Contents

Legislation and litigation

Swap expense

Counterparty risk concerns set to increase the cost of securitisation

Continuing Lehman Brothers-related litigation has ensured that counterparty risk has remained in focus since the bank's collapse. However, recent legal challenges to the inverted subordination clause - combined with rising rating agency scrutiny around counterparties - could increase the cost of bringing a securitisation.

Counterparty risk management continues to be in focus, confirms Navigant Capital Advisors md Pawan Malik, partly because many institutions underestimated it prior to last year's financial crisis. "In the past, pricing was the dominant factor in choosing a derivative counterparty. Since the fall of 2008, corporates are more diligent in who they trade with and under what terms. ISDA Master Agreements are being re-negotiated, large corporates now prefer to have mutual Credit Support Agreements in place and the larger treasuries are even tracking their exposures to individual counterparties," he says.

The uncertainty around counterparty risk has been heightened by the aftermath of bankruptcies such as Lehman Brothers. The bank was a counterparty to many swaps with SPVs on structured finance transactions.

In order to achieve a triple-A rating, the swap documentation stated that if the SPV owed money on the derivative at the time of default of the counterparty bank, the SPV's payment would be subordinated to the rated notes of the SPV (known as the inverted subordination clause). This clause is now being challenged in the courts (SCI passim).

The inability of the Silverstone issuer to enter into a cross-currency swap - and thereby hedge its exposure to euro-denominated notes (see last week's issue) - is a result of such concerns, for example. The cost of entering into a cross-currency swap has increased significantly due to the fear that rating agencies may insist on cash collateral to hedge the risk if a legal precedent is set on the inverted subordination issue.

Fitch last week released its revised rating criteria for counterparty risk in structured finance transactions, which includes increased collateralisation expectations as a counterparty's credit profile deteriorates or for derivatives positions that are deemed to be less liquid (see separate News story).

"It will be interesting to see where the market goes from here," observes Malik. "If legal precedent is set, securitisation documentation may have to be rewritten. Irrespective, the cost of bringing a transaction will increase significantly as the related swaps are now more expensive."

Reto Bachmann, head of European ABS research at Barclays Capital, points out in a recent report entitled 'Better Structures: Counterparty Risk' (published in European Structured Products Weekly) that eliminating counterparty risk by removing counterparties from transaction structures may not be possible in the case of operations counterparties or not in investors' interests in the case of financial counterparties. The services of operations counterparties are essential to securitisations and so the best that can be done is to reduce the risk their failure presents to the structure, he notes.

One obvious way of achieving this is via careful selection of counterparties. But hot, warm and cold back-up servicers can also be employed to mitigate the damage caused by a failure of the current servicer; while not concentrating too many services at the same servicer could be another mitigation strategy.

However, it might be possible to eliminate some financial counterparties from a structure. For example, a liquidity facility could be replaced with a larger reserve fund and deferability of non-senior coupon payments; basis swap providers could be eliminated by only securitising mortgages that match the reference rate of the issued notes or issuing notes that match the reference rate of the collateral; fixed-to-floating swap providers could be avoided if investors in a fixed rate mortgage pool are willing to accept fixed rate notes; and currency swap providers could be avoided by only issuing bonds in the currency of the collateral. But the success of any of these potential alternatives ultimately depends on investor preference.

Whatever that preference may be, once a counterparty no longer satisfies its eligibility requirements, remedies have to be put in place. Bachmann notes that the classic three remedies remain: counterparty replacement by an eligible counterparty; a guarantee of the counterparty exposure by another eligible counterparty; and posting of collateral.

Meanwhile, an area of continuing debate among swap professionals is the S 2a) iii) clause in the ISDA Master Agreement, according to Malik. This clause allows the non-defaulting party to terminate a derivative contract at a time of their choosing. Furthermore, they can stop payments on the derivative.

Unsurprisingly, this clause is only exercised when the non-defaulting party is out of the money on the swap. Recent rulings in New York have challenged the ability of a non-defaulting party to indefinitely keep a contract open without making any payments (SCI passim).

The intention of S 2 a) iii) was probably to allow non-defaulted counterparties to keep a contract open for a short time to avoid systemic risk and give them some time to pay. According to the recent rulings, courts appear to have taken the view that some counterparties have misused this clause so they can avoid paying altogether - they claim it's only fair that they either pay up or terminate the contract.

"From the bankruptcy estate's perspective, it's also difficult to know how much is available to pay its unsecured creditors without some clarity on what is owed to the estate," Malik adds.

Finally, one issue that has caused much pain to counterparties but now appears to be being resolved is re-hypothecation of client assets by broker-dealers. This process enables a reduction in funding costs that dealers can give to counterparties and was considered to be routine before the crisis erupted in September 2008.

The experience has emphasised the fact that in a default scenario there is considerable uncertainty as to who the money 'belongs' to (especially if collateral is held in a general pool) - the defaulted bank or the client who deposited the security. "At the peak of the crisis, many hedge funds rushed to get their security out of broker-dealer accounts, which served to amplify the turmoil in the financial markets. Interestingly, after a period of extreme reluctance to allow re-hypothecation, many hedge funds are now happy to allow dealers to on-lend their securities to bring their funding costs down materially," Malik concludes.

CS

CDS

Taking the initiative

CCDS trading expected to pick up in the New Year

Activity in contingent CDS (CCDS) remains lacklustre, due to a general lack of understanding about the product. But a number of initiatives are currently underway that - coupled with rising demand for the instrument - are expected to jump-start trading in the sector in the first quarter of 2010.

At present, CCDS are difficult to both sell and trade, confirms one risk manager. But he says he appreciates the potential utility of the product, given that banks typically prefer to decompose risks into separate buckets that can then be hedged out more efficiently.

"A CCDS is not some exotic new credit derivative; it is simply a representation of an esoteric risk that is currently warehoused within a bank's book when a bank transacts an interest rate swap, cross-currency swap or other vanilla derivatives transactions with end-users. The aim is to recycle this risk through the broader capital markets, allowing banks to better manage their retained counterparty credit risk and thus reduce systemic risk," the risk manager explains.

Two main issues are behind the lack of market activity in CCDS, according to Shankar Mukherjee, co-founder of the Novarum Group. First, there wasn't a good understanding of the positive impact that incorporating CCDS into bank risk metrics and exposure calculations may have. It was also apparent that banks weren't clear about the regulatory capital treatment of the product.

The second issue is that there is no natural provider of CCDS. Banks are understandably reluctant to sell CCDS protection due to concerns about reciprocity and the increased capital it would necessitate on their books.

However, an industry group has now been established to tackle the lack of understanding around CCDS. The risk manager indicates that the aim of the group is to publish a paper on the effectiveness of CCDS as a counterparty risk mitigant and to create a standard representation of these transactions for the bank's risk and capital metrics.

He says: "Hopefully, the exercise will demonstrate that if such transactions are recorded in a consistent way and shown to be an effective transfer of counterparty risk, the regulatory capital benefits - if any - can then be determined transparently. Ultimately, any such benefit will depend on the rating of the protection seller and the comfort the regulators have in the soundness of the operational implementation."

The second issue, meanwhile, is expected to be addressed by the launch of Novarum Global Trading (see SCI issue 125) in Q1 2010. The key difference between this highly rated company, which will sell CCDS protection to professional dealers, and previous CDPCs is that it will not simply retain the risk originated through the CCDS but will decompose the risk into single name CDS and other vanilla market hedges that will be continuously re-hedged in the market.

"Our operating guidelines force us to hedge everything, thereby transforming CCDS risk into vanilla components that can be more readily hedged in the market. The risk that remains is supported by a separate pool of capital. The idea is not to fully replicate the payout of a bank's derivative portfolio exactly. Rather, the bank portfolio managers can use the CCDS to optimise the amount of risk they wish to retain," Mukherjee explains.

To enhance CCDS price transparency and to facilitate an orderly exchange of collateral between professional counterparties, Novarum is also working with independent vendors to implement a suite of CCDS Standard Valuation Models. These models will be used by Novarum Global Trading in the determination of daily collateral and early termination valuations. Ultimately, if required by the banks or the regulators, the platform will clear all approved trading instruments through an industry-sponsored CCP or regulated exchange.

Once Novarum Global Trading is launched and regulators are comfortable with the efficacy of the CCDS, Mukherjee anticipates significant demand for the product. He suggests that FAS 157 could also drive more market participants to look at CCDS as a way of reducing the mark-to-market volatility of credit valuation adjustment.

Other institutions are looking for ways to reduce credit risk concentrations in specific names or sectors. Indeed, most banks have now set up groups to specifically manage counterparty credit risk.

In addition, Mukherjee says that - post-Lehman - corporates and the buy-side are concerned about their exposure to dealers and are looking for ways to reduce it. "The default of Lehman drew significant attention to the issue of counterparty risk [see also separate News Analysis], particularly because market participants had underinvested in the area for so long that often they did not even have tools to measure it," he concludes. "Equally, regulators are pushing all OTC market participants to collateralise their trades, but not everyone can post collateral - non-financials, for example. So, CCDS may be a particularly useful product to reduce counterparty credit risk to those counterparts who are unable or unwilling to post collateral."

CS

Technology

Technology commitment

Institutions prepare to comply with new regulatory directives

Asset managers with a long-term commitment to structured finance investments are coming under increased pressure to respond to recent regulatory directives relating to infrastructure. As internal credit analysis of issuer and loan data - alongside integration and monitoring of ratings - becomes the norm, technology is also having to step up.

"We are seeing a growing demand from financial institutions and investment managers looking to reduce the inefficiencies and risks associated with managing and integrating multiple databases and data sources for different structured finance deals," confirms Doug Long, evp business strategy at Principia Partners.

He adds: "Policymakers are making sure that organisations with long-term investment goals involving securitised assets have a robust operational framework in place to really understand their investments on an ongoing basis. That's not possible on spreadsheets and systems that aren't developed specifically to adapt to the dynamic requirements of structured finance."

Last month, the Financial Stability Board advisors to the G20 reiterated the importance of the Basel 2 Framework Enhancements to supervisors and regulators (SCI passim). Their address also highlighted IOSCO's recommendations on how to better inform and protect investors by 'including initial and ongoing information about underlying asset pool performance'.

The Basel 2 enhancements state that in order to qualify for the new risk weightings, institutions must be able to access performance information on the underlying pools on an ongoing basis, in a timely manner. Such information should include, as appropriate: exposure type; percentage of loans 30, 60 and 90 days past due; default rates; prepayment rates; and loans in foreclosure.

"Those investors that are committed to the ABS market have known since the onset of the crisis that regulation was going to come down hard and recent reports from Basel, IOSCO and the G20 have confirmed this," says Long. "Existing clients and participants we are currently speaking with see value in having a strong operational backbone to get a single view of their portfolios as they look to address the challenges highlighted by recent regulatory reports."

Long notes that while all aspects of data, such as loan-level data and performance metrics, have been available to investors in the past from various sources, the data is rarely consolidated into one engine that makes it consistent; from initial investment through to accounting. "Having a dedicated system that tracks and monitors all positions simultaneously gives investors the upper hand in spotting weaknesses in transactions and gives risk surveillance teams the ability to put controls and warnings in place as soon as possible," he adds.

Long continues: "Structured finance bonds feature a 'cliff risk' that doesn't necessarily feature in other fixed income assets. An ABS can move from triple-A to double-C very quickly. Although investors still value ratings - along with new metrics that the rating agencies offer - they now see the value in doing their own due diligence, stress testing and collateral tracking. In doing so, investors will be able to spot problems before rating downgrades occur."

Recent research on risk management practices published by the Senior Supervisors Group in the US highlights shortcomings in firms' management information system (MIS) infrastructure and in their ability to produce useful reports during the crisis. The document highlights the fact that better quality and more timely liquidity reporting is essential to effective management of liquidity and funding issues during a crisis.

In light of this, the research suggests that a number of firms are increasing their spending on infrastructure, improving their data and strengthening the quality and timeliness of their reporting. The importance of a resilient IT environment with sufficient processing capacity in periods of stress is also becoming increasingly evident, it says.

"Firms are constrained in their ability to effectively aggregate and monitor exposures across counterparties, businesses, risk strands and other dimensions because of ineffective information technology and supporting infrastructure," the report states.

Many firms, in their self-assessment submissions and in subsequent discussions with the Senior Supervisors Group, indicated that they are making considerable investments in risk management infrastructure. Many projects, however, are in the planning stages or in the infancy of execution, with significant work remaining.

One challenge to improving risk management systems has been poor integration resulting from multiple mergers and acquisitions, the report notes. One of the surveyed firms suggested that acquisitions over the years have produced an environment in which static data are largely disaggregated. Another firm echoed this view, reporting that certain products and lines of business have not been included in data aggregation and analysis processes.

AC

CDS

Thomson auction results 'perplexing'

The results of the Thomson CDS auctions, in particular those of the medium- and long-maturity auctions, have been deemed perplexing by analysts at UniCredit. They suggest that last week's auction again raises the question about the robustness of the auction process.

On 16 October, the ISDA Credit Derivatives Determination Committee published the final auction settlement terms for Thomson CDS. These terms specified that three auctions would be held: one for each of the CDS maturity buckets represented by CDS scheduled termination dates up to 20 June 2012, between 21 June 2012 to 23 October 2014 and 24 October 2014 onwards.

Maturity limitations for deliverable obligations for the CDS maturity bucket in general suggest that recovery-auction results should become smaller as the maturity increases. "This was actually observed in the final Thomson results: 96.25%, 65.125% and 63.25%. But that was probably the only result in line with general expectations," says Tim Brunne, senior credit strategist at UniCredit.

Auction data released by Creditex and Markit show that the bid-offer spreads for obligations deliverable into the short-maturity auction ranged from a minimum bid of 80 to a maximum offer of 100, leading to an inside market midpoint of 91.25. "At first glance, the final recovery of 96.25% is in agreement with the extremely broad bid-offer range of all participating dealers. A closer look reveals that, although there were more sellers of deliverable obligations in the auction than buyers, the final price was set at a surprisingly high level," adds Brunne.

He continues: "The explanation is that an apparently too small open interest of €81m permitted a single bidder (JPMorgan) to be able to buy the whole excess supply of paper in the auction at the maximum possible price using a single limit order. It thereby set the final recovery and clearly acted in the interest of all net protection sellers. This move demonstrates again that the economic interests of a dealer participating in the auction may be greater than the potential price he has to pay to drive the final result in a favourable direction. This fact facilitates recovery values that are driven by auction technicals rather than actual valuations."

In contrast to the first maturity bucket, the final results for the other two auctions were artificially depressed, suggests Brunne. Dealer bid-offer quotes were in a range between 72 and 90 and 68 and 90 respectively.

"Thus, the final recoveries of 65.125% and 63.25% are distinctly smaller than even the tightest bid quotes," he says. "One participating dealer (Deutsche Bank) apparently had a particular interest for low final recoveries, providing €602m of the €801m of deliverable paper, while initial buy physical settlement requests amounted to only €351m (aggregated figures for all three auctions). Therefore, the medium- and long-maturity auctions were particularly underbid and filling of many small-sized limit orders was necessary, yielding auction results which are definitely too low - once again a result of auction technicals."

UniCredit suggests that the Thomson auction cannot be regarded as a reality test for the ISDA Small Bang Protocol, the CDS 2009 Auction Settlement Supplement or related changes that were adopted by the CDS market this year. "Our concern is the auction mechanism itself. Of course, this auction mechanism was hardwired into the CDS documentation by the 'Small' and 'Big Bang' this year, but it already played a pivotal role for CDS credit event settlement before," the bank notes. "The strange Thomson auction results are also not related to the fact that, for the first time, a restructuring credit event had to be settled by means of recovery auctions."

UniCredit says the auction mechanism needs to be amended to make sure that final recovery values are not at odds with the price range for deliverable obligations as provided by the dealers themselves and, moreover, that dealers are not able to manipulate auction results at comparatively low costs.

AC

Ratings

Counterparty risk criteria revised

Fitch has revised its rating criteria for counterparty risk in structured finance transactions. The new criteria follows consultation with market participants representing a wide array of interested opinion, including investors, issuers, arrangers, swap desks, regulators and central banks in the wake of an exposure draft published in March 2009.

The core criteria remains largely unchanged from the previous criteria and expects counterparties to have a minimum Fitch long-term issuer default rating (IDR) of single-A and a minimum short-term IDR of F1 to support notes of double-A minus or higher. If collateral is posted, however, this core criteria is extended to counterparties rated at or above BBB+/F2.

For the purpose of rating new transactions, the core criteria has been enhanced by treating counterparties that are on rating watch negative (RWN) as one notch below their actual current rating for eligibility purposes, to mitigate any potential short-term adverse rating action. Aspects of criteria that are specific to derivative contracts used in securitisation transactions are detailed in a dedicated criteria report published alongside the core counterparty criteria report.

Stuart Jennings, Fitch's credit risk officer, says: "Fitch chose not to pursue the primary option outlined in the exposure draft of expecting collateralisation of derivatives from closing. The agency saw this as being the theoretical option that could best maximise structured finance transaction isolation from underlying counterparty risk. However, the reality is that the market in structured finance derivatives does not operate on this basis at this time."

He adds: "Adopting it now would have restricted the universe of eligible counterparties, thereby undermining one of the assumptions of the criteria - the replaceability of counterparties. Its application to existing transactions could also have potentially led onto renewed liquidity pressure, further undermining counterparties and their potential eligibility."

Additional enhancements to the criteria include a shortening of the period in which remedial actions are expected to be taken where collateralisation is possible and an increased focus on excessive counterparty dependency. Collateralisation expectations have also been increased as a counterparty's credit profile deteriorates and, separately, for derivative positions that are deemed to be less liquid (see also separate News Analysis).

While Fitch's revised rating criteria for counterparty risk limits the amount of time permitted for remedies to be put in place, the old pitfalls remain, according to Reto Bachmann, head of European ABS research at Barclays Capital. He notes in a recent report entitled 'Better Structures: Counterparty Risk' (published in European Structured Products Weekly): "Because eligibility is largely based on ratings and remedies are put in place only once counterparties no longer satisfy the required minimum ratings, a jump-to-default may not leave enough time for remedies to be put in place (with the Lehman Brothers jump-to-default the most prominent example). Fitch openly acknowledges that jump-to default remains a vulnerability for its regime of counterparty criteria and remedies."

Equally, failure of remedies to be put in place may not automatically result in a downgrade, due to other mitigating circumstances. This has in the past been used as a way for counterparties to avoid having to put remedies in place, Bachmann suggests.

Finally, rating agencies tended to publish presale reports without naming the transaction counterparties - presumably because they had not been finalised by the time the document was published. They therefore occasionally failed to document the counterparties to a transaction, despite the fact that the bonds' ratings depend on their ongoing satisfaction of the counterparty criteria.

"While we have no good solution to address the jump-to-default risk inherent in the rating agencies' approach to dealing with counterparty risk, we do feel that better disclosure of counterparties and the associated risks by rating agencies would be valuable to investors. We are therefore rather pleased to read in Fitch's publication that the agency aims to improve the transparency it offers on counterparty risks," Bachmann concludes.

Andreas Wilgen, senior director in Fitch's European structured finance team, says: "While Fitch maintains its opinion that the structural mechanisms, such as minimum rating thresholds, included in transaction documentation are usually sufficient to support the highest investment grade ratings, Fitch believes that certain counterparty exposures are so large that they cannot be simply addressed by such mechanisms alone. In such cases, ratings above those of the counterparty may not be possible."

Fitch will apply the principles of its updated criteria in assigning both new ratings and maintaining existing ratings as part of the surveillance process. For an existing transaction, where a counterparty fails to satisfy all aspects of the criteria, the ultimate impact on the ratings will depend on any transaction-specific structural mechanisms, the materiality of the counterparty exposure to the transaction, the materiality of their criteria non-compliance and the transaction's performance. The agency will therefore not automatically take rating action on a transaction where a counterparty no longer satisfies the provisions of its criteria - the specific circumstances of each transaction will always be considered.

For the large majority of transactions, Fitch does not expect rating implications arising from the update to the counterparty criteria. Some existing transactions may fall within the classification of excessive counterparty risk and will be reviewed as part of the ongoing review process. If identified as being exposed, such transactions will be formally placed on RWN, which will be resolved pending structural changes potentially affecting the rating analysis.

JA & CS

RMBS

Silverstone launches with fixed rate tranche

Nationwide has added a seven-year fixed rate tranche to its prime UK RMBS, Silverstone 2009-1 (see last week's issue for more). Final pricing, which came 5bp tighter than guidance on both publicly distributed tranches, was released on 27 October by lead managers Barclays Capital, Citi and JPMorgan.

The Class A1 tranche is sized at £1.25bn, with a five-year WAL, and was retained. The five-year Class A2s were upsized to £1.6bn from £1.5bn and priced at 145bp over three-month Libor.

The fixed rate Class A3 tranche was also upsized, from £300m to £650m, and priced at 145bp over mid-swaps. All three tranches of notes are rated triple-A by all three rating agencies.

ABS analysts at SG suggest that the addition of a fixed rate tranche to the liability structure is a sign that the ABS market is convalescing. With a bullet maturity due to the originator's put agreement, the tranche resembles - at least from the amortisation profile - a covered bond.

"The investor base in covered bonds is in place, unlike in ABS where it is being rebuilt," the SG analysts note. "The former is taking advantage of the current spread differential between RMBS and covered bonds, which makes RMBS very attractive in terms of relative value. This is a logical process of matching demand in the current adjusting market."

All notes benefit from a maturity purchase agreement entered into with Nationwide Building Society. The lender intends to purchase £1.25bn of the Class A1 notes on the closing date for the purpose of entering into a securities lending transaction with an affiliate of JPMorgan.

Meanwhile, JPMorgan has entered into a forward commitment with Nationwide to purchase £1bn of the Class A2 notes on the closing date.

AC & CS

Secondary markets

Pricing at the point of revaluation

Chris Zingo, evp sales and support, Americas at SuperDerivatives, finds that independent revaluation holds the key to fair valuation of complex derivatives

We are living in a period of unintended consequences. The effort to expand home ownership has contributed to one of the largest economic collapses in market history, while the traditional Wall Street model of distributing risk - "Sell it to the other guy" - was proven to be unsustainable.

The effort to ease interest rates and create liquidity has contributed to the precipitous decline of the US dollar, while efforts to establish a common framework for OTC securities valuations has led to fire-sale asset pricing, starting with the sale of US$30.6bn of CDOs by Merrill Lynch to the Dallas-based investment firm Lone Star Funds, for US$6.7bn.

This turmoil in the financial markets has made valuation of derivative securities a front-line priority for policymakers, bankers, custodians, brokerages and everyone connected to financial markets, or trading and lending activity. Confidence in financial markets hinges on the possibility of assigning reliable, verifiable and accurate marks to diverse portfolios of complex financial instruments.

Price discovery for complex securities depends on multiple factors, such as data quality, operational and IT support, models, implementation and skill in using the models. Each of these ingredients is instrumental in producing a defendable verifiable price level.

In 2008, FASB - the panacea of a post-subprime world - established a framework for measuring fair value and expanded disclosures about fair value measurements in the form of FAS 157. Officially, it defines fair value as "an exit price; the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants." A framework, however, is just that - a framework.

The challenge for most market participants is that there are complexities associated with OTC valuation that require interpretation, debate and plain-old good judgment; complexities that are difficult to fully define with legislation.

In September 2008, the SEC issued guidance around a number of practice issues that were the subject of much debate. It addressed issues, such as the use of broker quotes, stating that broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active and indeed liquid market does not exist. It also suggested that, in weighing a broker quote as an input, an entity should place less reliance on quotes that do not reflect the result of market transactions.

This is a logical determination; however, how would the entity know whether or not the price they received was reflective of an actual transaction, a purely modelled price, or an indicative price that is no longer reflective of the actual market? It also suggests that a quoted market price in an 'active market' for an identical asset is representative of fair value.

Again, this is a logical assessment; however, how would the entity know what an 'active market' is? Guidance suggests that entities should consider the spread differentials. The challenge is that, in this market, it is difficult to identify what a rational spread differential is for an active market.

The guidance also addresses the concept of disorderly transactions and how representative they are with respect to fair value. While on the one hand it suggests that fair value should reflect a true exit price, on the other hand it suggests that liquidation sales are not orderly and should not be considered.

To contend with this grey matter, it is clear that market participants will continue to unite in the form of debate, industry events and general dialogue to share and evolve best practices that have proven successful. Market participants will continue to seek the support of third-party valuation providers to implement these best practices as the requirements (data management, operational scale, expertise) to implement industry standards continue to increase, making it virtually possible for institutions to comply on their own.

To illustrate this, let's explore two common FAS 157 best practices guidelines that have evolved as industry standards - governance and data management.

Governance
With respect to governance, we have seen a uniform adoption of the segregation of responsibilities associated with the investment/trading process and the valuation process. The verification, or shadow-processes, of the valuations department must be completely segmented from the investment/trading process.

The challenge for many institutions is that most of the expertise with respect to OTC derivatives is contained in the front office (traders, portfolio managers, quants). While most institutions - both buy- and sell-side - have segregated roles for investment/trading and valuation, they are still reliant on the judgment of their investment trading team to define fair value.

In fact, many institutions still allocate the costs associated with defining fair value to the P&L of the investment/trading group they are supporting. This is a clear conflict that must be addressed if they are to achieve true independence in terms of valuations and revaluations.

Data management
The CPA Journal, in its January 2008 publication, noted that "the fair value hierarchy, defined in FASB 157, emphasises a market-based measurement and, in doing so, stipulates a fair value hierarchy. The hierarchy is based on the type of inputs applied (the data used) to measure fair value, not the model." The journal lists the fair value hierarchy, as summarised below:

• Level 1 lies at the top of the hierarchy, where inputs are quoted prices in active markets. Level 1 inputs may be observable in markets such as the New York Stock Exchange, Nasdaq, electronic communication networks and principal-to-principal markets, where prices are negotiated independently between the parties with no intermediary.
• Level 2 inputs are in the middle of the hierarchy, where data are adjusted from similar items traded in active markets, or from identical or similar items in markets that are not active. Level 2 inputs do not stem directly from quoted prices.
• Level 3 inputs are unobservable and generated by the entity itself. An asset retirement obligation for an oil well, for example, would include expected risk-adjusted cashflows, using the company's own data.

The focus of much debate in terms of valuations is around the classification of Level 2 and what constitutes a Level 2 asset verses a Level 3 asset. The values associated with Level 2 assets come from 'observable inputs', meaning they are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants.

Unlike Level 1, where the quoted prices are observable in the listed markets, the OTC markets are very distributed with respect to where trading occurs. Observable data can come from a variety of sources: the broker marketplace, the dealer community, third-party pricing providers and exchange publications.

In addition, within the sources themselves, the trading is very fragmented. Many of the sources' visibility into price discovery is limited to the 'flow' they observe in their trading operations.

Like most participants, they are forced to make assumptions about assets they don't trade or price daily. These assumptions can come from different interpolation methods, survey methods, historical comparisons, anecdotal information and traditional 'best-guess' estimates. As a result, differences in opinion about the same asset can be dramatic, especially in a volatile market environment.

The following example illustrates the common variances that exist between sources (contributions from two different sources for INR FX volatilities at a similar time in the same day).

Notice the three-month tenor. There is a 16% difference in the quoted market.

As an entity looking for observable inputs, what should you do? Do you average the two quotes? Do you assume one is correct and the other is incorrect? Do you assume both are incorrect?

The answer could be any one of the options listed above. You cannot determine the answer without truly understanding the nature of the source, consistency of the source and the competencies of the source. Furthermore, given the volumes, it becomes increasingly difficult to understand where the market truly is unless you employ quantitative procedures to check your data.

For example, the illustration below represents the term structure submissions from the previous sources. The jagged points from the contributor on the left should immediately result in a 'red flag' in your process. Jagged points are quantitative signs of potential model error or input bias.

Given the variance of the markets in the first illustration coupled with the quantitative red-flags in the second illustration, this currency pair should be flagged for immediate investigation. A manual intervention should then occur to assess and decide. This may involve communicating with both sources and/or checking additional sources.

Conclusion
It is becoming clear that institutions - both buy- and sell-side - accountants and regulators must seek independent valuation services that provide wider coverage and deliver independent price opinions reflective of the current market, backed by verified data, models and technology. Transparency facilitated by fair value accounting instills confidence in investors and in the financial system as a whole. Combine this with solid risk management practices and the route to the recovery of confidence is laid out.

Pricing derivatives at the point of revaluation is an art, underpinned by some serious science provided by independent and specialised third-party valuation companies, rather than a single bank source. This technique will meet the requirements for fair valuation of financial instruments, which I believe will become required for all money managers. The independent valuers will be the partners of the banks and funds, in the same way the auditors are the necessary partners of public companies.

CLO Managers

Ares Capital to acquire Allied Capital

Ares Capital is to acquire Allied Capital in an all-stock transaction currently valued at US$648m, or approximately US$3.47 per Allied Capital share. Both Ares Capital and Allied Capital are CLO managers, and the acquisition will bring into question the management of Allied Capital's three transactions.

In March of this year, Allied Capital took on the management duties of three middle-market senior CLOs (Emporia Preferred Funding I, II and III) from Cohen & Co. Allied also hired the majority of staff responsible for managing the CLOs at that time.

Ares Capital issued and manages 17 CDOs (CLOs and CSOs), all launched between 1997 and June 2006. It also launched its first European CLO in June 2007.

CLO Managers

Manager replaced on ABS CDO

LibertyView Capital Management has assumed the duties and obligations of collateral manager to the SKM-LibertyView CBO I transaction, an ABS CDO, from Lehman Brothers Asset Management. The move was made possible by an assumption agreement, which was signed between the three parties on 15 July.

Moody's has determined that performance of the activities contemplated within the agreement will not at this time cause the current ratings of the notes issued by the issuer to be reduced or withdrawn. The agency notes that it does not express an opinion as to whether the agreement could have non-credit-related effects.

CLO Managers

MFS takes on another CDO

Princeton Advisory Group is to be replaced as collateral manager on Palmer Square, an ABS CDO, by Massachusetts Financial Services (MFS). Arranged by Dresdner Kleinwort and launched in 2005, the deal was sized at US$1.25m.

Excluding Palmer Square, MFS is currently managing five US ABS CDOs.

CLO Managers

PIMCO waives CDO management fee

PIMCO, the collateral manager of Laguna ABS CDO, has entered into a management fee waiver agreement. The agreement provides that the base collateral management fee to be paid by the issuer to PIMCO will be reduced and that there will be no subordinated collateral management fee or incentive collateral management fee.

Investors

Credit hedge fund launches via JV

Matrix Alternative Asset Management (MAAM) and PVE Capital have joined forces to launch a new hedge fund, which - with further commitments - will have some US$150m assets under management. The Matrix-PVE Global Credit Fund will take advantage of the unique opportunities in global credit markets by trading in a broad range of liquid credit instruments, both long and short.

Under the agreement, PVE Capital will act as investment adviser to the fund. MAAM will provide a proven operations and risk management infrastructure, allowing PVE Capital to focus on investment management.

"After most of the beta has been captured in 2009 we now see substantial opportunities by identifying value, and then allocating and trading both long and short across different credit instruments and strategies in order to optimise the level of expected return," explains Gennaro Pucci, cio of PVE Capital. "This is the perfect environment for alpha generation and we believe investors should now start looking favourable again to long/short strategy."

He adds that the market will still be characterised by what PVE believes is going to be a long deleveraging process. Volatility is expected to continue to accompany the recovery path initiated at the beginning of the year.

The fund will express a strategic macro credit view using the most appropriate credit instruments to achieve high annualised returns (15% to 20% annualised net returns with 8% to 9% annualised volatility). It aims to deliver these in a variety of market conditions by fundamental analysis and active trading.

The fund's investible universe at this stage in the credit cycle will include: credit derivative and quant strategies; single name CDS; and ABS. Macro overlay, credit derivative and quant strategies are designed to exploit opportunities, as well as limit volatility across the fund. Optimal rebalancing will also allow the fund to capture the most interesting themes through the credit cycle.

The two firms note that current opportunities are being driven by:

• Continued deleveraging and central bank policy - although central bank policy might have been necessary to avert a deeper recession, their actions will likely pose further risks for a stable recovery and make the path to recovery volatile.
• Rating agency methodology changes will exacerbate the CDO deleveraging still taking place.
• Asset valuations continue to discount adverse scenarios in many areas.
• The latest rally in corporate credit has been broad, but many opportunities are still available on a relative basis in CDS. Standardisation in the CDS market should help improve liquidity and margins.
• Risky assets rebounded towards the end of Q209, with new cash being available.

In addition, they believe that further opportunities will develop as:

• Bank lending is still insufficient to ensure a stable recovery and governments are facing large deficit problems.
• The US mortgage market is still characterised by negative equity, with most of the prime residential market having only 10% of equity left.
• The commercial real estate market still represents a significant risk for financial institutions, with important funding gaps to be filled in next 3-4 years.
• Corporate defaults are still rising.

Pucci was previously head of trading at Credaris from 2005 to 2009, responsible for the management and trading of funds in excess of US$1bn. He also managed the Credaris Credit Fund (formerly called the Credaris Correlation Fund), which generated a performance of 5% in 2005, 26% in 2006, 58% in 2007, 56% in 2008 and 13% in 2009 (January to April).

PVE Capital was recently formed by Pucci, together with Joe Vittoria and Christian Evans. Rachel Barnard subsequently joined as partner and, collectively, they have more than sixty years' industry experience. PVE is wholly owned by its partners and controlled by Pucci.

MAAM appoints experienced fund managers who have taken risk in many different market environments, have strategy-specific expertise and are accustomed to operating within a risk management framework.

Listed products

Mezz and equity CDO valuations push up Volta GAV

Volta Finance has published its September monthly report. At the end of September 2009, the gross asset value (GAV) of Volta was €68.7m or €2.27 per share, an increase of €0.14 per share from €2.13 per share as of the end of August 2009.

The September mark-to-market variations of Volta Finance's asset classes have been: +2.0% for ABS investments, +27.1% for mezzanine CDO investments, +33% for residuals of CDO investments and -7.4% for corporate credit investments. The increase in the GAV is mostly due to price increases in the CDO bucket both from equity pieces and mezzanine debt tranches.

Volta's assets have generated the equivalent of €1.4m of cashflows during September 2009, bringing the total cash generated for the current semi-annual period that begun on the 1 August 2009 to €2m, compared with €3.4m for the same two-month period in 2008.

In September the company invested a total of €2.7m in four deals: a mezzanine tranche of a corporate credit portfolio (Valleriite), a large residual tranche of CLO (Confluent), a mezzanine tranche of a CLO (Duane 2006) and a very senior tranche of European ABS (Permanent Financing).

Listed products

Name change for permacap

T2 Income Fund Ltd has announced that, following the passing of the relevant resolution at its 16 October EGM, it has received approval from the Guernsey authorities to change its legal name to Greenwich Loan Income Fund Ltd. Consequently, as of 27 October, the company's ticker on the London Stock Exchange will be GLIF.L.

Operations

Consultant expands capital markets group

Capco is expanding its North American capital markets group. The expansion is in response to service demand from investment banks, broker-dealers, exchanges and clearing firms, as they seek to reduce costs, shift to fee-based revenue models, mitigate trading risks and achieve long-term, sustainable growth.

The group's focus covers front, middle and back office activities across the complex trading environment that includes derivatives, fixed income, structured products and credit default swap products.

Capco partners Joe Anastasio and Michael Haworth are set to co-lead the group.

Anastasio joined Capco from JPMorgan, where he was md of its North America Operations Group and a board member of JPMorgan Securities. During his career at Salomon Brothers, Anastasio served as the firm's md of domestic and global operations.

Haworth has over 25 years of experience in management and consulting to financial institutions. He joined Capco from CAST Management Consulting. Earlier in his career, he was md at KPMG Consulting in charge of its banking and investment services practice and directed the firm's capital markets practice.

Anastasio explains: "In today's post-subprime crisis era, trading firms are re-evaluating their business strategies, cost structures and internal controls, and looking for more balanced business models. During the boom market days, profits and gains were achievable based on huge risk bets that camouflaged inefficiencies in a firm's infrastructure and cost models. Now, with more pressure on trading margins, we're seeing a surge in demand to help companies identify new ways to cut costs, generate fee-based revenues and drive long-term, sustainable growth."

Operations

FIDAC wins another manager replacement mandate

The obligations of Highland Financial Holdings Group, as collateral manager of Citation High Grade ABS CDO I, have been transferred to Fixed Income Discount Advisory Company (FIDAC). Moody's has determined that the Collateral Management Assignment and Assumption Agreement, dated as of 22 July 2009, between the two firms and the performance of the activities contemplated therein will not cause the current ratings of the CLO notes to be reduced or withdrawn. The rating agency says it does not express an opinion as to whether the Agreement could have non-credit-related effects.

Real Estate

MBS vets to lead merged REIT

Enterprise Acquisition Corp, a blank check company formed for effecting a business combination, is proposing to merge with ARMOUR Residential REIT.

Upon consummation of the business combination, ARMOUR's investment team will be led by co-ceos Scott Ulm and Jeffrey Zimmer.

Ulm has 23 years of structured finance and debt capital markets experience, including MBS. Since 2005, Ulm has been ceo of Litchfield Capital Holdings, a structured finance manager. From 1986-2005, he held a variety of senior positions at Credit Suisse, including global head of ABS and global co-head of CDOs.

Zimmer has worked in the mortgage securities market for 25 years. From September 2003 through to March 2008, he was ceo of Bimini Capital Management, a publicly traded REIT that managed over US$4bn of agency mortgage assets. Prior to 2003, he was an md at RBS/Greenwich Capital in the mortgage-backed and asset-backed department, where since 1990 he held various positions that included working closely with some of the nation's largest hedge funds, mortgage banks and investment management firms on various MBS investments.

Enterprise stockholders and warrantholders are scheduled to vote on the proposals on 29 October. The meeting was postponed from 26 October to provide investors with additional time to consider and evaluate the proposals, with the aim of creating a higher equity base for the combined company.

RMBS

New York REIT plans further MBS investments

New York Mortgage Trust has filed a shelf registration statement with the US SEC in order to raise up to an aggregate of US$50m through the sale of common stock.

If approved, the net proceeds from the sale of any shares will be used to purchase agency RMBS, non-agency RMBS and other alternative assets, subject to maintaining the firm's REIT qualification and its exemption under the Investment Company Act of 1940, as amended, as well as for other general corporate purposes described in the shelf registration statement.

A number of other REITs have previously announced their intention to invest in this asset class (SCI passim).

Secondary markets

Bank makes small gain on CDO sale

Deutsche Pfandbriefbank, part of the HRE Group, has sold distressed CDOs with a notional value of €759m and made a small single-digit million euro book gain. The portfolio consists primarily of US CDOs.

The sale was conducted as an auction, which generated interest from major US and European investment banks, asset managers and investment funds. The CDOs were awarded to six winning bidders.

"We continue to reduce the size of our balance sheet. We are pleased to see our valuation of these CDOs confirmed by the market," says Deutsche Pfandbriefbank ceo Axel Wieandt.

Prior to the sale, HRE Group's CDO inventory amounted to around €2.64bn (notional value), of which around €1.44bn were US CDOs. The remaining €1.19bn consists of European CDOs.

The bank says it intends to continue to exploit opportunities that may arise to sell its remaining CDO exposure.

Technology

Ex-Citi director hired in MBS data push

1010data has hired Perry DeFelice as director of business development for capital markets customers. In his new role DeFelice will develop analytical solutions for clients of the hosted analytics and reporting platform, including investors, servicers, originators, insurers, rating agencies and regulatory entities.

Greg Munves, vp of 1010data, says: "We are devoted to continuing to attract quality experienced people, like Perry, who are passionate about what they do. His experience in leading the business development process in particular makes Perry a valuable addition to our leadership team and will help us continue to grow our position in the MBS/ABS market."

Previously, DeFelice worked as a director in the non-agency residential mortgage finance group within Citigroup's global securitised markets division. At Citigroup, he developed capital markets solutions for mortgage market participants, including securitisation, whole asset trades, repurchase/warehouse financing, ABCP and synthetic risk transfer. Prior to Citigroup, he served as an associate director at S&P, where he rated non-agency MBS transactions and developed MBS/ABS criteria.

Technology

Partnership broadens CDS data distribution

Fitch Solutions and Pricing Partners are set to form a strategic partnership allowing users greater access to market data on OTC credit derivatives.

The partnership will allow for the easy integration of CDS spread market data from Fitch Solutions into Pricing Partners' cross-asset independent valuation platform, Price-it Excel. In turn, Price-it Excel users will be able to access and use Fitch Solutions' market data source for CDS spreads on single name and index exposures.

Ian Rothery, global head of strategic partnerships at Fitch Solutions, says: "It will broaden market access to Fitch's CDS data, providing more users with greater transparency on pricing in OTC credit markets, and we look forward greatly to working with Pricing Partners."

Technology

Partnership to provide enhanced CDO sensitivities

Numerix has partnered with CDO Software to provide advanced pricing and risk sensitivities across synthetic CDOs and CLOs within the 'CDO Tools' application suite.

Steven O'Hanlon, president and coo of Numerix, says: "The integration of Numerix analytics within the CDO Tools application suite offers users a powerful and robust pricing and risk solution. The wide variety of available models means users can now value virtually any credit product using Numerix's different methodologies and custom model calibrations. We look forward to a successful partnership with CDO Software."

Users of the CDO Tools suite will be able to access the Numerix CrossAsset library of independent pricing models and methods to price and generate risk sensitivities across synthetic CDO and CLO instruments. The flexibility of the Numerix CrossAsset library allows users to calculate risk analytics by specifying the copula type, correlation model and base correlations from reference deals.

Sunay Shah, ceo and co-founder of CDO Software, explains: "The ability to seamlessly run Numerix analytics, stress scenarios and automatically generate risk reports within our CDO Tools platform will enable users to analyse information from several perspectives and give firms in the market a transparent understanding of where their real risks and values lie."

CDO Software's tools integrate risk models and market data feeds, automate rating agency models and generate investor reports in one fully-audited environment.

Trading

Broker adds five to its credit division

Execution has made a further five hires in its fixed income division, which launched in July this year. The agency credit business deals in high grade debt, ABS, emerging market debt, as well as high yield and distressed debt. The hires bring the total number in the division to 14, a number which is expected to grow to 25 by the first quarter of next year.

Those joining the team include Olivier Dega, who joins Execution with over 12 years of experience in fixed income sales, covering French accounts at Credit Suisse. He will be running French sales directly from a new office in Paris.

Karolina Kalkantara joins with over 10 years' experience in the asset-backed markets. She worked at Deutsche Bank, WestLB and Calyon, where she was a consultant on the structured credit trading desk.

She has a deep knowledge of ABS and will be a product specialist. In addition, she will cover Greek and Cypriot accounts on all asset classes.

Jaren Yeo joins from Citi, where she latterly traded ABS. Prior to this, she was an ABS correlation trader.

Michael Leonard joins Execution as a sterling specialist, covering UK asset managers, insurance companies and pension funds. Leonard has over 10 years' experience on the buy- and sell-side. He was a sterling credit market maker at JPMorgan and Deutsche Bank before joining Credit Suisse Asset Management as a sterling portfolio manager.

Also joining Execution is Toby Rackliff, who has more than a decade of experience as a money-market fund manager with ABN AMRO, which then became Fortis Investments. He has been recruited to focus on money market credit sales.

Trading

Two credit traders hired in Japan

Barclays Capital Japan has made two credit trading hires.

Takahisa Fujiki has been appointed vp of credit trading, having previously held a credit trading role at Morgan Stanley. Tetsuya Ukai has been appointed director of credit trading at Barclays Capital in Japan, having previously worked at JPMorgan Japan, where he was executive director of credit trading until November 2008.

According to a spokesperson at the bank, Barclays Capital has been expanding its credit business globally. The recent hires in credit trading in Japan form part of the enhancement of the bank's sales, trading, research and origination in credit.

"The hiring we've done will increase our ability to deliver yen-based credit to our global client base - both domestic and international," the spokesperson confirms.

CMBX sub tranches continue to suffer

Despite the positive tone to the CMBS cash market (see separate News Analysis), CMBX subordinate tranches continued to suffer last week - down by two to seven points on the week across different series. CMBS analysts at Barclays Capital point out that despite the recent sell-off, prices are still above 14 September levels - the date of the IRS ruling on REMIC rules, which spurred initial optimism on upside potential from loan modifications (see SCI issue 152).

"We remain sceptical of the upside of modifications for lower-rated tranches at current levels and continue to see value in shorting CMBX subordinate classes," the analysts note. "We think we are in the early stages of a ramp in credit deterioration and delinquencies, which should put sustained pressure on these contracts."

ABCP

ABCP vehicle subject to further restructuring

A proposal to restructure certain asset interests held by Master Asset Vehicle (MAV) I, one of the vehicles created under the Montreal Accord (SCI passim) ABCP restructuring, is being discussed by the relevant transaction parties in order to improve the credit quality of the notes. The restructuring is expected to be completed by early 2010.

Since final ratings were assigned to the MAV I notes in January 2009, numerous reference entities have been downgraded (in some cases by more than ten notches), resulting in higher probabilities of default for the underlying CDO asset interests. In addition, an increasing number of credit events, coupled with historically low realised recoveries, have reduced enhancement levels available to the CDO transactions. These factors have resulted in a rapid deterioration in the credit quality of certain CDO asset interests, according to DBRS.

Consequently, the agency says it is maintaining the single-A rating of the Class A-2 notes issued by MAV I under review with negative implications. The rating assigned to the MAVI Class A-1 notes is unaffected by this action.

DBRS placed the notes under review with negative implications on 11 August. It stated at that time that negative rating migration in the underlying asset interests held by MAVI, particularly in CDO transactions with relatively low levels of credit enhancement, had increased the required enhancement for the notes.

The agency says it will continue to monitor the situation closely. Further deterioration in the credit quality of certain underlying asset interests or the abandonment of restructuring discussions could necessitate negative rating action, it adds.

ABS

Coalition to tackle student loan ARS illiquidity

A new coalition of non-bank investors is hoping to help restore liquidity to the student loan auction rate securities (SLARS) market - and by doing so create up to US$63bn of stimulus and up to 441,000 jobs.

Members of the 'SLARS Coalition' hold approximately US$8bn of the aggregate US$25bn estimated to be held by non-bank corporations. Their goal is to advocate for a broader solution to the SLARS marketplace and, in so doing, to generate broader economic growth that would speed the recession recovery.

More than 25 non-bank investors have joined to form the SLARS Coalition, which is working to bring this issue to the attention of Congress, the US Treasury, the SEC and the Office of the NY Attorney General. The coalition commissioned University of Delaware economists James Butkiewicz and William Latham to investigate the potential impact that a systemic solution for non-bank SLARS investors would have on national economic growth, and to publish their research in a whitepaper (see last week's issue).

This whitepaper concludes that restoring liquidity to US$25bn of the frozen SLARS market currently held by non-bank investors would generate an immediate US$58bn to US$63bn of economic stimulus. If the restored liquidity was spent for capital expenditures in a single year, a total of 441,000 jobs would be created.

"The strain put on companies holding illiquid SLARS, such as heightened borrowing costs and weakened earnings, has the effect of aggravating the scarcity of credit and financing that many companies have experienced since the onset of the recession, which in turn further depresses overall economic activity," says Butkiewicz, whitepaper co-author and professor of economics, University of Delaware. "Restoration of liquidity to these securities would result in immediate stimulative effects from business capital investment and would likely be more rapid than those from the federal stimulus programme."

ABS

FASB changes to create ABS market uncertainty

Upcoming changes to the Financial Accounting Standards Board (FASB) rules regarding off-balance sheet securitisations have created some ABS market uncertainty regarding FDIC treatment of transfers of financial assets in the event of conservatorship or receivership of an FDIC-insured institution (SCI passim). A key concern is whether the changes introduced by the FASB could re-characterise existing transactions and how this issue would be addressed post implementation of the new accounting rules. Fitch has been in dialogue with the FDIC regarding these issues to seek clarity on how certain transfers and structures will be treated going forward.

While awaiting clarification, ratings higher than the origination entity may not be achievable on certain transactions, particularly master trust and other revolving structures absent mitigating factors, the agency notes. For static and discreet pool securitisations, where the ability of sponsors to lend support is more limited and there is greater clarity regarding true sale treatment, Fitch triple-A ratings are expected to remain achievable.

For all proposals pre- and post-implementation of the new FASB rules, Fitch will review the transaction structure, documents and opinions to determine whether the securitisation ratings for the senior tranche or tranches can be de-linked sufficiently from those of the seller or originating institution in order to achieve a triple-A level. The agency expects to be able to continue to assign ratings for junior or mezzanine tranches since those ratings are more likely to be closer to the sponsoring bank's rating, limiting the magnitude of a rating change in the event of a re-characterisation.

The comfort previously provided by the FDIC that it would not seek to recover financial assets transferred in connection with a securitisation or participation is being jeopardised by FAS 166 since the FDIC's Rule 360.6 regarding the treatment of the transfer of financial assets upon convervatorship or receivership contains a precondition that the transfer qualify as a sale under GAAP provisions. In the unexpected event that existing transactions are re-characterised and the assets are no longer sufficiently remote from the FDIC's receivership or conservatorship powers, senior ratings would likely move to the senior unsecured of the sponsoring financial institution.

ABS

Egg buys back more delinquent accounts

Egg has exercised an option to buy back at par certain delinquent accounts from the Pillar Funding credit card receivables trust. The purchased receivables have a face value of £111.7m and make up approximately 50% of delinquent receivables in the trust, as at 30 September 2009. Approximately 50% of receivables were repurchased from each of the 11 delinquency buckets.

Moody's expects that this will result in a significant depression of trust charge-offs over the next eleven months. As at September 2009, charge-offs stood at 9.23% and excess spread at 10.72%.

Furthermore, Moody's has received written confirmation from Egg that the accumulation period for the notes issued by the issuer will begin in November 2009 in preparation for the scheduled redemption date in November 2010. "The accumulation of cash for noteholders over the next year, coupled with the expected decreases in charge-off rates linked to the buyback of delinquent receivables is a positive development for noteholders. As such, Moody's believes that the assigned ratings of the notes remain appropriate at this point in time," says Cher Chua, avp at the rating agency.

Alternative assets

PDL BioPharma completes ABS

PDL BioPharma has completed a US$300m securitisation intended to monetise certain of its antibody humanisation patents and royalties. Upon closing of the transaction, which is expected to occur on 2 November, PDL will sell to QHP Royalty Sub (QHP) - a newly-formed wholly-owned subsidiary of PDL - certain rights under its non-exclusive license agreements with Genentech, a wholly-owned subsidiary of Roche Holding, including the right to receive 60% of the royalties from sales of Avastin (Bevacizumab), Herceptin (Trastuzumab), Lucentis (Ranibizumab) and Xolair (Omalizumab) and from sales of future products, if any, for which Genentech may take a license under the related agreements with Genentech.

The notes issued by QHP will offer an interest rate of 10.25%.

In July, Vertex Pharmaceuticals securitised milestone payments tied to a new hepatitis C drug (see SCI issue 145).

CDO

Fitch places Tropic, Soloso CDOs on watch

Fitch has placed 34 of the 38 notes issued by Tropic CDO I, II, III and IV, and Soloso CDO 2005-1 and 2007-1 on rating watch negative. The move follows notification of an offer by Trust Preferred Solutions to purchase Trups in each of the CDOs totalling US$355.8m for a price of US$17.8m in aggregate, or 5% of the par amount (see last week's issue).

The rating agency says it will resolve the RWN status of the notes pending the outcome of the TPS offer. Should the offer be accepted in full, it is likely that the ratings for a number of tranches in the CDOs will be downgraded to distressed levels of triple-C or lower.

If the TPS offer is accepted, the OC test for each transaction will fall, indicating that the senior classes of notes will be undercollateralised. In addition, a significant level of interest proceeds will be lost from these securities, with the possibility that interest proceeds would become insufficient to pay interest on some of the senior notes.

CLO Managers

Manager seeks index inclusion in Euro CLOs

Pramerica Investment Management is seeking to reference indices in the definition of 'credit improved' and 'credit risk obligations' in some of its Dryden CLOs. The manager has requested that Moody's provides its opinion to them as to whether the ratings on Dryden X - Euro CLO 2005, Dryden XIV - Euro CLO 2006 and Dryden XV - Euro CLO 2006 would be downgraded or withdrawn as a result of the reference to indices in the definition of 'credit improved' and 'credit risk obligation'.

In order to be qualified as credit improved or credit risk obligation, as an alternative to other tests, the manager must verify that the asset changed in price during the same period by a percentage either more negative or less positive than the percentage change in the index selected, plus a certain cushion. The indices approved for this rating confirmation are CSFB Western European Leveraged Loan Index, CSFB Western European High Yield Index, Barclay's US Loan Index, Barclay's High Yield Index and IBOXX European Corporates.

Moody's has determined that the inclusion of indices will not in and of itself and at this time cause the ratings of the notes issued by the issuers to be reduced or withdrawn.

CLO Managers

Citadel calls early end to CLO's reinvestment

Watchtower CLO 1, a Citadel-managed transaction that launched in April 2005, is to be wound down earlier than its documentation dictates. The collateral manager has determined that, in light of the composition of collateral assets, general market conditions, the investment criteria and other factors, the investment of principal proceeds in collateral assets within the foreseeable future would be either impractical or not beneficial to the holders of the subordinated notes.

The reinvestment period was terminated on 18 October - the last day of the due period immediately preceding the payment date occurring on 28 October.

CLOs

Double-A CLO rally 'highlights pricing disconnect'

Strong demand in BWICs and off-list trading pushed US CLO prices up again last week. According to data from JPMorgan, triple-A tranches tightened by 25bp to 350bp, double-As were up five points to US$75, single-As up five points to US$65, triple-Bs up five points to US$55 and double-Bs up five points to US$45.

"The rally in double-As highlights the pricing disconnect at the top of the structure," ABS analysts at JPMorgan note. "Triple-As at 350bp versus double-As at 500bp+ suggests triple-A spreads are too wide. We see significant value, given the minimal spread give-up to double-As in the context of the 20%+ current triple-A subordinations as tail risk dramatically declines, and maintain our 250bp spread target for triple-As."

The analysts add that the rally in CLO debt prices, stabilisation in collateral trends and easing in reinvestment conditions for managers has spurred interest in CLO equity as an option on recovery, with US$4bn of BWICs seen during September to October.

"We observe two types of demand: investors seeking fairly frontloaded returns or longer-term recovery plays (akin to distressed purchases in the last cycle)," they continue. "The investment case for CLO equity is predicated on the recovery story, the recognition of an easing in reinvestment constraints, the cheap locked-in term financing (impossible to source in today's environment), and the possibility of front-loaded returns as (some) currently non-performing transactions recover."

CLOs

Additional manager flexibility for Ares CLO

Ares IIIR/IVR CLO has entered into a supplemental indenture that amends the definitions for the minimum diversity/maximum weighted average rating/minimum weighted average spread matrix and current pay obligations. The amendment allows the asset manager to conduct purchases of the secured notes in accordance with certain conditions, including following the sequential order of priority and using principal proceeds for the purchase.

The amendment to the matrix adds cases under which the diversity, weighted average rating and weighted average spread tests would be in compliance. Meanwhile, the current pay obligation definition has been amended to remove the obligation's minimum market value requirement under certain circumstances pertaining to the obligor's initiation of a distressed exchange or buyback.

Notwithstanding the change, both treatment of a current pay obligation in the OC tests (any such asset would be carried at 95% of its market value for the purposes of the OC tests) and the 5% limit on the aggregate principal amount of all current pay obligations eligible to be held by the issuer remain consistent with Moody's rating methodology. Equally, the rating agency performed analysis of the matrix by testing the various cases proposed. The results of this analysis indicate that the changes proposed in the supplemental indenture have no impact on the current ratings assigned to the notes of this transaction.

CLOs

US CLO transactions downgraded

S&P has lowered its ratings on 216 tranches from 42 US CLO transactions and removed them from credit watch with negative implications. The affected tranches had a total issuance amount of US$16.71bn. The agency also affirmed its ratings on 24 tranches from 13 transactions and removed 21 of them from watch negative.

The downgrades reflect two primary factors. First, the application of S&P's new corporate CDO criteria; and second, for some of the transactions, deterioration in the credit quality of the collateral supporting the CLO tranches due to increased exposure to obligors that have either defaulted or experienced downgrades into the triple-C range.

Of the tranches that were lowered, 40 tranche ratings downgrades from 24 transactions were due to the application of the largest-obligor default test. S&P will continue to review the remaining transactions under the corporate CDO criteria and resolve the credit watch status on the tranches from these deals.

CLOs

Downward rating pressure continues for Euro CLOs

Increased loan defaults and negative rating migration in Europe's leveraged loan market are continuing to apply downward rating pressure on CLOs, according to Fitch.

Nick Apsley, associate director in Fitch's European structured credit team, says: "The deteriorating performance of European leveraged loans continues to place downward rating pressure on CLOs. Since May 2009, the level of leveraged loan defaults has accelerated significantly with the average percentage of defaults per CLO increasing from 2.9% to 5.7%, which is having a sizeable impact on the Fitch-rated European CLO universe."

He adds: "Most notably, the agency is seeing the overcollateralisation (OC) tests breaching higher up the payment waterfall, thereby cutting off interest payments to increasingly senior notes. With the OC tests becoming further and further underwater, the likelihood that they will return to compliance in the short-to-medium term - and thus resume interest payments to mezzanine and junior notes - is becoming increasingly remote."

The concentration of triple-C and lower rated obligors in CLO portfolios also continues to increase as leveraged loans continue their migration down the rating scale. This migration impacts the OC test calculations as triple-C assets are typically included in these tests at the lower of their market price or recovery rate. However, this effect has been offset somewhat of late because of increased market prices for both defaulted and triple-C rated leveraged loans since May 2009.

In August, Fitch placed 112 tranches from 23 CLOs on rating watch negative. The agency has since resolved the rating watch on three of these CLOs, affirming the senior triple-A tranches in all cases, but downgrading subordinated tranches.

The downgrades principally reflected the recent clustering of defaults and rating migration in the leveraged loan market. Fitch says it will resolve the outstanding rating watches on the remaining 20 CLOs in coming months.

CLOs

Euro CLO triple-C assets rise

The 2004, 2005 and 2006 CLO cohorts witnessed an increase in the percentage of assets rated in the triple-C category, while the 2007 CLO cohort remained relatively unchanged, according to S&P's European CLO performance index report for August. In addition, all CLO cohorts saw increases in the level of defaulted assets.

S&P's European CLO performance index report provides aggregate monthly performance statistics across its rated universe of European cashflow CLO transactions, which are backed primarily by loans to speculative grade firms.

The rating agency divides the performance information in this report into four cohorts, each containing data for a large majority of the European CLO transactions rated by us and issued in a specific vintage year from 2004 through 2007.

CMBS

Uncertainty for non-FCT SPVs after Windermere ruling

The latest in a series of court decisions leaves considerable uncertainty as to the performance of Windermere XII, according to Fitch. Moreover, various legal issues uncovered by the case may have implications for any securitisation with non-FCT (Fonds Commun de Titrisation) SPV borrowers.

In the case of the Windermere XII CMBS transaction, the borrower (a non-FCT SPV named HOLD) was unexpectedly awarded 'sauvegarde' protection by the courts in November 2008. The court ordered rental income to be trapped in an escrow account pending the agreement of a reorganisation plan for HOLD. Although this deprived Windermere XII of interest scheduled under the loan agreement, its noteholders have nonetheless continued to receive coupons as a result of drawings made under the liquidity facility.

In a more recent court hearing, Windermere XII's management company's standing to object to the opening of the sauvegarde procedure was recognised, although its objections were duly rejected. This generally confirms that sauvegarde protection can be obtained by non-FCT SPVs, which may have negative ramifications for existing and future securitisations involving such borrowers, Fitch notes.

In September 2009 the courts agreed a reorganisation plan for HOLD that created a package of rules principally governing the use of rental income for the remainder of the sauvegarde procedure (see SCI issue 153). However, this plan appears to have been undermined by a ruling in favour of Windermere XII by the Commercial Court of Paris issued on 19 October. This most recent ruling reaffirms Windermere XII's property right in rental income, pursuant to the 'Cession Dailly - cession de creances professionnelles a titre de garantie'.

As this puts an end to the escrow arrangements, money held therein as well as future rental income ought from now to be transferred to Windermere XII. While in itself this is positive for the transaction, it nonetheless leaves considerable uncertainty as to what will remain of the reorganisation plan for HOLD.

Under French law, any company at risk of imminent financial distress has the right to request precautionary protection against creditors, together with the ability to reorganise its business (the sauvegarde procedure). However, it had been commonly assumed that SPV borrowers used in commercial real estate transactions would not be granted such protection, despite not benefiting from the prohibition against insolvency mandated by French securitisation law for FCT issuers. This assumption rested on a view that such SPV borrowers have no business to reorganise, since they have few or no employees and simply own real estate and service the related debt.

Now that this view has been discredited, Fitch will monitor further events, including whether any of these decisions are appealed, in the course of its review of the Windermere XII transaction, which is on rating watch negative. Moreover, the agency will seek further insight as to the likely application of French law for similarly distressed vehicles. Any resulting change in the agency's view of the risk of protection against creditors for SPV borrowers in France will be reflected in its rating criteria both for existing and future securitisations involving such borrowers.

CMBS

Multi-family CMBS to benefit from legal proposal

The new coalition partners in Germany - the Christian Democratic Party and the Free Democratic Party - have reportedly agreed to change existing law to allow REITs to own German residential properties. According to a comment in Moody's latest Weekly Credit Outlook, such a change would be credit-positive for German commercial real estate loans that are secured by multi-family portfolios.

"A large amount of debt securitised in German multi-family CMBS needs to be refinanced in 2012 and 2013, and the proposed change would provide real estate companies owing this debt via subsidiaries with easier access to fresh capital. Thus it would reduce refinancing risk for related CMBS transactions," the rating agency says.

During 2005 and 2006, about 39% of German CMBS issuances were multi-family transactions - securitisations of residential portfolios with up to 160,000 units. With a combined securitised balance of more than €11bn, most of this debt matures in 2012 and 2013.

According to Moody's, the securitised debt is owed by subsidiaries of companies, such as Deutsche Annington, Immeo Wohnen or listed Gagfah. These, in turn, are fully or partially owned by private equity companies (Terra Firma in the case of Deutsche Annington and Fortress Investment in the case of Gagfah) or by other real estate companies.

"Outstanding multi-family transactions have single refinancing exposures that are close to and over €1bn. In the current market environment, refinancings of this size would be challenging, if not impossible," comments Moody's. "While we expect European commercial real estate property and especially lending markets to recover in 2012-13, whether refinancing loans of this size in the lending market will be easily manageable remains uncertain. Therefore, we believe the market warmly welcomes any additional sources of financing or actions that make it easier to source capital for German residential property portfolios."

Documentation

Two credit events pending

An ISDA Determinations Committee decision is pending as to whether a succession event occurred in connection with Britannia Building Society, following its merger with The Co-operative Bank.

Meanwhile, the agreement of a revitalisation plan for Japan Airlines Corp may trigger a restructuring credit event - the first credit event ever to be called in Japan.

Indices

ABX default rates moderating?

Remittance reports for the October distribution date indicate that default rates across the Markit ABX indices are moderating. However, according to ABS analysts at Barclays Capital, 30-day delinquencies are on the rise after continuous monthly declines while severities ticked slightly upwards.

"Default rates fell across indices yet again for a third straight month in October," the analysts note. "Moderating CDRs strongly suggests that a declining REO bucket is restricting aggregate liquidations."

CDRs are currently 17.2, 20.5, 17.9 and 17.4 for the 06-1through to the 07-2 indices respectively, an absolute change of -1.5 points, -0.8 points, -0.7 points and -1.4 points from last month.

"We believe the decline in REO inventories is due to servicers holding loans in foreclosure as they build up toward HAMP. We expect CDRs to pick up again once HAMP is up and running," the BarCap analysts add.

Meanwhile, total 60+ delinquencies generally grew in line with last month's figures. Aggregate 60+ day delinquencies climbed by 64bp, 77bp, 160bp and 126bp for the 06-1 through to the 07-2 indices, compared with changes of 78bp, 69bp, 99bp and 129bp last month respectively.

Early stage delinquencies came in generally higher across indices, the analysts note. The changes in the 30-day bucket were 22bp, 22bp, 3bp and -6bp for the 06-1 through to the 07-2 series. They suggest that this uptick is due to seasonal factors and expect early stage delinquencies to continue to deteriorate in the short term.

Severities averaged 69%, 72.5%, 74.5% and 72.4% for series 06-1, 06-2, 07-1 and 07-2 respectively - an absolute change from last month of -0.6%, 1.1%, 0.1% and 0.3% across the four indices.

Indices

'Bright spots' for home price index

The FHFA monthly home price index has shown a 0.3% price decline in home prices from July to August and a 3.6% 12-month price decline. ABS analysts at Wells Fargo Securities report that, overall, home price performance is within their expected range and that the latest FHFA figures offer some bright spots.

"The impending expiration of the first-time homebuyer tax credit, combined with the looming end of the Federal Reserve's mortgage purchase programme has prompted concern that an acceleration in home price declines will be reignited due to both potentially higher mortgage rates and reduction in liquidity to the housing market," the analysts note. "Although the end of these programmes poses a risk, we believe that the housing market has recovered to the point that it can stand on its own - albeit with very wobbly knees."

They point to the fact that the Pacific region, including California, has managed five consecutive month-over-month price gains. Equally, a comparison of year-over-year declines versus the previous year suggests that the market has already absorbed the majority of home price declines. The 3.6% year-over-year home price decline compares favourably to last year's 6.6% decline, the analysts say.

"Home prices, as measured by the monthly purchase index, have retreated to their February 2005 level. This is consistent with our outlook. Nonetheless, we may experience further home price declines, but we believe that downside with respect to the conforming sector is limited. However, the upside is also constrained and we believe that home prices will 'drag bottom', oscillating between posting modest gains and modest declines month to month," the Wells Fargo analysts conclude.

Indices

Card charge-off improvement unlikely to last

US credit card charge-offs improved for September, receding from the all-time high in August, according to Moody's credit card indices. In a recent report the agency found that the charge-off rate index fell to 10.72% in September from 11.49% in August. Nevertheless, rising delinquency rates, along with an expectation of rising unemployment rates, are expected to lead to higher credit card charge-offs in the months ahead.

Moody's expects the charge-off rate index to peak between 12% and 13% in mid-2010.

The improvement in September's charge-off rate index is due, in part, to the seasonal improvement in early-stage delinquencies earlier in the year. Moody's expects the charge-off rate index to stabilise during the autumn months (similar to autumn 2008) before resuming an upward climb towards the end of 2009 and into 2010.

Five of the 'Big 6' issuers experienced improvement in their trust charge-off rates, with Capital One being the only exception. AmEx and Citi improved the most, with each posting a decline of at least 15% from August to September.

Reliable seasonal trends also continued to prevail in September for early-stage delinquencies, as four of the Big 6 issuers experienced increases in this metric. For the industry, Moody's expects the normal industry-wide seasonal build in delinquencies heading into the winter months to emerge again this year, leading ultimately to higher charge-off rate levels in the first half of 2010.

The payment rate and yield indices also continued to be weak. Issuer discounting, a structural feature of most credit card trusts, is now contributing over three full percentage points to the bottom line index yield, but discounting merely re-characterises trust principal collections and does not reflect any real economic improvement in the card portfolios. Cardholder re-pricing initiatives, which are meant to bring about economic improvements in portfolio yield, have so far provided little net improvement, according to Moody's.

The September excess spread index improved to 6.81% from 6.15% the prior month as falling charge-off rates more than compensated for softer yields. The three-month average excess spread for the index is now above 6% for the first time since September 2008. Underscoring the impact of discounting, the three-month average excess spread would have been hovering between 3.5% and 4% for the past several months (levels not breached since 1997) without the manufactured yield benefit derived from issuers employing the discount option.

Operations

More scrutiny needed in non-Japan Asia SF reporting

Fitch notes that there has been a growing number of reporting errors in some outstanding structured finance transactions within non-Japan Asia, leading to an increased focus on data quality generated by originators/servicers post-closing. Data accuracy on the calculation of transaction performance ratios is crucial for investors and its rating analysis, according to Fitch, since surveillance after transaction closing relies heavily on data provided by the originators/servicers.

Stan Ho, head of the non-Japan Asia structured finance team at Fitch, says: "Fitch expects originators or servicers to consistently apply well-defined internal procedures when preparing performance reports. Asset performance data are integral parts of existing ratings. Therefore, diligent quality control and verification processes on the asset data provided by the originators or servicers are expected, in order to provide the comfort that performance data are reliable and potential losses resulting from erroneous data are minimised."

The agency explains that most reporting errors found to date relate to asset performance figures. Common errors found in performance reports include incorrect formula application, wrong numbers input in aging buckets and poor internal procedures for report preparation adopted by originators/servicers.

Besides data errors, Fitch has observed that noticeable time-lags exist in the circulation of performance reports for some transactions. The agency expects originators/servicers to improve their efficiency in preparing such reports. Furthermore, the corporate services provider - the counterparty that coordinates the report delivery process in some of the transactions - is expected to follow up on the release timing of the performance reports.

Based on Fitch's experience, data errors usually occur when the servicer upgrades its internal system or when there is an internal staff change. There were instances where calculations were not performed in accordance with definitions stated in the transaction documents, the agency notes.

Fitch believes that reporting errors can be avoided with tighter internal controls by originators/servicers. Clear and precise internal guidelines are expected to be in place for the calculation of reported figures. In addition, the report preparation role would preferably be separated from the report verification role.

It is the agency's view that servicers will be able to spot unusual data discrepancies if they perform regular checks between the securitised portfolio data and its company portfolio data, and compare current data with trends and prior collection periods. Special attention should be paid to the first performance report after transaction closing because any mistakes made may be repeated in the later collection periods without being detected.

Fitch intends to introduce issuer report grades (IRGs) for APAC structured finance performance reports during 2010. These IRGs will reflect not only the amount of performance data reported to investors, but also the accuracy and timeliness of reports.

Ratings

Moody's plans structured ratings indicator

Moody's has announced preliminary plans to add an indicator to its ratings of structured finance securities as early as the second quarter of 2010 in order to comply with anticipated regulatory requirements in the EU.

The agency plans to add the indicator to all outstanding structured finance securities it rates globally, as well as to new structured ratings as they are assigned - although the rating agency may phase in implementation beginning with European-rated securities. The indicator, if applied, would only denote that the rating is on a structured finance security; it would not otherwise change the meaning of the rating.

The EU has passed regulation for credit rating agencies that includes a requirement that ratings assigned to structured instruments be differentiated from those assigned to other types of securities. Other regulatory bodies globally have likewise raised the possibility of requiring such a differentiation. The EU regulation is expected to enter into force in the fourth quarter of this year, after which rating agencies are expected to have six to nine months to comply.

Moody's expects the indicator will take the form of an '(sf)', which would appear following the rating in all of Moody's press releases and research reports. The indicator would apply to all structured finance securities, including ABS, ABCP, RMBS, CMBS, and derivatives such as CDOs. Prior to implementation of the indicator, Moody's plans to publish a full list of the types of securities that it considers to be structured finance instruments.

Ratings

CDS-implied/credit ratings contrast explained

In a new report, Moody's discusses the significant disparity between its investment grade credit ratings on life insurers and the often high risk of default suggested by the CDS market.

Moody's svp Scott Robinson explains: "Over the past year life insurance is a sector where market sentiment, as reflected in CDS-implied ratings, has expressed apparent disagreement with Moody's Investors Service's credit ratings on the level of default risk."

During the financial crisis CDS-implied ratings initially fell to levels well below those suggested by Moody's fundamental credit ratings, but have been moving back toward Moody's ratings since March of this year. Robinson emphasises that the comparative trend for life insurers does not demonstrate the relative accuracy of either Moody's ratings or CDS spreads as measures of credit risk in the life insurance sector.

Nevertheless, he points out that the report has some value in highlighting the different properties of these complementary views of credit. Through discussions with market participants, including buy-side and sell-side research and counterparty credit analysts, Moody's determined that the reasons for the apparent divergence in views tend to fall into what it calls either 'fundamental' or 'technical' categories.

Fundamental factors describe reasons why the market may hold a different view and, especially during the first quarter of this year, a more pessimistic view than Moody's about the severity or significance of analytic considerations. They range from the market's seemingly more pessimistic estimation of potential losses from insurers' structured securities and CRE exposure to product liquidity risk and unease about holding company liquidity and financial statement opacity.

According to Robinson: "Moody's more sanguine view of these risks, such as the potential impact of ultimate CRE losses, is informed by systematic stress testing, which suggests a high degree of resilience for insurers, even based on highly stressful assumptions."

Market technical factors, which would apply to CDS-implied ratings in other market sectors, not just life insurance, include the relative ease of expressing a view about short-term credit fluctuations in the CDS (versus cash) market and other supply/demand considerations.

Robinson concludes: "Although we do not hold an opinion about the legitimacy of these 'technical' factors, Moody's Investors Service has considered each of the suggested fundamental factors for the CDS/ratings gap and continues to believe our credit ratings take appropriate account of the risks identified."

Ratings

EMEA SF outlook remains weak

In its latest EMEA structured finance sector outlook report, Fitch says that it expects poor asset performance to continue in most asset classes, despite the apparent stabilisation of economic conditions in Europe.

Ian Linnell, head of EMEA structured finance at Fitch, says: "Fitch remains sceptical that the early signs of economic recovery now evident in most major economies will translate into improved structured finance asset performance in Europe."

The agency expects a return to positive economic growth, but at a rate that is weak by historical standards and fragile to further potential shocks. In the report, Fitch highlights the key performance trends affecting all major structured finance asset classes throughout EMEA.

The report also provides changed sector outlooks for a number of asset classes.

Belgian RMBS asset performance is declining, although ratings are stable, according to Fitch. The asset performance was revised to declining from stable/declining.

Belgian RMBS delinquencies remain on the low side and transactions are still performing within Fitch's base-case expectations. Nevertheless, the country's unemployment rate is expected to increase to a record high of 10.5%, which is driving the negative view on asset performance. Fitch expects transactions to have deleveraged by the time higher defaults arrive, which is why the agency is maintaining its stable outlook on ratings.

Meanwhile, CDOs of European SMEs reveal declining asset performance and negative ratings. The asset performance was revised to declining from stable/declining.

SME CDOs are dependent on regional economic pressure, Fitch notes. Many Spanish SME CDOs are heavily exposed to real estate and construction-related enterprises. In addition, SMEs are likely to experience difficulty in securing alternative sources of credit in the present environment.

For the SME sector to improve, both broader economic fundamentals and access to credit would need to strengthen, Fitch adds. While seasoning and deleveraging will benefit some SME CDOs, the majority of transactions are expected to remain on an uncertain outlook for the foreseeable future.

Irish RMBS also has declining asset performance and negative ratings. The rating outlook was revised to negative from stable.

Russian future flow asset performance, on the other hand, is stable with negative ratings. The rating outlook was revised to negative from stable/negative.

UK CMBS asset performance is stable/declining and ratings are similarly stable/negative. The asset performance was revised to stable/declining from declining. The rating outlook was revised to stable/negative from negative.

Pan-European CMBS asset performance is declining and ratings are stable/negative. The rating outlook was revised to stable/negative from negative.

Finally, South African CMBS asset performance is found to be declining and ratings are stable/negative. The rating outlook was revised to stable/negative from stable.

Real Estate

Survey suggests Euro real estate recovery will lag US

US home prices are expected to trough in the next 12 months while default rates on underlying loans in UK RMBS will continue to rise, reaching a projected peak in 12 to 18 months time, according to a global survey of RMBS investors.

The valuation inputs consensus survey, which was conducted by S&P's fixed income risk management services (FIRMS) division, tracked the valuation projections of 64 institutions active in the US and European structured finance markets. The survey has been underway since Q109 in order to monitor investors' input assumptions for the valuation of these key securitisation assets.

Investor forecasts for US home prices for the next 12 months are trending upwards, with the projection for average home prices in Los Angeles to increase from -22% in Q2 to -13% in Q3; in Miami from -23% to -16%; and in Dallas from -9% to -5%. On the whole, investors expect the US real estate market to reach a bottom in the next 12 months.

Mortgage default rates have followed suit, with projected default rates for the underlying loans in US Alt-A and sub-prime RMBS improving since the Q209 survey. Expectations for default rates on loans in 2007-vintage RMBS are down to 12% from 30% on Alt-A and to 23% from 30% on sub-prime.

In the market for prime fixed rate RMBS, loan default rate projections have increased slightly from 2% in Q2 to just under 4% in Q3 for 2007-vintage deals, while loss severity projections have decreased notably for the same time period.

Peter Jones, global head of S&P's valuation scenario services business, says: "Because the majority of poorly performing securitised US mortgage loans have already defaulted or paid down, default rate forecasts for underlying collateral on US Alt-A and sub-prime RMBS are stabilising versus expectations for US prime RMBS."

He adds: "Furthermore, default rate expectations for US mortgage loans - although improving across most asset classes - remain significantly higher than UK loans, which are expected to deteriorate across all classes. Clearly, respondents see the UK and US assets in two very distinct ways."

When assessing asset class performance across an entire vintage, average default rate forecasts for 2004, 2005, 2006, 2007 and 2008 vintages on UK non-conforming loan (NCL) RMBS climb from 8.2% for the period covering the next six months to 9.8% for the period covering 12 to 18 months from today. Default rates on all vintages of UK prime RMBS are also expected to increase, from 1.8% to 2.2% over the same period.

Following these peaks, forecasters do not expect default rates to return to the historically high levels predicted for the next six months on either UK prime or NCL RMBS for at least another two and half years. Market participants on average expect a 7% decline in UK house prices over the next 12 months, down from a 10% decline forecast in the Q2 survey. However, there is no consensus regarding the timing of the bottom of the market - for each of the next five quarters, less than 20% of respondents are predicting the beginning of a recovery.

Despite stabilising house price expectations, over the next 12 months forecasts for loss severities on UK NCL RMBS have risen to 36% from expectations of 31% revealed in the Q2 survey. Jones explains: "The increased expectations for loss severity on UK NCL RMBS may well be influenced by banks' inclination to step up repossessions - crystallising any losses on the corresponding loans - on account of the apparent stabilisation in house price declines."

The survey was conducted between 14 September and 6 October with 64 participating institutions split equally between the buy-side and sell-side.

Real Estate

Impact of REMIC rule change analysed

The CMSA has released a paper that describes how recent changes to REMIC rules addressing CMBS loan modifications (SCI passim) may impact commercial real estate finance market participants. While the Revenue Procedure and Regulations relax certain constraints on modifying mortgage loans held in REMICs, the Association says it is not yet clear how significant an impact these changes will have in practice.

The flexibility incorporated into the changes in the REMIC rules may allow modifications to be made earlier without incurring adverse tax consequences if the servicer reasonably believes that there is a significant risk of default, the CMSA notes. These changes do not, however, accelerate the timing of transfers to the special servicer, allow for modifications not in the best interest of the certificate holders, negate the need for special servicer or controlling class holder approvals or amend any terms of the servicing agreements governing servicing of the loan. This suggests that the impact of the new REMIC guidelines in existing transactions will not be significant.

The REMIC rule changes loosen some tax restrictions and enhance opportunities for discussion of loan extensions or other modifications without concern that such actions would threaten the REMIC status of the trust. Now, if, based on all the facts and circumstances, the servicer reasonably believes that there is a significant risk of default upon maturity of the loan or at an earlier date, then the IRS will not challenge the REMIC status of the trust if the loan is modified, provided the balance of the requirements set forth in the REMIC rules are met. This, however, does not mean that under any PSA a loan can be modified simply because the tax rules permit modification, the CMSA notes.

If a borrower believes a significant risk of default exists and wants to request a loan modification or extension, the Association suggests that they generally should:

• Conduct a review of the loan documents to determine their contractual rights and obligations.
• Carefully analyse their property condition, performance and outlook to determine what factors indicate a significant risk of default, and make an assessment of the best plan to enable the borrower to perform its obligations under the loan.
• Prepare a written request outlining the results of the assessment, together with a proposal for the lender to consider.
• Communicate in writing with the servicer to which the borrower submits its monthly debt service and financials reasonably in advance of the perceived events creating risk of default.

RMBS

Overseas appetite increases for agency MBS

Overseas accounts may be poised to allocate more capital to agency MBS, according to securitisation analysts at Barclays Capital.

Comparing foreign purchases of US Treasury notes and bonds in relation to US Treasury bills, the analysts note that overseas accounts have added longer-duration assets over shorter-duration T-bills for four out of the past five months. "While this has likely been in reaction to the Treasury's trying to term out its debt by issuing more notes and bonds, it does suggest an increased appetite for risk on the part of foreign investors," they say.

The BarCap analysts also question whether, if overseas accounts are starting to add risk, they will be tempted to move more into spread or credit products at the expense of US Treasuries. "We do believe that the international community will gradually begin a risk reversal trade, which may be in its early stages already," they note. "For example, the latest monthly TIC data show that foreign accounts have been reinvesting their pay-downs back into agency MBS while decreasing their allocations to agency debt and US corporates."

They add: "This data point not only confirms a trend that has been building over the past three to four months, but also hints at what risk exposures overseas accounts are willing to accept."

First, the Treasury purchases suggest that foreign accounts are willing to take on more duration, given the same credit of the underlying. Second, these same accounts are prioritising agency product over the credit risk of US corporates. And finally, the yield pick-up of agency MBS is likely a further draw over agency debt.

"Taken together, we believe that these are positive signs, suggesting a growing level of comfort and demand for agency MBS from the international community," the BarCap analysts conclude.

RMBS

US RMBS ratings lowered to default

S&P has lowered its ratings to D on 712 classes of mortgage pass-through certificates from 654 US RMBS transactions. The rating agency removed 10 of the lowered ratings from credit watch with negative implications.

In addition, 59 other ratings from nine of the affected transactions were placed on watch with negative implications. The ratings on 97 additional classes from 10 of these transactions remain on watch with negative implications.

Approximately 86% of the defaulted classes were from transactions backed by Alt-A or subprime mortgage loan collateral. The 712 defaulted classes consisted of the following:

• 404 classes were from Alt-A transactions (56.74% of all defaults);
• 210 were from subprime transactions (29.49% of all defaults);
• 67 were from prime jumbo transactions;
• Six were from reperforming transactions;
• Five were from seasoned loan transactions;
• Four were from outside-the-guidelines transactions;
• Three were from closed-end second-lien transactions;
• Three were from risk-transfer transactions;
• Two were from first-lien high LTV transactions;
• Two were from HELOC transactions;
• Two were from RMBS 'other' transactions;
• Two were from re-REMIC transactions;
• One was from a document-deficient transaction; and
• One was from a non-performing transaction.

The move reflects S&P's assessment of principal write-downs on the affected classes during recent remittance periods. The watch placements reflect the fact that the affected classes are within a group that includes a class that defaulted from a single-B minus rating or higher. S&P lowered approximately 97% of the ratings from the triple-C or double-C rating categories, and approximately 99% from a speculative-grade category.

The rating agency expects to resolve the watch placements affecting these transactions after completing reviews of the underlying credit enhancement.

RMBS

Delinquency index improvement for UK RMBS

The rate at which borrowers are falling into repossession has slowed over Q2, while the overall repossession index rose slightly to 0.27% from 0.26%, according to S&P.The agency believes that a slowdown in new repossession cases is perhaps a sign that some borrowers are finding it easier to meet their loan payments, despite the fact that economic fundamentals in the UK, such as GDP and unemployment, remain negative and in fact continue to worsen in the case of the latter.

However, in Q2 S&P has seen some mildly positive signs from both the UK housing market and from its own analysis of UK prime RMBS transactions. Property prices have increased for the fifth consecutive month, according to Nationwide, but the number of property transactions remains low and credit conditions continue to be tight for all but the most credit-worthy borrowers.

S&P total delinquency index increased to 3.99% from 3.64% in Q109. Most of the deals saw upward movements in their 90+ day delinquencies over Q2, with the corresponding index rising to 1.91% from 1.70%.

The payment rate index remains below 20% for a second quarter. It had dipped to 15.3% in May and was 17.36% at June.

The Bank of England base rate (BBR) remains at 50bp. The gap between BBR and average standard variable rates (SVRs) in the market remains wide at 3.45%, contrasting with the long-term average difference of 1.8%.

The outstanding balance of mortgages backing transactions in S&P's UK prime RMBS index dropped to £290bn. There was no UK prime issuance in Q2.

RMBS

Arrears improve for Euro mortgage markets

According to S&P, Europe's homeowners are beginning to miss fewer of their mortgage payments. Since the onset of the financial market disruption in late 2007, European residential mortgage borrowers have increasingly found themselves in financial distress, although the degree varies by country and type of borrower.

The reported arrears on loans backing S&P-rated European RMBS have risen sharply as a result. But more recently the situation may be improving.

In early 2008, higher interest rates across Europe meant mortgage payments rose, squeezing many homeowners' finances. S&P believes that this was initially a major factor spurring higher arrears and, ultimately, defaults on mortgages. Furthermore, the disruption in capital markets raised banks' funding costs and led to significantly restricted access to credit for many borrowers, especially those in financial difficulty looking to refinance.

However, the sharp policy rate cuts by the Bank of England and the European Central Bank have now worked through to reach mortgage borrowers. As a result, arrears have moderated across various sectors, as borrowers in markets where floating-rate loans are common have benefited from lower scheduled mortgage payments.

This improves the prospects for credit ratings on outstanding RMBS transactions in Europe, though there is one important caveat. Even though interest rates are currently low, unemployment generally continues to rise in most European countries. Arrears could therefore start to climb again if employment deteriorates significantly.

So what of the future financial health of Europe's mortgage borrowers? S&P believes that unemployment will continue to be one of the key determinants of their future payment behavior - and, therefore, of the creditworthiness of European RMBS. Additionally, how and when the availability of mortgage credit recovers will be vital to Europe's consumers, giving borrowers greater flexibility to manage their debt.

Technology

US RMBS data feed unveiled

S&P's fixed income risk management services (FIRMS) has launched a new data feed for investors that can help them evaluate exposure and risk in the US RMBS market. The service provides investors with loan-level performance data on subprime, alternative-A, prime jumbo and additional collateral types.

The data feed's granular loan-level data include static origination details, as well as dynamic performance data, comprising delinquency status, current balance and current interest rate. Robust data quality standards and metrics have also been established to maximise the accuracy of the data. The monthly data feed will provide users with detailed performance information within a few days of availability.

David Goldstein, FIRMS md, says: "In today's environment, it is essential for investors to have access to granular and timely loan-level data. Because S&P collects much of this information for our own research and analysis, we recognised that we could further assist investors track month-to-month loan performance, identify loan default trends and monitor performance pools at a deal level by giving them access to Standard & Poor's global data solutions - US RMBS data."

Additionally, FIRMS is planning to include in the feed the American Securitization Forum's ASF LINC, a unique loan identifier applied at the loan level and intended to help identify and track mortgages throughout their lifetime as they are bought, sold and securitised (SCI passim).

Technology

MBS analytics solution launched

First American CoreLogic has launched a bond analytics solution for non-agency MBS. The offering is designed to deliver improved valuation and surveillance of RMBS through a more accurate prediction of loan-level behaviour that, in turn, drives more precise bond-level cashflows.

The bond analytics solution generates bond-pricing reports, which include principal loss projections, credit enhancement loss coverage ratios and implied ratings, as well as bond prices driven by user-defined or market-based spreads. In addition, the solution provides a single view of securities data, borrower data and real estate data by leveraging current open lien information and automated valuation models (AVMs), which provide updated and dynamic current loan-to-value (CLTV) on the underlying collateral.

The solution uses First American CoreLogic's TrueLTV, as well as the LoanPerformance Home Price Index (HPI) and HPI Forecasts, which provide post code-level historical and projected real estate trends across all local market segments.

George Livermore, ceo for First American CoreLogic, says: "Our bond valuation solutions represent the most complete and reliable bond pricing and analytics solution available in the market today. LoanPerformance loan-level data and analytics and Intex deal libraries are clear industry leaders in coverage and quality. Seamless integration of these best-in-class components leads to superior bond pricing."

Technology

Buy-side OTC derivatives solution launched

Misys is set to launch a buy-side derivatives solution that leverages the OTC and derivatives expertise of its Summit FT solutions.

Misys Summit Invest enables trading, risk management, trade processing and OTC lifecycle management in a tailored buy-side environment. It includes features to ensure organisations handle the complexity, risk and regulatory reporting of these complex products.

David Dixon, buy-side solutions manager at Misys, says: "Despite the financial crisis, we continue to see interest from buy-side firms who understand they need robust systems for handling these higher risk products. Industry research has shown that the trade processing cost of an OTC is between five and 100 times greater than an exchange-traded equity, depending on complexity. Much of this cost is related to the extended lifecycle, which can be 20 years or more. Additionally, the need to automate valuations and processes, such as rate resets and collateral, is particularly strong."

The solution is being deployed this month by a major UK-based asset manager, the firm says.

Technology

Upgraded SF operations platform unveiled

Principia Partners has launched Principia Structured Finance Platform (SFP) Version 6.2. The latest upgrade helps financial institutions and investment managers to track, monitor, analyse and report on the collateral pool performance of any fixed income asset, including ABS, RMBS, CMBS, CDOs, CLOs and covered bonds. The firm says it provides a standardised, end-to-end operational infrastructure to normalise and more efficiently manage ongoing collateral performance data, regardless of the asset class or data source.

A new standard interface into Principia SFP resolves the challenges and inefficiencies associated with integrating performance and cashflow data into the ongoing management and oversight of structured finance portfolios. The system automates the processing of external data from any independent performance data provider or bond trustee, as well as proprietary data resulting from the internal credit analysis of loan-by-loan information.

Data for multiple deals, from disparate data sources, is integrated on a single platform to display accurate and consistent performance metrics on-demand, across the business. Organisations can consequently manage and maintain compliance with risk limits, perform rigorous stress tests and deliver timely reports detailing performance measures at the portfolio, deal, tranche or collateral level.

Ratings

Rating roadblock falls for dealer floorplan TALF ABS

Katie Reeves, research analyst at Deutsche Bank, finds that – given higher credit enhancement levels for 2009 transactions – dealer floorplan ABS should be compelling for a range of investors

ABS backed by auto dealer floorplan loans, particularly those coming from the domestic captive finance companies, have been one of the last beneficiaries of this year's Term Asset-Backed Loan Facility (TALF) programme. Up until the last several weeks, auto dealer floorplan issuance had been anaemic, even before the ABS market seized up in mid-2008.

In early 2008, the dearth of issuance was less related to the health of the securitisation market and more to investor reluctance in the face of auto industry upheaval that had been in place since before the 2008 credit markets meltdown. But even in 2009, it took until September to see a dealer floorplan transaction from a domestic captive auto issuer. We discuss reasons for that and prospects for the sector going forward in this article.

Figure 1 below shows a historic comparison of how auto dealer floorplan issuance this year compares to previous years' issuance, as well as total ABS issuance in 2008-2009.

From Figure 1 we see 2008 and 2009 auto dealer floorplan issuance being well off previous years' volumes. In 2009 we attribute the relative quiet to two main factors.

The first is that, in order to qualify as an eligible transaction under TALF, a new ABS transaction must have triple-A ratings from two approved rating agencies. Fitch has not rated a new public auto dealer floorplan deal since 2007, including any of the 2009 deals so far. And for most of this year, Moody's took the stance that it could not assign a triple-A rating to any new auto dealer floorplan ABS issued by a domestic captive, regardless of credit enhancement levels or other structural mitigants.

Moody's concerns have been over the health of the manufacturers themselves, as well as with the uncertain environment overall for auto manufacturers. It was a softening of this stance, particularly vis-à-vis Ford, that allowed for Ford to issue its first public term floorplan deal as a TALF-eligible ABS transaction in September.

Ford issues the first 'Big 3' floorplan transaction of 2009
On 30 September Ford Motor Credit Company (FMCC) issued its first public TALF-eligible dealer floorplan transaction of 2009 - Ford Credit Floorplan Master Owner Trust A Series 2009-2 (see SCI issue 154). The Ford transaction was upsized during the marketing period to an ultimate size of US$1.5bn and was a three-year transaction that priced at 155bp over one-month Libor.

Achieving TALF status was made possible in large part because Moody's has become more comfortable with Ford Motor Company's financial condition and sees some stabilisation in the auto industry overall, such that it was able to assign a triple-A rating to the transaction. In a Moody's report released concurrently with its rating of the Ford transaction, the rating agency cited evidence from the General Motors and Chrysler bankruptcies, and how those issuers' outstanding dealer floorplan ABS transactions fared following those bankruptcy filings, as one of the biggest reasons for its change of heart. Additionally, the Ford transaction included Wells Fargo (Aa2) as a back-up servicer.

In its analysis of how the GM and Chrysler bankruptcies unfolded, Moody's noted that the significant dealer reductions that occurred in the GM and Chrysler bankruptcies did not result in a sizeable number of dealer defaults. They also noted that recovery rates associated with dealer floorplan loans in those programmes did not suffer dramatically, largely because related vehicle values held up well.

Monthly payment rates also held up relatively well through the bankruptcy reorganisations. However, Moody's also acknowledges that these two auto bankruptcies were much more controlled than they could have been. For example, here, there was substantial government assistance to help limit the damage from a bankruptcy.

The bankruptcies were also not long drawn-out proceedings. Additionally, the finance companies (who are the servicers of the ABS) avoided bankruptcy.

As a result, Moody's still applies stresses that are consistent with a less orderly bankruptcy. Consequently, the Ford transaction has initial credit support of approximately 33% (32% overcollateralisation, together with a 1% reserve account amount) - much higher than pre-2009 transactions.

While S&P never explicitly said that it could not rate dealer floorplan ABS from a 'Big 3' issuer a triple-A, it also had significant reservations earlier this year. In February 2009, S&P revised its auto dealer floorplan rating assumptions to mimic a more onerous bankruptcy scenario than it had in the past (for example, that the manufacturer starts a liquidation process earlier during the proceedings and that manufacturer and finance company support for dealers goes away). These resulted in more onerous assumptions for defaults, recoveries and payment rates, which in turn increased the amount of credit enhancement S&P required versus what it had required for transactions before the criteria changes.

In 2009 dealer inventories (and related financing need) fell precipitously
However, in a sense, the inability of issuers to tap the ABS market earlier this year came at a relatively opportune time, given shrinking underlying dealer inventory levels. US dealer inventories have shrunk dramatically in just this year alone.

Figure 2 shows the number of vehicle units available as dealer inventory at the end of September 2009, versus December 2008. Looking at the 'Grand Total', we see that there are 48% fewer units than there were just nine months earlier.

Among the domestic captives, GM, Ford and Chrysler inventories are down by 51%, 32% and 65% respectively over that same period. The only manufacturers to see inventory increases over the period are Hyundai, Kia and Porsche.

Will the ABS market be there to support an inventory re-build?
However, as business conditions stabilise in the auto industry, having access to the term ABS market will be a positive development for the domestic captive finance companies. But for these issuers, this in turn will depend on having the TALF programme available, at least given current market dynamics. The TALF programme is now set to expire at the end of March 2010.

For a three-year dealer floorplan transaction, the TALF loan rate is 100bp over the three-year swap rate and the TALF 'haircut' is 14%-15%. Given these parameters and Ford's transaction spread level of 155bp over, it is estimated that the TALF ROE for this transaction was approximately 7%.

By contrast, the ABS issuing spreads for asset classes, such as prime retail auto ABS and prime credit card ABS, have tightened to such an extent that we're increasingly seeing less reliance on the TALF programme as the returns become less compelling. While an argument could be made that, for some specific names and asset classes, expiration of the TALF programme may be a relative non-event (given the extent of non-TALF accounts participating already), the same cannot yet be said for auto dealer floorplan issuance, particularly any to come from the domestic captives.

Conclusion
Dealer floorplan ABS transactions have always been one of the few subsectors of the ABS market where investors can diversify away from taking direct consumer credit risk. With an unemployment rate of nearly 10% and rising, this should no doubt be a positive for many market participants. Its structures also make use of the same revolving trust/bullet pay mechanics used for credit card ABS; an attractive feature for those more sensitive to cashflow uncertainty.

With re-tooled rating agency assumptions resulting in much higher credit enhancement levels for 2009 deals, dealer floorplan ABS should be compelling to a range of investors, although light issuance impacts liquidity. However, until issuing spreads reflect a new comfort level with the current state of the auto manufacturing and finance worlds and the new rating agency approaches, we believe the TALF programme is necessary to support continued issuance going forward.

© 2009 Deutsche Bank Securities. All rights reserved. This Research Note is an excerpt from 'Securitization Monthly', first published by Deutsche Bank on 9 October 2009.

Trading

Trading ideas: marginal difference

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a pairs trade on Limited Brands and Jones Apparel Group

The holiday season is approaching and a question on many minds is whether or not retailers will get crushed. Without trying to make a grave forecast, we dig deep into the retailing industry before the madness begins and model several different fundamental factors on a quest to find those with the greatest explanatory power of credit spread levels.

The outcome is a long Limited Brands, short Jones Apparel trade. Limited's higher EBITDAR margins and coverage levels make the pairing a solid positive carry trade.

The initial starting point of credit picking is our quantitative credit model (MFCI) that covers all non-financial issuers with an actively traded CDS. Due to the highly idiosyncratic nature of the different industries (30+) embedded within the non-financial universe, it is extremely important to use the output of the model as an initial screen and then further model the individual sectors.

By doing so, the best explanatory fundamental factors can be ascertained for each specific industry - as they certainly vary. For instance, retailers hold significant portions of their 'debt' in rents and operating leases, which make direct ratio comparisons with other industries difficult.

After delving into the retailing industry and adjusting all factors for rents, we find that adjusted debt to EBITDAR, EBITDAR margins, adjusted interest coverage and adjusted debt to market capitalisation all have significant explanatory power for current spread levels. Interestingly and quite counter to expectation, several liquidity measures did not. As an example, Exhibit 1 demonstrates the strong non-linear relationship between EBITDAR margins and five-year CDS levels of the retailers in our universe.

The results of the retailing industry analysis provide several different means to determine expectations of credit spreads for all issuers within the group. Limited Brands - with its coverage ratio of 2.2x, EBITDAR margin of 16%, adjusted debt to EBITDAR of 4.7x and adjusted debt to market cap of 110% - is consistently marked as cheap, with its CDS trading at 255bp. All models used gave LTD an expected spread level between 160bp and 190bp.

On the other hand, Jones Apparel - with its coverage ratio of 1.62x, EBITDAR margin of 9%, adjusted debt to EBITDAR of 5.2x and adjusted debt to market cap of 98% - receives an expected spread level in the range of between 250bp and 350bp. The significant driver of the differential between the two credits is Limited's higher margins and coverage level.

A few items are worth noting. Though liquidity measures did not bear much fruit in our retailer analysis, Limited Brand's cash balance of US$1.5bn puts it in an enviable position. Jones recently announced renewed credit agreements; however, the net result was an actual reduction in total capacity and added covenants.

An issue of concern for the trade is that Jones' recently reduced total debt below US$600m. Its bonds don't actively trade and are not due until 2014 and beyond; therefore, stress for Jones will have to come from lack of profitable sales and a short-term liquidity crisis causing an inability to conduct business (i.e. breaking covenants) rather than a missed debt payment.

Only recently did Jones's CDS trade tight to Limited's (Exhibit 2). With 60bp of positive carry, the risk/return characteristics of the trade are good.

Position

Sell US$10m notional Limited Brands Inc 5 Year CDS at 255bp.

Buy US$10m notional Jones Apparel Group Inc 5 Year CDS at 195bp.

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).