Contents

Investors

European expectations

Optimistic outlook for the structured credit and ABS markets in 2010

After a roller-coaster year in structured credit and ABS, European market participants are wary of making too many firm predictions for the year ahead. Levels of optimism vary across the industry too. Nevertheless, several themes remain at the fore: the reopening of the primary market, the rebuilding of the investor base and continued consolidation among participants.

The re-opening of the primary markets in 2010 is not a foregone conclusion. Secondary spread levels, a sustainable investor base and regulatory developments will all play a role in determining the success of new issuance.

Secondary ABS levels are now at, or very close to, a level where most asset yields are able to support publicly placed bond spreads - at least where the senior part of the capital structure is placed, according to securitisation analysts at Deutsche Bank. However, junior bond spreads would need to tighten significantly for placement to be realistic. They add that a 2010 recovery in risk asset pricing and the tightening of liquidity spigots by the ECB and the scheduled end of the Bank of England SLS in 2011-2012 should aid the revival of the European ABS market.

"I'm not overly optimistic for significant ABS supply in 2010, but I expect to see a few specific cases," says Dean Atkins, director at Green Street Capital. "The Dutch appear to be leading the way in RMBS - demand for the Arena 2009-1 transaction was very strong and the pricing of the Eleven Cities 4 showed demand for some of the less-liquid Dutch names."

Atkins suggests there may also be some consumer ABS, perhaps in auto loan ABS, where the spreads make sense and the sponsor firms have a need for the financing. Issuance of CMBS would be less likely, however, given the continuing fallout in the commercial real estate market and that so much refinancing needs to take place on existing transactions.

The economics and ease of putting European transactions together may also be a sticking point. "Cross-currency swap margins are multiple times higher now than they were in the past, as are long-term counterparty credit charges," adds Atkins. "These charges will make deal economics difficult in some cases and may cause problems for UK deals looking for Euro distribution, particularly those with long-dated cashflows."

The Deutsche Bank analysts observe that another possible negative on the horizon is the revision to the Basel 2 market risk framework making ABS exposures in the trading book of banks subject to the same capital charges as the banking book. "While such a change could be punitive, resulting in reduced trading desk activity hitting liquidity, it will be least severe for the senior bonds likely to represent the bulk of new issuance. Also the ABS investor base features non-banks, while many bank buyers book holdings to banking books," they note.

The analysts note that further tightening in spreads, along with harsher financing terms from the ECB will be key in this regard. "The firmer tone in language recently emanating from the ECB with respect to the important role securitisation must play in aiding central bank liquidity exit strategies should support the latter. The sheer volume of bank financing needed over the next few years is such that securitisation most likely cannot avoid playing an important role and the rebound in European ABS primary markets should be significant."

Meanwhile, following the startling recovery in secondary CLO prices in H209, the foundations for the return of a primary market are currently being laid - although most expect issuance volumes to be less than US$5bn-US$15bn globally. "Our view is that the CLO secondary market will continue to strengthen in 2010," says Neil Basu, managing partner of Pearl Diver Capital. "We also see an alleviation of systematic risk in 2010: the Dubai crisis was a small blip and didn't have a huge effect on the CLO market."

Basu also points to the significant improvement of structural features in CLOs over the past six months and attributes this to effective portfolio management from the CLO managers. "They have had a noteworthy impact on the performance of the deals," he says.

Basu believes triple-A CLOs have the highest potential to show the quickest rise in prices in Q110. Meanwhile, he expects double-As to rise to the high-80s or 90s in the short term (Europe and US respectively), while single-As have the potential to reach the 70s in Europe and 80s in the US.

"Given that the issuance of high yield bonds has been much greater than that of leveraged loans recently, I wouldn't be surprised if the old-fashioned CBOs make a come back in a new format," says Basu.

But not everyone is so optimistic. According to Zeshan Ashiq, founding partner at Shooters Hill Capital, current market sentiment is too bullish.

"The rallies in fixed income asset classes - in particular CLOs - are overdone and I expect to see a readjustment in the New Year," he says. "Seeing single-As in the 70s just doesn't make sense at the moment. Sovereign issues still have to play out: impending downgrades will likely have an impact on securitisation (this has already been seen in Greece). Additionally, unemployment still has to filter through to certain RMBS and ABS, particularly in Spain and the UK."

"A number of bankers are talking up CLO and ABS issuance for 2010, but I don't envisage very much getting done," Ashiq adds. "Maybe five or six CLOs could get done, but these would be balance sheet, Basel 2 or capital relief trades. The ability to issue CLOs will be made difficult due to high liability costs and collateral/loan price volatility. There's also the question of who is going to warehouse the pools and where the triple-A investor comes from, given there's still no substitute for SIVs or monolines."

The absence of a sizeable senior investor base for ABS does remain problematic. According to ABS strategists at BofA/Merrill Lynch, the structured finance markets will continue to face formidable challenges associated with the investor base and the need to grow it internally and internationally in 2010. "[The markets] will seek to find their new supply/demand and pricing equilibrium, while continuing to struggle with legacy bond overhang - new issuance can vary widely between €50bn and €150bn," they note.

Atkins says that while triple-A investors such as ABCP-funded conduits or SIVs are unlikely to return any time soon, he does see a case for banks investing in senior structured finance bonds. "Banks will be debating where to invest cash in 2010 and, given there will be some black holes to avoid - such as sovereign debt - and given that highly-rated corporates are also becoming rarer, a triple-A RMBS with a low bank capital charge doesn't look like the worst option in this scenario, particularly if it is from a jurisdiction without headline risk," he says.

One of the main trends expected in the European structured credit market next year is the consolidation of CLO managers. Movement in this market segment finally started gaining momentum globally in Q409, with notable examples in Europe including KBC Financial Products' sale of its platform to Avoca Capital.

Ashiq suggests that sellers of CLO operations in 2010 could be banks, depending on the leveraged finance business of the bank. He says US managers with European outposts will also be evaluating whether they really need to keep these.

Atkins agrees: "I expect CLO manager consolidation to continue, either on a deal-by-deal basis or with the acquisition of a whole platform. I also see consolidation in some of the newer entrants to the market, such as the brokers or advisories. Bank dealer desks have come back relatively quickly, making operating conditions for the newer brokers increasingly difficult," he concludes.

AC

CLOs

NewStar CLO a "one-off"

The pre-placement of a US$275m managed CLO, NewStar Commercial Loan Trust 2009-1, grabbed the headlines last week. The inclusion of high-yielding middle market loans in the pool appears to have made the deal economically feasible.

The NewStar CLO's capital structure includes a US$150m triple-A tranche, which priced at par with a coupon of 375bp over Libor, as well as a US$40m double-A tranche (which came at a discount in the low-90s to yield 750bp over), a US$30m double-B tranche and an equity piece. Guggenheim is reportedly the main investor in the Wells Fargo-arranged transaction.

Michael Khankin, director of structured credit portfolio management at NewOak Capital, points out that some of the middle market loans underlying the NewStar deal yield over 10% - hence financing about half the cost at just over 300bp over Libor makes sense for the issuer. "The deal is static and short - a balance sheet financing for a player with limited direct access to the capital markets," he says.

Indeed, structured credit strategists at Barclays Capital suggest that the transaction does not augur a return of the CLO market, but is a one-off that could have occurred only with stressed middle market loans. A triple-A tranche of an institutional loan deal paying 375bp in the current environment would be economically impossible.

Given the significant rally in loan prices this year, with many loans trading in the US$80s and US$90s, yields aren't dramatically wider than secondary triple-A CLO spreads. Further, CLO liabilities are generally trading at a discount to the portfolio after taking fees and expenses into account.

Consequently, until triple-A spreads tighten by another 100bp-200bp relative to loans, a deluge of CLO new issuance remains unlikely. "However, I'd think that with the traditional triple-A CLO buyer base having gained a new appreciation for liquidity risks and leverage embedded in structured products over the last couple of years, this may take longer than many would like to anticipate," Khankin concludes.

CS

Regulation

FDIC balks at industry response to reg cap rule

The FDIC last week finalised the regulatory capital rule related to FASB's adoption of FAS 166 and 167. However, most of the securitisation industry's responses to the FDIC's Notice of Proposed Rulemaking appear not to have been incorporated in the final rule.

The aim of the final rule is to better align regulatory capital requirements with the actual risks of certain exposures, according to the FDIC. It notes that banks affected by the new accounting standards generally will be subject to higher minimum regulatory capital requirements.

"I believe this rule moves in the right direction and will reduce the likelihood of a recurrence of some of the problems we have experienced in the financial and securitisation markets," comments FDIC chair Sheila Bair. "The capital relief we are offering banks for the transition period should ease the impact of this accounting change on banks' regulatory capital requirements and enable banks to maintain consumer lending and credit availability as they adjust their business practices to the new accounting rules."

The final rule provides an optional delay and phase-in for a maximum of one year (versus the American Securitization Forum's request for a six-month moratorium and three-year phase-in) for the effect on risk-based capital and the allowance for lease and loan losses related to the assets that must be consolidated as a result of the accounting change. The final rule also eliminates the risk-based capital exemption for ABCP (contrary to the ASF's request for a continuation of the exclusion). The transitional relief does not apply to the leverage ratio or to assets in conduits to which a bank provides implicit support.

Further, Basel 2 was not made available - against the ASF's recommendations - under the new rule as a framework to compute risk-based capital for on-balance sheet securitisations. As ABS analysts at JPMorgan point out, the concern is that the lack of a Basel 2 framework will potentially put US-regulated banks at a capital disadvantage versus their foreign counterparts that can use Basel 2.

The other industry concern is that banks may curtail credit lending as a result of the higher capital cost. ABCP multi-seller conduits may also shift away from the US to European banks.

"The higher regulatory capital costs will definitely factor into lending decisions," the JPMorgan analysts note. "However, with credit spreads continuing to rally, funding costs can still be economical for bank sponsors of securitisations (term and ABCP). Furthermore, the regulatory capital calculation will be specific to and different for each individual banking institution."

They warn that higher regulatory costs will likely be passed through to borrowers - both consumers and corporate - in the form of more expensive credit and diminished credit availability.

Banks will be required to rebuild capital and repair balance sheets to accommodate the new accounting standards by the middle of 2011.

CS

Structuring/Primary market

Reputational capital reviewed post-subprime

The BIS has published a Working Paper entitled 'The risk of relying on reputational capital: a case study of the 2007 failure of New Century Financial'. The report explores the choices and incentives faced by the various types of institutions involved in what are described as the "linked processes" of origination and securitisation.

The author of the paper, Allen Frankel, points out that the bankruptcy court's examination of New Century Financial - one of the largest originators of subprime mortgages - discovered no change, over time, in how that firm went about its business. This is in spite of the quality of newly originated subprime mortgages visibly deteriorating for some time before 2007.

The BIS report consequently employs the court examiner's findings in a critical review of the procedures used by various agents involved in the origination and securitisation of subprime mortgages.

The paper highlights the limited roles played by the originators of subprime loans in screening borrowers and in bearing losses on defective loans that had been sold to securitisers of MBS. It also illustrates the apparent willingness of the management of the institutions that became key players in that market to put their reputations with fixed income investor clients in jeopardy.

"What is perplexing is that such risk exposures were accepted by investing firms that had the wherewithal and knowledge to appreciate the overall paucity of due diligence in the loan origination processes," Frankel notes. "This observation, in turn, points to the conclusion that the subprime episode is a case in which reputational capital - a presumptively effective motivator of market discipline - was not an effective incentive device."

CS

Investors

Leveraging experience

Sara Bonesteel, head of alternative products, and Mike Collins, senior investment officer and credit strategist at Pramerica Fixed Income Management, answer SCI's questions

Q: How did Pramerica become involved in the structured credit market?
SB: Pramerica has been involved in fixed income for more than 100 years. Our management of fixed income goes back to 1875. In terms of structured credit, we have managed CLOs/CBOs since 2001 and we currently have 23 deals under management and have around 40 people in our leveraged finance and CLO teams.

Our engagement in this market is quite extensive. We started our work on CLOs in the US, but in 2005 we began managing European CLOs. We now have a number of European or hybrid CLO portfolios (Euro/US) under management. We found this was a natural extension of our existing capabilities in high yield and in credit.

MC: We are a very large credit shop - we manage nearly US$100bn between corporate bonds and HY bonds and leveraged loans (as of 30 September 2009). We already had a very deep infrastructure in terms of credit research and credit selection and portfolio structuring skills, and we thought we should leverage that by growing into the structured products and CLO businesses.

Q: What are the firm's key areas of focus today?
MC: In traditional businesses, we've seen the pendulum swinging back from some of the more esoteric products, which include some of the structured products and hedged vehicles. Investors seem to be favouring some of the more traditional fixed income products and our investor base consists of large institutions around the globe, big companies and state and government pension plans.

We're seeing a lot of interest from these types of investors in traditional fixed income products, whether they are enhanced index products going against the Barclays aggregate bond index, or short duration corporate bonds in order to increase yields vis-à-vis money markets. In particular we're seeing a lot of interest in credit-related products, whether they're high yield, emerging market debt or investment grade corporate bonds.

We're also seeing strong demand from corporate pension plans for long-duration corporate bonds. The demand side of the equation has really shifted into traditional fixed income vehicles and we're well positioned for that.

Q: What has been the most transformative change in the credit markets in 2009?
SB: The liquidity-driven proliferation of structured products over the past five years has been a very significant factor in the market, followed by the bursting of the credit bubble. Although this bubble clearly caused a lot of harm, it has also provoked a lot of changes that from an investment mentality are very healthy, such as the reversion to the basics, getting back to fundamental credit research and truly understanding what you're buying.

We're also seeing a big uptick in the amount of due diligence and transparency that are demanded by investors and I think that's ultimately healthy for end-user investors as well and for the market as a whole.

MC: I don't know if it's transformative or more cyclical in nature, but the bursting of the credit bubble has forced investors to reduce leverage and reduce reliance on leveraged products because it's more difficult, if not impossible, to get leverage in certain areas of the market. Long-only products have come back into vogue.

But that's not to say that the pendulum won't start swinging back the other way. The strong performance of the credit markets, the access companies now have to credit markets and the strong demand for yield are already bringing increased interest to leveraged vehicles again.

We're seeing Wall Street firms offer total-return swap products; we're getting more queries into synthetic collateralised vehicles using CDS and ultimately it seems the CLO market will probably come back to life as well. Even though there have been a lot of defaults through the down-part of the cycle, recoveries have started to pick up and leveraged loans and bank loans are migrating towards par, which adds credence to the rebound in the CLO market.

SB: It's our view that there will be a CLO market in 2010. There are, to our knowledge, a number of parties that are working on these deals that will close in 2010.

I think we should expect lower leveraged deals, with initial deals being 'clubby'. There will be a transaction that is just one step out of a TRS. For example, if a bank will offer you three- or five-year funding on a TRS, it's not so far from there to go and get term funding in the form of a CLO - even if it's a very simple two- or three-tranche structure that might be only three- or four-times levered.

MC: The thing that has surprised us most in this cycle is how fast it happened - both on the way down and on the way back. This year alone we're going to see a record amount of new gross issuance in IG and HY corporate bonds. The European markets are picking up with a vengeance as well.

Q: Will Pramerica be involved in CLO manager consolidation?
SB: We have recently taken on management of a CLO where a key-man provision had been breached. We were contacted initially by an investor who didn't have control of the replacement manager assignment, but that investor recommended us to the investor that had the control over the appointment. We worked closely with the equity investor in this case and were able to show him our ability to manage the portfolio and get the assignment.

There are several other opportunities out there currently that we're working on and we see this as an area where we have a strategic advantage. We have a critical mass of deals on our platform already and have the added experience of coming in as replacement manager on deals back in the 2004 cycle of consolidation.

We go through an extensive process when we're looking at a portfolio to take on, which starts with triaging the existing portfolio, but also extends into looking at trading strategies before making suggestions for potential amendments that could be made to the deals to make them perform. We don't intend to be a passive manager. We come with ideas to improve the performance.

Q: What is your strategy for 2010?
SB: We can expect to see further manager replacement opportunities. I think this round has taken a lot longer than expected and the improvement in the market is what is encouraging some management platforms to trade now.

I think to the extent that new employment opportunities are opening up for individuals in smaller platforms, the motivation to hang on to a small number of deals diminishes - that dynamic has been very helpful in getting the consolidation process started. We'll have to see what happens in 2010 and whether that will continue, but I think it will at least for the first part of the year based on some situations that we're seeing.

In addition, we are looking at opportunities to manage new portfolios. I believe the CLO product is going to be proven out - if not in the highly leveraged form, then in the low leverage form.

When we look at our portfolio of deals, our low leveraged deals actually performed quite well through the crisis last year and the lowest levered deals did not turn off cashflows to any classes. That is going to be our touchstone - it's not the product in itself that's flawed: it is possible to create a structure that can withstand a lot of stress and create attractive tranches for investors.

Q: Do you envisage that new rating agency standards will cause difficulties in the new-issue CLO market?
SB: It helps that everyone's perception of acceptable leverage has fallen. Anyone that expects to get a senior bond rated triple-A (or attract potential buyers) if it has subordination comparable to the 2007-2008 era will find it difficult. The trick will lie in being able to create an attractive senior bond for senior investors and generating enough return for the equity investors.

Q: Which key trends do you expect to see in 2010?
MC: Broadly speaking, we see the economy on a sustainable recovery path - albeit one that will probably not result in strong growth. In the credit market, fundamentals should continue to improve and spreads in corporate bonds, HY bonds and bank loans - which are still wider than their general averages - will gradually grind tighter.

There should be a more sanguine, low volatility environment for structured product investors. The one caveat to that would be if the US Fed starts increasing rates. We think the market may have temporary setbacks too from 'growth-scares', where there is a knee-jerk fall back in fixed income markets - whether that be in the mortgage market or at the front-end of the treasury curve, but we think this will be a temporary phenomenon.

SB: In terms of the regulatory environment, it may remain very volatile. Already we've been warned of a number of potentially troubling changes that could affect structured credit - FAS 167 has caused a lot of concern, for example.

Although some of that fear has now simmered down, I think we'll continually face challenges that could impact the business. However, not all of them will necessarily ultimately come into effect.

MC: Regulatory reform, in our experience, tends to be eventually quite watered down. Our view in general is that it's not going to be a game-changer for the high yield market or for our products.

AC

CDO

ABN replaced on another two synthetic deals

ABN AMRO Bank has been replaced by BNP Paribas as issuer account bank, forward payment bank, reserve account bank and Dutch tax account bank on the Amstel Securitisation of Highgrade Exposures 2006 and 2007-1 transactions. This follows the downgrade of ABN AMRO by S&P earlier this year, with BNP Paribas being appointed as replacement entity across several Amstel balance sheet synthetic CDO transactions. The amendments affecting the two issuers are generally consistent with those in connection with the September 2009 amendments to another three Amstel transactions (Amstel Corporate Loan Offering 2006, Amstel Securitisation of Contingent Obligations 2006-1 and Amstel Corporate Loan Offering 2007-1).

Moody's has determined that the move will not cause the deals' ratings to be reduced or withdrawn.

CDPCs

CDPC completes block trade

Primus Guaranty has purchased one million of its common shares in a privately negotiated transaction with one of its largest shareholders. The CDPC agreed to pay US$3.20 per share, for a total cost of US$3.2m.

The block trade was conducted under the firm's previously announced share and debt repurchase programme. All shares purchased under the programme will be retired.

Since the repurchase programme's inception in 2008, Primus has purchased 7.9 million of its common shares for a total cost of approximately US$13.3m and 1.2 million of its 7% senior notes for a total cost of approximately US$11.5m.

CDS

Broadreach hires FI specialist for global markets push

Broadreach Group has hired Michael Nelson to build the firm's global markets search practice. Nelson joins as a partner and co-head of the global markets search practice and will lead the rates and credit asset classes.

Nelson's areas of expertise include fixed income and derivatives markets, rates, credit, MBS and real estate finance. Prior to joining Broadreach, he founded his own search firm based in New York City. Prior to his own firm, he held senior positions with two other prominent search firms based in New York City - Whitney Group and Options Group.

Prior to entering the executive search industry, Nelson was a trader in the fixed income markets and was a former CBOT member and a Treasury bond trader in Chicago.

Investors

Another TCW official joins DoubleLine

Ronald Redell has become the latest high-profile TCW official to join DoubleLine, the investment manager established by Jeffrey Gundlach and Philip Barach (see last week's issue). Redell was president and ceo of TCW Funds and TCW Strategic Income Fund, and has joined DoubleLine to develop its planned suite of mutual funds.

"Ron Redell was instrumental in growing the brand of TCW mutual funds, which became dominated by fixed income funds," Gundlach comments. "I've known Ron for many years and tremendously appreciate the support he gave to what is now the DoubleLine team in making the TCW Total Return Bond Fund one of the fastest growers in assets under management in the industry. I know that Ron's experience and professionalism will ensure that DoubleLine's future suite of products is successfully launched, distributed and administered in the years ahead."

Redell will work closely with Louis Lucido, a principal of DoubleLine, in establishing the company's complex of mutual funds across an array of fixed income sectors and strategies. During Redell's tenure at TCW, managed assets of the TCW mutual funds grew from US$1bn to nearly US$16bn.

Investors

Credit fund manager hired

Insight Investment has appointed Adam Mossakowski as a credit fund manager within its fixed income team. He joins Insight from F&C, where he was responsible for a range of institutional and retail funds. At Insight, Mossakowski's focus will be on UK portfolios, reporting to Peter Bentley, head of UK credit.

Adrian Grey, head of fixed income at Insight Investment, says: "Adam's arrival further strengthens our credit fund management capability and underlines our commitment to providing high quality credit management solutions to the UK market place."

Mossakowski has almost a decade of investment experience, spent mostly at F&C, but also at AXA Investment Managers.

Investors

Alternative investment firm names md

NIR Group has hired Robert Cohen as md, based in the firm's Roslyn headquarters. Cohen is responsible for overseeing operations and business development for the alternative investment firm.

Corey Ribotsky, managing member and head portfolio manager of NIR, says: "Bobby has a proven track-record in managing and building a successful firm in the financial services sector. We are confident that he will add significant value to us as we continue to build our operation."

Most recently, Cohen was md of Hudson Securities, based in Jersey City, NJ. For 15 years Cohen was founder and president of Robert Cohen, a full service brokerage firm specialising in investment banking, research and market-making with offices in Great Neck, NY and Greenwich, CT.

Investors

Final PPIF closes

The final pre-qualified PPIP fund manager, Oaktree Capital Management, has completed an initial closing of its Public-Private Investment Fund (PPIF). Oaktree has partnered on the PPIF with Arctic Slope Regional Corporation, a small and minority-owned business based in Alaska.

To date, nine PPIFs have completed initial and subsequent closings on approximately US$6bn of private sector equity capital, which has been matched 100% percent by the US Treasury - representing US$12bn of total equity capital. The Treasury has also provided US$12bn of debt capital, representing US$24bn of total purchasing power for legacy securities under the PPIP.

Following an initial closing, each PPIF has the opportunity to conduct additional closings over the following six months to receive matching Treasury equity and debt financing, with a total Treasury equity and debt investment in all PPIFs equal to US$30bn (US$40bn including private investor capital).

Legislation and litigation

Canadian third-party ABCP settlement reached

Canada's Autorité des marchés financiers (AMF), the Ontario Securities Commission (OSC) and the Investment Industry Regulatory Organization of Canada (IIROC) have reached settlements in connection with their investigations into the Canadian ABCP market, providing for the payment of C$138.8m in administrative penalties and investigation costs. Settlements were reached between the regulators and the seven institutions involved in the Canadian third-party ABCP market.

The penalties and investigation costs are split between: National Bank Financial (C$75m); Scotia Capital (C$29.27m); CIBC (C$22m); HSBC Bank Canada (C$6m); Laurentian Bank Securities (C$3.2m); Canaccord Financial (C$3.1m); and Credential Securities (C$0.2m).

The three regulators say that a "fair and appropriate" use for the sanction monies will be determined in accordance with applicable laws, court orders and in the public interest. In addition, the sanctions approved by the respective organisations include a focus upon compliance: each institution agrees to have an independent compliance review or verification of its fixed income department undertaken by an outside consultant.

The OSC has reached two settlements: one with CIBC and the other with HSBC. IIROC has reached three settlements, with Scotia, Canaccord and Credential. Finally, the AMF has reached two settlements - one of which is with NBF and the other with Laurentian.

Five of the institutions involved are alleged to have failed to adequately respond to issues in the third-party ABCP market, as they continued to buy and/or sell without engaging compliance and other appropriate processes for assessing such issues. In particular, they did not disclose to all their clients the 24 July email from Coventree providing the subprime exposure of each Coventree ABCP conduit.

In the case of Credential and Canaccord, these institutions are alleged to have failed to take adequate steps to ensure that its 'approved persons' understood the complexities of third-party ABCP and, in not taking these adequate steps, did not ensure that the purchase of third-party ABCP was appropriately understood by its clients.

The enforcement review activity related to the ABCP matter is the product of a close collaboration among the AMF, the OSC and IIROC, who worked together in the public interest to respond to the securities regulatory issues arising from the ABCP market freeze. The OSC and IIROC have begun disciplinary hearings against Coventree and Deutsche Bank Securities in this matter.

Legislation and litigation

Canadian bank fined for pricing errors

The UK FSA has fined Toronto Dominion Bank (London Branch) £7m for repeated systems and controls failings around the pricing of structured credit products - forcing the bank to make a negative adjustment of C$96m in July 2008. This is the bank's second fine for systems and controls failings and the fourth largest levied by the FSA.

The breaches relate to pricing issues that were uncovered on a proprietary trader's books within Toronto Dominion's credit products group. Among other failings, the FSA found that the bank failed to follow its established procedures in ensuring the trader's books were independently verified and did not have adequate controls in place, which could have detected the pricing issues.

In November 2007 Toronto Dominion was fined £490,000 when a fixed income trader, Simon Brignall, attributed false values to his trading positions and created fictitious trades to hide significant losses on his book.

Margaret Cole, FSA director of enforcement and financial crime, says: "This is one of our largest fines and it underlines the seriousness with which the FSA views repeat offences. When we uncover failings in a firm, we expect them to put it right immediately and to take special care to ensure it does not happen again. Toronto Dominion clearly failed to apply proper controls in this area, despite its previous sanction, and repeat offenders need to know that they will face severe consequences."

She adds: "It is important that firms trading in sophisticated and often illiquid financial products have robust controls in place, particularly in times of increased market volatility. Where a firm doesn't do this the FSA will take action."

Toronto Dominion cooperated fully with the FSA and agreed to settle at an early stage of its investigation. Without the discount, the fine would have been £10m.

Toronto Dominion's senior management promptly commissioned a thorough review of the matter, as well as a wider review of its systems and controls framework and business strategies.

Listed products

Permacap bolsters CLO coverage tests

Greenwich Loan Income Fund (GLIF) has acquired a senior secured corporate loan from T2 Income Fund CLO I. The cash consideration for the acquisition was US$8.55m, funding for which was provided by the company's recent equity capital raise (SCI passim). The loan has paid a cash interest of approximately US$675,000 over the past four quarters, based upon a variable interest rate of 625bp over Libor.

While on a consolidated reporting basis there is no net impact on the company's balance sheet, the acquisition could improve the CLO's likelihood of being in compliance with certain principal coverage ratios and the interest diversion test on the next payment date in January 2010 and will have the effect of increasing the probability of the company receiving future interest payments from the CLO. However, the probability of receiving any payment remains uncertain, the company notes.

In the announcement of the CLO collateral coverage and interest diversion test results on 17 November and 14 December, it was stated that a downgrade of an investment had resulted in a significantly lower carrying value for the purposes of calculating the CLO tests. The purchase of this investment by GLIF, at a value determined by an independent valuation firm as being fair value, significantly improves the CLO tests.

The CLO indenture contains a variety of covenants, compliance with which could be made more difficult or impossible, should credit markets deteriorate or the loans held by the CLO fail to make expected payments or otherwise not perform and which - if violated - could result in further principal paydowns and/or interest diversion. Should there be additional downgrades or defaults, the acquisition may prove to be insufficient to satisfy the collateral coverage and interest diversion tests at that time.

Any cash held within the CLO is generally unavailable to the company prior to the maturity of the CLO (with the exception of any quarterly interest payments received). The GLIF board notes that the acquisition was consistent with the stated objectives of the company's recent equity capital raise.

RMBS

Mortgage solutions provider names two to board

Richard Santulli, former chairman and ceo of NetJets, has joined the board of Loan Value Group as chairman. At the same time, Michael Goodman, former ceo of J.G. Wentworth, has joined the board through Corridor Quadrant's ownership position in Loan Value Group and will also take an active role as managing partner.

Loan Value Group ceo Howard Hubler, former head of Morgan Stanley's global proprietary credit group, comments: "Richard Santulli and Michael Goodman bring enormous credibility in creating and implementing innovative business and consumer solutions. They join a senior management team with more than 20 years of high level, hands-on experience in the mortgage, credit and asset-backed markets."

With an estimated 29% of all US mortgages, or 15 million homes, currently in a position of negative equity, the issue of strategic mortgage default is fast becoming one of the biggest problems facing mortgage security investors, loan owners and servicers. Loan Value Group works with owners of mortgage risk and servicers to positively influence consumer behaviour to help reduce the risk of strategic default in their mortgage portfolios. Using patent-pending technology, Loan Value Group provides a variable cost, highly scalable, turn-key platform designed to identify, assess and combat strategic default.

"Because strategic default is a discretionary, rational decision made by the homeowner, an effective solution must provide incentives for the homeowner to choose not to default, rather than subsidies to enable them to make payments," Hubler explains. "In doing so, our programme aligns the interests of the borrower with the mortgage owner. At the same time, it meets the needs of other important stakeholders in the current mortgage crisis, including regulators and the government as well as local communities, by lowering default risk and helping to stabilise the very neighbourhoods in which we live."

Technology

Trustee acquires structured credit analytics provider

BNY Mellon has acquired Portsmouth Financial Systems, a developer of modelling and analytics of structured credit transactions.

"This acquisition will allow us to provide clients and investors with a greater level of transparency around their structured credit holdings," says Patrick Tadie, evp and head of global structured credit at BNY Mellon Corporate Trust. "It will enhance their analysis and decision-making capabilities by providing them with an independent, centralised source of data and extensive modelling tools."

The acquisition of Portsmouth Financial Systems will allow BNY Mellon to offer a new service with a variety of features, including allowing clients and investors to review actual or predictive security cashflows, to access loan-level historical data analysis and cashflow scenarios, and to plug-in default and prepayment modelling.

BNY Mellon says the new service will initially focus on analysis related to US RMBS, growing over time to include other structured assets globally.

Technology

Data provider reorganises leadership

Market data provider Xtrakter has announced a series of changes to its leadership team, which will take effect from January 2010. Yannic Weber will become the new ceo for Xtrakter, replacing Kevin Milne, who will step down from the role to pursue interests outside the Euroclear group.

In addition, Chris Spires will step down as Xtrakter's cfo and from the organisation's leadership team in order to join the Euroclear group's finance division.

Weber will continue as ceo of Euroclear UK & Ireland (EUI) and EMXCo, sister companies to Xtrakter within the Euroclear group.

Under the organisational changes, Graeme Austin, director of product management & marketing, will also take on the new role of chief analytics officer, while retaining marketing responsibilities for the firm going forward. Jason Waight, head of product management at EUI, will join the Xtrakter leadership team and incorporate responsibility for Xtrakter's product and service developments into his existing portfolio.

Tim May, Xtrakter's chairman, notes: "We are very excited to begin this new phase in Xtrakter's development as part of the Euroclear group. Kevin and his leadership team have achieved success in transforming Xtrakter from a market services division within a trade association into a world-class fixed income service provider. We wish Kevin all the best and look forward to delivering more client benefits under the new leadership team."

Trading

Broker hires pair of securitisation vets

RAIT Financial Trust's broker-dealer subsidiary, RAIT Securities, has recruited two seasoned securitisation professionals - Steven Lewis and Daniel Hill. The pair brings market experience, combined with broad institutional issuer and investor relationships to help support RAIT Securities' strategy of growing its institutional fixed income sales and trading business.

Lewis joins RAIT Securities as an md and co-head of the firm's Charlotte, NC office. He spent the last 25 years at Wells Fargo Securities and its predecessor companies: Wachovia Securities and First Union Capital Markets. Most recently, he was an md in Wells Fargo's structured products fixed income sales group, focused on commercial real estate, asset-backed and CDO securities.

Hill joins RAIT Securities after 27 years with Merrill Lynch. He held a number of leadership roles at the bank, including head of LOC-backed CP trading and head of ABCP trading. Most recently, he acted as producing manager of Merrill Lynch's global money markets trading and marketing business, which encompassed all sectors of US and Euro CP, and asset-backed MTNs.

Scott Schaeffer, ceo of RAIT Financial Trust, says: "It's very exciting that market professionals of this caliber joined RAIT. Their hiring demonstrates RAIT's dedication to providing our clients with excellent sales and trading services."

ABCP

Royal Park SPV to begin arbitrage issuance programme

S&P has assigned an A-1+ credit rating to the short-term notes to be issued by Royal Park Investments Funding Corp (RPI FC), a fully supported arbitrage issuance programme backed by the portfolio of structured credit assets that the Royal Park SPV acquired from Fortis Bank in February (see SCI issue 122). The rating agency says that it is not, at this time, assigning a rating on any European CP that Royal Park Investments (RPI) may issue.

The Royal Park programme involves two issuing entities. RPI FC is established under Delaware law, is 100%-owned by RPI and will issue US dollar-denominated short-term notes to the US CP market. RPI also plans to have the capacity to issue European CP into the European market via the Belgium (XN) exchange, subject to confirmation from S&P that the issuance will not affect the rating on the programme.

A key distinction is that the European issuer will be able to issue CP, whereas RPI FC will issue short-term notes. The purpose of the programme is to repay the US$5.9bn and £236m bridge facility established between the Royal Park SPV and Fortis Bank when the portfolio was acquired.

Under the programme, RPI will issue 'registered' notes of up to US$5.85bn under a purchase agreement with RPI FC, which will fund the registered notes by issuing short-term notes into the US CP market. RPI will guarantee RPI FC's obligations under the programme, although S&P's rating does not place any reliance on this; the key guarantee is that of the Kingdom of Belgium.

The Royal Park SPV acquired €20.5bn nominal value of assets from Fortis Bank for €11.7bn. The portfolio comprises: €7.5bn-equivalent US RMBS, private and FFELP student loan ABS, CLOs, CDOs and ABS; €1.1bn-equivalent US ABS CDOs; and €3.1bn of European RMBS (predominantly Spanish and UK), CDOs and ABS.

CDS

'Empty creditor' hypothesis dismissed

ISDA has published an analysis of the issues and implications raised by the 'empty creditor' hypothesis, which relates to the effect of hedging credit risk on the behaviour of creditors in distressed institutions. It posits that creditors who hedge their exposures using credit default swaps are indifferent to a firm's survival. Others have extended the hypothesis to suggest that hedged creditors might benefit from a distressed firm's failure and prefer that such firms file for bankruptcy rather than engage in a work-out while remaining solvent.

The analysis is contained in the quarterly 'ISDA Research Notes', authored by David Mengle, ISDA head of research. "The empty creditor hypothesis has generated significant interest in the press and among legal practitioners," says Mengle. "Because it could influence future regulatory policy, it is important to analyse both the logic and the evidence in support of and against it. The hypothesis is not consistent with the way CDS work or with observed behaviour in debt markets."

The Research Note states that although hedging might affect behaviour because it changes risk exposure, it also involves a foregone opportunity to maximise the upside of an investment. Only if such hedging could lead to systematic opportunities that might distort economic behaviour or the functioning of legal institutions should it be treated as a cause for concern.

The analysis segments the hypothesis into three specific and operational hypotheses: exercise of contractual rights prior to bankruptcy; exercise of legal rights within bankruptcy; and negative economic ownership. The first hypothesis implies that hedged creditors are less likely to approve an out-of-court restructuring than unhedged creditors.

If the ability to hedge using CDS tends to make restructurings less likely than when the hedge was not available, the number of restructurings as a percentage of credit defaults should be lower when CDS are available than when they are not. Data shows this figure at about 9% over the entire sample period from 1984-2009. But restricting the data to the period of liquid CDS markets from 2003, restructurings as a percentage of credit defaults jumps to 90%, which does not support the hypothesis.

According to the second hypothesis, hedged creditors are indifferent to the value of the firm after bankruptcy, which leads to inefficient decisions on restructuring versus liquidation. But the analysis notes that this hypothesis seems implausible.

After settlement of CDS contracts, hedged creditors have been compensated for their losses and have the choice of either selling the defaulted bonds at the current price or retaining the bonds and engaging in the bankruptcy process. Rational bondholders in this case have incentives to maximise recovery values.

Finally, the third hypothesis implies that prior to bankruptcy, hedged creditors will not only be indifferent to the value of the distressed firm, but might even benefit from failure by building up CDS hedges for which the face amount exceeds the face amount owned. The Note states that it is not possible to determine from available data whether overhedging is a significant activity, or indeed if it occurs at all. But the paper presents actual examples that demonstrate the high expense and low returns that such a strategy would generate, from which it is reasonable to question the plausibility of this hypothesis.

CDS

Credit risk in bank trading books continues to decline

The Office of the Comptroller of the Currency reports in its latest 'Quarterly Report on Bank Trading and Derivatives Activities' that credit risk in bank trading activities continued to decline in Q309. Net current credit exposure (NCCE), the primary metric the OCC uses to measure credit risk in derivatives activities, decreased by US$70bn (or 13%) to US$484bn.

"As financial markets have stabilised, credit spreads have narrowed considerably and that has helped to reduce counterparty credit exposures," explains Kathryn Dick, the OCC's deputy comptroller for credit and market risk.

She notes that in 2008 crisis-related declines in interest rates and widening of credit spreads had caused the NCCE to reach US$800bn in the fourth quarter. "Current credit exposures are now 40% lower than at the peak of the crisis," Dick adds.

US commercial banks reported trading revenues of US$5.7bn in Q309, compared to US$5.2bn in the second quarter. "The return to more normal financial market conditions has allowed banks to generate more consistent trading revenues this year," Dick continues. She notes that the business of providing risk management services to help clients manage risks remains an important part of a bank's product set.

The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$804bn (or 0.4%) in the third quarter to US$204.3trn. Interest rate contracts increased by US$700bn to US$173trn, while credit derivatives fell by 3% to US$13trn.

The report also notes that:

• Banks hold collateral to cover 64% of their NCCE. The quality of the collateral is very high, as 82% is cash.
• Derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 97% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%.
• Credit default swaps are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.
• The number of commercial banks holding derivatives decreased by 45 in the quarter to 1,065.

CDS

Temirbank failure to pay determined

ISDA's EMEA Determinations Committee has ruled that a failure to pay credit event occurred on 8 December in respect of Temirbank. No auction will be held to settle CDS written on the entity, however.

CDS

Teamsters weigh in on CDS regulation

Teamsters Union general president Jim Hoffa has sent letters to the US SEC, state Attorneys General, state insurance officials and Congressional leaders on financial industry oversight, calling on regulators to review what he describes as the questionable promotion of credit default swaps for truck company YRC Worldwide. Hoffa is urging the oversight bodies to investigate firms that underwrite and/or market basis packages that consist of YRCW bonds and CDS.

"Certain financial firms have been or are marketing and/or underwriting a strategy where bonds in YRCW would be bought by investors with the intent of voting against the exchange, thereby triggering a bankruptcy that would pay the investors and possible other financial firms huge profits from the high CDS payments which would be triggered by a YRC bankruptcy or liquidation," Hoffa writes in the letters. "The profit from the YRCW CDS would far outweigh losses from the failed YRCW bonds."

The collapse of YRCW would destroy more than 30,000 jobs and the financial stability of tens of thousands of families, according to Hoffa. The Teamsters Union supports policies that would regulate CDS and what it describes as other "shadow financial market practices" currently being considered by Congress, because these instruments and the way they are packaged distort economic incentives and undermine economic recovery, it notes.

Clearing

ICE begins US single name CDS clearing

ICE Trust US has received regulatory approval to offer clearing services for single name CDS contracts in the US, following the launch of single name CDS clearing in Europe earlier this week (see this week's issue). Twelve firms are reported to have been active in the clearing of CDS trades related to the launch of its buy-side initiative on 14 December.

Single name clearing in the US will commence on 21 December, with the first tranche of contracts referencing companies in the utilities sector. ICE Trust currently clears 31 unique North American CDS index products. The single name reference entities cleared by ICE Trust are components of these indexes.

Dirk Pruis, president of ICE Trust, says: "The addition of single name clearing in the US complements our successful launch this week of buy-side clearing in the US and single name clearing in Europe. To date, ICE has cleared over US$4.3trn in notional value, resulting in US$344bn of open interest, achieving in excess of a 90% reduction of counterparty risk. Combined with increased price transparency, one of the industry's most highly capitalised guaranty funds and the strongest segregation protection available in the market, ICE is bringing important benefits to the CDS market structure."

ICE has developed a proprietary risk assessment methodology specifically for single name CDS contracts, which complements the risk assessment methodology employed in clearing CDS indexes, in recognition of the unique risk profile of single name contracts. The exchange's methodology was reviewed and validated by an independent risk management consultancy and several regulatory agencies as part of the regulatory approval process.

The risk assessment methodology is relied upon to determine initial margin, variation margin and guaranty fund requirements. This customised risk management model, together with ICE's industry-leading process to utilise executable pricing to provide the critical daily settlement prices of single-name contracts, is the cornerstone of its risk management framework.

CLOs

Euro CLO O/C ratios continue to improve

S&P has released its latest European CLO Performance Index report. The month saw an almost universal improvement in O/C ratios, continuing a modest improvement that appeared to have begun in September 2009. This improvement is perhaps due to the recent rally in the loan market, which generally has a positive impact on loan prices, thus potentially reducing the impact of triple-C and defaulted asset haircuts in O/C ratios.

The findings also show that during October 2009 all of the European CLO cohorts, except 2008, experienced an increase in the percentage of assets rated in the triple-C category compared with September 2009. By vintage, the level of assets within European cashflow CLOs rated in the triple-C category, as a percentage of total collateral, in October 2009 was:

• 2004 vintage CLOs: 9.67% of total assets (up from 9.52% in September 2009);
• 2005 vintage CLOs: 10.79% of total assets (up from 9.62% in September 2009);
• 2006 vintage CLOs: 9.06% of total assets (up from 8.09% in September 2009);
• 2007 vintage CLOs: 7.91% of total assets (up from 7.31% in September 2009); and
• 2008 vintage CLOs: 9.27% of total assets (down from 9.63% in September 2009).

In October 2009 all the CLO cohorts, except 2006 and 2008, experienced increases in the percentage of defaulted assets. The percentage of defaulted assets in each underlying collateral portfolio was as follows:

• 2004 vintage CLOs: 6.51% of total assets (up from 5.64% in September 2009);
• 2005 vintage CLOs: 6.01% of total assets (up from 5.74% in September 2009);
• 2006 vintage CLOs: 5.33% of total assets (down from 5.65% in September 2009);
• 2007 vintage CLOs: 5.94% of total assets (up from 5.60% in September 2009); and
• 2008 vintage CLOs: 4.72% of total assets (down from 5.39% in September 2009).

CMBS

CMBS restructured for tax purposes

Credent Limited noteholders have approved a restructuring proposal in relation to the CMBS. The aim of the restructuring is to relocate the place of management of the issuer, and thus its tax domicile, from Jersey to the Netherlands (although its place of incorporation will remain in Jersey).

Credent is a securitisation of a single loan secured by first ranking legal mortgages on a portfolio of out-of-town retail warehouse properties spread across Germany. Being a Jersey entity, the issuer is as a non-German resident lender subject to German non-resident tax liability with respect to interest income on the securitised loan.

Due to changes in the German tax legislation, the deductibility of expenses has been limited since 2009, resulting in a gross taxation of the interest income for the issuer. With the relocation of the tax domicile to the Netherlands, the issuer should be able to benefit from an applicable German-Dutch double tax treaty that provides for full exemption from German tax on interest income.

Within the scope of the approved restructuring, a number of other changes to the existing transaction structure will also be implemented. The shareholding structure of the issuer will be changed by replacing the existing sole shareholder, First Island Trustee, through an orphan SPV under Dutch law - Stichting Credent. First Island Trustee will also be replaced as corporate service provider by a new Dutch entity, Equity Trust.

In addition, the current issuer bank account held in Jersey will be closed and a new bank account will be opened with Lloyd TSB Bank in the Netherlands. Subsequently, for security purposes, a Dutch pledge will be created over this account.

Based on the tax and legal opinions provided, in Moody's view the intended restructuring does not negatively impact the rating on the notes. However, the agency points out that there is a remaining risk that the tax authorities and/or courts interpret the existing tax legislations in the relevant jurisdictions differently than the tax and legal advisors involved in the restructuring.

Such a different interpretation, in particular by the German tax authority or court, could potentially lead to an increased tax and costs exposure for the issuer. If such additional taxes or costs were to arise, this could have a negative rating impact, as the issuer does not have any committed contractual access to any excess cash generated by the property portfolio in order to pay such taxes and/or costs.

Under the loan agreement, the borrower is not obliged to indemnify the issuer for any increased tax and/or costs exposure, particularly if it results from any changes in tax legislations. However, in a non-binding comfort letter, the borrower has indicated its willingness to provide financial support to enable the issuer to pay any tax liabilities that it may incur, in case the German tax authority were to deny the relocation of issuer tax domicile to the Netherlands or the applicability of the German-Dutch double tax treaty.

Moody's also notes that the corporate service provider also performs the function of the cash manager in this transaction. This exposes the transaction to certain operational risk as, even with well performing collateral, a transaction might experience a substantial weakening of credit quality attributable primarily to the non-performance of a securitisation party. Moody's has been informed that there is an intention to introduce a rated entity as a back-up cash manager into the structure, however.

CMBS

Limited CMBS losses likely for US life insurers

Losses on US life insurers' commercial mortgage loans (CML) and CMBS will be less than those of both banks and the general market, according to Moody's. The agency believes that insurers' CRE losses will grow during the medium term. Nevertheless, the high quality of life insurers' CMLs and CMBS investments should make the losses manageable.

Moody's svp Jeffrey Berg says: "In our expected case scenario, we anticipate losses of approximately US$10bn for insurers over the next two to three years, which will dampen earnings, but should not result in many rating downgrades."

US life insurer exposure to CMLs, CMBS and real estate equity is moderate - approximately 16% of invested assets and 150% of regulatory capital. The life industry was much more heavily exposed to the commercial real estate markets 20 years ago when the last CRE downturn occurred.

Berg continues: "Life insurers' portfolios today demonstrate that they have learned from past missteps dealing with commercial real estate."

The report notes that losses on US life insurers' CML portfolios will likely be much lighter than banks' losses on CMLs, as well as CMLs within CMBS deals. Insurers' loans are well-diversified by both geography and property type; they are also conservatively underwritten and well-laddered by maturity, as well as being seasoned loans on fully-stabilised and leased properties.

Moody's cautions that the losses from its stress case scenario - which, it adds, would be a highly remote and unprecedented event - could come to US$40bn-US$45bn. Such a sum would have a major capital impact, resulting in many downgrades - some being multi-notch.

Berg adds: "In recognition of continued deterioration of the CRE market, we have updated our loss assumptions in our stress testing of life insurers."

Moody's increased the average lifetime expected - and stress-case - loss factors for CMLs to approximately 3% (or around US$8bn) for the industry and 10% (or around US$27bn) respectively, from about 2% and 5%, based on its recent publication on commercial real estate. For CMBS, the agency boosted the average lifetime expected - and stress-case - loss factors for CMBS to 1% (around US$2bn for industry) and 8% (around US$16bn) respectively, from 0.7% and 1.4%.

CMBS

Japanese CMBS downgraded

In Q309, S&P downgraded 77 tranches relating to 21 Japanese CMBS transactions and did not upgrade any CMBS tranches. The downgrades mostly reflected the agency's downward revisions of the recovery prospects of loans considered to be in default and the stressed recovery prospects of the loans that were already in default.

In the third quarter, nine underlying loans relating to Japanese CMBS transactions rated by S&P had defaulted. From the second quarter of 2008, when the first loan default relating to a CMBS transaction in Japan occurred, to 30 September 2009, the total number of defaults had increased to 38. Loans that are cross-collateralised/cross-defaulted with other loans are recognised as one loan.

Documentation

Standard coupons introduced for Asian CDS

Market practice changes to the trading convention for credit default swaps in Japan and Asia ex-Japan took effect on 21 December. These changes include the adoption of standard coupons and full first coupons in CDS transactions.

"These changes are a product of industry-wide dialogue and coordinated efforts among ISDA members to promote standardisation, transparency and liquidity in the Asia CDS markets," says Keith Noyes, ISDA regional director, Asia Pacific.

Firms will now trade Japan CDS with standard coupons of 25bp, 100bp and 500bp and full first coupons going forward. Asia ex-Japan CDS will be traded with standard coupons of 100bp and 500bp, and full first coupons.

Over the course of 2009, the industry successfully adopted fixed coupons in North America in April, in Europe in June and in emerging markets in Europe, the Middle East, Latin America and Australia/New Zealand in September (SCI passim).

Documentation

Swap counterparty replaced on Granite notes

Northern Rock has requested that Moody's assess the impact on the ratings of the notes issued out of Granite Master Issuer, following the replacement of the swap counterparty for the outstanding euro-denominated notes in the Granite Series 2006-4 transaction. Goldman Sachs Mitsui Marine Derivative Products has replaced Banque AIG as euro currency swap provider on the deal's Class A7, Class B3 and Class M3 notes, while Goldman Sachs Bank USA becomes euro currency swap provider on the Class C3 notes.

In Moody's opinion, the swap counterparty replacement is rating positive due to the higher long-term rating of the new swap providers compared with the outgoing swap provider. However, the note ratings continue to be linked to the swap counterparties' ratings.

There is credit exposure to Goldman Sachs Group and Mitsui Sumitomo Insurance Co as guarantors of the swaps. According to Moody's published criteria, the risk of default by a guarantor in relation to swap payments is substantially de-linked from structured finance transactions provided that the swap counterparty is required to take suitable remedial action, following a downgrade of the guarantor below certain rating thresholds, and the performance of such remedial action is irrevocably guaranteed by the guarantor.

In Moody's view, since the parental guarantees relate only to "monetary" obligations, they do not clearly guarantee the swap counterparties' obligations to post collateral. For the same reason, the rating agency believes that these guarantees probably do not cover the swap counterparties' obligations to take steps to find third parties that are willing to act as guarantors or replacement swap providers.

Additionally, as the replacement swap counterparties are US-domiciled, a recent US bankruptcy court decision means it is unclear how long the issuer would have to terminate a swap, should a counterparty be in breach of its obligations. In an extreme scenario this could conceivably lead to the issuer terminating a swap before a replacement is found, although it might be expected that a swift attempt would be made to rectify matters, Moody's notes.

Nevertheless, in the agency's opinion, this swap replacement does not impact the current ratings assigned to any of the Granite notes.

Legislation and litigation

LBIE resolution takes shape

The UK High Court this week ruled that the LBIE pre-administration client money pool consists of accounts used by LBIE in order to segregate client money. Under the judgment, the basis for a client's right to share in the client money pool is based on the amount that was actually segregated for the client. The court determined that the pool of client assets that was segregated before the administration can be distributed to clients.

Clients whose trust assets were not segregated, however, cannot share in the pool of trust assets controlled by the Administrators. Their shortfall claims will be treated with other unsecured creditors, according to lawyers at Schulte Roth & Zabel.

The client money pool does not form part of the general assets of an insolvent firm in administration or liquidation. LBIE may not set off debts owed by clients to LBIE against clients' distributions from the client money pool in the absence of an agreement to the contrary.

Meanwhile, parties wishing to be signatories to the LBIE Claim Resolution Agreement - the contractual alternative to the scheme of arrangement proposed by the Lehman Administrators to facilitate the return of segregated client assets to LBIE's creditors and establish a mechanism for closing out certain financial contracts entered into before 15 September 2008 (see SCI issue 155) - must elect do so by 29 December 2009. The CRA will become effective if 90% (in value) of those eligible to become Trust Asset Signatories sign the agreement by the deadline. The CRA will lapse if the 90% threshold is not met.

The CRA applies to two classes of LBIE creditors: TA Signatories and NTA Signatories. TA Signatories are LBIE clients with ownership claims to assets recorded on LBIE's books and records as held in a segregated manner from LBIE's assets, as of 15 September 2008.

NTA Signatories are LBIE clients who do not have ownership claims to trust assets, but who are party to financial contracts entered into with LBIE before 15 September 2008. Financial contracts include any bilateral or multilateral contract entered into with LBIE before that date (whether written or not), relating to one or more transactions or positions of a financial nature, including contracts for the delivery and/or custody of assets.

The Schulte Roth & Zabel lawyers point out, however, that the administrators have identified approximately US$2.1bn of trust asset claims, but only US$1bn of assets held in segregated accounts to satisfy those claims.

Monolines

Assured ratings affirmed

Moody's has confirmed the Aa3 insurance financial strength rating of Assured Guaranty Corp and the A1 insurance financial strength rating of Assured Guaranty Re, although the ratings outlook is negative. The rating agency also affirmed the Aa3 insurance financial strength rating (negative outlook) of Assured Guaranty Municipal Corp (AG Muni).

These rating actions reflect the effect of Assured's capital restructuring and conclude the ratings review of AGC and AG Re initiated on 12 November 2009. Moody's review focused on the successful execution of the monoline's plans to bolster the weakened economic and regulatory capital position of AGC stemming from mortgage-related losses.

Earlier this month Assured disclosed the intention to raise equity and implement inter-company capital support to enhance AGC's capital position. Since then, Assured has completed a US$575m common stock issuance and has indicated a portion of the proceeds have been downstreamed to AGC. Based on discussions with the company, Moody's understands that the remainder of Assured's planned capital support transactions have also been executed, although the specific details have not been publicly disclosed.

The agency believes that these transactions have replenished AGC's capital to a level consistent with the Aa3 rating, while still leaving its affiliates with capital structures appropriate for their own ratings.

The negative outlook for Assured's ratings considers the meaningful remaining uncertainty about the group's ultimate credit losses, including claims on mortgage exposures and its success in putting back mortgage loans to lenders. The outlook also reflects the dislocation in the muni market and recent volatility of Assured's new business volumes, despite limited alternative forms of credit enhancement and virtual absence of financial guaranty competition. In Moody's view, it is unclear how demand for financial guaranty wraps and the monoline's competitive position will evolve once the municipal finance market normalises.

Operations

Portfolio reconciliation feasibility study released

ISDA has published its 'Feasibility Study: Extending Collateralised Portfolio Reconciliations'. The report is intended to enhance understanding of the potential for a wider adoption of portfolio reconciliation across the industry.

"While portfolio reconciliation is clearly a subject of interest in the privately negotiated derivatives industry, actual take-up across the broader community is still relatively nascent," says Julian Day, head of trading infrastructure at ISDA. "The level of engagement on this topic has been encouraging and productive. To this end, buy-side and sell-side firms will work collaboratively and with vendors to identify solutions to support a wider rollout of portfolio reconciliation during 2010."

The study discusses the considerations that exist for expansion of a frequent reconciliation for collateral portfolios beyond the group of 15 major dealers that regularly report progress and commitments relating to industry infrastructure projects. It has been undertaken by representatives of dealer and buy-side firms under the guidance of the ISDA Collateral Committee.

In July 2008, ISDA and derivatives industry participants made the first of a series of commitments to regulators regarding collateral management, including portfolio reconciliation. These commitments led to significant improvements in market practice towards the goals set by the Counterparty Risk Management Group III (CRMPGIII). Among these improvements was the adoption by 30 June 2009 of a daily portfolio reconciliation standard between the Fed 15 dealer firms.

Daily reconciliation between Fed 15 dealers covers an estimated 60% of the global privately negotiated derivatives industry, across all asset classes. While this is a significant accomplishment in less than a year from the first formal industry commitment, participants are committed to addressing expansion to a broader constituency.

Ratings

Set-off risk approach updated

Moody's has updated its approach for analysing set-off risk in UK securitisation and covered bond transactions.

Edward Manchester, a Moody's svp and author of the report, says: "Moody's has re-assessed the risk that obligors will set-off deposits held with an insolvent originator against payments that they owe under securitised receivables."

The rating agency says that while it is legally possible for obligors to set-off their deposits against securitised receivables, an issuer's exposure to set-off is substantially reduced where obligors are entitled to compensation under the Financial Services Compensation Scheme (FSCS). For each transaction, Moody's estimates the proportion of deposits that will be compensated by the FSCS according to the available data. It points out that the type of data provided can have a significant effect on the assumed set-off exposure.

The report primarily affects UK RMBS, ABS and the structured features of UK covered bonds. In the affected transactions other than credit card master trust transactions, the revised methodology will not have any rating impact, Moody's notes. This is because set-off risk is already either modelled or covered by credit enhancement (without regard to the FSCS).

For credit card master trust transactions, credit enhancement is not specifically sized for set-off and Moody's is assessing the possible rating impact of the revised methodology. Manchester adds: "The impact for each credit card transaction will depend on various factors, including the rating of the originator, available data on obligor deposits, the seller share and the degree of correlation between the credit quality of the originator and the receivables."

Ratings

Tax lien methodology updated

S&P has updated its methodology for rating US tax lien securitisations.

US municipalities impose tax liens on real estate for the non-payment of property taxes, assessments, sewer rents and water rents. The liens can be removed only when the delinquent tax liens, including all interest and penalties, are paid in full, through voluntary redemption by the property owner; write-off by the tax lien holder; or foreclosure and liquidation.

The updated criteria include these notable changes:

• The use of historical performance to assess the lien redemption rates.
• The previous redemption rates now serve as a cap on S&P's updated redemption rate assumptions.
• The introduction of redemption haircuts when the historical performance is worse than the cap on redemptions. S&P bases the haircut on the single-B rating scenario on the historical redemption performance.
• The application of new rating scenario multiples to the redemption haircuts.
• Updated redemption bucket balance thresholds to account for the inflation estimate.
• Use of the tax lien's historical performance to assess the lien write-off rates.
• The use of the previous write-off rates as a floor for the updated write-off rate assumptions.
• The minimum size of the working capital accounts that S&P looks for now depends on the rating scenario.
• The introduction of new broker price opinion (BPO) haircuts that are tied to the underlying property value.
• Clarification of minimum ratings for liquidity providers.
• Clarification of S&P's approach to minimum servicing fees and the inclusion of back-up servicers.

The criteria, which are effective immediately for all new and outstanding tax lien transactions, could either have no impact or increase the minimum loss coverage levels for some transactions, depending on the historical performance information that S&P receives.

Ratings

US rental ABS criteria revised

S&P has updated certain of its criteria assumptions for US rental fleet ABS. The updates focused on the rating agency's residual-value stress assumptions for non-programme vehicles, which are subject to residual-value risk because they are generally sold at the prevailing market price determined at used-vehicle auctions, and its residual-value stress assumptions for vehicles that could be subject to residual-value risk.

In S&P's view, the insolvency-related risks associated with the rental fleet operator and the residual-value risk of the fleet of vehicles securing the asset-backed notes are significant risks in rental fleet ABS transactions. The agency's criteria update addresses the residual-value risk of used vehicles backing rental fleet ABS, and the used-vehicle residual-value stress assumptions (percentage haircuts) that it will apply when stress-testing the collateral values of the fleet backing rental fleet ABS transactions.

One notable change to the criteria is higher, explicit residual-value stress assumptions for rental fleet portfolios to reflect the substantial used-vehicle price volatility witnessed in 2008. S&P believes the magnitude of any downgrades that may result from the application of the revised assumptions will generally be within one rating category.

Real Estate

CRE price declines moderating

Commercial real estate prices, as measured by Moody's/REAL Commercial Property Price Indices (CPPI), dropped by 1.5% in October, as the pace of monthly declines continued to moderate. US commercial property values are now down 36.4% from a year ago and 43.7% from the peak in prices two years ago.

"The pace of declines has tapered off since the large drops measured in April and May," says Moody's md Nick Levidy. "However, further declines are anticipated."

Commercial real estate transactions have been holding steady at reduced volumes throughout 2009, with a small increase recorded in October. During the month there were 407 sales, the second highest monthly total for 2009, and a dollar volume of US$5.4bn - the highest for the year.

Annual indices for the four quarters ending 30 September 2009 show poor performance in New York over the past year, dragging down the eastern office market overall. New York offices saw the largest annual price declines among the three MSA-level office indices in the CPPI. Office prices in New York fell by 38.1% over the past four quarters and have dropped 39.3% overall.

In all, office prices in the East fell 37.3% annually and are now 40.6% from the peak.

Commercial real estate prices are showing their worst performance in the South, where three of the four property types in the CPPI (apartment, industrial, office and retail) recorded annual declines greater than 30%. Apartments in the South saw prices being cut in half over the past year.

Southern California properties saw relatively mild price declines, with no property type measuring an annual decline above 30%.

However, prices on Florida apartments have been falling for the past three years. This year they plummeted by 46.1%, Moody's reports. Florida apartment values are now 51.6% below their peak.

Regulation

Basel releases reform package for consultation

The Basel Committee on Banking Supervision has approved for consultation a package of proposals to strengthen global capital and liquidity regulations, with the goal of promoting a more resilient banking sector. Along with the measures taken by the Committee in July 2009 to strengthen the Basel 2 framework, the proposals are part of its comprehensive response to address the lessons of the crisis related to the regulation, supervision and risk management of global banks.

The Committee's consultative documents cover the following key areas: raising the quality, consistency and transparency of the capital base; strengthening the risk coverage of the capital framework; introducing a leverage ratio as a supplementary measure to the Basel 2 risk-based framework with a view to migrating to a Pillar 1 treatment, based on appropriate review and calibration; introducing a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress; and introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.

These reforms carry forward the 7 September 2009 mandate of the Governors and Heads of Supervision, the oversight body of the Basel Committee. The reform programme has also been endorsed by the Financial Stability Board and by the G20 leaders at their Pittsburgh Summit.

Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, states: "The capital and liquidity proposals will result in more resilient banks and a sounder banking and financial system. They will promote a better balance between financial innovation and sustainable growth."

In addition to the trading book and securitisation reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities. The strengthened counterparty capital requirements will also increase incentives to move OTC derivative exposures to central counterparties and exchanges. The Committee will also promote further convergence in the measurement, management and supervision of operational risk.

The Committee is also reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

The Committee says it is mindful of the need to introduce these measures in a manner that raises the resilience of the banking sector over the longer term, while avoiding negative effects on bank lending activity that could impair economic recovery. To this end, it is initiating a comprehensive impact assessment of the capital and liquidity standards proposed in the consultative documents.

Wellink notes: "Decisions on the final proposals and their calibration will be made only after a thorough analysis of the impact assessment and the comments received on the consultative documents. The Committee will ensure that implementation of the new standards is consistent with financial market stability and sustainable economic growth."

The impact assessment will be carried out in the first half of 2010. On the basis of this assessment, the Committee will then review the regulatory minimum level of capital and the reforms proposed in this document to arrive at an appropriately calibrated total level and quality of capital.

The calibration will consider all the elements of the Committee's reform package and will not be conducted on a piecemeal basis. The fully calibrated set of standards will be developed by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured, with the aim of implementation by end-2012.

Regulation

UK authorities outline CDS plans

The UK FSA and HM Treasury has released a paper that sets out the steps required to address what they have identified as deficiencies within the OTC derivative markets - shortcomings in the management of counterparty credit risk and the absence of sufficient transparency. The report, entitled 'Reforming OTC Derivative Markets: A UK perspective', also highlights further necessary work streams.

The two authorities propose that the following measures need to be implemented or developed to address systemic shortcomings in OTC derivative markets: greater standardisation of OTC derivatives contracts; more robust counterparty risk management; consistent and high global standards for CCPs; international agreement as to which products are 'clearing eligible'; capital charges to reflect appropriately the risks posed to the financial system; registration of all relevant OTC derivative trades in a trade repository; greater transparency of OTC trades to the market; and on-exchange trading.

Under the proposals, the FSA and Treasury intend to work with international regulators and the industry to take steps to identify and agree which products can be further standardised - both in terms of underlying contract terms and operational processes - and ensure that this is implemented on a timely basis. Further, they are working with CPSS-IOSCO and the Basel committees to revise existing CCP standards.

In terms of mitigating counterparty risk, the report states that all clearing-eligible products should be cleared via a CCP and those that aren't should be subject to robust bilateral collateralisation arrangements and appropriate risk capital requirements. But the authorities state that this approach may differ for non-financial firms, given the different nature of the risks they pose to the financial system.

With regard to international agreement about which products are clearing-eligible, consideration must be given to the degree of standardisation, the regular availability of prices, the depth of market liquidity and whether the product contains any inherent risk attributes that cannot be mitigated by the CCP. Once clearing eligible products are identified, regulators should set challenging targets for CCP usage, with active monitoring of progress against these.

Meanwhile, capital charges should be higher for non-centrally cleared trades, according to the paper. The two authorities are working through the Basel Committee to deliver a proportionate approach, with capital charges for exposures to CCPs also being risk-based.

While the report calls for access to better information around prices and volumes to help price formation and market efficiency, it states that this should be calibrated to minimise scope for an adverse impact on liquidity. Consideration should be given to using existing reporting channels to minimise costs.

The FSA and Treasury note that, once these steps have been taken, they do not see at this stage the need for mandating the trading of standardised derivatives on organised trading platforms. "Regulatory objectives of reducing counterparty risk and improving transparency can be achieved by other means and we will review progress of initiatives in this area. Moreover, mandating the use of organized platforms would imply a regulatory imposition of trading structure, which we do not believe is necessary," the paper says.

Regulation

APRA consults on Basel 2 enhancements

The Australian Prudential Regulation Authority (APRA) has released for consultation a discussion paper, accompanied by proposed amendments to relevant prudential standards and prudential practice guides (PPGs), on proposals to enhance the Basel 2 framework in Australia. The consultation package includes proposals aimed at ensuring that the risks inherent in banks' portfolios relating to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying public disclosures.

The proposed changes to prudential standards outlined in APRA's discussion paper include:

• higher capital requirements to capture the credit risk of complex trading activities and the introduction of a stressed value-at-risk (VaR) requirement;
• higher risk-weights for resecuritisation exposures to better reflect the risk inherent in these products and increased credit conversion factors for short-term liquidity facilities provided to off-balance sheet conduits;
• guidance in relation to valuation practices and capture of off-balance sheet and securitisation activities; and
• increased disclosure requirements for securitisations and off-balance sheet exposures.

APRA is also taking the opportunity to propose other amendments to its capital adequacy requirements to clarify existing provisions.

Subject to industry feedback and international supervisory developments, the Authority will release draft reporting standards and forms in the first quarter of 2010 for consultation. It intends to issue final prudential standards, PPGs and reporting requirements giving effect to these enhancements in mid-2010.

Regulation

House of Lords launches derivatives markets probe

The UK House of Lords' EU subcommittee on economic affairs has launched an inquiry into the European Commission's communications on ensuring efficient and safe derivatives markets. The communications in question provide an outline of proposals from the Commission to reform the regulation and supervision of derivatives markets in the EU (SCI passim).

As part of the inquiry, the committee is hoping to receive evidence on the economic benefits and risks associated with derivatives markets and the activities of central counterparties, including how clearing might be regulated. It will also be looking at trade repositories and who should be responsible for operating them.

Baroness Cohen, chairman of the committee, explains: "The Commission's proposed reforms on the regulation and supervision of EU derivatives markets need careful investigation to check if they have got it right. We want to hear from interested parties, so that we can understand properly how the communications would translate into an effectively regulated and supervised derivatives market, and how they would impact upon these markets."

The committee is keen to receive written evidence on this issue from any interested parties by 1 February 2010.

RMBS

US prime jumbo RMBS hit

Moody's has revised its loss projections for US prime jumbo RMBS issued between 2005 and 2008. On average, the agency is now projecting cumulative losses of 3.8% for 2005 securitisations, 8.0% for 2006 securitisations, 10.9% for 2007 securitisations and 12.3% for 2008 securitisations, reported as a percentage of original balance. As a result of the revision, it has now placed 4474 tranches of jumbo RMBS with an original balance of US$234bn and current outstanding balance of US$143bn on review for possible downgrade.

Moody's has already taken widespread rating actions on deals backed by jumbo collateral from the 2005-2008 vintages from March through July of this year. The updated loss projections will have the greatest impact on senior securities issued in 2005, the agency says.

The rapidly deteriorating performance of jumbo pools in conjunction with macroeconomic conditions that remain under duress prompted these actions, according to Moody's. Over the past nine months serious delinquencies (loans 60 or more days delinquent, including loans in foreclosure and homes that are held for sale) on jumbo mortgage pools backing 2005 to 2008 securitisations have increased markedly. Since March, serious delinquencies for the 2005, 2006, 2007 and 2008 vintages have increased to 3.2% from 2.1%, 6.0% from 3.8%, 7.6% from 4.8% and 7.8% from 4.6% respectively (reported as a percentage of original pool balance).

Even though the Case-Shiller index in recent months has reported very modest home price gains, Moody's believes the overhang of impending foreclosures will impact home prices negatively in the coming months. Moody's Economy.com expects home prices to decline by an additional 9% to reach a peak-to-trough decline of approximately 37%.

Adding to borrowers' financial pressure, unemployment is now projected to peak at around 10.6% from previous projections of 9.8% from the first quarter of this year. Both measures are expected to reach their peaks sometime in the second half of 2010, after which recovery is expected to be slow.

To estimate losses, Moody's first projected delinquencies through the second half of 2010. It estimated that the proportion of contractually current or 30-day delinquent loans today that will become seriously delinquent by the second half of 2010 will be 3.7%, 7.0%, 8.4% and 9.4% for the 2005, 2006, 2007 and 2008 vintages respectively.

Growth in new delinquency levels beyond the second half of 2010 is expected to decline with improving economic and housing conditions. To estimate delinquencies beyond 2010, Moody's decelerated the new delinquency rates by 15% for 2011, 25% for 2012, 35% for 2013 and 40% for 2014 and beyond. The deceleration rates reflect home price, unemployment and foreclosure projections beyond 2010.

To calculate the default rate on the projected delinquencies, the agency assumed an average roll rate of 88%. The loss on the loan upon default is expected to be around 50% on average - this is higher than historical severities, as home prices are expected to depreciate further.

In addition, the government's effort to curb loan defaults and foreclosures through loan modification has failed to gain traction - prompting Moody's to reduce the average modification benefit to projected losses across vintages from 15% in March to less than 5% going forward.

On senior securities, the extent of rating actions due to the revised loss projections will vary by vintage. Currently, over 70% of the senior securities issued in 2005 maintain investment grade ratings. Moody's anticipates a majority of these ratings to migrate to Ba/B ratings.

However, over 70% of the senior securities issued in 2006 and 2007 are already rated below investment grade and consequently are expected to experience smaller rating migrations. In general, bonds that have a short estimated life or are supported by other senior securities will more likely see smaller rating transitions. The rated subordinated tranches from 2005 to 2008 vintages have already been downgraded to Ca or C.

Moody's rates securities B2 or higher if they are likely to be paid off under an expected scenario. If a security is likely to take a loss under an expected scenario, it will typically be rated B3 or lower.

Securities with expected recoveries of 65% to 95% are rated in the Caa range. Securities with expected recoveries of 35% to 65% are rated Ca, while securities with expected recoveries below 35% are rated C.

Technology

Use of models in the ratings process clarified

S&P has published a report that summarises its definition of models, briefly describes what its models are used for, and discusses in general terms its view on methods of combining qualitative and quantitative considerations in the ratings process. The report also addresses some distinctions that the rating agency sees between models suitable for ratings analysis and models more suitable for use in valuation, portfolio optimisation and risk measurement.

"The ratings process can involve use of quantitative considerations, such as models, in addition to qualitative considerations," explains Martin Goldberg, senior director at S&P.

The applicable published criteria will, in general, outline the nature of those considerations. And the importance of models in the ratings process varies. Analysis of more complicated debt often calls for more elaborate tools, S&P notes.

"For certain securities, the use of quantitative financial models can be an important tool in the ratings process," Goldberg says.

The models S&P uses are built to embody its assumptions and are specifically designed for use in the ratings process. These models can differ from those intended for other purposes and from those embodying different assumptions. The agency may use these models earlier in the ratings process than qualitative analysis or later, or simultaneously, depending on its view on how best to analyse a particular aspect of credit risk.