Contents

Investors

Harvesting returns

CLO investors benefit from pre-summer purchases

Investors that entered the CLO market before the fierce summer spread rally are now beginning to reap the rewards. However, there should still be incentives for those investors that moved into the asset class more recently.

Blackstone Group, Pearl Diver Capital and Sankaty Advisors are some of the funds that appear to have timed their investments well. For example, Pearl Diver Capital's US$150m CLO fund - which invests in mezzanine and equity pieces of CLOs - has recorded a NAV growth of 88% in less than a year. "The fund's investment decisions are based on fundamental analysis, so while we were confident that the portfolio would perform, the speed at which the CLO market has recovered meant we got our returns at an earlier date than expected," says Neil Basu, managing partner at the firm.

He adds: "Since June, fundamentals have been improving: there's been a dialling down of loan defaults, the migration of loans to triple-C has slowed and loan prices have increased. The US refi market has also re-opened, so the fear that many CLOs would hit the wall in terms of refinancing has dissipated somewhat."

September set a record for CLO trading with close to US$2.5bn in public BWICs, bringing the total amount of public BWICs since late April to over US$8bn, when the successful liquidation of the Whistlejacket SIV jump-started the secondary CLO market (SCI passim). According to structured credit strategists at Citi, several factors contributed to September's volumes. These include workout groups in some banks looking to offload senior CLO tranches into the rally, the liquidation of Victoria SIV (even if just a fraction of the SIV's CLO portfolio traded in the open market) and a number of bid lists believed to have been originated by hedge funds that snapped up bonds early in the rally and who are now looking to lock in profits.

Citi notes that over the last few months, relative to the market size, most of the trading occurred in the mezzanine part of the capital structure. Trading at this level was predominantly driven by profit-taking and by CLO-squared liquidations, with at least three CLO-squared liquidations occurring in the last few months.

At the double-A and single-A level, most of the volume came from banks looking to liquidate their portfolios, as well as from high grade ABS CDO liquidations. The strategists note that some bonds have resurfaced from late 2008 to early 2009 CDO liquidations.

"Recently, we have also seen a significant amount of equity bid lists as some investors were looking to sell into the rally," the strategists add. "The key question going forward is whether the pace of CLO trading is sustainable. On balance, we think the answer is maybe."

They continue: "We believe there is still a lot of money on the sidelines waiting to be put to work and the improving credit outlook story only goes to stoke that demand. Looking at the universe of buyers and sellers, we notice an increasing presence of real money accounts involved in the secondary CLO market."

According to Matthew Natcharian, md and head of the structured credit team at Babson Capital in the US, higher CLO prices attract sellers of weaker deals. "However, it is the better-quality deals that have been setting the prices in the secondary market," he adds. "Those that have come to the market and have tried to sell weaker deals at these prices have found that they don't trade."

Natcharian expects the CLO rally to continue, although he suggests that the huge jumps in prices seen over the past year are unlikely. "Activity in the market will be sustained if bank loan prices remain stable," he says.

Pearl Diver Capital's Basu indicates that there is still around 20bp to the upside to go on mezzanine tranches of CLOs - although he expects to see the emergence of price tiering over the next couple of months. "Investors are now beginning to look more at idiosyncratic risks. The stronger CLOs, with better overcollateralisation ratios and collateral with better par values will be distinguishable," he says.

"The other opportunity we're seeing is the 10%-15% basis between European and US CLOs," he adds. "That basis is now beginning to close, although I believe a 5bp premium on each rating category is warranted on European CLOs."

Meanwhile, Aogán Foley, md at Incisive Capital Management, says that pricing differentiation between large and small CLO managers is already becoming more apparent. "This can be seen most clearly at the mezzanine level, although to some extent it can also be seen at the top of the capital structure. Paper from the smaller managers appears to be coming onto the market first," he says.

He continues: "The market has been building in a big drop in default ratios next year into current prices. I'd still caution on triple-C bucket exposures though - the reason that migration of loans into these buckets has been dropping is because some names have gone straight into the default bucket, rather than the triple-C bucket. European deals have potential other risks that the market sometimes underestimates."

In terms of price improvement in triple-As, Basu suggests a natural ceiling will be hit sooner rather than later. "When the credit crisis first struck, most firms marked down their triple-A CLOs to around 90c-95c on the dollar. When prices for those securities dipped lower than that level, the CLOs were moved to various accounting books," he explains.

He adds: "Now triple-As are touching the 85c-90c mark, but I don't think they will reach par again. As prices creep up further, large amounts of triple-As are likely to be made available for sale, putting a stop to any further improvement in prices."

Basu continues: "Supply is undoubtedly diminishing - especially for the quality names. Holders of performing CLOs have little reason to sell. Added to that is the amount of new real-money investors coming into the market. I'd say demand outstrips supply by about three to one."

Foley notes that it will be interesting to see how dynamics change on the sell-side. "It is likely that bank holders of triple-A CLO debt, and perhaps even double-A debt, will have less incentive to sell as prices improve," he suggests. "European banks that have shifted large portfolios of CLOs into hold-to-maturity books will also find it less easy to sell those assets at a loss, unless they return them to trading books where they are subject to mark-to-market accounting, which they probably won't be in favour of. However, we're beginning to see more mezzanine and equity tranches for sale, and more buyers for these assets."

The supply and demand issue appears to be more relevant to the European market than the US market, for now. Natcharian confirms that a supply and demand mismatch is yet to be seen in the US secondary CLO market, as there is sufficient supply across the capital structure. "As prices continue to rise, we'll see a return of a more natural market, where people will buy and sell for portfolio optimisation rather than credit reasons," he says.

Looking ahead, Natcharian also expects the primary CLO market to return. "Although when that will be is difficult to predict," he says. "Given the success some CLO managers have had over the past year in managing their deals, there should be an investor base that will accept primary issuance - albeit less leveraged than deals in the past."

AC

Documentation

The big squeeze?

Thomson auction to inform debate about value of restructuring credit event

The forthcoming Thomson CDS auctions have raised a number of thorny commercial and legal issues, including whether there even should be a restructuring credit event in Europe. However, the market appears to be engaging with these issues and potentially finding solutions to them.

The outcome of the Thomson auctions will inform market debate over whether a restructuring credit event has value to participants, according to one portfolio manager. "The decision post-auction about whether such an event has value will ultimately be price-related," he explains. "If the recovery is extremely high, buyers will question whether the protection is worth having. A distorted settlement with minimal collection will lead to doubts about the whole process."

The auction process is also likely to influence the approach of banks to restructuring negotiations themselves going forward, as well as the drafting of facility agreements at the origination stage to further facilitate any holders of CDS settling their positions in similar circumstances in the future. "Negotiations could shift in favour of lenders and/or potentially limit their participation in restructurings, but they could also result in more clarity around disclosure of CDS positions and transferability of obligations," the portfolio manager agrees.

ISDA announced last week that three auctions will be held with respect to Thomson, with settlement terms still to be published for each of the three designated range of scheduled termination dates - up to 20 June 2012, from 21 June 2012 to 23 October 2014 and from 24 October 2014 onwards. The final list of deliverable obligations has also been published and comprises nine private placement notes and three tranches of the revolving credit facility.

Following the publication of the final list, CDS sellers had two days to trigger their contracts and CDS buyers a further three days. The timing of the auctions will be confirmed once this process has been completed, with 21 October anticipated by many as the likely auction date.

The requirement to choose whether or not to trigger before knowing the details of the auctions was a difficult proposition for some investors, however. Together with concerns about recovery prices being pushed artificially high by a squeeze, other relevant considerations about whether to trigger include the possibility of waiting for a bankruptcy or failure to pay credit event to occur in the future, the potential for any debt held to be deliverable in the auction given the restructuring agreement (and, if so, would the price achievable be greater/less than the auction final price used for settling the CDS) and whether an indemnity would be required in relation to the revolving credit facility.

The likelihood of squeezes in baskets was a major issue for investors, the portfolio manager confirms. But he says that his understanding is that most protection buyers have triggered their contracts.

"This doesn't take anything away from the fact that it was a tough call to make, given the lack of visibility around a potential auction price," the portfolio manager adds. "Triggering means that you lose the value of the protection, so it is a question of weighing the decision to collect now against the potential for prices to rise after the auction or the likelihood of a bankruptcy/failure to pay credit event occurring in the future. Further credit events being called on Thomson look less likely now, however, given that it appears enough lenders have supported the restructuring."

Structured credit strategists at Citi point out that the zero to 2.5-year bucket, in particular, has the potential to see a significant price squeeze if the volume of protection sold is large relative to the volume of unrestricted outstanding deliverable obligations. "For holders of the obligations, though, this represents a sizeable opportunity," they add. "Upon completion of the restructuring, Thomson has stated that all holders will receive a package of restructured securities with the same value."

Looking ahead, there are a number of potential restructuring candidates in Europe, with CIT being the most obvious. CIT is widely traded in CDS indices and is a commonly occurring reference name for US and European CDOs, as well as first-to-default baskets. The Citi strategists note that an awkward auction for Thomson at a time when other restructurings are likely will focus attention on the CDS market - just at the time when it needs to be able to demonstrate reformed efficiency and fairness.

"An unsatisfactory Thomson restructuring CDS auction is likely to be too obscure to cause the market much reputational damage," they observe. "Long-term, however, such issues need to be ironed out. Restructuring events are likely to become increasingly common and more high-profile."

Thomson CDS are now said to be trading at post-restructuring levels of around 9/13, compared to around 19/22 in recent days.

CS

RMBS

Risk review

Stricter TALF criteria shrugged off, but wider concerns remain

Stricter criteria for submitting ABS to the TALF is expected to discourage top-tier issuers from using the programme. While this in itself is unlikely to unsettle the market, concerns remain that the non-consumer ABS market is being neglected, in particular the private label RMBS sector.

The New York Fed last week announced two changes to the procedures for evaluating ABS pledged as collateral to the TALF (see last week's issue). "We do not see this [criteria] change as a significant hurdle to ABS issuers," structured credit analysts at JPMorgan confirm. "Benchmark TALF-eligible ABS issues have already been sold entirely to cash investors. This will likely lead to top-tier issuers dropping the TALF-eligible label completely from their offerings. In the off-the-run space, the data requirement should not be a big burden, but it is one more factor to consider for issuers."

They continue: "The added step should serve the purpose of weaning the non-mortgage ABS market from the TALF programme, which is reasonable at this point given the strong cash demand and improved liquidity. We expect there to be less TALF-eligible and 'TALF-able' ABS, which will keep supply scarce relative to demand."

Total issuance volumes in the US ABS market are expected to reach US$130bn this year - roughly in line with the US$140bn issued in 2008 - but sharply down from the US$750bn issued in 2006. As of September 2009, TALF has directly financed US$46bn of ABS issuances out of the approximately US$80bn of ABS eligible for TALF that has been issued since March, according to figures from the American Securitization Forum (ASF).

Some US$1.2trn in RMBS has so far been issued in 2009, compared with a year-long total of US$1.3trn in 2008 and US$2.1trn in 2006. However, in 2009 less than 1% of this has been issued without a government or GSE guarantee; this compares with private-label MBS comprising over 23% of all issuance during the time period from 1996 to 2006.

George Miller, ASF executive director, reinforced concerns about the private-label MBS sector at a hearing last week of the Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance and Investment. "While there have been signs of recovery in certain parts of the securitisation market throughout the first three calendar quarters of 2009, some market segments - most notably, private-label RMBS - remain dormant, with other securitisation asset classes and market sectors remaining significantly challenged," he said.

"Furthermore, private-label MBS transactions that have occurred in 2009 involved pools of seasoned, conforming loans - no major private-label residential mortgage-backed securities deal of which we are aware has directly financed new mortgage loan origination this year."

Miller noted that the subordinate ABS markets are still relatively dormant and, unless banks are able to finance a greater portion of the capital structure, credit origination via securitisation cannot be fully restored. "Notwithstanding the success of the TALF programme and the restoration of a modest degree of securitisation financing and liquidity in some market segments, significant challenges remain, including establishing a stable, sustainable and broad-based platform for future securitisation market issuance and investment activity that is less reliant on direct government support," he concluded.

AC

Investors

PPIF managers advised to wait for price weakness

PPIF managers that have already announced equity raises are expected to start investing within the next few weeks. However, securitisation analysts at Barclays Capital question in a new report whether the managers will, in fact, start buying immediately and aggressively or if they will hold back in order to invest as and when weakness in prices is seen.

"If we look at what happened on ABS TALF as an indicator, investors who got in early were able to lock in 12%-15% yields, but yields dropped very quickly within a month or two, with current leveraged yields at 6%-7%," the analysts note. "However, at least in part, this compression in risk premiums has already occurred in the non-agency RMBS and CMBS spaces, with prices up by 10bp-15bp since the announcement in July."

This increase in prices had led to a significant tightening in yields, bringing most leveraged yields down to the low-teens range - a few percentage points lower in yield than the targets for most of the funds (see last week's issue). "In conjunction with the fact that we believe there will be further deterioration in housing and credit performance in the coming two to three months, there is clearly an argument to wait for a dip in prices before investments are made, except in select areas," the Barclays Capital analysts continue.

For funds that have already raised money, part of the manager fees depends on generating higher than 8% returns every year. "This is likely to increase the pressure to invest as soon as possible, since keeping the money idle as cash does not generate any returns," the analysts add. "Further, if the fund managers think the winter downturn will be mild or followed by a fairly strong housing market next year, they might be inclined to buy now in expectation that risk premiums would compress further or that losses will be much lower than what is currently priced in."

Securities eligible for purchase by the PPIF funds include CMBS and non-agency RMBS issued prior to 2009. These securities are required to have been rated triple-A by at least two rating agencies and be backed by loans and leases and not other securities and without any external bond level guarantees (no re-REMICs or wrapped bonds). Barclays Capital estimates that about US$1.381trn of non-agency RMBS and US$517bn of CMBS securities satisfy these criteria.

The analysts also discuss the types of assets likely to gain preference from the PPIF managers. They note that at the super-senior level, only select areas in Alt-A offer required yields to the PPIP. "Based on our models, Alt-A hybrid super seniors would make most sense, followed by Option ARM super seniors. A more optimistic model (around performance or recovery) would likely target bonds more levered to a recovery."

In addition, the analysts believe that the funds will likely prefer full-coupon WAC pass-throughs over floaters, primarily because of higher current yields. "Finally, it will make sense to allocate a small part to mezzanine bonds to boost yields without risking failure of asset coverage tests at the portfolio level. There again, we believe Alt-A hybrid senior mezzanine bonds offer most value," they conclude.

AC

Operations

Concerns grow over HAMP effectiveness

The Congressional Oversight Panel (COP) has released its October oversight report, which expresses concern about the limited scope and scale of the Making Home Affordable programme. The move comes as the US Department of the Treasury and Department of Housing and Urban Development (HUD) announced a new milestone of more than 500,000 trial loan modifications in progress, almost one month ahead of a 1 November benchmark set earlier this year.

The COP report notes that rising unemployment, weak home prices and impending mortgage rate resets still threaten millions of American homes. One in eight mortgages have been found to be currently in foreclosure or default, with the financial crisis forecast to produce 10 to 12 million foreclosures. While it recognises that the Treasury is still in the early stages of implementing its centrepiece foreclosure mitigation program - the Home Affordable Modification Program (HAMP) - the COP says it has three concerns with the current approach.

First, the panel found that: "It increasingly appears that HAMP is targeted at the housing crisis as it existed six months ago, rather than as it exists right now." The panel has pointed out that the programme is limited to certain mortgage configurations - many of the coming foreclosures are likely to be payment option ARMs and interest-only loan resets, many of which exceed HAMP eligibility limits.

Second, the panel has found that the Treasury's strategy also makes no provision for foreclosures due to unemployment, which now appear to be one of the biggest drivers of foreclosure. Foreclosures continue as the programme is ramped up, with foreclosure starts outpacing new HAMP trial modifications at a rate of more than two to one.

Some homeowners who would have qualified for modifications may have lost their homes before the programme could reach them, the COP notes. Even once the programme is fully operational, Treasury's own projections indicate, in the best case, fewer than half of the predicted foreclosures would be avoided.

Finally, the panel found that the result for many homeowners could be that foreclosure is delayed, not avoided. The report highlights the fact that HAMP modifications are often not permanent. For many homeowners, payments will rise after five years and although the programme is still in its early stages, only a very small proportion of trial modifications have converted into longer-term modifications.

The COP is also concerned about homeowners who face negative equity. For many borrowers, HAMP modifications increase negative equity - a factor that appears to be associated with increased rates of re-default.

The goal of 500,000 trial loan modifications by 1 November under the Making Home Affordable programme pushed servicers to ramp up programme implementation and sustain a faster pace of modifications, according to the US Treasury. It says that trial modifications are now being issued at a faster rate than new homeowners are becoming eligible.

Nevertheless, the Obama Administration believes that more can and should be done to assist struggling homeowners and to stabilise the housing market. As part of a continued effort to improve programme performance, senior Treasury and HUD officials held the next in a series of meetings with servicers last week, with discussion focused on improving servicer efficiency and responsiveness to borrowers during the modification process.

JA & CS

Regulation

RFC extended on credit ratings proposals

The US SEC last week adopted some of its proposed amendments that remove references to credit ratings under the Securities Exchange Act of 1934 and the Investment Company Act of 1940. However, the Commission also reopened the comment period for the remainder of its proposals, which are expected to impact the ABS market if introduced.

Most of the comments received initially on these proposals indicate a variety of concerns, including that the subjectivity of the new standards would be difficult to apply and that it is premature to consider these changes while the SEC's initiatives to improve NRSRO ratings accuracy and eliminate conflicts of interest are ongoing.

The adopted rule changes under the Exchange Act and Investment Company Act only eliminate references to NRSRO credit ratings in a small number of rules in which they appear, according to Bingham McCutchen. "The fact that action on all of the other proposals was deferred and the comment period reopened, but with no new substantive proposals, would appear to signal the SEC's continuing dissatisfaction with the rating agencies and the ratings process - but also significant frustration in its inability to generate workable alternative approaches to referencing credit ratings in the majority of rules in which they are used," the firm suggests in a recent client note.

It continues: "The Proposing Release also confirms the SEC staff's prior indications that participants in the ABS markets can expect a comprehensive set of proposed new changes to the overall ABS regulatory regime, in addition to changes in those rules specifically referenced in the Proposing Release." This point is further emphasised by the inclusion of improved disclosure/regulatory requirements for ABS in the SEC's five-year strategic plan.

Under current SEC rules, ABS currently are eligible to be registered on Form S-3 and offered from time to time in take-downs from a shelf registration statement, if the securities are rated investment grade by at least one NRSRO. The SEC has proposed changes in the criteria for S-3 eligibility of ABS that would permit even unrated ABS to be offered via shelf registration statements, thereby eliminating the need in many offerings for concurrent private placements of securities that are not investment grade rated. On the other hand, the proposed rules require that initial investors in any shelf offering of ABS be qualified institutional buyers (QIBs).

Resales of ABS initially sold to QIBs could be made to any investor. But in order to limit sales to relatively sophisticated investors the proposed rules would impose a requirement that the ABS be issued and transferable in minimum denominations of US$250,000. Delinquent assets could not constitute 20% or more of the dollar value of the pool and, for leases other than motor vehicle leases, the residual value could not constitute 20% or more of the dollar value of the pool.

Similarly, Section 3(a)(41) of the Exchange Act defines mortgage-related securities as securities that are rated in one of the two highest rating categories by at least one NRSRO. The SEC proposed to amend Rule 415 to delete the rating component for purposes of determining shelf-eligibility and instead permit mortgage-related securities to be eligible for shelf registration if initial sales and resales are made in minimum denominations of US$250,000 and initial sales are made only to QIBs.

Meanwhile, under Rule 3a-7 of the Investment Company Act, securities - if offered to the general public - must be rated by at least one NRSRO in one of its four highest rating categories. The SEC has proposed to remove this provision in its entirety, leaving only provisions that allow ABS relying on this rule to be sold (in both initial sales and resales) to certain types of accredited investors or to QIBs.

If adopted as originally proposed, these changes would effectively ban public offerings of ABS that rely on Rule 3a-7 for an exemption from the registration requirements of the Investment Company Act, according to Bingham McCutchen. The SEC says that it believes that most ABS issuers do not rely on this provision of Rule 3a-7, but rely instead on the exception from the Investment Company Act for companies whose securities are owned only by qualified purchasers. However, there are many types of public ABS transactions that do routinely rely on this provision of Rule 3a-7.

Two other provisions of Rule 3a-7 were proposed to be revised. The rule permits the issuer to acquire additional eligible assets or dispose of assets only if the acquisition or disposition does not result in a downgrading in the rating of the issuer's securities. The SEC proposes instead that the issuer have procedures to ensure that the acquisition or disposition does not adversely affect full and timely payment of the issuer's outstanding securities.

Second, the rule requires that cashflows from the asset pool be deposited in a segregated account, consistent with the rating of the issuer's outstanding securities, to minimise risk of loss of cashflows pending payment to securities holders. This provision would be amended to require that cashflows be deposited consistent with full and timely payment of the outstanding securities.

Finally, Rule 206(3)-3T under the Investment Advisers Act permits an adviser that is a broker-dealer to act in a principal capacity with clients only if the security is a non-convertible investment grade debt security. The SEC proposes to eliminate the adviser's ability to rely exclusively on an NRSRO rating to determine if the security is investment grade. Instead, the adviser would have to make its own assessment of the credit risks presented.

The amendments adopted by the SEC relate to the regulation of self-regulatory organisations and alternative trading systems under the Securities Exchange Act of 1934, as well as in rules that affect an investment company's ability to purchase refunded securities and securities in underwritings in which an affiliate is participating under the Investment Company Act of 1940. The Commission believes that the references to credit ratings in these rules and forms are no longer warranted as serving their intended purposes. Further, the amendments are designed to address concerns that references to NRSRO ratings in SEC rules may have contributed to an undue reliance on those ratings by market participants, the Commission says.

CS

Advisory

CRE advisory formed

MBH Enterprises has announced the formation of Ventras Capital Advisors, a company that will specialise in both residential and commercial real estate funds management and distressed asset management and disposition. Ventras has already become the replacement CDO asset manager for eight commercial real estate and diversified structured finance CDOs (see SCI issue 148), and is currently raising third-party capital to take advantage of the current investment opportunities within CMBS.

The Ventras team, led by Scott Roth and Patti Unti, comes from Capmark Investments. Roth and Unti have been involved in the CMBS market since 1997 and are experienced in all aspects of the investment process, including deal sourcing, bond analysis, credit due diligence, asset management, financing and disposition. The team has experience utilising both long and short strategies, while investing in the entire CMBS capital structure.

Previously, Roth and Unti served as co-heads of Capmark Investments securities team and as members of Capmark Investments' securities investment committee.

Steve Gutterman, an md of MBH, says: "We believe there are few management teams anywhere with this kind of experience and successful track record in managing commercial mortgage-related investments. We're very pleased that Scott, Patti and the team will provide top quality management and fiduciary standards to our existing assets under management, and that they will work alongside us to build Ventras."

Ventras Capital is the latest addition to MBH's portfolio of financial service companies. In 2007, MBH acquired Denver-based Integrated Asset Services (IAS), the nation's largest privately held collateral valuation and default management service company for residential real estate. The company provides a full suite of valuation, servicing and disposition services.

Together with IAS, Ventras will have the ability to manage large pools of assets, value and service individual assets, and facilitate the transition of assets to stable holders. The platform will also benefit by the addition of funds led by best-in-class fund managers.

Gutterman adds: "Over the next two to three years, there will be intense interest in opportunistically investing in distressed residential and commercial assets. We are uniquely positioned to do well in this market while helping to provide much-needed disposition solutions to banks and borrowers at the same time."

CLO Managers

Investor disputes Alesco CDO amendments

Cohen & Co's proposed collateral amendments to four Trups CDOs - Alesco Preferred Funding I, II, III and IV - are being vehemently disputed by Hildene Capital Management, an investor in the deals. Hildene says it objects strenuously both to the proposals, as well as to previous 'impermissible' exchanges of the collateral.

Under Cohen & Co's proposals, the static nature of the CDOs would be changed, with the collateral manager periodically substituting credits. Cohen states that it has identified many issuers of debt securities that seek to retire that debt at discounted prices. However, the investors are accusing Cohen of allowing its affiliates to engage in these exchanges in order to receive advisory fees.

"Since many of these issuers are advised by affiliates of Cohen, the proposed policy could be seen by skeptical investors as an opportunistic attempt by Cohen to allow its affiliates to engage in 'exchanges' in order to receive advisory fees from those issuers seeking to retire debt at discounted prices, to the detriment of the noteholders of the issuer," suggests Hildene.

The firm continues: "Introducing the ability for Cohen to conduct 'exchanges' (as outlined in the proposed policy) will turn the certainty of the existing portfolio into an investment in a changing pool of assets, lowering investor confidence in any such investments and reducing secondary market interest in the issuers' securities, to the detriment of existing investors."

In addition to opposing the proposals, Hildene disputes any implication that Cohen may legitimately engage in 'exchange offers' of collateral under the existing terms of the indenture unless the exchange is for new securities of the same issuer. "Apparently Cohen thinks that an unprecedented market dislocation and a self-serving interpretation of the meaning of an 'exchange offer' in Section 6.16 of the indenture permits it to engage in actions that are impermissible with respect to a fixed portfolio, despite the impact on investors," it continues. "Moreover, Cohen already has engaged in improper 'exchanges' of securities that do not satisfy the requirements of Section 6.16, to the detriment of the respective transactions. We disagree with the interpretation and object to Cohen's actions."

Hildene indicates that instead of seeking to adjust the portfolio to improve ratios - which could allow Cohen to be paid its deferring subordinate management fees - it encourages the manager to waive a portion of its senior management fee to accelerate the repayment of principal of the most senior tranches, improve the overall transaction and bring the transaction closer to compliance with its required ratios. "This would help investors by reducing the debt being supported by the existing portfolio and would bring Cohen closer to being paid its senior and subordinate management fee when the transaction was restored to a healthy status," the asset manager adds.

Hildene concludes that Cohen's actions with respect to 'exchanges' that have already occurred are a violation of the management agreement that could lead to Cohen's removal as collateral manager of the transactions.

CLO Managers

Change of collateral manager for Duane Street

Prudential Investment Management is set to assume the collateral management responsibilities for the Duane Street CLO V transaction from DiMaio Ahmad Capital. S&P has issued a preliminary rating confirmation in connection with the proposed amended and restated collateral management agreement, reflecting its opinion that the change in collateral manager will not, by itself, cause the current ratings on the transaction to be lowered or withdrawn.

CLO Managers

Babson set to take on more CLOs

Jefferies Capital Management is set to hand over the collateral management duties of St James River CLO and Clear Lake CLO to Babson Capital. The transactions, both launched in 2007, were arranged by Fortis and Citi, respectively.

With the addition of the St James River and Clear Lake CLOs, Babson will have 18 US CLOs under management.

The transfer of management duties will be carried out only if ratings are not affected, and if the consent of the issuer, requisite noteholders and the majority of the Class 1 subordinated notes are given.

CLOs

Two new CLO funds to launch

Pearl Diver Capital, a UK-based structured finance asset management firm, plans to launch two new CLO funds.

The first will focus on triple-A to single-A CLOs (original ratings) and, unlike the firm's current fund, it will be open-ended and more trading-based - making it more suited to hedge funds of funds. It could also potentially invest in ABS.

The second fund that Pearl Diver Capital is hoping to launch is similar to its current CLO fund (i.e. mezzanine and equity CLO tranches), but would have a return target in the twenties, rather than in the thirties that its current fund offers.

For more on CLO performance, see separate news analysis.

Distressed assets

Distressed CRE fund launched

Foxcode Real Estate has launched a new private real estate fund. Based in Miami, the fund expects to raise US$50m to take advantage of depressed real estate prices due to the current market environment.

The fund aims to take advantage of the current buyer's market in commercial, multi-family real estate by acquiring cash flowing properties at below market values, producing high current income for investors and realising capital appreciation of underlying properties.

Foxcode president Robert Willis says: "The current harsh economic climate has resulted in falling real estate prices and capital markets which are unable to finance real estate nationwide. Investors realise this, but have large single-asset risks if buying individual properties. Our fund structure offers a risk mitigation strategy that enables investors to own a smaller piece of a larger portfolio of properties. Big-picture fundamentals are the perfect storm for our fund - prices, interest rates, inflation and rental demographics."

The firm's founders - Willis, along with Fred Dupuy, Sean Quinn and Phil Cicio - have experience advising partners throughout many complex real estate and structured financing transactions across various market cycles. Their experience includes real estate restructuring and financing matters, including assessment, acquisition, development, management, operations and exit strategies.

Distressed assets

WestLB announces 'bad bank' plans

The supervisory board of WestLB has announced that it intends to ring-fence non-strategic assets with a volume of at least €87bn. The bank says it is currently engaged in intensive negotiations with SoFFin in connection with the move.

In a first step, a sub-portfolio of structured securities with a volume of up to €6.4bn has been guaranteed by SoFFin pursuant to § 8 of the amendment to the Financial Markets Stabilisation Act (FMStFG). For this, WestLB's owners have provided SoFFin with a pro-rata counter-guarantee amounting to €4bn. The sub-portfolio will be transferred to a permanent ring-fenced solution by 30 November 2009.

The provisional SoFFin guarantee for the sub-portfolio, as well as the next steps leading to the permanent ring-fencing of the entire portfolio will comply fully with the requirements laid down by the European Commission, WestLB says.

Dietrich Voigtländer, chairman of the bank's managing board, says: "These decisions mean that WestLB is on the right track. The bank is able to fulfill the requirements of the European Commission regarding the reduction of total assets and risk-weighted assets and at the same time successfully strengthen its business model, which is clearly focused on its clients and its competencies."

Distressed assets

Distressed analytics head appointed

BTIG has appointed Vikas Tandon as md and head of high yield and distressed analytics within its global fixed income group. Tandon joins BTIG from Joshua Tree Capital Management, a distressed fund focused on extremely illiquid securities that he founded in 2007.

Prior to that, he worked for Lonestar Capital Management, where he was the co-portfolio manager. Tandon has also held positions at Donaldson, Lufkin & Jenrette and UBS.

BTIG's global fixed income group was launched in February of this year by Jon Bass, formerly of UBS, and John Purcell, formerly of Citigroup. The group focuses on sales and trading of credit products, covering the full credit spectrum from investment grade to distressed debt, as well as emerging markets and mortgages.

Emerging Markets

Boutique eyes Asia-Pacific expansion

A new boutique investment bank focused on distressed trading and advisory in the Asia-Pacific region has opened in Hong Kong. SC Lowy Financial Services was co-founded by ceo Michel Lowy and cio Soo Cheon Lee. Chetan Baxi has been named coo of the firm.

All three come from Deutsche Bank's Asia Pacific strategic investment and distressed products group, which Lowy headed. The firm says it intends to expand further in the region, with Japan and Australia cited as potential locations.

Listed products

Additional share raise for CLO vehicle

T2 Income Fund reports that it has conditionally raised £11m, before expenses, by way of a placing with new and existing shareholders of 44,000,000 new ordinary shares in the company at a price of 25 pence per placing share. Application will be made for the shares to be admitted to trading on AIM and dealings are expected to commence on 20 October.

Following the admission of the shares, the company will have a total of 87,000,000 ordinary shares in issue. Shareholder approval for the placing - as well as whether to change the company's name to Greenwich Loan Income Fund - will be sought at the company's EGM on 16 October.

Operations

Warehouse pilot programme unveiled

Freddie Mac has partnered with warehouse lender NattyMac, a Guggenheim Partners company, in a new pilot programme to help lenders obtain warehouse lines of credit. The initiative is designed to help single-family and multifamily lenders find adequate lines of credit to fund loans for sale to Freddie Mac.

"The warehouse lending industry has nearly exited the market, making it increasingly difficult for lenders to fund loans," explains Charles Haldeman, ceo for Freddie Mac. "We're proud to help bring much-needed additional liquidity to the residential and apartment financing community."

Freddie Mac will provide participating warehouse lenders with standby commitments to purchase qualifying loans in the event a seller/servicer cannot meet its contract obligations or fails. Pre-funding reviews are required and normal Freddie Mac purchase and origination processes and procedures apply.

Freddie Mac is providing this standby purchase commitment arrangement with NattyMac as part of the pilot programme. Other seller/servicers interested and who qualify for this programme will have to enter into a separate agreement directly with the participating warehouse lender. The credit line from the warehouse lender that is supported by the standby commitment will fund only the loans the participating seller/servicer intends to sell to Freddie Mac.

SIVs

K2 SIV managers reprimanded over insider trading

The UK's FSA has censured Darren Morton, a director, and Christopher Parry, a vp at Dresdner Kleinwort (now part of Commerzbank) for committing market abuse in relation to a new issue of Barclays' bonds. The pair were portfolio managers with Dresdner's SIV, K2, which had US$65m of a Barclays' floating rate note issue in its portfolio.

The FSA says at 10:02 on 15 March 2007, Morton was given inside information about a potential new issue of Barclays FRNs on more favourable terms than the previous issue, which he shared with Parry. Acting on this inside information, Morton and Parry then agreed to sell K2's entire holding of the previous issue to two separate counterparties.

Both counterparties to the trades were unaware of the proposed new issue of FRNs. At 15.16 on that day, a new issue of FRNs was announced and the counterparties made mark-to-market losses of US$66,000 and independently complained to K2 about the circumstances of the trades.

Morton and Parry are said to have believed they were acting in accordance with market practice when selling the FRNs. The FSA says it does not accept that such a belief is reasonable.

Margaret Cole, FSA director of enforcement, says: "Morton and Parry's abuse of the privileged information they had directly resulted in K2's counterparties recognising losses. Our action reflects the fact that some market participants may, in the past, not have paid sufficient attention to their obligations in this area. Future offenders will be likely to face significantly more severe sanctions. We will be following up this case with future work with the industry to ensure that firms, and their staff, are fully aware of their obligations."

In determining the right action to take, the FSA took into account that Morton and Parry did not make a personal profit from the trades.

SIVs

Asset substitutions for restructured SIV

HSBC, as programme manager, effected two separate asset substitutions in the portfolio of Mazarin Funding in September. The first substitution involved the disposal of a triple-A rated leveraged super senior transaction and the purchase at a discount of a triple-A rated UK SME ABS transaction.

The second entailed the disposal of a triple-A rated US student loan transaction and the purchase at a discount of a triple-A rated US CMBS. In each case, the nominal amount of the purchased security represented less than 1% of the portfolio aggregate amount.

The restructured SIV's ABCP and MTN senior debt benefit from credit enhancement in the form of junior senior notes and incomes notes, as well as from overcollateralisation created by the difference between the nominal and original purchase price of securities. As of August 2009, the senior credit enhancement percentage based on non-defaulted assets was 21%.

Moody's says that the two asset substitutions have not resulted in the downgrade or withdrawal of Mazarin's rated notes. The agency analyses the SIV's portfolio as static for the time-being and accordingly the manager has confirmed that it will inform Moody's prior to any future proposed substitution of assets.

Structuring/Primary market

Americas fixed income heads appointed

Nomura has hired industry veterans Charles Spero and Jeffrey Michaels as mds and joint heads of fixed income in the Americas. They will be based in New York and will be responsible for all fixed income functions, including sales, trading, research and structuring.

The pair report globally to Tarun Jotwani, senior md and global head of fixed income, and locally to Shigesuke Kashiwagi, president and ceo of Nomura in the Americas.

Spero joins Nomura from Barclays Capital, where he was responsible for the trading of all non-agency, asset-backed and commercial mortgages, securities, derivatives and indices within the securitised products business. He previously spent 12 years at Lehman Brothers, most recently as head of securitised products for the Americas, which was one of the firm's largest and most significant businesses.

Michaels most recently served at Citigroup, as head of rates trading in North America. He previously served at Lehman Brothers for eight years, becoming head of US rates trading in 2006. Prior to that, he spent 11 years at JPMorgan, where he became its head of US volatility trading and ran the options trading desk.

In addition to hiring Spero and Michaels, Nomura has hired 28 mds in fixed income in the Americas since January 2009.

Structuring/Primary market

Barclays said to be spinning off CLO portfolio

Barclays is planning to spin off £4bn of CLOs, according to an FT article. The report details two options for the sale: one that could mirror last month's Protium deal, through which Barclays moved £12.3bn of RMBS and monoline exposures to a new company - funded and staffed by Barclays (see SCI issue 153). A second option would entail Barclays selling the portfolio to a third-party investor.

When Barclays announced the launch of Protium in September, the bank implied that the transaction would be a one-off. A spokesperson from Barclays Capital declined to comment on the move.

Trading

Structured credit pros flock to new brokerage

Amias Berman & Co (ABCo) has been granted regulatory approval to commence its international activities, based in London. Its sister company Amias Berman (Hong Kong) is in the process of seeking approval from the Securities and Futures Commission in Hong Kong.

ABCo, a fixed income advisory, origination and brokerage firm formed earlier this year, was founded by ex-Citi bankers Jeremy Amias and Charlie Berman. Evenly divided between London and Hong Kong, ABCo has already recruited 25 staff with average tenures in the industry exceeding 15 years.

Andrew Feachem, who is responsible for the European structured business at the firm, spent over 11 years structuring and marketing a broad spectrum of complex derivative products. For the past eight years he worked at ABN AMRO, where he ran a credit derivatives origination and syndication team.

The group pioneered numerous market developments, including credit CPPI, the CPDO, securitisation of derivative counterparty risk and the natural catastrophe CDO. Prior to ABN AMRO, he worked at Enron and EuroBrokers, where he helped develop the European weather derivatives market.

Tetsuya Ishikawa moves to ABCo from Morgan Stanley, which he joined in 2007 to cover UK-based hedge funds, asset managers, banks and SIVs for structured credit products and private deals, and was also involved in building Morgan Stanley's property derivative business. Prior to that, he was at Goldman Sachs syndicating all globally-originated securitisation and CDO deals, as well as structured products to European and Middle Eastern investors. He started his career at ABN AMRO as a structurer and marketer, where he helped grow the nascent credit derivative business through indices, bespoke correlation trades and CPPI.

Juan-Carlos Martorell also joins ABCo, having previously worked at ABN AMRO, where he was a senior member of its structured credit marketing and syndication team, responsible for structuring and marketing structured solutions and structured credit investments for institutional and private investors in EMEA. He worked on products such as cash and synthetic CDOs, CPPI, CPDOs, life settlements, CLO equity funds and credit long/short strategies.

Prior to ABN, he worked in S&P's European structured finance group, where he was the product manager of the cash and synthetic CDO group and the SIV business in the region. He developed credit risk and cashflow rating methodologies that have become benchmark credit tools for the structured finance industry.

Paul Thompson is the coo of ABCo and joined the firm at its inception in May 2009. He has over 25 years' experience in the securities industry, both as practitioner and manager, and has held senior roles at a number of investment banks, including HSBC, Merrill Lynch and Citi. Immediately prior to joining Amias Berman & Co, he was coo of global capital markets distribution at Citi.

Peter Cappuccini also joins the firm. He has over 30 years' experience in bond markets, covering a wide range of sectors, including credit, government and ABS markets. He spent 11 years at Salomon Brothers, six years at Bank of America/Merrill Lynch and five years at Paine Webber, with responsibility for sales coverage (directly and as a manager) to UK institutional investors.

"As a new firm we have no legacy positions and to ensure no conflicts ever exist with our clients we will not take any positions or engage in lending activities," say the Amias and Berman. "Given the experience of our exceptional and highly experienced team, we are in a position to be especially helpful in solving problems and sourcing opportunities for both investors and issuers in structured credit, ABS and in the field of regulatory capital for financial institutions."

ABCo is investing heavily in developing technologies to provide both analytics and financial modelling and also assist in the most efficient intermediation and execution of securities broking for large and small institutional investors. The firm has appointed Pershing Securities, a wholly-owned subsidiary of The Bank of New York Mellon Corporation, as its clearing and settlement agent on a full Model B basis.

The two founding partners hold the majority of the equity in the new business, while ICAP has taken a minority investment.

ABS

South African auto ABS rated

Moody's has assigned provisional global scale ratings (GSR) and national scale ratings (NSR) to the ZAR²bn issuance of Auto Series Investments Limited. This is the ninth public term securitisation of BMW Financial Services (South Africa) and the fifth issuance under the domestic MTN programme established in April 2005.

The portfolio, which has been consolidated with the existing Auto Series Investments pool, consists of auto loans and the contracts mainly finance the purchase of BMWs (72%). The composition of the additional pool is similar in most respects to the existing Auto Series Investments pool, except for the seasoning, which has increased to 36 months after the pool addition and the fact that the additional portfolio does not include residual value contracts and financial leases.

ABS

Aircraft leasing mergers have long-term advantages

Aircraft leasing mergers have short-term uncertainties, but longer-term advantages for aircraft ABS, says Moody's in its latest Weekly Credit Outlook.

AerCap Holdings announced its intent last month to acquire Genesis Lease in an all-stock merger of the two European aircraft leasing companies. Reportedly, several other aircraft leasing companies, accounting for approximately one-third of the global aircraft leasing market, are also considering sales of their businesses.

Moody's notes that both AerCap and Genesis, as well as most of the companies considering sales, have outstanding pooled aircraft securitisations for which they typically act as servicers. "We believe that re-shuffling in the industry may cause uncertainties and perhaps even negative ratings pressure for securitisations in the near term. Nevertheless, there clearly are some possible advantages in the longer term, such as greater stability," says the rating agency.

Aircraft leasing is a specialised industry and investors rely upon servicers for their industry expertise and their relationships with airlines and aircraft manufacturers, which are key ingredients to profitably manage a fleet of securitised aircraft. "Thus, when a leasing company is acquired or when leasing companies are merged, the capability and strength of the successor company to service the securitised pools is crucial," says Moody's.

"Credit risks may arise if the successor servicer were not able to extract the same value out of the pooled aircraft as its predecessor," it adds. "For example, the successor servicer may take on aircraft outside of its particular expertise, such as wide-body versus narrow-body, and may not have retained the appropriate expertise from the absorbed entity. Or problems could arise during the integration of diverse servicers' platforms."

However, Moody's believes that in the long-term the leasing sector is likely to benefit from consolidation. "The larger surviving leasing companies will eventually benefit from a more diversified global client base and greater negotiating power," it says. "This is evident in the AerCap Genesis merger; AerCap is expected to add 23 new clients to its customer list and to become the biggest independent leasing company."

The agency concludes: "According to AerCap's merger filings, its management also projects that Genesis will be a net generator of cashflow in the next few years. If those expectations materialise, then this cashflow should, at minimum, provide greater stability to the credit profile of the combined entity."

Alternative assets

Two timeshare ABS completed

Wyndham Worldwide Corporation has completed two term securitisation transactions involving the issuance of US$350m of investment grade ABS. Sierra Timeshare 2009-2 Receivables Funding issued US$175m of triple-A rated vacation ownership loan-backed notes, which have an advance rate of 55% and a coupon of 4.52%. Sierra Timeshare 2009-3 Receivables Funding issued US$175m of single-A rated vacation ownership loan backed notes, which have an advance rate of 70% and a coupon of 7.62%.

"We are pleased with the execution of these transactions, which reflect the quality of the underlying vacation ownership receivables and our strong history in the asset-backed market," says Tom Conforti, cfo, Wyndham Worldwide. "We are especially encouraged that the terms of these transactions suggest a steadily improving asset-backed securities market, evidenced by significantly better pricing."

CDS

CDS liquidity scores signal financials renaissance

Fitch Solutions has published its latest update on global CDS spreads/liquidity scores, in which it finds that the most notable development is the continued short-term renaissance for many financial companies, especially among some of the bigger market names. Credit spreads among companies such as Bank of America and Citigroup are narrowing as liquidity is falling, signalling further improvements for the financial sector overall, the firm notes.

Fitch Solutions md Thomas Aubrey says: "The magnitude of change in both CDS spreads and liquidity is an encouraging manifestation of longer-term stability for financials."

Conversely, the firm reports that the diverging trend of tightening spreads and increasing liquidity is denoting continued uncertainty - most notably in sectors where there has been long-term considerable stress, such as mortgage insurers (for example, MGIC) and airlines (Southwest).

CDS

Counterparty risk index stable for now

The CDR Counterparty Risk Index (CRI) remains just higher than its recent lows. With US members of the index due to announce earnings next week, most CRI members are trading close to their week-ago levels.

JP Morgan, one of the strongest credits in the index, performed the best over the past week as it shed 10% of its CDS risk. Credit Suisse was the worst performing, adding a little over 4% to its CDS premium. Citigroup remains by far the riskiest member of the index and, given negative earnings expectations, shows no sign of closing the gap soon.

European members of the index underperformed their US counter parts over the past week, trading unchanged on average, according to Dave Klein, manager of the CDR Credit Indices. US index members shed about 5% of their CDS risk.

He concludes: "In early July, the CRI followed a similar pattern as it levelled off after a big rally. Mixed economic data and a volatile earnings season briefly pushed the index wider before it rallied to current levels. As we enter another earnings season, mixed economic data is again pushing markets around and we wonder how long the current stability in the CRI will last."

CDS

Derivatives price comparison venue launched

An institutional retail derivative trade price comparison venue has launched. DerivativeSupermarket.com is an independent company covering a number of OTC derivative asset classes, including credit default swaps.

The website enables clients to compare prices on a range of vanilla and non-vanilla derivative products, with the aim of saving them time and money as banks compete for their business. The site anonymously relays retail trade requirements to dealers, who review these trade requirements and if it suits the bank's book, they request to contact the client directly.

Clients can supply as much or as little trade information as they like; in most cases product, currency, amount and duration is all that's needed. If they wish, clients can pre-vet or deny certain banks and there is zero commitment to trade and zero fees.

DerivativeSupermarket.com says it does not act as principal; retail clients trade directly with the dealer. Neither does it share client information, unless an internationally recognised bank is willing to price the trade.

CLOs

Recovery still distant for CLOs, CSOs

The credit quality of global credit derivatives is stabilising, according to a new Moody's report. However, the agency notes that issuance of CLOs and corporate synthetic obligations (CSOs) will be limited for a while longer.

Moody's says that although CLOs continue to experience all forms of stress - rating downgrades, collateral defaults and historically wide spreads - there have been some recent signs of stabilisation in the US high yield market, which in turn would stabilise the credit quality of CLOs. Moody's md Jian Hu says: "Indicators, such as loan prices, default rates and CLO portfolio metrics suggest a near-term bottoming out in the cycle; however, considerable uncertainty remains."

With liability spreads still wide and downgrades continuing, new CLO issuance remains weak, dominated by repackaging of existing notes, Moody's says. Hu adds: "The structure of recent transactions generally has been simpler than in the past and we expect investors will continue to seek simplicity and transparency in future transactions."

Meanwhile, investors remain cautious about CSOs and Moody's expects a slower recovery for such transactions as compared to CLOs. Hu explains: "The high level of volatility exhibited by CSOs relative to CLOs in the current crisis indicates it may take much longer for the CSO new issuance market to revive. At a minimum, a more stable credit profile for the corporate sector, sustainable arbitrage opportunities between CSO assets and liabilities, and greater clarity regarding the economic consequences of regulatory changes are necessary for issuance to resume."

Another potentially important impediment to overcome is banks' reduced availability of capital, constrained balance sheets and increased risk aversion to structured products in the current environment, Moody's concludes.

CMBS

Developers Diversified deal seeks TALF eligibility

Developers Diversified Realty Corporation has completed a US$400m CMBS via Goldman Sachs, it has announced. The five-year deal is secured by a portfolio of 28 shopping centres. However, Developers Diversified and Goldman Sachs say they are still continuing to work with the Federal Reserve to make the newly-originated transaction eligible for the TALF programme.

Proceeds from the financing will be used to repay existing debt on certain properties in the portfolio, to repay other first mortgage debt with near-term maturities and to reduce amounts outstanding on the company's revolving credit facilities.

CMBS

US CMBS delinquencies led by hotel sector

US CMBS delinquencies resumed their upward trajectory to end the month at 3.58%, according to the latest loan delinquency index results from Fitch. The hotel sector now leads as the property type with the largest proportion of delinquencies, at 5.83%.

Fitch md and US CMBS group head Susan Merrick says: "The recent surge in hotel defaults is consistent with Fitch's view that hotel property values will decline by as much as 50% from peak levels. While budget hotels have fared best during the downturn, continued pressure on the luxury, resort and gaming sub-sectors will likely push lodging delinquencies to approximately double that of the other property types."

Newly delinquent hotel loans in September included 26 loans totalling US$1.1bn, of which 92% by balance defaulted during the loan term. The largest of the new defaults was a US$587.7m note corresponding to the US$4.1bn extended stay America portfolio loan, collateralised by 681 financed and leased hotels located across 42 states.

The borrower filed for Chapter 11 bankruptcy protection on 15 June 2009 and court-ordered adequate protection payments have been remitted since approval of the cash collateral order. Similar to loan status classifications made at the outset of the General Growth Properties bankruptcy, Fitch anticipates that the loan may be re-classified as 'current' in future remittances; however, a potential correction of the loan is unlikely to reverse the rising CMBS and hotel-specific delinquency rates.

September hotel delinquencies also included the US$207.9m Resorts International - Casino Portfolio loan, comprised of three hotel and gaming properties located across two states. The loan became delinquent due to a significant decline in cashflow at the properties. Though it is classified as a mixed-use property due to a land component in its collateral, the declining performance and default on the US$192.5m Maui Prince Resort also exemplify weakness in hotel performance fundamentals, according to Fitch - particularly in those loans underwritten to a stabilised cashflow at issuance.

For the month of September, recent-vintage loan defaults were instrumental in pushing the index higher. Loans securitised in 2007 accounted for approximately 51% of all new delinquencies. Registering a month-over-month increase of 35%, 2007 vintage loans now under-perform the index, with a vintage-specific delinquency rate of 3.61%, compared to 2.68% in August.

Because certain property types are more prevalent in CMBS transactions and comprise a disproportionate percentage of the universe of rated loans, relative performance by property type is best measured on a sector-specific basis. When ranked by delinquencies within their individual property types, the hotel sector last month surpassed multifamily with the highest percentage of late pays, at 5.83% versus 5.72%. Delinquency rates within the retail, industrial and office sectors were 3.65%, 2.96% and 1.97% respectively.

By dollar balance, retail loans continued to lead the index with US$4.9bn of delinquent loans, compared to US$4.3bn the month prior. The delinquency volume for multifamily loans rose only slightly to US$3.9bn from US$3.7bn, while hotel loans posted a 53.9% increase to end the month at a total volume of $3.0 billion. Loans collateralised by office properties comprise US$2.9bn of the total, while industrial loans ended the month with US$719m of delinquencies - a 22.6% month-over-month increase.

CMBS

US CMBS loan delinquencies jump to 3.64%

Moody's has recorded the aggregate rate of delinquencies among US CMBS conduit and fusion loans at 3.64%, based on data from its delinquency tracker (DQT) through to the end of September. By comparison, the DQT was 0.54% a year ago and is now 342bp above the low of 0.22% measured in July 2007.

During September, the DQT rose by 41bp from August's 3.23% rate. It was the largest monthly basis point change in the history of the data included in the DQT, and slightly more than the monthly changes for June and July earlier this year.

Moody's md Nick Levidy says: "After tapering off for two months, the delinquency tracker appears to have resumed an upward trend, as expected. The delinquency rate is likely to continue moving higher over the next several months as troubles compound in the commercial real estate sector."

Of the five core property types tracked by Moody's DQT, the hotel sector had the largest increase in September, moving up 79bp to a 4.97% rate, resuming its climb after a small decline the previous month. The multifamily sector posted the second largest increase in September, rising 58bp to a level of 6.09% - the highest of any property type.

Retail properties had a 34bp increase in delinquencies during September, increasing to 3.76%. The industrial sector saw delinquency rates gain 21bp to reach 2.67%.

Finally, offices increased by 29 points to 2.30%. Four of the top-ten largest newly delinquent loans are backed by office properties.

Moody's DQT shows that the South continued to be the worst performing region, with delinquencies at 5.14%. It saw an increase of 48bp during the month. The increases were especially steep among offices and hotels.

In September, the West experienced the largest increase in its rate of delinquencies, rising 55bp to 4.06%. Three of the top-five largest newly delinquent loans are in this region.

The Midwest remained the second worst performing region, with a delinquency rate of 4.78% after a 39bp increase during the month.

The East remains the best performing region and is the only one to perform better than the national average. Its September delinquency rate was 2.14%, an increase of 30bp from August. None of the property types in the East have a delinquency rate that is greater than 3%, Moody's notes.

Three states - Arizona, Michigan and Nevada - have delinquency rates nearly 300bp higher than any other state, with rates of 9.32%, 9.29% and 9.14% respectively. Ohio has the next highest delinquency rate, at 6.22%.

CMBS

Increase reported in US CMBS special servicing

Fitch has reported a 6% increase in US CMBS loans entering special servicing this past month. While the agency's latest US CMBS loan delinquency index remained unchanged from July to August, this past month's increase in specially serviced loans (103 loans, totalling US$1.8bn) brings the total percentage within its rated CMBS portfolio to 14%.

The largest new addition is the US$375m One Park Avenue loan, which is secured by a 924,501 square-foot office property in New York. The loan transferred to special servicing on 12 August 2009 due to imminent default, following the announced vacancy of the second largest tenant.

Performing specially serviced loans continue to outweigh non-performing loans (59% to 41%), with the trend likely to persist through the remainder of the year, according to Fitch senior director Adam Fox. He says: "More borrowers will seek loan modifications since recent US treasury regulations allow servicers increased flexibility to modify performing loans."

CMBS

Japanese CMBS leads APAC downgrades

Fitch has reported that a total of 119 Asia Pacific tranches (including public, private, international and national ratings) were downgraded during Q309, while four were upgraded. Additionally, 334 tranches were affirmed, accounting for a quarter of all outstanding tranches rated by the agency in the region.

Alison Ho, director and head of performance analytics within Fitch's Asia Pacific structured finance team, says: "The most significant rating actions in Q309 were the downgrades of over 40 Japanese CMBS classes. These followed the implementation of the recently published Japanese CMBS surveillance criteria, a process that will continue into Q409."

She adds: "Over 50 publicly rated Australian RMBS tranches were also downgraded as a result of the agency's changed internal assessment of Genworth Financial Mortgage Insurance, a provider of lenders' mortgage insurance. Despite these downgrades, the majority of tranches rated in Asia Pacific continue to perform in line with expectations, as evidenced by the fact that most rating actions in the quarter were affirmations."

One tranche from a well-seasoned Australian non-conforming RMBS transaction was upgraded, despite high delinquencies, as credit enhancement has built-up following the redemption of senior notes. In addition, one CDO tranche was upgraded due to the build up of credit enhancement, as a result of which the notes can withstand the default of 80% of the current portfolio with no recovery.

Over 100 tranches from Japanese CMBS transactions remain on rating watch negative. Fitch says it aims to resolve these over the coming weeks, as it continues to implement its recently published Japanese CMBS surveillance criteria.

At the end of September 2009, 193 tranches in APAC had negative outlooks, an increase from the 157 at the end of Q209. Japanese CMBS accounted for the majority of the increase, reflecting Fitch's negative view of the Japanese commercial real estate market.

Correlation

Value in IG9 mezz after sell-off

The recent bout of volatility has seen investment grade CDS indices come under pressure, with mezzanine tranches affected in particular. Mezz tranches on the five-year CDX IG9 index have underperformed more than more recent series, providing a potential opportunity, according to structured credit strategists at Citi.

The 12-month rolling default rate is predicted to peak in Q4 and should decline dramatically thereafter. "At current levels, the CDX index and single name CDS spreads have this default decline priced in, while junior tranches have not. For example, the five-year CDX IG9 trades close to pre-Lehman levels, while the five-year CDX IG9 3%-7% is about 10 points cheap," the Citi strategists explain.

One reason for this underperformance is the fact that CDX IG9 includes a number of names that have already defaulted (Fannie Mae, Freddie Mac and WaMu), as well as names trading above 500bp (AIG, ILF and Liz Claiborne) and 1000bp (CIT, iStar Financial, MBIA and Radian). Another reason for the underperformance is the relative significance of the 3%-7% tranche.

The strategists note: "This is one of the most liquid points in the tranche universe, exactly because so many investors and correlation desks have exposure to CDOs of this vintage, composition and point in the capital structure. It therefore tends to underperform in a sell-off, as investors rush to hedge their bespoke exposures using the index tranche."

By the same logic, the tranche should outperform in a rally. And the Citi strategists believe that the market underestimates the extent of credit improvement likely over the next six months. Consequently, they suggest that now is a good entry point for a CDX IG9 3%-7% tranche trade.

Distressed assets

Negative equity hindering home price recovery

Negative home equity is preventing sustained improvement in US mortgage performance, according to a new report from Fitch. The agency estimates that approximately 60% of the remaining performing borrowers from the 2006-2007 vintages are in a negative home equity position, or 'underwater'.

According to Fitch senior director Grant Bailey: "Negative equity reduces a borrower's incentive to pay their mortgage and limits their options when faced with financial difficulties."

After notable improvement through the first half of this year, the percentage of previously performing borrowers rolling into a delinquency status stabilised at an elevated level through the summer months and increased modestly in the month of September. The sustained negative pressure on the remaining performing borrowers has also been driven in part by the continued rise in unemployment, which has reached 9.8% nationally and a record level of 12.2% in California, where the greatest percentage of RMBS borrowers is located. As projected in its 1 October 'Global Economic Outlook', Fitch projects that US unemployment will continue to rise and peak at 10.3% in the middle of 2010.

Despite positive home price figures over the summer, the agency forecasts over the next year a further home price decline of approximately 10% nationally, when weighted by outstanding mortgages. Home price figures in recent months were temporarily helped by the reduced share of distressed property liquidations due to foreclosure moratoriums and servicers' increased efforts to qualify borrowers for modifications. However, the number of distressed borrowers has continued to grow.

The number of non-agency borrowers at least three payments behind on their mortgage reached 1.66 million in September, according to LoanPerformance - the highest level on record. Bailey adds: "While increased modification efforts and an extension of the First Time Home Buyer tax credit may help home prices, the ultimate increase in liquidations from the growing distressed inventory will likely cause a further price decline."

With further employment and home price deterioration expected, Fitch projects performing-to-delinquency roll-rates to remain elevated across the prime, Alt-A and subprime RMBS sectors into 2010.

Documentation

SSP settled, another credit event pending

The final results of the SSP Financing first lien ELCDS auction were announced on 8 October. Six dealers submitted inside markets, with a midpoint value of 52.375. Due to zero net open interest being posted there was no subsequent bidding period and so the midpoint value is the final price.

Meanwhile, the ISDA Determinations Committee (DC) is deliberating over whether a restructuring credit event has occurred in connection with Cemex S.A.B. de C.V. The firm has entered into a financing agreement to defer principal payments on certain bank and private placement obligations.

Separately, it has been decided that a bankruptcy credit event has occurred in connection with Canwest Media Inc and a failure to pay credit event has occurred in connection with Fairpoint Communications Inc, but there will be no auctions for these names. In addition, DC votes on whether succession events have occurred with respect to Union Fenosa and Fortis have been deferred, pending further information.

Monolines

Assured, FSA cut by a notch

Fitch has downgraded the insurer financial strength (IFS) ratings of Assured Guaranty and Financial Security Assurance (FSA) to double-A minus from double-A and to double-A from double-A plus respectively. The agency has also downgraded the debt ratings of the US holding companies Assured Guaranty US Holdings and Financial Security Assurance Holdings to single-A minus. The ratings have been removed from rating watch negative and assigned a negative rating outlook.

Fitch's rating actions primarily reflect increased expectations of credit losses arising from the companies' residential mortgage securitisation exposures. To date, most of the claims activity experienced by AGC and FSA has been from exposures to securitisations of second-lien mortgages.

During 2009, however, Fitch's performance expectations for certain first-lien RMBS categories - specifically Alt-A and Option ARM - have weakened sharply. As a result, loss estimates related to first-lien RMBS exposures have been revised upward appreciably.

Dominic Frederico, president and ceo of Assured Guaranty, says he is pleased that Assured Guaranty and FSA remain in the double-A rating category, and suggests that it is a designation indicative of significant financial strength. "We believe the one-notch rating downgrades primarily incorporate Fitch's stress loss estimates based on an extremely pessimistic view of the future performance of residential mortgage exposures and point out that Fitch noted our ability to mitigate potential future losses and improve rating agency capital," he says.

Frederico adds: "Importantly, the removal of our ratings from rating watch negative to the longer-term designation negative outlook provides time for more clarity on the direction of the economy and future performance of the residential mortgage portfolio versus pure estimates."

Operations

Support extended for Australian RMBS

The Australian government has directed the Australian Office of Financial Management (AOFM) to provide up to a further A$8bn of support to new issuances of high-quality RMBS, depending on market conditions. The investment is designed to boost smaller lenders and promote competition in the mortgage market, helping to put downward pressure on borrowing rates over time, the government says.

It points out that this additional investment in RMBS does not add to net debt, as the government will be investing in - and become the holder of - triple-A rated assets. The government stresses that securitisation is an important source of funding for smaller mortgage lenders and enables them to compete with larger lenders.

The AOFM has been directed to extend eligibility for this initiative to RMBS backed by a greater proportion of prime residential mortgages used by small business owners to fund their businesses. The aim is to help small business owners who access finance for their business using loans secured against residential property.

To further encourage private investment in RMBS and complement independent issuances, the Treasury and AOFM is to consult with industry on the merits and commercial feasibility of delivering part of the support through a fee-based liquidity facility rather than direct investments by the AOFM. The liquidity facility would provide reassurance to private investors that, should financial markets be affected by further liquidity pressures, they would be able to access liquidity by selling eligible RMBS to the AOFM. The facility could also be structured so as to address investors' concerns about extension risk, the government notes.

Under the initiative, issuers would be required to apply to the AOFM for their RMBS to be eligible for this facility. The RMBS would be subject to strict eligibility criteria.

The decision to extend government support for the RMBS market follows the near completion of its US$8bn investment in new issues announced on 26 September and 12 October 2008 (SCI passim). To date, this initiative has helped five non-major Australian banks, four building societies and credit unions, and four non-ADI lenders to raise over US$10.4bn in funding.

However, should market conditions improve sufficiently, the Australian government will assess whether the full US$8bn extension programme is required.

In the past few months, there has been a notable improvement in investor sentiment in both primary and secondary RMBS markets, it says. Prices have fallen from spreads of around 450bp above the bank bill swap rate to as low as 150bp.

ME Bank and Suncorp-Metway recently raised over US$2.5bn from private investors. However, the Australian government recognises that the RMBS market continues to be affected by the fallout from the global financial crisis, and pricing and volumes have not yet improved enough to support affordable new issuance from a variety of smaller lenders.

Operations

FASB urged to review MBS treatment

The Mortgage Bankers Association (MBA) and the CMSA have filed a comment letter with banking regulators to address the proposed risk-based capital (RBC) treatment of assets coming on the books of banks on 1 January 2010, as a result of the implementation of FAS 166 and FAS 167. The new standards, issued by the FASB in June 2009, will generally require that assets and liabilities of prior private label RMBS and CMBS be put on the balance sheet of the issuer, servicer or special servicer.

"FAS 166 and FAS 167 will require hundreds of billions of dollars of assets to come onto the banks' balance sheets on 1 January 2010," says John Courson, MBA's president and ceo. "These assets would immediately require an allocation of capital under the regulatory capital rules proposed. Coming at a time when regulatory capital is already a scarce resource, it may hinder the current economic recovery underway."

In the joint letter, MBA and CMSA recommend that regulators grant regulatory capital relief if a security meets the following structure:

• If the primary beneficiary is the transferor, the transfer meets all other criteria for sale accounting under FAS 166.
• The beneficial interest holders of the variable interest entity (VIE) have no recourse to the general credit of the primary beneficiary other than standard representations and warranties.
• The VIE's assets can be used only to settle the obligations of the VIE.
• There are no explicit arrangements or implicit variable interests that could require the primary beneficiary to provide financial support (for example, liquidity arrangements and obligations to purchase assets) to the VIE, other than servicing advances, which are only required if the servicer deems them to be collectible.

"While the International Accounting Standards Board hasn't yet issued its FAS 166 and 167-equivalent reporting standards, there are significant differences in approach between FASB's and the IASB's exposure drafts," adds Dottie Cunningham, ceo, CMSA.

"This should serve as further reason to delay the regulatory capital impact of FAS 166 and FAS 167," she continues. "We and many other trade organisations have been consistent in our comments to both FASB and IASB that all standards related to financial instruments should be worked on jointly and converged on an accelerated basis."

Operations

Call for mandated CDS trade repository

The DTCC has called for legislative language to be introduced mandating a trade repository for OTC credit derivatives contracts in testimony submitted to the US House Financial Services Committee.

Larry Thompson, DTCC general counsel: "As the operator of the only global trade repository, we have a unique perspective on its value in helping regulators mitigate systemic risk during a crisis. We believe that all derivatives traded by US financial institutions should be reported to a single trade repository for each asset class, which would serve regulators as a comprehensive source of information. From a public policy perspective and in the interests of ensuring the stability and transparency of financial markets, there must be a consolidated, comprehensive single entity that collects and maintains the underlying position data and makes it available to regulators in the most efficient, timely and usable manner."

In the testimony, Thompson expressed concern that current legislative proposals, which require only those trades that are not cleared through a central counterparty to be reported to a repository, could undermine the goals of re-regulation and represent a step backward by reducing the level of transparency that now exists in the marketplace.

Thompson further stressed that when both the CCP and repository work in tandem to support each others' functions, risk can be significantly mitigated and transparency enhanced in the marketplace. "We are concerned that some in the OTC derivatives market may assume once a trade guarantee is provided through a central counterparty, there may be less need for a central registry to track the underlying position data," he said.

The DTCC rejects this view, based on its experience managing the risk flowing from the failure of a single member firm. "At the critical juncture of a firm failure, knowing the underlying position data of multiple transactions in a timely manner will be significant in providing transparency to regulators - and in protecting confidence in the market itself. We believe the role of having a central repository should be reinforced as a matter of public policy," Thompson continued.

Operations

Basel 2 securitisation framework explored

Fitch has published two papers that explore Basel 2's regulatory capital framework for securitisation. The reports review the various Basel 2 approaches for calculating capital charges on securitisation exposures, a study of the potential Basel 2 capital dynamics for a sample of securitisation transactions and in-depth analysis of the supervisory formula for unrated securitisation exposures held by internal ratings-based (IRB) banks.

Ian Linnell, head of the EMEA structured finance group at Fitch, says: "Understanding Basel 2 is important to understanding the future scope and shape of securitisation activity, given how bank capital requirements can influence origination, structuring and investment decisions. Recent rating volatility within some sectors of structured finance has sparked a fresh interest in Basel 2 amongst banks, investors and regulators."

In evaluating Basel 2 capital dynamics for securitisations, Fitch calculates and compares the capital charges on an underlying pool of collateral assets relative to the total charges on the securitisation of these same assets. This approach is useful in analysing the degree of capital comparability or 'neutrality' between the unsecuritised collateral charges versus the securitisation charges on a given transaction - an important consideration within the Basel 2 framework.

Krishnan Ramadurai, md of Fitch's credit policy group, explains: "Basel 2's impact on securitisation capital charges ultimately depends on a complex interplay of factors, including choice of Basel 2 capital calculation approach, deal structure and conventions, the type and credit quality of assets being securitised, and market conditions and investor risk appetite. Case-by-case analysis is therefore critical."

Additionally, the agency notes the importance of understanding how Basel 2's calibration and risk-sensitivity can affect capital charges. Martin Hansen, senior director of credit market research at Fitch, says: "Relatively subtle changes in the risk attributes of either the collateral pool or the capital structure can have a significant impact on capital. For example, Basel 2 securitisation charges accelerate rapidly when crossing the threshold from investment to non-investment grade, meaning that downgraded or junior tranches will tend to dominate overall capital dynamics."

In a separately published report, Fitch also provides an intuitive explanation of the IRB supervisory formula for unrated securitisation exposures. The supervisory formula is technically sophisticated and requires extensive mathematical analysis to understand the drivers and dynamics of the resulting charges, but does not fully capture the heterogeneity of types of assets included in securitisations and important elements of transaction structures, such as excess spread and priority of payment arrangements.

Atanasios Mitropoulos, senior director of Fitch's EMEA structured finance group, explains: "In practice, the supervisory formula tends to generate pronounced 'cliffs' and limited differentiation in charges across the capital structure, thus reducing its risk-sensitivity. Coupled with its demanding information requirements and limited transparency, the use of the supervisory formula could have a negative market impact if used as the primary basis for calculating regulatory capital requirements."

Ratings

Rating methodology revised for VRDBs

Moody's has revised its methodology for rating the underlying risk of variable rated demand bonds (VRDBs) backed by federally guaranteed student loans. The agency will now assume that the liquidity provider may have to provide liquidity, if the bond fails to be remarketed, for an extended period of time.

Moody's analyst Barbara Lambotte says: "Recent experience has shown that it is much more likely than previously thought that remarketings would fail and bonds would be 'put' to the liquidity providers and much more likely that, once 'put', the VRDBs would be held for an extended period of time as bank bonds."

Underlying risk in VRDBs is the degree of risk that the entity guaranteeing the liquidity of the transaction won't be paid in full on interest and principal, should the bond fail to be remarketed, requiring it to hold on to the bond. During the past two years, 31 outstanding transactions involving approximately US$4.1bn of a total of US$4.8bn outstanding Moody's-rated FFELP-backed VRDBs have failed to be remarketed.

A VRDB is a long-term instrument with an interest rate that resets periodically, usually daily or weekly, and provides an option to investors to sell (or put) the bonds back to the issuer's remarketing agent at each reset date, at par. Typically, if the remarketing agent cannot find a market-clearing interest rate at which it can remarket the bonds, the liquidity provider is required purchase them.

Ratings

Australian SF performance remains robust

A total of 200 publicly-rated tranches backed by assets in Australia or New Zealand were affirmed during Q309, one was upgraded and 59 were downgraded, Fitch reports.

Leanne Vallelonga, associate director in the agency's Asia-Pacific structured finance team, says: "Consistent with previous quarters, most Australian RMBS downgrades are not attributable to the deteriorating performance of the transactions, but rather to a change in Fitch's assessment of lenders' mortgage insurance providers. The Reserve Bank of Australia's increase in the official cash rate by 0.25% effective 7 October 2009 has signalled a change in monetary policy from historic lows. However, Australian interest rates remain at historically low levels and are not expected to significantly increase stress for borrowers at this point."

The one tranche upgraded during the quarter was from Interstar Titanium Series 2006-1, a well-seasoned Australian non-conforming RMBS transaction, which reflected the build-up in credit support following the significant pay-down of the most senior notes.

Five Australian CMBS tranches were downgraded during the quarter, however; four from Centro Shopping Centre Securities Limited - CMBS Series 2006-1 and one from Seiza Augustus Series 2007-1. The downgrades were primarily a result of declining commercial property prices, with further declines anticipated.

In the case of Centro, property values had fallen by nearly 10% by end-2008 from the previous peak portfolio value, although they remain above those at closing. As the outstanding loan balance remains unchanged since its origination, the reported loan-to-value ratio (LVR) was 52.2% as at July 2009, up from 46.9% as at end-December 2007, and marginally lower than the initial issuance level of 53.9%.

Incomes at the underlying properties supporting the loans have generally risen, but capitalisation rates have begun to widen. As a result, property values have begun to fall, leading to rising LVRs both at the property level and across the portfolio at the loan note level.

LVRs have thus become the drivers of ratings for the more senior classes of notes, rather than debt service cover ratios (DSCRs). Fitch anticipates further negative movements in Australian property values in the forthcoming reporting season and during the remainder of calendar-year 2009.

Approximately 41% of obligor loans are due for refinancing in December 2009, another 25% in December 2010 and 34% in December 2011. Given the extremely tight liquidity conditions in financial markets and, in particular, the Australian property market, Fitch anticipates the underlying obligors will have considerable difficulties in completing the refinancing of the upcoming maturing loans within the required timeframes. Under the transaction documentation and in the event that loans are not repaid on schedule, the obligors are required to proceed with the sale of sufficient properties to fully repay their outstanding obligation within 18 months of the due date.

In contrast, a combination of rising realised losses, together with a large number of properties in arrears taking longer than 300 days to sell and proceeds be realised, Seiza has seen charge-offs escalate significantly during Q309. This has resulted in notes not rated by Fitch being charged-off, thereby reducing credit support within the transaction.

As the loans progress through the foreclosure process, the agency expects recoveries to flow back to the transaction, resulting in partial or full reinstatement of notes not rated by Fitch, depending on recovery levels - although timing is uncertain at this stage.

Ratings

Stable outlook continues for non-Japan Asia SF

Fitch has affirmed a total of 16 publicly-rated tranches (including international and national ratings) backed by assets in non-Japan Asia were affirmed during Q309.

Alex Choi, associate director in Fitch's Asia Pacific structured finance team, says: "The performance of the outstanding transactions in Q309 has been steady or has improved. Most rated tranches continue to perform well within Fitch's base-case assumptions and we expect this trend to continue in the near future, as evidenced by the stable outlooks assigned to most of the rated tranches."

Three ABS tranches backed by Korean credit card receivables were affirmed, on account of the improvement of the delinquency and default ratios and net yield, following the deterioration of these ratios in H109. The improvement of the credit card receivables performance is the result of an improvement in Korea's economy, Fitch says. The current available credit enhancement (CE) levels of the three tranches are considered sufficient to support the respective ratings.

One tranche from Korea Ace Mortgage, a Korean RMBS transaction, was affirmed based on steady asset performance, low delinquency ratio and CE build-up as the notes are being paid off. None of the underlying mortgage loans have defaulted since transaction closing. The notes from Value Master 2008-1 Limited were also affirmed, with the outlook being revised to stable from negative in line with a similar revision for Korea Development Bank, to which the ratings are linked.

Two CMBS transactions in Singapore, Emerald Assets Limited Series P1-AAA-002 and Star Topaz, were affirmed with stable outlooks. The Emerald Asset notes were affirmed following the release of security over 14 of the original 50 industrial properties in the portfolio and the redemption of the Series P1-AAA-001 notes. The agency notes that the current rating is supported by Fitch's stressed debt service coverage ratio (DSCR), which is commensurate with a triple-A stress scenario.

Star Topaz was affirmed based on the actual portfolio cashflow being above the stabilised assumption and the strong average DSCR during the past 12 months.

Meanwhile, seven tranches from ABS backed by three Thai credit card receivables transactions were affirmed, reflecting the transactions' ability to maintain CE levels commensurate with the respective ratings. Yield and excess spread, as well as the default rate of all three deals, have performed within Fitch's base-case assumptions since closing.

The monthly payment rate (MPR) for Eternal Credit Card and Eternal 3 has been below the agency's base-case assumptions. However, Fitch believes that the expected CE levels and the satisfactory performance of yield and excess spread, as well as default rate of these two transactions should be sufficient to offset the weak MPR performance.

The outlooks for individual tranches remain unchanged over the quarter, with most being stable, Fitch concludes.

Ratings

Indian SF performance remains stable in Q309

A total of seven publicly rated series from Fitch-rated Indian structured finance transactions were affirmed in Q309, while one series was upgraded, the rating agency reports. The outlook for Indian SF deals remains stable.

Jatin Nanaware, associate director in Fitch's Asia Pacific structured finance team, says: "The stable performance of Fitch-rated Indian SF continued in Q309. The majority of Indian ABS transactions have credit enhancement cover in the range of 4x-6x and are therefore able to comfortably withstand the recent deterioration in the performance of commercial vehicle loans."

The seven affirmations during the quarter came predominantly from ABS transactions, backed by commercial vehicles (used and new), two wheelers, consumer durables and tractor loans. One RMBS series, from ICICI Bank - Nivas Trust Sr II - was also affirmed.

In all cases, credit enhancement continues to build as the series redeem. There has been little or no use of any credit enhancement.

One single loan sell-down transaction, KSE Loan Trust, was upgraded during Q309 following a similar rating on the underlying obligor, Shriram City Union Finance Limited, on 3 July.

Regulation

Call for policymakers to account for ABS variations

In testimony before the US Senate Banking Committee yesterday, CMSA executive committee member Christopher Hoeffel discussed the specific and current challenges facing the CMBS market, and the critical importance of tailoring any new regulatory requirements to ensure that they don't inadvertently hinder economic recovery. CMSA believes two aspects of the current securitisation reform proposal are of utmost concern: a plan to require bond issuers or underwriters to retain at least 5% of the credit risk in any securitised asset they sell and, second, an associated restriction on the ability of issuers to hedge the 5% retained risk.

"We suggest that any new reform proposals reflect key differences in the various securitised markets and particularly the unique nature of CMBS. As such, some aspects of the government's securitisation reform proposal could have the opposite and unintended result of stalling recovery efforts by making lenders less willing or able to extend loans and investors less willing or able to buy CMBS bonds - two critical components that aid in the flow of credit to the commercial real estate market," Hoeffel said in testimony.

While the Association says it recognises that there are challenges facing commercial real estate finance and understands that regulatory reforms are important and warranted, it cautions policymakers and Congress that new proposals should not detract from or undermine efforts to get credit flowing. To these ends, it urges Congress to ensure that reform measures are tailored to account for key differences in the various securitisation markets themselves.

"We feel any policies that make debt or equity interests in commercial real estate less liquid will have a further negative effect on property values and the cost of capital," Hoeffel added.

RMBS

Provide Gems tendered ...

Commerzbank has announced a tender offer on a seasoned synthetic German RMBS, Provide Gems 2002-1. The bank is offering to purchase up to €15.7m of the Class A notes (of €32m outstanding) and up to €22.5m of the Class B notes (€46m outstanding).

The indicative price ranges are 65%-80% for the Class As and 40%-60% of nominal for the Class Bs, according to securitisation research analysts at RBS. The originator has waived its right to call these notes until September 2012. The tender offer expires on 28 October.

RMBS

South African RMBS could face ratings volatility

Increased ratings volatility within South African RMBS transactions could occur due to the practice of originators repurchasing non-performing mortgage loans, says Moody's in a new special comment.

Dion Bate, a Moody's assistant vp, analyst and co-author of the report says: "Since 2007, Moody's has observed a general deterioration in the asset performance of South African RMBS transactions. This is a consequence of the weaker economic environment in South Africa and has led to a reduction in the level of headroom between the actual 90+ day arrears and the respective arrears trigger levels in RMBS transactions."

In the report Moody's notes that to manage the performance below the arrears trigger levels, it is becoming common practice amongst South African RMBS originators to use their option to repurchase non-performing loans at a fair market value, removing them from the pool and creating an upfront realised loss to the transaction.

Bate explains: "This loss is then covered by excess spread (if available), and if the structure is revolving, the funds from the repurchased loan are used to purchase a new mortgage loan which meets the relevant transaction's eligibility criteria. While this is contemplated in the transaction documentation and South African securitisation regulations, it is not in line with the standard practice of allowing a non-performing mortgage loan to follow the normal foreclosure process within the structures, as determined by each servicer's arrears management policy."

The rating agency cautions that while there are short-term benefits to purchasing non-performing mortgage loans, the long term impacts on future performance and ultimate losses are uncertain, which may introduce rating volatility for outstanding notes. For instance, it renders the arrears trigger ineffective as a stop purchase trigger and understates the true performance of the transaction, making it difficult to compare performance amongst peers and against Moody's initial modelling assumptions.

RMBS

Twelve-month lows for Australian RMBS arrears

Arrears on residential mortgage loans underlying Australian prime RMBS fell to their lowest level in a year, reaching 1.32% in July 2009. This is a fall from 1.44% in June 2009, according to a new report published by S&P.

"Over the last six months, arrears in loans underlying Australian RMBS have dropped significantly in each of the arrears categories: 30-to-60 days, 60-to-90 days and greater-than-90 days. We believe arrears are likely to stabilise at lower levels before the future impact of Christmas spending kicks in," S&P credit analyst Vera Chaplin says.

In particular, arrears in the early stages have decreased by a larger proportion compared to the other categories - by about a third or more from the January 2009 peak. In S&P's opinion, this is largely attributable to the supportive fiscal and monetary policy stimulus.

"While the more severe arrears (greater than 90 days) have also dropped, we believe the improvement is due to a combination of strengthening property markets supporting foreclosures, as well as fewer loans migrating into the greater-than-90-day category. Our observation suggests that with the ongoing credit-rationing environment, market conditions remain challenging for borrowers who are in severe arrears, particularly for self-employed borrowers and borrowers with adverse credit histories," Chaplin continues.

Although the economy is showing signs of improvement, the agency believes that key risks remain. Rising unemployment levels and potential interest rates rises could reverse the current improving trend in arrears.

Arrears on low-documentation loans that underlie prime RMBS experienced further declines in July. The percentage of lo-doc loans that are in arrears greater than 90 days fell below 2% for the first time since November 2008, to 1.98% in July.

Subprime RMBS arrears dropped to 12.72% in July 2009, from 13.61% in June. This is a further decrease of 89bp from the previous month. However, the decline in real terms (A$49m) in July is short of bigger declines in May and June of this year.

Further, S&P believes that there are loans in non-conforming portfolios with bullet maturities in the near term that could be exposed to default risk, as financially stressed borrowers in this space still face limited refinancing options.

Structuring/Primary market

Not all repacks eligible for ratings, says Fitch

Fitch has published rating criteria for repackaged senior structured finance notes. A new report details the ratings agency's key considerations for securities and notes that not all resecuritisations will be eligible for higher ratings, if any ratings at all.

The agency's structured finance obligation rating considers the relative vulnerability of transactions to a default on principal or interest, as opposed to a transaction's expected loss. Therefore it is possible that although an underlying note is exposed to elevated default risk, the recovery rate will be high in the event of a default.

Institutions that have either ratings-based capital needs or investment guideline limitations above certain rating thresholds may decide to repackage the security into a first-loss tranche and a senior tranche. The likelihood of suffering a loss on the new senior tranche is then significantly reduced because of the additional subordination provided by the junior tranche. This means that Fitch may be able to assign a rating to the new senior tranche that is higher than that assigned to the original security.

When determining whether to assign ratings to repackaged structured finance notes Fitch will take several factors into account, including the seniority of the original note, the capital structure of the new transaction and the expected performance of the underlying assets. It currently has a moratorium on rating resecuritisations backed by transactions with US RMBS subprime, US Alt-A with overcollateralisation structures or other esoteric assets, due to continued performance volatility in these sectors.

Technology

OTC XML publishing module launched

Riskart has released in beta test its new XML-based publishing module. This comes following the announcement of the decision from CESR to back European Commission plans to compel transaction reporting on OTC derivatives. The publishing module will allow the publication in XML, in compliance with FpML standards from its OTC derivatives middle and back office system, of all details concerning those derivative contracts whose underlying instrument is traded on a regulated market.

The design of the new publishing module will offer a standard publishing mechanism that may be easily adapted for reporting requirements both towards regulatory authorities' systems and other trade publishing platforms. On the basis of CESR on-going consultations with the market, riskart's back office system will also allow clients to easily add to contracts a unique new identification code, whether it be based on market standards such as ISO 6166 (ISIN), the Alternative Instrument Identifier (AII) or any new classification system agreed during the consultation process.

Technology

Vendor enhances calibration power

Pricing Partners has introduced Simplex, a new optimisation technique, to the Price-it Library to enhance its calibration power. The algorithm allows time-dependent Heston Model parameters, accelerates calibration procedure and improves calibration accuracy, the firm says.

A calibration procedure is a necessary step during which market data is used as an input to determine the parameters of a financial model. However, calibration can be time-consuming and depends on the size of the input data, the number of parameters to calibrate and the calibration algorithm itself.

Zaizhi Wang, financial engineer at Pricing Partners, explains: "Our newly implemented Simplex enables us to calibrate the time-dependent parameters for a stochastic volatility model with a good fit on the entire volatility surface. Users can even choose constant or time-dependent parameters. They can also easily retrieve calibration error and quickly measure the overall fitting error for the entire smile surface."

Whole business securitisations

... while Punch buyback oversubscribed

The results of Punch Taverns' £100m tender offer for the Punch Taverns Finance B Class A8 notes have been announced. The offer was nearly 1.5x subscribed and, as a result, the company accepted £102.154m of notes at an average cost of 97.9% of par.

This figure is substantially higher than the 80% minimum rate in the original tender document and equivalent to a margin of about 70bp, according to securitisation research analysts at RBS.

CDS

Butterflies - the ideal tail risk short?

Barclays Capital credit strategists Puneet Sharma, Rob Hagemans, Arup Ghosh and Aziz Sunderji find that CDS butterflies in certain names are almost priced to perfection

We have highlighted previously that protecting year-to-date returns using tail risk trades should be a core strategy for the coming quarter. With optimism priced in all risky assets, the risks regarding the housing market and central bank exit strategies, as well as the potential of an increase in M&A are making these limited cost downside protection trades all the more important.

A key characteristic of the ideal tail risk trade would be positive or near-zero performance if spreads continue to tighten, with a large pay-off if a tail risk event is realised. We believe the steepness of front-end CDS curves versus the flatness of back-end CDS curves offers some attractive options to structure such trades, so that the tail-risk nature of front-end flatteners is subsidised by back-end steepeners.

We believe that 3s5s10s CDS butterflies have straddle-type pay-offs and in certain names are almost priced to perfection. While we recommended this trade in the Main index previously, we now believe there are more attractive opportunities in single names such as:

• autos: all autos are good candidates, though we like Daimler in particular
• industrials: St Gobain, Lafarge.

The fundamental rationale behind curve trades
The term structure of forward default rates implied from CDS curves suggests that front-end default rates have normalised dramatically since March. Figures A and B below present the term structure of one-year forward CDS implied default probabilities for iTraxx Main and iTraxx Crossover at three different points in time over the past two years.

Despite increased risk perception in the market while the whole implied default curve moved up or down in absolute terms, of greater interest are the relative changes in implied default rates. While in November 2007, the market's biggest concern about default was in the back end (10-year), this overwhelmingly shifted to the front end (one-year) during the wides of March 2009. As the market has since recovered, this default concern has again started to shift back towards the 10-year point.

In the high grade space, following the strong March-August rally, the term structure of implied defaults at the front end of the curve is now the same flat shape as in November 2007. This implies that in a bullish scenario, with further spread tightening, there is little room for further steepening in the front end.

On the other hand, in a credit sell-off, there is clearly plenty of room for flattening, even if the curve does not invert to imply as many front-loaded defaults as it did at the end of 2008. At the back end of the curve, implied defaults are still high in the five-year space, leaving little room for 5/10 curve flattening and - in a bullish credit scenario - high potential for steepening.

Figure B repeats the analysis for iTraxx Xover. In this case, after massive front-loading of default, normalisation has moved default concern further back.

Thus, it seems as if the normalisation process in high yield has not progressed as far as high grade and there might be a further backwards shift along the curve of risk being priced in, causing back-end steepening. Moreover, in a credit sell-off, we would expect a substantial move flatter at the front end.

CDS butterflies have straddle-type tail risk payoffs
We believe these trades are very attractive as, even accounting for bid/offer spreads, they are almost priced to perfection. As can be seen from the figures below, P&L moves towards positive territory if spreads tighten.

Daimler

Lafarge

St Gobain

On the other hand, if there is a tail risk event, then these trades have a significantly positive pay-off. This is because these trades combine the attractive characteristics of front-end flatteners as tail risk hedges and back-end steepeners normalisation trades.

The opportunity has moved to single names
We have shown previously that while front-end CDS have steepened aggressively, the back end has been slow to follow. We show this using the 3s5s10s curvature metric below, which is effectively a difference of actual five-year CDS versus a five-year CDS constructed from the maturity weighting of three-year and 10-year CDS spreads.

While this opportunity looks very attractive from our selection of single names, it is less attractive now for the index. The important point to note is that while the index has already normalised the curvature, single names that we highlight are now gradually expected to do so.

Selecting the names
In our view, the sectors that are attractive for 3/5 flatteners and 5/10 steepeners - and therefore appropriate for butterfly trades - are autos and industrials. Within these sectors, we believe the following names are ideal for butterflies:

• autos: all autos are good candidates, we like Daimler in particular
• industrials: St Gobain, Lafarge.

We selected these names based on a combination of quantitative and fundamental factors.

Our selected credits pass two quantitative filters...
There are many potential approaches for using quantitative metrics to perform an initial screening for butterflies. We used two methodologies, which we describe below briefly.

Filtering by cost and historical ranges
We select credits that lie above a chosen range marker, which specifies where the current butterfly spread lies relative to its historical range (-100% means the current spread is at its lowest historical level; +100% means the current spread is at its highest historical level).

Filtering by cross-sectional analysis
We also find names whose butterfly spread is higher than that of their peers at a similar spread level. To do so, we adapt the slope model that we use to screen for steepener and flattener trades.

• Specify a spread window to define the peer group on which we will do the analysis.

For instance, if the window is 35%, then we only take into account names for which the five-year spread is greater than 65% and less than 135% of the five-year spread of the name under consideration. For the spreads in this peer group, fit a regression curve to the logarithms of the five-year spreads (on the x-axis) and the butterfly spreads (on the y-axis). The choice for algorithmic model (i.e., a power-law fit) has no theoretical significance: we choose it because it fits better to the empirical distribution.

• Score the name by the difference of its butterfly spread to the butterfly spread calculated from the regression.

...as well as qualitative metrics
Our analysts hold negative views on the selected credits (see table below).

© 2009 Barclays Capital. All rights reserved. This Research Note is an excerpt from 'European Credit Alpha', first published by Barclays Capital on 10 October 2009.

Trading

Trading ideas: outsized

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on Olin Corporation

The bond and CDS markets continue to offer relative view opportunities for those willing to filter through the noise. Olin Corporation, a small chemicals company with only US$250m outstanding debt, has been left by the wayside. The company's 2019 bond trades at a substantial discount to its 10-year CDS, making for an extremely attractive negative basis trade.

Relative to similar issuers, the bond's negative basis of -295bp is massive, even after facing a substantial bid/ask spread on the package. We are bullish on Olin as a credit, but prefer to trade within its capital structure rather than an outright, given the sheer size of the basis.

The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond - and thus is paid to take credit risk on the issuer - while paying for credit risk in the CDS market by buying protection on the issuer.

There are many drivers of the basis, both technical and fundamental, which we explain in our Trading Techniques articles. Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor earns positive carry because the credit spread that is collected in the cash market is greater than the spread that is paid in the CDS market.

Based on our valuation approach, the Olin Corporation's 8 7/8s of August 2019 bond fair value is US$127.71 against a purchase price of US$105. The figure below compares the bond z-spreads with the CDS term structure and shows that the recommended bond is indeed trading wide of the closest-maturity CDS with a basis of -295bp.

The position is default-neutral. There is a slight maturity mismatch because the bond matures on 8 August 2019 and the CDS expires on 20 December 2019, but we expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

Based on comparables, the Olin negative basis trade is extremely attractive. Within the chemicals industry, both Dow Chemical and Cytec Industries CDS trade within a couple of basis points of Olin Corp's (around 142bp).

The synthetic market estimates the three companies to have highly comparable credit risk; however, the cash market holds a different view. As the figure below demonstrates, the z-spreads on bonds (of similar maturities) of the three companies vary by almost 200bp.

Dow Chemical's 8.55s of May 2019 bond trades at a z-spread of 324bp and Cytec Industries 8.95s of July 2017 bond trades at a z-spread of 412bp. This puts the Dow Chemical negative basis package at a level much closer to -135bp, which is substantially lower than this trade.

Position

Buy US$10m notional Olin Corp. 10 Year CDS protection at 175bp.

Buy US$10m notional (US$10.5m cost) Olin Corp. 8 7/8s of August 2019 at US$105.00 (T + 465bp; z-spread of 487bp) to gain 307bp of positive carry.

The appropriate interest rate is dependent on the portfolio in which the trade is held. Customised rate hedge information is available upon request.

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).