Contents

Clearing

Access rights

CDS clearers could face headwinds from industry group

The move to clear more CDS contracts could face some headwinds from a few brokers who claim the road to transparency starts with increased access to the more established clearinghouses themselves. If a newly formed broker group - dubbed the Swaps and Derivatives Market Association - gets its way, there will be fewer clearinghouse restrictions and increased counterparty diversity.

StormHarbour Partners, for one, confirms that it is a member of the Swaps and Derivatives Market Association, but an executive at the company had no further comment. It is, however, understood to be among about 20 firms in the association that include BTIG, Hexagon Securities, Jefferies and Miller Tabak Roberts Securities. Law firm Venable is representing the group in Washington.

But the main clearinghouses and those still attempting to get their clearing legs are also lobbying for their right to charge the membership fees and requirements they say are necessary for sufficient responsibilities in the case of defaults, regardless of whether the price of admittance may seem high, say CDS traders. To become a member of the biggest CDS clearinghouse, IntercontinentalExchange's ICE Trust, participants must have a minimum of US$5bn of tangible net worth - though the requirement may be met by a direct or indirect parent.

Another sore spot debated in the industry is whether a dealer has to be a clearer and a clearer has to be a dealer, which is the case at ICE, notes one trader. There are discussions, he says, taking place in Washington to separate the two roles.

Letting more participants into the clearinghouses will enable markets to operate better for the end-user, the trader says. "Bid/ask spreads will tighten due to the competition, there will be more transparency and it will be cheaper to the end-user," he notes.

"Markets work more efficiently and in a more continuous manner when there are more market participants and more liquidity providers, not fewer," adds James Cawley, ceo of inter-dealer broker IDX Capital.

ICE Trust, which began clearing CDS indices in March 2009, currently has 13 dealers as members. ICE Clear Europe began in July 2009. According to an ICE spokesperson, ICE Clear Europe will soon be launching clearing in Europe for buy-side participants (SCI passim).

But the move from a bilateral contract to a clearing model is still anathema to several participants in an industry that is not known for its openness, says Stephen Bruel, research director at research advisory firm TowerGroup. "It's not an overnight shift."

The smaller brokers do not have much alternative but to lobby against the larger clearinghouses' strict membership requirements, according to one hedge fund manager. Most, he says, do not favour divulging their clients in order to trade through the larger dealers, so they have to alter current methods.

"They are trying to convince Washington to make an exception for them. I don't think it makes sense," he says.

According to TowerGroup's Bruel, the largest dealers do have a concentration in terms of CDS trading volumes. But he notes that is not unique to this asset class or unique to OTC derivatives.

Still, CDS clearing in general has a long way to go. Regardless of the more than US$6.6trn in CDS that has been cleared on ICE Trust as of mid-March, traders and market-makers say a majority of the single name CDS trades and some of the index trades are still not cleared at all.

"It will take time to work itself out. We will not see the true evolution of this for another two to four years," notes Bruel. But he concedes: "A measured step is not necessarily a sign of failure. The goal of the buy-side is not to rush into this as fast as possible."

The larger dealers are also said to be behind some of the stalled initiatives for more clearing. More than actually fighting with smaller dealers over the clearing issue, one buy-side participant says the larger firms are keen to delay progress.

"The large dealers are the ones pushing back, but everyone else wants to see a more vigorous clearing environment," he concludes.

KFH

Investors

Strategy shift

Managers look to relative value opportunities as sov risk prevails

Credit managers are adapting to the new environment in which sovereign risk is king. Many managers have begun to reduce or hedge credit and duration exposure to sovereigns with heightened downgrade or default risk, while the use of relative value strategies exploiting mispricing opportunities emerging between countries and regions are expected to take centre stage.

"The pollution of public sector balance sheets throughout the crisis and the rapidly-rising stock of debt undoubtedly have fiscal implications; however, the world has not yet come to terms with what this really means. Growth expectations are going to have to be managed down," says Luke Spajic, head of European credit and ABS portfolio management at PIMCO. "We see raised short-term uncertainty due to sovereign funding concerns, banks de-levering and corporate industrial's reluctance to spend. Longer term, governments are going to have to find ways to de-lever and this will have global implications."

He adds: "We were underweight peripheral European credits prior to the Greek troubles and we're in no rush to move back. We're very keen to watch how the financial system de-levers."

Fitch's new Credit Asset Management report points out that managers have not only reduced their direct allocation to countries with heightened downgrade or default risk through government paper, but also their indirect exposure; for example, reducing local Spanish banks or Portuguese telecoms and favouring companies that are internationally diversified. More protection buying has also been observed, in an effort to hedge exposure.

Manuel Arrive, senior director at Fitch, comments that although credit managers are reviewing decisions with regard to sovereign risk exposure and in what form they want to take it, it is difficult to determine a common trend in terms of the action that managers are taking. "Fixed income managers don't always express the same view," he says. "For example, some European money market fund managers have completely cut their exposure to Ireland or Portugal, while others have only reduced the tenor of their investments in these countries."

Arrive adds that one of the main themes to expect this year is credit managers refocusing on relative value strategies, such as those exploiting mispricing opportunities that may emerge between countries and regions; for example, US and European credits. "Last year credit managers were playing the recovery, but now that credit markets are less directional and technicals are less strong, managers will look to generate alpha through these channels," he says.

The sovereign risk issue is expected to remain for some time. Indeed, according to Fitch, credit managers believe sovereign risk has the potential to remain a key source of volatility for the duration of 2010, with managers highlighting that sovereign spreads were artificially lowered due to central bank zero interest rate policies and quantitative easing programmes - two drivers which are unlikely to remain in the medium term.

Fitch acknowledges that a prolonged intensification of broader sovereign risk concerns would also lead to greater volatility in risk appetite and interest rates. This may potentially curtail the availability and pricing of credit from banks and the market to the corporate sectors of each of the affected economies.

Meanwhile, incumbent emerging markets have largely demonstrated positive momentum. Many emerging market countries have shown much greater resilience in this crisis compared to previous ones, particularly the larger emerging markets, such as the BRICs economies (other than Russia).

"While performance has not been equal across all emerging economies, notably with weaker performance among many of the smaller emerging economies - including those in Eastern Europe, which have received supranational support (G7/IMF/EU) - key differentiating factors among the better performing emerging economies have included the large stocks of foreign assets and foreign currency reserves accumulated by their central banks," notes Fitch.

The agency forecasts net external debt across the emerging markets to reach -62.7% of current external receipts in 2010. In other words, the position of emerging markets as net lenders to the global economy has contributed to their resilience and momentum.

AC

ABS

Positive signs

European ABS market activity in the week to 23 March

European ABS over the past week has begun to show positive signs of stabilisation and growth, with some claiming that a spring awakening may be underway in the sector. This is evident in both the diversification of recent BWIC bidding and the positive reception for both the recent Volkswagen and NIBC deals (see also separate News story).

One portfolio manager says: "I would say this week has been better than last week. The tone feels a little bit stronger and bids are slightly higher for the most liquid paper. The new issuance market continues to improve. So it definitely feels a lot better than it did a few months ago."

A trader adds that while "the general credit markets have been a bit weaker in the past week, the ABS market is still holding up well and is looking positive in general".

In particular, there has been an increase in BWIC trading. As one dealer explains: "There have been a lot of bid-lists in CMBS and UK non-conforming RMBS paper. I think a lot of focus has been on that to see how those trade because they have obviously tightened a lot compared to the rest of the universe."

The portfolio manager explains that many market participants are trying to take advantage of the better market tone and offload certain positions. However, he is quick to add: "There is no overload yet. The BWICs are going well, but we've seen that if there is no interest in the paper, or if it is a bad bid, people don't sell. I think everything that needed to be sold, is sold. So the pressure to be selling is gone. Only if it's a good opportunity do we see people stepping in and selling positions."

Encouragingly, the BWIC space is showing signs of stabilising as it is no longer dominated by aggressive dealer bids. The trader describes BWIC activity as positive due to increased client involvement. He says: "There is still a strong dealer bid also, but we're seeing a better interest from clients who are participating in BWICs."

The portfolio manager confirms this: "The investor base is diversifying: it's not just banks anymore, we're seeing asset managers and insurance companies stepping in. It's a lot more diversified, which is a good sign as well."

The trader adds: "Usually, when there is an increase in BWIC activity, clients start to ask questions: why are there so many BWICs, why are people selling? But now it is a bit more constructive. People have interest and aren't being scared by the selling. So it's positive in those terms."

In addition, recent new issuance has been received well. Both Volkswagen's Driver deal and NIBC's Dutch MBS XV deal enjoyed a positive investor reception, although Driver has proved to be the more popular of the two.

The trader explains that both deals were well-received in the secondary market. He says: "Driver printed tight and was probably more popular, but I think for both it was quite positive. For the NIBC deal, focus was on the longer tranche and traded around par for a while, but is now trading above par. So it's slightly less positive for NIBC, but generally still positive."

The dealer elaborates on potential reasons for Volkswagen's popularity over NIBC, saying: "I think all the auto deals have generally been well-received for quite a while now, because a lot of people are looking for short duration paper." The trader adds that Volkswagen's success may also be because auto deals are a relative rarity at present.

Perceptions within the market also seem to favour the Volkswagen deal, as many investors recall NIBC's inability to call previous transactions during the financial crisis. The trader confirms: "For investors, it's weighing in that NIBC didn't call a deal in the past - which I think may be causing a little bit of negativity around the name."

The portfolio manager adds: "NIBC is not the strongest name. On the other side, with Volkswagen, it's all short-term maturity loan receivables, so there is no specific call and performance has been great over the past few years - even in the middle of the crisis."

However, the portfolio manager believes that this perception should be expected. He points out: "This has been the case since before the crisis. Auto loan deals have always traded slightly tighter than Dutch deals; not a lot, but relatively speaking. Dutch MBS is pricing at 10 or 11 over, while Driver is pricing at seven or eight over, so it's not that abnormal."

While there is certainly an increase in positive sentiment within the market, the dealer believes that there is some way to go before a full recovery is made. "There's not a huge amount of excitement and activity in the market. It's steady-as-she-goes, but I'm constructive in the medium term," he concludes.

JA

CMBS

Tightening top end

US CMBS market activity in the week to 18 March 2010

Dramatic spread tightening this week on the US CMBS market's benchmark deal, GSMS 2007 - GG10, has many suggesting that investor confidence has returned to the top of the capital structure in this sector. However, concerns regarding the lower end of the stack remain.

One CMBS trader observes: "There continues to be very robust trading in the CMBS market and we've seen continued spread compression. In general we've seen the cheaper paper inside of 400bp, so that's come in dramatically. We've seen a bigger rally in the cheaper paper versus the richer paper: the richer paper still seems to be trading within swaps plus 200bp."

In particular, investors have paid close attention to the dramatic spread compression of GG10, as it remains one of the most liquid and frequently traded deals in the market. Manus Clancy, senior md at Trepp, explains: "GSMS 2007-GG10 has tightened 125bp since early February. It was trading at around 400bp over swaps yesterday [17 March] down from about 525bp over swaps in early February... So it's finally come back to where it was in late September 2008. Whether it breaking the 400bp barrier will be a psychological lift for the market is hard to say, but it certainly seems to be a very positive sign."

Clancy explains the emerging positivity in the CMBS market: "I think that people have generally come to the belief that the top-rated classes, or the classes with the most protection and subordination, will fare OK in this environment... People are more confident that these bonds will be able to ride through the CMBS storm and remain intact."

The trader adds that much of the more recent spread compression is due investors capitalising on the increased confidence and momentum seen within the market. He says: "Part of what is driving the GG10 compression is that some traders are playing the momentum trade - they think spreads are going to compress more and they also want to buy relatively safe bonds. The GG10 has 30% credit enhancement and it's a great way to play the spread compression trade."

He continues: "You're going to get more bang for your buck with GG10 than with a high quality triple-A bond that is already trading close to swaps plus 200bp. Those high quality bonds already have premium dollar prices, so at some point the spreads can't compress that much more. People are continuing to reach for yield - you can still pick up an extra 200bp in GG10 versus higher quality paper."

However, Clancy is quick to point out that market confidence is predominantly within the upper half of the capital structure. He explains: "It's good news at least for the top of the credit stack... There's a lot more confidence, but there are still some concerns at this level - and further south in the credit stack - that losses will be substantial and that many classes will take write-downs over the next couple of years."

The trader elaborates, saying: "The concerns within the market at present are that the fundamentals, the performance of the underlying properties, will trump the technical factors that are in the market today. A small handful of deals could be exposed to some loss and I think those could get cheaper again in some cases, perhaps dramatically cheaper."

As an example, the trader cites the recent foreclosure of the Riverton Apartments loan, which is similar to Peter Cooper Village in terms of both property and loan type. He explains: "Riverton Apartments, a multi-family property in Harlem, was predominantly rent-stabilised and the party bought it thinking that they could flip the property from rent stabilisation to market rents and increase the NOI. They bought it on that assumption and it was financed on that assumption. And when those assumptions didn't hold true, it traded in foreclosure this week for US$120m - the loan amount when it was written was US$225m."

Another issue that remains a concern for the market is the withdrawal of government support from the market. Clancy confirms: "The big issue is that there has been a lot of government backing of the marketplace over the last year or so."

However, he believes that the market will remain resilient. "Although [government backing is] slated to end, we're optimistic that the levels will stay where they are. We don't expect spreads to gap out, even without the ongoing government intervention."

JA

ABS

Boost for Euro primary market

The European primary ABS market received a boost last week, with the public placement of two new deals - Driver 7 and Dutch MBS XV (see SCI issue 175) - and the first single-A plus rated tranche of 2010. However, investors say that more work still needs to be done to improve the sector.

According to Luke Spajic, head of European credit and ABS portfolio management at PIMCO, the European ABS market has seen a number of significant trends over the past year that have - and will continue - to help the market. "Banks have been bidding back their own ABS, a flurry of new deals have appeared - suggesting that the primary market is coming back to life - and there has been an emergence of long-term real money investors. These investors will likely dominate the future buyer base for the asset class," he says.

The VW-originated Driver 7 class A notes were 2.7 times oversubscribed and priced at 70bp over one-month Euribor - the lower end of guidance. The class B notes, rated single-A plus, priced at 165bp over - some 10bp below the price guidance of 175bp area. Those notes were 3.5 times oversubscribed and became the first publicly-placed single-A rated ABS of 2010.

"Clearly, the auto ABS market is currently thriving in Europe and the new generation of auto ABS publicly-placed within the last couple of months has improved impressively from a pricing perspective. The placement of the single-A plus tranche is supporting the price functioning mechanism in the non-senior parts of the capital structure, where bids and offers are still relatively rare," ABS analysts at UniCredit note.

They add: "Current auto ABS deals are being priced at levels comparable to pre-Lehman times... the September 2008 Driver 6 transaction placed just after the Lehman event was placed at plus 90bp for the class A notes and at plus 170bp for the class B notes."

40 investors participated in Driver 7's class A notes and ten in the class B notes. Banks accounted for 46% of the buyer base, fund managers 45%, agencies 7% and central banks 2%. Geographically, the book was split between the UK and Ireland (accounting for 29%), Germany (27%), France (21%), Austria (9%), Holland (4%), Spain (4%) and others (6%). The transaction was marketed by WestLB.

Meanwhile, NIBC, Credit Agricole and Credit Suisse placed the NIBC-originated Dutch MBS XV's two-year class A1 tranche at 110bp over one-month Euribor and the five-year class A2s at 150bp over. UniCredit notes that the originator on this deal is - from a reputational point of view - not among the top issuers on the Dutch market, given the fact that it is a triple-B rated, hedge fund-owned entity which failed to call the SWAFE 1 transactions in February last year (see also separate Market Report).

However, the analysts say potential risks related to NIBC were mitigated by the strong performance of the programme so far and the fact that the originator announced that it will call the upcoming Dutch MBS X transaction in April.

Demand was reportedly high for the short-dated triple-As, but the longer-dated paper was priced 5bp wider than the 145bp area guidance. The short-dated triple-As were bought by banks (50%) and asset managers/insurance companies.

The UniCredit analysts note that attention should be paid to the coupon for the longer-term MBS notes, which are priced over one-month Euribor. "When looking at the current difference between 3mE and 1mE of about 24bp, class A1 seems to be priced very tight at approximately 85bp," they say.

AC

ABS

Marlin, GreatAmerica Leasing eye more ABS deals

Marlin Leasing and GreatAmerica Leasing plan to return to the ABS market, despite the TALF programme for consumer ABS ending this month. Both companies, which were routine issuers before the credit crisis, brought TALF-eligible offerings in recent months.

Marlin, for one, wants again to be a regular ABS issuer, says ceo Daniel Dyer. New deals could potentially be larger than its US$80.7m offering last February, if it has more to securitise at that time, he notes.

GreatAmerica Leasing, similarly, is targeting a visit to the term ABS markets on an annual basis, according to Joe Terfler, cfo of GreatAmerica Leasing. The company brought a US$460m TALF-eligible offering backed by commercial equipment leases last autumn.

Both companies will not be completely relying on ABS markets to raise capital going forward, however. Marlin, for example, has other sources of funding, notes Dyer.

On a panel discussion at an IMN equipment finance conference, Dyer said Marlin received approval to become an industrial loan corporation (ILC), having applied for the charter in 2005. The ILC helps Marlin gain cheap access to capital.

But in January 2009 Marlin successfully converted its ILC charter into a bank. "If we are going to be in the business of banking, let's just become a mainstream bank. So less than a year after launching our bank we applied for full commercial bank status," says Dyer. Marlin Business Bank is now a member of the Federal Reserve.

GreatAmerica Leasing also has a pretty sizable funding cushion, according to Terfler. The company is looking at a committed facility of about 150% of its annual originations. "When factoring in amortisations, we've got more than a year and a half worth of funding, which is what we're looking to have in committed facilities," he says.

Also to mitigate costs, the company has two uncommitted facilities that it has utilised. Terfler notes the uncommitted facilities were two good sources of funding through the recent market disruption.

KFH

Distressed assets

FDIC securities sales leave investors in a quandary

Investors looking to buy whole loan, CMBS and distressed securities being unloaded by the FDIC lately have not exactly been pleased with the process. However, despite the challenges, the chance to make a few quick investing wins is keeping them from walking away just yet.

Calling the current transparency of the documents for sale by the FDIC "lumpy", one investor on an IMN equipment leasing conference panel said "what you end up with is not always as advertised". He added that the way the information on the failed bank assets is presented is difficult for participants to build a business around.

The FDIC's recent sales lists seem to have less colour on the securities than in prior years' auctions, said a second investor, who has bought FDIC assets since the 1990s. He would prefer more of a one-on-one sale with a bank itself, he added.

While the transparency of the documents can be a problem, not having enough consistency is also an issue. Some assets are well documented and others have minimal information, the investor noted. "The FDIC's process is inefficient. You'd probably do better throwing darts," he continued.

The FDIC also encourages information sharing in some aspects of the sale that investors do not favour. When investors have questions over the collateral, it is posted for all to see, which can often hurt a transaction. In this regard, "information sharing is a negative aspect", the investor said.

Brokers involved in the sales are also believed to have different approaches, which is another sticking point for investors. In addition, bidding wars have erupted when bank buyers step in with higher bids than the collateral is worth at the last moment, the second investor noted.

Still, buyers have often caused some of their own problems. Some have often reneged on the amount of capital needed to buy the securities.

Participants often do not have the capital lined up beforehand, which can hold up transactions, the first investor said. In such cases, the FDIC has even blackballed investors from participating in the sale process.

As part of its bidding qualifications procedure, the FDIC checks a bidder's credit history, financial background and funding and whether they have asset management and portfolio management services. Though investors are cautious over the assets, they all agree that the sales will keep coming - especially with over 700 banks on the FDIC's troubled watch list.

KFH

Insurance-linked securities

ILS queue builds

Deutsche Bank will be unveiling a "better version" of longevity bonds in the next couple of weeks, according to Michael Amori, head of longevity derivatives group at Deutsche Bank, speaking at a SIFMA insurance-linked securities conference. The deal is among a bevy of ILS and cat bond offerings expected for 2010, the latest of which - Merna Re II - has begun marketing.

The longevity product is being developed from the trades Deutsche Bank is currently putting on, but they are not based on trades put on BMW (UK) Operations Pension Scheme. In February, Deutsche Bank's insurance company Abbey Life executed a hedge worth nearly £3bn, the largest-ever insurance transaction. No size on the proposed new offering has yet been determined.

More longevity products are expected to develop from the trades in this market as the need for longevity swaps grows, particularly in the UK, says Amori. In May 2009, the first longevity swap in a corporate pension plan in the UK was executed.

"Corporate pension plans are worried about their longevity risk because the size of their risk is very large," says Amori. "There is a lot of potential for this market to become bigger."

Despite the current regulatory incentives in the UK for this market to develop, Amori sees a similar need for these products to develop in other countries. Similarly, a forward calendar for cat bond issuance in 2010 could total US$4bn, and possibly as high as US$6bn, says one investor. This would surpass last year's tally of around US$3.5bn.

The latest deal to emerge is State Farm Fire & Casualty's US earthquake catastrophe bond Merna Re II, which has received a preliminary double-B plus rating from S&P. The three-year deal is as yet of undetermined size - S&P's pre-sale report indicates US$250m, but market talk is of a final size of between US$400m and US$700m. The sponsor's inaugural Merna Re deal, which was issued in July 2007 (see SCI issue 45) and is due to mature in June this year, closed at US$1.06bn.

The new transaction's collateral will be invested in Treasury money market funds. Aon Benfield Securities is acting as bookrunner and structuring agent on the deal.

Merna Re II's notes are exposed to losses from earthquakes, including fires following and sprinkler leakage in the covered territory - Alabama, Arkansas, Illinois, Indiana, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Ohio, Tennessee and Wisconsin. Merna Re II will cover losses in this territory that result from earthquakes, regardless of whether the earthquake epicentre occurs in the covered territory.

More cat bond offerings could be on the horizon, given that spreads in the space have tightened dramatically since last year. At the same time, a large volume of cat bonds are due to mature in 2010 and many will need to be replaced with new deals.

While sponsors and underwriters will be the driving force behind the new bonds, investor interest was also flagged at the SIFMA conference as another impetus. Reinsurers have already returned as buyers of cat bonds in recent months, but pension funds are now taking a more serious look at this market, says one investor. Hedge funds, which dove into the securities in recent years, are still a sliver of the investor base but several funds exited during the recent spread tightening.

KFH

ABS

New recruit to boost SF capabilities

Berwin Leighton Paisner (BLP) has hired Matthew Kellett from RBS. He joins as a partner and will focus on capital and tax efficient structured funding arrangements for the banking and financial services sectors. The appointment follows that of James Duncan, who was hired as a derivatives partner earlier this year (see SCI issue 169).

Kellett has held senior positions in private practice and banking. As a banking partner at Linklaters, he led the financial structuring practice, before joining AIG Financial Products. At RBS he was UK head of financial structuring, where he had primary responsibility for the capital, tax efficient investment and fund-raising business of RBS. At BLP he will mainly work with tax head Michael Wistow and corporate tax experts John Overs and Neal Todd.

Simon Allan, BLP's head of finance, says: "Matthew's appointment is a significant step for us. We have spent recent years developing the structured finance team and have made a number of strategic hires to build a strong platform from which to grow. Matthew has an excellent reputation and his experience across financial and tax related structured products both in-house and in private practice will allow us to provide a more holistic service to our clients."

Asia

Manager rolls out Asian mezz platform

Babson Capital has expanded its Asia Pacific presence by creating an eight-member team to source mezzanine debt and private equity investment opportunities in the region. The firm has also received an Australian Financial Securities License, allowing it to manage a broad range of investments in the country.

Four members of the new team will be based in Sydney, with the others in Asia and the US. They will focus on investments in mezzanine debt and equity securities of middle-market companies in Australia and New Zealand, although they will also cover Hong Kong, Japan, Singapore, South Korea and Taiwan. Michael Hermsen, Babson Capital md and co-head of the firm's mezzanine and private equity group, will oversee the Asia Pacific team.

Hermsen says: "The Asia Pacific region offers attractive opportunities for profitable mezzanine investing due to the region's strong economic outlook, increasing demand for mezzanine as a source of buyout financing and a pullback by traditional investors in the marketplace as a result of the global financial crisis."

The Sydney team will consist of Shane Forster and Adam Wheeler, joining from AMP Capital Investors, who will both be mds sharing portfolio management and investment sourcing responsibilities; and director Elliott Wong and associate director Adrian Ng, who both joined Babson when the firm assumed management of a A$200m mezzanine debt portfolio the pair managed for an affiliate of Babcock & Brown. As well as Hermsen, the Sydney team will be working with Benjamin Silver, Los Angeles md, and Adam Nowak and Howe Wu, who will both be based in Asia.

"Babson Capital has been investing with private equity firms in the Asia Pacific region since 2005 and we believe these prior relationships, in addition to the talent and personal relationships that our new team members bring to Babson Capital will be valuable in securing access to high-quality mezzanine investment opportunities for our investors," adds Hermsen.

CDO

UBS, Leipzig dispute CDO claims

The German city of Leipzig is preparing to sue UBS over a €290m synthetic CDO contract entered into by a locally-owned water company, Kommunalen Wasserwerken Leipzig (KWL), and the bank. Leipzig refuses to pay €84m resulting from contracts between KWL and UBS because the city claims that the contracts were entered into by people who were not authorised to do so and who have subsequently been dismissed.

The fresh legal action comes on the back of legal proceedings undertaken by UBS against KWL in January of this year, following Leipzig's refusal to pay.

A spokesperson at UBS released the following statement: "On 18 January 2010, UBS issued proceedings in the English High Court against KWL to uphold the contracts between them. The parties chose to resolve all disputes in England. As this is an ongoing legal proceeding, we cannot give any further details other than confirming that UBS disputes KWL's subsequent German claims."

CDS

Bank beefs up in Connecticut

UBS has made a series of recent hires to its Stamford, Connecticut office, including a new head of global structuring for securities distribution and a trio of Deutsche Bank credit traders.

Matt Zola has been hired to run global structuring within securities distribution. He will be responsible for the equities and FICC structuring teams, and will also join the bank's securities distribution executive committee.

Zola will report to global head of securities distribution Roberto Hoornweg. The pair both previously worked at Morgan Stanley, with Hoornweg moving to UBS in January (see SCI issue 169).

Meanwhile, the three traders joining the bank from Deutsche Bank are David Gallers, Edward Hubner and Michael Wellins. They will all report to Anatoly Nakum, head of investment grade credit trading, and will start work in mid-May. Nakum himself only joined in August (see SCI issue 149).

CDS

Capital markets research firm expands in Europe

TABB Group has appointed Will Rhode as a research analyst in its London office, reporting to Miranda Mizen, the firm's head of European research.

Larry Tabb, founder and ceo of TABB Group, comments: "Based in our London office, [Will is] already deeply involved in interviewing European buy-side traders for a new, in-depth study on European derivatives - the first of its kind in Europe. We're also looking forward to Will assisting us in expanding our research and advisory services across Europe and Asia."

Rhode has 14 years of experience as a financial journalist specialising in risk management and derivatives. He has also previously co-authored two research reports for TABB as a contributing analyst.

CLO Managers

US manager ups CLO count

Deerfield Capital (DFR) has increased its CLO AUM by 45% after acquiring Columbus Nova Credit Investment Management - a Charlotte-based investment manager specialising in leveraged loan credit products, with US$1.8bn AUM - from Bounty Investments, an investment vehicle managed by Renova US Management (Columbus Nova).

The price paid by DFR includes US$25m of stock and deferred payments totalling US$7.5m of cash payable over five years. Additionally, Bounty has agreed to purchase US$25m in principal amount of senior subordinated convertible notes issued by the company.

The proceeds from the convertible notes, along with DFR cash, will be used to repurchase and retire all of the US$73.9m in principal amount of the outstanding senior notes for a total purchase price of US$55m plus accrued interest. The transactions, which are subject to closing conditions including stockholders approval, are expected to close during Q210.

"These transactions are transformative for DFR. In addition to achieving our goals of increasing AUM and growing top-line revenue, these transactions strengthen our balance sheet, which will now be structured to facilitate our future growth and provides us with a valuable partner in Columbus Nova," says Jonathan Trutter, ceo of DFR.

DFR now has US$5.8bn in CLOs under management. It also manages 28 CDOs totalling approximately US$9.2bn.

This latest development sees DFR taking on four CLOs previously managed by Columbus Nova (see CDO manager transfer table).

CLOs

Euro CLO manager expands

Avoca Capital Holdings has opened a London office and hired a new coo, Clayton Perry. Avoca says this has been prompted by an increase in investor demand.

Perry has been given responsibility for business development and marketing. He joins from Broadchalk Advisors, where he was the principal and md. Prior to establishing Broadchalk, he was head of global CLO business at Credit Suisse, where he was responsible for structuring, arranging and placing CLO transactions in the US and Europe.

Avoca says the London office will complement its Dublin headquarters and will be a hub for Avoca's global sales and marketing efforts.

Avoca ceo Alan Burke says: "Since we established the firm in 2002, Avoca has grown both organically and through acquisition to become a major player in the European leveraged loan market. Our AUM rose by approximately 30% in 2009 to €5.5bn."

He adds: "Our expansion is a response to an increase in demand from investors for teams with a depth of experience in leveraged loan management. As banks begin to suspend their leveraged lending arrangements to reduce balance sheet assets, they will leave a huge refinancing gap which creates opportunities for non-traditional sources of funding to fill."

CMBS

CRE advisory appointment follows alliance

CRE financing advisory firm BSC Group has appointed Noel Cain as a vp. His role will be to help support the company's recently formed alliance with 1st Service Solutions, a Dallas-based loan restructuring organisation.

Cain's previous experience is in underwriting, cashflow modelling, due diligence and site analysis, and he will advise BSC clients on debt and equity financing and loan workout services for all commercial property types, including self-storage. He joins from the Chicago loan production office of Dexia Real Estate Capital Markets.

"We are pleased to welcome Noel to our company. His expertise in supporting BSC Group clients with loan workout solutions will be particularly applicable as commercial real estate conditions and CMBS markets stabilise in coming years," says Devin Huber, a BSC Group principal.

The BSC Group announced on 24 February that it formed a marketing alliance with 1st Service Solutions to exclusively promote their loan restructuring services to self-storage owners and investors nationwide (see SCI issue 174).1st Service Solutions is believed to be the first firm in the US to serve as a borrower advocate in loan restructuring and assumptions for CMBS borrowers.

Investors

Fund of hedge funds manager acquired

Standard Life Investments is set to acquire a 75.1% stake in Aida Capital, subject to FSA approval. Aida Capital is a London-based fund of hedge funds manager, which has a solid eight-year track record of superior performance, including in distressed and credit assets. Clients range from high net-worth individuals, wealth managers and institutional investors from within and outside the UK.

Aida currently manages the Aida Open-Ended Fund, a Guernsey-listed investment vehicle, and the Aida Closed-Ended Fund, an investment fund listed on the London Stock Exchange. Aida Capital's existing management team will continue to manage these funds, as well as creating and managing fund of hedge fund products for Standard Life Investments and its clients.

Keith Skeoch, ceo of Standard Life Investments, says: "Standard Life Investments already has a strong track record in managing alternative assets, with over £8.5bn of commercial property, £4.6bn of private equity and over £2.2bn of Global Absolute Return Strategy funds under management. We have considered an expansion into new alternative asset classes for some time and believe that the acquisition of Aida Capital, with its proven track record in managing hedge funds, would present us with a great opportunity to strengthen our alternative capacity."

Investors

Investment manager promotes across global team

PIMCO has made numerous new appointments across its global team, including four promotions to evps in the mortgage and credit segments.

Among them is Michael Burns, an account manager in PIMCO's London office, focusing on institutional client service. He previously served as an account manager and mortgage product specialist in the firm's Newport Beach office. Prior to joining PIMCO in 2002, he worked in the MBS group at TCW.

Another is Marcellus Fisher, a manager of portfolio management trade support in the Newport Beach office. Prior to joining PIMCO in 2000, he spent 10 years in fixed income operations and in trading in the mortgage arbitrage group at Bankers Trust in New York.

Rudy Pimentel is a product manager in PIMCO's Newport Beach office, responsible for credit products, including distressed credit, high yield, bank loans, investment grade corporates, convertibles and absolute return credit strategies. Prior to joining PIMCO in 2003, he was with the global crude oil trading group of Chevron Corporation.

Finally, Rama Nambimadom is head of core analytics in the Newport Beach office. He previously served as head of analytics for PIMCO advisory and as a senior financial engineer developing credit and interest rate derivative models and trading ideas. Prior to joining PIMCO in 2002, he worked for three years as a quantitative analyst/trader on the interest rate derivatives trading desk at ABN AMRO and had consulting engagements with Morgan Stanley and the Bank of Montreal.

Legislation and litigation

Bank seeks to rescind RMBS purchases

The Federal Home Loan Bank of San Francisco has filed complaints in the Superior Court of California, County of San Francisco, against nine securities dealers in relation to some of the bank's investments in private-label RMBS (PLRMBS). The bank is seeking to rescind its purchases of 134 securities in 113 securitisation trusts, for which it originally paid more than US$19.1bn. The complaints allege the dealers made untrue or misleading statements about the characteristics of the mortgage loans underlying the securities.

All of the PLRMBS in the bank's mortgage portfolio, including those identified in the complaints, were rated triple-A when purchased, based on the information provided by the securities dealers. The bank says it employs conservative criteria and guidelines for all its MBS investments, and invests in high-quality financial instruments to facilitate its role as a cost-effective provider of credit and liquidity to its member financial institutions.

Monolines

Monoline chief to become president

David Buzen, currently coo and cfo of CIFG Holding, will also become president of the company, reporting to ceo Lawrence English. Before joining CIFG last summer, Buzen was cfo at CLO asset manager Churchill Financial Holdings. He also previously helped found Assured Guaranty forerunner Capital Re, where he was cfo.

"David has been instrumental in the implementation of CIFG's remediation and reorganisation plan, which has restored the company's solvency," says English. "He has done a terrific job and I am delighted to see him get the additional recognition he deserves. David will continue to work closely with me and the board of directors to further strengthen our balance sheet."

Operations

Supplementary investor meetings introduced

With official reporting rounds only occurring once a quarter around interest payment dates and the economic climate still in a state of uncertainty, Hatfield Philips International has introduced supplementary quarterly investor meetings. The firm says that the programme of investor meetings will provide in-depth, strategic insight into assets under management, as well as outline servicing challenges, strategies and issues arising between the standard reporting periods.

Over 70 investors attended Hatfield Philips first CMBS servicer-investor information meeting held in London earlier this month. Matthew Grefsheim, director of special servicing at the firm says: "It is important that investors are kept informed as to what is happening to their investments, especially in the current climate, and with official reporting only every quarter, a lot can happen in between. Not only are we working hard to ensure the best resolutions on all the loans we service, but we recognise how in this market investors can benefit from knowing what is happening and how we as the servicer can add value to their investments when structures are under stress."

Operations

New appointment as acquisition closes

ICAP has appointed Ian Chicken as director for market connectivity, a new role placing strategic focus on the firm's straight-through processing activities. ICAP has also announced it will complete the acquisition of the remaining TriOptima stock later this month.

Chicken will report to Mark Beeston, a relatively new arrival himself (see SCI issue 161). Chicken was formerly coo of ICAP electronic broking and has been with the firm for ten years.

Having received final regulatory approval, ICAP will now complete the acquisition of the remaining 61.78% of stock in TriOptima on 24 March 2010. The acquisition was announced on 5 February 2010 (see SCI issue 171).

A total initial payment of approximately SEK1.07bn (€111m) is payable in cash and this will be financed from ICAP's existing debt facilities. TriOptima will join Traiana, Reset and Rematch in ICAP's newly formed post trade risk division.

Beeston, director of business development for the post trade risk division, says: "Establishing a formal division of the company will enable us to maximise the potential of these businesses while preserving the entrepreneurial cultures of the individual companies."

"Demand for improvements in market infrastructure have continued to provide major opportunities for ICAP and post-trade and risk services have become an increasingly important part of our activities over the last few years," says ICAP Group coo Mark Yallop, who heads the post trade risk division. "In the first half of this financial year 19% of ICAP's profit came from post-trade and information services and we expect that proportion to continue to grow."

Ratings

Realpoint acquired

Morningstar is to acquire CMBS rating agency Realpoint. The NRSRO is being purchased for US$52m, subject to post-closing adjustments, including approximately US$42m in cash and US$10m in restricted stock.

Realpoint had revenue of approximately US$12m in 2009. Morningstar expects to complete the transaction in the next few months.

"We believe there's strong demand for unbiased ratings and research in the structured credit market and we think the time is ripe to bring more competition to this market. This acquisition also builds on our recent entry into corporate credit ratings," says Joe Mansueto, chairman and ceo of Morningstar.

Once the acquisition is completed, Realpoint will become a business unit of Morningstar, reporting to Catherine Odelbo, Morningstar's president of equity research. Over time, the company will be rebranded under Morningstar. Rob Dobilas, president and ceo of Realpoint, will continue to run the business and the company will retain its offices in Horsham, Pennsylvania.

Real Estate

CMSA becomes CREFC

The CMSA has been rebranded as the CRE Finance Council, with the intention of better serving all constituencies within CRE finance.

"Our intention always is to be responsive to our members and to the market's changing course, and the CRE Finance Council is a natural and logical extension of this new course," says Dottie Cunningham, CRE Finance Council ceo.

The CRE Finance Council will initially include five forums: investment grade bondholders, multifamily lenders, portfolio lenders, servicers, and securities and loan investors. Each of the forums will interact and address issues critical to its business sector and work to achieve solutions that serve a common purpose.

The CRE Finance Council intends to educate members, develop best practices, represent all Forum participants, manage disparate and converging views, and advocate the consensus of positions to policy and lawmakers on behalf of the industry. "We will always attempt to foster a consensus on issues that are important to our various stakeholders," says Patrick Sargent, CRE Finance Council president. "Where the CRE Finance Council finds consensus, it will advocate; where it finds differences of opinion, the Council will educate."

RMBS

Expansion continues for ABS strategy team

RBS Securities has appointed Paul Jablansky as senior consumer ABS md and non-agency residential strategist within its global banking and markets division in the Americas. He will be based in Stamford, Connecticut and report to Brian Lancaster, md and head of MBS, CMBS and ABS strategy at the firm. Jablansky will lead the team's consumer ABS and non-agency MBS strategy efforts, working alongside Desmond Macauley, non-agency residential strategy md.

Jablansky joins from 400 Capital Management, an investment management company focused on ABS, MBS and CMBS relative and absolute value strategies, where he was co-managing partner and a co-founder. He has also worked for Bank of America, Citigroup, Goldman Sachs and Salomon Brothers.

"We continue to take a very thoughtful and deliberate approach to expanding our comprehensive MBS, CMBS and ABS strategy team with the highest-calibre market professionals. The MBS, CMBS and ABS markets are full of opportunity," says Lancaster.

RBS announced the additions of Greg Reiter, agency residential security strategy md, and Jeana Curro, agency MBS/CMOs vp, last month (see SCI issue 172).

RMBS

Broker hires FI sales head

George Kenny has joined MBS broker-dealer Braver Stern Securities as md and head of institutional fixed income sales, responsible for expanding the firm's institutional sales force. He most recently served as head of Americas rates sales at Bank of America, and also has previous experience as head of Americas mortgage sales at Merrill Lynch.

"George is an excellent addition to our firm and his hiring underscores our commitment to become one of the leading fixed income broker-dealers in the industry. His in-depth knowledge of the marketplace will benefit us greatly as we expand our platform both geographically and into additional product lines," says Braver Stern managing partner of institutional fixed income trading Joseph Valentine.

Technology

Principia and Lewtan team up

Lewtan's ABSNet performance data, which covers over 20,000 global structured finance deals, can now be accessed via the Principia Structured Finance Platform (Principia SFP). Investors using Principia SFP and ABSNet will be able to load and refresh data from the ABSNet deal portal and efficiently reference Lewtan deal performance data - alongside their own proprietary sources of deal or loan-level analysis.

Access to this combination of asset performance data within Principia's infrastructure allows organisations to model their portfolio of structured finance and fixed income assets, along with their associated derivatives and funding products. Portfolio managers, risk and compliance staff can then more accurately analyse and report on the risk and performance of these positions, the two firms say.

"The provision of detailed deal structure information, ongoing analytics and performance data has always been the focus of the ABSNet solution. We can now see the regulatory and investor community in the securitisation market recognising the need for this level of independent deal analysis. This combined solution delivers the transparency to drill-down into individual deals, within a system that encompasses overall market and credit risk analysis," says Ned Myers, chief marketing officer of Lewtan.

"We are the first to fully automate independent ABS and MBS performance data into a complete out-of-the-box structured finance solution," adds Douglas Long, evp, business strategy at Principia. "ABSNet's wide coverage of deals across the globe and its impressive level of analysis made it an obvious choice for a data partner. By leveraging this analysis within Principia SFP, investors can see deal performance in the wider context of their portfolio or operations and have the confidence that they have the timely and accurate information required to diligently manage their investment portfolios."

Trading

Five new faces in fixed income expansion

Financial services firm Janney Montgomery Scott has hired two former Bear Stearns employees amongst a raft of new arrivals, including a director, two mds and two vps.

Former Bear Stearns executive Brent Giese will head the firm's newly-created whole loan initiative. He is joined by former colleague James Stauss, and between them the pair have nearly 50 years' industry experience.

Both men were mds at Bear Stearns, and Stauss had moved to Raymond James as vp of institutional sales. Giese was also head of the mortgage origination group.

"Buying and selling loans is a rapidly growing area for regional and community banks and this initiative allows us to further address the needs of our clients in a challenging market with a critical new capability," says Steve Genyk, md, head of fixed income at Janney. "Brent and Jim are two of the industry's top whole loan experts. They represent the perfect complement to our existing offerings."

Janney also announced that it has recently added three veterans to its fixed income sales and trading practice. Katrina Griessman was hired as a director of fixed income sales, Christopher Moses was also appointed as vp for non-agency MSB trading and Austin Derris was made vp of the institutional fixed income sales team, based in Boston.

Griessman has more than 25 years' experience and joins the Atlanta office from fixed income boutique Angel Oak Capital Partners. She was previously fixed income sales svp at UBS and Keefe Bruyette & Woods.

Moses joins the firm from Bank of America Merrill Lynch, where he was vp. He has also had trading roles at Washington Mutual Capital and The Winter Group. Derris comes from a post at Merrill Lynch's institutional fixed income sales team.

ABCP

Australian ABCP outlook 'stable'

Despite the decline of Australian ABCP issuance in 2009, Moody's says its ratings outlook for the sector in 2010 is stable, with asset performance expected to stabilise and strengthen. The impact of proposed changes to the Basel 2 framework remains uncertain, but is expected to lead to some restructurings and conversions to full support.

A new Moody's report says that by the end of 2009 the total Australian ABCP outstanding stood at A$23.66bn, a 38.73% decline from the previous year, even though several term securitisation transactions took place in the second half of the year.

Report author Jennifer Wu, a Moody's vp and senior analyst, says: "Moody's ratings outlook for 2010 is expected to be stable due to stable asset performance and the structural protections present in the conduits. However, as Moody's outlook for the bank ratings remains negative, there is downside risk to ABCP conduit ratings, should any negative short-term rating actions on the banks take place."

She adds: "Funding spreads became less volatile in 2009, though overnight issuance also materially decreased. As residential mortgage loans are the main assets funded by conduits, investors were concerned by the impact of negative rating action on mortgage insurers on loans. Therefore, conduit sponsors have restructured and enhanced their conduits to mitigate any exposure of their conduits to mortgage insurer ratings."

The Australian government's implementation of guarantees for the deposits and wholesale funding of authorised deposit-taking institutions has led some conduit sponsors to focus their funding sources on government-guaranteed bonds. Some major bank conduits have also kept their conduits dormant while they wait for ABCP funding conditions to become more favourable.

Moody's says the implementation of the Basel 2 framework has encouraged many bank conduit sponsors to take advantage of the more favourable capital treatment of highly-rated securities and they have actively restructured the assets in their conduits into MBS to be funded on their balance sheets, leading to further reductions in issuance in 2009. Wu adds that the decline reflects the impact of the global downturn on conduit sponsors and originators. As residential mortgage loans remain the main assets funded by conduits, the tightening of credit criteria by the conduit sponsors and increased competition from the major Australian banks led to reductions in origination volume by borrowers.

ABS

Revised Dodd bill reduces risk retention threshold

Senate banking chairman Chris Dodd released a second draft bill for financial regulatory reform last week. While substantially similar to the original draft, two features have implications for the securitisation market: the risk retention threshold for ABS originators has been reduced from 10% to 5%; and it specifically contemplates exemptions from (or reductions to) the risk retention requirements if certain underwriting standards are met.

Securitsation lawyers at Sidley Austin explain that the revised Dodd draft, like the earlier proposals, includes a risk retention requirement which is aimed at better aligning the interests of originators, securitisers and investors in ABS by requiring originators and securitisers to retain unhedged credit risk on the assets they transfer, sell or convey. However, in contrast to the House Bill, which would impose a risk retention requirement on any transfer of a loan by a creditor in the secondary market - whether or not in connection with a securitisation - the revised Dodd draft applies only to securitisers and originators selling to securitisers.

The revised Dodd draft would require the Federal banking agencies and the SEC jointly to adopt regulations that:

• require a securitiser to retain an economic interest in a material portion of the credit risk of assets that it transfers, sells or conveys to third parties through the issuance of ABS;
• establish asset classes with separate rules for securitisers of different asset classes, including residential mortgages, commercial mortgages, commercial loans, auto loans and any other class of assets the agencies deem appropriate;
• set the minimum level of risk retention at not less than 5% of the credit risk or less than 5% of the credit risk if the originator of the assets meets underwriting standards prescribed by the Federal banking agencies and the SEC specifying the terms, conditions and characteristics of a loan that indicate a reduced credit risk with respect to the loan within each asset class for which the Federal banking agencies and the SEC have established separate rules;
• prohibit a securitiser from hedging (or otherwise transferring) the retained risk;
• specify how the retention requirement should be satisfied and the minimum duration of the retention requirement;
• provide for a total or partial exemption from these requirements for any securitisation when in the public interest or for the protection of investors; and
• provide for the allocation of risk retention obligations between a securitiser and an originator if a securitiser purchases assets from an originator, as determined appropriate by the Federal banking agencies and the SEC.

Under the revised Dodd draft, the Federal banking agencies and the SEC may jointly issue exemptions or adjustments for classes of institutions or assets with respect to the risk retention requirement and the prohibition on hedging, note the Sidley Austin lawyers. Any exemptions and adjustments would be required to ensure quality underwriting standards for securitisers and originators of assets that are securitised or available for securitisation and to encourage appropriate risk management practices, improve the terms of consumer access to credit, or otherwise be in the public interest and for the protection of investors.

As with the other proposals, including the original Dodd draft, the revised draft would exclude ABS from the automatic suspension provisions of Section 15(d) of the Securities Exchange Act of 1934. The SEC would be authorised to adopt new suspension schemes for different classes of ABS under terms and conditions as it deems necessary for the protection of investors. The revised Dodd draft would also impose disclosure requirements on issuers of ABS under the Securities Act of 1933 with respect to asset-level information, including requiring: loan-level data necessary for investors to independently perform due diligence, as well as loan-level data with unique loan broker and originator-identifiers; the nature and extent of the compensation of the broker or originator of the assets; and the amount of risk retention by the originator and the securitiser of the assets.

In contrast to the House Bill and the Administration proposal (but consistent with the original Dodd draft), the revised draft would also require the SEC to adopt rules requiring an issuer of publicly-issued ABS to perform a due diligence analysis of the assets underlying the ABS and to disclose the nature of the analysis in the issuer's registration statement.

Sidley Austin lawyers also note that the revised Dodd draft tracks the earlier proposals with respect to requiring a description and comparison of the representations and warranties on the underlying assets by each rating agency in a report accompanying each rating of an ABS. In addition, it would require a securitiser to disclose fulfilled and unfulfilled repurchase requests across trusts aggregated by the securitiser, so that investors may identify asset originators who have clear underwriting deficiencies.

ABS

Innovative auto ABS rated

Moody's has assigned a triple-A rating to the €274.7m Class A fixed rate notes issued by VAB Auto Receivables 2009. The deal benefits from an unrated €50.4m Class B fixed rate trance due 28 February 2022.

VAB Auto Receivables 2009 is the first true-sale securitisation from Volvo Auto Bank Deutschland (VAB). The transaction is backed by a mixed revolving portfolio of auto loan and lease receivables (excluding the residual value part) resulting from amortising and balloon loans, as well as leasing contracts granted to German clients.

The deal has a fairly unique structure, with possible additional notes being issued in the future with a pre-defined mechanism. Specifically, the transaction will start with a total issuance volume of €325.1m at closing (split between €274.7m Class A notes and €50.4m Class B notes). During the three-year revolving period and provided certain trigger tests and eligibility criteria are met, additional auto loan and lease receivables can be purchased into the securitised pool to increase the issued Class A notes up to the maximum amount of €309.6m, with a corresponding maximum portfolio size of €360m.

Hence, initial portfolio subordination benefiting the Class A is 15.5% at closing and may decrease to no lower than 14% portfolio subordination through this structure, as no further Class B notes have been envisioned.

According to Moody's, the definitive ratings take account of the strong back-up servicing action plan at closing and a servicer rating trigger; and that the residual value portion under the lease contracts, which is not securitised, is pledged to the SPV to cover any defaults under the lease installments and thereafter to cover any seller's risk such as commingling. In addition, all receivabes are sold to the SPV at a mimimum discount rate of 8%, guaranteeing minimum interest collection to the SPV.

Commingling risk is inherent in the transaction as the collections are transferred from the servicer's collection account to the SPV's distribution account once a month. But this risk is mitigated by:

• A switch from monthly sweep to two-day sweep if the servicer (VAB) is downgraded below Baa3 or not rated anymore,
• market-specific legal aspects and
• structural features; i.e. debtors notification and redirection of payments upon a servicer termination, as well as a liquidity reserve being sufficient to bridge a period of 12 months.

ABS

Student loan ABS amended

Brazos Student Finance Corporation has added a supplemental indenture that will allow it to sell loans and transfer assets as part of a transaction in which outstanding notes are purchased, exchanged, cancelled or otherwise retired. The corporation has subsequently requested that Moody's provide its opinion as to whether the ratings on the notes issued under the amended and restated indenture of trust would be downgraded or withdrawn as a result.

Moody's explains that in order to sell loans or transfer assets from the indenture, several conditions must be met following the sale or transfer. The reserve fund requirement must be met; the senior parity and overall parity ratios cannot be lower than prior to the sale; and a rating confirmation must be obtained with respect to the sale and to transaction. In addition, for a loan sale, the characteristics of the loans sold cannot be materially different than the loans remaining in the indenture.

The rating agency believes that the execution of the supplemental indenture will not have an adverse effect on the credit quality of the rated securities issued under the indenture, since the supplemental indenture requires that the parity ratios be maintained and requires that the loans remaining are not materially different than the loans sold.

ABS

Mexican construction loan deals restructured

Moody's has stated that the amendments made in February 2010 to the legal documents for Metrofinanciera's METROCB 07 (Trust 590) and METROCB 07-3 (Trust 689) Mexican construction loan securitisations will not result in a change or withdrawal of the current ratings of the two senior certificates issued in conjunction with the affected deals.

The affected certificates are rated C (global scale, local currency) and C.mx (Mexican National scale). The last rating action occurred on 12 December 2008, when the global scale ratings were downgraded to C from Caa1 and the national scale ratings were downgraded to C.mx from Caa1.mx.

The February 2010 amendments include revisions to the priority of payments waterfall, a change in the promise to investors (from timely interest payment to ultimate interest payment by the legal final maturity date), the capitalisation of accrued and unpaid interest on the certificates, and the automatic extension of the certificates' legal final maturity date in the event that the term of the trust's revolving line of credit from Sociedad Hipotecaria Federal (SHF) is extended from 24 months to the maximum of 48 months. Under the SHF line of credit, ongoing disbursements of undrawn and committed amounts available to developers under their construction loans will be made, thereby financing the remaining construction for yet-to-be-selected and SHF-approved housing developments.

The transactions' original priority of payments was modified to reflect the fact that SHF has a first-priority interest in certain cashflows received from construction loans that benefit from SHF financing. This feature remains unchanged following the February 2010 amendments.

These amendments did, however, impact the payment waterfall associated with the cashflows for which investors have a first-priority interest. Prior to the February 2010 amendments, this waterfall contemplated that after covering fees and expenses, all available funds would be applied to amortise the senior certificates until paid in full. All other payments were subordinated, including principal payments on the subordinated certificates and any unpaid and 'capitalised' interest due to the senior and subordinated certificates.

Following the February 2010 amendments and to the extent funds are available after covering fees and expenses, the senior certificates will receive a partial prepayment equal to the amount of their accumulated unpaid and capitalised interest. Then, they will receive a partial prepayment equal to the amount of their accumulated and unpaid capitalised interest. Next, all available funds will be applied as principal payments to the senior certificates until paid in full.

Once the senior certificates are paid off, all funds will be applied as principal payments to the subordinated certificates until paid in full. Lastly, the senior certificates will be paid their accumulated and capitalised interest until paid in full, with the subordinated certificates' accumulated and capitalised interest payments following.

Moody's will continue to monitor the performance of the securitised loans and the extent to which SHF's financing may impact the level of expected recoveries on the securities. As of February 2010, 90+ day delinquencies, with respect to interest or principal payments, were 91% for METROCB 07 and 85% for METROCB 07-3 as a percent of their outstanding pool balances.

ABS

Flat card charge-offs suggest improvement

US credit card charge-offs held steady in February, finishing at 11.08%, just 1bp above a revised January rate of 11.07%, says Moody's. The trailing three-month charge-off rate reached 10.82%, the highest since last September.

Delinquencies fell to 5.91% last month, their lowest level since August. February payment rates fell slightly from January, which is to be expected in the shortest month of the year, but year-over-year performance continued a four-month long run of improvement. The February yield index of 22.23% represents the highest monthly rate in the history of Moody's credit card index.

"The nearly flat month-over-month change in charge-offs corroborates others signs of impending improvement in credit card performance," says Moody's svp William Black. "The pace at which early-stage delinquencies from this past fall have rolled through to charge-off has slowed markedly. As the effects of this past fall's spike in early-stage delinquencies begin to wane, we believe the ultimate peak in charge-off rates may be reached either this month or next."

Moody's believes unemployment will plateau in the second half of the year between 10% and 10.5% and that delinquencies will continue to improve, so the charge-off rate could peak slightly below its long-held forecast of 12%. Black notes though that if the economy deteriorates then charge-offs will follow. He says there is a one-in-four chance of a 'double-dip' recession.

The trailing three-month average charge-off rate reached 10.82% in February, the highest level since September 2009. Early-stage delinquencies also posted a fourth consecutive month of declines, coming down from the peak levels reached this past autumn. The slight fall in the payment rate in February was predictable, given the shortened month, which reduces the number of days available for collections.

The yield index is now approaching almost 500bp higher than year-ago levels, an increase that continues to be primarily driven by principal discounting. Excess spreads continue to receive significant support from issuer discounting initiatives and the strong yields and steady charge-off rates help catapult the excess spread index back above the 8% mark in February.

ABS

US auto ABS criteria enhanced

Fitch has updated its US auto loan ABS rating criteria, including several enhancements to its auto loan ABS credit analysis. The criteria remain broadly unchanged, as supported by the high level of rating stability in Fitch-related auto loan ABS transactions during the recession and credit crisis, and despite the bankruptcy of General Motors and Chrysler.

Enhancements to the criteria, most of which Fitch says were being incorporated since 2008/2009, include:

• Incorporating certain forward-looking stresses on loss frequency and severity;
• Conducting loss sensitivity analysis and its effect on future ratings performance; and
• Refining adjustments to seasoned collateral present in auto loan pools.

Fitch's criteria focus on: collateral analysis, credit analysis including derivation of the loss proxy, structural and cashflow modelling, legal structure and counterparty risks. The agency says these areas of focus address the major risks present in auto loan ABS, namely macroeconomic conditions including unemployment levels and consumer fundamentals; collateral characteristics; the state of the auto industry including the wholesale vehicle market; and counterparty risks including the strength and capabilities of servicers.

Additionally, the criteria incorporate several key areas Fitch has been focused on in the past two years, including deriving base-case loss proxies utilising performance data from the poorest performing vintages (the 2007 and 2008 vintages); and employing adjustments to derived loss proxies to address future conditions related to unemployment and wholesale vehicle values/recovery rates. Fitch's methodology addresses the main risks relating to loss frequency and severity in auto loan ABS.

The agency remains focused on several risks still present in the auto ABS sector that will continue to affect performance in 2010, however. These risks include the state of the US economy, including the labour market and its impact on loss frequency; the state of auto manufacturers and auto-lenders; the wholesale vehicle market and its impact on recovery rates; and servicing capabilities and operations.

ABS

US equipment ABS shielded from construction stress

Fitch says that stress in both the residential and commercial construction markets will keep loss and delinquency levels for US equipment ABS with construction equipment concentrations elevated. However, various structural features are expected to shield these transactions from negative rating actions.

Equipment ABS performance suffered in 2009 because of the poor global economic climate. "The construction sector has seen the most stress, further driving up losses and delinquencies in equipment ABS with higher construction equipment concentrations," says Fitch md John Bella.

Losses and delinquencies have been tracking higher than the rating agency initially expected, but amortisation and credit enhancement build have offset the performance deterioration. There were no downgrades within its rated portfolio last year due to the recent uptick in losses.

Fitch's equipment ABS delinquency index shows 60-plus day delinquencies for heavy metal - which includes agricultural, transportation and construction equipment - was 2.19% as of January 2010, up from 1.54% the year before. The value of annual residential construction put in place fell from US$620bn in 2006 to just US$260bn in 2009.

Bella comments: "As construction companies struggle to find projects, they remain at risk of falling behind on their equipment contracts."

A rise in residential housing starts could help the equipment ABS sector, however. They stood at a seasonally-adjusted annualised monthly rate of 611,000 in January 2010, up from 488,000 starts the year before.

February saw 575,000 starts, almost the same as 574,000 a year earlier. New housing starts are expected to increase this year as the economy begins to recover.

Fitch believes, however, that commercial construction has not yet felt the recession's full effect. The value of commercial construction put in place last year was US$279bn, far lower than the US$322bn in 2008.

The rating agency says improvement this year is unlikely because commercial real estate is still seeing declining rents and rising vacancies and delinquencies. Fitch's CMBS loan delinquency index - measuring CMBS 60-plus day delinquencies, foreclosures and REOs - stood at 6% as of January 2010, well up from 1.15% a year earlier.

Large ticket equipment manufacturers began decreasing production of construction equipment in 2007 in response to waning demand and higher losses. Construction concentrations among rated equipment ABS portfolios declined as a result, which Fitch views as a positive in light of the weakening performance.

Continued deterioration in commercial construction figures is expected to negate any improvements in residential and infrastructural construction, however, so Fitch expects the US construction sector to remain stressed, with delinquency and loss performance of construction-related transactions in 2010 possibly trending slightly worse than last year.

CDO

Spanish SME CDOs weighed by reserve depletions

Increasing Spanish SME CDO reserve fund depletions will mean performance remains under pressure this year, says Fitch. The rating agency expects increased defaults and for more transactions to draw on reserve funds as a result.

"As delinquencies roll into defaults, the transactions' reserve funds are deployed to redeem the senior notes," says Glenn Moore, senior director in Fitch's structured credit team. "Already two Spanish SME transactions have fully depleted the reserve fund balance and Fitch expects more to follow."

In many cases, the drawings are in addition to previous reserve fund releases, which were permitted by transaction documentation during periods of low defaults in 2005-2007. Recoveries will ultimately be available to replenish reserve funds, but Fitch believes that recovery timelines have been materially extended and so subordinate tranches could be undercollateralised for an extended period pending recoveries.

"Fitch expects senior SME CDO ratings to remain stable due to solid credit protection and continued transaction deleveraging," says Jeffery Cromartie, Fitch's head of EMEA structured credit surveillance. "Nevertheless, while 90-plus arrears have begun to level off across vintages and transactions, late-stage arrears buckets remain elevated and are expected to continue to erode reserve funds. Likewise, performance remains exposed to ongoing weakness in the real estate and construction sectors, weak economic conditions, tighter credit availability and the potential for interest rate increases."

The evolution of recoveries will be a key driver of Spanish SME CDO performance over the short-term because many transactions are backed by both residential and commercial real estate. Fitch notes a significant decline in recovery rates in recent vintages as fewer loans are able to cure and thus roll into default.

Also, property foreclosure and liquidation timelines are being extended. Given difficult housing market conditions and rising defaults, the agency says it is focused on the timing of recoveries as well as loss severities on defaulted SME loans.

"Banks are adopting different recovery rate strategies, with some banks holding on to collateral until market prices and liquidity improves. That could take some time and the longer the delay in recovery, the greater the chance that the SME transactions are forced to use principal proceeds to pay interest - which erodes credit enhancement levels," adds Moore.

CDS

Indices widen on the roll

The Markit CDX IG index hit 91.5bp on 22 March, the first trading day for series 14, with a roll value of around 5bp. Healthcare-related names were among the most active credits on the day, notably in the insurance sector.

"The narrow passage of the healthcare bill on Sunday is generally regarded as a negative development for insurers such as Aetna and UnitedHealth. However, after significant widening earlier in the session they recovered some ground and, given the roll, were little changed on the day," notes Gavan Nolan, vp at Markit.

Overall, the index roll was expected to run fairly smoothly. Tim Backshall, chief strategist at Credit Derivatives Research (CDR), says: "I think the recent stability in credit markets and compression in volatility has allowed this roll to be relatively well-handled by dealers and end-users alike."

Moving out of the new CDX.NA.IG index is the International Lease Finance Corporation and Wells Fargo & Company (see SCI issue 175) and replacing them are Freeport-McMoRan Copper & Gold and SLM Corporation. Overall, there is, according to Backshall, not a great deal to choose between the old (IG13) and new (IG14) iterations of the index.

He explains: "The new IG index is modestly wider (in fair value), but not enough to warrant an aggressive risk transfer for anything other than liquidity. The skew (IG13 trades notably tight to intrinsics) [compressed] in the last few days, suggesting any recent strength in IG13 was more momentum- than fundamental-driven."

Consequently, Backshall suggests that investors look to take advantage of the re-emergence of liquidity in this older index to position against some housing and retailer names.

The iTraxx roll into Series 13 also came in wider than expected at open, with negative sentiment on Greece and weakness in the equity market blamed for the jitters. The Main index roll value was five (and was expected to be two), Senior Financials was four (three), Sub Financials 5.5 (two) and Crossover was 35 (23).

CDS

CDS not meant for speculation - Trichet

European Central Bank president Jean-Claude Trichet on 19 March called for further improvements in CDS market transparency and the prioritisation of central counterparty facilities.

"We need more transparency in CDS markets and so do investors," he said in his opening remarks at the Commission conference 'Building a crisis management framework for the internal market'.

Trichet also commented that certain financial instruments, which were introduced in consideration of their positive effects for the hedging of risks [CDS], should not be misused in a speculative manner. "I share the consensus at a global level that regulators should be equipped with appropriate tools to be able to investigate and act in an effective and coordinated manner," he said.

In this respect, a key priority for the ECB - in terms of enhancing the resilience of the CDS markets - is the establishment of central counterparty facilities, said Trichet. "Such CCPs will help, in particular, to diversify and share risk exposures and their margining procedures will reduce the incentive to take excessive risks. Moreover, CCPs will deliver more of the much needed transparency for all parties involved."

CDS

DTCC to name counterparties upon regulatory request

The DTCC says that the choices some counterparties have made with respect to the regulators for which they will authorise the Trade Information Warehouse to provide counterparty 'named' data appears to have created unnecessary regulatory friction. It has therefore decided to include counterparty names in both aggregate and trade-level information provided by the Warehouse, if the requesting regulator or other governmental entity affirms that it has a material interest in that information in furtherance of its regulatory or governmental responsibilities, unless and until the OTC Derivatives Regulators' Forum indicates otherwise.

"It is a bedrock principle of the Warehouse that all interested regulators should have unfettered access to Warehouse information necessary in furtherance of their respective regulatory missions," the DTCC explains. The Warehouse Trust Company will consequently work with each requesting regulator/governmental entity to determine the practical procedures for accommodating each request.

The OTC Derivatives Regulators' Forum is believed to be developing a framework to provide guidance to the Warehouse about how it should evaluate requests for information from regulatory authorities/governmental entities. But the DTCC is also developing in response to Forum requests special regulator access protocols that will allow direct regulator access to its data under this global framework without the need to go through Warehouse Trust Company personnel, thus greatly enhancing the ability of regulators to obtain immediate access to relevant Warehouse data, it says.

DTCC had previously provided both aggregate and trade-level information from the Warehouse to any regulator that requested it. However, data confidentiality concerns for protection of proprietary client information led it to refrain from providing specific counterparty information in response to regulatory requests absent the consent of the specific counterparty.

"We recognise that, in the interim as the Forum develops its framework, we will continue to receive information requests from interested regulators around the globe. In light of recent developments, we believe that responding to these requests while continuing to observe the practice of not providing counterparty names absent consent may no longer be appropriate," the DTCC notes.

The Warehouse currently holds data on roughly 2.3 million CDS contracts from trading counterparties located in 52 countries, covering credit obligations of entities located in more than 90 countries around the world. In recognition of the systemic importance of the Warehouse and hence the need for a global regulatory framework, the DTCC recently established a limited purpose trust company (the Warehouse Trust Company) to operate current Warehouse services (see SCI issue 172).

The Warehouse Trust Company is a state member bank of the Federal Reserve System, subject to direct oversight by the Federal Reserve Bank of New York and the New York State Banking Department. It is also expected to be subject to a global cooperative oversight framework involving other US and non-US regulators.

CDS

Credit exposure in derivatives activity declines

The credit exposure from derivatives activities declined by 18% in the fourth quarter of 2009 and by 50% during the year, according to the Office of the Comptroller of the Currency in its latest 'Quarterly Report on Bank Trading and Derivatives Activities'.

The OCC reports that net current credit exposure (NCCE), the primary metric it uses to measure credit risk in derivatives activities, decreased by US$86bn - or 18% - to US$398bn. At the end of 2008, NCCE peaked at US$800bn.

Kathryn Dick, OCC deputy comptroller for credit and market risk, explains: "The continued decline in NCCE is a very welcome development."

NCCE fell in each quarter of 2009, as rises in interest rates and sharp declines in credit spreads helped to reduce receivables from derivatives, Dick notes. She continues: "Despite the substantial reduction in credit exposures from derivatives, NCCE remains historically quite high and so we continue to closely evaluate, as part of our examination priorities, banks' measurement and management of counterparty credit exposures."

US commercial banks reported trading revenues of US$1.9bn in the fourth quarter of 2009, which is down sharply from US$5.7bn in the third quarter. Trading revenues for the full-year 2009 were US$22.6bn, a sharp rebound from 2008's first-ever annual trading loss of US$836m.

Dick says: "We normally see trading revenues weaken in the final quarter of the year. It has happened eight times in the past 10 years. Clients start to close their books as year-end approaches, so client demand falls and the dealers become more risk averse in order to preserve their profits for the year."

The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$8.5trn (or 4.2%) in the fourth quarter to US$212.8trn. Interest rate contracts increased by US$7trn to US$179.6trn, while credit derivatives increased by 8% to US$14trn.

The OCC report also notes that:

• Banks hold collateral to cover 67% of their NCCE. The quality of the collateral is very high, as 81% is cash (US dollar and non-dollar).
• 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 35 in the quarter to 1,030.

CLOs

EMEA CLOs still lag US stabilisation

In Moody's 2009 global CLO review, the rating agency reports that the performance of the loan portfolios backing US and EMEA CLOs has started to recover. However, just as EMEA CLOs lagged behind the US in the pace of their deterioration, they are similarly behind in stabilisation (see also last issue).

Key performance metrics for CLOs issued in the US and EMEA deteriorated during the first quarter of the year and, while they stabilised in the US during the second quarter, they continued to deteriorate for EMEA deals. The second half of the year saw most key metrics stay at stable levels for US deals, while a few suggested improvements in performance. Certain indicators, such as the weighted average credit quality, continued to decline for EMEA CLOs.

Moody's says improvement in the US was also suggested by changes in the amount of overcollateralisation, but that EMEA CLO overcollateralisation levels only stabilised. The agency has a cautious outlook for US CLOs, while expecting EMEA CLO performance metrics to continue to deteriorate early this year before stabilising.

During much of 2009, the leveraged loans that back CLOs experienced increased price volatility, elevated levels of default and credit deterioration that led to many loan rating downgrades. In March 2009 Moody's launched a two-stage surveillance sweep of CLO ratings after revising its key rating assumptions, which concluded in January this year.

Improvement in certain collateral quality metrics such as overcollateralisation and weighted average credit quality of the portfolio has prompted the agency to place the ratings of certain notes, in particular the junior notes of a few US CLOs, on review for possible upgrade. Moody's says it continues to follow the performance trends of CLOs on a deal-by-deal basis and will make rating adjustments as needed.

CMBS

US covered bond legislation welcomed

The CMSA says it welcomes the introduction of legislation brought by the US House Financial Services Committee involving the facilitation of a covered bond market in the country. The move is being hailed as important for providing liquidity and new sources of capital for commercial real estate.

Assets from covered bonds, which usually carry a 2- to 10-year maturity rate and include high credit ratings, are kept on the issuer's balance sheet. CMSA says that the product could serve as an additive financing tool that would help raise much needed capital to fund commercial real estate loans, helping to ease the current downturn.

The new legislation includes commercial mortgages and CMBS as eligible collateral. Commercial debt is permitted in covered bond pools in most European jurisdictions and CMSA believes any US covered bond framework should ensure that US financial institutions, consumers and borrowers have a level playing field and equal credit opportunities.

CMBS

Small US CMBS loan closes

Ramco-Gershenson Properties Trust has closed on a new US$31.3m CMBS loan with JPMorgan, secured by its West Oaks II shopping centre in Novi, Michigan, and its Spring Meadows Place centre in Holland, Ohio. The financing has a loan to value of approximately 60% for the two properties and a ten-year term, with a fixed interest rate of 6.5%. Proceeds from the loan were used primarily to reduce borrowings on the REIT's revolving credit facilities.

"This loan is one of the first CMBS transactions to be completed this year and highlights that long-term, attractively-priced capital is available for quality assets in strong markets," says Dennis Gershenson, president and ceo of the REIT. "This new financing will improve our flexibility in executing our 2010 business plan."

CMBS

Special servicer replacements for Deco pair

The special servicers on two loans backing two Deutsche Bank CMBS deals are to be replaced. Capita Asset Servicers will be replaced by Hatfield Philips International on the Wildmoor Northpoint loan in Deco 11 - UK Conduit 3, while Hatfield is to be replaced by Deutsche Bank on the Allokton loan in Deco 17 - Pan Europe 7.

The second largest loan in the Deco 11 pool at 10% of current outstanding pool balance, the Wildmoor Northpoint loan is expected to be transferred to special servicing as a result of an LTV covenant breach. The loan is secured by a secondary shopping centre located in Kingston-upon-Hull in the UK.

A new valuation was called by the loan servicer (Capita Asset Services Ireland) in light of the upcoming loan maturity in July 2010. The valuation concluded that the property has a market value of £25.7m as of November 2009, resulting in a whole loan LTV of 177.5% and securitised LTV of 160.2%.

Moody's confirms that it has received a notice from the primary servicer (Deutsche Bank) acting on behalf of the issuer, regarding the proposed replacement of the special servicer for the Wildmoor Northpoint loan.

Meanwhile, the Allokton loan represents 5% of the current outstanding pool balance of Deco 17 and is secured by a portfolio of 12 mixed use properties located throughout Sweden. As per the latest investor report (January 2010), the loan was current and in primary servicing.

Moody's confirms it has received a notice from the servicer (Deutsche Bank) regarding the proposed replacement of the special servicer for the Allokton Loan. It is expected that special servicing fees will be waived by Deutsche Bank if the Allokton loan enters special servicing.

In the rating agency's opinion, based on its assessment of the capability of Hatfield and Deutsche Bank to perform the role of special servicer on the Wildmoor and Allokton loans respectively, the proposed replacements will not result in a reduction or withdrawal of the current ratings of the Deco 11 and 17 notes. However, it notes that the strategy and timing regarding the future work-out process for loans being subject to an event of default - impacting the potential recovery proceeds - is of significant importance in relation to the credit risk posed to investors.

Indices

Positive quarter for US CRE

US commercial real estate prices rose by 1% in January, marking the third monthly increase in a row, according to Moody's/REAL Commercial Property Price Indices (CPPI). This reflects a continued recovery from their October 2009 low, when prices were down 43.7% from their peak two years previously.

"Commercial property prices have increased in each of the past three months," says Moody's md Nick Levidy. "However, a few months of price gains does not necessarily indicate a sustainable trend, particularly in these difficult times. Higher transaction volumes are needed to enhance the price discovery process and, after a brief uptick in volume in December due to end-of-year sales, volume came back down in January."

There were 376 sales in January, 8% less than the same time last year. By dollar volume, sales totalled US$4.9bn, a 9% increase over the previous year.

The Eastern US saw office, retail, apartment and industrial prices all suffer significant double-digit price declines in 2009, falling by up to 39% from their peaks two years ago. The Southern US fared far worse than the national average, with all four property types experiencing annual price declines in excess of 25%. The New York office market also performed particularly poorly, with prices down 32.7% for the year, while the Florida apartment market saw value drop by 38%.

LCDS

ELCDS auction scheduled

Creditex and Markit have announced that the ELCDS credit event auction for McCarthy & Stone will be held on 15 April.

Operations

Proposed DWF extension sidesteps need to securitise

The Bank of England (BoE) is seeking views on proposed changes to its liquidity insurance facilities for the banking system. One such proposal would include an extension of Discount Window Facility (DWF)-eligible collateral to include 'raw' portfolios of loans, thereby allowing banks to sidestep the securitisation process.

Counterparties are currently able to temporarily exchange securitisations of loans they have originated themselves for gilts in the DWF. By extending eligibility to raw loans, the BoE says it is looking to ensure that in stressed circumstances the main assets of most commercial banks would be eligible for use as collateral in the DWF without the need for securitisation.

The BoE would apply the same rigorous standards for eligibility and risk management as for other collateral in the DWF. Counterparties would need to pre-position loan portfolios, which would be subject to regular review.

The second proposal under consideration - intended to improve the efficiency of the BOE's risk management of ABS and covered bonds - is an amendment of its eligibility criteria to require enhanced disclosure of information relating to these securities. One of the BoE's guiding principles for its market operations is that it must be able to manage risk and value the collateral accepted. The BoE has therefore been giving consideration to the information that it requires from issuers of ABS.

Amongst other things, the proposed revisions would require counterparties to make publicly available granular information in the form of loan-level data for most asset classes and standardised summary tables in investor reports, as well as key legal documents, summaries of structural features and models for each transaction. The public disclosure of such information - not just on a bilateral basis with the BoE - should create greater transparency across the market, it says. The consultation proposes that the BoE would begin to adopt these requirements during 2011.

Paul Fisher, executive director for markets at the BoE, says: "These proposals are designed to further enhance the Bank's facilities for providing short-term liquidity insurance to counterparties, thereby underpinning confidence in the financial system, and to help the Bank manage the collateral it holds more efficiently through greater transparency."

Ratings

SF ratings transition worsens

According to S&P's 2009 rating transitions study, the agency lowered global structured finance ratings by an average of 3.5 rating notches in 2009, which is slightly more than the 3.2-notch average decline in 2008. In addition, the rating agency downgraded approximately US$3.5trn of the roughly US$10trn original issuance amount of outstanding global structured securities during the year.

The downgrades reflect both criteria updates and assessment of the deterioration in the credit quality of the underlying mortgage and consumer asset collateral, S&P says. Notably, US adverse collateral performance in 2009 caused high levels of defaults among investment grade and speculative grade global structured securities.

That said, bonds with higher ratings continue to experience lower average default rates, while lower-rated bonds continue to default more frequently. At the same time, the annual triple-A absolute default rate declined to 33bp in 2009 from 54bp in 2008. Approximately US$370bn in securities defaulted last year, which represents 3.7% of the total outstanding original issuance amount of global structured finance securities.

S&P notes that while the global economic outlook had improved considerably by late 2009, the overall credit quality of global structured finance securities dropped sharply throughout the year. The degree of deterioration varied in different regions and sectors, but downgrades were far more prevalent overall than they were in previous years.

The rating agency points out that compared with a year ago financial conditions have significantly improved due to the extensive and coordinated stimulus packages that governments implemented around the world. These efforts contributed to improvements in the flow and availability of credit, which helped the world financial markets get back on track, stabilise credit spreads significantly and improve collateral performance to a certain extent. The performance of structured finance collateral tends to lag the overall economy, so the persistent high level of unemployment continues to pressure the sector's overall credit performance.

Many of the negative rating actions followed changes that S&P made to its structured finance rating criteria, but collateral credit performance played a key role as well. The rating agency points out that a significant number of downgrades in 2009 reflect the combined effect of both criteria changes and collateral performance.

S&P lowered a large number of CLO ratings because of criteria updates and revised many ratings on CMBS because of criteria changes and adverse collateral performance. It also made several changes to its methodology and assumptions for monitoring outstanding US RMBS ratings that prompted the rating agency to increase the projected losses significantly above the original expectations. Therefore, S&P believe the rating transition rates are less informative and do not solely reflect transaction performance.

Moving forward, S&P believes the improving credit spreads and stabilising collateral performance in certain sectors will likely bode well for global structured finance securities in 2010 and beyond. Elevated global unemployment levels may continue to weigh on consumer-related collateral and heavily on CMBS, but auto-related and credit card losses started to stabilise in 2009.

Delinquency rates on residential mortgages are still increasing in the US, but at a much slower pace. In most European countries, Asia, Japan and Australia, delinquency rates have either stabilised or started declining.

While S&P expects further price weakness and a large amount of shadow inventory continues to pose challenges, recent improvement in US house prices may also provide some relief in the US residential sector. However, credit performance among CMBS will likely remain depressed a while longer as this sector struggles with increasing delinquency rates, growing maturity defaults and higher loss severities, the agency concludes.

Ratings

Servicing continuity risk criteria published

Fitch has published its global rating criteria for analysing servicing continuity risk in structured finance transactions. The report formalises the rating agency's approach when assessing the risk of servicing disruption events, such as a servicer bankruptcy.

"Servicing continuity is a potential risk for all structured finance transactions," says Edward Register, Fitch EMEA SF operational risk group senior director. "Fitch's approach to analysing servicer disruption risk is consistent globally. However, the approach takes into account differences in market conventions and the robustness of certain mitigating factors between particular asset classes and jurisdictions."

Fitch says the potential for a servicing disruption to cause performance issues and even a default on SF notes, the lack of strength of the servicing arrangements and the limited depth of a particular servicing market may in some cases constrain the rating that can be achieved. Where servicing disruption concerns exist, Fitch expects mitigating factors to be present at either the transaction or jurisdiction level, or both. The existence of back-up or standby servicing arrangements at the closing of an SF transaction can provide mitigating features.

"When analysing individual transactions Fitch considers the position of the initial servicer, the legal framework and servicing environment within a given jurisdiction to determine the likelihood of servicing continuing following a servicer default," says Grant England, head of EMEA consumer ABS at Fitch. "Markets with established legal frameworks and significant precedents regarding the continuation of servicing activities post-bankruptcy may be viewed as fully or partially mitigating concerns around a disruption event, even in the absence of a back-up servicer within a given transaction."

Real Estate

CRE concentrations warrant 'special attention'

In a speech before the annual convention of the Independent Community Bankers of America, US Comptroller of the Currency John Dugan said that the recent surge in community bank failures raises difficult questions for policymakers and that commercial real estate concentrations warrant special attention.

"Given what we know, I think we need to revisit the issue of the appropriate regulatory response to CRE lending concentrations, especially for construction and development lending, and especially for concentrations supported by non-core funding," Dugan said. "While the concentration guidance we issued in 2006 was necessary - even though it was opposed by many parts of the industry - in retrospect, it has obviously not worked as well as we would have liked."

The Comptroller added that experience from the late-1980s and the early-1990s, as well as from the current period showed that significant concentrations in CRE lending leaves banks vulnerable to an economic downturn - "and the higher the concentration, the more vulnerable the bank". He explained that while a healthy economy will mask problems with poor underwriting for a while, a rapid build-up of CRE loans is likely to overwhelm risk management controls and some concentrations are so large that even the most sophisticated control systems cannot protect the bank from a serious economic downturn.

Dugan said policymakers should consider a range of options, such as harder limits, increased capital requirements, a more granular approach to defining concentrations (as not all CRE is the same), minimum underwriting standards, more stringent requirements for concentrations supported by substantial amounts of non-core funding or some combination of these. Noting that newly-chartered institutions are overrepresented among bank failures, he added that consideration should be given to minimum federal standards for all newly chartered depository institutions, with a particular focus on business plans that call for significant CRE concentrations or reliance on non-core deposits for extended periods.

However, the Comptroller also warned that regulators should exercise care in moving ahead during the current economic environment. "We should not do any of this in haste or in ways that would exacerbate the current problems of distressed banks. Any course of action would have to be carefully phased in taking into account the current activities of all banks." Since the start of the crisis, 195 banks - nearly all of them community banks - have failed and projected failures this year are expected to exceed the 145 that were closed last year (SCI passim).

While regulators have been criticised both for being too tough and too lenient, Dugan said balance is critical. "We have to be equally careful not to overreact and make problems worse by acting too precipitously or being more stringent than we need to be."

He concluded: "We need to take action, after thoughtful and careful study, to reduce the exposure of the industry and the insurance fund to such large losses - before the next downturn comes, as it surely will."

Regulation

Banking agencies agree on liquidity risk principles

The US federal banking agencies, in conjunction with the Conference of State Bank Supervisors, have released a policy statement on their expectations for sound funding and liquidity risk management practices. This policy statement, adopted by each of the agencies, summarises the principles of sound liquidity risk management issued previously and, when appropriate, supplements them with the 'Principles for Sound Liquidity Risk Management and Supervision' issued in September 2008 by the Basel Committee on Banking Supervision.

Given the recent market turmoil, the agencies are reiterating the importance of effective liquidity risk management for the safety and soundness of financial institutions. The policy statement emphasises the importance of cashflow projections, diversified funding sources, stress testing, a cushion of liquid assets and a formal, well-developed contingency funding plan as primary tools for measuring and managing liquidity risk. The agencies expect each financial institution to manage funding and liquidity risk using processes and systems that are commensurate with the institution's complexity, risk profile and scope of operations.

Regulation

Cross-border banking recommendations issued

The Basel Committee on Banking Supervision has issued its final report and recommendations of the Cross-border Bank Resolution Group. The report, which was first issued for consultation in September 2009, sets out 10 recommendations that fall into three categories.

The first category calls for a strengthening of national resolution powers and their cross-border implementation. The Committee believes that national authorities need to have powers to intervene sufficiently early and to ensure the continuity of critical functions.

Second, the Committee calls for firm-specific contingency planning. Banks, as well as key home and host authorities, should develop practical and credible plans to promote resiliency in periods of severe financial distress and to facilitate a rapid resolution, should that be necessary. The plans should ensure access to relevant information in a crisis and assist the authorities' evaluation of resolution options. One of the main lessons from the crisis was that the enormous complexity of corporate structure makes resolutions difficult, costly and unpredictable, the Committee notes.

Finally, the Committee believes that steps should be taken in terms of reducing contagion. Risk mitigation through mechanisms such as netting arrangements, collateralisation practices and the use of regulated central counterparties should be strengthened to limit the market impact of a bank failure.

The report also recommends that systemically important cross-border banks and groups provide a plan to preserve the firm as a going concern, promote the resiliency of key functions or facilitate a rapid resolution or wind-down, should that prove necessary. In addition, it recommends that supervisors work closely with their foreign counterparts and relevant resolution authorities to understand how complex group structures and operations could be resolved in a crisis. If an institution's group structures are too complex to permit an orderly and cost-effective resolution, national authorities should consider imposing regulatory incentives, through capital or other prudential requirements, to encourage simplification of the structures.

RMBS

FNMA clarifies loan buyout schedule

Fannie Mae has clarified the timeline along which delinquent loans will be repurchased out of MBS pools (see SCI issue 174). The agency is set to buy out loans on a coupon-by-coupon basis, starting with the highest coupons in the April report.

Further, FNMA will repurchase 220K loans in the April report, removing nearly all of the delinquent loans from 6.5s and higher coupons. By the May prepayment report, it plans to remove the delinquent loans from 6% and in the June report 5s and 5.5s.

ABS analysts at Barclays Capital anticipate that the Gold/FN 6.5 swap will likely collapse on the back of the announcement, as FNMA 6.5s for the April settlement should be clean bonds. Accordingly, they recommend shorting the Gold/FN 6.5 swap.

The move also appears to have assuaged market fears that servicer guideline changes regarding the removal of HAMP trial modifications could lead to a surge in HAMP-related buyouts. "Based on the numbers reported on the FNMA statement, the incremental increase in HAMP-related buyouts resulting from this servicing change seems to be moderate, at best, perhaps an increase of 20-30K loans," the BarCap analysts note.

RMBS

Suit highlights put-back recovery uncertainty

A New York Supreme Court ruling last week on a lawsuit brought by Syncora, CIFG and US Bank against Greenpoint Mortgage Funding has once again highlighted the legal uncertainty around disputed claims and the rights of different counterparties in a securitisation.

Greenpoint had argued that neither the monolines nor the indenture trustee (US Bank) had the right to sue it. The Court determined that the monolines did not have the right to sue for rep and warrantee damages because they "failed to show they were the intended beneficiaries to any reps and warrantees made by Greenpoint".

However, the Court determined that the indenture trustee can continue with its case. Greenpoint must now address the complaint from US Bank in the next 20 days.

According to ABS analysts at JPMorgan, to date most investors have been insulated from losses in HELOC/second-lien deals - despite exceptionally weak credit performance - because monoline insurance payments have typically absorbed collateral losses. Hence, in light of these extensive payments, monolines continue to pursue claims against originators to repurchase loans that do not meet reps and warrantees (SCI passim).

Indeed, as of Q409 MBIA, Ambac and Assured estimated that the net present value of recoveries from these repurchases will exceed US$4bn. In 2009, repurchases from wrapped deals totalled US$260m, or roughly US$22m per month, according to JPMorgan figures. Bank of America (via the Countrywide HELOC shelf) repurchased US$245m of that total.

The gap between monoline projections of repurchases and the 2009 run-rate is partly driven by timing delays between when a claim was originally made and when it is ultimately repaid, given that originators will typically dispute claims. Ambac, for example, estimates the average time to resolution of claims is approximately three years.

As the JPMorgan analysts conclude, "total recoveries from repurchases are still extremely uncertain, as sponsors deny claims or seek legal protection from having to make repurchases".

RMBS

No surprises in February non-agency performance data

The latest non-agency RMBS performance data shows that both prepayments and defaults decreased in February, while severities were roughly flat. But the proportion of short sales among total liquidations increased from January, for prime and subprime collateral.

Delinquencies in the 90+ bucket continued to rise rapidly, while the rest of the buckets were stable. Overall, 60+ delinquencies are at 46% for subprime, 8.5% for prime, 31% for alt-A and 43% for option ARMs. Months spent in foreclosure before liquidation/REO continued to increase, while months spent in REO before liquidation was roughly flat.

According to ABS analysts at JPMorgan, an interesting development is the increased 90+ to foreclosure transition rate across all sectors, but particularly for alt-A and prime. "It is too early to say if there is any change in pattern here; however, any sustained increase in this rate would be important, as it would mean that servicers are finally moving to tackle the huge 90+ delinquent inventory," they explain.

JPMorgan continues to favour 2006/2007 alt-A fixed-rate paper and longer reset hybrids for the coupon, and super/senior option ARMs for the yield. "We also find value in pro-rata last cashflow triple-As in the subprime space, including some of the worst performing deals, since these deals will go pro-rata within the next 6-12 months - creating a more front-loaded cashflow profile," the analysts note.

RMBS

Improved projections for US home prices

ABS analysts at JPMorgan have reported an improvement on their previous projection of US home prices over the last month. The firm's HPI model projects that home prices will bottom in the second half of 2010, with peak-to-trough HPA at -13.8% and -32.6% for the FHFA purchase-only and Case-Shiller national indices respectively.

"Although recent housing indicators have been mostly negative, this was expected as home sales and prices are typically lower in the winter months," the analysts explain. "More importantly, the trailing six-month price momentum has been very strong. This has laid the foundation for our improved projection."

However, they point out that downside risks still remain from the build-up of foreclosures and the pace and volume of loans that will eventually hit REO. Total foreclosure inventory represents a 20-month supply at the current liquidation pace. Although the REO months' supply fell back to normal levels, the foreclosure supply has risen since August 2009.

The LoanPerformance home price index declined by 2% in January - the fifth consecutive monthly drop since September 2009. The FHFA purchase-only index and the S&P/Case-Shiller 20-city composite dropped by 1.6% and 0.2% respectively in December.

But the LoanPerformance index recorded a 0.5% annual decline in January, compared to 3.0% in December and 4.6% in November. The FHFA purchase-only index and S&P/Case-Shiller 20-city composite were down 1.6% and 3.1% respectively in December over last December.

RMBS

ERF tender offer announced

Aviva Annuity UK has launched a tender offer for certain RMBS issued by Equity Release Funding (ERF) 3, 4 and 5 up to a maximum of £300m. Aviva's offer follows news that ERF 3 will not exercise its right to redeem the class B notes on the interest payment date falling in April 2010.

"Whilst no decision whether to call the ERF 4 notes and/or the ERF 5 notes at their respective step-up dates has yet been made, the company believes that some holders of the ERF 4 notes and the ERF 5 notes may also wish to be offered an opportunity to dispose of such notes," says Aviva.

Aviva is offering a maximum price of 80% for ERF 3 class B notes; 90% for ERF 4 class A1s and A2s; 75% for ERF 4 class Bs; 60% for ERF 4 class Cs; 55% for ERF 4 class Ds; 90% for ERF 5 class As; 75% for ERF 5 class Bs; and 60% for ERF 5 class Cs.

RMBS

Fourth UCI tender results in

Results of the fourth tender offer for class A notes of BNP Paribas' UCI RMBS issues 8 to 17 have been announced. A total of €109.1m face value of bonds was accepted, bringing the full amount repurchased by BNP Paribas to €1.2bn. The bank issued its first tender offer for the bonds in October 2009 (SCI passim).

According to UniCredit, the auction garnered the smallest number of acceptances to date, possibly because the maximum tender price was set below the levels paid in previous repurchases, especially for the less seasoned deals.

The results were: UCI 8 (maximum price 95, accepted range 95); UCI 9 (maximum price 94.5, accepted range 94-94.5); UCI 11 (maximum price 89, accepted range 88.95); UCI 14 (maximum price 80.5, accepted range 80.4-80.5); UCI 15 (maximum price 77.5, accepted range 77.45); UCI 16 A2 (maximum price 75, accepted range 75); and UCI 17 A2 (maximum price 73.5, accepted range 73.4-73.5). No tenders were accepted for UCI 10 or UCI 12.

RMBS

Little impact from UK loan modifications

Fitch says data submitted to it suggests that loan modifications, while being encouraged by the UK government, have had little impact on the country's mortgage market. The data also indicates that almost half of all loans reviewed for modification are deemed by the servicer to be unsuitable for modification.

Formalised loan modification programmes, first seen in UK RMBS in January 2008, enable mortgage servicers to effectively address the challenges facing delinquent loans at a time when legal enforcement and repossession is viewed as a less favourable workout strategy from both an economic and regulatory perspective.

"The Fitch study suggests that borrowers in distress, currently enjoying low lender standard variable rates and the historically low Bank of England base rate, have nowhere left to run," says Robbie Sargent, director in Fitch's European structured finance operational risk group. "Interest rates are so low that downward interest rate adjustment would be so negligible as to have no material impact on monthly mortgage payments, whilst high loan-to-value ratios limit the ability of servicers to offer other modification facilities."

Fitch believes that loan modifications have the potential to alter the speed and timing of prepayments in an RMBS transaction, and notes that loan modifications may provide some benefit to UK RMBS transactions - particularly given the current economic climate, which is characterised by falling house prices, negative equity and rising unemployment. However, concerns remain over potential re-defaults, whereby modifications are simply delaying an inevitable default and therefore storing up losses for the future.

"Loan modifications cannot be viewed as universally good or bad for a transaction," says Alastair Bigley, head of UK RMBS at Fitch. "Whether they are beneficial or not to investors depends how the operational risk inherent within a loan modification is managed and the position of an investor within the capital structure."

RMBS

UK RMBS extension risk measures introduced

Moody's has introduced new measures to assess the extension risk of notes issued by UK RMBS master trusts. The new measures are an attempt at quantifying the likelihood that the principal repayment of bullet, scheduled amortisation and controlled amortisation notes will not be made by their scheduled maturity dates.

Extension risk arises when, in certain cases, there are insufficient funds accumulated to repay bullet, scheduled amortisation or controlled amortisation notes on schedule and, as a result, repayment of these notes may extend beyond their scheduled maturity date. Recently, due to repricing of risk, decreasing principal payment rates (PPRs) in the mortgage market and trigger breaches in some of the trusts, extension risk associated with the senior notes of master trust transactions has become very relevant for investors.

"This risk is not assessed by the ratings on the notes as the ratings address the expected loss on the notes by their legal final maturity; i.e. they do not cover the likelihood of a non-payment of principal by the scheduled maturity," says Olga Gekht, a Moody's vp and senior analyst. "As such, these new measures will not result in rating implications for the notes."

There is considerable variation between master trusts in how much extension risk is expected to be experienced by their bullet, scheduled amortisation and controlled amortisation notes, according to Moody's. This is due to the differences in the amount of outstanding notes as a proportion of the trust size, as well as the amortisation schedule of the notes.

In addition, the assessment shows that, taking into account the low PPRs currently observed in the sector, overall there is a significant proportion of notes that are expected to extend, assuming originators do not provide the funds to make up for the shortfall. "Approximately 85% of all the notes have significant extension risk, taking into account principal payment rates currently observed in the trusts," says Anthony Parry, avp and analyst at Moody's. "On the other hand, if principal payment rates observed in the trusts were the same as during third quarter of 2007, which was when principal payment rates were at their highest, less than half of all notes would have been expected to extend."

Moody's says that it will regularly perform this analysis for the bullet, scheduled amortisation and controlled amortisation notes of the various trusts and include it in future new issue reports for UK RMBS master trust issuances. However, the rating agency cautions that this is a point-in-time assessment and the actual extension risk may change over time as the existing notes are repaid, new notes are issued and/or the principal payment rate changes in the master trust.

RMBS

Second-lien RMBS loss projections revised

Moody's has revised its loss projections for 2005-2007 second-lien US RMBS and expects cumulative losses to average around 25%-55% of outstanding balance for non-subprime closed-end second (CES) pools, 70-85% for subprime CES pools and 40-50% for HELOC pools. The updated numbers represent more than a 50% increase for non-subprime CES and nearly a 20% relative increase for subprime CES and HELOC pools.

Second-lien pools issued before 2005 are still experiencing rising loss rates and are therefore subject to increased loss expectations, but they are expected to realise lower cumulative loss levels than the recent vintages. Moody's has placed 948 tranches of second-lien RMBS, with an original balance of US$113bn and an outstanding balance of US$35bn, on review for possible downgrade as a result of the increasing loss expectations.

The elevated loss rates in second-lien mortgages have been caused by the decline in home values. Moody's says borrowers with second liens, particularly those originated in recent years, are almost universally in a negative equity position. Most had combined loan-to-value ratios approaching 100% at origination, but home prices have already dropped by nearly 30% since.

The rating agency says this is of particular concern because the most important predictor of mortgage default in the last few years has been the extent of negative equity in borrowers' homes. There is also a heightened risk of borrowers defaulting on their second lien to make payments on their first lien loan, because doing so does not typically result in foreclosure.

Subprime CES annual loss rates, measured as total annual losses against the pool balance at the start of the related year, averaged 38% over the past year. Six months ago it hit a high of 40%, but recently dropped to 37%.

Non-subprime CES and HELOC average annual loss rates reached 14% over the past year, although Moody's thinks HELOCs may stabilise at these levels. Non-subprime CES loss rates are still rising, tracking the increasing delinquencies in the prime-first lien sector which have risen from 3% to 9% in the past year.

Moody's expects continued severe pressure on second-lien borrowers as the overhang of impending foreclosures will impact home prices negatively in the coming months and predicts that home prices will fall by an additional 7%, reaching a peak-to-trough decline of approximately 34%. Adding to borrowers' financial pressure, unemployment is now projected to peak at 10.3%. Both measures are expected to reach their peaks in the second half of 2010, after which recovery is likely to be slow.

RMBS

Mexican RMBS concerns continue

Mexican RMBS performance will continue to deteriorate over the coming months, but at a slowing pace as unemployment begins to decrease, according to a new report by Moody's. Performance is expected to begin to stabilise by the end of the year, but the rating agency's outlook for Mexican RMBS remains negative for 2010.

The Sofoles (mortgage bank) sector should continue to see the greatest negative pressure, while ratings for Infonavit and bank RMBS continue to be well positioned. Moody's says the tough economic environment has only had a limited impact on banks because they generally lend to the more protected middle and high income segments of the population.

Increased levels of unemployment accompanying the recession last year led to performance deterioration among all the Mexican RMBS sectors, with Sofoles' transactions being the most affected, and downgrades being concentrated there. "Sofoles face several challenges in 2010, which include the lack of external funding, the increased delinquencies in their serviced portfolios and weak capitalisation levels," says Moody's avp Alonso Sanchez Rosario. "The survival of some Sofoles will largely depend on continued government support for the sector, as well as improved efficiencies in loan origination and collections processes."

The agency expects the Mexican government's SHF to continue to play an important role by providing funding or guaranties for Sofoles and believes that the Mexican RMBS sector is likely to see its first replacement of a servicer in 2010 after the sale of Credito y Casa. It is predicted that 2010 will be a demanding year for servicers as their collection abilities continue to be tested by increasing delinquencies.

Structuring/Primary market

CRE recovery creates investment opportunities

Investors could well capitalise on opportunities in US commercial real estate as it begins to recover this year. A new real estate report by Deloitte suggests that, despite declining values, debt maturity and tight credit access, and stalled construction all continuing to harm US commercial real estate in 2010, economic indicators do point to potential recovery in 2010.

"The Fed's Beige Book released this month indicates a nascent economic expansion, with commercial real estate lagging the overall economy as it has historically done. With the market poised for change, savvy investors with access to capital may find the time to act is drawing near," says Bob O'Brien, vice-chairman and Deloitte's real estate services leader. "The flip-side of opportunity is challenge, which is especially true for borrowers and lenders who are seeking solutions to a debt problem of historical proportions. As we navigate truly uncharted territory, the point where opportunity intersects with challenge is where the answers - and winners - may be found."

As recovery draws near, but still lags behind general economic recovery by three to six months, opportunities exist for investors. The anticipated increase in foreclosures and deeds in lieu as owners and mortgage holders continue to struggle with debt maturity is expected to mean investors are able to use foreclosed properties and distressed debt as a strategic opportunity to make acquisitions and expand their portfolios. Banks, mezzanine debt holders, CMBS special servicers and the Federal Deposit Insurance Corporation are all key targets approached to capitalise on these investment opportunities.

Deloitte's report also highlights other opportunities arising now that the market appears to have bottomed out, with REIT IPOs and secondary offerings expected as public capital markets' interest in commercial real estate intensifies. Foreign capital is anticipated from Asia, Germany and the Middle East, and well-capitalised REITs and funds should have opportunities to make distressed acquisitions.

Other trends for the next nine to 18 months may include an uptick in the job market and consumer spending, which may raise values as confidence returns in occupancy and rent increases, recovery for hospitality and multi-family residential property, and bright futures for the office markets of Washington DC and New York. Deloitte does not expect much new construction activity, however, and predicts historic low levels of new construction with excess capacity in almost every asset class.

RMBS

Understanding the credit quality of residual pools

Priya Balan, European ABS research analyst at Barclays Capital, explains why UK non-conforming RMBS residual pools may strengthen

With the recession having caused a substantial rise in delinquency and default rates in many European RMBS sectors, and with the risk of non-call remaining high in some of these sectors, investors have grown increasingly concerned about the quality of the residual pools; i.e., the quality of the collateral pools remaining towards the end of the life of these transactions. Many investors assume that all the high-quality borrowers in a pool will prepay, meaning that the residual pool will consist nearly entirely of only low-quality borrowers.

Of course, the mistake in this assumption is that it neglects the effect of defaults: even if only high-quality borrowers prepaid, poor-quality borrowers would still leave the pool as well - via defaults. Hence, whether the residual pool is higher or lower in overall quality than the initial pool crucially depends on how prepayments among high-quality borrowers are balanced out by defaults among low-quality borrowers.

The technical term for this concept is burnout. It is our observation that this concept is often not very well understood by European ABS investors, despite the fact that understanding burnout is the key to understanding the behaviour of ageing mortgage pools.

As investors already fear, burnout can indeed potentially transform a pool which started off as a strong pool into one that gets progressively weaker as it amortises. However, not many realise that burnout can also have the opposite effect and gradually strengthen a pool, even one that was initially weak.

The former effect is more likely to be observed during economic boom times, while the latter is - somewhat counter-intuitively - more likely to be encountered during a recession, such as the one we have just experienced. Hence, to understand the likely future behaviour of residual pools, a merely partial understanding of burnout is no longer sufficient.

The UK non-conforming RMBS sector stands out as one where burnout is likely to play a key role in the future performance of residual pools. Many investors are worried about the performance of UK non-conforming mortgage pools in the current weak macroeconomic environment, as economic growth in the UK has been poor, house prices have declined and unemployment levels have risen considerably.

This situation should, however, improve gradually over the coming quarters (and, to some extent, it already has). Despite this, some investors expect collateral performance to deteriorate further and not benefit from any improvement in general economic conditions in the UK.

As best as we can tell, these expectations are at least in part reflecting an incomplete understanding of burnout. And indeed, sector overviews from rating agencies show UK non-conforming pool performance as improving. The S&P total delinquency index for UK non-conforming borrowers fell for the first time since September 2007, and Moody's indices indicate a general decline in delinquencies since June 2009.

In this report, we take an in-depth look at exactly how burnout can affect a mortgage pool as it shrinks over time. We introduce our burnout model and use it to analyse the behaviour of the pool under different scenarios - a strong macroeconomic environment, a weak macroeconomic environment and one in which the macroeconomic environment is initially strong but later deteriorates into a recession.

We find that the credit quality of the residual pool is highly dependent on the relative speeds of prepayments and defaults. When prepayments are more dominant, as we would expect to see during a period of economic growth, the quality of the pool deteriorates as it shrinks.

On the other hand, when defaults are dominant, as is usually the case in a recessionary environment, the credit quality of the pool steadily improves as it shrinks. Finally, when we look at a combination of the two environments with prepayments dominating initially but defaults dominating subsequently, we find that the trend in pool credit quality declines at first, but the pool then starts to cure.

Based on the insights gained from our scenario results, we believe that many investors may be too pessimistic in the forecasts for residual pool performance, including in the UK non-conforming sector. In our opinion, pool performance in this sector may very well benefit from the gradually improving macro-economic environment, especially given that these pools have just gone through a period where burnout may have caused their fundamental credit quality to undergo more favourable dynamics (for the residual pool) than many investors realise. Consequently, we believe that fundamental performance in the UK non-conforming RMBS sector will be fairly stable from here on out and may even continue to show signs of noticeable, if gradual, improvement.

The residual pool problem
The behaviour of the residual pool has been analysed in more detail and tends to be better understood in the US than in Europe. While the European understanding of burnout is not wrong, it often appears incomplete. The general belief in Europe is that borrowers of a higher credit quality will always prepay as they refinance their mortgages at a better rate and, over time, this will lead to a concentration of borrowers of low credit quality who are unable to refinance in the pool.

This may be true in an environment where initial mortgage rates are low and refinancing options abound. For example, in UK non-conforming RMBS in times past, most borrowers would have tried to prepay when their teaser period came to an end and switch into a different mortgage product that allowed them to benefit from yet another teaser period.

Given the big jump in interest rates post-teaser period, the incentive to refinance before the teaser period ends was very high. Most borrowers who could prepay would have done so and it is usually only those who were of the lowest credit quality and therefore unable to qualify for a new mortgage product that got left behind in the residual pool. Under some conditions, this refinancing behaviour could have led to an increasing proportion of weak borrowers in the pool over time, resulting in a low-quality residual pool.

However, when refinancing options are limited, lending constrained and mortgage rates high, the incentive to prepay - even for high-quality borrowers - diminishes. This is in fact currently evident in the UK non-conforming sector, where post-teaser period mortgage rates are actually lower than the alternatives available in the non-conforming mortgage market (to the extent any non-conforming mortgage product is available at all).

Pool dynamics now are very different from those described above. Since there is nothing to be gained by prepaying, even the high credit quality borrowers continue to stay in the pool.

Weak borrowers who cannot afford to keep up their interest payments once the post-teaser rates kick in go into arrears and could eventually default. As weaker borrowers default out of the pool, the concentration of higher credit quality borrowers grows and pool quality improves, leading to a stronger residual pool.

Indeed, the US markets recognise these two distinct situations and correspondingly define two types of burnout: prepayment burnout and credit burnout, each of which leads to a very different type of residual pool.

Defining burnout
Burnout in general refers to the change in the composition of a mortgage pool as certain types of borrowers shift out of the pool in response to external macroeconomic drivers. Burnout occurs because borrowers tend to fall into categories that behave differently under pressure.

Most pools are made up of a mix of borrowers in terms of quality. Some borrowers are of high credit quality with stable income, extensive savings and low mortgage LTV and DTI ratios, easily able to keep making payments on their mortgages. Others are of a poorer quality with unstable incomes, low to no savings and higher LTV and DTI ratios and, as a result, are more vulnerable to an adverse environment.

We adopt the US definitions and differentiate between prepayment burnout (which is more evident in a strong economic environment) and credit burnout (which is generally observable in a weak, recessionary environment).

Prepayment burnout
When times are good, most borrowers tend to refinance their mortgages at the end of the teaser period in order to avoid switching to a higher rate. This is easy to do because in good times, refinancing options are not hard to find. Even lower-quality borrowers who may have gone into arrears on their mortgages can prepay out of the pool because strong economic environments usually mean rising house prices, which means that the property can be sold for a profit and the proceeds from the sale could be enough to not only repay the existing loan, but to also take out a new one to possibly buy another property.

In times such as these, only the very worst quality borrowers would find themselves unable to refinance. This phenomenon is known as prepayment burnout and, as a result of it, a pool that starts off with a strong credit profile, over time, could end up consisting only of weak mortgages.

Credit burnout
Credit burnout usually occurs in a harsh economic environment when weaker borrowers find it increasingly difficult to keep up their mortgage payments and start to default out of the pool. If the environment remains harsh, more and more default thresholds are breached and an increasing number of borrowers default until only the strongest borrowers with the highest default threshold are left in the pool. If refinancing opportunities are limited, as is often the case in a recessionary environment marked by falling house prices and rising mortgage rates, the stronger borrowers, lacking the incentive to prepay, remain in the pool and the credit profile of the pool actually improves over time.

Modelling burnout
A two-repline pool
We model a simple mortgage pool with two replines - one representing strong, high credit quality mortgages (the 'good' repline) and the other representing weaker mortgages of a lower credit quality (the 'bad' repline). In periods of strong economic growth, the prepayment probability of good mortgages is higher than that of bad mortgages and the default probability of both categories of mortgages is low. In a stressed environment, the default probability of the bad mortgages is much higher than that of the good mortgages and the prepayment probability of both types of mortgages is low.

To model this effect, we assume a zero default probability for good mortgages and a zero prepayment probability for bad mortgages and consequently apply the CPR value exclusively to the good repline and the CDR value exclusively to the bad repline (note that our CPR and CDR values are applied to the corresponding replines, not to the overall pool). Because we are primarily interested in illustrating the changing composition of our example pool as a result of prepayment and credit burnout, we do not have to model loss severities or recovery lags.

Three scenarios
We analyse the behaviour of this pool under three different scenarios - a growth scenario, a recessionary scenario and a 'historical' scenario where the environment switches from growth to recession. For the growth scenario, we assume a high CPR and a low CDR and find that, as expected, the concentration of bad mortgages in the pool increases as the pool amortises.

Because only the good repline prepays, its outstanding balance reduces quickly as it prepays. The outstanding balance of the bad repline also reduces over time, but only due to defaults and hence only slowly. Since the good repline amortises at a much faster rate than the bad repline, its outstanding balance reduces at a much faster rate than that of the bad repline.

For the recessionary scenario, we assume a low CPR and a high CDR. The results are the opposite in this case, as the concentration of bad mortgages in the pool declines over time.

The CDR for the bad repline is higher than the CPR for the good repline in this scenario (note, however, that typically the good repline will be much larger than the bad repline; hence, even in this scenario, the pool CPR will be higher than the pool CDR). Consequently, the bad repline now amortises faster that the good repline, leading to a residual pool increasingly dominated by the good repline.

For the 'historical' scenario, we introduce a regime switch, which we let occur after about 3.5 years into the life of the mortgage pool. We assume that up until the switch date, we are in a growth environment and that after the switch date the economy shifts into recession.

To model this, we combine the two scenarios above and use the growth CPR and CDR assumptions until the 'switch' date and from thereon use the recessionary CPR and CDR assumptions. As expected, the pool quality deteriorates at first, but starts to cure following the regime switch.

Numerical simulation results
Growth
To simulate economic growth, we use a CPR of 35% and a CDR of 2%. We assume that the pool initially consists of 85% good mortgages and 15% bad mortgages. (Incidentally, this implies an initial pool CPR of 85% * 35% = 30% and an initial pool CDR of 15% * 2% = 0.3%.)

The high CPR value causes the good mortgages to amortise very quickly, while the low CDR value only causes a small number of defaults, which means that the outstanding balance of good mortgages drops sharply while the outstanding balance of bad mortgages barely reduces (Figure 1). As a result, the concentration of bad mortgages in the pool steadily increases.

Figure 2 shows how the proportion of good mortgages decreases relative to bad mortgages as the pool shrinks. By the time the pool is down to 20% of its original size, the good-to-bad ratio drops below 1, to 0.6 as the total outstanding balance of bad mortgages is now close to double that of good mortgages.

Recession
To model a recession, we make our assumptions harsher and allow defaults to overtake prepayments. We assume a CPR of 4% and a CDR of 7%. The initial pool composition remains the same with 85% good mortgages and 15% bad mortgages. (Of course, this also means that the pool CPR at 85% * 4% = 3.4% is still considerably higher initially than the pool CDR at 15% * 7% = 1.1%.)

The outstanding balance of the bad repline now declines very quickly (Figure 3) and the proportion of good mortgages in the pool rapidly rises as the pool shrinks (Figure 4). For a 20% residual pool, the outstanding balance of the good repline is nearly 11 times that of the bad repline; in fact, almost double what it was before the pool started to amortise.

Growth followed by recession
Here we combine the two previously described scenarios and model pool behaviour in an environment that starts off robust and strong and then switches into a recession. We assume a CPR of 35% and a CDR of 2% for the growth regime and a CPR of 4% and a CDR of 7% for the recession regime. The initial pool composition remains the same as before, with 85% made up of good mortgages and the remaining 15% of bad mortgages.

As we can see from Figure 5, the total outstanding balance of good mortgages initially declines rapidly because of the high CPR value characteristic of a strong economic growth environment. Once the economy switches into recession, the big fall in CPR significantly slows down the pace of decline of the good mortgage outstanding balance.

Figure 6 is a good example of both types of burnout. Initially, we see prepayment burnout. The concentration of good mortgages in the pool falls as the high CPR and low CDR causes good mortgages to prepay out faster than bad mortgages can default out.

The situation then reverses when the regime switch takes place and we see the start of credit burnout. Bad mortgages begin to default out of the pool faster than good mortgages can prepay, as the CDR value now exceeds the CPR value and the concentration of good mortgages begins to increase in the pool.

Conclusion
Our analysis shows that burnout can have a strong influence on pool credit quality and, as a result, the residual pool can look very different depending on whether it has experienced prepayment burnout or credit burnout.

We looked at three different scenarios to see how the pool behaves under different conditions. Of these, we deem the final scenario - growth followed by recession - to be the most relevant at the present time.

In recent years, we have shifted from a period of very strong economic growth to a much weaker environment. Non-conforming mortgage pools, which in the past experienced high levels of prepayment and very limited defaults, are now finding the situation reversed and as a result are ideal candidates for experiencing credit burnout - which, as our analysis shows, bodes well for the quality of residual pools.

We are already starting to see some evidence of the increasing strength of residual pools in the UK non-conforming sector, with all the main rating agencies reporting an ongoing improvement in pool performance. Of course, some of this performance improvement will be a reflection of a stabilising, and partially improving, economic environment - but to some extent, the improvement in performance is likely to reflect a positive residual pool dynamic brought about by credit burnout.

We believe that if investors bore the above results in mind, they would find themselves much better placed in running collateral scenarios and valuing bonds, especially subordinate bonds in sectors where credit burnout may have been substantial over the past few years - such as UK non-conforming RMBS.

© 2010 Barclays Capital. All rights reserved. This Research Note is an extract from Barclays Capital's recent European Securitised Products Weekly publication, published on 15 March 2010.

Trading

Trading ideas: keep it short

Dave Klein, senior research analyst at Credit Derivatives Research, looks at an equity basket trade

We inaugurate our weekly equity basket trade with a short-heavy list of names. Strong equity performance over the past month kept the ratio of expensive equities to cheap ones high. Consumer cyclicals make up a large portion of the basket (see Exhibit 1 - basket sector breakdown), as they currently do in our daily equity portfolio.

Methodology
CDR's CDS-equity model forms the basis of our equity long-short strategy. The relative value of CDS contracts and company market cap are estimated based on the past trading relationship of the two securities.

When a company trades with a large disconnect, we go long or short the equity accordingly with a beta hedge. When possible, our equity recommendations are matched with the credit outlook from our directional credit model, since we are taking one side of a relative value trade. A beta hedge is transacted to minimise the effect of any overall CDS-equity disconnect.

A three-step process is followed when selecting names to go into the basket. First, companies that trade between 5% and 25% away from fair value are chosen. Testing over the past 2.5 years' data (since spreads came off their tights) shows this range to be the 'sweet spot' for the model.

Next, companies whose credit outlook matches our equity outlook are selected; the idea being that credit improvement (deterioration) will be matched by equity improvement (deterioration). Finally, the basket is completed by selecting names trading farthest from fair and possessing the best model fit (see Exhibit 2 - equity basket composition). Once the list is constructed, we dig into company fundamentals and news and eliminate any names that justifiably trade away from our quantitative model.

Longs
MBIA Inc trades with a tight connection between CDS and market cap; not surprising, given that its wide spreads make its debt 'equity-like'. Over the past month, the company's equity underperformed its CDS and a rise in share price is expected to bring the securities back together.

Avis Budget Group's equity dropped last week, while its CDS held steady. Barring massive credit deterioration in the near term, shares should rise to come back to fair.

The New York Times Company had a rough March so far in equity-land. Although we are not bullish on the company's credit, NYT's CDS-equity model performed well this year and its disconnect is wide enough to invite entry.

Shorts
TRW Automotive has been an equity short since the beginning of February. Although its share price improved, the company lagged the overall market and further equity underperformance is expected.

Alcoa Inc shares rallied last week after the PPI report tamped down inflation expectations. Although modest improvement to AA's credit profile is expected, the equity jump was dramatic enough to warrant a short-term pullback.

Sunoco Inc makes our list of credit shorts due to weak margins, interest coverage and free cashflow, bolstering our view of equity deterioration.

The Boeing Company is fairly valued in credit-land. The company's equity trades near 52-week highs and its CDS is nowhere near recent tights. With an expectation of CDS stability, an equity decline back to fair is forecasted.

Office Depot Inc trades close to fair, according to our directional credit model. At different times this year, we have been long and short ODP with good results.

PMI Group trades with a good relationship between CDS and equity. Those looking to put on a pairs trade should consider a long MBI/short PMI position.

Liz Claiborne is fairly valued, according to our directional credit model, leading to our expectation that company's share price will drop to reconnect with CDS.

For more information and regular updates on this trade idea go to: www.creditresearch.com

Copyright © 2010 Credit Derivatives Research LLC. All Rights Reserved.

Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).