Contents

Regulation

Capital idea?

High barriers to entry for contingent capital solutions

Attempts by global regulators to address the pro-cyclicality of financial catastrophes have introduced the concept of contingent capital as a market-driven solution to increased capital requirements (see last week's issue). But without an appropriate redistribution of capital in the financial markets and the proper management of operational risk, such a development is likely to be slow and costly.

"Contingent capital can be a smart way to manage severe event/low probability risk exposures and could also provide end-users with the ability to finance opportunities as they emerge, especially under tight credit conditions like we're seeing at the moment," says Stefan Holzberger, avp at AM Best.

He adds: "But the cost/benefits have to be weighed against those of more traditional insurance in the primary market. While it is generally agreed that the involvement of the capital markets is beneficial for insurance companies, it is difficult for capital market solutions to compete, especially in soft market conditions where plenty of reinsurance capacity is available."

Contingent capital is contingent upon a given event and provides the acquirer with the right to call capital on preplaced terms and conditions. The difference between contingent capital and an insurance-linked security, by comparison, is the type of trigger mechanism agreed to call it down.

A contingent capital facility will likely have a simpler trigger; for example, to protect a balance sheet and core capital from impaired earnings. The trigger has to be broad enough for the capital markets to understand it - otherwise the product will lack the liquidity required for it to be of practical use in a global market.

While it is possible to create derivative instruments that enable the end-user to eliminate certain risks and preferably retain some margin, as Lehman's collapse illustrates, success depends on liquidity (or being 'good for the money'). This is where properly structured contingent capital meets the issues raised by Basel 2 and the G20, according to Stefan Wasilewski, ceo of Contingent Capital Ltd.

"Certainly, contingent capital is a product that can meet end-user requirements to protect their balance sheets," he says. "But is the market at present diverse enough to sustain such a product or capable of generating revenues sufficient enough for it not to be called? Is the economy working in such a way as to not precipitate another crisis? I don't think it is."

Wasilewski says that historically the problem with contingent capital solutions has been buyers wanting to massage their earnings, rather than wanting to protect their regulatory capital or cashflow. "There is currently a dichotomy in the market: the drive to squeeze margins and make a profit instead of protecting the ability to deliver to investors has meant that many companies have forgotten what a balance sheet is and how it should be used. Boards of companies became more focused on keeping the business running rather than on whether the business is capable of being run."

At the same time, the market lacks methodologies to prove to investors that new technologies can create more efficient economies. One way could be to show that it is possible to create new businesses and spread risks safely by managing operational risk at the most fundamental level, but this would mean properly identifying what a 'system' is.

Ill-considered introduction of contingent capital now would only marginally improve the economy, Wasilewski argues. Over the last 20 years real capital has gradually moved up from primary industry into the realm of fast money, feeding pro-cyclical financial catastrophes and leaving primary industry starved of cash. Consequently, contingent capital prices would currently be high - essentially a gamble on when the next catastrophe will happen.

"If there are other such gamblers out there, it is possible to create a market for contingent capital, but it would be unstable because these facilities are reviewed on an annual basis," he explains. "They are supposed to be out-of-the-money risk products; price variation wouldn't occur because the implicit volatility of the trading account isn't being dealt with. Buyers of contingent capital bias it towards the risks inherent in a balance sheet, but when it's impossible to separate lending from trading within an institution, the seller's price will be higher because of the lack of transparency of risk."

He continues: "This strikes at the heart of the need to separately capitalise the trading and lending functions. Economic value at risk for contingent capital is dependent on the structure of an institution: if, for example, the institution is supposedly a lending operation, has high leverage or an unknown trading arm, contingent capital terms will be expensive and the trigger high because of this transparency risk."

Holzberger notes that pricing of contingent capital facilities is opaque because of the complexity of the product. For example, structures differ in terms of the type of underlying instrument - debt, equity or hybrid - and time horizon, depending on the end-user.

"In parallel to the development of the catastrophe bond market, there needs to be some standardisation of contingent capital facilities before costs can be reduced - but, as is the case with the cat bonds market, this process is likely to be slow," he adds.

Nevertheless, Contingent Capital Ltd is working with FinAxiom Ltd, a new investment manager, to create an infrastructure that provides contingent capital facilities across this spectrum. The platform is expected to leverage knowledge of how to price operational risk properly and achieve the necessary liquidity for the product for a global marketplace.

In terms of the impact on the structured credit market, providing the economy does ultimately become more efficient and diverse, contingent capital acts as the last buttress with regard to the statement 'good for the money'. "In other words, a CDS counterparty knows that the liquidity in that company is safe and it has guaranteed cashflow. This is everything that the credit market needs: diversification with the ability to transact safely and create more transparent data," Wasilewski concludes.

CS

Secondary markets

Pressure drop

Tender offer result endorses improved Euro investor sentiment

Santander's €16.5bn European ABS tender offer saw less than 4% investor take-up (see last week's issue). While this may have been a disappointing result for the bank's balance sheet, it is perhaps a more positive reflection of the increased confidence felt by European ABS investors.

"The outcome is interesting," says Marcus Ernst, structured credit strategist at UniCredit. "It shows that investors are quite confident with respect to Spanish triple-As and see no reason to sell without significant pick-up potential. Moreover, the low acceptance rate underlines that the seller overhang on the structured finance market has also come to an end in Spain - a market sector that is exposed to relatively higher fundamental downside than other European jurisdictions."

"The need to sell and liquidate ABS at any cost is clearly over as technical pressure has abated," he adds. "This unfortunately only applies to the senior universe. We doubt that participation would have been as low if Spanish mezzanine paper had been tendered as well."

Santander's tender offer related to 27 senior tranches of 24 Spanish RMBS, CLOs and ABS. Of those 27, investors tendered for 20 deals, with seven seeing no take-up at all (SHIPO 3 A3 [RMBS]; SHIPO 3 A1 [RMBS]; BTOA 2 A2 [SME CLO]; BANES 4 A [RMBS]; SANFT 2 A [SME CLO]; HMSF X A [RMBS]; and SANTM 3 A3 [SME CLO]). Four of the deals that did not see any take-up are currently on review for possible downgrade by one or more of the rating agencies.

Only two auto ABS (acceptance above 9% of the theoretical bid-volume) and two consumer ABS (acceptance levels 6.6% and 8.7% respectively) - which featured the upper tender price range of 95%-95.5% of par - as well as some of the low performing UCI issues (acceptance levels from 1.16% to 7.1%) attracted notable demand. Barclays Capital ABS analyst Dipesh Mehta suggests that while the total amount tendered may seem low when compared to the €16.5bn outstanding amount, he suspects that Santander may have already purchased a number of bonds in the secondary market during the past year and therefore the listed amount outstanding is not necessarily held by investors, making it difficult to analyse the results.

"Ignoring the existing holdings by Santander of these tranches, the low take-up of the tender offer may be due to the rally seen in the secondary prices for these securities recently," Mehta says. "On announcement of the tender, prices for a number of these securities rallied (alongside a general tightening in ABS secondary spreads) that may have left investors better suited to trading in the secondary market rather than tendering back to Santander."

He continues: "In addition, investors - particularly buy-and-hold investors - may also be comfortable with the credit risk of these bonds. This will only have been affirmed by the offer from Santander to buy back these bonds, showing a level of comfort for the credit risk in these tranches, particularly at the current price."

Dutch Bank SNS has, meanwhile, announced a €1bn tender offer for 23 tranches of Hermes RMBS Series eight to 13. Unlike the Santander tender offer, it will be carried out via the Dutch auction process, where price ranges are specified, and is soliciting bids on the whole capital structure. The results of the tender offer are expected to give the market an indication of where spread levels for these bonds lie, as well as providing market levels for revaluating the debt already bought back by the issuer.

AC

CDS

Back-to-basics approach confirmed

One year on from the collapse of Lehman Brothers, the global financial markets are taking a back-to-basics approach of cautious deal making and risk analysis, according to a report published by Allen & Overy. Entitled 'Life after Lehman: Changes in market practice emerge from the aftermath', the report surveys partners from the firm across 20 countries around the world on changes in market practices in their jurisdictions.

The report shows that, while regulators and politicians continue to debate reform of the financial system, the market has responded to recent events and is conducting business with a far more cautious approach to transactions and deals - albeit with a greatly reduced flow of deals in some areas. Philip Wood, A&O special global counsel, says: "Our report indicates that, in addition to higher pricing and reduced leverage, there has been a significant tightening up of the terms of legal documents. But recent events have not resulted in a revolution in the coverage of the documents for syndicated credits or bond issues, or a fundamental reappraisal of non-financial terms."

He adds: "Legal risk management by banks in relation to their dealings with counterparties in the market and by their regulators has intensified, as one would expect. Aside from much nervousness in credit analysis, the focus has been on the three major risk mitigants: set-off (and its companion close-out netting), security interests and trusts (usually in the form of custodianship of securities)."

Among the key findings of the analysis are that financial covenants have tightened, more guarantees and security are being sought, and there are restrictions on where third-party debt is taken. For example, the survey shows that in the few structured finance deals that have been launched there is more interest in the structure and location of debt, but not a fundamental shift to some other architecture. Senior lenders have become even more preoccupied with ensuring that subordination of junior creditors means what it says, according to A&O.

In terms of changes in risk management practices, almost universally there has been greater scrutiny of such matters as the validity and monitoring of collateral, the need for the mutualisation of criss-cross claims so that set-offs and close-out netting (which require mutuality instead of being split amongst a group) can be effective on the insolvency of a counterparty, and whether custodianship of securities stands up on insolvency.

However, the survey finds that the reasons for issuing securitisations haven't changed, although there are various regulatory and accounting threats on the table. In drafting documents, A&O notes a keener attention to counterparty risk, a greater degree of credit enhancement provided by the originator and the fact that disclosure documents have grown longer by reason of more detailed information.

Finally, CDS holders have been shown not to be distorting restructurings. "Our survey seems to indicate that this situation has been less common than perhaps is currently thought," the report states. "One reason may be that many restructurings have involved highly leveraged transactions which have not enjoyed CDS protection."

Another reason is that sometimes the reorganisation has been pitched so that the CDS protection is technically triggered with the result that the CDS holder is happy. And a third reason appears to be that sometimes the CDS holder has other unprotected exposures that they wish to rescue by participating in the reorganisation.

CS

CLOs

Continued spread tightening expected for CLOs

Structured credit analysts at JPMorgan expect US CLOs to benefit from the solid gains made in credit markets over the past week, with incremental spread tightening likely to continue. A world of declining yields, a 'low for long' interest rate outlook and a visible broadening of the investor base all serve to reinforce this view, the analysts note.

While JPMorgan maintains a 300bp spread target for triple-A paper, the analysts believe this is attainable at the nearer end of their initial three- to six-month timeframe. They have also lowered their double-A yield target from 10%-12% to 8%-10%.

However, in a recent research note the analysts suggest that there are three main risks to their positive view as the fourth quarter unfolds. First is renewed volatility in broader markets - although JPMorgan maintains a bullish outlook and forecasts incremental tightening in credit, with the analysts' CLO targets still looking cheap in this context.

The second risk is selling pressures from capital-constrained holders, such as banks. The analysts note that many bank holders have improved capital positions and have withstood downgrades of a fairly minor nature, so they generally remain sceptical of a supposed 'wall of supply'.

"However, as triple-A prices increase, it's conceivable some choose to exit and - though we cannot speculate on the sensitivity or price threshold - we would think many holders will be 'sticky' with selling in an overall market rally (and there is a lot of demand for such risk in any case)," they add. "Further, as double-As increase, we see some further 'recycling' of the risk from hedge funds and other participants who bought when market value coverage was inadequate to some of the real money entering the CLO market who have yield targets too high for triple-As."

Finally, the third risk is extension risk scenarios. But the analysts point out that, while the propensity of loan issuers to extend as well as the flexibility of the manager to reinvest principal proceeds makes extension scenarios a real impediment to triple-A spread tightening, they feel comfortable with their 300bp target. "More broadly, we see investors adjusting down yield hurdles with the broader market," they conclude.

CS

CMBS

CMBS distressed opportunities expected next year

A new survey undertaken by PricewaterhouseCoopers reveals that investors anticipate near-term defaults, combined with looming due dates on CMBS maturities, to jump-start distressed buying opportunities in the sector during 2010. So far, the deleveraging of the commercial real estate industry has disappointed many investors wanting to acquire quality, stable assets at distressed pricing, according to the firm.

Susan Smith, director of PwC's real estate advisory practice and editor-in-chief of the survey, says: "Investors seem surprised at the lack of quality buying opportunities, given the problems in the financial markets and the continued weakening of the industry's fundamentals."

She continues: "Some investors sense that near-term defaults with commercial banks will allow them to acquire quality assets at steep discounts, as banks may no longer be able to continue to 'pretend and extend' troubled loans and would be forced to place assets up for sale."

While some investors are looking to the US$153bn of CMBS loans due in 2012 to spur buying opportunities, commercial banks account for a much greater percentage of the total looming debt and could provide distressed sales sooner than 2012, according to the survey.

Smith adds: "It appears many banks are playing a 'timing game', attempting to replenish their capital reserves in anticipation that the economic recovery will bolster property values. This may be a risky proposition, given that commercial real estate's performance often lags what happens in the economy and in this game the banks can ultimately lose."

Surveyed investors believe the massive amount of leverage used to fuel the buying frenzy during the peak of the cycle in 2006-2007 will greatly increase the number of commercial properties for sale, primarily due to owners who are unable to cover their debt service obligations and incapable of refinancing. If such buying opportunities do come to fruition, the next challenge for investors will likely be asset pricing.

The report cites that a bid-ask pricing gap still exists across all property sectors and geographies. In addition, the unravelling of the debt markets appears to be keeping offering bids from buyers low. The industry's current challenges are also keeping some investors focused on asset management and value preservation rather than on new acquisitions.

Overall, surveyed investors anticipate further deterioration in the underlying fundamentals of the commercial real estate industry through the remainder of 2009 and into 2010. Investor pessimism in the industry's near-term performance is evidenced by the use of much lower market rent change assumptions in cashflow analyses, the survey reveals.

JA

Ratings

Further reforms necessary to tackle CRA issue

Rating reform measures proposed so far only tackle issues peripheral to the key problems that caused rating inaccuracies and the widespread dependencies on these ratings, according to PF2 Securities Evaluations in a recent special report entitled 'First Steps Toward Real Rating Agency Reform: Knowing Where We Need to Go'. For economic reform as a whole to be successful, the paper calls for the financial system to be reinforced against the systemic risks resulting from its deep dependence on ratings. It also recommends certain rating agency-level initiatives that would encourage accuracy and, ultimately, the regeneration of investor confidence in ratings.

"Unfortunately, the CRA reform measures implemented so far and most of the proposals for additional reform under discussion, though well-intentioned, will not in our view restore investor confidence in the CRAs or revive foreign investment interest in US-based financial products," says Gene Phillips, director at PF2.

The report highlights a number of reform objectives that the firm says will substantially limit the likelihood of future ratings errors triggering into catastrophic economic failures. It is important to recognise that future errors will occur and that reforms should limit the repercussions of forthcoming errors.

Specifically, two economy-level reform objectives are put forward by PF2: decrease the proliferation of ratings across the financial regulatory structure; and decrease the dependence and over-reliance of market participants on ratings accuracy. "In sum, we cannot continue the current regulatory practice of having capital requirements dictated by ratings, especially if these ratings are purely 'opinions' without ramifications for being wrong," Phillips adds. "To buffer against this risk, adequate measures need to be put in place to ensure sufficient analysis is done by investors - both before and after investing in securities."

Second, the report proposes two key initiatives towards improving the CRAs themselves: incentivise both the accuracy of ratings and the transparency of the methodology that supports the ratings; and create a mechanism external to the CRAs that supervises the monitoring of their performance. These initiatives aim to increase investor confidence in the quality and reliability of the ratings produced by CRAs and the measurement of each CRA's historical performance.

A key step towards CRA-level reform is to reward CRA accuracy or penalise inaccuracy. One way to achieve this objective could be to align carefully the payment for ratings with their accuracy, whereby CRAs are paid more for accurate ratings but have their pay reduced, or cut, for poor performance. Further, supervision would facilitate consistencies across the CRAs, such as in their definitions of default for the purposes of ratings performance.

CS

Alternative assets

Broker expands alternative investments group

ICAP has expanded its alternative investments business with the recruitment of Laura Prager and Linda Prager, who will act as co-heads and mds of the group based in Jersey City, New Jersey.

Doug Rhoten, ceo of ICAP Americas, says: "The secondary markets are an exciting area and we look forward to expanding the ICAP platform with the addition our new Alternative Investments Group."

The alternative investments group will provide personal and strategic assistance to investors interested in buying and selling secondary interests in hedge funds, private equity funds, real estate funds and other illiquid assets. The group aims to provide sellers of illiquid positions the ability to gain liquidity, rebalance portfolios and/or reduce exposure to distressed assets. For buyers, the group will provide access to mark-to-market priced limited partnership interests and other illiquid products, positions with shorter investment horizons and a channel for rebalancing portfolios.

Linda Prager adds: "We are extremely excited about joining the ICAP family and our diverse backgrounds, knowledge and contacts in the investment and general partner community will be invaluable to our providing a premium service to new and existing ICAP customers."

CLO Managers

Manager change for Amber CDO

Lyxor Asset Management is to take on asset management duties for Amber CDO from Société Générale Asset Management Alternative Investments (SGAM AI). The replacement of SGAM AI is due to the merger of SGAM AI with Société Générale Asset Management (SGAM) and partial assets contribution, resulting in the legal transfer by SGAM to Lyxor AM of certain management activities related to structured products and hedge funds. Lyxor AM is also taking on asset management duties for Ivory CDO (see last issue).

CMBS

CRE debt capital markets head hired

Michael Mazzei will join Bank of America Merrill Lynch as md and head of commercial real estate debt capital markets. Mazzei will be responsible for the origination and securitisation of debt financing, including CMBS, syndicated loans and term loans for real estate companies. He will be based in New York and report to Michael Nierenberg, head of global mortgages and securitised products.

Nierenberg says: "With nearly 25 years of working in the business, Mike has one of the most informed perspectives on the industry. We are very excited to add someone of his industry leadership and experience to our already strong real estate franchise."

Mazzei joins Merrill Lynch from Barclays Capital, where he was an md and co-head of global real estate capital markets and CMBS since 2004. Previously, Mazzei worked at Lehman Brothers for 20 years, where for most of his tenure he was head of CMBS and subsequently co-head of its real estate investment banking unit.

Distressed assets

Distressed credit fund closes above target

The final closing of the OHA Strategic Credit Fund, a US$1.125bn corporate credit distressed fund that targets opportunities in stressed and distressed loans, bonds and other investments, has been announced. The fund was formed by Oak Hill Advisors, an investment management firm specialising in below investment grade credit.

The fund was initially formed in March 2008, but - consistent with its opportunistic mandate - began investing in October 2008. Investor interest in the fund exceeded by over 50% the firm's initial target of US$750m. The fund's limited partners represent a diverse group of domestic and international investors, including corporate and public pension plans, endowments, insurance companies and family offices.

In addition to having made several senior hires focusing on corporate and structured product distressed assets over the past 18 months, the firm has raised more than US$3bn of capital for distressed and performing assets during that period.

Glenn August, president and senior partner at Oak Hill, says: "My partners and I are excited about the opportunities available in the distressed market and we are grateful for the favourable response from our investors. For nearly 20 years, our team has worked hard to build confidence among our investors and establish a track record of success, which has allowed us to raise this capital during challenging market conditions."

Investors

Asian credit hedge fund prepped

Blue Rice Investment Management has launched the BRIM Asian Credit Fund, an absolute return fund targeting opportunities in Asian fixed income and credit. The fund can invest in all levels of the capital structure and will include credit derivatives exposures. Its size is expected to total between US$30m-US$50m, as different investor commitments come online over the next two months.

The fund aims to profit both from the current dislocation in credit markets and as Asia begins its recovery. Betting on winning and losing credits in this situation is expected to bring significant opportunities.

Investors

Alternatives manager launches mortgage fund

IMC asset management has launched a new US mortgage fund. The fund is designed to exploit inefficiencies in the US residential mortgage market resulting from the credit crisis.

The fund will be run by IMC's New York team headed by Greg Drennen, who joined IMC last year bringing a wealth of experience trading mortgage-related products among others at Clinton Group and Goldman Sachs. "It speaks to the quality of our offering that we were able to raise this fund in such a controversial asset class and challenging fund-raising environment," says Sander Nieuwland, md at IMC asset management. "We believe this is a very attractive investment opportunity for which we have a strong team and infrastructure."

He adds: "We are delighted with the high quality and diversity of the group of investors who have chosen to participate. Given the relative illiquidity of the assets, the fund has had a one-shot closing and no further investors will be able to participate. We will be looking to bring more of these opportunity funds in Europe, as well as the US."

IMC asset management is a specialist alternative investment manager with a focus on fundamental credit, ABS and quant strategies. The firm has offices in Amsterdam, Boston and New York.

Investors

Special situations analyst moves to asset manager

Knight Vinke has further strengthened its investment team, with the hire of Jeremy Ozen. In his new role he will support the principals on all projects with research and analysis of current and potential investments. Ozen was previously an analyst at Goldman Sachs, working for its special situations group in London.

Investors

Capital markets firm adds head of client development

NewOak Capital has appointed William Denton as md and head of client development for its integrated advisory, asset management and capital markets businesses. He will be responsible for coordinating all client development efforts for advisory and capital markets areas of the firm.

Denton has over 28 years of global corporate and investment banking experience at leading US and European banks. Prior to his recruitment by NewOak Capital, Denton was md at Credit Agricole and head of the financial institutions group at Calyon Securities, as well as a member of the executive committee of Calyon Americas in New York. Previous to this, Denton had a 20-year career at JPMorgan Chase.

NewOak president and co-founder James Frischling says: "Bill brings a tremendous amount of product knowledge as well as client coverage to NewOak Capital and we're thrilled to continue to be able to attract such experienced and successful professionals. Bill's prowess in risk analysis for the banking, asset management and insurance space will be a value-add for our clients as they continue to navigate through these difficult markets."

Investors

Chief economist appointed at investment manager

Aladdin Capital Holdings has appointed Kathleen Stephansen as chief economist. Stephansen has previously served as head of global economics at Credit Suisse and co-head of economic research/chief international economist in the fixed income division of Donaldson, Lufkin & Jenrette. She was most recently a senior advisor and task force member for the Asia Society on rebalancing the US - Asia economic relationship.

Neal Neilinger, chief investment officer at Aladdin, says: "Economic research is a key ingredient to business strategy. Current market events and investment decisions are being driven by macroeconomic developments as the economy faces the double challenge of overcoming a dramatic cyclical downturn and equally profound structural changes. In light of this, we are thrilled to have an economist of Kathleen Stephansen's caliber join us at Aladdin. Her appointment adds a great deal of depth to the firm in terms of forecasting, client focus and brand."

Legislation and litigation

Bank fined over 'probable' CDO fraud

A Connecticut Superior Court judge has ordered UBS to pledge assets or post a bond amounting to US$35.5m within 10 days, after the court found 'probable cause' that the bank used secret insider information obtained from its 'special relationship' with Moody's and S&P to commit securities fraud in the sale of CDO notes to a Connecticut hedge fund, Pursuit Partners.

A report of the trial and its findings has been published by law firm Burg Simpson Eldredge Hersh and Jardine, which represented Pursuit Partners.

Superior Court Judge John Blawie made several findings in the trial. These include:

• The UBS defendants were in possession of material non-public information regarding imminent ratings downgrades on the notes it sold to the plaintiffs - information UBS withheld from the plaintiffs.
• On 11 July 2007, the day that Moody's publicly announced it was putting 184 CDO tranches on review for possible downgrade, Morelli (head of the UBS syndicate desk) sent an email simply stating 'put today in your calendar'. In explaining the context of that email, the significance of that day was described to the court by Morelli as: "Today was essentially the beginning of the end of the CDO business, meaning the bonds were getting downgraded, they were probably going to get downgraded further and we [UBS] were going to lose a lot of money."
• UBS failed to disclose and actively concealed the fact that based upon this change, the notes being marketed by UBS would not maintain their investment grade rating and would lose a significant amount of value, if not the liquidation of the entire investment.

The court's order was issued at the conclusion of a one-week hearing. The Court took testimony of various UBS employees and reviewed documents, including internal email communications within UBS, and among UBS and the rating agencies. The evidence showed that the bank was given a private 'head's up' that the rating agencies' ratings were false and that downgrades were imminent months before they actually occurred.

UBS had moved to dismiss all of Pursuit's claims at the same hearing, and that motion was denied as to most of the claims in a 66-page order issued by the Court earlier this summer.

Legislation and litigation

Law firm hires structured products counsel

Dechert has hired Matthew Kerfoot as a counsel in its financial services group, based in the firm's New York office. Kerfoot was most recently svp on HSBC's global structured fund products desk. He also previously practiced in the areas of derivatives, commodities and securities law at Credit Suisse and an international corporate law firm.

Joseph Fleming, co-chair of Dechert's financial services group, says: "Matt has extensive derivatives experience and he will further enhance our existing, very talented, derivatives and structured products team. Matt has worked on structuring a wide variety of complex derivative products and he understands both the legal and operational intricacies of these products, having spent many years counselling the derivatives trading desks of various financial institutions."

Kerfoot advises clients on the structuring and documentation of equity, credit and commodity derivatives transactions. He has particular expertise in margin, bankruptcy and bank regulatory issues related to derivatives and structured products.

Legislation and litigation

Law firm adds two in distressed investing

International law firm Nixon Peabody is expanding its distressed investing and trading team with the addition of two seasoned associates, Patrick Maschio and Roberto Ristorucci, who will be based in the New York City office. The pair will report to Doug Schneller, who joined Nixon Peabody earlier this year as leader of the firm's distressed investing and trading team.

Schneller says: "I worked closely with Patrick and Roberto at my prior firm. I've seen first-hand their ability to handle a high volume of complex loan and claims trading work for sophisticated clients."

Maschio and Ristorucci join Nixon Peabody from Kramer Levin Naftalis & Frankel. They represent commercial banks, investment banks and hedge funds that invest and trade in distressed situations. Additionally, they advise domestic and international clients in a wide range of sophisticated transactions in the distressed debt market.

Legislation and litigation

Ashurst pair find new home

Latham & Watkins has hired two attorneys formerly serving at Ashurst.

Riccardo Agostinelli has been recruited as a partner in the finance department, based in the Milan office. He has nearly 20 years' experience in leveraged finance, banking and restructuring transactions. Prior to his hire at Latham & Watkins, Agostinelli served as md of Ashurst's Milan office.

Counsel Lorenzo Vernetti joins Latham & Watkins with Agostinelli. His practice focuses on acquisition finance, leveraged finance, debt restructurings, real estate finance and corporate banking matters.

Listed products

Permacap portfolio beats forecast again

Queen's Walk Investment Ltd has reported a net loss of €5m, or €0.19 per ordinary share, for the quarter ended 30 June 2009, compared to a net loss of €2.3m or €0.08 per ordinary share in the quarter ended 31 March 2009. However, the permacap reports that its investment portfolio generated more cash than forecast for the third successive quarter.

Total cash proceeds amounted to €6m versus an expectation of €5.5m. The company's overall cash position was also slightly higher than expected, with €13.3m of cash on the company's balance sheet at 30 June 2009, compared with a forecast of €13m.

Fair value write-downs for the quarter were €8m, up from €5.2m for the quarter ended 31 March 2009. Write-downs include a €3m charge against hedging positions.

The company's net asset value at quarter-end was €3.69 per share, compared to €3.96 per share at the previous quarter-end.

Real Estate

Real estate investment unit established

AllianceBernstein has established a real estate investment unit that will be led by Brahm Cramer and Jay Nydick. This initiative aims to capitalise on global real estate opportunities.

Both Cramer and Nydick have experience in private and public real estate markets, structured finance, commercial mortgages and corporate capital markets. The pair have led teams that built global, multi-billion dollar businesses with operations in a variety of product areas.

Cramer was previously co-head of the Goldman Sachs Group's real estate principal investment area and will join AllianceBernstein in the first quarter of 2010. Nydick will join the firm after serving as president of iStar Financial, where he has been responsible for its investments platform and operations divisions - including new investments, asset management, construction management, risk management, servicing and workouts of distressed real-estate.

AllianceBernstein expects to have a US-focused real estate offering for its high net-worth and institutional clients in place by mid-2010, followed by both core and global offerings. These real estate services will complement the firm's research and investment platforms in fixed income and growth and value equities. The additional resources will also provide a deeper perspective on real estate markets, thereby enhancing the firm's existing investment research on securitised real estate debt and equity.

Real Estate

Real estate investment group founded

The CREF Group, a real estate advisory and investment group, has been founded by former Wachovia md Steve Russo. The CREF Group will work with real estate developers, investors and financial institutions with interests in commercial and multi-unit residential real estate to assist them with financial restructurings, modifications, debt renewals, equity raises, acquisitions and dispositions.

Russo was previously md and regional executive for all commercial and multi-unit residential lending in Florida, the Caribbean and Latin America for Wachovia Bank. During his fifteen years with the firm, he oversaw a multi-billion dollar real estate loan portfolio as well as production of fixed and floating rate CMBS, construction lending, bridge loans, mezzanine loans, preferred equity and agency debt.

The CREF Group has already restructured a US$40m CMBS loan in Palm Beach County, Florida and has been engaged for assignments ranging from multifamily construction loans to repositioning office buildings.

Real Estate

Promotion for real estate investment pro

Arthur Nevid has been appointed chief investment officer of Mountain Funding, a real estate investment company, and managing director of its special servicing affiliate Mountain Special Servicing. He will be based in the company's Charlotte headquarters.

Since 1997, Nevid has served as Mountain's md of lending and investment, overseeing the emergence of the company as one of the country's premier private capital providers for opportunistic real estate transactions. In his new position as cio, he will be spearheading Mountain's plan to acquire US$1bn of distressed real estate debt portfolios over the next two to three years, while also continuing the firm's focus on opportunistic one-off transactions. He will also help expand its special servicing and asset management business, which currently manages more than 90 assets aggregating in excess of US$1bn of original loan amount.

Nevid has over 25 years of diverse real estate ownership, development, finance and management experience nationally. Prior to joining Mountain Funding, he was the US executive md of a French-owned development company based in New York and a real estate investment banker and asset manager at Merrill Lynch Hubbard.

RMBS

Opportunity fund increases headcount

Structured Portfolio Management (SPM) has hired Vishal Bhutani as an md to trade within the SPM Opportunity fund. SPM Opportunity will invest in SPM Core - SPM's successful group of flagship funds specialising in relative value MBS strategies - and also in opportunistic, short- to mid-term strategies across capital structures. This is expected to expand SPM's ability to take advantage of market anomalies in order to continue providing investors with superior risk-adjusted returns.

"SPM has an outstanding track record of fully understanding the particulars of the assets in which we invest and executing trades accordingly," comments Donald Brownstein, ceo of SPM. "Vishal's considerable experience will add to and complement the existing team of talented portfolio and risk managers who have contributed significantly to SPM's growth."

Bhutani joins SPM from Alexandra Investment Management, where he was a portfolio manager from 2002-2008. At Alexandra, he was responsible for managing the firm's event-driven credit portfolios. While there, he also supervised and helped build the firm's research department.

Secondary markets

Valuations provider appointed for LBHI unwind

Numerix has been selected by Lehman Brothers Holdings Inc (LBHI) to provide independent valuations for its portfolio of one million outstanding derivatives contracts. The move is a critical step in unwinding LBHI's derivatives book and the ultimate reconciliation of outstanding creditor claims, the firm says.

Daniel Ehrmann, md of Alvarez & Marsal and co-head of LBHI's derivatives asset team, says: "Lehman performed an extensive search to identify a partner that could provide the analytics and technology capable to value the depth and breadth of derivatives products that were transacted in the Lehman derivatives portfolios. It became clear that Numerix was best positioned not only to provide LBHI with the valuations we need to resolve derivatives claims, but also to flex the market inputs and transaction terms to ensure that those valuations are reasonable."

LBHI selected Numerix to accelerate the resolution of intercompany accounts and systems and resolve derivative claims. The Numerix team of on-site financial engineers sit side-by-side with LBHI traders and risk managers and provide ad hoc, real-time valuation services along with software support and project management. The firm is actively aggregating existing trade information from all of LBHI's legacy systems onto a single platform - Numerix Portfolio - and providing independent valuations on the entire LBHI book.

Secondary markets

Secondary market auction platform launched

An online auction platform built for traders of specialty financial instruments and investment products on the secondary market has launched. The new exchange, dubbed TrinkTik, was founded by company president John Johnson.

Johnson explains: "The concept is simple; TrinTik is what you would get if you combined eBay with the current financial secondary market trading arena - which is pretty much an insider's free-for-all."

According to Johnson, trading is usually conducted primarily by individuals at financial institutions that have long-established relationships and networks. He believes that due to the insular nature of these relationships, traders may have little incentive or demand to seek the best price or to get the best deal.

TrinTik provides traders with a centralised trading floor designed to facilitate the trade of a broad range of specialty financial instruments and investment products, he explains. Like eBay, trades will be conducted in an auction format. At the close of the auction, sellers will select the best bids and proceed to close the transaction with the winner.

The platform will include offerings in CDOs, commercial loan portfolios, credit card debts portfolios, CDS, MBS and real estate investment trusts.

Johnson notes: "The portfolio sizes and dollar volumes of trade among these organisations reach well into trillions of dollars. The secondary market is ready for some type of reform to increase efficiency and lower costs. Market potential and need for reform make our business concept and TrinTik, timely, viable and lucrative."

Structuring/Primary market

Boutique adds in structured finance

Reynolds Partners has appointed Stuart Macfarlane, formerly of Deutsche Bank, to lead its new structured finance section.

Macfarlane says: "We will be offering tailored tax advice as an integral part of the existing advisory work mandated to Reynolds, as well as offering bespoke structured financing and investment transactions to third-party investors."

Prior to this appointment, Macfarlane was coo of the structured capital markets business at Deutsche Bank, where he negotiated and executed structured finance transactions in Asia, Europe, North America and in the UK across all asset classes, ranging from €50m to more than €3bn.

John Reynolds, ceo of Reynolds Partners, says: "Reynolds Partners is positioning itself to act as a source of high added-value ideas and transaction execution expertise to our clients. The addition of Stuart extends our expertise into structured tax, bringing further value to existing and new clients."

Technology

BarCap buys minority Tradeweb stake

Barclays Capital has taken a minority equity stake in Tradeweb. In connection with the transaction, Thomson Reuters and its dealer-owners will also invest an additional US$68m in total.

Tradeweb's combined business is majority-owned by Thomson Reuters, along with now ten active dealer-owners. In total, more than 35 dealers provide liquidity to Tradeweb's online fixed income and derivatives markets. Barclays Capital's investment reflects the continued expansion of the Tradeweb business since January 2008, when Thomson Reuters and nine banks completed a capital restructuring of the firm.

Tradeweb's active bank investor group now comprises: Bank of America/Merrill Lynch, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley, RBS and UBS.

Trading

Veteran MBS hedge fund manager hired

Coinciding with the recent expansion of its platform to include trading in all MBS and ABS, Beacon Capital Markets has announced two senior appointments.

David Weisberger, a veteran mortgage derivatives investment manager who founded Watch Hill Investment Partners, has joined the firm as co-ceo to work with senior management to further build the platform's business. Beacon Capital Markets has been expanding the base of buy- and sell-side users of its Trade Discovery electronic marketplace, which is dedicated to trading the complete range of MBS and ABS.

"This is an opportune time for market participants to embrace a trading platform that will assist them in finding both liquidity and price transparency in the current, difficult market environment," says Weisberger. "With the recent addition of non-agency MBS, ABS and CMBS to the platform, we have a bigger opportunity than ever to help market participants reach their trading goals."

Weisberger will serve as co-ceo along with founder Norman Epstein. He launched several funds and private accounts under Watch Hill Management Partners and, from 1994 to 2006, saw firm assets grow to more than US$1bn with average net returns of more than 20% a year. He was an md at Prudential Securities in mortgage- and asset-backed analytics prior to launching his fund business.

In addition, John Knox has joined Beacon as md of sales and marketing. In this role, he will oversee all sales and support functions and will seek to further build out the sales team. Most recently, Knox was an md in the institutional equities division at Bear Stearns, where he worked on developing an electronic trading platform for equities for institutional clients.

ABS

French bank brings debut credit card ABS

Banque Accord has launched its first credit card receivables ABS. Arranged by Natixis, the €880m FCT ONEYCORD notes are backed by a portfolio of receivables arising from drawings made on revolving loans originated in France by Banque Accord.

S&P has assigned a preliminary triple-A rating to the Class A notes. The issuer will also issue €168.6m unrated Class B notes, €37.9m unrated seller notes and €300m unrated units.

Banque Accord is the captive finance company of the French retail Auchan group. The firm sells financial products, including revolving loans supported by credit cards.

CDS

Decrease in credit derivatives outstanding revealed

According to the results of ISDA's Mid-Year 2009 market survey of privately negotiated derivatives, the notional amount outstanding of credit derivatives decreased by 19% in the first six months of the year to US$31.2trn from US$38.6trn. Over the preceding twelve months, credit derivative notional amounts decreased by 43% from US$54.6trn at mid-year 2008. For the purposes of the survey, credit derivatives comprise CDS referencing single names, indexes, baskets, securitised obligations and portfolios.

As of December 2008, gross mark-to-market value of all derivatives was approximately 5.7% of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.8% of notional amount outstanding. Applying these percentages to the total ISDA market survey notional amount outstanding of US$454.1trn as of 30 June 2009, gross credit exposure before netting is estimated to be US$26trn and credit exposure after netting, but before collateral, is estimated to be US$3.8trn.

Eraj Shirvani, chairman of ISDA and head of fixed income for EMEA at Credit Suisse, says: "The derivatives business overall showed consistent growth in the first half of 2009, demonstrating the need for customised risk management solutions to help navigate the more uncertain economic landscape. This continued growth is a testament to both the utility of derivative instruments and to the industry's ongoing efforts to reduce risk and enhance operational efficiency."

Robert Pickel, executive director and ceo of ISDA, adds: "These survey results reflect the continued resiliency of the privately negotiated derivatives industry and its benefit to businesses globally. The reduction in CDS outstanding highlights the great progress made through the industry's implementation of operational enhancements, in particular through its achievements in portfolio compression."

The ISDA Mid-Year 2009 market survey reports notional amounts outstanding for the OTC interest rate derivatives, CDS and equity derivatives as of 30 June 2009. The notional amounts are an approximate measure of derivatives activity, and reflect both new transactions and existing transactions. The amounts, however, are a measure of activity, not a measure of risk.

The Bank for International Settlements (BIS) collects both notional amounts and market values in its derivatives statistics and it is possible to use the BIS statistics to determine the amount at risk in the ISDA survey results. All notional amounts have been adjusted for double counting of inter-dealer transactions.

ISDA surveys its primary membership twice yearly on a confidential basis. In this survey, 86 firms provided data on interest rate swaps, 78 provided responses on credit derivatives and 77 provided responses on equity derivatives. Although participation in the survey is voluntary, all major derivatives houses provided responses, the Association says.

Clearing

...and comments on CCPs

The BIS' Quarterly Review also comments that the wider use of central counterparties (CCPs) for OTC derivatives has the potential to improve market resilience. However, the introduction of CCPs alone is not sufficient to ensure that OTC derivatives markets operate efficiently and remain resilient. The report says it is important to complement their introduction with improvements in both trading and settlement infrastructure and capital regulation.

CLOs

Barclays completes bumper Euro CLO

Moody's has assigned a triple-A rating to €4.6bn of notes issued by Setter Capital CLO. This is a managed cash, balance sheet CLO relating to a portfolio of senior secured and unsecured loans from corporate entities and export credit agencies, backed by sovereign governments denominated in multiple currencies. The portfolio is made up of approximately 800 loans and 200 parent entities.

The portfolio, which will be 100% ramped by 24 September, is originated and managed by Barclays Bank. It is due to close on 15 September.

Moody's says it used its correlated binomial expansion technique to analyse this transaction. The modelling is done at covenant levels.

The main parameters are a weighted-average rating factor (WARF) of 1150, a recovery rate of 31%, a Moody's asset correlation (MAC) of 7% and an initial overcollateralisation of the Class A notes of 122%. The WARF is transformed into the default probability that corresponds to the maturity being analysed, and then stressed by 30%.

Using the stressed default probability and the covenanted MAC, the correlated binomial distribution is calculated. This distribution is then used in a cashflow model replicating the deal's interest and principal proceeds waterfall to assign the ratings.

A subordinated tranche totalling €1.8bn was not rated by Moody's.

CLOs

Equity injections for market value CLOs

Two market value CLOs - the Avoca Credit Opportunities and OHA Finlandia Credit Fund deals - have issued additional Class E subordinated notes, of €30m and US$100m respectively. Moody's has determined that the move will not cause the current ratings of the notes to be reduced or withdrawn.

The note issuances are an additional equity contribution to the transactions and, although they have a positive effect, such additional subordination was not material enough to justify an upgrade of the ratings of the notes. This is because Moody's only gives partial effect to excess collateral cushions out of concern that there are no legal requirements to maintain them.

Separately, OHA Finlandia Credit Fund has established a wholly-owned subsidiary in Luxembourg to acquire loans and bonds issued by non-US obligors.

CMBS

IRS action to facilitate CMBS loan mods

A new Internal Revenue Service (IRS) tax rule that will allow US commercial real estate borrowers to proactively discuss possible modifications to securitised loans that are at risk of default without triggering tax penalties has been welcomed by industry participants. Until now, administrative tax rules applicable to real estate mortgage investment conduits (REMICs) and investment trusts imposed severe penalties for changes made to commercial mortgage pools or investment interests after the start-up date of the securitisation vehicle. As a result, borrowers were unable to even begin discussions with their loan servicers until they had already defaulted or were within weeks or months of defaulting.

"Amidst a massive wave of maturing commercial real estate debt - and still virtually no credit available for refinancing - borrowers need to be able to talk with their loan servicers about restructurings in a timely manner, before the point of default," says Real Estate Roundtable president and ceo Jeffrey DeBoer. "By easing the tax penalties on changes to securitised conduit debt - i.e. loans held within a REMIC - IRS has taken a very positive step toward easing today's crushing liquidity crisis in commercial real estate."

CMBS

US CMBS triple-As range-bound for now

US CMBS spreads continue to stay relatively range-bound at the triple-A level, according to analysts at Trepp. Most 10-year triple-A bonds were unchanged midweek, with benchmark GSMS 2007-GG10 A4 5bp-10bp tighter.

"It is unclear at this point what will drive the market out of its current range," the Trepp analysts note. "Buyers of bonds up the curve seem content with the levered returns that they can achieve by participating in the various Federal programmes, but don't appear terribly willing to move much tighter. There will be a continuation of ratings downgrades for the next few weeks or months as the agencies plow through deals, but the market has already anticipated these moves."

The analysts add that there are a number of credit issues looming - most notably Stuy Town - but they suggest the market has already assumed the worst. "Absent a CMBS Black Swan, it would not surprise us to see the market stay range-bound in the short term," they say.

However, potential candidates for unnerving the market anew include new twists in the GGP case (SCI passim), according to Trepp. Seeing other borrowers with liquidity issues attempt this strategy could have a similar effect, or an unanticipated default from a trophy property could also provide grounds for a sell-off.

But until one of these events appears, a tight trading market could remain in place, Trepp concludes.

CMBS

Second Tesco CMBS rated

Preliminary ratings have been assigned to Tesco Property Finance 2 - a UK single-tranche sale and leaseback CMBS backed by 17 properties owned by the Tesco Atrato Limited Partnership. This is the second CMBS to be issued by the supermarket chain this year, the first having launched at the end of June (SCI passim).

Like Tesco Property Finance 1, the fixed-rate bonds in the latest transaction are credit-linked to the rating on Tesco. Goldman Sachs is again the arranging bank. Fitch, Moody's and S&P have assigned a rating of single-A minus to the Class A notes, sized at £559.1m. The bonds are expected to price around 220bp over gilts. 

Tesco Property Finance 1 priced at 340bp over mid-swaps in June, the transaction having been upsized from £415m to £430m, and was three times oversubscribed. Paper from that transaction was placed with approximately 60 accounts. According to a UK-based CMBS trader, Tesco Property Finace 1 paper has been subject to tighening in the secondary market over the past three months, and now trades approximately 100bp tighter than its launch levels.

CMBS

Borrower seeks to repurchase CMBS notes

Proposals have been put forward to investors in the Mall Funding CMBS transaction with respect to the purchase of up to £150m of notes by the borrower, to be executed via three different strategies.

The first strategy involves the borrower purchasing the notes, surrendering them to the issuer and making an upfront payment related to swap breakage cost, while the underlying loan is reduced by the same principal amount as the surrendered notes. Under the second strategy, the notes would not be transferred to the issuer (and hence not cancelled), but a put and call option agreement would enable the borrower to put (at any time) and the issuer to call (most importantly upon insolvency of the borrower or loan maturity) for the notes. Upon exercise of put or call both the notes and the loan amount would be cancelled.

In the third strategy, the notes are also not directly transferred to the issuer and cancelled, but a Jersey borrower subsidiary would hold the notes and enter into put and call option agreements rather than the borrower.

If implemented, Moody's notes that Strategy 1 is likely to be beneficial to the credit risk profile of the notes, since the outstanding loan amount would be directly reduced, thereby decreasing both refinancing risk and total exposure of the borrower. Based on its current understanding of Strategies 2 and 3, the agency does not expect a detrimental impact on the ratings of the notes.

If one or more of the proposed strategies are accepted in the noteholder meeting, Moody's will monitor the amount of notes repurchased by the borrower and the strategies chosen for the purchase and review the legal integrity of the structure.

Moody's downgraded the deal on 7 July 2009, prompted by a number of factors, including: (i) the refinancing exposure, with the single loan securing the transaction maturing in April 2012; (ii) the value decline the property portfolio has experienced since the closing of its tap issuance, coupled with Moody's expectation that the property value will decline further until 2010 and not recover significantly until the maturity date of the loan; (iii) the expectation of rental cashflow declines due to falling market rents, increasing vacancy rates and increasing tenant defaults; and (iv) the high leverage of the loan, following realised and expected property value declines, increasing both the risk of non-payment at loan maturity in April 2012 and the potential loss upon default. The loan's ultimate sponsors are Capital & Regional and Aviva Investors Global Services.

Separately, Moody's has assigned a triple-A counterparty instrument rating to the liquidity facility agreement in the Opera White Tower France FCC CMBS. The rating is the fourth such public rating to be assigned by the agency (see last issue).

Indices

CMBS total return swap index minted

Markit has launched a commercial mortgage total return swap index, dubbed the Markit TRX.NA. The index is designed to provide investors with the opportunity to gain exposure to CMBS through total return swap (TRS) contracts, the firm says. It will be based on a standardised basket of 118 CMBS reference obligations drawn from the Markit CMBX.NA.AAA index series.

Malay Bansal, md at NewOak Capital, suggests that the new TRX total return swap contracts have the potential to have a significant impact on CMBS trading over time. "TRX will likely make it easier for dealers to hedge CMBS positions and will provide some interesting possibilities to those who want to take a leveraged position, and others who have been active in the CMBX market," he says.

The TRX.NA will use consensus pricing on the TRS and there will be 12 contributors to the daily pricing process. A TRS allows investors to benefit from a security's price appreciation or depreciation without having to purchase the security outright. The new index will allow investors to isolate the movement of CMBS prices, in contrast to the synthetic CMBX contracts, which are exposed primarily to the default risk of the reference obligations.

The index will be tradable from inception, with market participants on both the buy- and sell-side expected to participate. All swap contracts will have standardised documentation and the DTCC will offer trade confirmation and settlement. Markit will provide third-party oversight and consensus pricing for use in trade settlement.

Kevin Gould, president of Markit North America and head of structured finance at Markit, says: "Markit is a leader in providing transparent, independent data to the structured finance market. The TRX index builds on the success of the CMBX to offer the market a total return index based on independently verified and consensus-driven pricing."

Indices

Lehman anchoring belies systemic risk

Counterparty risk is considerably below its peak levels surrounding the September 2008 systemic crisis anxiety, says Credit Derivatives Research in a new report. However, while the CDR Counterparty Risk Index (CRI) is trading back to July 2008 levels (post-Bear Stearns), cognitive biases to anchor on the worst case are misleading as the largest 14 OTC derivative counterparties remain 5-10 times more risky than in early 2007.

"The improvement in credit risk perceptions among these most systemically critical financial institutions has been driven by many factors, not the least of which is an availability cascade as implicit Fed/Treasury support combined with ceo/analyst/press comments dragged us from the edge we teetered on again in early March 2009," says Tim Backshall, CDR's chief strategist.

"It is interesting to note that the CRI is trading 40bp (26% less risky) below the 9/12/08 levels, still above recent tight levels as the average equity price of the CRI components is down over 21% over the same period. This seems appropriate in terms of the TLGP/TARP/ZIRP support for the capital structure (senior unsecured outperforming equity)," he adds.

The drop in credit risk for the major CDS dealers has also been driven by counterparties lifting protection measures as centralised clearing and regulatory pressure to margin more effectively appear closer by the day, notes CDR. Only two (Citigroup and Dresdner Bank) of the CRI members are wider than pre-Lehman levels, with Royal Bank of Scotland, Bank of America and Credit Suisse all practically unchanged since then.

CDR notes that US banks and brokers outperformed European banks in credit, but underperformed in equity as JPMorgan, Merrill Lynch, Morgan Stanley and Goldman Sachs were the best performing credits of the CRI over the last year.

Dispersion among the members of the CRI has been cut in half over the past year, indicating much more systemic than idiosyncratic discrimination among these institutions as Europe's spread volatility has been far lower than for the US banks. This relative difference in risk compression and volatility is opposed by the changes in European and USA sovereign risk levels.

The systemic risk transfer from corporate/financial balance sheets, as well as currency volatility, has played out aggressively in the sovereign protection markets with the CDR Government Risk Index (GRI) only back to October 2008 levels and 20-25 times higher than the levels of early 2007.

"While financial institution risk (as measured by the CRI) is about even with July 2008 levels, major sovereign risk (as measured by the GRI) is almost three-times its July 2008 levels and, coupled with the massive derisking seen in the DTCC data for sovereigns, it is apparent that systemic risk remains elevated but has been transferred (rightly or wrongly) to (arguably) the most creditworthy balance sheets," continues Backshall. "As governments begin to unwind emergency relief measures such as TLGP/QE/POMO, we wonder where systemic risk will appear next and will be looking at credit term structures for signs of weakness."

Indices

Surprise exclusion from XO roll for Accor

Markit has published the provisional list of constituents in the upcoming iTraxx Series 12 indices and LevX Series 5, with the index rolls due to take place on 21 September.

The iTraxx Europe Crossover Series 12 will comprise 50 entities instead of 45 to extend coverage and ensure the most liquid eligible entities are included in the index, Markit says. Based on liquidity polls, five constituents have also been replaced in the iTraxx Europe Main index, six constituents removed and eleven added to the XO index, and seven constituents replaced in the HiVol index.

Structured credit strategists at Citi estimate that the roll will result in a tightening in the intrinsic value of iTraxx Europe of about -4.5bp. "Entrants into the Crossover are split between six low-spread and four very high-spread names," they add. "We estimate the net effect will be about 28bp of widening on the intrinsic value. The only slight surprise to us is that Accor has not been included in the Crossover, probably reflecting the late timing of the S&P review for downgrade (10 September)."

The number of constituents in the Markit iTraxx LevX Senior index has been reduced from 50 to 40 names to ensure that only the most liquid entities are selected for inclusion in the index, Markit reports. CBR, Elior, Gambro, Kion, Orion Cable, Panrico, Provimi, SIG (Rank), Tata Steel and YBR/European Directories have been removed from the index. Coupon and recovery rate for the new series have been set at 500bp and 70% respectively.

Indices

US CMBS delinquencies continue to climb

Though US CMBS delinquencies held steady at 3.04% in August, a closer look reveals a de facto increase of 18bp after adjusting for standardisation in servicer reporting, according to the latest Loan Delinquency Index results from Fitch. The adjustment consisted of the loan status reclassification of six large loans sponsored by General Growth Properties (GGP) totalling US$819m.

"While the delinquency rate remained unchanged in August, it does not reflect a sign of broader recovery in commercial real estate fundamentals," says Fitch md and US CMBS group head Susan Merrick. "Several large imminent defaults in the pipeline, including US$668m in hotel loans tied to the gaming industry and three additional loans above US$100m that are 30 days delinquent, suggest that performance deterioration will continue."

The now-current GGP concentration corresponds to loans whose special purpose entity (SPE) borrowers filed for bankruptcy as part of the parent company's reorganisation that began in April of this year. With cash collateral orders now in place, several servicers in August reclassified the affected loans as current due to their adherence to the court-imposed modified loan terms.

In addition to the GGP loan corrections, three Red Roof Inn (RRI) portfolio notes totalling US$294m reverted to 30 day delinquency (from 60 days), removing them from August's index. According to the special servicer, the change in status on the RRI loans occurred because two debt service payments have been made from funds collected following the occurrence of the cash trap event.

The most significant of the US$1.7bn of new defaults in August was the US$195.1m Babcock and Brown FX 3 Portfolio loan, secured by 14 cross-collateralised and cross-defaulted multifamily properties located in several markets across six states.

Indices

CRE CDO delinquencies decline

Asset managers continue to extend maturing loans, with 54 extensions (4.8% by number) reported in August. This helped to bring US CRE CDO delinquencies down slightly last month, according to the latest CREL CDO Delinquency Index results from Fitch.

Fitch senior director Karen Trebach says: "While these extensions reduce the number of matured balloon loans entering the CREL DI, they are in many cases merely deferring eventual losses to the CDOs."

The Fitch CREL CDO Delinquency Index (CREL DI) for August declined to 7.5% from 7.6% last month, with the removal of six loans offsetting the addition of 10 new delinquent ones. Realised losses on the removed loans were US$65m, including a total write-off of a US$26m mezzanine loan interest backed by an office portfolio.

The average recovery on loans resolved in August was 55.8%. Had the loans that were resolved at a loss over the past four months (1.9%) remained in the transactions, the CREL DI would have been 9.4% this month.

In August, a total of 11 of the 35 Fitch-rated CREL CDOs were failing at least one overcollateralisation (OC) test, which is one higher than last month. Failure of OC tests leads to the cut-off of interest payments to subordinate classes, including preferred shares, which are typically held by the CDO asset managers.

Fitch says it is concerned about the additional stress these asset managers face as their cashflow continues to be cut off. If a manager loses its financial wherewithal, it may no longer be able to effectively manage the collateral of the transaction. For example, less financial capacity could lead to the loss of experienced staff, the inability to make protective advances or the weakened ability to defend its position in litigation or foreclosure.

Assets that are 30 days or less past due totalled 2.8% in August, led by delinquent interests in the Resorts International Portfolio loan (41bp).

Fitch anticipates high default rates and low recoveries on the loans within CDOs as these loans mature into the trough of the current commercial real estate cycle. The agency is finalising review methodology and anticipates significant downgrades to all Fitch-rated CREL CDOs in the coming months, it says.

Indices

Euro credit card index shows signs of stabilisation

The overall performance of the S&P European credit card index continued to worsen in Q209, following deterioration in Q109 and for most of 2008. However, some metrics, such as delinquencies and payment rates, are showing signs of stabilisation.

According to the agency, in the transactions it rates, overall performance has continued to worsen in the sector in Q209, with charge-offs continuing to increase significantly. However, it reports that the delinquency index decreased in June 2009 from an all-time high and this may be due to concerted efforts by originators to improve collection procedures and reduce credit limits. Nevertheless, S&P expects delinquencies to continue to rise in future months due to the continued strain on cardholder finances.

Listed products

ETF to offer iTraxx exposure

EasyETF has expanded its fixed income range with a new product - EasyETF iTraxx Europe Main. The new fund will be managed by BNP Paribas Asset Management teams through synthetic replication.

Operations

HAMP loan mods rise, but re-defaults remain key test

The US Treasury released its second Servicer Performance Report on mortgage loan modifications on 9 September. Overall, the performance data shows a steady increase in both trial plan offers extended and trial modifications started. In Moody's Weekly Credit Outlook, analysts William Fricke and Debash Chatterjee note that although the volumes are encouraging and tracking the agency's expectations, re-default rates - which will not emerge for some time - will determine ultimate losses and further rating actions, if any.

The report shows that of 2.9m borrowers 60 or more days behind on their mortgages, over 500,000 have been offered Home Affordability Modification Program (HAMP) modifications by participating servicers. "This means that around 20% of borrowers who are seriously delinquent on their mortgages will likely see some relief," the agency says. "How effective these modifications will be at preventing defaults is the big question."

But it adds: "The ramp-up in modification rates is encouraging. Specifically, the Treasury reported over 571,000 trial plans have been extended, an increase of 4% over the total at the end of the previous month. Over 360,000 trial plans have been started, an increase of 3% over the total at the end of the previous month."

Data from the report also suggests that some of the larger servicers that were ramping up their modification frameworks in July have now fully implemented HAMP. For example, Wells Fargo Bank and CitiMortgage increased their trial plan offers by a combined 23%. "Based on performance trends to date, the Treasury goal of 500,000 trial modification starts should, in all likelihood, be achieved (if not exceeded) by November 2009," the Moody's analysts note.

The agency reports that nine additional servicers have signed on for the programme since the July report and 85% of eligible mortgages are now covered by servicers that participate in HAMP.

Operations

2011 recovery expected for US ABS

Underlying collateral performance in most US securitisation sectors is to remain poor well into 2011, according to Moody's latest 'Road to Recoveries' report. The agency expects troubled performance to linger in consumer-backed securitisations, despite positive GDP growth, because employment levels and home prices will continue to deteriorate well into 2010.

In CMBS, performance remains linked to both employment and the improved prospects for the US business sector. Moody's does, however, expect the volatility of collateral performance to decline in the coming months.

With commercial real estate usually one of the last sectors both to enter a recession and exit one, the agency expects CMBS performance to continue to deteriorate into 2010 or 2011. Loan delinquency, property value and other underlying performance metrics have deteriorated significantly from their pre-credit crisis levels.

Keys to improved ABS performance will be the effectiveness of the economic stimulus and government-sponsored lending programmes on employment, home affordability and business profitability. As for a recovery in the volume of issuance, some securitisation markets face high degrees of uncertainty over investor acceptance as well as evolving regulation, says Moody's.

Moody's senior md Claire Robinson says: "There is significant uncertainty around changes in disclosure and regulatory regimes for the securitisation markets, which - along with higher investor risk premiums - will result in increased cost of securitisation for issuers."

RMBS performance should continue to deteriorate into 2010 as housing prices continue to slide, despite some recent signs that the decline is slowing. Moody's does not expect investor demand to be a factor in a recovery of RMBS for another 12-18 months.

Auto ABS have seen a slowdown in loss acceleration over the last six months, but Moody's expects performance deterioration to continue into 2010.

The agency expects the performance of credit card securitisations to improve only after unemployment peaks in mid-2010. Moreover, the credit card industry faces significant legislative and regulatory changes in the coming year, adding to uncertainties in the sector.

The performance of FFELP student loans should be helped by the spread between Libor and the CP rate declining as credit markets improve. The performance of private student loans can be expected to deteriorate into 2011, Moody's concludes.

Ratings

Revised ratings criteria for US RMBS

S&P has published its refined methodologies and assumptions for rating US RMBS transactions backed by prime, Alt-A and subprime mortgages. The core of S&P's approach was to establish a triple-A credit enhancement level to enable securities rated at that category to withstand an extreme economic downturn without defaulting.

The primary point of the updated criteria was to define an 'archetypical pool' and its associated credit enhancement level at the triple-A rating category. S&P arrived at a 7.5% triple-A credit enhancement level for the archetypical prime pool.

This higher credit enhancement level is primarily based on the agency's assessment of potential borrower default behaviour and property value declines under conditions of extreme stress. This represents a major recalibration of S&P's RMBS criteria and is intended to make US RMBS ratings more comparable with ratings in other sectors, such as US corporates, US municipals, sovereigns and other areas of structured finance.

S&P expects that an archetypical pool that has similar characteristics to Alt-A and subprime loans would have triple-A credit enhancement levels of 18% and 30% respectively.

The revised methodologies and assumptions affect the ratings on 248 tranches from 16 RMBS transactions issued in 2008, but will not materially impact the ratings on RMBS transactions issued before 2008, the agency says.

Ratings

Mortgage servicer advance criteria issued

Fitch has published its criteria for rating securitisations of US residential mortgage servicer advance receivables, which have seen a gradual rise in new issuance in recent months. In a servicer advance receivables trust (SART), the servicer pledges advance receivables from selected pools of RMBS deals.

According to the underlying pooling and servicing agreements (PSA), US RMBS transactions require servicers to advance delinquent principal and interest, as well as other expenses, until the advances are deemed non-recoverable. These advances are reimbursed when a borrower becomes current on payments, when a property is liquidated or when a delinquent mortgage is modified.

Servicer advance receivables are typically paid at the top of the cashflow waterfall, before any payments are made to bond investors as principal or interest. "While recovery is fairly certain and the rate of recovery is high, there is risk in these transactions relating to the timing of the ultimate collection of recoveries," says Fitch md Roelof Slump.

In addition to analysing the transaction structure, Fitch's analysis focuses on servicer risk factors, including its historical performance on advance recoveries, and the financial strength, operational condition and Fitch rating of the servicer.

Ratings

Fitch takes action on US prime RMBS

Rising unemployment and negative home equity are resulting in an increasing number of US prime RMBS mortgage borrowers falling behind on their monthly payments, according to Fitch. In response, the agency has taken various rating actions on 581 prime RMBS transactions issued between 2005 and 2008.

Unemployment has risen significantly since the start of the year, particularly in California where it has reached the highest level on record. "Job losses are particularly detrimental for borrowers with negative equity," says Fitch senior director Grant Bailey. "Approximately 45% of the borrowers in the pools reviewed currently owe more on their mortgages than their home is worth."

Fitch's rating actions highlight expected collateral loss on the mortgage pools and cashflow analysis of each bond. The average updated expected collateral loss as a percentage of the original pool balance for the 2005, 2006 and 2007 vintages are 2%, 6% and 8% respectively. As a percentage of the remaining pool balance, average expected loss for the same cohorts are 4%, 8% and 10% respectively.

Ratings

Ratings criteria adjustments enhance ABS stability

Adjustments made by S&P to the rating criteria of non-mortgage ABS are believed to have benefited the sector, resulting in its relative stability, the agency says.

As of July 2009, of the 6,151 triple-A ratings issued on non-mortgage ABS since 1982, approximately 90% have remained triple-A. The agency has only downgraded approximately 1% to below investment grade, and only four triple-A transactions in this group - or approximately 0.07% - have ever transitioned to default.

S&P has revised its criteria for non-mortgage ABS - including student loan, auto loan, credit card and equipment lease - and adjusted loss assumptions to reflect current economic conditions and near-term forecasts. These adjustments have resulted in a more conservative credit analysis, which in turn has led originators to provide higher levels of credit enhancement at all rating categories.

To date, these sectors have benefited from a combination of higher credit enhancement and the amortisation and fast pay-down of liabilities. These factors have all contributed to the relative stability of ABS ratings.

S&P notes that the original triple-A ratings across most ABS asset classes have generally performed as expected, although some ratings volatility is expected in the ABS sector in the coming months. The agency does not expect this to spur major criteria changes in other non-mortgage ABS asset classes.

Ratings

French RMBS ratings remain vulnerable

Although the worst of the recession in France is probably over and a recovery has started, unemployment will continue to rise and with that comes a risk of a disruption in the servicing capability of households to their loans, according to Moody's latest index report for French RMBS.

Nitesh Shah, a Moody's economist and co-author of the report, says: "The recovery remains fragile and highly dependent on the stimuli provided by the state. Falling house prices have some way to run their course, but the slower acceleration in their rise and a more propitious economic backdrop stacks the cards against an as precipitous fall as witnessed in the UK, Ireland and Spain."

In the report, the agency says that key performance measures indicate that the weighted-average delinquency 90 days plus index increased to 0.61% over the past year. Maria Divid, a Moody's senior associate and co-author of the report, explains: "The weighted-average cumulative defaults/credit events and cumulative net defaults also continued to increase at a moderate pace."

One new public French RMBS transaction rated by Moody's was issued in H109, which was the first non-conforming transaction in the French market. There were no rating upgrades or downgrades of French RMBS during the period.

Real Estate

Additional buyback for CRE CDO

Fortress Investment Group is proposing a further buyback of the Class A notes issued by Duncannon CRE CDO I, following an earlier repurchase of €121.4m of Class As in June 2009 (see SCI issue 141). Under the new proposal, the repurchase of €9.5m of the Class A notes is to be undertaken at a discounted purchase price, with the notes to subsequently be cancelled, thereby increasing available credit enhancement to all rated notes.

As per condition 7 (h) of the Duncannon CRE CDO I prospectus, the issuer may at any time, at the direction of the portfolio manager, purchase senior or mezzanine notes in the open market or in privately negotiated transactions, at a price not exceeding 100%. The repurchase will be funded using cash available in the principal collection account.

The transaction's senior par value test is currently passing, but the second senior and mezzanine par value ratios are currently in breach of their limits. Fitch says that all par value ratios will improve as a result of the repurchase of the notes. The move won't impact the rating of the notes at this time.

Regulation

Call for collective change over financial crisis

The International Centre for Financial Regulation (ICFR) has published a comment that aims to take stock of the market's development since Lehman's collapse, as well as what remains to be done. The note warns that if the market fails to think collectively and cooperatively about change, the foundations for the next financial crisis could end up being built.

In the comment ICFR ceo Barbara Ridpath says that it is to the credit of regulators and policymakers that the propitious action taken was accommodative - rates were lowered, abundant liquidity made available and fiscal stimulus applied liberally. "Regulators took their time to consider the appropriate regulatory responses, recognising that knee-jerk reactions on capital, leverage, liquidity and pay and bonuses could have the devastating short-term outcome of deepening the financial and economic crisis, and significant long-term unintended consequences. Regulators and policymakers discussed these issues across borders and recognised the need for concerted action," she notes.

Incrementally, markets have regained some semblance of confidence, according to the ICFR. Signals of economic revival and house prices bottoming out have occurred sporadically, liquidity has returned to some key markets and asset prices are improving. Equally, accommodative monetary policy has permitted banks to rebuild interest and trading income without looking like they have received a further direct government subsidy.

However, Ridpath points out that the sector's problems are not yet over. "Loan losses, which lag other indicators, will continue to build and cost banks in provisions for some foreseeable time to come. Nonetheless, some in the financial sector are choosing to think the worst is behind them. They hope that systemic change is no longer necessary because they have begun to make money again in such a low interest rate environment."

Indeed, it appears that banks have returned to 'business as usual'. The debate on changing the business models and the culture of financial services seems to have fallen by the wayside.

But the ICFR warns that patience is waning. "There is a risk that we arrive at a stand-off, where out of frustration politicians respond to the conflict between populism and bankers' recalcitrance by becoming ever more shrill in their demands, and bankers become ever more threatening in their responses. We shall end with a 'dialogue of the deaf'," it says.

Ridpath indicates that central bank policy will gradually become less accommodative and banks will have to begin to earn money the old fashioned way again. She argues that bankers, regulators and policymakers need to eliminate their self-interest to arrive at a domestic and international financial regulatory structure which genuinely serves the good of the economy, the private sector and the general population at the same time.

"All parties need to recognise that it is worth giving up some of what they feel they need to get most of what they want," the ICFR note concludes. "This can best be done by open and honest dialogue and debate, not polemics and posturing. Should we miss this opportunity to think collectively and cooperatively about change, there is a good chance that we are currently sowing the seeds of the next financial crisis."

Regulation

BIS report proposes flexible ABS retention rules...

'One size fits all' ABS retention requirements aimed at aligning incentives between originators and investors are unlikely to achieve the desired objective, according to a report in the BIS' September Quarterly Review. According to report authors Ingo Fender (BIS) and Janet Mitchell (National Bank of Belgium), retention requirements should be kept flexible, while esuring that investors are aware of all necessary details concerning retention both at issuance and over the lifetime of a transaction.

Fender and Mitchell also argue that measures aimed at eliminating the overhang of legacy assets are showing some signs of success, but that ultimately changes in the structure of the securitisation process are required to attract new investors to the sector.

RMBS

Prepays unlikely to impact UK prime RMBS ratings

Fitch says that the marked decline in the UK residential mortgage prepayment rate over the past 18 months is unlikely to negatively impact the ratings of the RMBS issued from the 12 Fitch-rated UK prime master trust programmes.

"Fitch's ratings address the repayment of principal in full by the legal final maturity and as such are unlikely to be affected by a slow-down in the prepayment rate, given that the majority of bonds have long-dated legal finals," says Francesca Zwolinsky, director in Fitch's UK RMBS team.

Fitch says it has been closely monitoring the prepayment rates of the 12 programmes. In anticipation of bond extension risk, the agency stressed each programme as part of its UK prime stress test performed in January 2009, by applying various prepayment speeds, including scenarios where the prepayment rate is assumed to slow considerably. With the exception of Aire Valley and Granite, all notes repaid by their respective legal final maturity dates without incurring a principal loss.

Although a reduction in the prepayment rate reduces the speed at which trust sizes decline, and hence a non-asset trigger is breached, it also has the effect of slowing the rate at which credit enhancement can accumulate and may cause certain classes of notes to be repaid less rapidly than expected. This in turn could result in certain notes extending past their step-up dates in the absence of being refinanced. Following a step-up date, all relevant notes are re-classified as pass-through notes and are entitled to receive their pro-rata share of principal only.

The annual prepayment rate in the Aire Valley programme declined to 5.35%, as of the date of the latest investor report in July 2009, compared with 16.94% in January 2008. Consequently, there were insufficient principal receipts to redeem the 2007-2 Class A1 £500m note scheduled to be repaid in full on its step-up date in October 2008.

Not only does this note face significant extension risk, given it is now entitled to a pro-rata share of principal receipts only, but the resulting increase in coupon to 1% from 0.44% is having a negative impact on the level of excess spread generated by the transaction. Moreover, the failure to repay a note in full on its step-up date breached the substitution conditions, a feature common to master trust programmes.

The prepayment rates in the Arkle and Permanent programmes have declined to the extent that insufficient principal has been generated to redeem a number of notes in full. However, in contrast to Aire Valley, the sponsors of these two programmes have supported their structures and injected cash into the trusts to ensure the bonds are redeemed on time. In the absence of such support, master trust programmes potentially face the same fate as Aire Valley.

In certain circumstances, slow prepayment rates may cause the deferral of principal to scheduled amortisation and pass-through notes. Master trusts feature several mechanisms designed to protect senior noteholders in the event of a reduction in the prepayment rate.

For example, when bullet and scheduled amortisation notes are issued, transactions are structured to accumulate sufficient principal receipts to redeem the scheduled amount in full in advance of such payment. This involves a cash accumulation period that is set to occur at a predetermined number of months in advance of such a payment date, unless the repayment rate falls below a required level, in which case, the cash accumulation period will begin earlier.

While there is a cash accumulation shortfall for a bullet note, principal payments to scheduled amortisation and pass-through notes are deferred. Slow prepayment poses an additional complication because if it falls below a certain level, principal deferral to junior notes is permitted.

Since the onset of the liquidity crisis, there has been a marked decline in the annualised prepayment rates of each of the 10 Fitch-rated master trust programmes established prior to 2008. In addition to scheduled and voluntary prepayments, the prepayment rate also includes 'structural' prepayments. The mechanics of several programmes are such that loans subject to further advances and/or unpermitted product switches are repurchased by the seller and the related payment to the master trust will have the same effect as a prepayment.

"The decline in loan redemptions since the beginning of 2008 is particularly apparent in the non-conforming programmes, Aire Valley, Pendeford, Lanark and Mound, reflecting not only the non-conforming nature of the collateral, but Aire Valley and Pendeford's greater-than-average exposure to high loan-to-value mortgages," says Zwolinsky. "This emphasises the difficulty that these borrowers are having in refinancing, following the widespread tightening of underwriting criteria and, in some cases, the complete withdrawal of these mortgages from several lenders' product ranges."

The reduction in structural prepayments may have resulted from a reluctance among borrowers to stretch their affordability by taking a further advance. Furthermore, UK house price declines are contributing to slower prepayments, leaving some borrowers with insufficient equity in their homes to permit them to draw down further amounts on their existing mortgage, given the reduction in loan-to-values that lenders are prepared to lend against. The tightening of underwriting criteria, coupled with the increased costs of refinancing, means that is often cheaper for borrowers to remain on the standard variable rate rather than switch to a different product with either the same or an alternative lender after their teaser rate has expired.

RMBS

US RMBS assigned LS/RR ratings

The on-going US housing crisis has driven widespread and substantial downgrades of US RMBS credit ratings, reflecting expectations that many formerly highly-rated securities are at risk of default, according to Fitch. While structured finance (SF) credit ratings address the probability of default, they do not address the recovery prospects of defaulted bonds. In response, the agency has developed new tools to aid investors in measuring loss-given default risk and recovery potential on performing and distressed US SF securities.

Fitch's new SF loss severity (LS) ratings and SF recovery ratings (RRs) provide an extended ratings framework for understanding loss risk, which complement the default risk addressed by credit ratings, it says. In a recently released report, the agency provides a case study of a sample Alt-A RMBS transaction detailing how its LS ratings and RRs can help investors understand the loss-given default risk potential for performing securities as measured by the LS rating, as well as a dollar estimate of a bond's recovery prospects once it has become distressed or defaulted as indicated by the RR. Additionally, the RMBS example demonstrates the use of Fitch's loss metrics database to provide detailed performance and ratings information on individual SF securities.

While bonds with the same long-term credit ratings have the same default risk potential, losses to the bonds, once defaulted, can vary widely depending on their size relative to other securities within the structure as well as the underlying collateral supporting the bonds. The case study illustrates how LS ratings, which are assigned to performing securities rated in the single-B category or higher, indicate the amount of additional losses after credit enhancement is exhausted that would cause a bond to incur a 100% loss. LS ratings allow for a comparison of the loss potential risk across bonds from various deals or asset classes and are a relative indicator of the potential RR.

RRs reflect Fitch's estimate of the absolute dollar recovery potential once a bond has become distressed or defaulted and downgraded to triple-C or lower. The RRs calculated for the sample transaction as well as all US RMBS securities apply the same methodology and assumptions used in Fitch's surveillance of prime, Alt-A and subprime RMBS transactions.

RMBS

Perma funding share purchased

HBOS has asked Moody's to assess the impact on the ratings of the Permanent master trust notes, following the purchase by the seller of a portion of the Funding 1 share of the trust property. The rating agency says that, in its opinion, the purchase of the trust property does not impact the current ratings assigned to any of the notes.

The Class A notes of Perma 4 (Series 4), 5 (Series 4) and 7 (Series 3) were scheduled to pay down part of their outstanding principal balance on 10 September. However, due to prevailing CPR levels, the trust did not accumulate sufficient principal to make the payments on this date. Therefore the seller has chosen to purchase approximately £119m of the Funding 1 share of the trust property in order to make up for the shortfall and enable the notes to amortise as scheduled.

In Moody's opinion this purchase is, in this instance, rating-neutral since: no triggers are breached as a result of the notes not following their scheduled amortisation at this date; the legal final maturity dates for the above notes are in March 2034, June 2042 and September 2032 respectively; (iii) the weighted average note margin in Funding 1 is only negligibly impacted by the purchase; and although the purchase results in a small increase in the seller share of the trust property, currently 27%, there is already little prospect of a breach in the required minimum seller share, currently 7.59%, in the near term.

The step-up dates for the notes are March 2011, June 2011 and December 2011 respectively. A stop substitution trigger would be caused by a failure to pay down the notes by this later date, the agency notes.

SIVs

SIV auction to entail six lots

Victoria Finance's US$8.4bn portfolio is scheduled for liquidation on 25 September, with capital noteholders and other interested parties invited to bid for the SIV's assets. The process will effectively entail 12 auctions, as there are six different lots available for bid, each with a transferable and non-transferable portion (NTP) of assets.

Each lot comprises 15 different asset buckets, divided between ABS, aircraft ABS, ABS CDOs, CMBS CDOs, corporate CDOs, synthetic CDOs, Trups CDOs, high yield corporate bonds, investment grade corporate bonds, non-US ABS and RMBS, first-lien RMBS, second-lien RMBS, small balance CMBS, small balance loans and student loans. Buyers can bid for full lots, by asset bucket or both. If the lot bid is higher than the combined total bid for each bucket, the lot bidder wins; if not, assets will be awarded on a bucket-by-bucket basis.

Due to minimum denomination issues, the NTP of assets will be placed in a trust with Deutsche Bank Trust (the collateral agent), with all cashflows flowing through the trust to the auction winner. Buyers can bid for both transferable portion and NTP or either.

Stone Tower Debt Advisors is the auction agent. Stone Tower Capital assumed management of the SIV from Ceres Capital Partners in early 2008.

Technology

Vendor adds CLO coverage

CDO Software has expanded its coverage into the CLO market and signed up Pearl Diver Capital. The investment firm will be using the CLO module within the CDO Director platform to manage its CLO funds.

CDO Software now provides portfolio management capabilities across asset classes, including: synthetic CDOs, CLOs, loans, bonds, CDS, LCDS, credit indices and credit funds. CDO Director has new CLO-specific functionality, including a pre- and post-trade compliance engine, waterfall modelling and editing capabilities and a cashflow monitoring tool.

Additionally, clients can drill down and manage exposures across asset classes at both a portfolio and fund level. Automation of data and calculations, together with a full audit trail ensures that operational risks are mitigated, the firm says.

Technology

Analytics platform expands asset coverage

The ABSXchange structured finance analytics platform has been upgraded with a complete cashflow model library for all UK master trust deals, as well as increased, comprehensive coverage of EMEA CLOs and Australian RMBS. The latest series of enhancements enable users to create hypothetical collateral pools for more robust cashflow projections and to aggregate cashflows at the portfolio level, according to S&P.

Operations

Loan modifications by servicer

Chris Flanagan, head of global structured finance research at JPMorgan, examines the differences in loan modifications undertaken by the top 12 servicers

We revisit loan modifications in subprime RMBS, examining differences between the modifications done by the top 12 servicers by outstanding subprime balance (Table 1). Modifications per month peaked for most servicers in the beginning of this year, but have decreased sharply in the last three months.

 
Table 1

Chart 1 and Chart 2 show the modifications per month and the cumulative modifications since the beginning of 2008 for the top subprime servicers. Option One and Ocwen have clearly modified the most loans, although the pace of Ocwen's modifications has decreased very sharply lately.

Chart 1

Chart 2

Though the number of new modifications has been decreasing, the quality of modifications (as measured by payment reductions for the borrower) has been clearly increasing for most servicers. Earlier modifications had a higher proportion of capitalisations, which often led to payment increases, and thus no actual relief. Chart 3 shows the percent of modifications with more than 10% monthly payment reduction for borrowers, grouped by half-year periods.

Chart 3

For most servicers, this percentage has improved in 2009; very significantly in some cases, such as WaMu (Long Beach), Wells Fargo, Saxon and Litton. The notable exception to this trend is Chase, where this ratio seems to have decreased from 61% in first half of 2008 to 41% in 2009 so far.

Since the current trends are more relevant, we break down the modifications done in 2009 by these servicers by various criteria. Table 2 shows the distributions of modifications by the MBA status of the loan in the month prior to modification.

 
Table 2

Chase and Litton seem to be targeting borrowers across the delinquency spectrum and have a much higher proportion of current borrowers being modified. Almost all the other servicers concentrate on the 90+ delinquency bucket, which accounts for 40%-80% of their modifications. Litton, Saxon, Ameriquest and Option One have one-quarter of their modifications coming from foreclosure inventory.

Table 3 shows the distribution of the actual types of modifications attempted. Rate modifications, generally with capitalisation, are the most popular modification type.

Table 3

Principal forgiveness is the least popular, with only Litton applying principal forgiveness on a significant scale, and even including a rate modification along with the principal reduction in many of them. Forbearance is also not very frequent, and only HomeEq and Litton have more than 10% forbearance modifications.

Countrywide, National City, Ameriquest and Option One are still doing a majority of pure capitalisations, which are not helpful to borrowers, as evident from Table 4, which shows the distribution of payment reductions for the various modification types. Capitalisations almost never lead to any payment drops and lead to payment increases in 36% of cases.

Table 4

On the other hand, rate reductions and principal forgiveness (together) lead to the greatest payment relief for borrowers. Forbearance has also proved an effective technique in reducing borrower payments.

Finally, we look at the loan balances and CLTV ratios of the modified loans in Table 5 and Table 6. EMC, Ocwen and WaMu have targeted a larger proportion of low-balance mortgages, but the majority of modifications have been for the more expensive homes in the subprime sector.

 
Table 5

Table 6

Chase, Litton, Ocwen and Ameriquest have a higher proportion of modifications for <80 LTV borrowers. The majority of modifications, however, have been for borrowers with >100 LTV, which is not surprising as approximately 53% of subprime borrowers (63% for 2006-2007 vintages) are underwater on their mortgages.

Re-delinquencies and re-defaults
Table 7 summarises the delinquencies and defaults on the modified loans, while Chart 4 shows the 60+ delinquency rate of modified loans by loan age since modification. Delinquencies have been rising very rapidly for the modified loans with 40%-75% of loans already in 60+ within a year after modification.

Table 7

WaMu and Countrywide are the worst performing among the servicers. If we look back at the modification breakout tables above, these two servicers modified 60%-65% of the loans from the 90+ delinquency bucket, and 85%-95% of the modifications were capitalisations (though most of them also included rate reductions for WaMu); WaMu and Countrywide also had the lowest payment reductions in their 2008 mods (WaMu has ramped up the payment reductions significantly in 2009, so future performance should be better). On the other side of the spectrum, Chase and HomeEq have the lowest delinquencies among the servicers on modified loans.

Chase is helped by the large number of modifications from the current and 30-day buckets, high proportion with low LTV ratios, low proportion of capitalisations and the fact that 80% of its modifications led to payment reductions. For HomeEq, the relative good performance is explained by 51% of modifications with >20% payment reductions (overall 67% had payment reductions).

Litton is an outlier here; though its modification portfolio is similar to Chase (large payment reductions, a high number from current borrowers, a majority with low LTVs), 60% of its loans are seriously delinquent within a year of modification. In comparison to the 60+ delinquency pipeline, only a small proportion of modified loans have been liquidated.

For most servicers, the cumulative default is in the 1%-3% range, except for Litton and National City, which have liquidated 5.5% of their modified mortgages. For most servicers, severities on modified loans are ranging in the 55%-65% range. WaMu, Ocwen and EMC are seeing severities higher than 70%; these three also have the lowest loan balances on modified loans.

© 2009 JPMorgan Securities. All rights reserved. This Research Note is an excerpt from 'ABS Fixed Income Market Strategy', first published by JPMorgan on 28 August 2009.

Trading

Trading ideas: energised

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on Talisman Energy Inc

Signs of life in the natural gas market sparked our interest in the energy sector and we make an outright bond recommendation. When making such buy recommendations, we like to find issues that have both fundamentally and technically positive attributes and Talisman Energy's 7 3/4s of June 2019 is a perfect candidate.

As of its latest earnings report, the company's net debt dropped dramatically due to non-core asset disposal and its interest coverage level remains one of the best amongst its peers. We believe Talisman's credit spread will outperform and the negative basis of the 2019 bond provides an additional boost.

Talisman Energy strengthened its balance sheet after disposing of non-core assets during the first half of 2009. The company cut its net debt from US$3.9bn down to US$2bn. Its current cash balance is US$2.3bn against total debt of US$4.3bn (see below exhibit).

Even with such a relatively sizable debt load, the company's total interest expense for the year will only be roughly C$180m. With LTM EBITA well above C$6bn, Talisman's interest coverage level continues to be the best amongst its peer group. Talisman's interest coverage factor ranks as the absolute best based upon our decile ranking system used within the context of our quantitative credit model (see below exhibit).

We see a 'fair spread' of 45bp for Talisman Energy's five-year CDS due to its interest coverage, margins and liquidity factors (see below exhibit). A company's traded CDS spread is related to bond spreads; therefore, the positive view on Talisman's CDS is directly applicable to the z-spread of its June 2019 bond.

 
If its CDS converges to its expected spread, then we expect the bond to rally as well. However, this is only the first prong of potential bond outperformance.

At a price of US$116.50, the bond's z-spread is 218bp. Given Talisman's current CDS curve (five-year at 85bp), the bond is US$10.40 cheap to fair value with a bond-CDS basis of -123bp.

The average basis for similar tenor bonds from the energy sector is only -50bp; therefore, even if Talisman's credit spread does not converge to our expected spread, we believe over time the basis will tighten, leading to bond outperformance. The long duration of the bond also provides increased exposure to the tightening of the basis.

Position
Buy US$10m notional Talisman Energy's 7 3/4s of June 2019 bond at US$116.50 (T+260bp, Z-sprd 218bp).

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).