Contents

Emerging Markets

Revival of the fittest?

New EM CDO issuance contemplated

Citi and Sydbank are hoping that the successful pay-down of their first local currency emerging market (EM) CDO will pave the way for further issuance. However, timing, investor appetite and rating agency co-operation are all expected to be crucial in getting such a deal off the ground.

"Evolution I - the first of our local currency EM CDOs - matured just over two weeks ago. Despite the harsh environment, all rated noteholders got back par and equity holders got a return north of 11%," says Gursev Riyat, structurer in EM credit trading at Citi. "On the back of this deal rolling off successfully, it allows us to go back to investors for a similar deal in the future. However, this is not immediate and [is] subject to a credit rating agency process."

Any new issuance from Citi and Sydbank is likely to follow in the footsteps of the Evolution transactions, but may be subject to a few tweaks. The structurers are understood to be in talks with rating agencies regarding any potential new issuance.

The previous Evolution CDOs (I & II), issued in 2006 and 2007, offered investors full capital structure exposure to emerging market local currency credit and FX risk. Both deals were managed by Sydbank and referenced CLNs issued by Citigroup Funding. Moody's rated both deals.

The Evolution CDOs are widely recognised for having outperformed similar structures over the past couple of years and commentators have speculated that EM CDOs may be the first type of CDO to make a comeback post-crisis (SCI passim). Riyat notes that the main competition for the Evolution deals were CFXOs - similar transactions (CDOs) with local currency FX exposure, but which were structured to include option strategies that effectively meant that losses were crystallised once the options were triggered.

"This feature was not inherent in the Evolution transactions and any losses incurred due to FX depreciation against the dollar in the Evolution deals weren't realised straight away," he says. "This meant that when local currencies appreciated against the dollar over the last six months or so, investors have had the ability to participate in that rally."

"The Evolution CDOs are fully managed and so our portfolio managers were able to actively reduce risk last September and put it back again in April," adds Rune Juel Hansen, senior portfolio manager at Sydbank. "This added value to the CDO."

"We feel the Evolution deals were very conservatively structured," continues Riyat. "The leverage was much less than you would usually see and the thickness of the equity tranche was 30%. In addition, the triple-A super-senior attached at 70%, giving a fair amount of subordination."

Despite the success of the two Evolution deals, the timing of bringing a new deal to market is expected to be crucial. According to one EM asset manager, local market yields are currently very low and, given where liability spreads are, the economics for such a deal may not work at present.

"But who knows what the market might look like in six months' time," he says. "If liability spreads come in and yields rise, the economics may suddenly make sense. There's no doubt that investors are more risk-willing and the focus on emerging markets is getting stronger. After the rally in high yield bonds and loans, many are now looking at EM instead."

Indeed, emerging markets have outperformed those in the West over the past year and Riyat points out that a fair few investors are showing interest in local currency risk, meaning that they are happy with the underlying collateral within this type of portfolio. The next step is, of course, to facilitate their interest in structured investments in the same asset space.

Hansen suggests, however, that the CDO market is slowly opening up again. "Looking back six to twelve months, nobody wanted to invest in a new CDO. But when we closed this CDO [Evolution I] with success we spoke with investors: they now look at this structure more favourably and see it as a way of getting leverage and getting paid well for risk taken."

AC

ABS

Looking east

Positive outlook for asset-backed sukuk

The global issuance of Islamic bonds (sukuk) has surged in recent months in a marked turnaround from earlier on in the credit crisis. While issuance has so far been dominated by sovereigns and government-related entities, there is an optimistic outlook for issuance of asset-backed sukuk.

"We believe that asset-backed sukuk structures will gain traction as the market perception of risk changes," confirms Faisal Hijazi, business development manager for rating services and Islamic finance at Moody's in Dubai. "Unsecured issuance will dominate the market for the time being, but once the market stabilises and opens for all forms of funding, there should be potential for asset-backed sukuks."

Many factors indicate that asset-backed sukuk are likely to come back in the near future, confirms Roula Sleiman, vp in the capital markets group at BSEC. "The AAOIFI recommendations - confirmed also by Moody's and S&P - following the debate about the conformity of most sukuk issuances is one indicator," she says. "The first principle highlighted by the organisation is about the true sale and the transfer of the right over an asset, which is not ensured in most sukuk structures. This in itself gives the asset-backed sukuk an advantage over other type of securities."

She continues: "In addition to that, if we look at the MENA market, it constitutes in itself a source of growth for sukuk issuances, due to the large Muslim population. It is estimated that around US$200bn of assets under management are from Middle Eastern clients. Also, we should not disregard the increasing liquidity of regional Islamic banks and the increasing demand for Shariah- compliant instruments."

The issuance of asset-backed sukuks began to take off shortly before the global financial crisis, with a small handful of deals being publicly marketed. There have been few issuances since 2007, however.

Hijazi points to a clear difference between ratings performance of secured and non-secured sukuk issuance following the crisis. "For example, Tamweel's secured sukuk [Tamweel ABS - issued in 2007] has maintained its Aa3 rating, despite the originator being downgraded to Baa1, whereas Tamweel's unsecured sukuk were downgraded in line with the issuer's credit rating," he says.

Given the global negative sentiment, many intermediary or advisory firms have found it difficult to prepare or make feasible an asset-backed sukuk. The costs associated with preparing a deal have also been prohibitive - especially if the transaction would then be met with scepticism from investors.

"Although the region was not directly impacted by the subprime crisis, nevertheless negative sentiment around securitisation does exist," Hijazi notes. "Post-crisis, there's a feeling that investors would not necessarily be interested in buying asset-backed sukuk."

He adds: "However, one of the benefits of asset-backed sukuk is that you cannot structure a deal without having specifically targeted certain tangible assets or investments. This should give comfort to investors. Also, in the Middle East structures such as CDOs and other derivative-based investment products are not permitted as they do not comply with Shariah law."

Global sukuk issuance rose over 40% in the first ten months of 2009 compared to the same period last year. Moody's anticipates that full-year growth in global sukuk issuance will reach around 50% this year, offsetting the 55% decline seen in 2008.

In a new special report, the rating agency notes that the renewed sukuk issuance - in particular from sovereigns and government-related entities - is a development that will foster a more efficient and soundly-based sukuk market. The launch of sukuk funds and various legislative measures in certain countries should also deepen the market and add transparency and efficiency, it says.

Moody's believes the gradual introduction of such funds will help create a secondary market for sukuk, whereby investors, including banks, can price their sukuk fairly, enhancing both liquidity and secondary market tradability.

This year most sukuk issuance has consisted of ijarah sukuk (lease, hire or the transfer of ownership of a service for a specified period for an agreed lawful consideration). Hijazi explains that this is less questionable in terms of Shariah compliance and is due to there being plenty of assets that it can be structured around.

"It is also an easier process for governments looking to raise new capital, especially in times of economic uncertainty and investors' risk aversion," he says.

Meanwhile, ISDA's Islamic derivative documentation is expected to be published before the end of the year, although a definite date has not yet been set.

AC

Monolines

Monoline explores liquidity solutions

Ambac notes in its latest SEC filing that it is contemplating a prepackaged bankruptcy as one potential strategy to address its liquidity needs. Credit strategists at BNP Paribas suggest that such a move could trigger the termination of US$23bn of CDS contracts.

Based on the holdings of cash, short-term investments and bonds of US$164,700 as of 30 September 2009, Ambac believes that it has sufficient liquidity to satisfy its needs through the second quarter of 2011 - although it says no guarantee can be given that Ambac Assurance will be able to dividend amounts sufficient to pay all of its operating expenses and debt service obligations in the long term or that it will be able to access alternative sources of capital. The filing states that Ambac Assurance is unable to pay dividends in 2009 and will likely be unable to pay dividends in 2010, absent special approval from the OCI, thus constraining its principal source of liquidity. Further, other contingencies (for example, an unfavourable outcome of the outstanding class action lawsuits against the monoline), could cause additional liquidity strain.

While management believes that Ambac will have sufficient liquidity to satisfy its needs through to Q211, no guarantee can be given that it will be able to pay all of its operating expenses and debt service obligations thereafter, including maturing principal in the amount of US$143,000 in August 2011. Indeed, the monoline points to the possibility that its liquidity may run out prior to Q211.

Ambac is consequently developing strategies to address its liquidity needs, including a negotiated restructuring of its debt through a prepackaged bankruptcy proceeding. If the monoline is unable to execute these strategies, it says it will consider seeking bankruptcy protection without agreement concerning a plan of reorganisation with major creditor groups.

"Overall, it is hard to escape the feeling that Ambac is living on borrowed time from a statutory capital perspective," says Michael Cox, structured finance strategist at Chalkhill Partners. "However, as others have shown, the closer a monoline gets to death, the easier it is for it to commute problematic exposures and therefore it is hard to say for certain that Ambac Assurance will come under regulatory control or have to suspend claims payments, which would be a credit event for CDS purposes."

He adds: "Holdco liquidity remains more of a problem, however, and it is difficult to see how Ambac Financial will not run out of cash within the next two years without some form of restructuring or capital raise."

CS & AC

Operations

Concerns raised over new impairment model

The IASB has published an exposure draft on the amortised cost measurement and impairment of financial instruments. However, there is concern over whether the proposal will simply serve to obscure impairment losses further.

Moody's observes in its latest Weekly Credit Outlook that although improvement of the current impairment model is a desirable goal, it remains unclear whether the IASB solution will result in investors obtaining additional useful information or cause impairment losses to be obscured in provisions built up over the life of the instrument. "The IASB approach will surely result in more conservative balance sheets and less earnings volatility, which could contribute to greater safety and soundness of financial institutions. But the smoothed earnings that are likely to result from the IASB model could also hinder investors' ability to identify problem institutions and make it more difficult for investors to differentiate between stronger and weaker performers," the rating agency notes.

The IASB's proposals form the second part of a three-part project to replace IAS 39 'Financial Instruments: Recognition and Measurement' with a new standard, to be known as IFRS 9 'Financial Instruments'. Proposals on the classification and measurement of financial instruments were published in July (SCI passim), with a final standard expected shortly, while proposals on hedge accounting continue to be developed.

Both IFRS and US GAAP currently use an incurred loss model for the impairment of financial assets. An incurred loss model assumes that all loans will be repaid until evidence to the contrary (known as a loss or trigger event) is identified. Only at that point is the impaired loan (or portfolio of loans) written down to a lower value.

The global financial crisis has led to criticism of the incurred loss model for presenting an initial, over-optimistic assessment of no credit losses, only to be followed by a large adjustment once a trigger event occurs. Responding to requests by the G20 leaders and others, in June 2009 the IASB published a request for information on the practicalities of moving to an expected loss model. The responses have been taken into account by the IASB in developing this exposure draft.

Under the proposals, expected losses are recognised throughout the life of the loan (or other financial asset measured at amortised cost) and not just after a loss event has been identified. This would avoid the front-loading of interest revenue that occurs today before a loss event is identified, and would better reflect the lending decision, the IASB notes.

Therefore, under the proposals, a provision against credit losses would be built up over the life of the financial asset. Extensive disclosure requirements would provide investors with an understanding of the loss estimates that an entity judges necessary.

The IASB says it is aware of the significant practical challenges of moving to an expected loss model. For this reason an expert advisory panel (EAP) comprising experts in credit risk management is being established to advise the board. An eight-month comment period has been provided to allow adequate time for entities to consider the impact of such a change within their organisation.

Although moving to a single impairment model significantly reduces complexity, the challenges of applying an expected loss approach should not be underestimated, according to the IASB. For this reason it says it will "tread carefully" and seek input from a broad range of interests before deciding how to proceed.

Meanwhile, Moody's points out that FASB has been involved in its own financial instrument project and, while no official proposal has been published, FASB's initial views differ in some material respects from the IASB's published exposure draft. In particular, FASB is of the view that virtually all financial instruments should be carried at fair value on an entity's balance sheet.

"The divergent paths of the FASB and IASB to date raise a concern for investors that differing views could ultimately derail the convergence efforts that have been taking place for several years," Moody's adds. "Although the projects remain ongoing, it would be unfortunate for financial statement users if the boards cannot ultimately reconcile their views."

The proposals in IASB's exposure draft 'Financial Instruments: Amortised Cost and Impairment' are open for comment until 30 June 2010. After considering comments received on the exposure draft, the IASB plans to issue an IFRS in 2010 that would become mandatory about three years later with early application permitted.

CS

Operations

Q3 volumes highlight government intervention

SIFMA's latest research quarterly shows that global CDO issuance continues to remain anaemic, with US$134.6m issued in Q309 from two issues - a decrease of 92.7% from Q209 and a decline of 99.1% from Q308. Unsurprisingly, issuance of mortgage-related securities dominated volumes during the quarter, with agency and non-agency pass-throughs, as well as CMOs, totalling US$512.7bn. This represents a decrease of 20.9% from the previous quarter, but an increase of 78.9% from Q308, according to SIFMA data.

As in 2008 and 2009, issuance has been driven largely by the agency market, with US$509.4bn of agency securities issued in Q309. Ginnie Mae issuance continues to grow, with US$130.6bn issued in Q309 alone - nearly half the full-year Ginnie Mae issuance in 2008 and an increase of 11.6% from Q2. While Fannie Mae and Freddie Mae MBS outstanding has increased slightly or stayed relatively even, Ginnie Mae outstanding has increased by 29.8% to US$803bn since December 2008 and is on track to reach US$1trn by 2010.

However, the non-agency RMBS sector posted a decline of 66.9% from the US$10.2bn issued in Q2, with US$3.4bn RMBS issued. Resecuritisations (re-REMICs) accounted for 65% of the total, with the remainder stemming from a privately-placed seasoned loan securitisation.

Meanwhile, the SIFMA figures indicate that ABS issuance in Q309 reached US$48bn - a 10.8% decrease from Q209, but an increase of 139.2% from Q308. As in prior quarters, housing-related issuance (home equity and manufactured housing) continue to be non-existent.

Three TALF auctions for financing were held during the quarter, for a total of US$17.8bn - a reduction of 25.1% from the second quarter. Of these TALF-eligible issues, 38.7% was financed by TALF, with the remainder cash-financed.

Bids for TALF financing through the third quarter were dominated by auto and credit card transactions, which accounted for 72.9% of all TALF financing during the period, similar to the take-up in Q209. Auto and credit card issuance totalled US$19.1bn and US$16.2bn respectively, with auto issuance comprising nearly 40% of all issuance in the third quarter. However, SIFMA notes that despite tightening spreads, credit quality continued to deteriorate in all asset classes as unemployment continued to rise in the third quarter.

The SIFMA figures also confirm that no non-agency CMBS securities were issued during the quarter. The Association points out that commercial real estate continues to be of concern to the market.

CS 

Ratings

NAIC ratings proposal approved, rebuffed

The members of the National Association of Insurance Commissioners (NAIC) have approved a proposal to develop a new model for determining the regulatory treatment of RMBS (see SCI issue 157). But the move has been met with scepticism from some.

NAIC's new model will produce ratings designations for approximately 18,000 RMBS owned by US insurers by the end of 2009. The result of the assignment will be the production of a set of NAIC designations used by insurers to calculate the risk-based capital charges for each specific RMBS that they own. These designations will apply only to year-end 2009 reporting.

This action reflects a loss of confidence in the ratings for RMBS produced by nationally recognised statistical ratings organisations (NRSRO), NAIC says. Problems with MBS began to appear during Q305, yet NRSRO ratings failed to represent these problems until late-2007.

Insurance regulators have expressed concerns that current ratings do not treat RMBS losses appropriately for the purposes of determining risk-based capital and about the inherent conflicts of interest that exist within the current 'issuer pays' rating agency model. Roger Sevigny, NAIC president and New Hampshire insurance commissioner, says: "The NRSROs have had an important role in the financial markets, but the situation with residential mortgage-backed securities exposed their blind spot. By reducing regulatory reliance on the rating agencies for these securities, at this time, we can better assure consumers that their insurance companies will remain strong and fulfil their financial obligations."

Moody's has responded by suggesting that the move is partly to capture estimates of recovery in addition to default and partly due to an apparent conviction that RMBS ratings have been downgraded too far. The rating agency notes that it does not advocate overreliance on credit ratings for the purpose of assessing regulatory capital.

Moody's svp Debash Chatterjee explains: "We have always encouraged users of ratings, including regulators, to consider carefully whether ratings meet their needs, including whether ratings address the risks they seek to measure. However, as our ratings are considered and assessed, we would like them correctly understood."

In a recent special comment the rating agency strongly disagrees with the perception that it has overestimated losses in the US residential mortgage area. Chatterjee says: "Our research shows that the recoveries implied by our ratings are no lower than those indicated by market prices on the ABX index. As to ignoring recoveries, we have repeatedly stated that Moody's rates to expected loss - the product of default probability and loss-given default. For example, if two securities are both likely to default, the security that is expected to have the lower severity of loss will be assigned the higher rating."

The NAIC formed the Rating Agency Working Group earlier this year to examine the use of ratings by state insurance regulators and determine the risk that such ratings inject into the regulatory process. The Association plans to partner with an independent third-party to develop an appropriate model for analysing the securities and will announce the selection in mid-November.

Moody's announced on 29 October that - given recent, and worsening, trends in delinquencies and loss severities - it is revising upwards its loss estimates for RMBS.

JA

RMBS

'Alternative' Fed MBS exit strategy suggested

Amid continued speculation about the US Federal Reserve's exit strategy with respect to its agency MBS purchase programme, ABS analysts at Wells Fargo Securities have suggested one potential alternative solution.

"We do not believe there is an exit strategy per se and offer an alternative hypothesis," they note.

The analysts believe that the Fed will likely not sell 'wholesale' its portfolio. Rather, the purchase, sale, dollar roll and reverse repo of MBS may become part of its toolkit of open market operations.

"That is, the Federal Reserve would simultaneously provide liquidity to the mortgage-funding markets and add or drain reserves through its various operations in the agency MBS market," they explain.

In terms of the purchase programme's impact on duration, Bank of America figures indicate that roughly US$256bn in 10-year equivalents has been added to the 30-year MBS universe from December 2008 to the end of September 2009. However, the Fed has absorbed roughly US$351bn in 10-year equivalents from its purchase programme, resulting in a drain of US$95bn in duration from the system.

But Annaly Capital Management suggests that much of the added duration in the market has come in the 4% and 4.5% part of the coupon stack, which is also where the Fed had focused much of its buying as part of its effort to keep primary mortgage rates below 5%. "As for what the market will look like once the Fed steps aside, investors are thinking about how the market will absorb MBS duration and how the less than sturdy housing market will react to reduced credit creation at lower rate levels," the asset manager adds. "Only time will tell, but in the face of such uncertainty it is reasonable to conclude that there will be spread volatility in the months ahead."

The US Federal Reserve last week confirmed that it will purchase a total of US$1.25trn of agency MBS to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets. In order to promote a smooth transition in markets, the FOMC is to gradually slow the pace of its purchases of agency MBS and anticipates that these transactions will be executed by the end of the first quarter of 2010.

The Committee says it will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Fed is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programmes as warranted.

CS & AC

CMBS

Repricing risk

Scott Roth and Patti Unti, principals at Ventras Capital Advisors, answer SCI's questions

Q: How and when did Ventras Capital Advisors become involved in the structured credit market?
A: All the Ventras principals and co-founders are former executives with Capmark Investments (see SCI issue 156). We lead the investment team, having previously served as co-heads of the securities team for Capmark.

We have both been involved in the CMBS market since 1997, with experience in all aspects of the CMBS investment process, including deal sourcing, bond analysis, credit due diligence, asset management, financing and disposition. The team has experience utilising both long and short strategies while investing in the entire CMBS capital structure.

Greg McManus, who previously served as Capmark's cfo and was responsible for the successful restructuring of the firm's affordable housing equity group, heads asset management and special servicing for Ventras. He brings over 21 years of experience in commercial real estate to his role, with an extensive background in capital markets, asset management and resolution of distressed assets.

Jimmy Parsley brings to Ventras more than 15 years of capital markets sales and trading experience, including extensive practice in the trading of various mortgage-backed securities and the structuring and implementation of hedging strategies. He was formerly the co-head of sales and trading at Capmark Securities Inc and a member of the firm's Board of Directors.

Q: What, in your opinion, has been the most significant development in the credit market in recent years?
A: The systematic re-pricing of risk. Over the past 24 months, countless investors have moved to the sidelines to 'wait out' the current market cycle. This mass exodus has caused the markets to seize up, as either cash is unavailable for transactions or investors simply don't understand how to underwrite the risk.

But with dislocation comes opportunity. So, while the majority of investors remain on the sidelines, risk underwriters like Ventras can step in, reprice the risk and put capital to work for its investor base.

Q: How has this development affected your business? What is your strategy going forward?
A: The market dislocation has created a real need for a risk underwriter like Ventras to step in, reprice the risk and put capital to work. The investment team believes it has the appropriate experience for investing in the market when it is out of balance and providing investors with excellent returns. We see a clear market imbalance in commercial real estate securities right now and believe we are well positioned to underwrite the risk on behalf of our investment partners.

We have also recognised a need in the market for commercial real estate workout experts. More than a decade of asset appreciation has masked property level issues, resulting in the need to restructure the underlying debt or, in more distressed cases, a liquidation of the collateral. We are in the process of building a platform of commercial real estate workout/asset management experts, many of whom earned their stripes in the late 80s and early 90s.

By bringing an established fund investment advisor and an experienced servicing/workout platform under one parent company, Ventras is in a unique position to mitigate risk for investors and still provide greater access to superior investment opportunities.

Q: What are your key areas of focus today?
A: Ventras is currently raising funds to invest in commercial mortgage-backed securitisations. Over the next two to three years, we expect there to be intense interest in opportunistically investing in distressed residential and commercial assets. We believe we are uniquely positioned to do well in this market, while helping to provide much-needed disposition solutions to banks and borrowers at the same time.

Q: What major developments do you need/expect from the market in the future?
A: We expect the commercial real estate debt markets to continue to decline as mortgage defaults increase with the wave of loan maturities beginning in 2010. This decline may present opportunities to raise distressed debt funds and perhaps equity funds as assets are liquidated post-foreclosure. We also believe this will be an excellent opportunity for us to partner with banks to assist them with their special servicing/workout needs.

CDPCs

Manager preps two new credit funds

Primus Asset Management announced during its Q309 results call that it has developed two new fund offerings. The first will comprise both long and short individual corporate credit investments via highly liquid corporate bonds and single name CDS, and the second - a credit opportunity fund - will invest primarily in non-investment grade corporate investments, including bonds and loans.

Primus Financial has been authorised to invest a small amount of seed capital in both funds and the firm will seek to attract third-party capital early next year. Toward that end, Primus says it is in the process of analysing and reviewing various options for broadening and strengthening its reach into the investor community.

"We are further extending our asset management platform with the addition of a new senior portfolio manager with significant experience and a track record in managing investment grade bond portfolios, as well as long short credit portfolios," says Primus ceo Tom Jasper. "This is in addition to the two senior portfolio managers and four credit analysts that joined Primus Asset Management with our acquisitions of CypressTree."

Primus also announced that it is continuing to pursue additional acquisition opportunities of credit asset managers (see also SCI issue 156).

Meanwhile, the CDPC has completed its third credit mitigation transaction, which entailed assigning a portfolio of credit swaps with its largest single counterparty - comprising notional principal of US$2.65bn of bespoke tranche transactions and approximately US$250m of single name CDS - to a newly formed subsidiary. Primus Financial paid its subsidiary an assignment fee of US$100m.

The subsidiary and the counterparty have agreed to restructure the portfolio such that the single name CDS are terminated and the bespoke tranche transactions are revised to reflect a new notional principal totalling US$1.75bn. In addition, the attachment points on certain of the restructured tranche transactions have been increased.

The subsidiary has paid the counterparty a restructuring fee of US$10m. Future credit swap premiums payable by the counterparty on the restructured portfolio are approximately US$15m less than the future premiums on the portfolio prior to restructuring. The last restructured tranche matures in December 2014.

Each of the three credit mitigation transactions included certain reference entities that Primus Financial concluded had a high risk profile, the company says. To date, it has terminated approximately US$2.5bn of single name credit swaps and has capped its exposure to an additional US$2.9bn of credit swaps, assigning them to wholly-owned subsidiaries.

In aggregate, counterparties have received US$31.5m to terminate or amend credit swaps, with Primus Financial paying net assignment fees amounting to US$126m to its subsidiaries in these transactions. Any capital remaining at the final maturity of the credit swaps in the two subsidiaries will be returned to the company, it says.

The company continues to discuss with its counterparties potential credit mitigation transactions, as it actively manages its credit protection portfolio in amortisation. Primus Financial says it is addressing certain concentration issues in a small number of higher risk sectors - including insurance, building/development and retail - to reduce the overall risk its portfolio and thereby preserve its capital.

CLO Managers

Dynamic Credit takes on RMBS CDO

Dynamic Credit Partners is tipped to replace Summit Investment Partners as collateral manager for the Summit RMBS CDO I. S&P has issued a preliminary rating confirmation in connection with the proposed substitution.

Summit RMBS CDO I's portfolio is comprised entirely of RMBS assets. Of these, 15.5% were originated in 2006 or later, 73.1% were originated during 2003-2005 and 11.5% were originated in 2002 or earlier.

CMBS

Cadwalader hires CMBS lawyer

Cadwalader, Wickersham & Taft has appointed Susan Neuberg to the finance group of its corporate department. She will be resident in both the Washington D.C. and New York offices.

Neuberg has diverse expertise in the areas of real estate and structured finance. She represents clients in all facets of real estate, including development, acquisitions, dispositions, commercial leasing, workouts, foreclosures, portfolio and securitised lending. She also has extensive knowledge of capital markets and structured finance products, including CMBS, mezzanine debt, syndications, participations and alternative real estate investment vehicles, and has been involved in the workout and restructure of numerous debt instruments collateralised by commercial properties of all types, including hotels, marinas and resorts, retail, condominium, industrial and office properties throughout the US and abroad.

She joins Cadwalader from the real estate and global finance practice at Nixon Peabody.

Distressed assets

Distressed debt team expands

Morgan Stanley has expanded its London distressed debt desk through both a hire and a transfer. David Chene has been hired from DA Capital Asia as a senior trader of distressed debt. In addition, Morgan Stanley has tranferred Lucas Detor, an md from New York, to run the London distressed debt business. Chene will report to Detor, who in turn reports to Patrick Lynch, head of credit trading in EMEA.

Investors

DIP opportunity fund closed

Tennenbaum Capital Partners (TCP) has announced the second closing of its DIP Opportunity Fund, an over US$330m fund focused on debtor-in-possession (DIP) financing. The fund will lead, structure, agent and participate in DIPs and DIP refinancings, using TCP's unique experience with distressed investing to guide debtors through their restructurings.

"With the closing of this fund, the first of our funds to exclusively focus on DIP financing, TCP will be able to assist companies severely affected by this downturn," explains Howard Levkowitz, managing partner of TCP. "TCP will partner with management teams and other parties to provide loans to enable debtors sufficient time to reorganise properly."

The fund targets DIP loans of a minimum US$10m. "This new DIP fund, comprised primarily of large institutional investors, puts us among the handful of firms that are willing and able to provide DIP financing," adds David Hollander, a partner with TCP. "In the recent past, companies who otherwise would have been able to reorganise in Chapter 11 have instead had to restructure before they have time to reorganise properly or liquidate due to a lack of available financing. DIP financing is an unprecedented market opportunity."

Legislation and litigation

Bear pair 'not guilty'

A verdict of not guilty has been handed down by a federal jury in the case against Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. 

Cioffi and Tannin faced charges of securities fraud, wire fraud and conspiracy, with an additional charge of insider trading against Cioffi. The pair was acquitted of all charges. 

Regarding the verdict, US department of justice attorney Benton Campbell released a statement saying: "Of course, we are disappointed by the outcome in this case, but the jurors have spoken and we accept their verdict." 

After the month-long trial, jurors took less than one day to deliberate and reach a verdict of not guilty. 

Juror Ryan Goolsby is quoted in press reports as saying: "We never found anything beyond a reasonable doubt," while juror Serphaine Stimpson told reporters she believes that the defendants were "scapegoats for Wall Street". 

Cioffi and Tannin still face investor litigation (SCI passim), as well as an SEC lawsuit.

Operations

Seventh PPIF unveiled

RLJ Western Asset Management is the latest firm to complete an initial closing of a Public-Private Investment Fund (PPIF) established under the PPIP facility. RLJ Western Asset Management is a minority-owned partnership between The RLJ Companies and Western Asset Management.

Seven PPIFs have so far completed initial closings on approximately US$4.09bn of private sector equity capital, which has been matched 100% by the US Treasury, representing US$8.18bn of total equity capital. The Treasury has also provided US$8.18bn of debt capital, representing US$16.36bn of total purchasing power for all PPIFs.

Initial closings for the remaining two PPIFs mandated under the programme are expected to be announced in the coming weeks. Following an initial closing, each PPIF has the opportunity to conduct additional closings over the following six months to receive matching Treasury equity and debt financing, with a total Treasury equity and debt investment in all PPIFs equal to US$30bn.

Operations

Fannie Mae requests further government funds

Fannie Mae reported a net loss of US$18.9bn in Q309, compared with a loss of US$14.8bn during the previous quarter. The Federal Housing Finance Agency (FHFA) has consequently submitted a request for US$15.0bn from the US Treasury on the company's behalf, to be provided on or prior to 31 December 2009.

Including US$883m of dividends on its senior preferred stock held by the US Treasury, the net loss attributable to Fannie Mae common stockholders was US$19.8bn (or US$3.47 per diluted share) in Q309, compared with a loss of US$15.2bn (US$2.67) in Q209. Third-quarter results were largely due to US$22bn of credit-related expenses, reflecting the continued build of the company's combined loss reserves and fair value losses associated with the increasing number of loans that were acquired from MBS trusts in order to pursue loan modifications, the GSE says. The loss resulted in a net worth deficit of US$15bn as of 30 September 2009, taking into account unrealised gains on available-for-sale securities during the third quarter.

The company reports that it continued to concentrate on preventing foreclosures and providing liquidity to the mortgage market during Q309, with much of its effort focused on the Making Home Affordable Program. As of 30 September 2009, approximately 189,000 Fannie Mae loans were in a trial period or a completed modification under the programme. In addition, Fannie Mae completed loan workouts outside of HAMP, including modifications, HomeSaver AdvancesTM, repayment plans and forbearances, pre-foreclosure sales and deeds in lieu of foreclosure.

Operations

DTCC hires systemic risk officer

The DTCC has appointed Anne Noonan to the new position of md and chief systemic risk officer, reporting to Larry Thompson, DTCC's general counsel. In this new position, Noonan will oversee the management of the systemic risk framework for DTCC and its subsidiaries to ensure that the organisation can identify and assess the systemic risk implications for all existing and new DTCC products, activities, processes and systems.

In leading these efforts for the DTCC, Noonan will work closely with its direct regulators - the US SEC, the Federal Reserve Bank of New York and the New York State Banking Department - and with regulators globally on systemic risk issues. She will also work closely with Douglas George, DTCC's chief risk officer, to review the organisation's enterprise-wide risk management methodology. She will have leadership responsibility for identifying systemic risk management changes needed and developing and implementing those solutions.

Noonan joins the DTCC from CLS Bank International in New York, where she was evp and global head of risk management and regulatory affairs - a post she has held since 1999. As a founding member of CLS Bank International, Noonan played a key role in orchestrating and negotiating regulatory approval with approximately 25 central banks and regulators for the purpose of eliminating foreign exchange settlement risk, with daily transaction flows of US$3trn-US$5trn, and expanding CLS Bank's settlement service to other products.

She served as a director on the board of CLS Bank International, as a member of the CLS management committee and as an executive member of the CLS Bank risk management committee.

Regulation

Hires made to new SEC risk division

The US SEC has hired three experts in the fields of structured finance, risk management and corporate transactions to senior positions at its division of risk, strategy and financial innovation. The division was created in September to help identify developing risks and trends in the financial markets.

Adam Glass has been appointed as counsel to Henry Hu, the director of the division. Glass comes to the SEC from Linklaters, where he founded its structured finance and derivatives practice. During his tenure at Linklaters, he represented banks, investment banks, monoline insurance companies and hedge funds.

Richard Bookstaber has been appointed a senior policy advisor to the director. Bookstaber served as the md in charge of firm-wide risk management at Salomon Brothers, director of risk management at Moore Capital Management and Morgan Stanley's first market risk manager.

Finally, Bruce Kraus has been appointed a counsel to the director. Kraus comes to the SEC from Willkie Farr & Gallagher, where he practiced corporate and securities law for more than 20 years. His practice included mergers and acquisitions transactions and other corporate finance work.

Hu says: "I am pleased that Adam, Bruce and Rick have agreed to come to the Commission. The role of the SEC has never been more critical. How modern capital markets, derivatives and structured products, and systemic risk are addressed today may well affect the nation for generations to come."

The SEC's division of risk, strategy and financial innovation combines the office of economic analysis, the office of risk assessment and other functions to provide the Commission with analysis that integrates economic, financial and legal disciplines. The division's responsibilities cover three broad areas: risk and economic analysis; strategic research; and financial innovation.

RMBS

MBS opportunity fund in the works

Nuveen Investments is set to make a public offering of a new closed-end fund, Nuveen Mortgage Opportunity Term Fund. The fund's investment objective is to generate attractive total returns through opportunistic investments in MBS. It will invest in MBS directly and indirectly through a separate investment in a public-private investment partnership formed pursuant to PPIP.

The new fund has a limited term of ten years and plans to liquidate all of its assets, retire or redeem its borrowings and distribute any remaining net assets to common shareholders on or before 30 November 2019. Nuveen Asset Management will be the fund's adviser and will be responsible for determining the fund's overall investment strategy, including whether and to what extent to invest in a PPIP vehicle.

Wellington Management Company will be the fund's sub-adviser and will have day-to-day responsibility for managing the fund's direct investments in MBS and other permitted investments. Wellington, which was selected by the US Treasury in July as one of nine managers eligible to participate in the PPIP (SCI passim), also serves as investment adviser of a public-private investment partnership in which the fund may invest.

RMBS

Asset managers team up to implement loan mods

Paladin Strategic Partners has acquired a controlling interest in HomeSaver Mortgage Management. HomeSaver is an asset management company formed to utilise private capital in acquiring bank-owned portfolios of troubled mortgage assets and implement modification and remediation strategies.

Carl Webb, managing partner of Paladin, says: "Many of the current loan remediation programmes are simply not working. HomeSaver is uniquely positioned to step in and work with homeowners during this crisis, as well as with selling banks. HomeSaver employs an aggressive and 'socially responsible' workout approach toward loan remediation. We feel that HomeSaver has demonstrated what the non-bank private sector, unburdened by legacy assets, can do to achieve ultimate resolution of the residential mortgage nightmare."

HomeSaver and its partners believe that the number of borrowers facing foreclosure will increase considerably over the next 12 months. It says that the continuation of present trends mitigates in favour of alternative forms of resolution, consistent with prudential regulation of the banking system (which holds over US$2.9trn in residential whole loans), political realities and social responsibility.

Indeed, First American CoreLogic estimates that over 32% of the over 52 million US homeowners with mortgages are currently 'underwater' relative to home value, with many housing analysts expecting that figure to exceed 45% in 2010. According to RealtyTrac, foreclosure actions in 2009 are expected to exceed 3.4 million and move higher in 2010.

Moreover, actual repossessions of homes in the US this year are expected to exceed one million, over ten-times the rate of a typical year. At the same time, RealtyTrac estimates that over 500,000 such repossessions are being held off the market by foreclosing lenders, for fear of causing additional real estate market disruption.

Len Blum, a managing partner of Westwood Capital Holdings, notes: "Recent stabilisation in home prices is not likely to be sufficient to reverse the ballooning numbers of foreclosures and underwater mortgages. Nor is it reasonable to expect that residential real estate values will be restored to those of the bubble-era, for the foreseeable future. Consequently, strategies that emphasise eventual loan principal reduction, such as those employed by HomeSaver, are the only realistic alternatives."

He adds: "The banks that are most exposed to the risks posed by legacy loans are signalling their understanding of the predicament they are in, by amassing record levels of balance sheet liquidity and conserving capital, in preparation for increased loan disposal losses and provisioning."

RMBS

REIT details RMBS purchases, losses

PennyMac Mortgage Investment Trust (PMT) confirms that it invested approximately US$69.5m of the proceeds from its equity offerings in RMBS. The acquired securities are backed by non-agency Alt-A, subprime and prime jumbo loans and are currently cash-flowing senior priority securities with a weighted average remaining life of approximately 1.5 years and a weighted average yield of 7.13%.

The company's initial investments produced total revenues of US$816,000, offset by management fees and other expenses, resulting in a net loss of US$730,000 (or US$0.04 per share) for the period ended 30 September 2009.

"In PMT's first two months of operations, our manager reviewed residential whole loan and securities portfolios with cumulative unpaid principal balances of over US$6.9bn and bid on several of those portfolios at levels consistent with our yield requirements. While some market participants have been willing to accept lower yields and bid more aggressively, we still believe that it is in the best interest of our shareholders over the long term to remain patient in order to maximise the returns from our long-term investment opportunities," says Stanford Kurland, chairman and ceo of PennyMac.

He continues: "Currently, our manager is reviewing over US$1.9bn in unpaid principal balances of residential whole loan and securities portfolios, and we expect that the volume of troubled residential mortgage loans available for sale will continue to grow. Additionally, our manager continues to build a conduit operation that could potentially allow us to capitalise on current market opportunities to provide small mortgage lenders an outlet for their newly-originated mortgage loans."

RMBS

Third-party due diligence provider approved

Opus Capital Markets Consultants has been approved by S&P as a third-party due diligence provider for RMBS transactions. The firm provides operational and loan-level consulting expertise to investment banks, hedge funds, originators, servicers and insurance providers both domestic and international.

With the acquisition of the due diligence unit of Mortgage Data Management Company (MDMC) in June, Opus CMC is now an industry leader in mortgage services consulting, the firm says. It has participated in more than 500 secondary market transactions, reviewing over US$55bn in mortgage assets.

Trading

Fixed income business expands

BNP Paribas has expanded its fixed income business in New York, with the appointment of three staff in credit.

Sean Farrell will join as an md to head the newly formed US short-term team that has been created to cover accounts for both rates and credit short duration products. Farrell brings 22 years of experience to the role, including positions held at Countrywide and UBS. He reports to Patrick McKee, head of North America credit sales, and Mallory Brooks, head of US interest rate sales at the bank.

Marc Badner starts as an md in North American credit sales. He joins from RBS, where he spent four years in credit sales, and prior to that worked at Morgan Stanley and Lehman Brothers.

In his new role he will cover hedge funds, insurance companies and asset managers. Badner also reports to Patrick McKee.

Joseph Lyons joins BNPP as a director in North America credit sales. Lyons has been working in North American credit markets for nine years, four of those at Goldman Sachs in Chicago and five at Morgan Stanley in New York and Chicago. He also reports to Patrick McKee.

ABS

Return to optimism for Australian ABS

The Australian ABS market is showing signs of stabilisation and a return to optimism, echoing similar developments in the wider Australian economy, according to Moody's.

Ilya Serov, a Moody's senior analyst, says: "Securitisation markets are starting to see some activity, arrears rates are levelling off, and both global and Australian macroeconomic conditions are improving."

Serov adds: "In terms of performance, we continue to pay close attention to delinquency rates of some individual transactions, but the overall outlook is stabilising. There was material performance deterioration in the first half of 2009, but the impact has so far proven to be limited. We are now cautiously optimistic."

The Moody's report outlines the performance and outlook of the ABS sector for Q309. According to the report, the quarter was characterised by the following factors:

• The Australian economy is performing better than expected, with recession seemingly avoided and unemployment rises to date limited.
• Recovering fortunes of global auto manufacturers: Moody's had in October 2009 revised its outlook for the industry from negative to stable.
• After some deterioration through Q1 and Q209, loss and delinquency rates are stabilising.
• Divergence in performance between 2006 and 2007 vintages, which are outperforming Moody's expectations, and the more recent transactions that track closer to expectations and, in some cases, are performing poorer.
• Issuance activity returning, with CNH Australia Capital Pty Limited issuing A$400m in the first successful placement of an Australian ABS transaction since 2008.

In addition to providing commentary on trends in the Australian ABS market, the report contains detailed performance overviews of individual ABS deals rated by Moody's.

Clearing

Guidelines published for CCP give-up agreements

ISDA has published a set of recommended common principles intended to guide documentation for give-up agreements across CCPs or clearing houses. The principles address: fallbacks in the event of rejection for clearing; the ability to reject trades; reduction of trading limits; and determinations of market decisional bodies in relation to CCPs.

These principles are the product of an ISDA-led working group comprising buy- and sell-side participants and CCPs. The group has worked to promote industry-wide dialogue and coordinated solutions to facilitate buy-side access to clearing by 15 December.

CLOs

US CLO index reveals slowdown in credit deterioration

Credit deterioration among US CLO transactions appeared to slow in September 2009, according to S&P's most recent US CLO index report. The report provides aggregate performance statistics across the agency's rated US cashflow CLO transactions.

The rating agency reports that the pace of downgrades of speculative-grade corporate issuers moderated in September. An increase in the market values of triple-C rated obligors resulted in an improvement in the senior overcollateralisation ratios for 2003-2008 vintage CLOs. S&P also observes the following performance trends for most cohorts from the September CLO data: a decrease in the percentage of triple-C rated assets; an increase in the percentage of defaulted assets held; and higher cushions in the overcollateralisation test ratios.

S&P's monthly CLO index report highlights a number of key risk areas for these transactions, including rating migration within the underlying collateral portfolios and changes in the levels of senior and subordinate par coverage ratios and interest coverage ratios. Performance information in the CLO indexes is divided into six cohorts, each containing data for a large majority of US CLO transactions issued in a specific vintage year from 2003 through 2008.

CLOs

Little movement in top-10 CLO obligors during Q3

To determine the concentration risk in CLOs for Q309, S&P reviewed 645 outstanding rated US cashflow CLOs. Out of the approximately 5,000 corporate obligors that these CLOs hold, the top 100 corporate obligors that appeared most often in these rated CLO portfolios were reviewed and ranked based on their total outstanding principal amount.

While there is still little movement on the list of top 10 corporate obligors across these rated CLOs, in some instances the obligor's relative ranking may have changed slightly. Of the top 10 obligors from the rating agency's previous exposure report, all but one retained their status in the new report. Metro-Goldwyn-Mayer dropped to number 11 on the exposure list and was replaced by NRG Energy.

CMBS

Debut new issue TALF CMBS takes shape

Further details have emerged on the US$400m Developers Diversified CMBS, which is now understood to have gained TALF eligibility. The transaction, underwritten by Goldman Sachs, is expected to comprise a US$323m triple-A tranche. Double-A and single-A rated notes are also likely to be offered.

The five-year deal is secured by a portfolio of 28 shopping centres. If successfully placed, the deal will become the first new issue CMBS under the TALF programme.

Correlation

CIT short squeeze anticipated

The bid for CIT bonds from correlation desks could raise the auction final settlement price 2.5 to four points higher than the inside market midpoint, according to structured credit analysts at Barclays Capital. CIT Group is one of the most widely referenced single names in synthetic CDOs, sparking concern that correlation desks' hedging needs could cause a short squeeze during the credit event auction.

"We believe that the bespoke technical...could have a material effect on the CIT auction process, given the amount of exposure that correlation desks have relative to the US$30bn of senior unsecured bonds that are eligible to be delivered at the ISDA CDS auction," the BarCap analysts note.

They suggest that correlation desks would have about US$4bn of CIT bonds to buy to hedge their bespoke positions. This estimate is based on a US$160bn bespoke market that has been about 50% unwound and a 5% recovery delta based on the BarCap pricing model.

"Assuming that bespoke desks choose to buy all their bonds in the auction and that this represents the final net open interest to buy, the final settlement price could exceed the IMM by 2.5 to four points," the BarCap analysts add. "This estimate is based on the past behaviour of CDS auctions, where we adjust for the fact that the amount of net open interest relative to bonds outstanding varied across auctions. The final effect could be lower if bespoke desks chose to buy bonds before or after the auction."

Other efficient credits from the 2005-2006 vintage that are currently trading at very wide spreads include MBIA, ILFC, Radian Group and PMI Group. "Assuming that the demand from correlation desks [during a credit event auction] would be of a magnitude similar to what we estimate for CIT, it is clear that a potential short squeeze is possible for all [these] names, pushing auction recovery rates artificially higher and potentially by a magnitude that is more than what we estimate for CIT," the BarCap analysts conclude.

Documentation

CLO discount obligation definition modified

ACAS CLO 2007-1 has entered into a supplemental indenture, which primarily modifies the definition of discount obligation. The amendment allows the issuer to purchase certain obligations at discounted prices using proceeds from the sale of an obligation that is not a discount obligation and, subject to certain conditions, to have them excluded from treatment as discount obligations.

These conditions state that the purchased obligation should: be purchased within five business days of the sale; be purchased at a price at least equal to the sale price of the obligation sold and not less than 65% of par; and have a default probability rating at least equal to that of the obligation sold. They also specify that the aggregate par amount of purchased obligations excluded from treatment as discount obligations is not more than 5% of the collateral principal amount (or 2.5% of the collateral principal amount if such obligations have been purchased at a weighted average price less than 75% of par) at the time of such measurement and US$39.1m (i.e. 10% of the collateral principal amount as of 10 September 2007) when considering all such obligations purchased up to the time of such measurement.

Moody's has determined that entry by ACAS CLO 2007-1 into the supplemental indenture with The Bank Of New York Mellon Trust Company, as trustee, dated as of 30 October 2009 will not at this time cause the current ratings of the notes to be reduced or withdrawn. The rating agency does not express an opinion as to whether the supplemental indenture could have non-credit-related effects.

Documentation

Operational risk in securitisations analysed

Moody's is to publish a series of reports that will detail its views on how operational risks in securitisations affect credit in different jurisdictions and geographic regions. In a special comment, the rating agency notes that the performance of a securitisation transaction depends not only on the creditworthiness of the underlying pool of obligors but also on the effective performance by various parties, such as servicers, calculation agents, trustees and cash managers. The specific details regarding that performance will vary greatly based on the specific legal and operational environments prevailing in each jurisdiction.

The new special comment includes a summary of recent examples of transactions that have experienced credit deterioration due to operational risk, including transactions involving Taylor Bean & Whitaker in the US and DSB Bank in Europe.

"Operational risk has received substantial attention recently as several transactions (some with well performing collateral) have experienced a substantial weakening of credit quality attributable primarily to non-performance of a securitisation party," according to Nicolas Weill, Moody's chief credit officer for the structured finance group.

Important operational risks and how they vary from region to region will be further explored in the forthcoming series of reports. These include: back-up servicing; the role of the trustee; and the cash manager.

Transactions with adequate replacement servicing or cash management arrangements may still not be able to achieve the highest ratings, Moody's notes. For example, transactions sponsored by originators in asset classes with a high degree of volatility and a history of linkages to the originator/servicer may have difficulty achieving high ratings due to the lack of certainty in projecting performance, particularly in times of originator distress.

Indices

2004 subprime index performance drops

While prices among recent vintage US subprime RMBS continue to stabilise, 2004 saw a substantial drop-off in performance with no signs of improvement, according to Fitch in its latest RMBS CDS indices results. The ratings agency's 2004 vintage subprime RMBS price index fell by 16.7% this month to 11.57%, down from 13.91% the month before.

However, the Fitch total market subprime RMBS price index showed only a marginal fall to 8.02%, down from 8.4% the previous month. All other vintages from 2005, 2006 and 2007 showed small gains on a month-on-month basis.

Recent loan-level analysis conducted by Fitch of the indices' constituents found that the constant prepayment rate (CPR) and the constant default rate (CDR) were largely responsible for not only precipitating the fall in the 2004 vintage, but also explaining why the 2005-2007 vintages have not been affected. When looking at the average six-month CPR of the constituents of the indices, the agency identified a significant uptick from June this year towards the 7% mark.

This was largely due to the higher quality loans of the 2004 vintages being able to refinance, given the current low interest rates. The six-month CPR for the 2005-2007 vintages remained stable in the 3%-4% region, due to the lower quality loan-to-value ratios precluding much refinancing.

While the six-month CDR for 2005-2007 vintages improved somewhat from all-time highs in May, there has been no significant improvement in the six-month CDR of the 2004 vintage. Fitch Solutions md Thomas Aubrey says: "As the good quality loans are refinanced, the remaining pools are on average of lower credit quality - a factor that largely caused the drop in price for the 2004 subprime price index. Credit quality among the pools will continue to converge over time as better quality borrowers take advantage of refinancing opportunities, thus leaving the remaining pool with more consistent weaker borrowers."

Investors

Euro investor sentiment improves

European investor sentiment has continued to improve during Q309, although at a slower pace than in Q209, according to a recent investor survey conducted by Fitch. In addition, investor fears of a major bank collapse receded further.

Trevor Pitman, Fitch's regional credit officer for EMEA and Asia-Pacific, says: "European investor sentiment continued to improve in the third quarter, perhaps buoyed by firm signs of an emerging, albeit weak, global economic recovery. However, the pace of improvement was less dramatic than in the second quarter, with 84% of investors surveyed now believing markets are past their worst disruption compared to 72% last quarter."

He adds: "The risk of a major bank collapse is now the lowest ranked risk of those highlighted in the survey, whereas last quarter investors were least concerned about the impact of shareholder oriented activities."

As part of its quarterly survey, Fitch asked investors for their opinions on how fundamental credit conditions would develop in the next 12 months in different asset classes, including structured finance.

A consistent view emerged in the survey, according to the rating agency. In every asset class - including the sub asset classes of structured finance but excluding investment grade corporate bonds - investor opinion became more positive. However, the survey results showed that some investors still believe European credit markets are vulnerable to shocks, although in smaller numbers than during the second quarter.

Fitch surveyed investors about the chances of various risks occurring. These were a hedge fund collapse, a major bank collapse, geopolitical risk, housing market disruptions, exposure to availability of global liquidity, inflation and shareholder-oriented activities. In the majority of cases, those believing that these risks were high had fallen.

Where there was an increase in the percentage believing risks had increased in these areas, the increase was only small. For example, those believing that a hedge fund collapse had a high degree of risk rose to 13% from 8% previously.

LCDS

MGM LCDS auction posts 'low' result

The final results of the MGM LCDS auction were determined to be 58.5 on 10 November, with 10 dealers submitted inside markets, physical settlement requests and limit orders. Analysts at Credit Derivatives Research indicate that the settlement is one of the lowest LCDS auction results on their records and slightly lower than the 60 levels that had been touted in the run up to the auction. They add that it appears most participants had managed their CLO exposure successfully.

Legislation and litigation

Dante payment waterfall confirmed

The UK Court of Appeal has ruled against Lehman Brother's plea to gain preferential access to the collateral within Dante CDO - a synthetic CDO - and confirmed that the swap counterparty's claims (i.e. Lehman's claims) are subordinated to those of the investor post the counterparty's default. While an earlier court hearing ruled in favour of the bankruptcy-remoteness of the SPV (SCI passim), a ruling had not been made on whether trustees of the SPV should disburse the collateral to the investors according to the specified payment waterfall.

Related cases have been heard in both the UK and the US. Lehman's lawyers argue that English courts do not have jurisdiction over the case as it includes US bankruptcy proceedings. The transaction documentation is based on English law, but the swap counterparty has an American connection.

Legislation and litigation

Concerns over 'best effort' requirements for Japan ABS

Following the proposed legislation bill on the facilitation of financing to SMEs in the country, Fitch continues to monitor how Japanese banks implement the best effort requirements.

After Fitch published its initial comment on this issue, a cabinet decision on the bill was made on 30 October 2009, which includes the following information:

• The scope of eligible borrowers has been expanded; in addition to SMEs, mortgage borrowers will also be subject to this scheme.
• Third-party opinions need to be seriously taken into account if banks receive requests from borrowers for modification of loan terms.
• Deadline of the application for loan term modification is March 2011.

Although the scope of eligible borrowers under the proposed scheme has expanded, Fitch's initial view that the subsequent impact on securitisation will be limited remains broadly unchanged. However, the level at which banks are required to carry out the best effort requirements to consider borrowers' request for modification of the loan terms is still unclear. Therefore, a prospective detailed implementation guideline is required, in order for the agency to provide a more comprehensive impact estimate.

Should the obligation to carry out the best effort requirements be higher than that of the contractual obligations under the terms of the securitisation - in other words, should the origination banks be forced to accept the modification of loan conditions even if they breach covenant - Fitch will be concerned that the true-saleability of the relevant transactions could be affected. More specifically, if the origination banks continuously and intentionally breach their covenant - which prohibits loan modification in the securitised portfolio - in order to abide by this proposed bill, it could be considered as evidence that the banks effectively maintain their control over the already transferred loan receivables for securitisation.

Accordingly, the true-saleability of such transactions could be under question if the affected banks enter bankruptcy proceedings. However, Fitch does not expect such circumstance to arise at this stage.

Operations

Treasury urged to disclose status of guarantees

The Congressional Oversight Panel has released its November oversight report, entitled 'Guarantees and Contingent Payments in TARP and Related Programs'. The report finds that the programmes' income will likely exceed their direct expenditures and that guarantees played a major role in calming financial markets. These same programmes, however, exposed American taxpayers to trillions of dollars in guarantees and created significant moral hazard that distorts the marketplace, according to the Panel.

Altogether, the federal government's guarantees have exceeded the total size of TARP, making guarantees the single largest element of the government's response to the financial crisis. At its high point, the federal government was guaranteeing or insuring US$4.3trn in face value of financial assets under three guarantee programmes.

The enormous scale of these guarantees played a significant role in calming the financial markets last year. Lenders who were unwilling to risk their money in distressed and uncertain markets became much more willing to participate after the US government promised to backstop any losses.

The Panel did not identify any major flaws with the implementation of the guarantee programmes. However, it notes that these programmes carried significant risk, with the American taxpayer in many cases standing behind guarantees of high-risk assets held by potentially insolvent institutions.

These guarantee programmes also created significant moral hazard, according to the COP. "Guarantees create price distortions and can lead market participants to engage in riskier behaviour than they otherwise would," it notes. "In addition to the explicit guarantees analysed in the Panel's report, the government's broader economic stabilisation effort may have signalled an implicit guarantee to the marketplace: the American taxpayer stands ready to provide a financial backstop for certain markets and large market players to avert possible economic collapse. To the degree that investors, lenders and borrowers believe that such an implicit guarantee remains in effect, moral hazard will continue to distort the market."

The COP says that the extraordinary scale of the guarantees, the significant risk to taxpayers and the corresponding moral hazard leads it to conclude that these programmes should be subject to extraordinary transparency. The Panel specifically identified the guarantee of Citigroup assets under AGP - the largest single guarantee offered to date - and strongly urges the Treasury to provide regular, detailed disclosures about the status of the assets backing this guarantee.

The Treasury should also disclose greater detail about the rationale behind guarantee programmes, the alternatives that may have been available and why they were not chosen, and whether these programmes have achieved their objectives. This should include an analysis of why Citigroup and Bank of America were selected for AGP and not other banks, the COP notes.

Ratings

Credit impact of originator insolvency assessed

Moody's will continue assessing the credit impact of originator insolvency in UK credit card master trust transactions and will endeavour to conclude its assessment by mid-December. The rating agency believes that the ratings of outstanding notes backed by receivables in UK credit card master trusts may be negatively impacted if the issues remain unresolved. The increased focus on these risks has arisen in the context of greater rating pressures observed on bank originators combined with deteriorating performance, it notes.

The assessment relates primarily to certain consequences on the master trust upon the occurrence of an originator 'insolvency event'. Among other things, an insolvency event currently exposes the noteholders to the risk that the master trust may be exposed to a fully declining pool. This arises due to the provision in the transaction documents which stipulates that receivables that arise following the insolvency of the originator may no longer be assigned to the receivables trustee.

Furthermore, transaction documents of most UK trusts provide that, following an originator insolvency event, the receivables trustee is obliged to dispose of the securitised assets and dissolve the master trust unless, within 60 days of such an event, it is instructed not to do so by the relevant investor beneficiary.

Since it started its assessment, Moody's has been in frequent dialogue with the relevant credit card originators to understand the manner in which these risks may be mitigated. The agency has been made aware that certain issuers are evaluating alternatives to mitigate some or all of the risks; however, it notes that no amendments to the transactions have been implemented thus far.

In the event of an issuer failing to address the 'assignment risk', Moody's would be prompted to consider a declining pool in its modelling of a stressed amortisation scenario. In the absence of any additional support, this would likely result in a reduction in the ratings assigned to the notes; in particular, the senior class of notes could be downgraded to a level closer to the rating of the originator.

Apart from these document provisions, Moody's is currently assessing the likelihood that an originator might continue generating credit card receivables notwithstanding a default on its financial indebtedness. The rating agency is also in the process of analysing further the impact of set-off and commingling risk in UK credit card trusts. It will incorporate the conclusions in its rating analysis of credit card ABS in the UK.

Ratings

Increasing delinquencies weigh on SF ratings

Negative ratings persist for global structured finance sectors in the third quarter, according to Fitch. The trend reflects the tentative nature of the global economic recovery and rising delinquencies. However, many EMEA and US non-mortgage sectors continue to demonstrate a good level of rating stability and are expected to remain resistance to downgrades, particularly at the highest rating levels.

In the US, Q309 saw a dramatic increase in downgrades in the RMBS, CMBS and CDO sectors, reflecting the cumulative effects of the economic and financial market conditions experienced over the past year. Additionally, negative rating actions were the result of adjustments to Fitch's base-case loss assumptions based on recent data for certain sectors.

However, negative rating actions for the core US consumer assets remained minimal in Q309. While asset performance has been negatively affected by economic conditions, most notably increasing levels of unemployment, this year will likely see significantly fewer downgrades than 2008 in core consumer as well as commercial asset types. Meanwhile, Latin American structured finance ratings have been performing well, reflecting the strength of the future flow asset class and the stable political and economic climate of the region.

In Europe, performance in UK credit card ABS continues to worsen due to historically high charge-off levels during the last six months. In Spain, deteriorating economic conditions continue to heavily impact consumer ABS transactions as rising delinquencies and defaults lead to reserve fund draws for many transactions.

Andy Brewer, senior director of EMEA structured finance performance analytics at Fitch, says: "Year-to-date 2009 EMEA structured finance downgrades already exceed the level reached for the whole of 2008. However, significant repayments in the ABS and RMBS sectors resulted in a small number of upgrades too during the last quarter."

In Asia-Pacific, negative rating action for the quarter was concentrated on Japanese CMBS, with 46 tranches of Japanese CMBS remaining on rating watch negative. Alison Ho, director of performance analytics for Asia Pacific structured finance at Fitch, explains: "The most significant rating actions in Asia during Q309 were the downgrades of over 40 classes of Japanese CMBS, reflecting Fitch's negative view of the Japanese commercial real estate market. This process is continuing in Q409, and includes the downgrade to D of one Japanese CMBS tranche."

Over 50 publicly rated Australian RMBS tranches were also downgraded as a result of Fitch's changed assessment of Genworth Financial Mortgage Insurance, a provider of mortgage insurance. Despite these downgrades, the majority of tranches rated in Asia Pacific continue to perform in line with expectations and most rating actions in the quarter were affirmations.

Ratings

Charge-off index shows signs of stabilisation

Moody's UK aggregate credit card charge-off index increased to 11.8% in September 2009, almost doubling from the levels observed in Q108. The sharp increase in the index charge-off rate observed over the last quarter is primarily driven by the MBNA I and MBNA II master trusts.

After months of continuous deterioration, the sector is beginning to show some preliminary signs of stabilisation, however. Delinquency rates have been flat or decreasing across most trusts for the past three to four months. The pace of increase of charge-offs appears to be reducing across most trusts.

Durga Bhavani, co-author of the Moody's report, explains: "However, it is too early to draw definitive conclusions from these trends as the possibility of a double-dip recession cannot be ruled out. It is also unclear as to whether the increases in unemployment rate have already been reflected in the current charge-off numbers, given that there is often a six- to nine-month gap between the borrower losing their job and charging off on their debt."

Moody's highlights that Christmas spending could lead to a post-Christmas rise in arrears and a mid-2010 increase in charge-offs. Furthermore, Q309 figures released by the Insolvency Service revealed that personal insolvencies had reached their highest level since records began in 1960, up 28% on the same period last year. It is widely anticipated that personal insolvency filings are likely to remain elevated while unemployment continues to grow.

Payment rate, another key credit card index, remained broadly stable over 2009. Cher Chua, co-author of the report, says: "Most trusts are reporting healthy excess spread levels, benefiting greatly from the lower cost of floating rate bonds. Some trusts have been reporting excess spreads greater than 10%, which has not been observed in the UK market since 2004."

Moody's continues to have a negative outlook for the UK credit card sector. The rating agency has placed on review for possible downgrade several classes of notes issued out of some UK credit card trusts due to concerns surrounding performance deterioration and a review of the purchase rate assumption.

Regulation

Concerns raised over financial stability draft

ISDA has commented on the discussion draft, 'Restoring American Financial Stability', proposed by senate committee on banking, housing and urban affairs chair Chris Dodd.

Robert Pickel, executive director and ceo of ISDA, says: "ISDA and the industry recognise the need to improve the regulatory framework to modernise and protect the integrity of the financial system."

He believes the market consensus includes four initiatives: appropriate regulation for all financial institutions that may pose a systemic risk to the financial system; stronger counterparty risk management (including clearinghouses); improved transparency; and strong, resilient operational infrastructure. However, while significant progress is being made around these initiatives, ISDA and the industry remain concerned about key aspects of the legislative proposals that have been introduced.

Pickel stresses: "Preserving flexibility to tailor solutions to meet the needs of customers is essential. Efforts to mandate that privately negotiated derivatives business trade only on an exchange would reduce their availability."

He adds: "Banning naked shorting via CDS would adversely impact the credit markets. Cross-border regulatory coordination on these matters is imperative."

According to lawyers at Dewey & LeBoeuf, the draft combines many of the proposals originally made by the Obama Administration, but frequently changes their force or emphasis. "In the course of this bill-drafting process, Congress appears to be gradually creating a more general system of financial regulation, changing in potentially fundamental ways the basic orientation of regulation in the US from one focused on a specific industry or product to one concerned with the effects and importance of financial activities and products in general, regardless of their history or specific characterisation," they note. "In the draft, this change manifests itself in the near omnipresence of the defined term 'financial company' and its variants and in the generality of the proposed remedies."

For example, in certain portions of the draft, the word 'company' alone (without the modifier 'financial' and without appearing in the defined form of 'financial company') plays a significant role, at least in circumstances in which the entity being subjected to regulation engages in significant financial activity. To accommodate institutions whose activities might be dramatically affected by an abrupt implementation of more general financial regulation, the draft also creates an unusual transitional or grandfathering mechanism, the Dewey & LeBoeuf lawyers note.

Regulation

Nine out of 10 banks meet SCAP target

The US Federal Reserve has confirmed that nine of the 10 bank holding companies (BHCs) that were determined in the Supervisory Capital Assessment Program (SCAP) earlier this year to need to raise capital or improve the quality of their capital to withstand a worse-than-expected economic scenario (SCI passim) now have increased their capital sufficiently to meet or exceed their required capital buffers. The one exception, GMAC, is expected to meet its remaining buffer need by accessing the TARP Automotive Industry Financing Program and is in discussions with the US Treasury on the structure of its investment.

In the SCAP, it was determined that these BHCs needed to augment their capital by US$74.6bn - almost all in the form of common or contingent common capital - by 9 November. These 10 BHCs took the following capital actions:

• New issuance of common equity or other eligible securities of US$39bn;
• Conversion of existing preferred equity to common equity in the amount of US$23bn; and
• Sales of businesses or portfolios of assets that increased common equity by US$9bn.

Some firms also increased capital through other actions, including reduced dividend payments, issuance of common shares to employee stock ownership plans and larger-than-anticipated pre-provision net revenue, to meet their required buffers.

Regulation

Initial guidance released on systemic risk assessment

The IMF, the BIS and the Financial Stability Board (FSB) have submitted to the G20 their initial considerations on assessing the systemic importance of financial institutions, markets and instruments. The report outlines conceptual and analytical approaches to the assessment of systemic importance and discusses a possible form for general guidelines.

The report recognises that current knowledge and concerns about moral hazard limit the extent to which very precise guidance can be developed. The three organisations note that assessments of systemic importance will necessarily involve a high degree of judgment, will likely be time-varying and state-dependent, and will reflect the purpose of the assessment. The report does not pre-judge the policy actions to which such assessments could be an input.

It suggests that the guidelines could take the form of high-level principles that would be sufficiently flexible to apply to a broad range of countries and circumstances.

There are a number of policy issues where an assessment of systemic importance would be useful, the three organisations add. One critical issue is the ongoing work to reduce the moral hazard posed by systemically important institutions. The FSB and international standard setters are developing measures that can be taken to reduce the systemic risks these institutions pose.

A second area is the work to address information gaps that were exposed by the recent crisis, where assessments of systemic importance can help to inform data collection needs. Finally, a third area is in helping to identify sources of financial sector risk that could have serious macroeconomic consequences.

RMBS

Refinancing contribution for Arkle

Lloyds TSB has made a refinancing contribution into the Arkle Master Issuer RMBS programme. This contribution, along with retained principal receipts, will be used to redeem in full Classes 2006-2 2A, 2B, 2C, 2M and 2008-2 2A, 2B, 2C and 2M on 17 November 2009.

European securitisation analysts at Deutsche Bank suggest that without the sponsor's action the trust is unlikely to have been able to redeem the bonds on schedule, given the low current CPR of 16%. "While perhaps not entirely unexpected, the signalling of support is positive for all Lloyds trusts (ARKLE, PERMA, MFPLC, PENDE)," they add. "That junior bonds will be redeemed at par should aid their pricing; in an environment where redemption dates are met, prices of c90 on short-dated triple-B subs look attractive."

RMBS

Seller share indirectly supports master trusts

In a new report, Moody's examines how expected fluctuations in the seller share of UK RMBS master trusts can provide indirect credit support to the issued RMBS notes.

"One of the standard features of master trust structures, which sets them apart from typical standalone RMBS transactions, is that the seller retains an interest in the trust property, referred to as the 'seller share'," says Anthony Parry, a Moody's avp. "In total, across all UK RMBS master trusts the sellers have retained a share of approximately £66.7bn or 25.6% of current outstanding mortgage trust assets."

In the report, the rating agency notes it is typically stated in the prospectus that the seller share does not provide credit enhancement to the issued notes. "Whilst this is true in the sense that losses are allocated pro-rata between funding and seller in proportion to their respective shares at the time they are realised, the combined impact of the lower CPR environment and relatively aggressive maturity profile of the notes means that the seller share can provide indirect support to the notes," says Jonathan Livingstone, a Moody's avp.

RMBS

UK non-conforming delinquencies remain stable

Delinquencies in the UK non-conforming RMBS market have remained stable since June 2009, according to the latest index report for the sector from Moody's.

In September 2009, the weighted-average delinquency trend was 20%, up from 11.6% a year previously, but only 1% above the March 2009 level. The repossessions trend was 1.4% lower in September than its peak at the beginning of 2009 when it was at 3.5%. The total redemption rate remained low at 10.6%, significantly lower than one year ago when it was at 23.8%.

The decline in outstanding repossessions was mainly driven by a large number of sales of repossessed properties, which resulted in further losses, according to Moody's. The weighted-average cumulative loss trend increased to 1.3% from 0.5% one year previously.

Georgij Ludmirskij, a Moody's senior associate, says: "While it is good news that the rise in delinquencies has abated, the levels remain very high. There are currently 20 transactions that account over 30% of their portfolios as 90+ days delinquent."

The high numbers of delinquent loans are likely to result in further repossessions and losses, the rating agency notes. Although the market is displaying marginally improving credit conditions, refinancing opportunities for non-conforming borrowers remain rare.

Currently, 43 transactions have drawn on their reserve funds. In fact, 11 of these transactions have recorded a principal deficiency, after their reserve funds have been fully drawn. This means that, due to losses in these 11 transactions, the size of the mortgage portfolios has decreased and there has not been sufficient cash to cover the notes.

Moody's expects the UK GDP to return to growth in Q409, after six consecutive quarters of decline. However, the recovery will be slow, dragged down by weak credit conditions and poor consumer demand. In 2010, GDP is expected to grow by a modest 0.8% after contracting 4.7% in 2009.

The unemployment rate is expected to continue to increase into 2010, peaking at 9% in Q310 from the current level of 8%. Households have benefited from a low interest rate environment during this crisis and a continuation of low interest rates for most of 2010 will support households further.

House prices have been increasing for the past six months. Nitesh Shah, a Moody's economist, explains: "The current increases in house prices are a product of tight supply of houses for sale. However, houses for sale are starting to increase once again and this will temper the growth in prices and could lead to them falling once more."

While low interest rates are helping to contain the number of home repossessions, rising unemployment and tight credit conditions will continue to place downward pressure on house prices.

Moody's outlook for the UK non-conforming RMBS market is negative. Although recent forecasts indicate that the leading economic indicators may improve in the near future, conditions are likely to remain unfavourable for non-conforming borrowers. Approximately one in five borrowers is currently more than 90 days delinquent.

RMBS

European RMBS arrears stabilise

Despite arrears levels in European RMBS transactions showing some signs of stabilisation in Q309, it is too early to know whether this is the beginning of a sustained improvement, according to Fitch.

Andy Brewer, senior director in Fitch's RMBS performance analytics team, says: "Increases in arrears levels may have slowed in the last quarter, but they remain at historical highs for nearly all jurisdictions. Ratings of RMBS transactions, particularly at lower rating categories, remain exposed to any further deterioration in the economic environment."

There were 137 tranches downgraded in the last quarter, an increase from 91 in the previous quarter. The downgrades were nearly all from UK non-conforming transactions, which continue to represent the biggest performance concern in European RMBS.

Five tranches were upgraded, all from well seasoned transactions that have seen significant credit enhancement growth since issuance. The majority of the agency's European RMBS ratings remain on a stable outlook (2,221 tranches) and the number of tranches assigned a negative outlook or currently on rating watch negative has remained relatively constant at 501 tranches - one less than at the end of the previous quarter.

Technology

ResiEMEA to include Portuguese coverage

Fitch has expanded the coverage of its European residential mortgage risk analysis tool, dubbed ResiEMEA, to include Portugal.

ResiEMEA is the ratings agency's analytical model for the risk assessment of residential mortgage loans in accordance with its RMBS criteria. It was originally launched for the UK and Dutch RMBS sectors in February this year and has since expanded to cover Ireland, Italy and Spain in September.

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

The flexible interface allows users to adjust Fitch criteria assumptions and stress the loan, borrower and property-specific factors that most influence default probability and loss severity, the rating agency says. The model can process regular sized loan portfolios in seconds and pools of master trust magnitude in minutes.

Technology

Global data solution launched

S&P's fixed income risk management services (FIRMS) is set to launch a global data solution - a comprehensive, enterprise-level data feed solution that brings together a wide range of data and analytics to allow financial institutions to evaluate and monitor the financial instruments in their portfolios. Addressing the investor's need for a more robust, cross-asset approach to assessing risk and value in their portfolios, the new data feed solution combines the full scope of S&P's market intelligence.

Global data solutions combines high quality market data from across S&P's investment, credit and risk evaluation research units, providing single-source access to the following data streams:

• S&P's credit ratings and ratings research
• Cross reference services and security master
• Ownership hierarchies
• Fixed income terms and conditions
• Bond notification services
• Equity corporate actions
• US RMBS pool and loan-level performance data
• Synthetic CDO reference obligor data
• S&P proprietary analytics.

Jonathan Reeve, S&P md, says: "We developed global data solutions to help investors keep up with the rapidly increasing demands of the financial marketplace, including analytical and risk management, regulation and pre- to post-trade operations."

Technology

Platform integration to enhance data access

An integration of the Bloomberg Server API and the Calypso Platform via Sky Road has been completed. The Bloomberg Server API is a significant enhancement to the multi-asset class portfolio and risk management hosted solution that Calypso Technology and Sky Road launched in 2005, the two firms say.

Bloomberg has completed the certification of the API integration and Bloomberg's high-quality real-time data is now available to Calypso Technology and Sky Road joint clients. Calypso Technology and Sky Road undertook this initiative so that their clients have access to reliable and accurate market data. The strategic partnership has resulted in numerous joint customers in the US and UK, with several new fund managers expected to license the solutions by year-end 2010.

John Borse, ceo of Sky Road, notes: "We're very excited to be offering our clients access to Bloomberg data. The joint clients of Calypso Technology and Sky Road need sophisticated market data alternatives and we believe that the Bloomberg Server API integration will open up new opportunities and benefits for these firms."

Technology

Trade matching engine upgraded

Euroclear Bank and Xtrakter have released TRAX 3.0. The new version of the trade automation engine facilitates pre-settlement matching at Euroclear Bank on trade date, enabling matching to occur earlier in the settlement lifecycle and thus reducing the level of unmatched trades between counterparties.

"In addition to providing a range of new user capabilities, TRAX 3.0 will provide firms with an immediate cost saving by looking upstream to trade matching. Xtrakter and Euroclear Bank have managed to increase system efficiencies, lower back office costs and eliminated a layer of fragmentation within the trade life cycle," comments Graeme Austin, director, product management at Xtrakter.

TRAX 3.0 offers clients a range of new benefits, including regulatory reporting of complex derivatives.

Trading

Trading ideas: technicalities

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on KB Home

KB Home reported weaker than expected earnings at the end of September and the follow-on action in the equity, bond and CDS markets sparked our interest. While the company's sales remain anaemic, its margins finally turned positive; however, this sent its stock down and CDS spread wider.

Interestingly, after jumping 90bp post-announcement, KB's CDS continued to be bid up and now trades almost a full 100bp wider, while its stock was range-bound at around US$15/share. Given KB Home's strong liquidity and balance sheet (no substantial debt is due until 2014), downside risk is heavily tilted towards the equity portion of the capital structure, making long credit/short equity a solid trade.

Price action of KB Home securities in the month following its 25 September earnings announcement created an interesting trading opportunity. Its equity initially led the charge (pre- and post-earnings), trading down 25%, while during the same time period its CDS shot up by 80bp. Both took a breather, trading in ranges, until mid-October when its CDS resumed its ascent (see Exhibit 1).

After the second leg wider, KB's CDS trades an additional 100bp wider at 370bp, while its equity remains roughly flat. Also, the z-spread of its 6 ¼ of June 2015 bond widened by 50bp post-announcement; however, it did not participate in the late October sell-off of the CDS (actually tightening by 20bp). We find this to be indicative of a technically-driven underperformance of its CDS.

Relative to other homebuilders, KB's CDS is the biggest underperformer over the past three months (see Exhibit 2). Its CDS spread is wider by 140bp since early August, while a duration-weighted index of builders (ex-wide spread credits) is only up by 38bp.

Fundamentally, we find the risk of underperformance to be weighted towards the equity of the company rather than the debt. Even though KB's operating margins finally tipped into positive territory and are now well above the average of the last four quarters, sales remain absolutely abysmal, putting a huge strain on future earnings (see Exhibit 3).

That being said, the company maintains a decent balance sheet, with little risk of immediate trouble. KB holds US$950m in cash, plus inventory of US$1.9bn. While the company now generates positive cashflow from operations, it will also capitalise a percentage of its interest payments (60% in 2009), reducing the constraint on its cash.

The greatest demand on funds will come from the US$185m outstanding balance on its 2010 revolver and a US$100m note maturing in 2011. Beyond these two maturities, no debt comes due until 2014. Though KB Homes is far from solid profitability, the risk of a drop in the value of the company's stock price is much greater than that of further spread widening.

Position
Sell 10,000 shares KB Home at US$15.60.

Sell US$1m notional KB Home 5Y CDS at 355bp.

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).