Contents

CLOs

New avenues

Can leveraged loans find investors away from CLOs?

High yield bond issuance has outstripped leveraged loan issuance by almost two to one year-to-date - a reversal of pre-crisis activity. With the natural investor base for leveraged loans - CLOs - unlikely to return soon, other product avenues are being explored.

"I have never been convinced that leveraged loans have a pure buyer outside of the structured products marketplace, notwithstanding yield profiles we saw in 2008," says Jason Pratt, md at Peritus Asset Management. "In normal markets, it's hard to see the value in a total return context, given what investors have typically expected in terms of price volatility. As spreads got ridiculously tight and second- and third-lien issues came to market, we couldn't see a reason to participate in our total return efforts - or frankly our CDO issues either."

He continues: "Now the market is pursuing secured floating rate notes, as well as fixed rate debt, as issuers look for ways to refinance out of their existing leveraged loans, with significant maturities on the horizon and concerns about economic recovery. They are paying up for this transition and, with questions about inflation, you have to think about the cost for issuers and whether the company can cope with that growing expense, and for how long."

In a recent report published by DBRS highlighting the discrepancy between high yield bond and leveraged loan issuance, the analysts also point to the role that inflationary pressures will play. "Even though the high yield bond market yield of 9%-10% may seem high in the current low-rate environment, borrowers anticipating inflation - once the effect of deficit spending and monetary growth kicks in - may view it as a prudent long-term bet," says the rating agency. "If this view is correct and we end up in a high-inflation environment for years to come, then this is a one-time opportunity to lock in relatively low rates."

Another reason for high yield bond issuance being chosen over leveraged loans is the cfo 'peace of mind' issue, the agency continues. "After a year in which liquidity was often hard to come by at almost any price, many borrowers are delighted to lock up funding at a fixed rate for ten years or so. Those who believe credit markets will snap back to normal quickly see this as merely a temporary factor. Those who see a longer-term liquidity crunch believe this will tilt the ground towards bonds more permanently."

DBRS adds that, once rates are high - and expected to stay there - the playing field between fixed income and floating rate lending will be level again, since the high rates will be built into the entire structure. "In fact, if the high inflation becomes a constant, then eventually the long-term fixed rate market will likely atrophy and short-term floating rate will become the only real alternative for most borrowers."

The agency notes that there is, however, a good argument that the natural investor base for leveraged loans - CLOs - will return at some point. "Unlike many of their cousin CDOs, CLOs are relatively straightforward investments, for which there is a natural market of investors seeking an 'equity-like' return from a debt based vehicle," it says.

But Pratt is less optimistic. "Changing business models and questions about ratings methodology, liquidity and market valuation have combined for a general lack of demand for financially-engineered 'triple-A', which leads me to conclude that the likelihood of CLOs returning is remote," he says. "I wish it wasn't the case, but I think people in the business all understand it isn't the concept of structured products that is the problem. I don't think it would be unreasonable to suggest that subordination levels would have to be much more significant and the cashflow necessary to drive lower leverage in the capital structure much higher."

He adds: "Nobody wanted to have to sell much mezz or sub debt out of those deals when markets were strong. What would that theoretical return need to be for an investor to put up equity in a CLO today?"

Assuming the CLO market does not return in any meaningful way, ETFs and closed-end funds have been touted as a potential new investor base for leveraged loans. However, these products come with high distribution costs, particularly in the case of closed end funds.

The DBRS analysts also question whether the equity risk associated with investing in closed-end funds - which are primary vehicles for retail investors to access the loan market - scares off potential investors. Whether additional open-end funds, which appear more user-friendly to many smaller investors, will enter this market is debatable as well.

"While there has certainly been yield in the leveraged loan asset class, coupon cashflow is very important in these vehicles," says Pratt.

He confirms that Peritus Asset Management is considering the development of products in these channels, either through actively managed ETFs or some form of a term trust structure. "Our focus in high yield bonds can provide not only attractive yields over time, but also a significant dividend income from the higher coupon cashflow. [However] leveraged loans issued over the past several years would not have a coupon profile that would be remotely attractive for this more retail-oriented market in my opinion."

Pratt concludes: "Creating products like these address issues such as transparency and liquidity, as these structures tend to be listed on an exchange, such as the NYSE. We think that these products are a fantastic way to get our strategy into a new market and fulfil a need of investors in the wake of 2008. We are focusing on a message of getting paid for the risk you are taking as an investor. We think our strategy does just that and we are excited about creating opportunities to deliver with these potential new initiatives."

AC

Technology

Granularity rules

Market-led initiatives to further liquidity risk management goal emerge

Regulatory authorities have identified liquidity risk management as a key issue in the aftermath of the financial crisis, but so far there has been little guidance about how to even measure it. Nevertheless, market-led initiatives designed to help address this issue are emerging.

"Liquidity risk is a term that's so vague it conveys hardly any meaning. As good as your estimate may be, there is always uncertainty about an entity's true default probability," says Donald van Deventer, Kamakura Corporation chairman and ceo.

He adds: "Then there is also the fundamental meaning of liquidity to consider: the risk of not being able to reverse a transaction. We've heard many complaints from issuers looking to execute and the bids suddenly disappear. The market has less depth than many participants expected - although the recent dramatic spread tightening has helped its tone."

A number of challenges exist in terms of measuring liquidity in the CDS market, in particular that traded data is proprietary or incomplete. However, at least two vendors have recently begun to make progress in this area.

Thomson Reuters and Kamakura Corporation last week announced their creation of a market premium ratio (see last week's issue), which helps identify the portion of a traded CDS spread that indicates actual default risk and the portion of the spread that reflects other factors, such as liquidity. "CDS spreads capture much more information than pure default risk, so the tool is a way of parsing these risks out into separate pieces," explains van Deventer. "We're trying to help end-users figure out how to achieve the largest premium per basis point of default risk, which will eliminate to some extent the current noise in CDS pricing."

Expected loss is generally assumed to account for 100% of a default swap spread, but 45 other variables - in addition to the five-year default probability - are statistically significant in predicting CDS levels, according to van Deventer. Among these variables are the size of the underlying company (because it influences the size of the spread) and its jurisdiction (Japanese companies, for example, typically have narrower spreads due to the country's 'main bank' system and Japanese institutional investor preference for Japanese counterparties).

Meanwhile, Fitch Solutions has developed a framework for measuring relative liquidity across all credits, regions, credit types and through time. It is designed to help risk managers pin-point which of their assets are riskiest from a liquidity perspective to help meet pending Basel Committee guidelines.

Under this framework, Fitch identified three factors that drive liquidity in CDS: inactivity on a given name, the scaled bid-ask spread and the dispersion of mid quotes across market makers (the more dispersion there is the less liquid a name is). "Used together, these factors can create a liquidity score," explains Mirela Predescu, associate director, quantitative research at the firm. "This is not the same as a liquidity rating, however, because it doesn't indicate a long-term view of an entity's ability to fund on a continuing basis."

Liquidity scores can be used to derive liquidity risk premiums as spread risk components. The liquidity spread component in turn can be analysed historically to construct liquidity risk measures and, ultimately, set corresponding capital reserves.

Key insights from Fitch's CDS liquidity model indicate that names at either end of the ratings spectrum are relatively less liquid than those in the middle of the spectrum. "This makes sense because there are more imbalances at the ends of the spectrum due to buying and selling pressures," notes Predescu.

Equally, the quality of a name is shown to matter in times of stress. "During the financial crisis, there was a significant flight to quality, with liquid names becoming more liquid and vice versa. This finding is important for risk managers in terms of anticipating which names become stressed in times of crisis," Predescu adds.

Van Deventer concludes: "Looking at default risk from a truly granular perspective is good for investors and bad for Wall Street. The more information available about what's driving default probabilities, the more investor uncertainty is reduced, which in turn brings more depth to the market."

CS

Investors

Euro benchmark deals price

Two eagerly anticipated transactions have launched and priced in the European market - Permanent 2009-1 and VCL 11 (SCI passim). An additional auto loan ABS hit the market in quick succession.

The Perma £1.65bn five-year Class 2A notes priced at 170bp over three-month Libor, with a slight discount to par (99.551%). The €750m five-year Class 3As were issued at par at 170bp over three-month Euribor. Margins on the retained £1.65bn Class 1A notes have not been disclosed.

Meanwhile, the VCL 11 €500m 1.4-year Class A notes came at 110bp over one-month Euribor and the €19.1m 1.8-year Class Bs at 250bp over. Both tranches were upsized slightly from previous guidance.

The deals are said to have respectively attracted participation from 56 investors across 16 countries and 63 investors across 17 countries.

ABS analysts at SG describe the size and number of bids for the HBOS issue in particular as "remarkable" - although the participation of certain new buyers, who viewed the deal more as secured issuance from a bank at an attractive level, may be a one-off event. "Indeed, the particular structure of the senior notes, including a repurchase agreement from Lloyds after five years, triggered a lot of interest from non-ABS buyers," the analysts note. "Uncertainty over the depth of the ABS investor base may explain this extra cautiousness by originators and arrangers. However, the market has come a very long way in just three months."

Deutsche Bank followed hot on the heels of the Perma and VCL pricings, launching the €507m Globaldrive 2009-C, a German auto loan ABS. The triple-A rated Class A tranche is sized at €467.35m and priced at 235bp over one-month Euribor with a WAL of 2.2 years. The tranche was pre-placed.

The Class B and C tranches of the deal were both retained, pricing at 5% and 10% respectively. The deal was priced to a 10% CPR and a 10% clean-up call. Deutsche Bank acted as lead manager and bookrunner, and FCE Bank is seller and servicer of the assets.

The European Securitisation Forum (ESF) has welcomed these pricings, pointing out that the deals provide an important indication as to the priority which many issuers place on the restarting of the securitisation market. Rick Watson, md and head of the ESF, says: "This initial return to the market by some of the best-recognised names in the European securitisation primary market, which follows a recent compression in spreads, is a positive initial step in the right direction. As recently stated by a number of public institutions, it is important to recognise the many benefits associated with sound securitisation."

CS & JA

Investors

Fortis non-call sparks extension risk fears

Fortis Bank Nederland has announced that it will not call the Beluga Master Issuer 2006-1 Class A1 notes on the step-up date, 28 October. The move follows a similar decision in respect of Delphinus 2003-1 last week and has sparked concern about extension risk in Dutch RMBS.

Securitisation analysts at RBS suggest that this appears to be the start of a trend for transactions sponsored by the part of Fortis now owned by the Dutch government agency.

The pressure on entities that have received government aid to not call their bonds first became apparent in the UK with RBS' announcement that it will not call four of its bank capital securities following regulators' objections, according to ABS analysts at Barclays Capital. In particular, the UK's FSA had instructed the part state-owned bank not to call the notes after the European Commission had made it clear that state aid to banks should not be used to repay equity or subordinated debt.

"This tiering seems to be further emphasised with SNS Bank (which has received no capital injection from the government) recently stating that it will call the HERMES VI transaction," the BarCap analysts note. Based on the assumption that entities which have received a form of government aid are unlikely to call the transactions on the call dates, they suggest there are high risks of non-call with the EMS, Match, Shield, Saecure, Delphinus, Candide, Beluga, Collier, Solid and Stichting Memphis programmes.

Fortis says that investors will be offered alternatives to the non-call. These are anticipated to be in the form of a tender offer.

The BarCap analysts estimate that the extension on the affected Delphinus transaction ranges from 15 years for triple-A bonds to as much as 73 years for triple-B bonds in a 5% CPR scenario. A 0% CDR rate is assumed, as defaults aren't expected to rise significantly in Dutch RMBS.

CS

Advisory

Supporting change

Rizwan Hussain and Pawan Malik, principals of Navigant Capital Market Advisors – the capital markets advisory arm of Navigant Consulting in the UK – answer SCI's questions

Q: How and when did Navigant Consulting become involved in the structured credit market?
PM: Navigant Consulting is a US-listed firm, with around 2000 consultants focused on the health, construction, energy and financial services sectors. Our business incorporates financial analytic and litigation support, investigations and operational consultancy. The firm has office across North America and in the UK and Asia.

Navigant's financial analytic advisory team in the US, which was augmented by the acquisition of an economic consulting firm called Chicago Partners two years ago, has been advising clients in the financial services space for many years. As the markets evolved, so did our ability to advise clients on structured products and derivatives. In the past three years, we have been involved in advising clients on structured products and derivatives.

The structured products and derivatives solutions (SPDS) practice was set up as an extension of our US practice to help clients with issues arising from the financial crisis. Our role is to provide independent valuation of complex financial products, risk management and restructuring solutions to mitigate derivative and counterparty risk, and analytical support in numerous disputes and litigation cases.
Pawan Malik

Our clients include major banks struggling with legacy debt portfolios, US and European central banks that have provided guarantees or set up bad banks to deal with these assets, the fund management industry and their legal counsel.

RH: We also set up Navigant Capital Market Advisors (NCMA) to provide advisory in the real estate and distressed areas across traditional structured and alternative investments. NCMA is currently undergoing the FSA approval process and we expect this to be in place in the first quarter of next year. NCMA also provides strategic wholesale solutions and execution capabilities with respect to acquisitions, restructurings, divestitures, capital raisings and private placements of debt and equity for the European traditional and structured credit space.

Q: Which market constituent is your main client base?
RH: We've found that clients are interested in not only valuation, restructuring and litigation expertise, but also practical solutions to their problems. For example, helping lenders to divest their non-core assets or setting up operational infrastructures for first-time investors in the space.

PM: There are two different types of sellers in the market at the moment. First are those that have been told to divest non-core assets by their credit committees and those who can either 'park' their assets somewhere else with no restraints or simply remain in the structure hoping the real price will move up to their marks.

Q: How do you differentiate yourself from your competitors?
PM: Our approach is to house a variety of experts, including bankers, traders, structurers, forensic accountants, risk managers, valuations and economics professionals, operational strategists and discovery professionals under one roof so we can work with our clients across the entire lifecycle. Unlike a number of start-up boutiques, we can call on a wide range of resources. The aim is to be a full-service solutions business.

Q: What, in your opinion, has been the most significant development in the credit market in recent years?
RH: The most significant event was the onset of the subprime crisis and tied in with this is Lehman's collapse. Leverage, as well as aggressive marketing and structuring of increasingly sophisticated product, meant that their impact spread globally.
Rizwan Hussein

PM: I agree; in hindsight, the straw that broke the camel's back was the structured credit assets linked to US subprime. There was a general lack of understanding of how complex products work and very few investors really understood the 'fat tail' risks they were taking on.

The Lehman bankruptcy is also throwing up some interesting issues. For instance, it seems that the courts may be leaning towards contract law becoming subordinate to insolvency law. This will change the face of the securitisation market in particular, as rating agencies have relied upon contractual subordination clauses to preserve the rating on notes.

Q: How has this affected your business?
PM: There is a lot of interest amongst clients to use our services as they find the unique skill-sets especially useful at a time like this.

Whereas the US is a more litigious environment and contracts between two parties are open to interpretation in courts, the UK courts have generally frowned on mis-selling claims and most disputes are historically dealt with in-house. However, looking at our work flow and from discussions with senior litigation counsel and clients recently, it appears that a fair amount of work is building up in Europe now.

Q: What major developments do you need/expect from the market in the future?
PM: I'm not sure that the system has felt enough pain yet; financial markets continue to be wrapped in cotton wool, but deep structural change is required. Reform proposals are constantly being watered down and are introduced in phases, which just seem to prolong the comfort zone unnecessarily.

It is also not certain that regulators will be able to force the industry to change. In any event, real regulatory change takes a long time to make any difference, as evidenced by the introduction of the Glass-Steagall Act in the 1930s.

Nevertheless, big institutions could be restricted to be principal and agent at the same time because it is difficult to remain independent.

Equally, investors should spend more time doing due diligence on transactions. Because of the wall of money entering the ABS market in 2006/2007, deals were getting done in days rather than weeks. But now there is greater awareness to analyse and model transactions correctly.

RH: Everyone's talking about 'green shoots' at the moment. But I'm not so sure that the market is on the road to recovery yet - investors are still very cautious and it is difficult to see how sustainable a recovery can be, given current fundamentals. There seems to be a disconnect between what the markets are predicting and what is happening in the real world.

I don't expect the new issue ABS market in Europe to begin thawing until a benchmark RMBS master trust deal is successfully placed with third-party investors. But this will first entail a combination of different factors coming together, including further spread tightening and calmer market conditions.

PM: It will be interesting to see how the banks will continue to fund themselves once the central bank guarantees expire soon. Although the banks are flush with liquidity, it is unclear how much of this will be used to buffer capital against potential write-downs versus lent out to corporates to fund capital investment. I reckon 2010 will be a very interesting year in the markets.

CS

Advisory

Capital markets advisory adds two

Merriman Curhan Ford Group has hired two senior investment bankers to help grow its investment banking platform and strengthen the firm's expertise in capital markets advisory, structured finance and private placements.

Andy Arno, the firm's new vice chairman of the investment bank and head of capital markets advisory, was most recently the ceo of Unterberg Capital. Arno was an md at Collins Stewart. In July 2007, Collins Stewart acquired C.E. Unterberg, Towbin. Arno joined C.E. Unterberg, Towbin in 1990 as an md responsible for capital markets and was appointed ceo in 2006.

Jonathan Lowenberg, Merriman's new md and co-head of structured finance and private placements, was most recently at Kaufman Bros as an md and head of private placements. Lowenberg led the origination and execution of private placement transactions within alternative energy, digital media and internet industry sectors.

Investors

Asset management firm expands

GoldenTree has expanded its team with a number of new hires.

Most recently, Yung Lee has joined the firm as a senior advisor for the team. Lee has over 25 years' experience across many facets of the financial services industry, including portfolio management, asset allocation, product development, sales and trading, and marketing of investment management products.

Prior to this appointment, Lee served at Kyobo Life Insurance in Seoul as a senior adviser to the chairman. While at Kyobo, he was also a senior evp and cio and oversaw the firm's investment management division with US$39bn AUM.

Brian Pennington has been appointed director of risk and quantitative resources at GoldenTree. He was previously a managing partner of Rock Ridge Advisors, a thematic global macro fund. He was responsible for all aspects of management, including capital commitment, quantitative resource development, risk measurement and business operations.

Meanwhile, James Kelly, portfolio manager, joined the firm in August. Kelly is responsible for researching, evaluating and recommending investment opportunities across the capital structure for GoldenTree's European investments. Prior to GoldenTree, he was an md at Greywolf Capital Management's London office, where he helped to establish a European presence and managed long/short European investments for the firm's distressed and special situations fund, as well as the firm's CLO fund.

David Richards also joined the company in August and has been hired as a research analyst. Richards will be responsible for security research and idea generation for the financials sector, including banks, insurance, investment banking, specialty finance and asset management. Prior to this appointment, he served at Citadel Investment Group in New York, where he was a senior analyst for the fundamental credit business.

Investors

Asset manager adds in credit portfolio management

Aviva Investors has appointed Simon Blundell as a senior portfolio manager in credit, as part of the firm's efforts to increase its capabilities in credit derivatives. The firm says it is looking to bring others on board with experience in such hedging techniques.

Blundell, who is joining Aviva on 12 October 2009, will be part of the management team for active credit funds. He will report to Mark Wauton, head of credit at Aviva Investors.

Wauton says: "We are delighted to have someone of Simon's calibre onboard. His past experience managing both long and short portfolios and his high profile in the UK credit market are great assets to our team. Simon's arrival further broadens the set of skills available to the team. We expect him to be a senior figure in assisting in the build out of our investment process as we continue to implement cutting-edge credit fund management techniques in order to source sustainable levels of out-performance in a changing credit landscape."

Blundell joins Aviva from Fortis Investments/ABN Amro Asset Management, where he had worked in a variety of roles - the most recent being head of investment grade credit. Simon has extensive management experience of both benchmarked and absolute return funds, having previously run various long/short, carry and mean-reverting strategies alongside traditional long-only portfolios.

Legislation and litigation

Partner hired to business reorganisation group

Schulte Roth & Zabel has appointed a new partner to its business reorganisation group, based in the firm's New York offices. Brian Pfeiffer joins from Fried, Frank, Harris, Shriver and Jacobson, where he was partner.

He has experience in all aspects of in-court and out-of-court restructuring of financially distressed businesses, including representations of corporate debtors, creditors' and equity committees, bondholder committees, lenders, and purchasers and sellers of distressed assets and businesses. Pfeiffer also has experience representing companies in connection with restructurings and sale transactions.

Operations

TALF compliance practise established

Ian Reid has appointed former US SEC branch chief Alicia Marshall as md. She will be responsible for leading the firm's capital markets and asset management compliance practice.

Marshall will be joining Thomas Batties, currently an md at Ian Reid, in launching the firm's capital markets and asset management compliance practice. This practice area is specifically designed to offer extensive, thorough counsel to asset management firms, investment funds and financial institutions participating in the US Treasury's toxic asset and economic recovery programmes. Services will include helping clients develop a compliance programe, respond to regulator's inquiries, navigate relevant agencies and provide legislative intelligence and analysis on issues critical to meeting Treasury's economic recovery goals.

Jarvis Stewart, chairman and managing partner of Ian Reid, says: "We are very fortunate to have Alicia join our firm. Her depth of knowledge and stellar reputation in the compliance and financial regulatory arena is well-known. With banks, asset management firms and other financial institutions struggling to understand and meet the transparency guidelines detailed by TARP, TALF, PPIP and other Treasury programmes, we are confident our team can provide valuable insight and strategic counsel."

Prior to joining the firm, Marshall was the chief compliance officer for RLJ Select Investments, a hedge fund of funds formed in joint venture with Deutsche Asset Management (DeAM).

Ratings

Ratings veteran hired for Canadian market

Fitch is expanding its focus on ratings in Canada by hiring Charles Gamm as a senior director to head its Canada office. Gamm, who previously led Moody's structured finance efforts in Canada, will be based in Toronto and will focus on working with investors, issuers and arrangers to broaden Fitch's involvement in rating major corporations and financial institutions, as well as important structured finance sectors like ABS and ABCP.

Doug Murray, group md and global head of structured finance business development at Fitch, says: "Fitch is very pleased to bring someone of Charles' skill set, background and perspective on board. Charles' addition reflects Canada's position as an extremely important player in the global capital markets and our commitment to increase Fitch's presence in this region."

Gamm was a 10-year veteran at Moody's, with the past six years spent in its Canada office following a four-year stint in London. Prior to his time at Moody's, he worked at Citigroup in Toronto, Germany and London, with a focus on commercial real estate and CMBS.

RMBS

RMBS third-party review approval won

Allonhill has won approval from S&P to perform third-party reviews on RMBS. The certification means that Allonhill is an approved contractor to perform due diligence on publicly traded RMBS. The programme was designed by S&P to help companies identify third-party review firms that meet standards of accuracy, accountability, transparency and independence.

The months-long review by S&P explored aspects of Allonhill's business, including experience, systems, infrastructure and policies. In addition, a recent load test by Web Performance verified that Allonhill's systems can handle the review of one million loans by 300 simultaneous users spread across the country with no impact on performance.

Structuring/Primary market

Bank hires structuring head

Paul Levy has joined UBS as md and European head of FICC structuring. He was previously a partner at Prytania Investment Advisers and before that head of exotic credit structuring (EMEA) at Merrill Lynch.

Structuring/Primary market

Corporate risk solutions team expanded in Asia

The Royal Bank of Scotland has made key appointments in its corporate risk solutions team in Asia Pacific.

Inseok Cha has been named head of corporate risk solutions for Korea. He will be responsible for leading the build-out of the corporate solutions team in the delivery of the bank's risk management products across the entirety of its corporate client base. This includes providing physical and derivatives solutions to corporate and public sector clients across the key asset classes, such as FX, rates, credit, equities and commodities.

He will report to John Cummins, head of corporate risk solutions for Asia Pacific, and locally to Sy Choi, head of GBM for Korea.

Also joining the corporate risk solutions team in Korea include Jong Joon Lee and Seung Hyun Park, who will both take on the roles of corporate directors, corporate risk solutions for Korea, reporting to Cha.

Cha and his team join RBS from Barclays Capital, where he was an md and head of FX corporate/derivatives risk management. Prior to Barclays Capital, he held senior sales positions at Bank of America, JPMorgan, Morgan Stanley and Deutsche Bank.

In Singapore, Ron Pathak also joins RBS from Barclays Capital as senior director of structured risk solutions reporting to Mathew Simpson, head of structured risk solutions, Asia Pacific. In his new role, Pathak will provide multi-disciplinary liability hedge solutions for event-driven transactions, emanating predominantly from RBS' structured finance and investment banking activities.

Technology

MBS analytics platform unveiled

MBS Data has launched its new MBS deal and loan-level data and analytics platform. The platform has over 6,000 MBS deals containing loan-level data, deal-level data, prepayment speeds, loss severities, capital structures, loan modifications and tranche level data. The offering has also compiled 10 years of loan performance history.

MBS Data was founded by managing partners Thomas DeLorenzo and Ted Wahlstrom. The pair has spent over 20 years in the mortgage data and analytics marketplace, with firms First American, Basis100 and Mortgage Risk Assessment Corportion (MRAC).

Technology

Contract analysis tool strengthened

docGenix has joined Mark Logic Corporation as a technology partner in launching the online application, Synopsys. The legal risk management solutions company had previously implemented MarkLogic Server as the delivery mechanism for XML content generated by its inSight service in July of this year.

inSight transforms into XML the legal, credit and operational terms contained in the legal agreements that govern relationships between participants in global OTC derivatives markets. Synopsys gives subscribers the ability to access, search, analyse and report on the content of these complex and important legal agreements.

Michael Will, founder and chief technology officer of docGenix, says: "As a technology partner of Mark Logic, we are in a position not only to work closely with Mark Logic to ensure that our products operate together seamlessly, but also to help drive forward the development of what is already the industry's leading contract analysis tool."

Trading

Bank adds in securitised products sales

Bank of America Merrill Lynch has added a senior hire in securitised product sales. Michael Hokin will be based in New York and report to Bryan Weadock, head of Americas fixed income sales.

Hokin joins the company as an md and head of Americas mortgages and securitised product sales. He most recently was head of North American rates and global securitised markets sales at Citigroup, which he joined in 1997.

Trading

Portfolio trading platform established

Lighthouse Financial is expanding its institutional sales and trading operations by launching a global portfolio trading platform. The new platform consists of eight professionals that will be led by Christopher Foxall, head of global portfolio trading and partner, based in New York. The team will cover all areas of portfolio trading, including global fixed income execution, transition management, transaction cost and risk analysis, execution consulting and index- and event-driven research.

Foxall joins Lighthouse with twelve years of experience in global portfolio trading. Most recently, he worked for JPMorgan Chase as the md of global portfolio sales for the Americas.

He had previously held this role at Bear Stearns and continued in the position after the firm was acquired by JPMorgan. Foxall was given the task of integrating the two teams, technology and accounts.

Rob Weinstein, Lighthouse financial partner and head of institutional sales and trading says: "The addition of a global portfolio trading platform is a natural complement to our existing sales and trading operations, enabling our firm to provide even more value to institutional clients. Having worked with Christopher at Bear Stearns, his team uniquely takes a more consultative approach with customers and that has proven successful, and will further enhance the strategic expansion of the Lighthouse Financial offering to the buy-side."

In addition to Foxall, David Sauer and Art Ayzerov will be joining the firm as mds and global portfolio traders. Sauer brings extensive Latin American experience, which will be a focus of the group going forward. In addition, Louis Mancini will be joining as an md and head of portfolio technology.

The launch of the portfolio trading platform is the third trading group the firm has announced this year, having previously added a derivatives platform and prime services group.

ABS

Floorplan ABS ratings criteria clarified

Moody's has identified certain key factors which, where present, could support a top rating for senior tranches of floorplan ABS linked to a US auto manufacturer. In a special comment, the agency outlines how the lessons learned from the Chrysler and GM bankruptcies, as well as the addition of a backup servicer to the trust, affected its analysis of the Ford Credit Master Owner Trust Series 2009-2.

According to Moody's vp and senior analyst Felix Hu: "The financial condition and challenging market environment for US auto manufacturers had previously raised the level of uncertainty regarding the volatility of future performance of floorplan transactions to a place that was inconsistent with Aaa ratings."

Moody's issued provisional ratings on 23 September for US$1bn of Class A notes to be issued by the trust.

Hu adds: "We will continue to rate any future floorplan deals on a case-by-case basis. In this case, the presence of the backup servicer, the quality of Ford's vehicle portfolio and the evidence of Chrysler and GM's stable floorplan loan performance throughout their bankruptcies were among the factors that allowed us to conclude that the level of enhancement in FCMOT 2009-2 is sufficient to justify Aaa ratings on the bonds."

ABS

Canadian credit card performance deteriorates

The performance of Canadian credit card debt continued to deteriorate in the second quarter of 2009, with charge-off rates reaching a new record level of 4.8%, according to Moody's latest credit card indices for the country. Moody's expects charge-offs to continue to worsen in the coming months, though at a relatively slower pace than earlier in the year.

Moody's vp and senior analyst Sumant Inamdar says: "The intensity of the current recession has led to charge-offs that have exceeded previous cyclical highs by a relatively wide margin. So far, this deterioration has not translated into many rating actions for the Canadian credit card sector. Nevertheless, if charge-offs rise more steeply than expected, then there may be negative rating consequences for the related credit card ABS securities."

The rating agency says that a surge in the number of personal bankruptcy filings underscores the persistent weakness in the economy and the unemployment rate continues to rise. Trends in the unemployment rate and credit card charge-offs are highly correlated.

The Canadian unemployment rate was 8.7% in August. Moody's current forecast calls for it to peak at approximately 9.6% in the second quarter of 2010, approximately when charge-offs should also peak.

With its rise to 4.8% in the second quarter, the Canadian charge-off rate index is up by nearly 60% from the year-ago mark of 3.07%. This is the tenth consecutive quarter of year-over-year increase for the index.

By comparison, charge-offs climbed 65% in the US to 10.45% from 6.38% a year earlier. The charge-off index for UK credit cards also rose sharply, to 8.71% from 6.57% a year earlier (up nearly 33%).

In Canada the delinquency rate was 2.82% in the second quarter, up from 2.29% a year earlier, but a slight improvement from the first quarter rate of 2.90%. By comparison, the US and UK delinquency rate indexes are more than twice as high as that in Canada, the agency says.

ABS

Unemployment hits Euro consumer ABS performance

Growing unemployment across Europe has had a negative impact on the collateral performance of consumer loan ABS, says Moody's in its annual European consumer loan ABS sector review.

Cher Chua, a Moody's avp/analyst and co-author of the report, says: "To date, the large majority of consumer loan ABS downgrades have occurred in the Spanish market, where unemployment is expected to rise to an average of 18.4% in 2009 and 20.7% in 2010, from an average of 11.4% in 2008. Rating actions were taken on seven Spanish consumer loan ABS deals in Q408 due to portfolio performance concerns. In addition, in July 2009, Moody's placed six previously downgraded transactions on review for further downgrade and placed three new transactions which closed in 2008 on review for downgrade. On 23 September 2009, Moody's downgraded all rated notes on one of the nine transactions placed on review for downgrade in July."

In the report, the agency says that it is in the process of re-evaluating its portfolio default expectations for eight Spanish consumer loan ABS transactions, where notes were placed under review for downgrade in July 2009.

Chua adds: "The review process takes into account unemployment growth (experience and expected), as well as current and expected levels of portfolio delinquencies. Moody's also anticipates potential further increases in delinquencies, and hence defaults, from unemployed borrowers who currently benefit from state unemployment benefits provided by the Spanish government for up to two years following job loss."

The rating agency believes that this dynamic may be allowing borrowers to continue making payments following a loss of income, thus delaying arrears from increasing immediately in line with unemployment trends. Carole Gintz, a Moody's vp/senior credit officer and contributor to the report, cautions: "However, if unemployment growth were to rise well above current projections, it is likely that portfolios will suffer higher defaults than anticipated and this could also lead to further ratings volatility in the sector."

The agency notes in the report that consumer loan ABS transactions in other
European jurisdictions are broadly performing in line with Moody's expectations. Sebastian Hoepfner, a Moody's associate analyst and co-author of the report, concludes: "However, despite the emergence of some positive signs in recent months as the recession shows signs of slowing, Moody's maintains a negative outlook for the consumer loan ABS sector as uncertainties remain and the impact of macro-economic stresses feed through to certain portfolios."

CDS

CDS spread reaction to rescue packages analysed

The BIS has published a report entitled 'Time to buy or just buying time?', which reviews the market reaction to bank rescue packages announced in six countries - the US, the UK, France, Germany, the Netherlands and Switzerland - between October 2008 and January 2009. The study distinguishes the impact on creditors as seen in the change of CDS spreads from the impact on shareholders as seen in the movement of bank stock prices.

It concludes that government interventions benefited creditors at the expense of shareholders, with bank CDS spreads narrowing around the announcements in all cases. Despite a brief positive reaction, bank stock prices continued to underperform in all countries except the US, where the favourable terms of the government support allowed bank stocks to outperform.

The paper measures the market reaction using an event study of the 52 largest banks in these six countries. From a systemic standpoint, bolstering the confidence of creditors was viewed as more important than protecting shareholders whose capital investment is designed to bear losses, according to the report. More weight is therefore given to the impact on CDS spreads when assessing the effectiveness of government interventions.

While bank CDS spreads widened relative to the market following Lehman's bankruptcy, these spreads recovered around the announcement of government rescue packages and continued to narrow over the subsequent weeks in all six countries studied. "We find that creditors anticipated the formal announcement of rescue packages, with bank CDS spreads outperforming the market following the rescue of key banks in late September and prior to the formal announcements in early October," the report continues. "Despite this anticipation, CDS spreads show a large reaction to the announcements. Creditors in banks that did not receive government capital injections or asset support reacted similarly to banks targeted by government actions, suggesting rescue efforts reduced the likelihood of a default across all banks on average."

Despite a brief positive reaction when the rescue plans were announced, bank stocks underperformed the market over the subsequent weeks in the six countries studied - led by the German, Dutch and UK banks. The stock prices of banks accepting government support significantly underperformed banks not receiving support, suggesting the receipt of government capital or asset support was viewed as a negative signal of the bank's health. However, while these results are clear at the level of the banking system as a whole, the results are mixed when looking at banks targeted by specific actions, the BIS concludes.

CLOs

Bank undertakes jumbo CLO buyback

Barclays Bank has repurchased a portion of the notes issued by Newfoundland CLO I and amended the terms of the transaction to broaden the eligibility criteria that assets have to meet to be included in the portfolio, modify the portfolio guidelines and change the covenant parameter tests.

US$4.05bn of the senior notes and US$12.16bn of the senior S-1 notes have been repurchased by the issuer at par plus accrued interest. The repurchase will be funded by the sale of the same par amount of assets initially backing the notes. As a result of this repurchase, the outstanding notional amount of the senior notes and senior S-1 notes will be reduced to US$12.55bn and US$4.3bn respectively, with the par amount of the portfolio reduced to US$19.998bn.

Moody's believes that these repurchases and amendments do not have an adverse effect on the ratings of the rated securities.

Newfoundland is a managed cash CLO backed by a portfolio of primarily senior secured and unsecured corporate loans denominated in multiple currencies. The portfolio is managed and was primarily originated by Barclays Bank.

CMBS

Pros and cons for CMBS share deals

Property acquisitions reported over the last two weeks suggest that the UK commercial property investment market is beginning to show some signs of revitalisation, Moody's notes in its latest Weekly Credit Outlook. Blackstone's purchase of a 50% share of the City of London office complex Broadgate is one such example (see last week's issue).

"These tentative signs of capital flow into UK commercial real estate are a credit positive for CMBS," says Alexander Zeidler, avp-analyst at Moody's. "However, the individual credits may be affected differently if 'share deal' structures are used."

Traditionally, an investor would purchase a property outright, which implies that the seller prepays the existing debt secured by this property. 'Share deals' involve the investor acquiring the property by purchasing the equity interest in the property holding company. As such, the property is purchased with debt attached.

A share deal structure is beneficial for the new investor as it allows for the acquisition of properties with a relative low equity outlay. The investor also receives debt financing often on more favourable terms than if the property was bought outright and refinanced.

Share deals can have a number of implications for a CMBS deal, according to Zeidler. For example, the change to the ownership structure of the equity interest could trigger a default due to change of control clauses in the loan agreement. A share deal can also be combined with a partial loan prepayment.

Arguably, it is in the best interest of the noteholders if the servicer waives a change of control loan default in return for a partial loan prepayment. This would be credit-positive for the affected loan as it rebases the loan metrics to the new reality of often lower rental cashflows and substantially lower values.

However, the impact on particular notes of CMBS transactions that include the affected loan is less clear-cut. For example, while the average credit quality of the securitised pool would typically improve, it can split the portfolio in terms of loan quality because share deals will often happen for the better loans in the CMBS pool - resulting in these loans potentially partially prepaying, while worse loans remain fully outstanding.

Zeidler notes that this 'adverse selection' may be mitigated if prepayment proceeds are allocated sequentially to the more senior CMBS notes. However, many transactions apply such proceeds (modified) pro-rata or even reverse sequentially. As a result, partial prepayments from share deals could have a negative impact on the credit characteristics of senior CMBS classes.

Correlation

Liquidity expected to pick up for IG.13 tranches

Although liquidity has failed to pick up for on-the-run tranches since the IG.9 roll, structured credit analysts at Barclays Capital believe that this trend may change for IG.13. They suggest in a recent research note three tranche ideas for implementing different views on the new on-the-run index on a fundamental or relative value basis: purchase inexpensive protection on wide IG.9 names by buying IG.9 equity protection and funding it with IG.13 equity; sell three-year IG.13 7%-10% tranche protection as a fundamental long; and sell the five-year 3%-7% tranche as a bullish strategy to maximise the benefit from roll-down.

The BarCap analysts indicate that IG.13 is a significantly safer portfolio than IG.9 and so the first trade idea provides investors with an easy way to buy protection on the widest IG.9 names. "The trade outperforms if two or more non-overlapping IG.9 names default with less than 40% recovery," they note. "We believe there are at least four strong default candidates among the non-overlapping IG.9 names (CIT, iStar, MBIA and Radian). The trade returns a 19% P&L in our base case (MBIA and Radian default with 15% recovery) and 51% P&L in our bearish case (CIT and iStar default as well with a 40% recovery)."

With respect to the second trade idea, under the new S&P ratings methodology the three-year IG.13 7%-10% tranche is likely to be an attractive long for ratings sensitive investors looking for yield, according to the BarCap analysts. Their analysis indicates that the tranche would achieve an initial rating of single-A plus and have a running spread of around 185bp. The tranche would be able to sustain 1.95% index losses in the first year and 3.33% losses in the first two years, while still maintaining its initial rating.

For bullish investors who believe that spreads are likely to continue to grind tighter, meanwhile, the analysts recommend selling protection on junior mezzanine tranches to monetise roll-down. "Our analysis shows that among non-equity tranches, five-year 3%-7% has the most attractive roll-down per unit of delta, while the three-year 15%-30% tranche has the least attractive roll-down profile," they conclude.

Documentation

Manager establishes tax blocker subsidiaries

Invesco Senior Secured Management has amended its documentation to allow the issuers in 10 CLOs to establish tax blocker subsidiaries solely to acquire, hold and dispose of certain securities, such as equity interests in an operating company it may receive in a bankruptcy proceeding or restructuring. The move is designed to ensure that the issuer will not be deemed to be engaged in a US trade or business as a result of an exchange of collateral obligations for such tax-sensitive equity securities.

The amended transactions are Moselle CLO, Limerock CLO I, Nautique Funding, Katonah V, Belhurst CLO, Avalon Capital, Sagamore CLO, Wasatch CLO, Champlain CLO and Atlantis Funding. According to Moody's, the documentation changes will not impact ratings on the deals.

Documentation

CLO discount obligation definition amended

American Capital Asset Management says it intends to modify the existing discount obligation definition for the ACAS CLO 2007-1 transaction. The indenture currently defines a discount obligation as a collateral obligation acquired for a purchase price of less than 85% of par. The investment guidelines limit discount obligations to 5% of the collateral principal amount.

The new supplemental indenture will exclude some assets from the discount obligation definition if they are purchased with the sale proceeds of an asset that was not a discount obligation, providing the following conditions apply: the asset is purchased within five business days of the sale; the purchase price of the asset is at least equal to the sale price of the asset sold; the purchase price of the asset is not less than 65% of par; and the credit quality of the purchase asset is equal or better than the asset sold. Assets that qualify under these conditions that are excluded from the discount obligation definition will be limited to 5% of the collateral principal amount at any time, or 2.5% if the weighted average purchase price of such assets is below 75% of par, and will be limited to US$39.1m on a cumulative basis.

Fitch notes that the proposed supplemental indenture won't adversely affect its current ratings of the CLO liabilities. However, changes to the collateral pool as a result of the additional flexibility afforded the collateral manager through the supplemental indenture will be reflected in the agency's ongoing credit opinion of the deal.

The impact of the proposed changes, although currently unquantifiable, could benefit one noteholder over another, Fitch says. For example, the purchase of discount obligations may inflate the par balance of the assets, thereby overstating the overcollateralisation (OC) ratios, which may reduce the likelihood of breaching the OC tests and diverting proceeds to redeem the rated notes. Fitch believes, however, that the conditions to the revised definition of discount obligations are sufficient to limit the potential par-building effect of such purchases.

Indices

90+ bucket drives ABX delinquency spike

The latest remits for the Markit ABX index show that 60+ delinquencies increased by roughly 75bp-125bp, about 20bp faster than its average pace this year, according to ABS analysts at JPMorgan. Unlike previous months, however - when the increases were driven equally by the 90+ and foreclosure buckets - foreclosure inventory was flat or down, while the 90+ bucket increased by 229bp for the 06-2 and by 116bp-147bp for the other sub-indices.

The JPM analysts note that severities posted another decline this month and have declined by 2%-3% for the 06-1 through 07-1 indices in the past four months. Severities for the 07-2 index have been quite volatile, declining by 5.7% this month after rising by 4.9% in the previous month.

Meanwhile, cumulative losses rose at a steady pace to reach 9.5% for the 06-1 sub-index and roughly 13.5% for the remaining indices. Default rates declined for a second consecutive month to reach 18.3% for the 06-1, 21.3% for the 06-2 and 18.7% for both the 07-1 and 07-2 sub-indices.

But voluntary prepayments were roughly unchanged for the 06-1, 06-2 and 07-1 indices at 2.1%, 1.4% and 1.8% CPR respectively. Prepayments for the 07-2 index dropped by 80bp from already very low levels to reach 0.98% CPR, the analysts add.

"Overall, market reaction to the remits was muted, with most tranches roughly unchanged (0-0.3 points down) for the day," they conclude.

Indices

CMBX delinquencies remain steady

The overall pace of new delinquencies across the Markit CMBX indices was fairly steady versus prior months, according to CMBS analysts at Barclays Capital. Across the fixed rate universe, the 30+ day delinquency rate increased by 32bp to 5.08%, roughly in line with the trailing three-month average.

"However, we did see a sharp uptick in specially serviced but current loans, which tend to be a strong leading indicator of future delinquencies. We expect this figure to increase in future months, given the recent IRS ruling around CMBS loan modifications and a likely increase in borrowers seeking relief," the analysts note.

Net new specially serviced current loans increased by 25bp to 1.96%, ex-GGP - versus only a 3bp net change in the previous month. The increase was led by larger loans from recent vintages.

"Within the SS-Cur bucket, it is useful to distinguish between loans that are nearing a balloon date and struggling to refinance, and those that are suffering from cashflow issues," the BarCap analysts add. "Among the new loans transferred to special servicer this month, approximately 24% fall into the former category compared with 76% in the latter."

Indices

HSBC least risky in counterparty risk index

The CDR Counterparty Risk Index (CRI) has maintained its recent lows and continues to trade at mid-June 2008 levels, with all index members trading close to their week-ago levels. However, BNP Paribas - recently the least risky index name - performed the worst, as its risk rose by almost 13%. HSBC is now the tightest-trading (least risky) member of the CRI.

"Among US names, JPMorgan continues to show the greatest strength, followed by Goldman Sachs and Bank of America. Citigroup remains the riskiest name in the index but managed to hold on to recent gains," says Dave Klein, manager, CDR credit indices.

European members of the index continue to trade with less risk than their US counterparts. Average European CRI CDS levels stand at 74bp, one-third less than US members' average of 117bp and 20% less than the current index level of 92bp.

"Whether CRI members can maintain, or even improve upon, current levels is an open question," continues Klein. "News of the Fed slowing the pace of its MBS purchases, as well as looking at reverse repo agreements to tighten money supply, signals hope for economic recovery. With Citigroup continuing to issue TLGP paper, financial recovery still is a work in progress."

Indices

US credit card charge-offs surge in August

After signs of improvement over the previous several months, the performance of US credit cards deteriorated broadly in August, according to Moody's Credit Card Index. In particular, Moody's charge-off rate index advanced dramatically to the record-high level of 11.49%.

Moody's svp Will Black says: "August has traditionally begun a seasonal period when delinquency rates start to rise and this August is no exception."

The agency continues to call for a recovery in the credit card sector to begin once charge-offs peak in mid-2010 at between 12% and 13%. Macroeconomic indicators will strongly influence the actual figure, in particular the unemployment rate, which Moody's expects to peak in the 10%-10.5% range, also in mid-2010.

The charge-off rate measures those credit card account balances written off as uncollectible as an annualised percentage of total outstanding principal balance.

Accompanying the rise in charge-offs in August was an increase in the delinquency rate, with the overall rate rising to 5.79%. The increase ended four months of seasonal improvement. A substantial increase in early-stage delinquencies drove the rise in the total delinquency rate.

Black adds: "We expected to see such an increase in August, and more increases should continue as back-to-school and holiday expenditures compete with credit card payments."

For the first time since November 2007, the yield index moved above 20%, reaching 20.48% in August - almost 400bp above its low point this cycle reached in January. Much of the improvement in yield Moody's attributes to issuer discounting. The effect could further push up yields by as much another 100bp by early next year, the agency says.

The rise in the yield index was not enough to offset a jump in charge-offs during the month, leading to a narrowing of the excess spread index for August to 6.13%. This decline follows two consecutive months of improvement.

Investors

Credit investor survey reflects abundant liquidity

Banc of America Securities-Merrill Lynch's latest credit investor survey reflects the abundance of liquidity in credit markets at present and how this has impacted investors' perceptions of risk and reward. Over the last three months almost 80% of respondents have seen net inflows into their credit funds, according to credit strategists at the bank. Net outflows were experienced by just 2%.

Looking ahead, investors appear confident that this trend of new money is unlikely to dissipate soon. 75% of respondents to the survey expect cash inflows to continue, even though spreads have tightened significantly already. Institutional inflows are expected to remain strong as pension funds and insurance companies address their under-allocation to credit.

"With so much liquidity, investors remain relatively comfortable about emerging micro risks in the credit market," the BAS-ML strategists add. "Although many bonds are now trading tighter than CDS, a large proportion of investors (40%) feel that the cash/CDS basis has no bearing on bond valuations. For them, M&A is even less of a concern: 66% are untroubled by rising acquisition risk and have not changed their investment stance accordingly."

Monolines

MBIA junked

S&P has lowered its counterparty credit, financial strength and financial enhancement ratings on MBIA Insurance Corp to double-B plus from triple-B. At the same time, the agency lowered its counterparty credit rating on MBIA Inc, the group holding company, to double-B minus from double-B. The outlook on MBIA and the holding company is negative.

However, S&P has affirmed its single-A counterparty credit, financial strength and financial enhancement ratings on MBIA affiliate National Public Finance Guarantee Corp. The outlook on National remains developing.

The agency says it downgraded MBIA and the holding company because macroeconomic conditions continue to contribute to losses on the group's structured finance products. Losses on the monoline's 2005-2007 vintage RMBS and ABS CDOs could be higher than expected, it notes. However, the downgrade also reflects potentially increased losses in other asset classes, including but not limited to CMBS and - for other years prior to 2005 - within RMBS.

S&P affirmed its ratings on National, which assumed MBIA's US public finance business, because it is not exposed to structured products. The rating on National reflects the agency's view of both its uncertain business and capital-raising prospects, however.

Management's stated goals are to raise additional capital to bolster National's current resources and effectively ring-fence National from MBIA and its more volatile book of business. However, the ring-fencing actions it has taken so far have had limited impact in that S&P views National as no more or less ring-fenced than any typical bond insurance subsidiary operating in a consolidated group. In addition, the legal challenges the company faces as a result of its restructuring are, in the agency's opinion, an impediment to both business prospects and capital-raising efforts.

The negative outlook on MBIA and the holding company reflects the view that adverse loss development on the structured finance book could continue. In the next few years, liquidity will likely be adequate to meet debt-service and holding-company obligations. However, increased losses and earnings volatility could still occur.

Considering the runoff nature of the franchise, S&P says it is unlikely that it would raise the rating. Alternatively, if there were increased losses within the investment portfolio, potential reserve charges or diminished liquidity, it could take a negative rating action.

However, the agency could raise the rating on National if there is a favourable resolution of the current litigation, which in turn could facilitate capital-raising efforts and lead to more tangible separation of National from MBIA and MBIA Inc. Improving business acceptance could be an outgrowth of these developments, which could lead to a rating in the double-A category. Alternatively, an ongoing lack of market acceptance and continued weak financial flexibility could result in a downgrade to the triple-B category.

Operations

Pace of Fed MBS purchases to slow

The Federal Open Market Committee has extended the Federal Reserve's purchase of agency MBS until the end of March 2010, at which point it is anticipated that it will have bought a total of US$1.25trn of such securities. However, the Committee says it will gradually slow the pace of these purchases in order to promote a smooth transition in markets.

To implement these decisions, agents acting on behalf of the Federal Reserve Bank of New York's open market trading desk will gradually reduce the average weekly purchase amounts of agency MBS, starting with purchases conducted during the reporting week beginning 24 September 2009.

Operations

No rejected legacy CMBS in latest TALF round

The New York Fed has announced that no legacy CMBS bonds were rejected in the 17 September TALF operation. Some 59 transactions totalling US$1.4bn were accepted.

Operations

GFSR highlights role of securitisation in recovery

The IMF has released its latest Global Financial Stability Report (GFSR), which notes that the immediate outlook for the financial system has improved markedly since the last GFSR was issued in April and extreme tail risks have abated. While financial markets have rebounded, emerging market risks have eased, banks have raised capital and wholesale funding markets have reopened, the report says that credit channels are still impaired and economic recovery is likely to be slow.

Given the importance of repairing credit intermediation, one chapter of the GFSR examines the role of securitisation and assesses proposals to restart the market. It emphasises that a combination of new regulation and better private sector practice will be needed to align incentives of institutions taking part in securitisation and avoid it contributing to systemic instability once more. In redesigning regulation and market practices, the benefits of transferring credit risk outside the banking system and the ability of lenders to diversify funding sources need to be retained, the report says.

The chapter illustrates the potential dangers of uncoordinated responses by examining the impact of retention policies and capital requirements imposed on originators and shows that these could, in some cases, fail to encourage screening and monitoring or, in other cases, make securitisation prohibitively expensive. Undertaking careful impact studies before introducing new regulations should ensure that their interaction and potential for damaging unintended consequences is recognised in advance.

Another chapter of the GFSR looks at the impact of intervention announcements made by 13 advanced economies. The report shows that interventions aimed at supporting liquidity were most effective prior to Lehman Brothers' default, but were less so once it was evident that the financial crisis had become one of solvency rather than liquidity risk in a number of countries. Correspondingly, announcements of capital injections were most effective in reducing the default risk of banks in the post-Lehman period, as was the announcement of the potential use of asset purchases.

Although the IMF says it is too soon to gauge with confidence the longer-term effects of these policy actions, initial evidence suggests that some facilities have been effective in supporting funding and issuance activity. Examples include the bank liability guarantees introduced in several countries, the US TALF programme and the European Central Bank's decision to purchase covered bonds outright.

However, while the time is not ripe for a full-fledged disengagement from all the unconventional policies undertaken - indeed in some countries additional public resources may still be needed - it is time for policymakers to consider and articulate how and in what sequence policies may be unwound, the report continues. Timing is complicated by the fact that some policies may be effective even if their usage is limited, as they may be bolstering confidence or acting as a backstop to a class of institutions or investors.

Ratings

Realpoint gets NAIC vote

The National Association of Insurance Commissioners (NAIC) has voted to include Realpoint as an acceptable rating organisation, which means that US insurance companies can now rely on its CMBS ratings to calculate their capital strength and their required reserves. The move is expected to help mitigate potential losses and forced sales precipitated by possible mass downgrades undertaken in the sector by other rating agencies (see SCI issue 141).

Rob Dobilas, president and ceo of Realpoint, says: "Our recognition by the NAIC was driven by strong investor support from the insurance industry. This action by the NAIC, and the insurance industry as a whole, indicates that investors and regulators recognise that positive change in the ratings business is necessary to restore confidence in the structured finance markets. This decision by the NAIC, as well as recent rule changes by the SEC to encourage the adoption of investor-paid ratings models, demonstrate positive steps toward meaningful change in the market."

Realpoint evaluates every CMBS deal on a monthly basis, eliminating much of the ratings volatility that has plagued ratings from other agencies.

Ratings

Recently-launched re-REMIC downgraded

S&P has downgraded class 2-A-2 of JPMorgan Resecuritisation Trust Series 2009-3 from triple-A to triple-B minus. The deal was launched in May this year.

According to the rating agency, the downgrade reflects the significant deterioration in the performance of the loans backing the underlying certificate. "Although this performance deterioration is severe, we affirmed the rating on class 2-A-1, which is within loan group 2, because class 2-A-2 provides credit enhancement to it," says S&P.

JPMRT 2009-3 is a re-REMIC RMBS transaction, collateralised by two underlying classes that support two independent groups within the re-REMIC. The loans securing the two underlying classes, which are included in two different trusts, consist predominately of fixed-rate and adjustable-rate prime mortgage loans.

Classes 1-A-1 and 1-A-2 from JPMRT 2009-3 are supported by the I-A-1 class from Wells Fargo Mortgage Backed Securities 2005-AR1 Trust (currently rated triple-A). This pool had experienced losses of 0.17% of the original pool balance as of the August 2009 distribution and currently has approximately 6.5% in delinquent loans as a percentage of the current pool balance, according to S&P. Based on the losses to date, the current pool factor of 0.500 (50.0%), which represents the outstanding pool balance as a proportion of the original balance, and the pipeline of delinquent loans, S&P's current projected loss for this pool is 1.16%.

Classes 2-A-1 and 2-A-2 from JPMRT 2009-3 are supported by the 1A-11 class from GSR Mortgage Loan Trust 2006-1F (currently rated single-B). In recent months, the performance of the loans securing this trust has declined considerably.

This pool had experienced losses of 0.41% as of the August 2009 distribution and currently has approximately 8.42% in delinquent loans. Based on the losses to date, the current pool factor of 0.728 (72.8%) and the pipeline of delinquent loans, S&P's current projected loss for this pool is 2.99%, which exceeds the level of credit enhancement available to cover losses passed through to the class 2-A-2 within the re-REMIC.

Real Estate

Financial flexibility remains key for Singapore REITs

Singapore REITs have, to a large extent, refinanced their maturing debt obligations in 2009 and have benefited from a recent share price recovery, according to Fitch - though questions still remain regarding their financial flexibility and refinancing ability. In its special report, the agency discusses some of the aspects of S-REITs' structures, highlighting its concerns, and discusses the impact of the financial crisis and the outlook for S-REITs and their ratings as they emerge from the crisis.

S-REITs have been negatively affected by the financial crisis as a limited availability of debt financing and stock price corrections forced them to restrict their previous aggressive asset acquisition programmes and concentrate on survival and tenant retention in a difficult market. The vehicles responded to the changing market dynamics by sourcing bank loans in advance for their refinancing and by reducing their capex and acquisition plans, and development pipelines; some S-REITs have also successfully issued equity. These steps are positive, from a ratings standpoint, but do not address other aspects of the debt structure and liquidity profile on which Fitch continues to have concerns.

Peeyush Pallav, director with the agency's REIT team, says: "The requirement for S-REITs to distribute a major portion of their earnings affects their liquidity profiles. This coupled with concentrated debt maturity profiles can significantly increase the refinancing risk around S-REITs."

S-REITs are moderately geared at an average of 31% (as of June 2009), although industrial S-REITs are more highly geared at an average of 39.6%. In the year ending June 2009, S-REITs have faced falling asset valuations as well; for instance, office S-REITs reported a 4.2% drop in total assets in the year ending June 2009, compared with an increase of about 54% in the previous year, while retail S-REITs added 1.5% to their total assets in the same period. Fitch does not expect leverage to increase significantly in the near term as S-REITs are currently focused on tenant retention and organic portfolio growth, and may only look to acquisitions when they become yield accretive.

The ability of S-REITs to access the capital markets and maintain adequate liquidity for their debt refinancing and capex requirements remains critical to their ratings outlook. Pallay adds: "S-REITs would benefit from long-term undrawn committed bank facilities, less reliance on secured financing and a wider spread of debt maturities to ensure debt refinancing funding is available even in the most difficult circumstances."

Fitch's overall outlook for the sector remains negative, owing to negative asset performance expectations; however, the sector's credit performance is expected to be driven by the industry sub-sectors and therefore individual S-REITs may have different outlooks.

Regulation

RFC on ABS post-trade transparency

The IOSCO Technical Committee has published a consultation report, 'Transparency of Structured Finance Products'. The report sets out a number of factors to be considered by market authorities when considering enhancing post-trade transparency of structured finance products in their respective jurisdictions.

The report was prepared following the Subprime Task Force's mandate in 2008 to the Technical Committee Standing Committee on the Regulation of Secondary Markets to examine the viability of a secondary market reporting system for structured finance products (SFPs), with a particular focus on the nature of the market and its participants as well as on the potential benefits and drawbacks of such a reporting regime.

While it acknowledges that there are divergent views on the possible benefits and drawbacks of a post-trade transparency regime, the Technical Committee believes that greater information on traded prices of SFPs could be a valuable source of information for market participants. It therefore encourages each member jurisdiction to actively consider enhancing post-trade transparency in its own jurisdiction.

In seeking to develop an appropriate post-trade transparency regime for SFPs, the Committee suggests that member jurisdictions may wish to consider the following factors:

• The degree of liquidity or secondary market trading for a particular SFP;
• The initial and outstanding amount of the issue;
• Whether the SFP was publicly offered or offered via private placement;
• Whether there is a broad investor base for the particular instrument;
• The degree of standardisation. Factors such as the structure of the product and the homogeneity of underlying assets could be considered in determining the degree of standardisation; and
• The extent to which existing post-trade transparency systems could be extended to SFPs at reasonable cost.

With respect to the kind of information that could usefully be disseminated, Technical Committee jurisdictions may wish to also consider:

• Publication of trade-by-trade transparency information or publication of aggregate trade information (such as high, low, and average prices) on a periodic basis;
• Measures to ensure anonymity of the market participants;
• Reasonable delays before trading information is disseminated; and
• Publication of trade information without disclosing data relating to the volume of the transaction, possibly depending on a certain threshold.

The Technical Committee acknowledges that some member jurisdictions may find it helpful to consider other factors in determining whether and how to enhance post-trade transparency. This could include consideration of the availability and quality of information about the underlying assets of SFPs through indices.

The Committee believes that enhanced post-trade transparency should be provided in the most cost-effective way possible, while at the same time seeking to avoid a negative impact on efficiency and liquidity of markets. Moreover, it believes it may be appropriate in some jurisdictions to introduce post-trade transparency on a step-by-step or phased-in basis.

Regulation

FSB reports on ABS/OTC markets

The Financial Stability Board (FSB) has submitted two reports to the G20 leaders at their Pittsburgh Summit, detailing policy measures for improving financial regulation and progress in implementing the London Summit recommendations (see SCI issue 151) for strengthening financial stability. The FSB says its members are taking forward a major programme of financial reforms based on clear principles and timetables for implementation, which are designed to ensure that a crisis on this scale never happens again.

These reforms cover the following key areas:

• Strengthening the global capital framework for banks. New rules will be set out by end-2009, calibrated in 2010 and phased in as financial conditions improve and recovery is assured.
• Making global liquidity more robust. A new minimum global liquidity standard for banks will be issued by end-2009 and measures that could mitigate cross-border liquidity problems at the national level reviewed.
• Reducing the moral hazard posed by systemically important institutions. Measures will be developed over the next 12 months that can be taken to reduce the systemic risks that these institutions pose.
• Strengthening accounting standards. Further work is encouraged to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards.
• Improving compensation practices.
• Expanding oversight of the financial system. Work is progressing to ensure that all systemically important activity is subjected to appropriate oversight and regulation, including relating to hedge funds and credit rating agencies.
• Strengthening the robustness of the OTC derivatives market. Standards will be strengthened and consistently applied to address systemic risks, including covering capital requirements to reflect the risks of OTC derivatives and further incentivise the move to central counterparties and, where appropriate, organised exchanges.
• Re-launching securitisation on a sound basis. The official sector must provide the framework that ensures discipline in the securitisation market as it revives.
• Promoting adherence to international standards. The FSB is developing a system of peer reviews of regulatory and prudential standards and of policies agreed in the FSB.

The Basel Committee is set to issue new standards by mid-2010 to take full account of counterparty credit risks, the benefits of centrally cleared contracts and collateralisation. Regulators need to ensure that equivalent rules are applied outside the banking sector, the FSB notes.

Industry commitments to supervisors should include: expanding central clearing of OTC derivatives trades; improving risk management for trades that are not cleared, meet increasingly stringent targets for operational improvements and report data on their performance to their regulators; and reporting all non-cleared trades to regulated trade repositories. If the private sector does not meet these and future commitments, the FSB warns that supervisors will develop alternative approaches to ensure the improvements are made.

The Basel Committee's measures to support the revival of securitisation markets include strengthening the capital treatment of securitisation and establish clear rules for banks' management and disclosure of transactions (SCI passim). In addition, the FSB recommends implementing IOSCO's proposals to strengthen practices in the securitisation markets and suggests that other ways of aligning the incentives of issuers with investors should be examined. Namely, the retention by issuers of a part of the economic exposure of the underlying assets of a transaction, as well as encouraging greater use of the contractual form used in covered bonds, which tie issuers to the instruments by obliging them to act as the de facto guarantor in the event of underperformance by the underlying assets.

Regulation

Tranche retention screening model analysed

The BIS has published a Working Paper entitled 'Incentives and tranche retention in securitisation: a screening model'. The report examines the power of different contractual mechanisms to influence an originator's choice of costly effort to screen borrowers when the originator plans to securitise its loans.

The analysis focuses on three potential mechanisms: the originator holds a 'vertical slice', or share of the portfolio; the originator holds the equity tranche of a structured finance transaction; and the originator holds the mezzanine tranche, rather than the equity tranche. These mechanisms will result in differing levels of screening, with the differences arising from varying sensitivities to a systematic risk factor.

Equity tranche retention is not always the most effective mechanism, according to the report, and can be dominated by either a vertical slice or a mezzanine tranche if the probability of a downturn is likely and if the equity tranche is likely to be depleted in a downturn. If the choice of how much and what form to retain is left up to the originator, the retention mechanism may lead to low screening effort, suggesting a potential rationale for government intervention, the BIS concludes.

RMBS

Positive trend for non-agency mortgage severities

August data for non-agency mortgages indicates that serious delinquencies and foreclosure inventory continue to increase and REO inventory to fall, although new delinquencies remain roughly unchanged. The positive news, according to ABS analysts at JPMorgan, is in terms of severities - which decreased across the board for a third consecutive month, particularly for Alt-A and prime jumbo ARMs.

"Subprime severities haven't declined significantly, but have been stable in the 73.5%-74% range," the analysts explain. "Option ARM severities were unchanged this month at around 62%. Default rates decreased modestly in July, but overall are on a secular increasing trend for Alt-A and prime jumbo mortgages, while remaining range-bound for subprime." Voluntary prepayments were unchanged for the month.

The data also shows that the number of loan modifications continued to decrease for a fourth consecutive month. The JPM analysts point out that delinquency rates on these modifications are quite high for subprime and option ARMs at 56% and 44% respectively, 12 months after modification.

"On the positive side, however, the quality of modifications has been improving - servicers are targeting more mortgages with negative equity and are also offering greater reductions in monthly payments to borrowers, thus improving the chances of the recent modifications to be more successful," they conclude.

RMBS

UK RMBS on review as EOD looms

Moody's has placed all notes and Mercs on review for possible downgrade from GMAC-RFC-originated UK RMBS Alba 2006-2 and Alba 2007-1. This action follows a late payment on the notes in both transactions.

Moody's received written confirmation from the issuer that payments of interest and principal for Alba 2006-2 were made on 22 September, hence five business days after the interest payment date and within the grace period. The agency was also been informed that no payment was made on Alba 2007-1 at the interest payment date falling on 17 September, although payments were subsequently made within the required five-day grace period.

The reasons behind the non-payment are thought to be due to reconciliation issues. If a payment hadn't been made within the five-business-day grace period, it could have triggered an event of default in accordance with the terms and conditions of the notes.

Moody's says it has received no explanation on the reasons that have caused the delay in processing the payments in Alba 2006-2 and therefore it is not certain if the issue has been only temporary resolved and it will not occur again in the future.

RMBS

NC RMBS delinquencies stabilise

Economic fundamentals in the UK remained negative in Q209. However, S&P says it has seen some mildly positive signs from both the UK housing market and from its own analysis of UK RMBS transactions.

According to a report from S&P, the total delinquency index for UK nonconforming borrowers has stabilised at 29.46%. Its index for the stock of repossession cases also fell to 2.44% in Q2 from 2.90% in Q1, and from 3.47% in Q4 2008. However, losses have increased for several transactions over the second quarter and the agency continues to see higher losses appearing earlier in the life of some transactions.

"The stabilisation of our total delinquency index and a reduction in the indices for early-stage delinquencies are likely to be primarily driven by the ongoing positive effect of relatively low mortgage payments for borrowers with floating-rate loans linked to key benchmarks," says S&P credit analyst Neil Monro.

He adds: "BBR remains at a historical low and notably this quarter we have seen a significant fall in three-month Libor, reducing the gap between the two rates which had widened since the onset of the credit crisis. This is particularly significant for the UK nonconforming market, where many borrowers' mortgage rates are linked to Libor."

RMBS

Australian RMBS arrears drop again

Arrears on residential mortgage loans underlying prime Australian RMBS transactions eased for the fifth consecutive month, to 1.44% in Q209, according to S&P. This was from a record high of 1.84% in January 2009.

The subprime S&P mortgage performance index (SPIN) also recorded its lowest level since its peak at 17.09% in January 2009. It fell by a large single-quarter decline of 2.85% to 13.61% by end-Q209, which is back at the levels seen before the impact of the global capital market dislocation on the Australian securitisation market in mid-2007.

S&P notes that historically arrears levels tend to be higher immediately after Christmas before declining thereafter. "This year, however, we believe that a significant proportion of the arrears reduction is attributable to the support households received from the government's monetary and fiscal policy stimulus. With the economy showing signs of improvement, we believe that arrears could improve further and stabilise at a lower level before household budgets tighten due to Christmas expenses later in the year."

Nevertheless, S&P notes that key risks remain - including the likely shallow path of the economic recovery, continued rise in unemployment and a greater-than-150% household debt-to-income ratio - which could reverse this improving trend.

Secondary markets

Securitised loan ID codes released

The American Securitization Forum and S&P Fixed Income Risk Management Services (FIRMS) have launched their standardised universal code for identifying critical information about individual loans that are securitised in the mortgage- and asset-backed securities markets. First announced in July (see SCI issue 146), the new global ASF Loan Identification Number Code (ASF LINC) is a sixteen digit identification code that captures underlying loan type, origination date and country of origin, in addition to randomised alphanumeric data, to create a unique ID for a wide range of loans that may be pooled and sold into the capital markets.

"A major goal of ASF Project RESTART is to improve information flows to investors via enhanced disclosure and reporting. The global ASF LINC will be instrumental in meeting this goal, as it offers investors, for the first time, the ability to follow a loan throughout its life," comments Tom Deutsch, ASF deputy executive director. "This is an important step towards ASF Project RESTART's ultimate goal, which is to help rebuild investor confidence in mortgage and asset-backed securities, restore the capital flows to the securitisation markets which are essential to our economic recovery and, ultimately, increase the availability of affordable credit to all Americans."

The code is a foundational component of ASF's Project RESTART initiative to improve the securitisation process and reshape critical information and data flows with market-based solutions. With its ability to provide detailed information on the underlying collateral in these kinds of products, the global ASF LINC has been developed in a format that can be easily integrated into existing computerised analytics and risk modelling programmes used by investors, governments and regulators to evaluate mortgage- and asset-backed portfolios.

"The global ASF LINC allows investors across a wide spectrum to track a loan from, literally, Main Street to Wall Street, identifying counterparties, obligors and other crucial risk criteria through the lifecycle of the loan - no matter how many times it is bought, sold or securitised," adds David Goldstein, FIRMS md. "Best of all, the code provides a higher level of transparency and protects sensitive borrower privacy-protected information."

The ASF LINC captures the following information for each loan:

• Underlying loan type: The first two characters in the code depict specific loan type, making each loan instantly recognisable as a residential mortgage (RM), auto loan (AU), credit card (CR) or student loan (ST).
• Loan origination date: The next six characters in the code indicate the loan origination date in a MMYYYY format.
• Country code: The next two characters in the code are used to indicate where the loan was originated, utilising International Organisation for Standardisation (ISO) country codes.
• Random element: The next five characters in the code are an alphanumeric sequence designed to prevent duplicates, with scalability to 40 million different permutations.
• Check digit: The final character in the code is an algorithmic check-digit, which is used to confirm that all other digits in the code are correct.

The global ASF LINC is linked to the CUSIP and/or ISIN number of the securitised product, allowing investors to track the loan throughout its lifespan and provide a chain of accountability between loan originators and investors. In addition, it provides a means to connect added-value data and information from third-party providers like credit bureaus.

Assigned at no cost to issuers, the ASF LINC is stored in a central loan data repository administered by FIRMS.

Secondary markets

Trade repository consultation launched

CESR has launched a consultation on trade repositories in the EU. The number of European entities active in the OTC derivatives markets, the European origin of many underlying instruments, the number of contracts denominated in European currencies, the volumes involved and the need to satisfy the information needs of EU regulators justify its interest in the establishment of trade repositories, CESR notes.

Trade repositories should aim to foster transparency, thus supporting the efficiency, stability of and orderly functioning of financial markets, according to CESR. The purpose of the consultation is to collect stakeholders' views on trade repositories, including their functions, data and transparency requirements, their location and legal framework.

CESR says it takes as a preliminary position that the establishment of one or more trade repositories should be market-led. The Committee notes that it does not want to impose trading of all CDS, nor other OTC instruments in general, on regulated markets.

Structuring/Primary market

Report on SPEs to inform policymakers

The Joint Forum has released the final version of its paper entitled 'Report on special purpose entities'. The report provides background on the variety of SPEs found across the financial sectors, the motivations of market participants to make use of these structures and risk management issues that arise from their use. It also suggests policy implications and issues for consideration by market participants and the supervisory community.

The Joint Forum emphasises that the usage of SPE structures is not inherently problematic and that the vehicles have contributed to the efficient operation of the global financial markets by providing financing opportunities for a wide range of securities to meet investor demand. In instances where parties to an SPE possess a comprehensive understanding of the associated risks and possible structural behaviours of these entities under various scenarios, they can effectively engage in and benefit from using SPEs, the report notes.

It also notes that the current market crisis that began in mid-2007 essentially 'stress tested' these vehicles. As a result, serious deficiencies in the understanding and risk management of SPEs were identified. While recent market events have resulted in a dramatic reduction in issuance of securities using SPEs, the Forum expects that such vehicles will continue to be used for financial intermediation and disintermediation going forward.

John Dugan, chair of the Joint Forum and comptroller of the currency in the US, says: "This paper significantly adds to the understanding of the use of these vehicles, both on how they are structured and operate and on how risk is transferred. This work will serve to inform supervisors and other market participants of the benefits and risks associated with use of SPEs. Policymakers can use this analysis for important contextual background to help advance the ongoing discussions on updating the regulatory and supervisory landscape for structured finance transactions and securitisation markets."

Technology

Vendor mints counterparty risk solution

Numerix has launched Numerix Counterparty Risk, powered by CompatibL - its integrated solution for calculating potential future exposure and credit valuation adjustment for derivative portfolios. The solution uses a high-performance Monte Carlo simulation engine based on the Numerix model library.

Built on the Numerix pricing and risk analytics platform, Numerix Counterparty Risk enables institutions to actively manage their exposure and make more informed day-to-day trading decisions, the firm says. Traders and risk managers have access to a fully integrated and comprehensive platform for managing counterparty risk and measuring future exposure during pre-trade discovery for all major asset classes and an infinite variety of instruments, including complex deals.

CompatibL's flagship software product is CompatibL Analyst, a software for quants and business analysts that also powers the Numerix Counterparty Risk application. CompatibL Analyst provides data management capabilities combined with an embedded code editor and execution environment, making it easy to write analytics code in different programming languages and to configure this code for multicore, cluster or cloud execution without the need for complex database or parallel programming.

Technology

Mortgage risk analysis tool extended

Fitch has extended its European residential mortgage risk analysis tool, ResiEMEA, to cover Ireland, Italy and Spain, with Portugal to follow in the coming weeks. ResiEMEA was originally launched for the UK and Dutch RMBS sectors earlier this year.

Available to arrangers, originators and investors, ResiEMEA is used by Fitch as the first stage in the quantitative analysis of a new EMEA RMBS transaction and helps determine the weighted average default probability, loss severity and recovery at different rating categories.

Gregg Kohansky, md of EMEA RMBS at Fitch, says: "Individual loan-level analysis is vital for investors in the current market conditions. ResiEMEA meets this demand by offering users the ability to run pool cuts against Fitch published criteria and to perform detailed collateral calculations."

The flexible interface allows users to adjust Fitch criteria assumptions and stress the loan, borrower and property-specific factors that most influence default probability and loss severity.

Trading

Fair value reporting impacts trading results

US commercial banks reported trading revenues of US$5.2bn in Q209, compared to record revenues of US$9.8bn in Q109, according to the OCC's quarterly report on bank trading and derivatives activities.

OCC deputy comptroller for credit and market risk Kathryn Dick says: "After such a strong first quarter, we expected to see a seasonal decline in trading revenues, and indeed that occurred. Still, second-quarter trading revenues were the sixth strongest since we've been keeping records."

As in previous quarters, trading results continue to be influenced by the reporting of fair value adjustments for derivatives payables and receivables.

Dick continues: "On balance, trading results in the second quarter benefited from the significant tightening of corporate credit spreads, as the positive impact of increasing receivable values exceeded the negative impact of increasing payable values."

The OCC also reports that net current credit exposure, the primary metric it uses to measure credit risk in derivatives activities, decreased by US$140bn - or 20% - to US$555bn.

Dick adds: "Rising interest rates and falling credit spreads have combined to reduce the fair values of both derivatives receivables and payables. As a result, we have seen material reductions in net current credit exposure over the past two quarters, although by any standard these exposures remain very high."

Dick notes that concerns about counterparty credit exposures have driven bank supervisors to continue to encourage banks to increase the volume of derivative contracts cleared by central counterparties. She says: "The use of central counterparties is an important step forward in addressing the systemic risk of large counterparty credit exposures."

The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$1.5trn (nearly 1%) in the second quarter to US$203.5trn. Interest rate contracts increased by US$2.5trn to US$172trn, while credit derivatives fell by 8% to US$13.4trn.

The report also notes that derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%. Additionally, credit default swaps are shown to be the dominant product in the credit derivatives market, representing 98% of total credit derivatives.

Finally, the number of commercial banks holding derivatives increased by 47 in the quarter to 1,110.

Alternative assets

High subordination mitigates industry/maturity risk

Structured credit strategists at Citi find that TruPS CDOs can offer impressive returns for investors who know the regional banking industry well

CDOs of trust-preferred securities have been a niche asset class within the structured credit market, not being at the forefront of most investors' minds. Until recently, that is, when the liquidation of Victoria Finance threatened to release up to US$800m of senior tranches into this somewhat sleepy market.

The SIV had an unusually high exposure to CDOs: almost half (by notional) of the US$8bn of assets (see Figure 1). Although very few TruPS CDOs actually traded in the auction, the amount of such assets held by the vehicle was nonetheless impressive, representing roughly 2% of all the senior TruPS CDO bonds outstanding and a good multiple of trading volumes. Though the TruPS CDO market also comprises real estate and insurance collateral, bank TruPS is by far the largest segment of the market and is the focus of this note.

Figure 1

Bank collateral is the largest share
Compared to CDOs of other asset classes, such as loans and mortgage-backed assets, the TruPS CDO market has had modest issuance (Figure 2) of roughly US$50bn. Of this amount, CDOs backed by US banks- and thrifts-issued TruPS make up the lion's share (Figure 3). That is why investors focusing on the future performance of this asset class should familiarise themselves with how US regional banks are expected to perform in the current economic environment.

Figure 2

The remainder consists of CDOs backed by insurance TruPS and a family of deals whose collateral consists of debt issued by real estate investment trusts (REITs). These deals, which we will not discuss in this note, also include debt issued by homebuilders and financial institutions specialising in mortgage lending.

Figure 3

Banks, as Figure 4 shows, have been performing none too well. The FDIC has been declaring an increasing number of institutions as insolvent.

Figure 4 

The banks that ran into trouble were typically those that operated geographically in stressed regions within the US (Midwest, Southeast and West). These banks (and regions) had been characterised by a rapid deterioration in mortgage activity.

Moreover, many of the banks also had significant exposure to common and preferred equity issued by Fannie Mae and Freddie Mac. To make matters even worse, many also had large commercial real estate exposure, high balance sheet growth and reliance on wholesale funding and/or hybrid capital.

How about the future? On one hand, there is a definite improvement in macro conditions and improvement in liquidity. Citi's leading indicator of economic activity (Citi Financial Conditions, plotted in Figure 5) has recovered to minus one standard deviation weaker than norms as of August and is on track to approach zero or "normal" readings within the next couple of months (this was as low as minus four earlier this year, its lowest value since 1999).

Figure 5 

Liquidity has improved too: the Citi US Rate Liquidity Index shows substantial improvement (Figure 6). This index contains rates, volatilities and credit spreads of various markets, including corporate and securitised markets.

Figure 6 

Despite these broad improvements, much of the benefits may accrete only to bigger banks that have taken steps to improve the quality of their balance sheets. Though all banks face a constrained funding environment, the deterioration in consumer and commercial credit may have a bigger impact on smaller banks. US regional banks have a big sword hanging over their heads: a large exposure to US commercial real estate.

According to Fitch, this is a dominant asset class for many banks referred in trust preferred CDOs. With a drop in commercial real estate values and rising delinquency in loans, the commercial real estate market is under stress.

They may have other problems too. According to Fitch, the stressed auto sector, including dealer floor plan loans and working capital loans for auto part suppliers, will also have a negative impact (see Figure 7). Finally, there is high likelihood that regulatory pressures will stop banks from making TruPS interest payments, even if they have the cash, until balance sheets improve and banks are able to demonstrate sustained profitability.

Figure 7

Regulatory pressure on bank TruPS
Banks have the right to defer TruPS interest for up to five years without causing default. This is, however, little comfort to investors in CDO junior tranches as a deferral counts the same as a default for purposes of CDO overcollateralisation calculations. History offers little guide as to how many banks will defer interest.

TruPS are relatively new and have not gone through the US banking crisis of the late-80s to early-90s. The Federal Reserve granted Tier 1 capital relief to banks issuing TruPS only in 1996.

Based on the current climate, we think regulators such as the FDIC will take a hard stance in determining if interest on a TruPS should be deferred and the duration of such deferral. TruPS are issued by holding companies and the regulators are most interested in protecting depositors whose money is typically given to the bank operating company.

Statutory constraints already exist on how much dividend a bank can give its holding company for the latter to service, among other costs, the TruPS debt. These constraints are typically based on amount of retained earnings and profitability, but ultimately are only a guide. Regulators have considerable discretion on how much capital the operating bank needs to reserve.

Regulators may also have a say in future distressed debt exchanges. The need for 'better quality' capital for banks has recently been stressed by G20 leaders, though the exact implications are not clear. Hybrid capital, such as TruPS, is likely to be less in favour than common equity.

A few banks have executed, or tried to execute, offers for common equity in exchange for TruPS debt. This theme may become more important in the next couple of years as regulators try to recapitalise weaker banks.

Value in CDO TruPS
Though bank TruPS within CDOs are performing in line with the industry stresses that we have described, senior tranches may still provide value for investors. Let's start with the collateral performance.

The total amount of assets classified as "defaulted" (which includes banks and thrifts that are deferring interest) has rapidly increased, as Figure 8 shows. Real estate-based REIT TruPS had deteriorated about a year ago, but the underperformance of bank TruPS is catching up to these levels. For the moment, insurance TruPS-based deals are showing the best performance.

Figure 8 

As defaults have increased, the overcollateralization (OC) levels supporting all CDO tranches have declined. This has led to the junior tranches, including equity, of many CDOs having to miss interest payments as the levels have gone below the trigger levels for cash diversion (Figure 9). With deteriorating asset quality and regulatory pressures in mind, we expect to see increasing levels of default and deferral from regional banks for the next few months.

Figure 9 

As a result, the picture for junior debt is likely to get worse before any de-leveraging of the CDO portfolio starts to improve the possibility of junior debt receiving cash. A small source of comfort for junior debt is that only two of the bank TruPS CDO platforms (Alesco and Trapeza) have event-of-default language linked to the deal's OC triggers.

For the most senior tranches, the picture is somewhat better. Because most TruPS deals are static, the borrowers in some of the earlier deals (2003 and prior) refinanced their expensive debt and rolled them into newer CDOs. Seniors in some of the early deals, therefore, now have a high subordination.

Even for the others, moreover, though the absolute level of collateral support is declining, the average is still quite high compared to other types of CDOs, such as CLOs (Figure 10). Many triple-As have close to 50% collateral subordination, which provides protection against a substantial number of defaults, even assuming negligible recovery rates for TruPS collateral.

Figure 10 

Moreover, close to 2% excess spread per annum can be used to amortise senior tranches in case of breaches of cash diversion triggers. In fact, most senior debt is currently seeing some benefit of cash trapping.

Paying down seniors by diverting excess spread away from junior debt because of OC trigger breach is the most common mechanism. Certain deals also have a OPDA (optimum principal distribution amount) mechanism wherein part (and sometimes all) of the excess spread is used to redeem the senior bonds as soon as the first collateral deferral occurs.

There is, however, significant dispersion in the collateral protection below the senior tranches, as Figure 11 illustrates. Amortisation of some of the earlier portfolios and differences in collateral performance have contributed to this.

Figure 11 

Moreover, the collateral subordination should be seen in the context of portfolio diversity. The earlier deals are likely to have fewer obligors (and thus more event risk) and possibly the problem of adverse selection (any borrower who was able to refinance would have done so).

In our view, some of the super-senior tranches of bank TruPS CDOs are attractive. They have significant subordination and are exposed to an industry, which has probably bottomed out.

Given the current prices on senior bank TruPS CDO tranches of 40s for triple-As, investors would be looking at high-teen returns, assuming none of the assets are called. Clearly, early redemptions - for example, as a result of acquisition of smaller regional banks by bigger rivals with cheap financing - would make senior CLO yields even higher.

Nonetheless, this product will not appeal to mainstream investors. The two biggest challenges are a fair appraisal of the financial health of the smaller regional financial institutions and the longer-dated nature of the collateral.

In many cases, the maturity of TruPS securities extends beyond 2035. Ultimately, this is a product for a careful investor who knows the regional banking industry well. For such an investor, though, the returns can be quite impressive.

© 2009 Citigroup Global Markets. All rights reserved. This Research Note is an excerpt from 'Global Structured Credit Strategy', first published by Citi on 17 September 2009.

Trading

Trading ideas: can it

Dave Klein, senior research analyst at Credit Derivatives Research, looks at an equity underperform trade on Alcoa Inc

We revisit Alcoa Inc. Last May, we recommended buying Alcoa CDS protection, a Trading Idea that performed very well initially but finally succumbed to the overall market rally.

Since early March, Alcoa's CDS and equity rallied dramatically, with its equity up over 140%, handily beating the S&P on a beta-adjusted basis. We recommend selling Alcoa's equity short and hedging with a beta-adjusted long SPY position.

The exhibit below compares Alcoa share prices to aluminium spot prices over the past six months. The rally in aluminium prices is a driver of Alcoa's equity rally, leaving the company vulnerable to a reversal in commodity prices. The US$64 question is whether aluminium prices are being driven higher mainly by a weaker dollar or if the global economy will recover enough to justify the rally.

The exhibit below charts market and adjusted MFCI CDS levels for Alcoa. Alcoa market CDS remains well below fair value, leading to our expectation of credit deterioration. Alcoa ranks weakly across all fundamental factors except change in leverage (due to strong equity performance) and accruals.

Carol Levenson, Gimme Credit's Metals and Mining expert, maintains a deteriorating credit outlook for Alcoa. Carol notes that, even though aluminium prices have risen, they are still below where the company can make money. We recommend that clients look at Carol's full Alcoa analysis at Gimme Credit.

The exhibit below charts Alcoa's five-year CDS against its equity. The red line indicates the fair value curve for five-year CDS given equity price.

The blue triangle indicates current market levels and the yellow diamond shows expected three-month levels for CDS and equity. The green circle shows current fair value for CDS and equity from our CSA model.

There are a couple of takeaways from this chart. First, we expect both CDS and equity to deteriorate over the next few months (yellow diamond). Second, in the near term, we expect CDS to underperform equity (green circle). Thus, we reiterate our previous short AA Trading Idea.

If you can buy AA CDS protection efficiently, that is a great way to get short the name. If not, we believe the company's equity is due for a tumble even though it may outperform credit in the near term.

Our model-implied three-month target for Alcoa shares is US$11.33. Since we recommend going short against a long SPY hedge, we would not place a specific stop on the trade. We look to exit the trade when one of three events occurs.

First, we will exit if Alcoa converges to fair value, eliminating further profit potential. Second, if Alcoa continues to trade too expensive according to our model over the next four months, then we must assume that the company is trading under a new CDS/equity/vol relationship and the trade will be reevaluated for potential exit. Third, if Alcoa outperforms SPY by more than 10% on a beta-adjusted basis, we will cut our losses.

Position
Sell 10,000 shares Alcoa Inc at US$13.12.

Buy 2,100 shares SPDR Trust Series 1 at US$104.32.

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).