the agency MBS market, particularly if the Fed's purchase activity is offset with continued foreign purchases, and we continue to remain neutral on the mortgage basis," they add.

Investors

SCI '09 New York initial line-up announced

The initial line up of panellists for SCI '09, the third annual Structured Credit Investor conference to be held in New York, has been announced. The conference will take place on 4 November at India House, One Hanover Square.

Experts speaking at SCI '09 include representatives from: Alcentra, Citi, Credit Derivatives Research, Declaration Management & Research, EIM USA, Goldman Sachs, Gorelick Brothers Capital, Guggenheim Capital Markets, Institutional Credit Partners, Invicta Financial Group, Peritus Asset Management, Structured Finance Solutions, Schulte Roth & Zabel and Wells Fargo Securities. This year the conference will dig deeper into opportunities, strategies and reform in structured credit and ABS; offering explanations of how regulatory reform is shaping the future of the market, as well as discussions regarding pricing and valuations of ABS, CDO and CDS instruments.

Buy-side investors are invited to attend the conference free of charge. For more information on the event, regular updates and reservations please click here.

LCDS

ISDA to publish auction terms for SSP

Markit iTraxx LevX market makers have voted to hold an auction for European LCDS transactions referencing certain first lien loans of SSP Financing, according to ISDA. The auction was called due to SSP Financing failing to make payments on its senior facility. An auction will be held for ELCDS transactions referencing any loans that would constitute reference obligations for purposes of the LevX senior indices.

ISDA will publish the auction terms in due course. The auction terms will set out a settlement mechanism similar to that used to settle recent credit events, including Edscha, Ferretti, Sanitec and British Vita.

Legislation and litigation

FAS 166 prompts safe harbour concern

The American Securitization Forum (ASF) has submitted a formal proposal to the FDIC in connection with a concern that FAS 166 has created for bank-originated securitisations. When the new standard comes into effect later this year, banks will no longer be able to account for transfers of financial assets to securitisation vehicles as GAAP sales. Yet the FDIC requires an accounting sale to be present to qualify under its 'safe harbour' regulation in 2000 for the FDIC to treat securitisations as a sale when the FDIC acts as a conservator for insolvent institutions.

Although true sales for FDIC purposes may still be achieved through state/common law interpretations, a number of ASF members have expressed a strong desire to have the FDIC alter its 2000 rules to decouple those rules from accounting sale treatment. The ASF's proposal removes the requirement that the conditions for sale accounting treatment must be satisfied and the requirement that the documentation for the securitisation or participation reflects the intent of the parties to treat the transaction as a sale for accounting purposes.

Instead, the Association is proposing a number of alternative requirements. For securitisations, the transfer must be to an SPE that is separate from the insured depository institution; to be separate, the SPE must have trustees, partners or at least one director who are not insiders or affiliates of the insured depository institution.

Consistent with the current requirement for sale accounting treatment under FAS 140, at least 10% of the beneficial interests of the SPE or of any series of beneficial interests issued by the vehicle must also be held by investors other than the insured depository institution or its insiders or affiliates. If the assets are consolidated on the balance sheet of the insured depository institution, its financial statements must reflect or otherwise disclose that the financial assets have been transferred in a securitisation or participation.

The ASF believes that the above requirements, among others, will adequately ensure that only bona fide securitisations and participations will qualify for the safe harbor provided by the FDIC rule. "We also believe that these requirements, importantly, are sufficiently unambiguous that they will support the issuance of necessary legal opinions in reliance on the rule," the Association concludes.

Legislation and litigation

Basel releases accounting recommendations

The Basel Committee on Banking Supervision has released a set of high-level guiding principles to assist the IASB in addressing issues related to provisioning, fair value measurement and related disclosures as it develops new financial instrument accounting standards. The principles are aimed at helping the Board produce standards that improve the decision-usefulness and relevance of financial reporting for key stakeholders, including prudential regulators. Moreover, the principles would ensure that accounting reforms address broader concerns about pro-cyclicality and systemic risk, the Committee says.

The principles are in response to recommendations made by the G20 leaders at their April 2009 summit to strengthen financial supervision and regulation. The G20 leaders called on "the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards".

The principles reflect accounting lessons learned from the financial crisis and note that the new standard should:

• reflect the need for earlier recognition of loan losses to ensure robust provisions;
• recognise that fair value is not effective when markets become dislocated or are illiquid;
• permit reclassifications from the fair value to the amortised cost category, which should be allowed in rare circumstances following the occurrence of events that have clearly led to a change in the business model; and
• promote a level playing field across jurisdictions.

To address particular concerns about pro-cyclicality, the new standards should provide for valuation adjustments to avoid misstatement of both initial and subsequent profit and loss recognition when there is significant valuation uncertainty. Moreover, loan loss provisions should be robust and based on sound methodologies that reflect expected credit losses in the banks' existing loan portfolio over the life of the portfolio.

Operations

Final AOFM submissions limited to non-deposit takers

The Australian Office of Financial Management (AOFM) has requested proposals for the third and final selection round from arrangers of RMBS issues (SCI passim). On 26 September 2008 the Office announced that it would purchase up to A$8bn of RMBS to support competition in Australia's mortgage markets, including A$4bn to be allocated to issuer/originators that are not authorised deposit-taking institutions.

To date, the AOFM has invested a total of A$7.382bn across 17 mandates. Of that amount, A$3.929bn has been in securities of issuers that are authorised deposit-taking institutions and A$3.453bn has been in securities of issuers that aren't. Consequently, this selection round is limited to issuers that are not authorised deposit-taking institutions.

One or more mandates may be issued and they may be allocated over time to avoid congestion.

Operations

Accounts receivable securitisation launched

Dutch staffing company Randstad has launched a standby facility with Fortis Commercial Finance that gives it the opportunity to securitise up to €125m of accounts receivables from its Belgian entities. Randstad says the facility is an insurance policy to strengthen its balance sheet, if needed. The company is entitled to activate the facility, which runs for at least 18 months, at any time.

Ratings

Fitch to update ratings models

Fitch says it is taking steps to mitigate operational risk exposure within the rating models that it uses in its analysis of structured finance transactions. These measures include utilising an independent review of all major rating models to be supervised by independent risk officers.

Consideration will also be given for a reduction in the complexity of rating models at every major review. In conjunction with this, the potential for a reduction in the number of models is also taken into account.

Fitch is also proposing standardisation of datasets that form inputs into rating models and greater disclosure of potential exposure to rating model risk and key assumptions in transaction presale reports.

Atanasios Mitropoulos, senior director in Fitch's European structured finance risk group, says: "Used responsibly, models help to promote consistency in risk assessment across the structured finance transactions Fitch rates. This can only be achieved by keeping models transparent and regularly updated. Fitch puts particular emphasis on these two goals."

Ratings

Granite notes placed on watch negative

S&P has placed on credit watch negative 101 classes of notes issued by Granite Master Issuer, Northern Rock's UK RMBS master trust. At the same time, the agency affirmed all other classes of notes issued by the trust.

The watch placements follow an extended review of the performance of the underlying collateral pool. In S&P's opinion, the collateral pool for many months has exhibited deteriorating performance. Declines in UK house prices over the past two years and generally rising arrears and losses have also seen the perceived credit quality of UK mortgages deteriorate.

In the particular case of the portfolio backing the Granite trust, long-term arrears have risen to 4.67% from 0.44% since the last issuance in September 2007, while house prices have fallen by approximately 13% over this period. Given the high loan-to-value (LTV) ratios of many of the mortgages in the underlying portfolio (78.33% unindexed and 86.34% indexed) and loan origination policies that have attracted borrowers with affordability metrics lower than the long-term average, S&P believes that a significant proportion of the underlying pool may come under increasing payment pressure, ultimately leading to increased realised losses. Although the agency has observed that the more recent upward trends in severe delinquencies have tempered somewhat, at a time when house price indices have registered their first meaningful rises in almost two years, it does not yet consider that either of these trends is sustainable.

Repossession levels continue to rise, which may further increase portfolio losses, given the loss severities witnessed for loans of comparable leverage across the market. Repossession rates, as calculated by S&P, have risen to 0.87% from 0.42% between September 2007 and today - approximately three times the levels in the agency's prime RMBS market index.

Over the same period, average losses per property have increased to £26,058 from £14,961. In addition, S&P believes that general tightening of lending criteria across the market may reduce refinance options for higher LTV ratio borrowers coming to the end of low, fixed-rate teaser periods, leading to a natural adverse selection within the portfolio.

The agency notes that the watch placements do not mean a rating change is inevitable, however. S&P intends to hold discussions with Northern Rock over the coming weeks to gain further insight into trends in collateral performance. It will then use any information from these discussions to resolve watch placements, which should be completed within three months.

S&P will also review the Whinstone Capital Management and Whinstone 2 Capital Management transactions, which reference the Granite reserve funds. These reviews will be based on its updated credit numbers for the trust.

Ratings

First Australian RMBS default recorded

S&P has lowered its rating on the Class F notes of Seiza Augustus 2007-1 to single-D from double-C because no interest payment was made to the noteholders on 28 August, a monthly payment date. This is understood to be the first default recorded on an Australian RMBS. Seiza Mortgage Company went into administration last year and is currently under the control of Causeway Asset Management.

Ratings

RFC issued on recovery analytics tool

S&P is requesting feedback on a potential new product to provide market participants with a tool to analyse projected recoveries on structured finance securities. The agency is proposing to offer an interactive web platform, called Structured Finance Recovery Analytics, that would incorporate its assessment of a security's recovery under various stress scenarios.

Recovery Analytics would provide users with the capability to perform a more in-depth analysis of the projected recovery under a variety of stresses than the stressed recovery rating. Although both stressed recovery ratings and Recovery Analytics are based on current published criteria, output obtained from the Recovery Analytics tool would not constitute official ratings and may differ from official credit ratings and stressed recovery ratings, S&P says.

The aim of the tool is to provide a window into S&P's ratings analytics, enabling the user to view the output of the agency's stress scenarios from various angles, thereby increasing the transparency of its ratings. S&P says it will design the platform to complement its traditional credit ratings and the proposed stressed recovery ratings (see last issue) by providing supplementary data indicating the projected timing and magnitude of recovery and (inversely) write-down amounts.

The product might include, for example, estimated recovery amounts, the timing of projected recoveries and losses, the net present value of projected cashflows and collateral-related performance statistics. It would initially target US RMBS prime, alternative-A and subprime securities, but the platform could be expanded to include other structured finance asset types and/or regions.

Ratings

US credit card performance improves

The charge-off rate on US credit cards dropped to 10.52% in July, marking the first month-over-month improvement in the charge-off rate index since September 2008, according to the Moody's Credit Card Index. The charge-off rate was a record-high 10.76% in June, measuring those credit card account balances written off as uncollectible as an annualised percentage of total outstanding principal balance. Other key metrics, including the payment rate and yield, also showed improvement, while delinquency rates fell for the fourth consecutive month.

The agency continues to call for charge-offs to peak in mid-2010 between 12% and 13%, to coincide with an anticipated peak in the unemployment rate of 10%-10.5%. However, according to Moody's svp William Black: "Further and persistent improvement in delinquency and charge-off rates in the months to come may challenge our macro-driven charge-off rate forecast."

The overall delinquency rate declined to 5.73 %, its lowest level of 2009, according to the Moody's Index. The July drop follows seasonal improvements in April, May and June.

Black explains: "July tends to mark an inflection point with respect to seasonal trends. As we move into the second half of the year, we expect delinquencies will again rise as back-to-school and holiday expenditures compete with credit card payments."

The index also shows payment rates rising sharply for the second consecutive month, reaching 17.43%, its highest point since October 2008. Increases in the payment rates were unanimous across all of the 'Big 6' issuers - a likely result of decreasing delinquencies in the month.

The index yield surged ahead to 19.82% in July, a 130bp improvement over the prior month, and its highest level since December of 2007. "The combined effects of issuer discounting and the realisation of continued issuer re-pricing initiatives should continue to support yield in the months ahead," continues Black. Thanks to the markedly higher excess spread of 6.42% for July, the three-month average excess spread also increased from last month's ten-year low and now stands at 5.22%.

Moody's Credit Card Index is based on the credit performance of approximately 300 individual credit card-backed securities rated by Moody's, covering approximately US$410bn of bank credit card receivables.

Ratings

South African securitisation performance negative

The performance outlook for South African auto ABS, RMBS and CMBS remained negative in the first half of 2009. Portfolio performance continued to deteriorate against a background of a rising unemployment rate and still-weak - albeit improving - consumer confidence, says Moody's in its latest review of the sector. The negative performance outlook also reflects the poor industry outlook, as well as expectations of slow and delayed asset recoveries.

No new Moody's-rated South African transactions closed during H109 in the dominant asset classes and all asset classes suffered a contraction in outstanding note balance in H109.

The agency notes that although the South African Reserve Bank (SARB) has cut interest rates by 500bp since December 2008 (to 7% as at mid-August 2009), the softening of monetary policy has yet to have an impact on the performance of South African securitisations during H109. Yuezhen Wang, a Moody's senior associate and author of the report, says: "Indeed, in the six months under review, the delinquency trend for RMBS transactions rose to 1.38% (H108: 0.65%) and delinquencies for auto loans ABS transactions rose to 4.72% (H108: 1.84%)."

However, Moody's also notes that despite recessionary pressures, personal insolvencies have been declining, which according to the rating agency is partly attributable to the influence of the National Credit Act.

In terms of losses, the agency observes that the weighted-average cumulative loss trend for RMBS increased to 0.20%, mainly from issuers under the Blue Granite Investments programme and the Homes Obligors Mortgage Enhanced Securities (Proprietary) Limited Series 1 programme. The cumulative loss trend of auto loans ABS transactions rose to 1.42% in H109. Moody's expects this deterioration in performance to continue in H209 as the recession persists and labour markets remain weak in South Africa.

In H109, 12 Moody's-rated South African RMBS transactions were outstanding. Five of these transactions reported delinquency trigger breaches by the end of H109, which has led to excess spread being trapped in the respective arrears reserves. Furthermore, three RMBS transactions triggered a stop-purchase event due to the high level of arrears. For the auto loans ABS sector, delinquency trigger breaches remained in place for three transactions in the Nitro Securitisation series.

Despite this, during the first half of 2009 Moody's took no performance-related rating actions on outstanding South African RMBS or auto loans ABS transactions, as structural features provided protection to the transactions.

However, the Class A notes of MfP Finance, a trade receivables transaction, were downgraded to Ba3.za and remained under review for possible further downgrade in July 2009. The rating was subsequently withdrawn on 14 August 2009 at the request of the trustee and issuer.

In addition, on 30 July 2009 Moody's downgraded 75 tranches rated on a global local currency basis in 28 transactions in response to the downgrade of the South African Local Currency Bond Ceiling to Aa2 from triple-A. These actions were not performance-related and did not impact the national scale ratings.

Ratings

European RMBS performance indicators worsen

Performance indicators generally continue to worsen across Europe, particularly for Spanish and UK non-conforming transactions, Fitch says in its quarterly European RMBS performance update. However, Italian deals saw a stabilisation of arrears levels during the quarter, mainly due to floating rate loans and a low interest rate environment.

Andy Brewer, senior director in Fitch's RMBS surveillance team, says: "Performance indicators, such as arrears and default levels, continue to worsen across Europe, although the extent of future potential rating actions will depend on individual transaction characteristics and performance. Many transactions should be able to absorb some deterioration and therefore minimise or avoid negative rating action."

Fitch took 414 rating actions in the second quarter of the year, of which 309 were affirmations, 91 were downgrades and 14 were upgrades. Most of the agency's European RMBS ratings - across 2,340 tranches - are on stable outlook, while 470 tranches are on negative outlook and 222 have a positive outlook. A total of 33 tranches are on rating watch negative.

Ratings

EMEA consumer ABS criteria updated

Fitch has updated its criteria for rating EMEA consumer ABS transactions to incorporate forward-looking considerations for setting base-case assumptions, as well as variable default and recovery stresses. The updated rating criteria are applicable to ABS transactions backed by diversified and granular portfolios of loans and leases, advanced to individuals and small corporate entities within EMEA jurisdictions.

Fitch has updated its methodology with respect to the analysis of obligor default risk. The agency has replaced the VECTOR ABS model with a range of default and recovery stresses that facilitate the incorporation of multiple qualitative considerations into the application of rating stresses for individual ABS transactions.

RMBS

UK prime RMBS concerns 'overdone'

ABS analysts at Barclays Capital have published a report that provides investors with a 'health-check' of the UK prime RMBS sector. The research compares the collateral performance and the key structural features of the six largest UK master trusts.

"Historically among the best-performing RMBS sectors in Europe, UK prime RMBS has seen its headline performance deteriorate dramatically over the past 18 months, with three-month+ arrears now above those seen in Italy," the analysts note. "While some of this deterioration is indeed owing to fundamental credit deterioration, we believe the worries around fundamentals are partly overdone and that performance is not as bad as it appeared less than a year ago."

Key concerns for the sector are related to prepayment speeds, the structural complexity of master trusts - that still causes uncertainty for bondholders - and potential further increases in unemployment, which could affect collateral performance.

The analysts believe that originator actions, such as the one that led to the Granite master trust wind-down last year (SCI passim), are now less likely - even in the case of trusts with part government-owned sponsors - as the lessons from the Granite experience have hopefully been learned. Fears of non-call of notes have also subsided in most trusts, reducing the risk of maturity extensions.

RMBS

RMBS cashflow modelling criteria updated

Fitch has updated its cashflow modelling criteria for analysing RMBS, effective on 1 September.

Fitch's fundamental cashflow modelling methodology for new issue transactions has not materially changed since the publication of the prior cashflow analysis criteria. However, the agency has made changes to the criteria assumptions to reflect recent market conditions and borrower behaviour.

The criteria report focuses on the structural analysis of the rated securities and their cashflows, and does not cover the methodology to determine the expected loss at each rating category for a pool of mortgage loans. In conjunction with its cashflow modelling criteria, Fitch is releasing a cashflow assumptions workbook that can be used to tailor the benchmark curves to each deal.

RMBS

Steep increase in delinquencies for Irish RMBS

Irish RMBS delinquencies experienced another steep increase, according to Moody's in its latest index report for the sector. The recent rating action where Moody's decided to place certain notes issued by seven RMBS transactions on review for possible downgrade was driven by the expectation of a prolonged recession, rising unemployment and steep house price declines, which may have a material impact on the Irish economic model and the performance of the underlying RMBS portfolios.

In the report, Moody's says that the weighted-average 90+ days delinquency trend reached 2.3% in Irish prime RMBS transactions in Q209, up from 1% in Q208. The weighted-average total redemption rate (TRR) remained low at 5.8%, which is less than half of the 14.4% recorded in Q208.

Moody's also notes that the weighted-average 360+ days delinquency trend stood at 0.37% at the end of Q209, which compares with 0.14% a year ago. Seven transactions recorded more than 0.60% of 360+ days delinquencies, while three showed more than 1%.

Georgij Ludmirskij, a Moody's senior associate and co-author of the report, says: "The 360+ days delinquency trend is a lagging indicator, which means the full effects of the strong economic deterioration may not yet be fully reflected. In the near future, repossessions are unlikely to lead to any significant reduction of the 360+ days delinquencies, as they are considered a last resort. The more common reduced payment schemes and payment holidays will not reduce the amount of already delinquent loans."

The rating agency also cautions that as house prices continue falling, more borrowers will face negative equity. Nitesh Shah, a Moody's economist and co-author of the report, adds: "Similarly, the risk of borrowers becoming unemployed continues to increase. While leading economic indicators do not show any signs of recovery in Ireland, the performance of mortgages may not yet reflect the full depth of the current recession."

RMBS

UK RMBS delinquencies rise

Key performance indicators for the UK prime RMBS market show that delinquencies continued increasing in Q209, reaching 1.8%, according to Moody's in its latest index report. This is a 121bp increase since Q407 and an 18.3bp increase during the quarter. Meanwhile, outstanding repossessions decreased marginally to 6.6bp on average and cumulative losses continued to trend upwards.

In the report, Moody's says that 86 UK prime RMBS transactions were outstanding at the end of the quarter, with a total outstanding volume of £334.4bn. The agency did not take any performance-related rating actions on outstanding UK prime RMBS transactions.

RMBS

Recession takes toll on NC RMBS performance

Fitch says in a new report that the ongoing recession continues to negatively affect the performance of collateral portfolios securitised within UK non-conforming RMBS transactions. In particular, recent downgrades in the sector have been primarily driven by increased loss severities realised on sold possessions due to house price depreciation.

Fitch continued to take negative rating actions on UK non-conforming RMBS transactions during the second quarter of 2009, with 96 tranches being downgraded by the agency. The transactions that have experienced the largest negative rating actions are those which contain a large proportion of loans originated at the peak of the housing market in 2007. These transactions have been most affected, as they experienced no period of price appreciation.

Along with deteriorating collateral portfolios, further negative rating actions were taken on transactions that were not hedged against their respective note indices. The lack of an interest rate swap to hedge the spread between loans earning the Bank of England base rate (BBR) and notes linked to Libor has stressed revenue funds for a number of transactions. Although the differential between BBR and Libor has narrowed considerably of late, these transactions have already taken a significant hit from the absence of an effective hedge, the agency explains.

Secondary markets

Fair value disclosure exposure draft issued

The FASB has issued an exposure draft (ED) of a proposed accounting standards update intended to improve disclosures about fair value measurements. The proposed update would improve 'Fair Value Measurements and Disclosures - Overall Subtopic (Subtopic 820-10)' of the FASB Accounting Standards Codification, originally issued as FASB Statement No. 157, 'Fair Value Measurements'.

The Board has proposed the improvements to disclosures about fair value measurements based on input received from users of financial statements. Users have requested more information about fair value measurements that use significant unobservable inputs (that is, Level 3 inputs) because of their greater degree of uncertainty and subjectivity. Therefore, for Level 3 inputs, the Board has proposed disclosures about any significant effects on fair value measurements if the reporting entity were to use reasonably possible alternative inputs.

The proposal also addresses requests from users for segregating information for different classes of assets and liabilities that are determined based on their nature and risk characteristics and their placement in the fair value hierarchy (that is, Level 1, 2 or 3). Further, users need more robust disclosures about valuation techniques and inputs for both Level 2 and Level 3 measurements, according to the FASB, because many consider these measurements to be less reliable than Level 1 measurements.

"A number of constituents have recommended that the Board improve disclosures about fair value measurements. The Board believes that the increased transparency resulting from the proposed disclosures would benefit financial statement users," confirms FASB chairman Robert Herz. "We encourage constituents to review the proposal and provide comments on whether they believe it would accomplish this goal in a cost-beneficial manner."

The proposed update would affect all entities that are required to make disclosures about recurring and non-recurring fair value measurements. The deadline for comments on the proposed update is 12 October 2009.

Technology

Enhancements made to surveillance tool

S&P has released Version 2.18 of its ABSXchange platform (see also SCI issue 148). New enhancements include the ability to create a reinvestment file for analysis of CLOs; portfolio-level cashflow analytics, including aggregated cashflow projections and statistics; functionality in the portfolio monitoring module that displays a simplified view of portfolio concentrations; and comprehensive coverage of EMEA CLO and Australian RMBS asset classes.

Ratings

Reconsidering ratings in a post-crisis market

Katie Reeves, research analyst at Deutsche Bank, finds that for non-mortgage ABS in general the ratings framework has not been discredited over the past several years and is not due for a huge overhaul

One of the roadblocks to full recovery of the securitisation markets has been the need to regain confidence in the rating agency process and understand the rating paradigm going forward. As the credit crisis played out, confidence in ratings was shaken, much more in some asset classes (CDOs, subprime RMBS) than others.

Investors and regulators alike have taken the rating agencies to task, and the agencies have been taking steps to respond. They are taking a fine-tooth comb to their criteria and methodologies, as well as their base-case assumptions, to determine whether - given the 'stress scenario' of the last two years - those approaches still make sense.

The non-mortgage ABS sector ratings have generally been much more stable when compared to the bond ratings in mortgage-related sectors. With that acknowledged, the focus of this article will be on non-mortgage ABS, as the new issue structured products market this year has been dominated by non-mortgage ABS, facilitated by the Term Asset-Backed Loan Facility (TALF) programme.

In this article, we review how rating agencies are now approaching non-mortgage ABS to see whether their approaches to those asset classes may be changing and, if so, how. We find that in most cases, the underlying principles behind the ratings approaches have not changed, but that certain risks that may have been viewed as tertiary in the past are getting more scrutiny during the ratings process today.

For example, there is now more linkage being assumed back to the issuing company than was the case 'pre-crisis' in many cases. Additionally, the rating agencies are scrutinising their base-case performance (including loss) assumptions, in the face of what has actually occurred during the current downturn. The rating agencies are also taking steps to add more disclosure about their analyses and assumptions.

Much of this initiative probably stems from a desire to 'self-regulate', in an effort to stave off more onerous rules that may be imposed on the rating agencies by the government. The most visible initiative coming out of the Obama administration that targets the rating agencies is included within the "white paper" for "Financial Regulatory Reform" that the US Department of the Treasury released in July 2009. The section that addresses the rating agencies includes the following broad points:

• That the SEC continues to strengthen regulation of the rating agencies and that the SEC requires that the rating agencies have "robust policies and procedures that manage and disclose conflicts of interest",
• That structured finance ratings be differentiated from those assigned for other products. (So far there has not been much momentum from the market or the rating agencies to further this goal),
• That the SEC requires that the rating agencies disclose exactly what the ratings are meant to capture and what they do not, and disclose more detail about their methodologies, and
• That regulators "reduce their use of credit ratings in regulations and supervisory practices, wherever possible".

This last point is somewhat out of the rating agencies' hands. Others, such as the requirement to fully disclose rating definitions, are not new for the rating agencies. But where such details may have been buried in the past the rating agencies are increasing the degree of disclosure and transparency that they disseminate about their processes.

Need for ratings overhaul is less critical for non-mortgage ABS
For most structured product investors the experience of the last few years has been sobering to say the least, particularly for any who purchased largely on ratings alone. As measured by the stability of original credit ratings, the damage was far worse for investors in mortgage-related structured products, such as RMBS and structured finance CDOs.

All of the major rating agencies publish "rating transition" studies that measure the percentage of bonds that were originally rated in a certain category that still retained that same rating after a certain period of time (e.g. one-year horizon, five-year horizon, etc). From this, in Moody's version, it also reports related metrics, such as the "downgrade rates", for various categories of rated securities.

For Moody's universe of global structured finance securities, there was a downgrade rate of 7.38% over the 1999-2008 time period. But when structured finance CDOs, 2005-2007 US HEL, RMBS and "other" mortgage-related securities are excluded, the downgrade rate over that same time period falls to 3.18%.

The difference is even more striking when looking just at downgrade activity over 2008. For the entire universe, the downgrade rate was 35.5%; excluding the mortgage-related segments, that dropped to 12.1% for 2008.

Moody's also provides "downgrade/upgrade" ratios. For 2008, the whole rated structured finance dataset had a "d/u" ratio of 51.59%, which compares to just 9.23% when the mortgage-related sectors are excluded. A key conclusion to be reached from this for non-mortgage ABS is that the need for significant criteria overhaul is probably lower than what is required on the mortgage side in order to restore confidence in the rating process.

Major rating agency ABS initiatives weighted towards more disclosure
In speaking with three major rating agencies (Moody's, S&P and Fitch) and reviewing recent changes to their criteria and analytics for non-mortgage ABS, several broad themes emerge:

1) The definitions of what their ratings are meant to capture largely have not changed and are not likely to in the near future,
2) However, as information about performance through the credit crisis continues to become available, underlying "base-case" assumptions are being revised to reflect this new worst-case data point. In many cases this has already resulted in more credit enhancement being required,
3) While the major considerations underlying the rating definitions are still intact, all of the rating agencies are more carefully considering risks that may previously have been viewed as ancillary. Within consumer ABS, perhaps the most visible example of this is risk associated with the finance company business model. Before the credit crisis a company's ability and relative need to access the securitisation market may have been noted in the ratings process. But the fact that the ABS market all but shut down for the second half of 2008 has led the rating agencies to much more explicitly consider the liquidity positions of the companies issuing the ABS. For companies with few sources of funding outside the ABS market, this has generally meant higher credit enhancement requirements or, in some cases, hard ceilings on the ratings which fall short of the desired "triple-A," and
4) All are responding to investor and regulatory calls for more transparency and disclosure.

Below, we share specific highlights from our conversations with each of the rating agencies about initiatives on the non-mortgage ABS side, as well as a refresher on how each of the rating agencies define their own ratings.

Moody's Investors Service
Moody's ratings address relative creditworthiness of securities. In its explanations of the ratings, Moody's emphasises that they are meant to be a forward-looking, long-term risk assessment and, as such, they do not exclusively rely on historical models, but also incorporate qualitative considerations. As with the other agencies, Moody's ratings attempt to capture relative likelihood of a security receiving full and timely payment of principal and interest on this specific debt obligation.

In terms of basic underlying approach, Moody's continues to follow the same principles as before the credit crisis. However, certain aspects of the credit context that may have been considered more ancillary in the past, such as operational issues, corporate linkages and the issuer access to markets and their liquidity positions, are now given more weight.

Consequently, there have been some asset classes within consumer ABS where the agency has not been able to reach a triple-A rating regardless of the amount of credit support. The most clear-cut example of this has been for auto dealer floorplan transactions, due to linkage to related manufacturers. This limitation has also been seen for certain credit card issuers, time share transactions and equipment lease deals.

Among recent new initiatives from Moody's has been the decision to provide 'V-scores' and 'parameter sensitivities' with increasing numbers of their rating analyses. Briefly, the V-score is a measure of potential variability of rating inputs. Parameter sensitivities provide sensitivity analysis around the given rating inputs.

Standard & Poor's
Standard & Poor's ratings also address relative (rather than absolute) rankings of creditworthiness among its rated universe. For S&P, the most important measure of creditworthiness is likelihood of default. Beyond this primary concept, secondary factors that S&P also considers include consideration of payment priority, recovery rates and credit stability.

S&P has also been trying to achieve more comparability of ratings across sectors. To this end, it has introduced a series of macroeconomic scenarios to which various rating categories are meant to correspond.

For example, a bond rated triple-A by S&P should be able to withstand a scenario comparable to the Great Depression. Specifically, during that period GDP fell by 26.5% over the period, the unemployment rate reached 24.9% and the stock market fell 85% over the period. By contrast, a triple-B scenario corresponds to something closer to what we have been through recently: unemployment rate of 10% and a stock market drop of 50%.

To our knowledge, S&P is unique in attempting to assign various macroeconomic scenarios to the ratings. S&P reinforces that these are not a part of their formal definitions, but merely an attempt to "enhance the consistency and comparability of ratings across sectors and over time".

Fitch Ratings
As with the other agencies, Fitch's ratings are also meant as an assessment of relative creditworthiness, not an absolute measure. And they do not measure bond characteristics apart from creditworthiness, such as market risk. Fitch's emphasis continues to be on assessing probability of default.

Over the last year or so, Fitch has released up-to-date criteria articles for most asset classes. Fitch has also joined its peers in revisiting base-case loss assumptions in light of the current economic downturn. And, also like its peers, Fitch is more heavily weighting risk related to its financial company ABS issuers, including their access to funding.

Fitch has started rolling out two new measures: 'loss severity ratings', which speak to the adequacy of tranche thickness (given certain loss expectations), and recovery ratings. They are also adding outlooks for all of their ratings, which are meant to represent a medium-term view of the credit risk of the related security. (This is in contrast to a rating watch, which is a shorter-term view of the risk that the rating could change.)

On the surveillance front, Fitch reviews all of its ratings for whether they should be included in a monthly "Smartview" universe. In any given month, the securities captured by Smartview will either be up for their annual review or will otherwise have come on to the rating agency's radar screen (perhaps for performance deterioration/improvement). At the conclusion of its monthly review, Fitch will then take some action to either affirm the existing ratings or make changes where necessary.

Auto dealer floorplan and auto lease deals have seen the most scrutiny
There have been a number of changes by the rating agencies for specific asset classes.

The chart below shows, for eight major non-mortgage-related asset classes, the biggest recent changes. We note that, where "no major changes" is indicated, this does not mean that there haven't been revisions to base-case performance assumptions (for example, increases to base-case loss assumptions, which can result in higher credit enhancement, all else equal), just that the overall approach to the asset class hasn't been meaningfully revised.

One take-away from the chart is that, while the rating agencies have been tweaking categories, in most subsectors they have not largely felt the need to do wholesale revisions to their approach. Rather they are in some cases looking at and incorporating certain risks more explicitly and, in almost all cases, trying to provide more information.

Conclusion
Investors choosing to participate in the market today are more willing and able to perform their own credit work than in the past and much less inclined to "buy on rating", given the experience of the last several years. This appreciation of the limitations of a credit rating and understanding of the risks that ratings do and do not address is key, and internal credit expertise will serve as a good check on the rating agency approaches.

However, we believe investors will still turn to the rating agencies for an outside assessment of credit quality. In some cases, to the extent that certain regulatory regimes are still based on ratings (e.g. risk-based capital rules, TALF rating requirements), this will be required.

The good news for non-mortgage ABS is that in general the ratings framework has not been discredited over the past several years and is not due for a huge overhaul. Investors with a solid understanding of what the ratings incorporate should only benefit from some of the recent initiatives, particularly on the disclosure side.

© 2009 Deutsche Bank Securities. All rights reserved. This Research Note is an excerpt from Deutsche Bank's August 'Securitization Monthly', which was first published on 7 August 2009.

Trading

Trading ideas: run for the border

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a pairs trade on El Paso Corp versus CDX HY 12

El Paso's margins, accruals and implied volatility all improved with its latest earnings announcement and we expect its CDS to tighten relative to the rest of the market. El Paso's CDS now trades less than 100bp below the CDX High Yield Index. This is the tightest differential since August 2007; therefore, we recommend selling protection on El Paso against the CDX HY Index.

Our Merton-style structural model implies a credit spread derived from balance sheet variables and current equity data. Two major drivers benefited El Paso's implied spread over the past few months.

First, El Paso's market capitalisation just about doubled since hitting its lows earlier this year. Second, its equity-implied vol, not surprisingly, dropped precipitously along with the rise in equity price.

El Paso's three-month ATM-implied vol currently trades just above 40% (compared to a high above 120% set late last year). Both factors led to a substantial decrease in the company's equity-implied credit spread. El Paso also fares well relative to other high yield energy companies.

The exhibit below charts the difference between actual and model-implied spreads for all HY energy companies in our universe. The difference between El Paso's actual and equity-implied spreads is the fourth largest of the group and is 50% of its current traded spread. Though we tend not to use the absolute results when making investment decisions, we do find the relative rankings to be highly powerful with regard to capital allocation.

We see a 'fair spread' below 400bp for El Paso based upon our quantitative credit model, due to its equity-implied factors, margins, change in leverage and accruals factors. Throughout 2008 and most of 2009, our model's expected spread tracked El Paso's traded CDS level well (see exhibit below).

However, as the high yield market rallied into this year's summer, we do not believe El Paso's spread kept pace. Currently, the difference between its expected and traded spread is at an all-time high.

However, we are leery of taking an outright position due to the recent rally in spreads and inherent risk of trading high yield credits; therefore, we recommend buying CDX HY protection against the El Paso long. The below exhibit shows that the differential between the two spreads is at the lowest level of the past couple of years. We believe the payout of the combined position will be positive in both up and down markets.

Position
Sell US$10m notional El Paso Corp 5 Year CDS at 6.50% upfront.

Buy US$10m notional CDX HY12 5 Year CDS at 785bp (US$89.75).

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).