Contents

CDS

Sovereign concerns

Increased liquidity and spreads for emerging and developed economies

Sovereign CDS levels have once again been on the rise as unprecedented government funding requirements and negative economic outlooks for 2010 are priced in. However, CDS liquidity levels indicate that developing economies are not the only ones subject to increased activity.

According to Chris Parkinson, head of research at Christopher Street Capital, emerging market sovereign CDS remain the most actively traded sovereign names, although developed economies are also beginning to gain more traction - especially riskier names such as Greece. "There are several reasons behind the widening spreads - some technical and some that are driven by the economy. On the technical side, banks have been buying more government debt this year than last, and are then hedging that with sovereign CDS," he says.

He adds: "On the economic side, credit traders are clearly concerned with the data that's coming out of countries such as Greece, Spain and the UK. After quite a significant period of cheap capital from governments and with growth not necessarily accelerating in 2010, there's a risk that some of these countries could head back into recession. CDS spreads are reflecting these concerns."

Jon Di Giambattista, senior director of risk & performance analytics at Fitch Solutions, confirms that sovereign CDS spreads have widened 11% across the globe in the past month. "The main drivers behind the spread widening are that ongoing stimuli are needed. Developed western sovereigns have seen the biggest percentage increase over this time period, however most are still priced at extremely low spread levels, so the absolute change is not as significant. The more concerning big movers are the likes of Italy, Greece and Ireland, all three of which have widened more than the global sovereign average, and are pricing at higher spread levels."

Indeed, the iTraxx SovX Western Europe index reached 65bp late last week - its widest level since it began trading in September and 15bp wider than the previous week. Greece and Ireland are by far the widest trading names in SovX, and between them account for 35% of the total risk in the index, according to strategists at Credit Derivatives Research.

"The SovX trades within 2bp-3bp of the iTraxx Financials Sen-Sub differential now and we suggest that while the Maastricht Treaty holds EC members back from running huge deficits and managing out of a balance sheet recession, it suggests to us that bailing out of the major banks (which are reportedly under-capitalised) will lead to pain up and down the capital structure rather than the US approach of supporting the top of the capital structure," they add.

Credit strategists at Barclays Capital also point to the noticeable underperformance of SovX against the iTraxx Main and note that, in terms of relative pricing of sovereign versus corporate risk, the ratio of Main to SovX is now 1.4 - down from a range around 1.6 since August. "This compares to a ratio of 1.1 at the peak of the systemic crisis in March 2009. In the absence of yet another systemic event, we find it unrealistic that SovX and Main will trade at such a ratio for any prolonged period of time," they note.

The BarCap strategists add: "Investors who share that view may want to consider selling protection on SovX and buying protection on Main. That said, in a market where liquidity has been worsening as investors are reluctant to take risk ahead of the year-end, we might see more momentum in the widening of SovX in the near term before we see a normalisation of the Main-SovX relationship."

Parkinson notes that while EM sovereign CDS spreads still represent more risk than developed economies overall, trends are converging. "Commodity-rich emerging market names are definitely more bullish than other emerging economies and credit momentum is certainly more bullish than most developed economies," he says. "This is particularly relevant when looking at those counties that are on the cusp between emerging and developed economies."

According to Fitch Solutions' global percentiles for liquidity, several developed economies have moved up the ranks recently. In the last month, Portugal has seen the most dramatic rise in liquidity, and is now in the 9th global percentile. Greece is the third highest riser, moving from 42nd to 23rd. France has also moved from the 28th percentile to the 10th percentile. "In terms of overall rank, we're still seeing Brazil, Mexico, Russia, South Africa, Turkey and Peru in the first percentile of liquidity: there's not necessarily been a huge change in spreads but they are the most liquid," says Di Giambattista.

"The UK has actually dropped over the past week to the 64th percentile. The US is in the 31st percentile. The UK is less liquid than it was a year ago, the US is more liquid than it was a year ago," he concludes. 

AC

Structuring/Primary market

CLN redux

New sources of charged assets expected to emerge

A rising interest rate environment, combined with tightening corporate bond spreads is expected to drive volume in CLNs next year. However, given the repricing experienced by traditional CLN funding collateral over the last two years, new sources of charged assets are likely to emerge.

A number of banks operating in Japan report that they have had their busiest year ever in terms of domestic CLN issuance. "The structures are fairly straightforward, featuring single name CDS exposure and a funded note," confirms one market observer. "Demand is being driven by the low spread environment: corporate treasurers and institutional investors want to put their money to work in yieldier product."

The observer anticipates CLNs to return more broadly in other jurisdictions in the coming months too. "There's no reason why CLN issuance shouldn't pick up. If interest rates are low, the capital base of institutional investors can be destroyed by simply sitting on cash - and CLNs are one solution to this problem. Equally, banks are cash-rich and so will be eager to put their money to work."

Sivan Mahadevan, global head of credit derivatives and structured credit strategy at Morgan Stanley, suggests that a potential rising rate environment in 2010 - combined with tighter corporate bond spreads - will drive credit flows towards floating-rate CLNs linked to single names, portfolios and tranches. However, the significant repricing of traditional CLN funding collateral during the financial crisis is set to increase the scrutiny of these assets going forward.

"Investors today are even more aware of the need to manage and understand the funding component of CLN risk, in addition to the swap portion," notes Mahadevan. "While many of the collateral types in existing CLNs (for example, triple-A credit cards, covered bonds, corporate bonds and GICs) have tightened in from the wides they experienced at the peak of the credit crisis, we still expect that different types of collateral will be more popular than some of those used in the past."

US treasuries and money market funds (MMFs) are two types of collateral that are expected to become more common as charged assets in CLNs. While both have been used in such transactions in the past, due to their sub-Libor funding they weren't as popular as securitised and corporate bonds.

However, both asset types are stable and exhibited low volatility throughout the crisis. "Additionally, they are far less correlated to the swap portion of the CLN, whether that is a tranche or a single name. Finally, MMFs offer a greater degree of diversification than using a corporate bond referencing a single entity or a securitised product referencing a specific set of cashflows," Mahadevan continues.

Repurchase agreements are another alternative being used to fund CLNs. In the specific instance of CLN collateral, repos are sold back to the sponsor at par a few days before the CLN matures, with the sponsor on the hook for any mark-to-market fluctuations and credit risk in the securities instead of the CLN noteholder. If there are mark-to-market changes on the securities, the sponsor is required to post additional collateral to the SPV as margin.

One major reason for using repos is that the CLN holder gains additional credit protection against the dealer who issued the notes. If the sponsoring dealer were to become bankrupt, the repurchase agreement would terminate; however, the SPV would own the securities.

CS

Investors

Back in vogue?

Long/short credit opportunities gain favour

The hedge fund industry appears to have reached a trough in terms of asset flows: for the first time in 18 months, Q3 saw inflows - of around US$1bn - as opposed to net outflows. At the same time, institutional investors are now considering including long/short credit exposure in their traditional portfolios - indicating that credit hedge fund investments could be returning to favour.

Gennaro Pucci, cio of PVE Capital, suggests that the credit market is experiencing a shift from long-only investment to alpha generation. "However, risk remains in terms of fundamentals, which the market appears to be underestimating," he says.

He adds: "For example, 23% of US homeowners are estimated to be in negative equity, which is likely to push delinquencies further out. Consequently, strategies that source both long and short opportunities make sense at the moment - what we're aiming to do with our fund is exploit this risk in the right direction."

The Matrix-PVE Global Credit Fund employs a multi-strategy approach, which ensures flexibility in terms of allocating cash and risk (see SCI issue 158). "The fund can take advantage of opportunities in ABS (up to 30%), with the remaining employed in liquid instruments across single name CDS, indices and correlation to generate alpha and manage volatility. A large allocation in liquid instruments will ensure the liquidity profile of assets and liabilities of the fund is matched," explains Pucci.

Luke Reeves, head of retail and institutional business development at Matrix Money Management, says that investors have supported the fund well because of the PVE team's experience in trading these assets. "The team has a good track record of navigating difficult credit conditions with a positive outcome. In addition, our timing has been good because we've launched with clean money and can capitalise on clean opportunities."

But Howard Eisen, md at FletcherBennett, says that while some appetite remains for complex systematic strategies, the industry remains tainted by the events of the last two years. "Although this sector will inevitably return, investors currently favour simplicity - and there is an abundance of such product to invest in at the moment," he notes.

Eisen indicates that current hedge fund strategies are premised on the fact that: US rates are low and are likely to remain low; European rates are also low, but may rise slightly; credit spreads are likely to narrow; M&A activity is picking up; and the weakness in the dollar is likely to continue. "While the distressed story has already performed well, there is even more to go in this strategy," he adds. "There has also been a strong move into convertible arbitrage and relative value, but the opportunities in this strategy are likely to be limited next year as compared to 2009."

Moreover, event-driven strategies will make sense, given the rising M&A activity and the fact that credit is gradually returning to the sector. Emerging markets haven't been as battered by the financial crisis as developed markets, so investing in these regions is also a popular strategy.

Furthermore, three macro themes will dominate the hedge fund landscape going into next year, according to Eisen. First, it will be more complicated and expensive to both market and run a hedge fund, due to pressure on fees, regulatory requirements and investors demanding greater liquidity and operational soundness. For example, while performance fees typically remain 20%, management fees have dropped at many firms from 2% to 1.5%.

Second, because the hedge fund industry was nearly halved in terms of both assets and leverage in 2008, opportunities in the markets are being chased by fewer dollars. Combined with the current market dislocations, this has resulted in increasing opportunities to perform more profitably.

Finally, the industry has swung from being a sellers' market to being a buyers' market. Having spent the last 12-18 months firing managers and significantly reducing their portfolios, allocators are now re-engaging in manager identification.

"Investors hold more leverage than ever before in terms of manager selection," notes Eisen. "This is a significant change in direction for the industry and is being driven by the recognition that while beta-driven portfolios were down by 40% last year, hedge fund portfolios were only down by 19% on average. Consequently, it has become obvious to investors that if they'd had more capital allocated to hedge funds, they would have suffered less."

Reeves notes that investors are 100% choosier about which funds they invest in, especially in terms of ensuring that liquidity is appropriately matched to the underlying. The Matrix-PVE fund, for example, features monthly liquidity with 15 days' notice.

He adds: "The Matrix view is that different investors require different fund characteristics, but hedge funds remain the vehicles that offer the most investment flexibility. If transparency around operational and risk management aspects is superior it tends to provide comfort to asset allocators, whether the vehicle is a hedge fund or a UCITS III fund."

While there has been a lot of discussion around managed accounts, this appears to be a knee-jerk reaction to the gates introduced last year. "Conceptually, managed accounts make sense because they're not subject to redemption cycles and provide the liquidity and transparency that investors are seeking," observes Eisen. "But the risks and infrastructure requirements of these structures may outweigh their advantages: what happens if an investor has many different accounts and one needs to make a margin call? The documentation becomes an operational nightmare."

He says that the responsibilities may be even greater for fund of funds and other fiduciaries, due to the potential liabilities associated with receiving position-level transparency daily. Instead, investors are opting for soft locks, which they can exit for an early redemption fee.

Meanwhile, operational due diligence has become as important as investment process due diligence - not only because of headline risk, but also as a function of dealing with hard-to-value securities. Hedge funds are increasingly requiring a third-party administrator to check valuations and ensure the proper checks and balances are in place.

"In an environment where a ready bid can't be found for certain assets, hedge funds have either been forced or chosen to move into more liquid instruments, such as corporate and high yield credits. They are also now having to engage in shadow accounting to ensure that they're close to the third-party figures," continues Eisen.

Indications are that hedge funds will need to realign their resources and investments to remain competitive in the new environment. "One solution is to outsource the marketing, back office and compliance functions," he adds. "Such service providers will likely emerge from being a cottage industry into the mainstream next year, focusing on different specialisms. But whether to use these services will depend on a fund's cost/benefit analysis."

CS

Documentation

Basis unwinds drive CIT recovery

The CIT settlement continues the upward trend in CDS recoveries so far this year. It also appears that the auction was biased more towards basis unwinds than correlation desk risk management.

The final price for CIT CDS was determined to be 68.125. 13 dealers submitted inside markets, physical settlement requests and limit orders at the CIT auction on 20 November. CIT deliverable obligations are denominated in Canadian dollars, Swiss francs, euros, sterling, Japanese yen and US dollars.

The bid for CIT bonds from correlation desks was widely anticipated to raise the auction price higher than the inside market midpoint (see SCI issue 160). But analysts at Credit Derivatives Research (CDR) indicate that the proximity of the final price in the CIT auction to the weighted average bid was notable - demonstrating that the auction process functions well.

As the settlement of bespoke deals occurs later than the ISDA auction process, the bias between correlation desk-based demand and basis trade-based demand can often be gauged by looking at price action post the Chapter 11 announcement and the size and level of final bids in the auction. "It would appear from the stability of bond prices and general tightness of the auction that [the CIT] auction was more biased to basis unwinds than correlation desk risk management," explain the CDR analysts.

They add: "The relative lack of correlation offer activity could perhaps imply dealers expect CIT bond prices to drop a little more into the next month (and be cheaper to pick up at bespoke settlement), but this is a risky game to play and is certainly not clear-cut - it could just have been over-hedged going into the auction (which is likely, given the growing talk of more managed risk/position-taking than simple delta-hedging on these desks)."

The CIT auction was also notable for bringing the average CDS recovery in 2009 over 24 for the first time this year. This compares to a more 'normal' average (for senior unsecured) of about 43 in 2008.

Atish Kakodkar, analyst at CreditSights, notes that CIT's recovery is almost three times the average senior unsecured CDS recovery for this year prior to the auction. The settlement, therefore, continues the clear upward trend in overall CDS recoveries compared to the first half of this year, when defaults were recovering at record lows (SCI passim).

Senior unsecured CDS recoveries averaged around 13 in the first half of 2009, compared to the second half average (so far) of 63. "The number of auctions has also fallen dramatically, with only seven auctions since July (three of which were associated with Thomson) compared to 24 auctions in the first half of this year," Kakodkar adds. "Average senior unsecured CDS recoveries in 2009 bottomed out in June at around 13 after taking into account Visteon's abysmally low recovery of 3. Since then, recoveries have shown a dramatic improvement."

However, the standard deviation of recoveries in 2009 is much lower at 26 compared to a level of about 40 in 2008. This suggests that the relatively tight concentration of recoveries around a low mean that was established in the first two quarters continues to dominate the recovery statistics for this year, according to Kakodkar.

In Q109 average recovery was only 15.8, with a relatively tight standard deviation of 11.6 around the mean. The average recovery in Q209 declined to 11.5, with an even tighter standard deviation of 8.5. However, the average recovery of about 63 since July was accompanied by a wider standard deviation of about 29.

CS

Ratings

ECB tightens rating requirements for ABS

The governing council of the European Central Bank (ECB) has decided to amend the rating requirements for ABS to be eligible for repo purposes. As of March 2010, the Eurosystem will require at least two ratings from an accepted external credit assessment institution for all ABS.

The changes may result in slightly less 'funding-efficient' structures, but aren't expected to have a substantial impact in the majority of cases. Securitisation analysts at Barclays Capital confirm that the disruption caused in the European ABS market by these more stringent rating requirements should be quite limited. "At the same time, the requirements should indeed be effective in mitigating rating shopping and methodology targeting," they add.

In determining the eligibility of the ABS, the Eurosystem will apply the 'second-best' rule. This means that not only the best, but also the second-best available rating must comply with the minimum threshold applicable to ABS.

As of 1 March 2011, the second-best rule and the requirement to have at least two ratings will be applied to all ABS, regardless of their date of issue.

The ECB governing council says it has deemed it necessary to introduce the amendments to ensure that the Eurosystem's requirement of high credit standards for all eligible collateral is met. In addition, the changes - which the ECB says reflect recent market developments - aim to make a further contribution to restoring the proper functioning of the ABS market.

However, the BarCap analysts point to an apparent further ECB objective. "It seems to want to align the rating requirements it imposes with those investors have insisted on for years in order to nudge originators further in the direction of relying on public issuance for funding, rather than on retained issuance repo'ed with the ECB," they explain. "We are not optimistic that this will have much of an effect for now: the cost of funding in the European ABS, including RMBS, market may simply be prohibitive. Instead of placing bonds with the European ABS investor base, originating banks may either elect to fund in other asset classes or simply shrink their loan book, with the latter clearly not conducive to an economic recovery in Europe."

In January 2009, the ECB ruled that repo-eligible ABS must be rated triple-A from 1 March 2010, but at that stage said just one rating was necessary. The previous minimum rating was single-A minus.

Meanwhile, new plans to revitalise the primary European ABS market are underway. According to Rick Watson, md and head of the European Securitisation Forum/AFME, a working group has been established by the ESF and the European Financial Services Round Table to this end - although discussions are at very early stages.

"The question remains why the European securitisation market is taking so long to come back and the truth is that there are still several aspects of the market that are not functioning properly. These include transparency, liquidity and the overall perception of European ABS," he says.

He adds: "While there have been steps to improve transparency of deals, more can still be done. The success of the recent Lloyds, VW and Nationwide deals indicate that there is demand for high quality deals."

Watson continues: "We need to bring back confidence to the sector and one topic that we have on the table is an ABS quality label - but again there are many avenues that need to be explored before anything concrete is decided. One of the most pressing concerns is that many investors perceive securitisation, as a broad asset class, to have significant uncertainty due to headline risk."

He stresses that the ESF is not trying to create a new credit rating agency and that the quality label would be something very separate. "We hope to have something ready by the second half of 2010," Watson concludes.

AC & CS

Advisory

Wealth management

Tarek Khlat, co-founder and ceo at Crossbridge Capital, answers SCI's questions

Q: How and when did Crossbridge Capital become involved in the structured credit market?
A: We launched 15 months ago, with the idea of creating an independent advisory firm. Historically, the team was at Credit Suisse, but we wanted to step away from having the approach of a single institution in order to get a broader view of client portfolios.

Clients typically limit allocation to one institution and so we couldn't objectively provide advice on their whole portfolio. We wanted to be able to be truly objective and not conflicted in terms of the advice we provide.

Another aspect of our service that clients find useful is the opportunity to network. Our clients have similar backgrounds and naturally want to meet other people with similar backgrounds, so we're happy to bring clients together when appropriate.

Q: Which market constituent is your main client base?
A: Our clients are ultra high net-worth investors and are typically extremely sophisticated.

Q: Do you focus on a broad range of asset classes or only one?
A: We provide clients with access to different asset classes by structuring tailored investment products. They suggest an underlying they'd like exposure to and we then create a customised product accordingly - essentially we tailor the mechanism based on the desired risk profile.

We use all underlyings, but have recently arranged CLNs linked to sovereign issues, first-to-default baskets on sovereigns and single name financials. The process involves going out to the Street, naming the parameters and then sourcing the best price. Liquidity, bid/ask spread and service all count in choosing a provider - we're looking for the best overall execution.

What is important when investing in structured products is that the client understands what they're buying. When such investments are properly structured, they are an efficient way of achieving a good risk-adjusted return.

When we first launched clients weren't interested in buying new product for a while; it was more about restructuring their existing portfolios rather than taking on new risk. But there certainly seems to be growing opportunities in bonds, credit, commodities and FX now.

Q: How do you differentiate yourself from your competitors?
A: Traditional wealth managers don't typically offer the broad ranges of financial services we offer at Crossbridge. We find our clients value our advice as much about their personal wealth as they do their operating and corporate assets.

I think what's unique about our model is that it combines wealth and merchant banking advisory in one boutique; most other firms only provide one of these services. It means we can be more flexible and offer a broader range of services.

Q: Which challenges/opportunities does the current environment bring to your business and how do you intend to manage them?
A: Having launched on 1 September 2008, we've had a trial by fire. It has certainly been challenging: not only in terms of building a new business, but also in terms of the environment. Surviving the turmoil in the financial markets is a huge achievement and has given us the strength to continue building and investing in the company.

In a way, our timing was perfect because clients had an even stronger desire to get advice from an unbiased organisation - i.e. one that didn't want to sell them something (we don't have a fund, for example). We were able to provide asset allocation advice, as well as risk analysis based on the reality of what they own - both in terms of their personal and corporate assets.

We've had a good year: the business model has been shown to work. We began with seven people and expanded to 16. We currently have around 100 clients and US$2bn assets under management.

We're well capitalised, which has been important in this environment. Julius Baer is a 10% equity holder and having such a name behind us is helpful from a future growth perspective too.

Going forward, we intend to diversify our client base in terms of geographical spread. At the moment, the majority of clients are based in the Middle East. But we'd like to build investment banking franchises in India, central Europe, Russia and Latin America. Wealth is being created at a faster pace in these emerging regions.

Q: What major developments do you need/expect from the market in the future?
A: The market is likely to go back to being driven by fundamentals rather than sentiment. The VIX, for example, has dropped from its historic highs of 80 to 20 - indicating that people believe the worst is behind them.

In terms of what happens next, the market needs much more economic data around whether it will be a 'V' or 'W' shaped recovery. At this stage, there are still too many unknowns.

CS

ABS

BofA poaches Flanagan

BofA Merrill Lynch Global Research has hired Chris Flanagan as head of US mortgage and structured finance research. In this role, Flanagan will be responsible for the strategy and development of the bank's research product, analytics and modelling across all US mortgage and structured finance disciplines. He will report to Michael Maras, head of BofA Merrill Lynch Global Credit Research.

"Chris adds formidable expertise to our US mortgage and structured finance research franchise and we are delighted to have him on board," says Maras. "His in-depth knowledge in all aspects of asset securitisation, mortgages and modelling will enable us to significantly enhance our existing research capabilities and grow our range of innovative products and solutions."

Flanagan joins from JPMorgan Chase, where he was co-head of securitised products research and head of ABS, CDO and CMBS research since 2000. Previously, he spent over ten years at Merrill Lynch.

Matthew Jozoff is replacing Flanagan as head of securitised products researchat at JPMorgan.

ABS

MS hires Moffitt

Morgan Stanley is understood to have hired David Moffitt as head of global credit solutions. Reporting to Raj Dhanda and John Hyman, co-heads of global capital markets at the bank, he will be based in New York.

In his new role, Moffitt will be responsible for all primary securitisation and asset restructuring. He will partner with JD Pearce, who will lead the sales and trading efforts.

Prior to joining Morgan Stanley, Moffitt oversaw structured product sales in the fixed income division of Merrill Lynch.

ABS

ASF's Miller resigns

George Miller, executive director of the American Securitization Forum since 2004, is to resign from his position as of 16 December. Deputy executive director Tom Deutsch, who has also been with the ASF since 2004, will become acting executive director. A permanent executive director is expected to be named by the ASF board of directors prior to the ASF 2010 industry conference at the end of January.

"I have been honoured and privileged to serve ASF since the forum's inception and am proud of the organisation that I have helped to build and manage, working together with ASF's dedicated membership and talented staff team," Miller says.

"While I have decided to pursue other opportunities at this stage of my career, I firmly believe in the importance and value of securitisation to our financial markets and broader economy, and intend to remain professionally connected to the business, albeit in a different capacity," he adds.

CDS

ISDA appoints new ceo

ISDA's board of directors has appointed Conrad Voldstad as ceo. Robert Pickel, ISDA executive director and ceo since January 2001, will assume the newly-created position of executive vice chairman. Voldstad and Pickel will serve on the association's board of directors.

As executive vice chairman, Pickel will continue to be a member of the association's senior management team, providing leadership for and assistance with strategic initiatives.

Voldstad is a senior industry executive whose career in the financial markets spans three decades. Most recently, he served as director of RAM Holdings, a credit reinsurance company. Earlier this decade, he was founding principal of New Jersey-based Arlington Hill Investment Management, a global debt investment management firm.

From 1988 to 1999, Voldstad was employed at Merrill Lynch, where he held several senior positions, including membership on the oversight committee responsible for liquidating Long-Term Capital Management; co-head of global debt markets in New York; and head of European debt markets in London. He was also the founder of Merrill Lynch Derivative Products, the first triple-A rated derivatives products company.

CLO Managers

CLO management agreement amended

New York Life Investment Management has amended the collateral management agreement of NYLIM Flatiron CLO 2005-1 to eliminate the right of the subordinated noteholders to remove it as collateral manager without cause. The amendment required the consent of a majority of the subordinated noteholders.

Moody's has determined that the amendment and performance of the activities contemplated therein will not cause its ratings on the notes to be reduced or withdrawn because it is not inconsistent with the agency's rating methodology.

CMBS

Merger and acquisition creates real estate giant

Babson Capital Management's real estate finance group (REFG) is set to be integrated into Cornerstone Real Estate Advisers in Q110. The newly expanded Cornerstone will then become a subsidiary of Babson Capital Management. At the same time, Cornerstone is acquiring Protego Real Estate Investors, Protego Real Estate Investors Finance and their subsidiaries (Protego), thereby establishing Cornerstone's presence in the European market.

Cornerstone will consequently have a full service, global real estate investment organisation with capabilities in public and private debt and equity. The global organisation will have offices in the US, UK, Europe and Asia, with a combined staff of approximately 250 people and US$30bn of assets managed and serviced.

"Our new organisation will allow us to participate across the entire real estate capital spectrum and best serve our clients with a full complement of debt, equity and real estate securities expertise," comments Cornerstone president and ceo David Reilly. "As the global marketplace rapidly continues to evolve, we will be well-positioned to satisfy the demands of investors for more comprehensive and creative public and private real estate finance and equity products."

Babson Capital's REFG specialises in commercial mortgage lending and related products, has US$21bn in assets managed and serviced, and employs approximately 100 people in offices throughout the US. Robert Little, who currently heads REFG, will continue to lead the debt business reporting to Reilly as cio - finance and as a senior member of Cornerstone's management team.

Protego, a privately-held, UK-based real estate investment firm, has approximately US$2.5bn of assets managed and serviced, 31 employees and offices in London, Rotterdam and Stockholm. Primarily focused on office, retail and industrial property, the firm provides real estate investment advisory services to a variety of clients through funds and separate accounts.

"Protego has grown rapidly since its creation five years ago as demand for real estate investment expertise has grown among institutional and wealth management clients," notes Protego ceo Iain Reid. "Protego as a subsidiary of Cornerstone will be able to bring a wider and more integrated array of investment opportunities to our global clients, as well as expand the Cornerstone platform to include the European marketplace."

CMBS

CMBS special servicing capability strengthened

CB Richard Ellis (CBRE) has appointed Paul Lloyd to its real estate finance division in London. He becomes head of loan and special servicing - reporting into Philip Cropper, who heads up the division - in a move that further signifies the importance of the burgeoning CMBS market and one that strengthens the firm's increasing presence in loan and special servicing, it says.

Lloyd's appointment is the second senior banking hire to be made by CBRE since the summer. With over 20 years' experience with Hill Samuel, Sanwa Bank, Morgan Stanley and latterly Deutsche Bank (from 2005), he was instrumental in creating the Morgan Stanley Mortgage Servicing platform and, more recently, in establishing and leading Deutsche Bank's CMBS European servicing and special servicing platforms.

Recent research published by Morgan Stanley indicates that there is approximately €130bn of outstanding CMBS in Europe with upcoming maturities of over €10bn that are due for repayment in 2009 and into 2010. Lloyd notes: "One of the real challenges facing the CMBS market at the present time is how banks and borrowers will refinance the flood of maturing and defaulting CMBS."

Cropper adds: "Given the fall in commercial real estate values as well as the reduction in liquidity in the debt markets, it is likely that more CMBS is going to default and transfer into special servicing. Therefore, it will become increasingly important to find innovative and alternative means of servicing, restructuring and working out the loans to maximise the return for the noteholders. Paul is one of the most experienced operators in this field and his arrival reflects the growing importance of CMBS worldwide and reinforces CBRE's commitment to developing a specialist real estate investment banking capability to service the market."

CMBS

Subordinated CMBS holdings consolidated

Issued Holdings Capital Corporation, a wholly-owned subsidiary of Dynex Capital, has completed the purchase of a Deutsche Bank affiliate's 49.875% interest in their joint venture for US$9.5m in cash. Through its subsidiary, the firm now owns 99.75% of the venture, which currently holds subordinated CMBS with a par value of US$38.7m and redemption rights for approximately US$182.5m of callable CMBS.

The callable CMBS are collateralised principally by seasoned multifamily housing loans originated by the firm from 1996 to 1998 and carry a coupon of 8%. Depending on market conditions and potential structure, portions of the CMBS could be refinanced at a substantial net interest rate savings to their current coupon, Dynex says.

Thomas Akin, Dynex chairman and ceo, comments: "This purchase greatly simplifies our balance sheet and represents another step in the company's efforts to secure seasoned, high quality assets with substantial spread income. We had retained an interest in these assets over the years for the purpose of being in a position to harvest this opportunity. We expect a return of approximately 20% on our investment based on estimated cashflows and actual returns could be higher, depending on the outcome of the refinancing of the callable CMBS."

Combined with the timely purchase of agency MBS in the past 18 months, this transaction is expected to make a significant contribution to the firm's income for several years. The refinancing of the callable CMBS is anticipated to close in the next 30-45 days.

Distressed assets

Japanese bank to spin off structured credit assets

Mizuho Securities is, subject to approval from the relevant government authorities, set to establish a new holding company under the trade name Mizuho Securities UK Holdings. The firm says the new structure should enable it to pursue the further vigorous development of client-oriented businesses in the European market, as well as a more efficient withdrawal from the securitisation business.

Mizuho Securities' existing UK subsidiary - Mizuho International - recorded significant losses on its securitisation business, which predominantly referenced US mortgage loans. The company is now implementing a business restructuring programme in order to cut costs and develop a "more robust and client-oriented" business model.

In terms of the securitisation business, the company is focusing on the early liquidation of outstanding transactions. However, Mizuho says it may take some time to complete this process, in light of the continued difficult market situation.

Consequently, it was decided to spin the securitisation business out as a separate entity from Mizuho International and introduce a holding company structure, under which both Mizuho International and the new entity - dubbed Structured Credit America - would be repositioned as its subsidiaries.

Emerging Markets

Bank hires in emerging market sales

BNP Paribas has hired Courtney Johnson as a director in the global local markets sales group. He will join a team of sales people distributing a full range of emerging markets products, including FX, rates, derivatives and credit to real money and hedge fund clients.

Johnson joins BNP with 11 years of fixed income sales experience, including nine years in emerging markets. He was most recently at Citigroup, covering institutional clients from the emerging markets team.

Legislation and litigation

Ohio to take rating agencies through the ringer

Ohio Attorney General Richard Cordray has filed a lawsuit against S&P, Moody's and Fitch. The lawsuit, filed in the US District Court for the Southern District of Ohio on behalf of five Ohio public employee retirement and pension funds, charges the rating agencies with "wreaking havoc" on US financial markets by providing unjustified and inflated ratings of MBS in exchange for lucrative fees from securities issuers.

According to Cordray: "The rating agencies were central players in causing the worst economic crisis in Ohio since the Great Depression. The rating agencies assured our employee pension funds that many of these mortgage-backed securities had the highest credit ratings and the lowest risk. But they sold their professional objectivity and integrity to the highest bidder. The rating agencies' total disregard for the life's work of ordinary Ohioans caused the collapse of our housing and credit markets and is at the heart of what's wrong with Wall Street today."

The lawsuit alleges that the rating agencies improperly gave many of these investments the highest investment grade credit rating, indicating that the investments were extremely safe with a very low risk of default. According to preliminary estimates, the improper ratings cost the Ohio funds losses in excess of US$457m.

"Contrary to the representations of the rating agencies, these mortgage-backed securities were, in fact, high-risk investments that lost tremendous value as the housing market collapsed and mortgage foreclosures accelerated," explains Cordray.

The lawsuit further alleges that the rating agencies made spectacularly misleading evaluations of MBS due in part to the lucrative fees they received from the same issuers they were supposed to be objectively evaluating. Public statements and testimony indicate that rating agency executives and analysts knew their ratings of MBS were wrong, according to the suit.

The Ohio lawsuit is being brought on behalf of the Ohio Public Employees Retirement System, the State Teachers Retirement System of Ohio, the Ohio Police & Fire Pension Fund, the School Employees Retirement System of Ohio and the Ohio Public Employees Deferred Compensation Program.

"The OPERS Board of Trustees authorised filing this litigation to ensure that we can rely upon the industry credit rating agencies to give us independent, objective information when making our investment decisions in the best interests of our members," notes Cinthia Sledz, chair of the OPERS Board's Proxy Policy and Corporate Governance Committee.

Legislation and litigation

Wells Fargo settles ARS complaints

Wells Fargo has agreed to purchase auction rate securities (ARS) from eligible investors who bought them through one of three of its broker-dealer subsidiaries prior to 13 February 2008. The settlement resolves all active regulatory investigations and enforcement actions concerning the firm's participation in the ARS market, without it admitting to any of the allegations against it. The company has, however, also agreed to pay US$1.9m in fines and expenses.

The announcement was made in conjunction with separate agreements reached with the State of California Attorney General's office and the North American Securities Administrators Association regarding Wells Fargo's participation in the ARS market.

The bank notes that since shortly after the liquidity crisis hit in 2008 - and well before any firm agreed to a buyback in connection with an ARS settlement - it has been voluntarily providing significant liquidity to customers who purchased auction rate preferred securities (ARPs). Since April 2008, these customers have had access to up to 90% of the par value of their ARPs through a Wells Fargo loan at advantageous rates that is non-recourse as to principal. The loan was intended to provide temporary liquidity until issuers refinanced their ARS.

"We have been working with ARS issuers since the auction rate market froze and, while there has been progress, redemptions by issuers have not occurred as fast as anyone would have hoped or predicted. We are glad to have resolved this for our customers through an actual repurchase of their ARS," explains Charles Daggs, ceo of Wells Fargo Investments.

The buyback offer will be available to Wells Fargo Investments' retail clients, individual investors, certain 501(c)(3) charitable organisations any other customers with less than US$10m in investable assets, as of 31 January 31 2008. Based on these agreements, the firm expects to purchase up to US$1.4bn of ARS, with an estimated financial impact of approximately US$150n after tax in Q409. The firm expects to recover this cost over time through redemptions of the securities.

Monolines

ABS vet to head up Syncora

Syncora has appointed Susan Comparato ceo and president. Comparato has been serving as the company's acting ceo and president since August 2008. She will now also serve on the board of the company as well as the boards of Syncora Guarantee and Syncora Capital Assurance, the company's two principal operating subsidiaries.

Comparato joined Syncora Guarantee in 2001, serving as associate general counsel with a focus on ABS and CDOs. She was subsequently promoted to md and general counsel, where she played an integral role in the firm's transition to a public holding company. In February 2008, Comparato was appointed general counsel of the company, with responsibility for interaction with all regulatory institutions and for legal counsel and guidance for all the company's key business initiatives.

Prior to joining the firm, Comparato worked for Barclay's Capital, where she was an associate director in risk finance. She began her career at Sidley & Austin, as associate attorney in the firm's securitisation group.

Ratings

Rating agency named in EC antitrust investigation

The European Commission has sent a Statement of Objections (SO) to S&P, which outlines the Commission's preliminary view that S&P is abusing its dominant position by requiring - as the sole-appointed National Numbering Agency (NNA) for US securities - financial institutions and information service providers (ISPs) to pay licensing fees for the use of International Securities Identification Numbers (ISINs) in their own databases. The Commission takes the preliminary view that this behaviour amounts to unfair pricing and constitutes an infringement of Article 82 EC Treaty.

ISINs are the global identifiers for securities and are governed by International Standardisation Organisation (ISO) standard 6166. They are indispensable for a number of operations that financial institutions carry out (for instance, reporting to authorities or clearing and settlement) and cannot be substituted by other identifiers for securities.

S&P is the sole-appointed NNA for US securities and therefore the only issuer and first-hand disseminator of US ISIN numbers. The Commission's preliminary conclusion is that S&P is abusing this monopoly position by enforcing the payment of licence fees for the use of US ISINs by banks and other financial services providers, as well as information service providers in the EEA.

This preliminary finding is based on a comparison with the charging policy of other NNAs that either do not charge any fees at all or, if they do, do so only on the basis of the distribution cost as opposed to usage, according to ISO principles. According to the Commission's preliminary findings, S&P does not incur any costs for the distribution of US ISINs to financial service providers because the latter do not receive the ISINs from S&P but from information service providers such as Thomson Reuters or Bloomberg.

S&P has eight weeks to reply to the SO and will then have the right to be heard in an oral hearing. If the preliminary views expressed in the SO are confirmed, the Commission may require S&P to cease the abuse and may impose a fine.

The EC opened a formal investigation into S&P in January 2009. A Statement of Objections is a formal step in EC antitrust investigations in which the Commission informs the parties concerned of the objections raised against them.

The parties can reply to the SO, setting out all facts relevant to their defence against the objections raised by the Commission. They may also request an oral hearing to present its comments on the case.

The Commission may then take a decision on whether the conduct addressed in the Statement of Objections is compatible or not with the EC Treaty's antitrust rules.

RMBS

PIMCO named for NAIC analysis

Members of the National Association of Insurance Commissioners (NAIC) have selected PIMCO as a third-party financial modeller that will assist state regulators to ultimately determine the risk-based capital (RBC) requirements for RMBS (SCI passim). For approximately 18,000 RMBS securities owned by US insurers at the end of 2009, the new model will produce expected losses at the RMBS security level for insurers to map their holdings to the appropriate NAIC designation and accompanying RBC requirements.

"Creating this new assessment process is an important step toward providing more transparency about these complex securities," says Roger Sevigny, NAIC president and New Hampshire insurance commissioner. "This unique treatment of residential mortgage-backed securities distinguishes the NAIC as the only regulator to analyse these securities and require capital based upon the expected loss amount for a particular company."

PIMCO will work with regulators to develop a set of price ranges for designations one through to six, to be used by insurers in their statutory financial statements and to calculate the risk-based capital charges for each specific security they own. These designations will apply only to year-end 2009 reporting.

Secondary markets

Fed brings MBS purchase operations in-house

The New York Fed is to stop using external investment managers for MBS purchases and will start using internal staff from the end of the month. Four external managers were originally mandated by the Fed for the role, which was subsequently streamlined in August to two - Wellington Management Company for trading, settlement and as a secondary provider of risk and analytics support, and BlackRock as the primary provider of risk and analytics support.

The Fed notes that the agency MBS programme has matured since it began in January, and it has had time to further develop its internal analytical and operational expertise in this area. The change in the number of external investment managers was not performance-related, it notes.

From an operational perspective, the Fed's trading approach will replicate the one currently employed by the programme's trading investment manager, Wellington - although the New York Fed will be trading in its own name. From a settlement perspective, the Fed will continue to leverage the middle office settlement support of Wellington for any trades executed by Fed staff.

Technology

Tie-up to improve access to US MBS loan data

S&P's Fixed Income Risk Management Services (FIRMS) and Experian have formed a strategic alliance to improve transparency in the securitised loan market. The two firms will collaborate on integrating Experian's credit data and analytics with FIRMS securitised loan data and models, with a particular focus on the individual loans that are packaged in MBS.

The alliance will provide investors worldwide with more detailed information on the underlying loans in US MBS by combining Experian's consumer credit data and analytics and S&P's loan-level data products. In the first step of the partnership, Experian Capital Markets will connect consumer credit information and attributes to S&P's US RMBS Edition loan-level data feed product.

David Goldstein, md of FIRMS, says: "Securitised loan investors need to be able to drill down to the foundation of each individual loan in their portfolios to gain a truly comprehensive picture of their risk exposures. Through our partnership with Experian, we will be able to provide investors with an amazing level of granularity on the fundamental risks in each loan and the ability to benchmark their portfolios against this data."

Ethan Klemperer, svp and general manager of Experian Capital Markets, adds: "The goal of our collaboration is to provide investors with the transparency needed to value structured finance products and to make more informed buy and sell decisions. Our partnership with Standard & Poor's is a critical step in improving market efficiencies needed to restore liquidity and investor confidence."

Technology

Hedge fund technology provider expands in Asia

Paladyne Systems has opened a Hong Kong office in order to expand its hedge fund technology and services in the Asia-Pacific region. Paladyne has appointed Eric Royer as the new regional director of Paladyne Asia, with responsibility for managing all aspects of its Asian business operations.

Prior to joining Paladyne, Royer served as md of Tradar Asia and established its Hong Kong office. He managed all local operations for Tradar Asia, including sales, client support, account management, product management, quality assurance and professional services.

Royer says: "Paladyne has developed an extremely comprehensive suite of products and a robust ASP solution that addresses the operational requirements of both start-up and complex Asian fund managers. Paladyne's order and portfolio management solution supports multiple prime broker relationships, as well as managed accounts and addresses the needs of investors regarding transparency and operational control and risk mitigation."

Paladyne will provide alternative asset managers in Asia Pacific with its standardised and integrated front-, middle- and back-office solution.

ABS

Euro triple-A ABS 'top pick' for 2010, says manager

ING Investment Management Europe (ING IM) announced at its Annual Outlook Conference in London that it expects to see greater divergence in macro, market and sector themes. The manager predicts that emerging markets will continue to outperform developed markets, based on superior growth dynamics and ample liquidity. It further predicts a preference for risky assets over risk-free assets, albeit with a defensive bias within the risky asset allocation.

In the fixed income market, ING IM favours the higher-rated and fundamentally stronger parts of the credit markets, and warns investors to be on guard for a short-term shift in liquidity conditions towards the end of the first quarter of 2010.

Valentijn van Nieuwenhuijzen, head of fixed income strategy and economics at ING IM, says: "In an environment of rising divergence in financial markets, we recommend diversifying risk in fixed income portfolios to focus on relative balance sheet strength. Therefore, we are overweight corporate, household and (emerging) sovereign sectors. Moreover, we expect to see somewhat higher levels of volatility in 2010. As a result, we prefer the higher rated segments of credit markets and will look for exposure to healthy macroeconomic fundamentals in the emerging world in a diversified fashion."

He continues: "Our top pick is European triple-A ABS, as it is one of the few markets where some liquidity premiums are still present, while at the same time underlying fundamentals are on an improving trend. The strong liquidity conditions also support this asset class, just as they do for most asset classes with a significantly higher yield than cash."

ING IM's other overweight positions in fixed income are corporate investment grade credit and emerging market local currency debt. Nieuwenhuijzen adds: "Given our conviction that central banks will keep interest rates lower for longer than markets anticipate, we do expect that most other fixed income markets will also produce reasonable outperformance in 2010. However, they seem more exposed to possible risks related to a shift in quantitative easing measures in the course of the year and signs that the cyclical recovery is losing some steam in the first half of 2010."

ABS

US credit card charge-offs to remain choppy

Credit card charge-off rates continue to show signs of stabilising, according to the latest master trust servicer reports released for the major US credit card ABS issuers. However, ABS analysts at Wells Fargo Securities suggest that charge-off rates are likely to remain elevated until the economy and labour markets begin to improve.

In a new report, the analysts highlight the credit performance of the six general purpose credit card trusts - AMXCA, BACCT, CHAIT, COMET, CCCIT and DCENT - that comprise the Wells Fargo Securities Credit Card Indexes. The charge-off rate for the index was 9.41% in November, down from 10.14% in October.

"Most of the improvement came from better charge-off numbers from AMXCA, BACCT and CCCIT," the analysts note. "We expect credit card charge-off rates to plateau at 10%-11% for our index, though the month-to-month figures are likely to be choppy."

Receivables balances among the index's credit card ABS issuers continued to shrink in November, reflecting tight lending standards by card issuers and weaker demand on the part of consumers. The dollar amount of charge-offs also improved again in November, suggesting that the amount of troubled accounts in these trusts is falling, the analysts add.

But delinquency rates rose to 4.32% in November from 4.20% in October, though they are still within the range seen in the last nine months. "The elevated level of delinquencies seems consistent with the continued stress on the consumer sector, in our opinion," the analysts conclude.

ABS

FFELP ABS rating methodology updated

Moody's has updated its rating methodology to incorporate an additional assessment of the risk posed by slow loan repayment rates when analysing bonds backed by Federal Family Educational Loan Program (FFELP) student loans.

"We have recently observed a considerable decline in actual repayment rates of securitised FFELP student loan pools across issuers," says Moody's avp Tracy Rice. "The risk posed by slow loan repayment rates is most pronounced for transactions with negative excess spread, which have become more common in the past two years."

Under the updated methodology, the cashflows of the transaction must be sufficient to make full and timely payments to investors in a new repayment stress scenario where the combination of voluntary prepayments, defaults, forbearance rates and deferment rates results in a total repayment rate that is considerably lower than the existing stress scenarios. The new repayment stress scenario will be applied in conjunction with the most stressful interest rate stress scenario in each rating category.

"The ratings of a small number of existing transactions could be affected by the revisions to our methodology, with rating downgrades - if any - likely limited to at most two notches," explains Rice.

CDPCs

CDPC's ratings cut by a notch

S&P has lowered its issuer credit rating on Athilon Capital to single-A minus from single-A and its rating on the senior subordinated notes issued by the CDPC to double-B minus from double-B. The rating agency's outlook on Athilon is negative.

The rating actions reflect S&P's view of the further credit deterioration of the reference entities in Athilon's corporate tranche CDS portfolio and the associated rising capital requirements. Since its last rating action on the CDPC - on 23 July - the agency has lowered its ratings on a number of reference entities in Athilon's corporate CDS portfolio.

Based on the latest report that S&P received from Athilon, the corporate tranche CDS portfolio's contribution to the required capital alone would have to increase to US$266m from US$216m (calculated as of July 2009) to maintain the single-A issuer credit rating. The required capital amount includes the impact of potential counterparty termination payments.

CDS

"Naked" CDS model legislation adopted

The National Conference of Insurance Legislators (NCOIL) has unanimously adopted model legislation that seeks to prohibit what it terms "naked" credit default swaps. The organisation further aims to establish a regulatory framework for "covered swaps", or what it believes should be known as credit default insurance (CDI).

The model legislation - which was sponsored by Financial Services & Investment Products Committee Chair Joseph Morelle and modelled on New York State financial guaranty insurance law - would include a definition of CDI and establish a state regulatory regime to oversee the CDI market. The model would contain requirements regarding company licensing; contingency, loss and unearned premium reserves; policy forms and rates; and reinsurance.

It would also define authorised CDI and prohibit and penalise parties that engage in unauthorised CDI. In doing so, NCOIL believes the model would eliminate "naked" CDS.

The model legislation is premised upon the controversial belief that certain CDS are a form of insurance and, thus, products to be regulated by state regulators.

CLOs

CLO buyback cuts exposure by half

Newfoundland CLO I has entered into a supplemental trust deed with the rest of the transaction parties to reflect the decrease of the notional amount of all the notes outstanding. Under the agreement, US$9.3bn of the senior notes and US$1.1bn of the senior S-1 notes were repurchased by the issuer at par plus accrued interest.

The repurchase was funded by the sale of assets initially backing the notes. As a result, the outstanding notional amount of the senior notes and senior S-1 notes will both be reduced to US$3.25bn and the par amount of the portfolio will be reduced to US$7.7bn.

Moody's has determined that the agreement and performance of the activities contemplated therein will not cause its ratings of the notes to be reduced or withdrawn.

CLOs

US CLO exposure to Simmons reviewed

68 S&P-rated CLOs across 34 collateral managers have exposure to Simmons, some of which have exposure to multiple types of Simmons debt, according to S&P. The rating agency has reviewed its outstanding rated US CLOs to identity the portfolio's exposure to Simmons Co and its subsidiaries Simmons Bedding Co and Simmons Holdco Inc after they filed a prepackaged Chapter 11 bankruptcy on 16 November.

The prepack's terms provide for full repayment to the senior secured noteholders of Simmons Bedding, which consists of a US$465m term D bank loan that had an original maturity date in December 2011 and a US$75m revolving credit facility that had an original maturity date in December 2009.

As of Q309, Simmons ranked number 372 in terms of notional exposure across the US CLO transactions that S&P rates.

CLOs

Spanish SME CLOs remain under pressure

Adverse economic conditions are continuing to weigh on asset performance in Spanish SME CLOs, despite some recent stabilisation in delinquencies, according to the latest quarterly index report published by Moody's. In particular, those transactions most exposed to the real estate market are suffering most severely at this point in time.

"The recession in Spain extended further in Q309 and a further weakening is anticipated, especially in the labour market," says Nitesh Shah, a Moody's economist. "Although a return to growth is expected in Q409, this is likely to be weaker than elsewhere in the Eurozone. The faltering real estate sector has already resulted in large numbers of company bankruptcies, higher unemployment and dampened domestic demand in general."

Shah adds: "This has acute implications for the SME sector and has been largely responsible for the rise in delinquencies among SME ABS transactions in recent quarters, albeit with some stabilisation in the past quarter, as well as an increasing number of defaults and draws on reserve funds."

In this context, Moody's credit outlook for the Spanish SME sector remains negative. "We believe the economic climate will continue to adversely affect asset performance in Spanish SME ABS, with recoveries taking time to materialise," says Ludovic Thebault, associate analyst at the rating agency.

CMBS

Fortress CMBS set to follow DDR

Bank of America is expected to sell a US$460m CMBS for Fortress Investment Group before the end of the year. The deal will not necessarily take advantage of TALF funding, according to reports.

TALF loan requests published earlier this week showed that just US$72.2m was requested for new issue CMBS - a fraction of the US$323m triple-A DDR 1 2009 CMBS that was launched on 16 November (see last week's issue). The New York Fed has posted accepted and rejected legacy CMBS for the 17 November TALF subscription. Three CUSIPs were rejected - 05947U2R8, 059511AB1 and 12514AAE1 - and 60 CUSIPs were accepted.

CMBS

Hotel delinquency rate 'set to explode'

The delinquency rate for hotel loans, which was 8.67% at the end of October, seems poised to blow past the 10% level when November numbers are finalised, according to Trepp.

"The big culprit will be the Extended Stay loan, which makes up all of the collateral for WBCMT 2007-ESH," the firm notes. "The loan is split up into multiple components, but only one - the US$583.6m A-1 component - was required to amortise. When the borrower stopped paying principal in July, the A-1 component was listed as delinquent, but since interest was otherwise being paid on the loan, the other components were showing up as current. Now that the borrower stopped paying interest in September, those other components have now become 30 days delinquent too."

Trepp adds that the other components total well over US$3bn and this alone could push the 30-day delinquency rate well into the double digits when the numbers are tallied later this month. "A number of 13% or higher would not surprise us in the least," Trepp concludes.

CMBS

Further US CMBS downgrades anticipated

Property valuations on US commercial real estate have further to fall before they experience a modest rebound to be followed by a long, gradual recovery, according to Moody's. The ratings agency expects that cashflows from properties that back CMBS will recover slowly over a period of several years. In addition, refinancing risk on CMBS will grow as maturities near on bonds issued during the peak of the market.

Because of these trends, Moody's anticipates further downgrades of up to three notches for many subordinate tranches of 2006-2008 vintage conduit/fusion CMBS. Ratings on the most senior bonds are likely to remain at current levels. Rating actions will take place over time, following detailed individual deal reviews.

While average realised losses for CMBS deals issued between 2003 and 2008 are currently less than 0.2%, Moody's expects that under its base case those numbers will range from just over 2% to just under 6% depending on the vintage.

Moody's base case reduces losses incurred at loan maturity for the 2005-2008 vintages by up to 50%, reflecting its current view as to the substantial uncertainty surrounding potential maturity defaults. Later vintage loans will benefit from maturity date extensions and a financing environment that is likely to be more favourable than the current one. Refinance prospects will become a bigger ratings driver as loan maturities approach.

The base-case expected loss numbers translate to: one notch downgrades of originally-rated junior triple-A bonds from 2007-2008 from their current typical ratings of around A1; two notch downgrades of originally-rated A3 bonds from the same vintages from their current typical ratings of around Ba1: and three notch downgrades of originally-rated Baa3 bonds, from their current typical ratings of around B3.

Under the stress scenario losses at loan maturity for the 2005-2008 vintages are fully captured and CMBS bonds below the original mezzanine triple-A class in 2006-2008 vintage deals would be downgraded to very low speculative grade or impairment (Ca or C). Super-senior and mezzanine triple-A bonds would be subject to multi-notch downgrades, but remain investment grade.

Moody's md Nick Levidy says: "Cashflows for properties with short-term lease structures, such as hotels and multifamily, will likely hit bottom in 2010 or early 2011. The bottom for office, retail and industrial properties will take longer to form."

Commercial property values, which have fallen by 42.9% since their October 2007 peak, will remain depressed for far longer than cashflows. Moody's expects property values to decline to 45%-55% off their peak in the coming months.

Levidy adds: "We believe that valuations will rebound off the bottom and settle in for the longer term at levels 30%-40% below the market top as liquidity and investors return to the sector and property cashflows begin to recover."

Commercial real estate lags the overall economy and is dependent on both business and consumers for demand; therefore, the sector as a whole only benefits from a broad based and lengthy recovery. Specific macroeconomic metrics factor in to a greater or lesser degree among specific property types.

Levidy continues: "Employment growth is fundamental, for example, to the office property market. The health of the residential housing market is a key for the multifamily sector and retail properties are greatly dependent on rising consumer confidence."

Moody's expects office market fundamentals to bottom out in 2011, once employment rates begin to rise and tenants determine their ultimate space needs. Office sales activity and valuations will increase as financing becomes more readily available and as money waiting on the sidelines is deployed in the sector in response to improving office market fundamentals.

The rating agency notes that weak consumer spending, increasing unemployment rates and stagnant wage growth are significant drags on demand for consumer goods, particularly discretionary goods. Moody's does not expect US consumers to return to pre-recession spending levels until employment and wage growth resumes and sufficient time passes for consumer confidence to rebound. This may not occur until 2011 or later.

On a positive note, the number of store closings in 2009 has been lower than early expectations, as retailers have been able to renegotiate leases and improve their ability to operate in underperforming locations. Lease restructurings reduce cashflow available to service mortgage debt, but keep retail centres vibrant by reducing vacant storefronts.

Market vacancy rates are expected to peak within the next few months. Resumption of rental rate growth will likely stall until 2011 as employment and household formation return to positive growth from the recession sometime next year. Government programmes to encourage home ownership, the recent steep decline in single family home prices and the significant number of shadow rentals (condominiums, single-family homes) will also negatively influence the supply and demand relationship for multifamily housing.

Moody's corporate rating outlook for US lodging remains negative, with US revenue per available room (RevPAR) down by 18% year-over-year and appearing to be on track to revert to 2004-2005 levels. There is significant performance differentiation in the hotel sector by location, price and destination type.

CMBS

Performance pressure rising for Euro CMBS

Fitch warns of the threat to European CMBS performance posed by a rising trend of commercial mortgage loan defaults, which for Fitch-rated debt currently stands at 7%. In light of this, the agency has so far this year downgraded €47.2bn of European CMBS notes (nearly 60%) and maintains either rating watch negative or negative outlook on €52bn of notes.

Negative rating action has been concentrated in European CMBS with non-UK exposure, with 69% of such tranches downgraded. The most severe rating action centred on junior tranches, especially those from multi-borrower transactions.

Euan Gatfield, senior director in Fitch's CMBS team, says: "As measured by the degree of erosion of borrowers' equity in property portfolios, the distress in commercial real estate markets in the last 12 months explains both the volume of Fitch's downgrades and the severity of rating changes - averaging between three and four notches. This has taken place, despite the fact that few borrowers have yet to deal with a loan maturity in European CMBS. With a prolonged wave of maturities arriving in two years time, financing pressures are building in the sector."

Although less than 5% of European CMBS loans have suffered a missed payment, Fitch notes that the growing number of financial covenants that are in breach signals the difficulties even performing borrowers will face when it comes to repaying largely bullet debt. Across Europe the €5bn maturing in 2010 will be overshadowed by the €61bn due between 2011 and 2014, a third of which is due in 2013.

CMBS servicers have placed 19% of the commercial mortgage loans they administer in Europe on their 'watchlists'. Fitch's own watchlist takes in an even higher share (28%) of the sector.

Moreover, whereas a quarter of loans on servicer watchlists are fully performing, this ratio rises to almost a half in Fitch's case. This reflects differences between the agency's estimates of value and those contained in formal appraisals, few of which were commissioned recently.

This disparity is underlined when comparing the weighted-average LTV of 75% reported across European CMBS loans with Fitch's estimate of approximately 95%. The scale of the declines in commercial property value estimated by Fitch largely explains why only three of the 20 CMBS loans due this year managed to repay.

While one, the Quattro loan, is still in its grace period, the majority - including the loan underpinning White Tower 2006-3 - failed to redeem at maturity. This caused their transfer into special servicing, pending possible restructuring or liquidation. In the case of eight loans, there has been an extension to the term, as a result of the exercise of an option or a rescheduling of loan maturity.

Balloon risk remains centred in the UK due to the distressed commercial property market and because most underlying CMBS debt due this year has been secured on UK property, with more due next year. However, there are early signs of value stabilisation, although this is largely limited to prime assets.

Gatfield adds: "It is questionable whether a recovery in UK values and refinancing availability will be in time and in sufficient magnitude to absorb the wave of bullets falling from 2011 onwards, which peak at a sterling equivalent of €6.6bn in 2012. However, there is hope that the worst is over for UK commercial real estate, something that cannot be said for most mainland European markets. Refinancing risk for pan-European CMBS could be even greater than in the UK, given so many transactions were completed in 2006 and 2007, at or near the market peak."

With three in every four European CMBS tranches issued in 2006 or 2007 suffering a downgrade this year, rating action has been skewed towards non-UK CMBS, despite conditions in the key German, Dutch and French commercial property markets being less distressed. However, this apparent strength could be down to the effect of markets lagging, which would suggest further deterioration is in store for Germany, the Netherlands and France - just as CMBS loan maturities begin to gather pace.

In each of the next five years more underlying CMBS debt is due from borrowers in mainland Europe than UK borrowers. There is a particular bottleneck in Germany, with the €13.5bn worth of CMBS loans due in 2013, including a staggering €10bn from just four multifamily housing mortgages - being twice the UK's peak of €6.6bn projected for 2012. Combined with the point in the respective property market cycles, the sheer volume of commercial mortgages maturing in the next five years across mainland Europe will be a major test for pan-European CMBS credit quality.

CMBS

CMBS loans in special servicing rise

On the heels of another rise in US CMBS delinquencies, Fitch rated loans in special servicing rose by an additional 7.4%, according to the rating agency. Following a 54bp increase in Fitch's US CMBS Loan Delinquency Index to 3.86, the balance of specially serviced loans in Fitch-rated transactions increased to US$35bn in September from US$32.6bn in August.

The largest addition is the US$217.4m World Market Center loan in BSCMSI 2005-PRW10. The loan transferred to special servicing due to the borrower's inability to fund operating shortfalls at the 1.1 million square foot Las Vegas furniture show room, due to declining occupancy because of the ongoing economic downturn.

While all property types continue to see performance declines, Fitch expects retail and hotel properties to see the immediate effects of such deterioration.

Documentation

Hellas credit event called

ISDA's Determinations Committee has determined that a bankruptcy credit event has occurred with respect to Hellas Telecommunications (Luxembourg) II, following the company's receipt of the necessary consents on 17 November to apply for an administration order from the English High Court. An auction has been announced to settle Hellas CDS.

Meanwhile, the auction to settle credit derivative trades for National Joint Stock Company Naftogaz of Ukraine is to be held on 16 December.

Emerging Markets

Fund first investor in Indian MFI CLO segment

A recent micro-loan securitisation completed by IFMR Capital and Equitas Micro Finance (see SCI issue 127) has enabled the launch of the first mutual fund investment into the Indian microfinance sector.

The US$10.4m-equivalent transaction is backed by over 55,000 micro-loans originated by Equitas Micro Finance, a Chennai-based microfinance institution with approximately 700,000 low-income clients. The transaction was structured by IFMR Capital, which operates as a financial guarantee company for sectors impacting low-income households and which co-invested in the junior tranche of the securitisation.

"We are pleased to be the originator in the first-ever microfinance securitisation programme to reach capital market investors," says S. Bhaskar, coo at Equitas. "This is an important milestone in diversifying the sources of funds for microfinance companies and will benefit a large number of microfinance borrowers over time."

The transaction has been structured into three separately rated tranches to match investor risk-return profiles, thus expanding the range of institutions that can invest in the asset class. CRISIL (a subsidiary of S&P) rated the tranches P1+ (so), double-A (so) and triple-B (so).

ICICI Prudential Asset Management, India's third-largest mutual fund, subscribed to a majority of the securities. Axis Bank, Dhanalakshmi Bank and IFMR Capital also subscribed.

Primary credit enhancement is provided by Equitas in the form of cash collateral, which will absorb any realised losses up to 10.6% of the portfolio cashflows. For the senior and mezzanine tranches, additional credit enhancement is provided by the junior tranche, to which IFMR Capital subscribed.

Investors

UCI tender offer results announced

BNP Paribas has announced the results of the tender offer for ten UCI Spanish RMBS. Offers for seven out of the ten were accepted for a total of €486m. This is significantly above the amount accepted during the previous BNP tender offer last month, ABS analysts at Barclays Capital point out.

Prices for the tendered bonds ranged between 70% and 90%, with earlier vintage deals achieving the highest prices.

LSS

Asset substitution for LSS deal

The Starts (Cayman) Series 2007-34 leveraged super senior (LSS) transaction reports that it has accumulated US$25m due to collateral amortisations and has reinvested this in a senior unsecured floating rate note issued by HSBC Bank, due December 2012. Moody's has determined that the ratings currently assigned to the deal will not be reduced or withdrawn solely as a result of the acquisition of such new collateral.

The transaction features time-dependant thresholds that, if exceeded, could lead to deleveraging or early termination of the transaction at market value. It is exposed to a static reference portfolio of 125 corporate entities for approximately three years and has a noteholders' option to sell the notes three business days after the maturity of the credit default swap, in which case they will receive collateral assets if still outstanding or proceeds of those if matured.

Moody's notes that the risk is heavily front-loaded in such transactions. Specifically, for the remainder of the credit observation period ending in December 2012 noteholders are primarily exposed to the credit risk arising from the reference portfolio, which is considerably higher than the risk arising from the collateral assets. Upon termination of the credit default swap in 2012, however, noteholders will solely be exposed to the credit risk of the collateral, should they not exercise their put option.

Monolines

FGIC payment suspension to trigger CDS?

The New York Insurance Department (NYID) has ordered FGIC to suspend paying any and all claims. The move is likely to result in a credit event for CDS written on the monoline. The best recent precedent was SCA, where the auction set recovery at 15 cents in the dollar.

On 20 November FGIC filed with the NYID its quarterly statement for the period ending 30 September, in which FGIC reported a surplus to policyholders deficit of US$865.8m and an impairment of its required minimum surplus to policyholders of US$932.2m. The Superintendent of Insurance has directed the monoline to submit a plan to eliminate this impairment.

FGIC says it is currently formulating a comprehensive restructuring plan, which contemplates its commencement of a tender offer for the acquisition or exchange of certain RMBS guaranteed by FGIC in the primary market; its continued pursuit of commutations with the holders of FGIC-insured ABS CDOs; and the commutation, termination or restructuring of FGIC's exposure in respect of certain other obligations for which it has established statutory loss reserves. This is with a view to remediate its RMBS, ABS CDO and other exposures, remove its capital impairment and return it to compliance with the applicable minimum surplus to policyholders requirement.

The NYID order requires FGIC to provide the Superintendent with a detailed and final plan of the proposed Surplus Restoration Plan no later than 5 January 2010. In the event that the monoline fails to provide the Superintendent with the Final Plan by such date, the NYID Order provides that the Superintendent shall seek an order of rehabilitation or liquidation of FGIC forthwith.

The NYID Order further requires FGIC to take such steps as may be necessary to remove the impairment of its capital and to return to compliance with its minimum surplus to policyholders' requirement by not later than 25 March 2010, or such subsequent date as the Superintendent deems appropriate. Until FGIC achieves compliance with such requirement, the NYID Order prohibits it from writing any new policies and requires it to otherwise operate only in the ordinary course and as necessary to effectuate the Surplus Restoration Plan.

The Board of Directors of FGIC says that, in the absence of a successful restructuring, it may request that the NYID seek court appointment of a rehabilitator or liquidator for FGIC.

Monolines

Further rating action for Ambac

S&P has lowered its counterparty credit and financial enhancement ratings on Ambac Assurance Corp to SD (selective default) from double-C. These rating actions are based on its criteria for distressed exchanges and not due to unexpected business developments, the agency says. At the same time, S&P placed the double-C financial strength rating on Ambac on watch with positive implications to reflect the likelihood that it will raise the rating as a result of the monoline's commutation programme.

These actions follow Ambac's announcement that it has commuted four ABS CDO exposures from multiple counterparties. The transactions, which have an aggregate of approximately US$5bn of notional outstanding, were settled for cash payments of approximately US$520m.

In S&P's view, the likely losses under these exposures would have been significantly higher than the cash settlement amount. Further, it is likely that without the commutations, Ambac would have reported a negative statutory surplus for the quarter ended 30 September 2009. As a result of the exchanges, the company avoided a potential regulatory action and improved reported statutory surplus to US$856m.

The positive credit watch on the financial strength rating indicates that the agency is likely to raise the rating in the near future to reflect the positive impact of the commutations on the monoline's balance sheet. S&P expects to complete its review in a relatively short period of time and the ratings, if raised, will most likely be in the triple-C category.

Operations

Special servicing opportunities attract new participants

Due to financial institutions' continuing low lending levels, European servicers have reported that they are receiving subdued amounts of new business, according to the latest European servicer report card published by S&P.

"In our opinion, the environment is still problematic for new lenders to enter the market or for lenders who have withdrawn to return," comments S&P servicer analyst Beverley Dunne. "Servicers tell us that most actual and potential new business is in the form of non-performing loans or loans in special servicing transferring between servicers."

She adds: "As a result, we have found that many of our ranked European servicers are managing reducing, but more challenging portfolios. This has not had an effect on our rankings."

Servicers' portfolios have changed significantly over the past couple of years and the focus of their work has changed accordingly. Since the downturn started in 2007, the main focus for servicers has been refining, reviewing and enhancing their processes to enable them to effectively manage increasing arrears and loan covenant breaches. Loan prepayments have reduced significantly as there are few refinance options and thus servicers are having to come up with new strategies to manage these more challenging portfolios.

"As a result of these changes in portfolio characteristics, we have seen the number of servicers interested in a special servicer ranking continue to increase over the past six months," Dunne continues.

Currently, the European market is attracting commercial loan servicers that wish to capitalise on the increasing special servicing opportunities. These servicers fall into two main categories: those that currently operate in one or two European countries, but wish to expand their remit into other European jurisdictions; and those that currently operate outside Europe and are looking to enter the market for the first time.

Although S&P has not yet observed complete newcomers entering the European special servicing market, it says it has spoken to some organisations that are considering it.

Ratings

UK credit card indices begin stabilising

Moody's UK aggregate credit card charge-off index declined to 11.4% in October from 11.8% one month previously, while its UK aggregate delinquency index remained stable at 7.7%. After months of continuous deterioration, the sector is beginning to show some preliminary signs of stabilisation, the rating agency notes.

Delinquency rates have been flat or decreasing across most trusts for the past three to four months. Payment rates have remained broadly stable over 2009, while excess spread levels are on the rise due to the lower cost of floating rate bonds.

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

Real Estate

CPPI points to moderating CRE deterioration

Commercial real estate prices as measured by Moody's/REAL Commercial Property Price Indices (CPPI) fell by 3.9% in September, following the general pace of decline of the last several months. US commercial property values are now down 37% from a year ago, 42% from two years ago and 42.9% from their peak in October 2007.

Volumes of commercial real estate transactions continued to be low in September, with the 363 sales during the month totalling slightly more than US$5.1bn.

"Further price declines are almost certain over the short term," says Moody's md Nick Levidy. "However, it is notable that the pace of deterioration appears to be moderating. Over the four-month period June through September the monthly declines averaged 3.2%, significantly lower than the sharp drops of more than 7% seen in April and May."

Looking at the quarterly performance of the four commercial real estate property types, Moody's says at the national level three of the four saw slightly better performance in the third quarter as compared to the second quarter, with the office sector representing the exception. Office took back the small gain it recorded in the second quarter and then some, according to Moody's CPPI, with a value decline of 12.2% in the third quarter. This put the overall price decline for the national office sector at 36.2% since the peak in 2007.

Apartments recorded the second largest decline, with values falling 10.9% in the third quarter. National apartment prices have recorded declines in excess of 10% in three of the past four quarters, bringing the sector's total peak-to-trough decline to 39.5%.

After a record-making 20.4% decline in the second quarter (the largest national quarterly decline in this recession), the industrial sector saw a more modest 8.1% drop in prices in the third quarter. Industrial properties have seen values decline by 37.4% peak-to-trough, on a national level.

After seven consecutive quarters of flat to negative price growth, retail properties saw values increase 2.5% in the third quarter on a national level. This minor gain comes after a nearly 20% value drop in the first half of the year, putting retail prices 27.4% below their peak.

Regulation

Retention requirement amendment passes

An amendment to the House Financial Services Committee financial regulatory reform bill that reduces the maximum retention requirement from 10% to 5% for securitisations has been passed. The amendment also includes language that would customise retention provisions to reflect the unique nature of the CMBS market.

The CMSA had previously urged policymakers to structure retention provisions carefully in order to maintain and strengthen the safeguards that exist in the CMBS market by explicitly recognising the important role of third-party investors who purchase the first-loss position and perform due diligence. The Association says it is strongly encouraged by the House Committee's approval of the Minnick amendment that would not preclude retention by the originator/issuer, but instead grant additional flexibility to allow a third-party investor to satisfy the retention requirement. If market participants choose to utilise this method, the third-party purchaser would be obligated to retain the associated credit risk for its first-loss position in those asset-backed securities.

The retention issue - which has been a top priority for CMSA - is of particular concern in light of new accounting standards, FAS 166 and 167, which could result in significantly less credit availability (see this week's issue). In this regard, the House Committee also approved another amendment that would require the Federal Reserve and financial regulators to examine the combined impact of new retention requirements and accounting standards on credit availability, and to report to Congress with specific recommendations prior to any rulemaking on the retention.

"Considering the challenges facing commercial real estate, these reforms must provide certainty and confidence for all market participants to help kick-start the lending markets," says Patrick Sargent, president, CMSA. "Tailoring retention language to support, rather than impede, the CMBS market is absolutely critical to recovery efforts in commercial real estate and our overall economy."

"We urge financial policymakers in Washington to maintain and strengthen safeguards in the CMBS market by structuring the 'skin-in-the-game' requirement to incorporate third-party investors who purchase the first-loss position, perform due diligence and retain this risk," he adds.

The overall legislation, known as the Financial Stability Improvement Act of 2009 (H.R. 3996), is expected to move to the House floor in December after the House Financial Services Committee completes its consideration.

Regulation

Call for global mortgage underwriting standards

Regulators around the world should address the problem that sparked the financial crisis of the past two years by establishing minimum underwriting standards for all mortgages made in their respective countries, according to US Comptroller of the Currency John Dugan. These standards would form the minimum that must be observed to keep lenders from risking too much loss to both themselves and their customers.

In a speech to a seminar on international banking and finance sponsored by the Japan Financial News Company, Dugan explained: "These standards would not dictate every underwriting feature of a mortgage product; instead, they would focus on core practices of sound underwriting, on which there is the broadest consensus."
The Comptroller added that these standards should not be the same everywhere in the world.

"Each country has its own unique credit culture and different approaches to mortgage financing, and what works well in one might not work well in another," he continued. "What I am suggesting, though, is that each country should articulate what those standards are for their lenders, and should report periodically on how well those standards are working."

Dugan points to the US as an example, where at least three underwriting standards should be mandated. First is verification of income and assets and second is meaningful down payments. Third, for mortgages with monthly payments that increase over time, borrowers should qualify on their ability to afford the later, higher payments rather than just the initial, lower payments.

In addition, Dugan says it is critical that any new mortgage regulations apply to all providers in order to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past.

The Joint Forum has been asked to provide recommendations to the Financial Stability Board to address differences and gaps in the regulation of financial services around the world. One set of recommendations under consideration involves minimum mortgage underwriting practices.

Secondary markets

Analysis of CLO reinvestments gains importance

With CLO triple-As pricing firmly in the high-80s to low-90s region, the market appears to have switched to trading the paper based on spread rather than price. The key to coming up with the right spread is to come up with the right average life for the bonds. Given that so many variables are in play, structured credit strategists at Citi note that a careful analysis of deal reinvestment conditions has consequently become all the more important.

The length of the reinvestment period and the repayment speed are among the most important determinants of the WAL. However, some less obvious factors may have a significant impact on average life and, therefore, discount margin.

One such factor is the treatment of defaulted assets within the CLO, according to the Citi strategists. "In many deals, any recovery proceeds from defaulted collateral may not be reinvested if the deal OC tests are failing," they explain. "In many others, though, proceeds from the sale of defaulted securities may be reinvested, extending the WAL. Furthermore, even when recovery proceeds cannot be reinvested, lower defaults can contribute to lower repayment speeds for senior tranches. Additionally, since managers receive full fees for managing defaulted assets, they are incentivised to hang on to these assets for as long as possible, potentially delaying cash to senior tranches."

The manner in which the expected loan refinancing wave during 2012-2014 plays out also remains a wildcard. If a significant amount of loans are exchanged for longer maturity loans, triple-A WALs may see significant extension.

"Somewhat counter-intuitively, faster prepayment speeds may also cause triple-As to extend since managers will use repayment proceeds to buy new issue loans in the primary. Though deals have collateral WAL constraints, it is certainly possible that managers could seek amendments," the strategists add.

Technology

'On-demand' SF workstation launched

Moody's Analytics has launched Structured Finance Workstation Online, a web-based cashflow and valuation solution for structured securities. With an intuitive interface and robust modelling and reporting tools, the offering allows on-demand access to a sophisticated workstation, the firm says.

Structured Finance Workstation Online enables structured finance investors to efficiently monitor, value and stress test ABS, RMBS and CMBS portfolios. It offers a streamlined solution that eliminates the need to spend time and resources gathering performance data or validating deal waterfalls.

Technology

Capital markets solution upgraded

Misys has released Version 5.4 of its treasury and capital markets solution, Misys Summit FT. The new Market Risk Limits Module builds on the service's current coverage of limits.

Banks that allocate credit and market risk limits across multiple trading systems will now be able to use Misys' enterprise-wide monitoring and control platform, Misys Eagleye, with the introduction of an out-of-the-box interface from Summit FT. Banks may also combine Eagleye and Summit Market Risk Limits where market risk limits are allocated by business unit and credit limits are allocated and monitored across the enterprise.

The Summit FT Market Risk Limits module is designed to manage risk limits, enabling real-time monitoring, control and action against limit breaches in a wide selection of Summit applications. It monitors a multitude of numbers, including positions, risk indicators and profit and loss, ensuring that trading activity is scrutinised and controlled as it happens. Limits and breaches are displayed in the blotters of Summit on a real-time basis, along with pop-ups alerting the user to critical issues.

The out-of-the-box Misys Summit FT interface to Misys Eagleye provides banks with multiple capital markets applications with an extensible solution that provides a wider view of activity across all trading platforms. Misys Eagleye provides a control layer above a bank's many systems, monitoring exceptions as well as distributing this information via alerts and dashboards around the bank.

Larry Mitchell, vp of solutions management, treasury & capital markets with Misys, says: "We strongly believe financial institutions need to have complete transparency of their business risks through instant notification of exceptions to business-defined rules, so that appropriate decisions can be made in a timely manner. Through our choice of solutions, our Summit clients have been provided with the capability to proactively monitor within Summit and across other applications. Our core focus at Misys is to deliver integrated solutions to customers for true consolidation of risk management measures."

CLOs

Tightening triple-A spreads key to new issue

Structured credit strategists at Citi find that triple-A demand is key to making new issue CLOs work

With most of the financing of a CLO being present in the triple-A tranche, the spread at which CLO triple-As can be placed is key to whether there is sufficient excess spread to lure equity buyers and make a deal work. Triple-As have tightened (Figure 1), but we believe there is still room to go.

We reach that conclusion by looking at a cross-asset relative value. CLOs are a product of securitisation, which implies that they can be compared with other traditional products, such as credit cards and CMBS.

Looking at Figure 2, we see that CLOs are cheap to credit cards and student loans but expensive to CMBS. Student loans and credit card spreads - at well below 100 for triple-As - have benefitted from US government-backed financing, and may arguably be even expensive to fair value, according to our analyst Mary Kane.

On the other hand, CMBS senior bonds appear to be unable to shake off the fears around a commercial real estate bust and offer significant excess spread to investors. (Even here, a recent TALF-financed new issue was able to price its triple-As at 140bp). We think the future direction of CLO spreads will be closer to credit cards than CMBS, as news about the default prospects of CLO collateral is steadily improving.

CLOs are also about corporates, as they repackage bond and loan risk. We have previously suggested that investors should view CLO triple-As as an alternative to investing in untranched IG corporates. Investors give up some liquidity, but gain substantial protection from credit defaults.

Hence, we compare CLO triple-A spreads to the broad investment grade (BIG) corporate bond index, as well as the CDX.NA.IG series of indices (we choose IG 12 seven-year, as it has some history and a tenor comparable to a CLO triple-A). We also look at the LCDX 12 five-year 30%-100% tranche, since it has the superficial similarity with typical CLO triple-As in that it is the super-senior tranche of a portfolio of reference leveraged loans. (There are big differences though - LCDX is unfunded, the five-year is a slightly shorter maturity and does not benefit from the amortisation through spread diversion that CLO triple-As possess.)

Looking at its corporate peers, the comparison in Figure 3 would argue that CLO triple-As have already outperformed, particularly relative to synthetic unfunded risk such as CDX 12 seven-year and even LCDX 12 30%-100% five-year. This has been a general trend over the last few months, where cash has outperformed CDS (note from the figure how IG basis has gone from negative 300bp to just negative 30bp).

We expect this trend to continue for some time yet, as the flow of retail and institutional money is being put to work in cash assets. Likewise, the difference between CLO triple-As and BIG has narrowed. But, as Figure 4 shows, there is significant room to go to reach historical averages.

Who will buy the triple-As?
For the triple-A spread levels to tighten to sub-200 levels, as we anticipate, the natural question is: who will be these buyers? The pre-summer CLO rally was driven by mainly relative value players, who bought senior bonds earlier in the year and then, as yields compressed, moved into mezz and junior tranches.

The main support for the triple-As so far has been that their legacy owners - the banks - have not engaged in distressed selling and the rating downgrades have not been quite as draconian as people feared (making it easier to hold on them). Post the pre-summer rally, we have only recently started seeing greater flows of long-term real-money (pension funds, insurance companies, money managers investing for similar third-party clients) into secondary triple-A CLO assets. Much of this real-money had been sitting in money-market funds (Figure 5) and is gradually moving into riskier or less liquid assets.

It is this long-term money plus limited allocations from liquidity pools that will be the main buying centres for the new triple-As. Money managers have seen allocations from smaller insurance companies and pension funds, but for bonds higher up in the CLO capital structure.

Moreover, treasury departments of banks and insurance companies have bought bonds in the secondary markets. These investments, particularly from the banks, are different from the 'carry-trade', which consisted of buying long-dated assets in vehicles and financing them with short-term commercial paper.

They are more akin to investing part of depositors' cash (or premium income in the case of insurers) in low-risk assets that offer a premium for their lower liquidity. In the absence, however, of structured vehicles buying triple-As, the depth of real-money investing in structured and illiquid assets is likely to lead to much lower issuance than we saw during 2005-2007.

To a much smaller extent, leveraged investors may also participate in triple-A assets, but for that to happen, a greater volume of repo-financing needs to become available. Moreover, many such investors are somewhat gun-shy of having margin calls after the lessons of last year.

Multi-tranche deals possible
Though CLOs had never been as hyper-tranched as CMBS and RMBS, a six-tranche structure (triple-A down to double-B for rated debt, plus equity) was typical. There were natural buyers for each tranche.

Banks bought triple-As, insurance companies bought mezz and equity, structured vehicles (such as CLO-squareds) bought junior mezz and leveraged money bought equity. Though many banks are deleveraging and we do not foresee CLO-squared issuance for any foreseeable future, much of the premise for buying still remains intact.

Though the current wisdom is that only two-tranche (financing and equity) deals will be seen, we think some multi-tranche deals are probable. Insurance companies both have cash and are somewhat agnostic between single- and triple-As (based on regulatory capital differences) and may be natural single-A buyers.

Many credit funds will have yield and subordination constraints and will gravitate towards mezz, even if they are indifferent towards ratings. Without CLO-squareds, there may not be a strong demand for BBB/BB rated debt. (This will also influence the thickness of the equity tranche).

In contrast, the search for structural, non-recourse leverage is as strong as ever, so we do not currently see a constraint in finding equity buyers for clean loan pools. The secondary markets also show that there is demand at the right price for all tranches (Figure 6 shows spread of CLO buyers in 2009). The key point for new deals, we repeat, will be the triple-A demand.

Smaller, better-quality deals with bond buckets
Partly based on investors' requirements and partly on new rating agency criteria, deals will be more robustly structured. New criteria from the agencies imply that the tranches will need more support (Figure 7) below them.

The collateral mix is also likely to be cleaner. We foresee, at least initially, little by way of buckets for other structured finance and subordinated assets. We think these improvements could drive new issue spreads through secondary spreads.

The first few are likely to be smaller and less broadly syndicated than during the peak issuance period of 2006-2007. The Street has less risk capacity to warehouse assets, which means that CLOs - like most other forms of securitisation - will need to be distributed rapidly after the initial purchase of assets.

Participating investors are thus likely to have a greater say in deal features than previously. These could include collateral mix, cash diversion features, events of default and early call, portfolio reinvestment and sale criteria, and manager compensation.

It is too early to tell, but we also suspect that - given investors' preference for shorter-dated risk - a deal with a shorter reinvestment period will be easier to execute, even if equity returns are somewhat diluted. Overall, we feel senior investors have the upper hand in this part of the cycle, much as we saw in the early days of CLO issuance.

For someone who has lived through the birth and death of the high-yield CBO market, the resurgence of high yield bond issuance (Figure 8) poses an interesting question - will CBOs come back? Our best answer is that the new CLO will have a bigger bond bucket through lack of choice, but investors will need to see security before they sign up.

It so happens that much of the bond issuance this year has been of the secured variety and, though these assets do not give investors the benefit of covenants, they do offer security. Moreover, agencies appear to penalise even secured bonds by having a significant haircut between bond and loan recovery rates, which may appeal to senior investors. Further, by having longer maturities, bonds should have their principal due well after the period when a plethora of loan borrowers need to refinance.

So, as with the long-awaited birth of a new baby, there is a lot of speculation as to size, shape and complexion, but the market has the feel of one approaching the ninth month.

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

Trading

Trading ideas: riled up

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Ryland Group Inc

Homebuilders pose quite a conundrum to the credit market. They carry plenty of debt on their balance sheets and do not generate a dime of profit; yet, their credit spreads trade just above multi-year tight levels.

Clearly, government interaction in the form of tax refunds along with large cash and inventory balances help to offset what generally would be viewed as a business gone wrong. Government handouts will run out before the real estate market returns to decent levels, leaving certain builders in precarious positions. Ryland Group is the worst of its cohort and we recommend buying CDS protection.

Given the intricacies of the housing market alongside government intervention, identifying short opportunities within the industry is a complex issue. For instance, with the recent passing of the Worker, Homeownership and Business Assistance Act of 2009 - which extended the first-time home buyer tax credit and Net Operating Loss carryback - Ryland announced it "plans to book a tax benefit in the fourth quarter for the full year 2009 and anticipates receiving a federal income tax cash refund of approximately US$80m to US$120m during the first quarter of 2010."

Regardless of the cash refunds the taxpayer (willingly?) is passing onto the homebuilders, Ryland has not generated a positive operating profit in 11 quarters going back to the fourth quarter of 2006. Over this time period, seasonally-adjusted new housing starts plummeted.

The October number - 529,000 - was well below estimates and demonstrated a continued decrease (Exhibit 1). A recovery of earnings for the builders looks bleak at best; therefore, tax credits will do little to save the companyies from their own demise. Given our outlook, we recommend taking a short position on Ryland as a short CDS position offers the best value.

In order to identify the weakest homebuilder from a credit valuation standpoint, we undertook a cohort analysis of the four single-B minus rated builders (Lennar, DR Horton, Ryland and KB Home). Ryland's CDS trades at a substantial discount to the other three (its spread is roughly half of KB Home's); therefore, we would expect its fundamentals to be significantly stronger than the others.

Ryland's third-quarter EBITDA to total debt ratio was almost double the worst of the three (-5.1% versus -2.7%). And, given that ALL EBITDAs are negative, this implies a much greater relative loss.

In the volatility space, Ryland's three-month implied vol trades at the same level as Lennar's and four points higher than DR Horton's. As Exhibit 2 shows, this implies a much wider spread for Ryland's CDS.

The builders all hold substantial inventory on their balance sheets, which in dark times may buffer them from going bust (though it's not clear who they would sell land to given that scenario). However, Ryland's inventory to total debt is the lowest of the group, leaving it with less land to sell for cash.

We also like the trade from a technical perspective as Ryland's CDS trades 35bp wide of its tightest level set this year (Exhibit 3). We would set a stop-loss at this level (145bp). Given our bearish view on the industry as a whole, Ryland's negative comps and limited downside on a short position, we recommend buying CDS protection on Ryland.

Position

Buy US$10m notional Ryland Group Inc 5 Year CDS at 182bp. 

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).