Contents

RMBS

HMBS potential

Reverse mortgage securitisation hinges on housing

The secondary market for reverse mortgages is still very much a negotiated market. However, participants suggest that growth in FHA's Home Equity Conversion Mortgage (HECM) programme - which is expected to take off over the next few years - could lay the groundwork for more securitisations to occur.

As the older generation ages, reverse mortgages are expected to grow steadily in popularity. The mortgages are particularly a means for senior citizens to tap equity in their homes similar to home equity lines of credit.

"Given the rapid increase in HECM loan endorsements, it is likely that issuance will increase in the future," note Barclays Capital ABS analysts in a recent report. "Over the past 10 years, this product has gained a foothold with seniors across the country. It looks to expand further as population demographics continue to shift."

The first private reverse mortgage securities transaction in the US, called SASCO 1999-RM1, was completed in 1999 by Lehman. But after the credit crisis the market for private reverse mortgage transactions all but shut down. This has left Ginnie Mae HECM mortgage-backed securities, called HMBS, as the only kind of reverse mortgage securitisations available.

After about US$5bn in issuance from 2006 to 2009, the new HMBS market is decidedly different from HMBS in the past. The recent securitisations are backed by reverse mortgage collateral that is mostly fixed rate as opposed to floating rate, which dominated years ago.

"Recently there's been strong demand for the fixed rate product because of the profiles of the cashflows," says Matt Brodin, director and fixed income specialist at Interactive Data Corporation. "It's easier for an investor to do an analysis on the cashflow stream. In some of the older programmes, there was some uncertainty because of the draws in the interest rate pieces; they [investors] didn't feel comfortable investing." Interactive Data last month added the ability to offer daily evaluations for fixed rate GNMA HMBS to their suite of analytics services.

The government guarantee is also a plus for investors in HMBS currently, since the underlying reverse mortgages are guaranteed by the US Department of Housing and Urban Development (HUD) and Ginnie Mae.

Mark Hecker, senior director of Interactive Data's Evaluated Services, says the firm has seen some of its clients become more interested as investors in the securities, since some of the largest institutions are HECM originators. Bank of America, MetLife and Wells Fargo are among the lenders of reverse mortgages.

Though a true secondary market is unlikely to develop until home values begin to appreciate once again, an actual securitisation market would be welcome news for both originators and investors alike. There are profitable pools in this asset class to be securitised, says one bank lender. "They are HUD government-insured loans; the quality is there," he adds.

"We've definitely been seeing the secondary market develop a bit more over the past year or so; that being said, it's still a relatively niche product," explains a credit analyst. "It could take off more if you see some more reverse mortgage issuance." Recent transactions have so far ranged from as low as US$1m to about US$300m or US$400m in size.

Spreads on HMBS could also be a draw for some investors. On average, they trade at around 70bp over swaps. "It is comparable on a static basis to where you see a lot of the PACs in the agency space trading. A big difference is they don't have the interest rate risk of regular mortgage-backeds; because of that they have much better cashflow properties," notes the credit analyst. "Once you adjust for optionality in MBS, these have a huge spread pick-up relative to traditional CMOs that a bank or insurance company might buy."

But a problem one investor sees is the long duration of the assets. "It's a product without a home. It's very long duration and hard to hedge," he says. Generally, fixed rate reverse MBS have an average life of five to seven years.

With some of the most natural buyers of HMBS securities out of the market, some wonder if there is enough natural interest for the product. As the investor notes, several dealers have bought the securities and have not been able to sell them in the market currently. But life insurance companies are still touted as the most logical investor.

However, the credit analyst expects activity in this sector to pick up this year and next year. "A lot of HECMs will be securitised into MBS this year, but it's a question of how big the overall market will become."

KFH

LCDS

Shot in the arm

New terms expected to revitalise LCDX tranche trading

The new bullet LCDS standard terms documentation (SCI passim) was published on 5 April, in tandem with the implementation of market practice changes to the trading convention for North American LCDS transactions. As well as increasing liquidity in single name LCDS, the move is expected to revitalise LCDX tranche trading.

The new bullet LCDS standard terms documentation allows parties to enter into LCDS transactions with a fixed 'bullet' maturity that is not subject to acceleration in the case where the reference entity's loans are repaid. The cancellation feature in the old LCDS documentation had limited the expansion of single name and portfolio products.

However, LCDX index and tranche trading are now expected to approach the levels of liquidity seen in CDX HY. The composition of the two indices have almost a 40% overlap.

Among the trading opportunities likely to arise from the changes are: LCDX index arbitrage; secured versus unsecured trades; and - since the old contracts would continue trading - the ability to determine the market-assumed probability of cancellation, by comparing bullet and cancellable contracts. Certainly, structured credit analysts at Citi suggest that LCDX tranches should now offer good relative value post the 2009 rally.

For example, LCDX tranche prices have climbed since the first half of 2009, in tandem with the rally in cash CLOs. But investors are nonetheless expected to look at the relative merits of both products.

The Citi analysts suggest that the choice of product ultimately depends on the investor's risk threshold. "Those who are bullish on the loan class and believe that the refinancing needs post-2013 will not be a major challenge should buy CLO equity," they explain. "We have argued for this trade recently on the basis of attractive current carry and overall returns. However, those looking for a little more protection than the first-loss piece will find many reasons to debate between the LCDX 12%-15% tranche and a CLO single-A, for example. Both offer approximately 9% yield."

However, LCDX tranches have a shorter life (ending before the refinancing window kicks in) and a higher running spread. In this context, the CLO single-A's longer life looks negative - although it does have the benefit of higher subordination.

On the other hand, investors are exposed to single name risk with LCDX tranches. The more junior the position, the greater that risk is.

By way of an example, the LCDX10 index includes Boston Generating, US Airways, United and Swift Transportation, as well as several other high-spread names. "While the first is considered to have significant default probability prior to 2013, the current 6% subordination below the 12%-15% tranche should [provide] adequate protection for even a reasonably bearish scenario. All of these factors leads us to conclude that senior LCDX tranches should be on the due-diligence list of most credit investors," the analysts note.

Away from tranches, the new trading convention for single name LCDS transactions will be similar to those that have been adopted for other standardised CDS contracts over the course of 2009, in which the industry successfully adopted fixed coupons for CDS contracts in North America, Europe, Asia and emerging markets.

Under the changes, firms will trade North American LCDS with standard coupons of 250bp, 100bp and 500bp going forward. 250bp will be the most liquid strike, with the others being used for tight or wide names respectively. Firms will also now trade with full first coupon and T+3 upfront settlement.

The LCDS market practice changes are the result of coordinated efforts among market participants and serve to further promote standardisation and liquidity in the market, according to ISDA.

CS

CLOs

Increased clarity around CLO consolidations

Increased clarity regarding the estimated market price of CLO management mandates has emerged due to the recent sale of CLO management contracts by Columbus Nova to Deerfield Capital (see SCI issue 177). Structured credit analysts at Citi note in a new report that the sale is a rare case of CLO management consolidation transaction details becoming public, due to Deerfield's status as a publicly traded entity.

Columbus Nova received US$25m in Deerfield stock (worth roughly US$25.9m as of 30 Mar) and US$7.5m in deferred cash under the transfer. Additionally, the parent company of Columbus Nova provided funding to help redeem Deerfield's outstanding debt.

"With US$1.8bn across four CLO vehicles (all but one are passing all OC tests, with the other likely to cure its most junior OC test at its next payment date) and assuming 50bp in senior and subordinated management fees, the transaction price implies roughly 3.5 years of annual fees," the Citi analysts note. "The number will likely serve as an anchor point for other managers (and their parent companies), such as Stanfield and Nomura, who are looking for buyers for their CLO platforms."

In addition, the Citi report points out that while the selling of CLO platforms is often used as an avenue to raise cash by parent companies that face financial strain, in the case of the Deerfield-Columbus Nova transaction, the party in need of cash was the acquirer.

Meanwhile, Navigare Partners has become the latest manager seeking consent to reassign its transactions - in this case to Ares Capital. The manager has three transactions with a total notional of US$1bn, with all three transactions passing all of their respective OC tests.

Overall, close to 40 deals have already changed hands and more transactions are likely to follow. Manager consolidation is also expected to increase across Europe.

Examples cited by Citi include the recent resignation of GSC as a manager of two of its transactions. Earlier in the year, Bacchus 06-1 CLO was reassigned to Halcyon while Avoca replaced KBCFP as the manager of Lombard Street CLO (see CDO manager transfers database).

JA

CMBS

First step towards multi-borrower revival

A new US$309.7m 144A CMBS offering from RBS Securities marks an important first - albeit 'baby' - step in the return to multi-borrower issuance. Though the multi-loan offering - which is expected to price on 8 April - is receiving widespread interest, it is also laying the groundwork for how different the CMBS new issue landscape is now compared to years ago.

The largest tranche of the RBS Commercial Funding (RBSCF) 2010-MB1 offering is the A2 US$222.09m triple A-rated note, which has a WAL of 4.93 years. Price guidance is talked at 90bp over swaps. The deal also has an A1 US$18.7m triple A-rated tranche with a WAL of 2.48 years and class B,C and D tranches, which have WALs of 4.98 years, that total US$68.9m in aggregate. RBS and Natixis are joint leads on the offering, with Banc of America Securities, Barclays and Citi as co-managers.

The collateral is backed by six highly rated first mortgage loans, which - according to one investor - is a "mixed blessing". The small size of the loans makes it easier to review and examine the collateral as opposed to looking at the usual 50-100 loans on a typical conduit deal, but it also increases exposure to event risk inherent in any one particular credit, he says.

The loans in the deal originate mainly from Texas, followed by New York, Missouri, Wisconsin and New Jersey. But, as a second investor notes, the good credit support in the deal is offset by the large loan risk. One loan represents 25% of the deal and another represents about 23%, which is extremely concentrated, he says.

"The concentration risk is clearly greater than you would have seen in a deal years ago," adds the first investor.

The transaction is backed by 81 commercial real estate properties in the US, with 66.3% in retail, 32.7% in office and less than 1% in industrial. This appears to be the right mixture for what will sell currently, the investors say.

Debt yields range from 20.3% on the A1 tranche down to 15.8% on the D tranche. LTVs range from 41.5% to 53.4%.

More multi-borrower CMBS offerings from banks as well as REITs are in the offing, according to the investors and syndicate officials. REITs have been rumoured with multi-borrower CMBS deals for months (see SCI issue 176).

KFH

Insurance-linked securities

Cat bond sees good execution

State Farm Fire & Casualty's new Merna Re II catastrophe bond (see SCI issue 177) saw "good execution" owing to its simple structure and tight pricing. The US$350m three-year offering, which has an indemnity quake trigger, was led by Aon Benfield Securities.

The issuer actually had a larger offering rated but originally planned on issuing US$250m, says a source familiar with the deal. The double-B plus rated tranche priced at 365bp over money market treasuries - the tight end of early price talk.

Merna Re II's notes are exposed to losses from the comparatively safer earthquake peril zones in the US. "Relative to California, this was less of a peak zone for the market. It's not surprising that it went off pretty tight for a cat bond relative to its expected loss," says the source.

The pricing was enough to entice a camp of investors that one market participant describes as being "starved for product". The order book was about US$500m.

"It's not handing too much to investors, but given the current market conditions it's fair to investors," says an investor, who looked at the deal.

From the issuer's perspective, the investor suggests that Merna Re II has a different primary purpose than its predecessor. "State Farm is getting close into the realm of risk transfer as opposed to some type of capital adequacy," he says.

Merna Re I, State Farm's investment grade US$1.06bn cat bond, was brought in July of 2007. That transaction was structured specifically to have higher quality tranches, which also enticed a non-typical cat bond investor base.

"It was not even on the radar screen of a model of a traditional cat bond," the investor adds.

The Merna Re I cat bond consisted of three-year indemnity-based variable rate notes and term loans. The offering is exposed to catastrophe losses from the US and Canada.

KFH

Technology

Demystifying the black box

Jeremy Hintze, coo at ClearStructure, answers SCI's questions

Q: How and when did ClearStructure become involved in the structured credit/ABS market?
A: ClearStructure started as the IT\systems group of Atlantic Asset Management (Atlantic) in Stamford, Connecticut, back in 1993. We built an internal portfolio management system to manage all of Atlantic's fixed income portfolios.

In 1998 Atlantic issued its first CDO. When we were unable to find anything in the market which could handle CDO management, we decided to build it ourselves. Other institutions heard about the strength of our system and expressed interest, so shortly after that we decided to start selling our system to the broader market.

Q: How has your service/offering developed since then?
A: ClearStructure originally focused on the CDO market, but - given our clients' demand for our system's sophistication across other classes along with the market's growth - we quickly expanded to handle any type of collateralised asset. In addition, we built a robust loan administration module to handle syndicated loans.

Currently, in the ABS space we offer structured finance capabilities, such as waterfall and compliance, as well as front to back office portfolio management tools, such as Performance Measurement & Attribution, GIPS-compliant reporting, reconciliation and data integration. We've added integration with several cashflow engine providers to provide cashflows for ABS tranches our clients may hold.

Our experience in the CLO market led to a robust loan administration system and eventually a new syndicated loan trading product we launched in 2009, Sentry LT.

As far as how we offer our products, back in 2004 we converted Sentry from a legacy-type client-server application to a web-based application utilising the latest technology. We saw the move towards web-based systems that were easier to deploy and could be hosted, thus eliminating the need for the client to install costly hardware and deal with the daily maintenance. We pride ourselves on keeping the product in lock-step with the latest technological advances to best position our clients to take advantage of opportunities as the market presents them.

Q: Which market constituent is your main client base? Do you focus on a broad range of asset classes or only one?
A: Coming out of Atlantic, we have traditionally serviced the buy-side and the majority of our client base is from the buy-side. However, we do have products that are sold to the sell-side; specifically our loan trading product, Sentry LT.

We support a broad range of asset types in addition to ABS. We handle syndicated loans, futures, options, swaps, equities, credit default swaps of all types, repos and several additional financial instruments.

Q: How do you differentiate yourself from your competitors?
A: Our vast experience in the structured finance world and specific knowledge of the complexities and the quick changing nature of the structures forced us to ensure our application architecture was flexible, so that we could quickly adapt to changing market requirements as well as client requests for enhancements and new features. Having started as part of an asset management firm, we tend to approach product development from the business side of the problem and have a deep understanding of what asset managers need. Clients have always appreciated our ability to close the gap between technology and user requirements.

Q: Which challenges/opportunities does the current financial environment bring to your business and how do you intend to manage them?
A: The current environment demands an increased focus on transparency and accessibility. We've found that the turmoil in financial markets has altered investor habits and heightened the need for information.

Our platform was built with ultimate transparency in mind and we find our clients leveraging all aspects of this functionality. All of our calculations are spelled out, so there are no 'black-box' calculations or wondering where a particular waterfall value, compliance test result, interest amount, pay-down, trade fee etc came from.

As part of all of our Sentry products, we offer an internet portal for our clients to make available to their investors and even others within their organisation. The portal includes interactive reporting, portfolio stratification and several other customisable features which provide value to the investor, but which the manager can restrict in terms of permissions and accessibility.

Given the elevated focus on risk management, we have added many risk analysis tools that aid in determining risk in the current portfolio and forecasting performance based on multiple scenarios.

Q: What major developments do you need/expect from the market in the future?
A: A major trend that we see continuing on the part of investors and asset managers is the diversification of their investment strategies. For such diversification to be successful, investors need to seek better, more comprehensive tools to manage and monitor risk. Such a single platform that supports multiple asset types and management strategies, while providing the transparency investors are increasingly coming to require, will be demanded and certainly plays to our strengths.

CDS

Three credit funds launched, another prepped

BlueMountain Capital Management has raised more than US$250m for three new funds. In addition, the firm plans to launch a multi-client ABS fund by the end of Q3 this year.

The newly-launched funds are the BlueMountain Long/Short Credit Fund, the BlueMountain Distressed Fund and a single-client fund focused on securitised investments. These funds will provide clients with access to trading strategies already tried and tested in the asset manager's flagship fund, BlueMountain Credit Alternatives, but in dedicated products with bespoke liquidity terms.

Stephen Siderow, president and co-founder of BlueMountain, says: "The opportunities created by the fallout from the financial crisis are compelling, but asset managers need strong fundamental, quantitative and technical skills to exploit them effectively."

He adds: "This credit cycle is the first to take place in a world with large and developed markets for credit derivatives and corporate structured credit. Additionally, the scale and complexity of the asset-backed securities market is unprecedented."

CDS

ISDA DC members named

ISDA has announced the firms that will be members of its five regional Determinations Committees, which comprise the global decision-making structure around events in the CDS industry. Each regional Committee includes 12 dealer firms, two of which are consultative, non-voting firms and six are non-dealer members, of which one is consultative. Determinations are made in accordance with criteria set out in the Determinations Committees Rules.

"The Determinations Committees have proven to be an important addition to the CDS market infrastructure and an effective mechanism for resolving a range of questions that impact the CDS industry," says David Geen, ISDA general counsel. "In their first year of operation the Determinations Committees have resolved more than 50 questions raised by market participants. We would like to thank all the institutions involved for the time and resources they have dedicated to this important process."

The global voting dealers for all regions are Bank of America Merrill Lynch, Barclays, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley and UBS. The global consultative dealer for all regions is HSBC. Voting non-dealers for all regions include Citadel and D.E. Shaw (effective this month), BlueMountain Capital and Aviva Investors (effective from July), and BlackRock (effective from November).

Americas voting dealers are Citi and RBS, while BNP Paribas will be consultative dealer for the region. RBS and BNP Paribas have been named as Europe voting dealers, while Citi is consultative dealer for the region.

In the Asia Pacific region, BNP Paribas and Mitsubishi UFJ become Japan voting dealers, with Mizuho consultative dealer. Citi and RBS will be Asia Ex-Japan voting dealers, and BNP Paribas consultative dealer. Voting dealers for Australia/New Zealand are Citi and SG, while RBS is consultative dealer.

Finally, Rabobank has been named consultative non-dealer for all regions.

CLOs

CDO acquisitions confirmed

GSO/Blackstone Debt Funds Management has completed its acquisition of the collateral management agreements for all nine CDO and CLO funds previously held by Callidus Capital Management, a portfolio company of Allied Capital. GSO first announced its plans to do so in January (see SCI issue 169).

The funds invest primarily in leveraged loans and high yield bonds. Total assets within the funds subject to this initial closing are approximately US$3.1bn. The purchase price has not been disclosed.

Distressed assets

Distressed real estate funds closed

Starwood Capital Group has closed an aggregate of US$2.8bn for its two newest funds: Starwood Global Opportunity Fund VIII (SOF VIII) at over US$1.8bn and Starwood Capital Global Hospitality Fund II (Hotel II) at US$965m. The closing of the new funds brings Starwood's total capital raised since January 2009 to more than US$4.4bn, including the successful closing of its Starwood Debt Fund II and the public offering of Starwood Property Trust.

Barry Sternlicht, chairman and ceo of Starwood Capital Group, says: "Our conservative investment discipline led us to dramatically decrease our investment pace between 2005 and 2008 as the markets became overheated. In 2009, however, we returned to the markets aggressively and have since invested nearly US$1.5bn of total equity capital across all of our investment vehicles."

He adds: "Starwood recently led the acquisition of the US$4.5bn loan portfolio of the failed Corus Bank in partnership with the FDIC. In addition, we acquired more than 5,000 residential lots from the bankrupt, formerly public homebuilder TOUSA for approximately US$81m in cash."

Starwood manages approximately US$16bn of assets across three businesses, with a primary focus on its private real estate funds.

RMBS

New MBS fund launched

DoubleLine Funds Trust has launched two open-end mutual funds - the DoubleLine Total Return Bond Fund and the DoubleLine Emerging Markets Fixed Income Fund. The funds will be managed by newly-established fixed income asset manager DoubleLine Capital, investment adviser to DoubleLine Funds.

Ron Redell, president of DoubleLine funds, says: "The fund launch will bring to investors what I believe is a unique opportunity. DoubleLine Funds represents a new mutual fund platform, devoted to creative, thoughtful investment insight and superior investor service, and led by a team of highly experienced investment professionals who have a long history of working together. With a wide range of eligible distributors, we look forward to helping our investors achieve their financial goals in the years to come."

Jeffrey Gundlach, ceo of DoubleLine Capital, and Philip Barach, president of DoubleLine Capital, are the portfolio managers of the DoubleLine Total Return Bond Fund. In accordance with the fund strategy, the portfolio managers intend to invest primarily in MBS. Gundlach and Barach have managed MBS portfolios together for more than 20 years, including 17 years managing mutual funds.

ABS

Hybrid financing facility closes

Consumer Portfolio Services (CPS) has entered into a new US$50m financing facility. The firm describes the facility as having a similar structure to an unrated term securitisation transaction with an extended pre-funding period. The facility will therefore allow for contribution of receivables over a period of time until US$50m in asset-backed notes have been issued or the end of 2010 - whichever occurs first.

The company explains that at that point, no additional notes will be issued and the notes will be repaid over the remaining life of the receivables. Approximately US$9.1m of asset-backed notes were issued at the closing of the facility last week.

ABS

ECB repo clarifications 'increase ABS eligibility'

The ECB's recent clarification of ABS eligibility criteria for its repurchase facilities will significantly increase the number of eligible securities, says Fitch. The updated guidance clarified that the second rating for structured finance transactions 'at issuance' for transactions that closed between March 2009 and March 2010 means the second rating needs to be single-A minus at the time of being assigned rather than the triple-A originally required. Transactions issued after March 2010 will need to be rated triple-A at issuance by at least two agencies.

Previously, the ECB required only one initial rating and downgraded transactions which were rated this way will be most affected, as they may now no longer need to be restructured to meet the minimum rating threshold when applying for the second rating. Fitch says the change will also benefit issuers that had initially selected the rating agency for initial rating with the lowest criteria loss rate assumptions, as these transactions may now achieve a second rating that meets the eligibility criteria without undertaking a restructuring to achieve the previously required triple-A rating.

Fitch estimates that approximately €475bn of ECB-eligible collateral was issued as banks rapidly responded to the changing credit environment, but since then the pace of new issuance of securitisations has decreased steadily. In 2009 just under €300bn was issued and new issuance this year is expected to be lower still.

The rule clarification is expected to have the greatest impact on transactions that were rated by a credit agency with the most positive credit view of the sector, in which case it is probably that at the time of closing another credit rating agency would not have rated the transaction triple-A, but the time between a transaction closing and the second rating being assigned may occasionally mean a triple-A rating is achievable. This could be the case where prepayments and loan amortisation have resulted in an increase in credit enhancement for a transaction that has performed within initial expectations.

Of the 76 new transactions Fitch rated triple-A between March 2009 and March 2010, none have been downgraded to date, but the agency has put Dutch RMBS with exposure to NHG loans on rating watch negative because of a change in criteria, and has imposed a ratings cap on Greek transactions to reflect the increased risk due to a sovereign downgrade. The agency would not assign a new triple-A rating to NHG RMBS or Greek structured finance transactions issued in March 2009 and already rated by another credit rating agency, but the ECB's clarification that the second rating can be as low as single-A minus means these transactions could now be eligible for the ECB's scheme if rated by Fitch.

Notwithstanding this clarification, Fitch says new transactions from March 2010 onwards will require a second rating to be triple-A, which is attainable for Dutch NHG transactions with sufficient credit protection going forward, but not currently possible for Greek transactions.

The clarification of the second rating requirement was published on 4 March 2010 in ECB Guideline ECB/2010/1, amending Guideline ECB/2000/7 on monetary policy instruments and procedures of the Eurosystem (SCI passim).

ABS

Aircraft lease ABS criteria updated

Fitch has updated its global aircraft operating lease ABS rating criteria. The updated criteria report describes several enhancements, including the introduction of a rating cap of single-A for most transactions and the refinement and disclosure of stress assumptions related to aircraft aging, asset values and lease rates.

Fitch explains that some of these enhancements were already incorporated in its analysis since the 2007/2008 time period. However, the changes - notably the rating cap - evidence the asset class' historically volatile performance and significant exposure to risks.

Fitch details potential risks as being:

• Aviation market cyclicality;
• Heavy reliance on the servicer;
• The presence of re-leasing risk; and
• The exposure to multiple legal jurisdictions.

The updated criteria will apply to the agency's existing portfolio of operating lease aircraft ratings. Fitch anticipates minimal rating changes to result from the implementation of these criteria, with any rating actions directly resulting from the implementation of these criteria expected to be limited to a single rating category.

ABS

US auto ABS delinquencies continue to improve

Delinquency and annualised net losses (ANL) posted year-over-year improvements for the fourth consecutive month through February, despite another monthly increase in US prime auto loan ABS late-pays, according to Fitch. The ANL index posted six straight year-over-year declines, while 60-plus days delinquencies declined for four straight months on an annual basis.

"Buoyant wholesale vehicle values have bolstered recovery rates on defaulted and repossessed vehicles and constrained loss severity," says Fitch senior director Hylton Heard. A bottoming-out of certain economic indicators that impact the performance of auto loan ABS has occurred, including signs of stabilisation in unemployment in recent months.

Fitch's prime 60-plus days delinquency index rose to 0.8% in February, 3.9% above January's total. Despite the rise in delinquencies in February, the month marked the fourth consecutive year-over-year decrease, 8% lower than in February last year.

Prime ANL were 1.56% in February, a 3.1% monthly decrease and 24% below the level in 2009. The index has produced loss levels in the 1.66%-1.52% range for the past six months.

"Performance pressures still abound with many Americans out of a job, slow new job creation and rising personal bankruptcies," warns Fitch director Ben Tano. "Loss frequency remains Fitch's biggest concern and should continue to drive delinquency levels and pressure loss rates throughout the year."

However, tax refunds and rebates should bring about lower levels of delinquencies and losses in the coming months, Fitch says.

Used vehicle values continued to strengthen in February, as measured by the Manheim Used Vehicle Value Index, which increased to 118.1 in February - a gain of half a point over January and an increase of 11.9% compared to a year earlier. Fitch notes that the stronger collateral characteristics of the 2009 vintage are starting to have a positive impact on the index.

The 2009 vintage has a high level of credit quality and other improved characteristics than the weaker collateral securitised in the 2007-2008 vintages. The 2009 vintage is expected to produce lower losses and delinquencies than these prior vintages and support performance in 2010.

ABS

24 deals downgraded after Greek review

The increased credit risk of the Greek sovereign has prompted Moody's to downgrade 24 structured finance transactions backed by pools of Greek assets, including more than €6.9bn of tranches from 11 RMBS deals, €10.7bn of tranches from 11 ABS deals and €2.1bn of tranches from two CLOs.

The rating agency downgraded RMBS triple-A senior classes two or three notches and downgraded mezzanine classes rated above the Greek government's A2 rating to A2. In ABS, seven deals backed by loans of leases to small and medium enterprises, and four backed by consumer assets were downgraded. Triple-A classes were downgraded one to three notches, whil Aa2 and A1 classes from two of these 11 transactions were downgraded one to two notches. The agency also downgraded two CLO triple-A classes to Aa1.

The downgrades incorporate Moody's view on the impact of increasing country risk in Greece and it says the ratings were reviewed with an extreme worst-case economic scenario in mind, such as Argentina in 2000. The availability of liquidity support and the impact of operational risk were also analysed.

ABS

Stable performance for golf course-backed deals

The performance of Japanese transactions backed by golf courses is stable, according to a new report by Moody's. The rating agency expects the net operating income of its rated portfolios to be stable, as operators strive to maintain earnings and constrain costs.

Over the medium term the number of rounds should be stable following a recent period of limited growth, which should mitigate the continuing decline in revenue per round. Moody's says a number of course operators have been able to protect profitability in the face of persistent stressed business conditions, which has made for stable asset performance.

Course numbers have not changed for a decade, as limited new supply has been offset by closures due to bankruptcy. No new major supply is expected that would negatively affect the current balance between supply and demand.

The number of rounds being played has been increasing slowly since 2004 and Moody's expects baby-boomers taking up the game to help keep levels stable over the medium term. The agency says any decline in the number of rounds could translate into a decline in the number of rounds per course, likely polarising the industry between courses that can retain competitiveness and those that cannot.

Profitability will be stressed by the ongoing decline in revenue per round and, even with demand remaining stable, it is expected that raising revenue will be difficult. Moody's says operators must keep a stable number of rounds and price strategically to mitigate against this.

The portfolios in its rated transactions have alleviated negative impacts on profitability, with 'occupancy' rates 30% higher than the market average, thanks to good management. Furthermore, operators have maintained earnings and constrained expenses by cutting costs and maintaining stable net operating income almost equivalent to Moody's estimates, and the agency expects net operating income to be stable.

Prices are expected to normalise following a recent spike, because buyers should become more selective in their investments. The ratio of net cashflow to debt in Moody's rated transactions is high because portfolio returns are high. Consequently, the agency says, stable cashflow is supporting steady amortisation and mitigating balloon risk.

Portions of Moody's-rated transactions have been prepaid in full before maturity, from which the agency infers that the lenders providing refinancing have evaluated the portfolios' stable cashflow and steady deleveraging positively.

ABS

Canadian credit card ABS stabilising

Canadian credit card debt performance stabilised in Q409 as the charge-off rate index pulled back to 4.86%, according to a new Moody's report. This follows a record high of 4.92% in the previous quarter.

Charge-offs are expected to continue to decline in 2010 as a result of fewer personal bankruptcies and lower unemployment. Bankruptcies in Q410 are predicted to be approximately 21,500, down from 25,000 in Q409.

"We expect the unemployment rate and bankruptcy filings - two key drivers of credit card performance - to improve throughout 2010 and for these trends to translate into better credit card performance," says Moody's vp and senior analyst Sumant Inamdar, who co-authored the report.

All metrics of card performance worsened on a year-over-year basis for the fourth quarter, but improved or were stable from the third to the fourth quarter.

The delinquency rate index, measuring the proportion of account balances for which monthly payment is more than 30 days past due, is often an indicator for charge-off trends. For Q409 it was 3.16%, higher than 2.79% a year before, but very close to Q309, which was 3.14%. The payment rate index improved again quarter-over-quarter, climbing 47bp in Q409 to 30.76%.

Credit card performance in Canada continues to compare favourably to that in the UK and the US, where charge-off rates are 10.54% and 10.31% respectively, each more than double the Canadian 4.86% rate.

Moody's Canadian credit card indices are composed of owned and managed portfolios of Visa and MasterCard issuers in Canada. As of 31 December 2009, it tracked the performance of approximately C$70.5bn in receivables, or over approximately 80% of the outstanding Visa and MasterCard credit card receivables in Canada.

CDO

Maiden Lane holdings revealed

The New York Fed has made available to the public information on all of the holdings of the Maiden Lane II and III vehicles, and all the holdings of Maiden Lane (ML) with the exception of residential whole loans (due to violations of individual borrowers' privacy). The additional information includes the CUSIP number, descriptor and the current principal balance or notional amount outstanding for all of the positions in each of three Maiden Lane portfolios.

The release of this information comes after the Fed reached agreements on issues of confidentiality with JPMorgan with respect to the assets of ML and AIG with respect to ML II and III. ML was formed to facilitate the merger of Bear Stearns and JPMorgan, while ML II (which mainly holds RMBS) and ML III (CDOs) were formed to facilitate the restructuring of the US government's financial support to AIG.

The Fed already provides information that describes the formation of the ML portfolios, as well as the nature, quality and valuation of the assets acquired by them. But it says it recognises the importance of transparency to its financial stability efforts and will continue to review disclosure practices with the goal of making additional information publicly available when possible.

CDO

ABS CDO notes repurchased

IMC Asset Management has bought back a portion of Faxtor ABS 2003-1's €223m Class A-1E notes. €17.34m of outstanding principal notes (representing €28m of the original principal amount) were repurchased by the issuer at an aggregate price of €14.16m. The repurchase was funded using principal proceeds in the principal account of the issuer received from amortising portfolio assets.

The total remaining outstanding amount of the Class A-1E notes after the repurchase is €120.7m. The repurchase follows a tender offer announced by the issuer on 12 March. The maximum price was upped by IMC to 82% of face value in the tender offer, having previously offered (unsuccessfully) investors 75% of face value on the notes in a tender offer in October 2009.

Faxtor ABS 2003-1 is a CDO backed by European mezzanine ABS. It is managed by IMC Asset Management.

CDPCs

New triple-A rated CDPC prepped

Moody's has assigned a provisional triple-A counterparty rating to Martello Capital, a newly created CDPC that will be managed by Martello Capital Management (MCM). The rating agency has also assigned provisional ratings of triple-A to the senior secured capital obligations and Aa3 to the mezzanine secured capital obligations issued by the vehicle.

Martello has been established in Ireland for the primary purpose of buying and selling protection on senior tranches of diversified portfolios of corporate reference entities. The CDPC will issue debt and subordinated capital, the proceeds of which will constitute the primary resources to fund its payment obligations under the CDS and other contracts.

Issuance proceeds and retained income will be invested in eligible assets, which will initially be restricted to short-term cash deposits. However, Martello also has the option to invest in non-eligible assets that may be longer-dated and/or less liquid. But these investments and their projected income are fully excluded from the CDPC's capital model for the purpose of determining compliance with capital adequacy requirements.

The adequacy between the amount of available resources and potential payment obligations arising from the various contracts entered into by Martello will be determined by a bespoke capital model developed and maintained by MCM. Failure to meet the capital adequacy tests, as determined by this model, will lead to a series of restrictions on the CDPC's operations, including ultimately its wind-down.

Moody's notes that counterparty default risk is particularly relevant in the case of Martello. Given the ability of the manager to invest part of the debt issuance proceeds in non-eligible assets (to which no credit is given in the analysis), the CDPC may have to rely on the collection of CDS premiums from the counterparties to repay its debt. For the purpose of the rating analysis, an ad-hoc 50% asset correlation assumption was retained between bank counterparties, given the importance of the risk to counterparties (which are expected to belong to the banking sector).

Another source of risk lies with the management and the general governance of this transaction, according to Moody's. MCM is a newly created manager of limited size, but - following an operational review at the manager's premises - the agency concluded that the experience of the principals, and the processes and systems in place were consistent with the ratings assigned.

The reliance on the manager and the governance risk are also mitigated by:

• independent directors, who are required to approve any modification to Martello's corporate purpose and capital structure, as well as material amendments to its operating guidelines, investment limits and accounting policies
• security over all assets of Martello granted to the security trustee for the benefit of Martello's counterparties and debt holders
• the appointment of an internationally recognised accounting firm (believed to be Ernst & Young) to report to Moody's, MCM and the security trustee on behalf of the debt holders and counterparties on a monthly basis on the CDPC's compliance with its operating guidelines, including the processing of transactions, the maintenance of required resources and the various capital and cash flow calculations
• the appointment at the outset of the transaction of an internationally recognised accounting firm as wind-down supervisor in charge of the orderly wind-down of the structure in accordance with pre-established procedures
• stressed capital adequacy requirements that facilitate the pre-emptive protection of its rated obligations against the impact of credit deterioration and unexpected severe credit shocks
• and a US$30m additional reserve factored in for rating purposes, in addition to the required capital suggested by the capital model to cover non-quantifiable sources of risk, such as operational failures.

Moody's has assigned a V Score of medium-high to the vehicle, which is consistent with the score for the CDPC sector. The agency notes that while Martello's complexity is greater than the sector and that the lack of Moody's experience of the manager as an institution is a source of greater uncertainty, as a whole, all other parameters were in-line with the sector average and the overall score was not impacted materially. It also notes that Martello's stressed capital adequacy requirements are more conservative than the sector average.

CDS

Euro CDS clearing launch confirmed

LCH.Clearnet has confirmed that it successfully cleared its first CDS index contracts on 29 March, following months of testing from member banks BNP Paribas, Societe Generale, Credit Agricole and Natixis (see last issue). Initially, the service will cover European indices, with the intention to expand the offering based upon market demand.

CDS

Buy-side clearing account class approved

The US Commodity Futures Trading Commission (CFTC) has approved final rules that enhance certainty regarding protections under the Bankruptcy Code and CFTC regulation Part 190 with respect to OTC derivatives and related collateral that customers clear through a futures commission merchant (FCM) on or subject to the rules of a derivatives clearing organisation. The rules enhance such certainty by creating a sixth and separate account class, applicable in the event of FCM bankruptcy, for cleared OTC derivatives.

In addition, the final rules codify the appropriate allocation between account classes of positions and collateral, in the event of commodity broker bankruptcy, where cleared OTC derivatives are subject to a CFTC order under Section 4d of the Commodity Exchange Act.

CDS

Succession event determination postponed

ISDA's Americas Determinations Committee has agreed to postpone the deadline for voting on whether a succession event occurred with respect to Northwest Airlines (NWA) until 21 April. The issue was first mooted at the beginning of March (see SCI issue 175) and follows NWA's merger with Delta.

CDS

Troubled companies index improves again

The Kamakura index of troubled public companies improved in March for the eleventh time in the last 12 months, dropping to 9.69% from 9.96% in February. The index had peaked a year ago at 24.3% in March 2009.

Kamakura defines a troubled company as one whose short-term default probability is in excess of 1%. Credit conditions are now better than credit conditions in 72.9% of the months since the index's initiation in January 1990, and the index is 4.02 percentage points better than its historical average of 13.71%.

Kamakura president Warren Sherman says: "The rated firms showing the largest increase in one-month default risk in March again included Blockbuster Inc, whose one-year default probability rose 17.97% during the month. Other firms showing large increases were Cable & Wireless, Dynegy Inc, RRI Energy Inc and Allied Irish Banks."

The index's all-time low of 5.4% was recorded in May 2006, while its all-time high of 28% was recorded in September 2001. It is based on default probabilities for more than 29,200 companies in 32 countries.

CDS

Processing platform completes clearing house links

Tradeweb has confirmed its completion of electronic links to the major derivatives clearing houses. To date, the platform has integrated with ICE Trust and ICE Europe via ICE Link, and CME Clearing for the clearing of CDS. In addition to these interfaces built for its CDS business, Tradeweb has further developed connectivity to MarkitSERV, the electronic OTC derivative trade processing company.

Clients of the platform are able to automate their workflow on Tradeweb from trade execution through to clearing, enabling institutions to better manage operational, systemic and market risk.

The completion of the clearing house links follows a surge in electronic trading on Tradeweb's global swaps platform, the firm says. Total global notional swaps volume since the introduction of the platform in 2005 now exceeds US$5trn from more than 50,000 trades (representing a compound annual growth rate of 55% in DV01). Currently, sixteen liquidity providers make markets to more than 150 institutional clients.

Lee Olesky, ceo of Tradeweb, believes that CDS clearing is likely to increase in the coming months. He says: "The buy-side appetite for clearing credit default swaps is in its formative stages. We expect demand to accelerate as the industry watches the legislative and regulatory framework develop."

Olesky continues: "The industry is at the threshold of a fully-integrated electronic trading workflow for OTC derivatives. The development of these links represents an important step towards a more automated marketplace, which will reduce systemic risk and promote transparency, efficiency and prevention of market abuse that global regulators and market participants are seeking."

CDS

Bank offers OTC settlements platform

JPMorgan's securities services business has launched DerivClear, a centralised OTC derivatives platform supporting its derivatives business, and says that existing clients are already switching to it. The bank says DerivClear offers an end-to-end OTC derivatives solution providing trade capture and lifecycle management, confirmation control, settlements and reporting. It can be accessed online for a wide range of OTC products across multiple asset classes, including CDS.

"With the OTC industry undergoing significant change, clients are required to review their infrastructure to address new connectivity, reporting and timing challenges," says Susan Ebenston, JPMorgan global fund services executive. "Clients need to reduce costs associated with OTC processing, and require the scale and control of an industrialised infrastructure and support operation to manage their portfolios."

CLOs

Headline risk still plagues CLO market

CLO tranches continue to look cheap for their risk compared to similarly-rated corporates, according to structured credit strategists at Citi. However, they also comment that headline risk and the perception that CLOs remain illiquid are still putting off potential investors in the primary market.

COA Tempus CLO, managed by WCAS Fraser Sullivan and arranged by Citi, became 2010's first US arbitrage CLO to be publicly placed with investors this week. The deal was upsized to US$525m (SCI passim).

The US$343.25m triple-A tranche is a significantly smaller percentage than the portion of the capital structure originally rated triple-A from 2006-2008 vintage deals. The changes have been driven by higher default stresses, higher correlation assumptions (thus sizing for greater tail risk) and some additional stresses to penalise large obligor and sector concentrations, note the strategists.

"More deals are expected in the course of the year but, as we said in our year-end outlook, the arbitrage between loan spreads and high financing costs (welcomed by CLO debt investors) continues to keep CLO equity returns at the tighter end," they add.

Because of the additional protection incorporated in new CLO structures, new issue spreads are tighter to the secondary market. The comparison between primary and secondary spreads also needs to take into account downgrades, given that most CLO tranches of 2003-2007 vintage have been downgraded by at least one whole category.

"Either way, CLOs are looking cheap to similarly rated corporate," says Citi. "Yet, despite the high protection from idiosyncratic risk that CLO senior tranches offer, it seems many investors are unwilling to buy a product that is still perceived to have headline risk and is illiquid (all this in spite of the recovery that we saw in the CLO market in 2009)."

CLOs

Significant Euro CLO overlap noted

S&P notes that portfolio characteristics determine the extent to which underlying collateral performance affects rating on CLOs. In a new report, it also says European economies are recovering and the default rate for leveraged loans in Western Europe has peaked and will decline throughout 2010.

"Our study of a sample of 206 European CLO transactions indicates that the 'overlap' between different portfolios is significant. This means that credit deterioration among a few key corporate obligors could affect a large number of CLO transactions," says S&P credit analyst Andrew South.

The agency notes that there is significant similarity or overlap between European CLO portfolios, with an average pair of transactions having 27% of their portfolios in common and that a number of key corporate obligors feature in almost all transactions. "A default of the most widely held obligor could have a negative effect on portfolio credit quality in nearly 90% of European CLOs," South explains. "However, in this type of scenario, we generally expect that the severity of any CLO rating effect will be mitigated because each CLO's exposure to any individual obligor is typically low. This is perhaps unsurprising, given that transaction documentation typically includes obligor concentration limits to which CLO managers must adhere."

Since S&P's last 'overlap' report in February 2009, many European economies have begun to stage tentative recoveries and it is thought that the default rate among leveraged loans in Western Europe peaked in Q309 and is likely to gradually fall throughout 2010. As a result, the agency believes European cashflow CLOs could also see slower deterioration in their credit performance.

However, S&P says the default rate among underlying corporates will still remain elevated from long-term average levels for some time. Furthermore, it says it may downgrade some European CLOs as it continues to work through the application of recently updated criteria for all CDOs backed by corporate credit risk.

CLOs

Negative outlook, despite Spanish SME stabilisation

Fitch says Spanish SME delinquency rates are now showing signs of stabilisation, but maintains its negative outlook on all European SME CLOs. The rating agency has also published an SME tracker report on European CLOs and launched Fitch SME Compare, a new tool to compare transaction performance.

The number of Spanish SMEs that are more than three months late on debt repayments has stabilised over the past four-to-six months at 2.5% of the Fitch Spanish SME CLO universe. The stabilisation coincides with a levelling-off and slight reduction in the Spanish unemployment rate, but Fitch expects unemployment to increase slightly in the rest of 2010. The agency also believes it reflects more proactive loss mitigations strategies implemented by servicers, including loan refinancing and restructuring strategies.

"Although it is a positive sign that the pace of deterioration on Spanish SMEs has slowed, Fitch believes that delinquency rates will remain at the current elevated levels in the short term, with a significant proportion of these delinquent debtors ultimately defaulting during the next 12 months," says Glenn Moore, senior director in Fitch's structured credit team.

SMEs employ between 60%-70% of Europe's working population, and contribute approximately 60% of the gross income from operating activities. Fitch says the reduction in global demand for goods and services and the reduction in the availability of affordable credit for the refinancing of existing debt have created a difficult environment. The agency expects continued delinquency volatility during 2010, which is reflected in the negative outlooks on the majority of junior tranches of Fitch-rated SME CLO transactions.

"When the current and expected SME defaults are combined with extended recovery timelines it places pressure on junior notes of SME CLO transactions," says Moore. Currently, two Fitch-rated Spanish SME transactions have depleted their reserve funds due to rising defaults and the agency expects more to follow.

"Over the past year, German SME portfolios have generally witnessed increasing negative credit migration across all transactions," says Jeffery Cromartie, Fitch's head of EMEA structured credit surveillance. "Fitch associates the weaker credit scores with the triple-C and lower rating categories - including default - which now range between 3% and 13% across transactions."

The agency expects negative portfolio migration to steadily increase. To date defaults for German balance sheet transactions are on average 1.7%.

Secured loans that have completed the work-out process have, on average, recovered 67%. Fitch expects that unsecured loans will recover 20% on average.

Fitch has published an SME Tracker report comparing the performance of 87 Fitch-rated European SME CLO transactions, and an accompanying tool called SME Compare for investors to compare transaction performance and view average vintage benchmarks.

CMBS

CMBX remittances raise concerns

Credit deterioration within the CMBS sector remains a growing concern, according to ABS analysts at Barclays Capital.

In their March report for the sector BarCap analysts say: "The pace of credit deterioration accelerated materially in March. We remain concerned that delinquent/specially serviced loan statistics may become more of a leading than a lagging indicator of credit performance."

However, the analysts confirm in the report that they have seen an improvement in the ability of maturing loans to pay off by maturity or with a short lag. The analysts explain: "Only 31% of the maturing loans in March net of defeasance, or US$493m of US$1.574bn, paid off on time. If we strip out GGP-related loans in which the SPE filed for bankruptcy, this ticks up slightly to 33%."

In terms of liquidations and loss severity, the analysts explain that although the pace of loss liquidations rose slightly, it continues to be low relative to the tremendous volume of delinquent loans. "The total balance of loans liquidated this month totalled about US$350m, compared with the trailing six-month total of US$260m. However, this is still well below the pace in late 2005/early 2006, even though the delinquency pipeline today is more than 10x higher than during that period."

The analysts note that reported loan modification activity remains low, but add: "We expect an uptick in future months given servicer comments."

Finally, the analysts conclude, saying: "We continue to see a notable divergence between pre-2005 and 2005+ vintage credit performance trends, with the latter showing significant underperformance. Across CMBX series, CMBX.3 and 4 both showed 100+bp of upticks in delinquency this month."

CMBS

US CMBS delinquencies hit new high

According to the April 2010 Trepp delinquency report, the delinquency rate for CMBS loans rose sharply in March to a new high of 7.61% from 6.72% in February - the highest delinquency rate in the history of CMBS. The numbers were influenced sharply by the inclusion of the Stuyvesant Town loan, which entered foreclosure during the month, but even without this loan the delinquency rate would have experienced the biggest spike since the summer of 2009.

Trepp notes that all major property types saw delinquency rates rise in March. Just one year ago, the delinquency rate was under 2%.

Trepp also comments that weakening commercial real estate and construction loans will continue to drive bank failures, with the highest concentration of at-risk banks in boom/bust markets of Florida, Georgia and California. Trepp's latest forecast calls for 200 banks to fail in 2010, up sharply from 140 in 2009 and just 25 in 2008.

CMBS

Signs of Japanese CMBS recovery?

A new report on Japanese CMBS shows that nine of the loans backing Moody's-rated transactions, amounting to Y124.2bn, were paid down or matured during March 2010. One (accounting for Y8.2bn) was paid down in full by its maturity date, five (Y7.1bn) defaulted and three (Y108.9bn) had their maturities extended.

Three of the defaulted loans (Y24.4bn) had been resolved in March. At the end of the month, defaulting loans amounted to Y271.7bn, down approximately 6% from February.

Five defaulting loans (Y32.5bn) were recovered between January and March 2010. Ten defaulting loans in total were recovered in 2009.

Moody's says the actual numbers for January to March 2010 indicates that special servicing activities for defaulting loans had intensified compared with the previous year. Three of the five defaulting loans were recovered fully, while the remaining two were partially recovered and had incurred losses on their remaining principal balances. The recovery rate per defaulting loan averaged 79% and the duration of the collection periods averaged approximately 11 months.

Correlation

Correlation stress tests should be 'realistic'

ISDA, AFME and the British Bankers' Association (BBA) have provided initial analysis and feedback to the Basel Committee on Banking Supervision's (BCBS) consultation document 'TBG/10/05', which was released on 15 March.

The July 2009 revision to the Basel 2 market risk framework requires banks to meet certain conditions to calculate specific capital risk charges for correlation trading portfolio using a the Comprehensive Risks Measure (CRM). One of these conditions is that banks using the CRM approach must conduct, at least weekly, a set of predetermined stress-tests for the correlation trading portfolio resulting from shocks to market parameters related to credit - recovery rates, credit spreads (or default rates), credit correlations and so on.

In the referenced consultation document, BCBS' Trading Book Group proposed a set of tests for the correlation trading portfolio. The consultation document requires certain historical 'large credit-related shocks' to estimate the mark-to-market changes that would be experienced by the correlation trading portfolio.

ISDA, BBA and AFME's initial feedback on the consultation document includes the following key messages:

• After reading of the consultation document, banks require a confirmation from the TBG that only market parameters will be shocked.
• Banks remark that recovery rates are not generally observable in the market, as they have no history.
• The consultation document proposes perhaps more than 30 different stress tests, but the industry expects that only a few would be used and anticipates that these will be agreed between the banks and their supervisors/regulators.
• The industry also requires further clarity on how to shock 'individual spreads' with some index based on the current rating of each individual name.
• The period (one month/three months) should be the same for the whole industry and agreed with the regulator.
• Shocks and correlations should be further clarified.

In conclusion, the key guiding principles for CRM Stress Tests should be that they result in realistic scenarios and assumptions about market movements, which will add value in both regulatory oversight as well in internal decision-making and control for the participating banks (aid senior management, risk and business lines to control and assess the correlation business of the bank), according to the three associations. For this to be achieved, the CRM Stress Tests will need to consider actual market experience and reflect realistic assumptions regarding key market variables. This is particularly important with regards to issues such as default scenarios, observed recovery rate behaviour and liquidity of hedging instruments.

Emerging Markets

Call for derivatives innovation in Islamic finance

Moody's says in a new report that a combined use of securitisation and derivatives offers considerable scope for reducing risk exposures of Islamic financial institutions (IFIs), thereby improving their overall creditworthiness. However, the rating agency warns that Islamic finance must develop its own innovation phase instead of imitating conventional derivative instruments in order for IFIs to maintain their special status and Shariah-compliant approach.

Islamic finance bucked the global economic trend by reaching new heights last year, with the industry's total assets for 2009 rising to US$950bn. Moody's believes the market will continue to expand and has the potential to reach US$5trn.

"In this context, IFIs are continuing to deliver Shariah-compliant returns whilst, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives," says Anouar Hassoune, a Moody's vp, senior credit officer and author of the report.

"If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty - two practices forbidden under Shariah," Hassoune explains.

Conflicting scholarly opinions on the legitimacy of derivatives in Islamic jurisprudence has seen them used on a limited scale in some countries and banned outright in others. "IFIs aim to utilise derivative instruments to hedge against risk and to improve risk monitoring practices. However, they are keen to do so in a Shariah-compliant manner, rather than imitating conventional derivative instruments - in order to avoid losing their special status as Shariah-compliant banks, which makes them very attractive to a large population of Muslims. For this reason, a new innovation phase in the industry is critical," Hassoune concludes.

LCDS

LCDX, MCDX roll

The Markit LCDX.NA and MCDX.NA indices rolled into their fourteenth series on 5 April. LCDX tranche indices will roll on 12 April.

Three constituents have been replaced in the LCDX.NA index: Dex Media West, Charter Communications Operating and Supermedia replace NewPage Corporation, Getty Images and Warner Chilcott Company. The constituents of the MCDX.NA indices remained unchanged.

Additionally, due to the launch of the new LCDS bullet contract (see SCI issue 175), certain changes have been made to the LCDX contract to make the trades more standardised (see also separate News Analysis). The index coupon has been set at 250bp and the recovery assumption set at 70%.

RMBS

Latest FDIC structured sale closed

A RoundPoint Financial Group subsidiary has purchased a 50% stake in US$490.7m of residential loans from the FDIC via a competitive auction held in February, beating off competition from eight other groups. The bid was accepted as it was deemed to be the offer that resulted in the greatest return to the participating receiverships. The sale, which closed on 1 April, is one of a series of structured sales of residential loan pools offered by the FDIC.

The sale involves a newly created LLC, dubbed Multibank Structured Transaction Single Family Residential 2010-1, which holds assets transferred from 19 failed bank receiverships. As an equity participant, the FDIC will share in the returns on the assets owned by the LLC. The percentage of the LLC interests owned by either party may be adjusted based on the performance of the mortgage loans.

Under the agreement, Roundpoint and the FDIC each own a 50% equity interest in the newly created venture. RoundPoint Capital Group will provide asset management services to the LLC, while RoundPoint Mortgage Servicing Corporation will service the loans in the portfolio.

"RoundPoint's unique high-touch approach to special servicing and asset management creates value by aligning the interests of borrowers and asset owners," says Shaun Ahmad, RoundPoint Capital Group president.

As receiver for the failed banks, the FDIC conveyed a portfolio of 3,373 single-family residential mortgage loans to the LLC, of which approximately 51% were 30 or more days delinquent. Around 80% of the portfolio's collateral is located in Florida, Georgia and Arizona.

RoundPoint paid approximately US$34.4m cash for its stake - equating to a value of about 42% of the unpaid principal balance of the portfolio. Bids were submitted to the auction to purchase either a 50% leveraged ownership interest or a 20% unleveraged ownership interest in the newly formed LLC.

The 19 participating FDIC receiverships provided financing to the LLC by issuing more than US$137m of corporate guaranteed notes. The FDIC-guaranteed notes will receive payments of interest and principal on a monthly basis. All of the loans contributed to the portfolio came from banks that had failed between August 2008 and March 2009.

RMBS

Integration unlikely to affect GRAN/AIREM investors

ABS analysts at RBS believe that the planned integration of Northern Rock Asset Management and Bradford & Bingley is unlikely to affect investors in their respective securitisation programmes. As there is no planned integration of the existing mortgage master trusts (Granite and Aire Valley), the two will be kept separate in terms of legal and structural perspectives.

The analysts do believe, however, that concerns exist regarding the servicing of the trusts. "We would argue that servicing quality for the two pools, in particular with regard to delinquency management, would be better optimised if kept distinct. Our second point would be on the long-term (common) management strategy for the trusts, which we of course expect to centre on runoff."

However, the analysts note that this is not a major concern, given that "both Aire Valley and Granite master trust securitisation programmes are already in run-off, with principal payments entirely dependent on principal receipts from mortgage borrowers, therefore leaving investors subject to extension risk".

RBS describes the current performance of each trust, saying: "Granite and Aire Valley master trusts both reported in the last week, with differing results. AIREM saw its arrears continue to improve with losses still low in comparison to many UK prime trusts. Granite in contrast saw total arrears continue to increase, albeit 3m+ arrears were marginally lower. The key improvement was in losses, which declined to £2.2mn in Feb compared to a peak of £14.9mn in Jul 2009 - if sustained, this could see GRAN reporting positive excess spread in the next few months."

Plans to integrate the businesses, operations and management of the companies were announced by the UK Chancellor during his budget speech. The proposed integration would have the two companies remain as separate legal entities, but under a single holding company, with common management and governance. No indication of a timescale for the integration has been given.

RMBS

RBA rate hike won't wreck RMBS

Moody's says the Reserve Bank of Australia's (RBA) decision on 6 April to raise official interest rates by 0.25 percentage points to 4.25% is unlikely to prompt large increases in delinquencies or any downgrades in the Australian RMBS market.

"Indeed, it is fair to say that most mortgage borrowers can absorb much greater upside in interest rates," says Arthur Karabatsos, a Moody's vp and senior analyst. "While the central bank has been gradually tightening policy since late 2009 - as the Australian economy, particularly the housing market, has been one of the first in the West to rebound robustly from the global financial crisis - the impact on the repayment abilities of mortgage borrowers has been restrained."

Borrowers have already shown they can repay mortgages at even higher rates, while lenders have been tightening lending practices for some time, such as by requiring larger deposits, or down payments. Low unemployment and higher house prices are further mitigating the effects of higher interest rates, says Moody's.

"The latest rate rise is part of the RBA's goal of returning interest rates to more 'neutral' levels where monitory policy is neither stimulating nor constraining economic growth. The neutral setting is believed to be around 5%. If official interest rates rise a further 0.75 percentage points to this level, delinquencies in the Australian RMBS sector are unlikely to significantly increase," says Karabatsos.

The Moody's report notes that a level of 5% would still be 2.25 percentage points below the level reached in March 2008. On an A$300,000 mortgage, over 25 years, this 2.25-percentage-point relief means monthly savings of A$415 when compared to March 2008. The report says borrowers demonstrated they can service their mortgages at the higher level recorded at this date.

The two largest Australian mortgage lenders, Commonwealth Bank of Australia and Westpac Banking Corporation, both say that when rates fell from 7.25% between 60% and 70% of borrowers continued to make higher-than-required payments, building up a financial buffer that assists in preventing delinquencies.

CDS

Basis basics in a normalised world - part 2

In the second of this two-part series, Morgan Stanley credit derivatives strategists Sivan Mahadevan, Ashley Musfeldt and Phanikiran Naraparaju look at CDS basis opportunities in IG versus HY and US versus European names

Measuring the basis: factors to consider
The simplest measure of the basis (raw basis) is the difference between the five-year CDS spread and the actual cash spread of the bond. This basis can be considered as an "actionable" metric based on bond Z-spreads and CDS spreads quoted widely in the market.

For bonds trading close to par and roughly five years to maturity, the raw basis is a pretty good estimate of the yield pickup an investor can gain by exploiting the arbitrage opportunities between the cash and CDS spread. However, apart from the potential maturity mismatch between the bond and CDS, this metric does not take into account the effect of credit curve shape and bond dollar price, which greatly affect the fair value of the basis.

Credit curve shape. Extremely negative basis packages are often driven by flat to inverted credit curves, as seen during the credit crisis of 2008-2009. Inverted credit curves in theory imply a lot of near-term risk to bond coupons, which in turn makes bonds less attractive in a fair value sense. The raw basis calculation uses a simple Z-spread measure, which assumes a flat credit curve and does not assign survival probabilities to bond coupon cashflows, even if it is implied in the CDS market.

Bond dollar price. For bonds trading at a discount (or premium), buying CDS protection on par notional could mean that an investor is buying too much (or too little) protection. For bonds trading at a significant discount or premium, this tends to distort the fair value of the basis.

Basis metrics: adjusted and CAPS basis
The adjusted basis uses the simple raw basis as a building block and then makes an adjustment based on the dollar price of the cash bond. To compensate for the deviation of bond dollar price from par, we purchase (or sell) additional protection for a premium (discount) bond, based on the average forward price of the bond for each year until maturity and calculate an adjusted Z-spread metric. The maturity mismatch of the cash bond and CDS contract is also adjusted for by interpolating the CDS contract along the CDS curve.

The curve adjusted par spread (CAPS) basis uses the adjusted basis and takes it one step further by adjusting for the risk implied by the CDS curve. CDS curves can be interpreted as indicators of default risk over time, given that they are par instruments, unlike corporate bonds. The fair value measure (alternatively the curve adjusted par spread or CAPS) is based on a curve adjusted Z-spread, which is more accurate than the simple Z-spread, given that it takes into account how default risk varies over time.

It also takes into account that losses from default are a function of dollar price and assumes a certain recovery, whereas the conventional Z-spread assumes zero recovery. Inverted credit curves mean that near-term bond coupons are more risky than implied by flat or steep curves.

Exhibit 1 compares the three metrics (raw, adjusted and CAPS) through 2009. The first half of the year was characterised by inverted credit curves and low dollar prices never seen before.

The difference between the CAPS and raw basis was nearly 70bp around April 2009, when spreads were at their widest and curves at their most inverted. Normalisation of credit markets was accompanied by curve steepening, which meant that the basis began tightening. Naturally, we saw a convergence between the raw basis and the fair value basis through the second half of the year.

What our basis metrics do not capture
The most important shortcoming of the basis metrics we discussed above is the inability to capture shifts in funding environment. Being long the basis is ultimately a funding trade - something investors took for granted pre-crisis.

As the cost of funding rises and falls, it is natural for the basis to move as well. A rise in funding costs was the key driver of a negative basis in 2008-2009.

With hindsight, swap spreads (or double-A cash spreads in Europe) were a good leading indicator in terms of signalling a regime shift in the basis, both going into and coming out of the crisis (Exhibit 2). With swap spreads at historic lows post-crisis, it seems that the basis should be driven by the factors and technicals we discussed earlier and funding should be a less important driver of basis.

Another omission is differentiation of funding costs - for example, of IG (which get better funding) versus HY bonds or, as has come under focus recently, bonds of different sovereigns within Europe. Many investors look at the spread to government bonds as a measure of value and the significant divergence between bonds of core and peripheral Europe made it difficult to assess value.

Because the basis metrics we discuss above are based on value relative to the swap curve, it totally circumvents the choice of benchmark issue. As long as the swap curve is not differentiated across investors across sovereigns and largely representative of the cost of funding for high quality counterparties, the basis is unaffected by this divergence in government bond performances.

Finally, we advocate using greater caution when analysing basis trades in the HY space, particularly for those with a high probability of default, as these credits can trade with a significant difference in the structure and timing of cashflows between the bond and the CDS. We discuss this in greater detail in the HY basis section later in the note.

Investment grade basis: European versus US
The US basis hit more extreme negative levels relative to Europe, given credit events in actual investment grade names (Lehman, FRE, FNM, WaMu), the significant presence of nonbank financials and a generally lower quality and wider trading universe of credits in the US. Unsurprisingly, financial cash bonds were the worst hit and the sector basis touched an all-time low of -350bp and at the time traded almost 150bp tighter than the rest of the universe (see Exhibit 3).

The financials basis remained negative through the first half of 2009, even as nonfinancial cash credit began the long road to recovery. In fact, the basis in financials credits touched all-time wides in April 2009, when the nonfinancials basis had already tightened more than 50bp from its wides seen in October 2008 following the Lehman bankruptcy.

Post-crisis, the European basis has normalised and sectors are trading with a positive basis today. In contrast, the US basis is modestly negative and negative basis trades are still available, albeit in the riskier end of the credit spectrum.

Overall, there is more two-way flow in the basis now. We see positive basis ideas in Europe, where taking risk through CDS in credit-linked note format can generate more yield than in corporate bonds with potential for lowering dollar prices. We also see negative basis opportunities in HY and US IG and the first signs of a return of M&A/buyout risk, which should encourage buying of covenanted basis packages.

Rates and the basis
We first addressed the impact of rising rates on the cash bond-CDS basis last November. We advocated selling the basis, or more accurately, unwinding negative basis positions that were close to flat or already positive, because of the advantages of selling protection versus buying bonds. We also advocated going long floating rate CLNs as opposed to fixed rate bonds to take advantage of potentially rising rates - something that led to several trades being marketed as "positive basis" trades, whereby an investor would sell a bond to the dealer and buy a CLN in one package, thus swapping out the fixed rate cash exposure for floating rate funded CDS exposure.

On the bond side, a key factor for the IG corporate bond universe is dollar prices. Higher dollar prices are likely to be an impediment to the performance of bonds and also make the basis look less attractive, as the higher initial cash outlay would require more CDS hedges, all things being equal.

On the CDS side, curve steepness can be impacted by rates as well. Shorter-maturity CDS generally trade with a negative upfront (pay an upfront amount and then receive 100bp when selling protection), whereas the longer-maturity CDS contract is likely to trade with a positive upfront, making it more attractive for protection sellers from a funding perspective. Bottom line, from both a CDS and bond perspective, the longer-maturity bond holders are likely to find selling CDS interesting.

Furthermore, the structure of the upfront contract after the SNAC protocol was implemented has rates implications as well. If the upfront value is positive, which we define as a situation in which the seller of protection receives the upfront payment in addition to the running coupon, the benefit is to the seller of protection or the investor going long the credit risk. The opposite is true of the buyer of protection, who should prefer to receive the upfront as well.

In addition to the standard funding reasons we've discussed in the past, the benefit of receiving an upfront prior to a rise in rates is that as rates rise, the discount factor applied to PV the running coupon increases as well, thus lowering the present value of the remaining coupon. To illustrate, if a CDS were trading at 600bp and had a 500bp coupon and a duration of four, the upfront would be 4% (100bp x 4).

Even if credit risk on the single name stayed the same, the 500bp coupon would be subject to mark-to-market fluctuations as rates changed. Alternatively, if the coupon had been 100bp, the upfront would be much greater and the coupon at risk would be much lower.

The high yield basis: a different animal
The high yield basis has always been a much harder relationship to analyse for a plethora of reasons as we discuss below.

High default probabilities: The basis metrics we capture are a probability weighted measure of fair value versus CDS. For IG names, the probability of survival to maturity is quite high and is the more likely outcome. In the case of HY, many outcomes are more probable than survival to maturity (default in year one or year two, etc.) and the payoffs for each of these scenarios are different.

Dollar prices and structure of cashflows: HY bonds have a greater tendency for dollar prices to trade away from par due to higher coupons and volatility of spreads. HY CDS also traded on an upfront basis even before the shift to fixed coupon convention, creating substantial mismatch in timing of cashflows in CDS versus bonds.

High default probabilities and mismatch in cashflows result in very different P&Ls depending on timing of a default. Consider a hypothetical bond trading at a dollar price of 50 and coupon of 500bp, and assume CDS protection on the name trades at 30 points upfront plus coupon of 500bp.

The basis package is now similar to a zero coupon bond (price of 80 points), except that the entire principal may be redeemed before bond maturity, if the name defaults. Depending on when the credit defaults we end up with different IRRs (see Exhibit 4).

Call features: Since many HY bonds have issuer calls, unlike CDS which is a bullet instrument, calculating the basis becomes more complicated, as these features introduce significant duration mismatches into the equation. We adjust for this by calculating a basis to the worst date of the bond - i.e., buy the bond and buy protection to the worst date rather than the maturity, as is the case with IG bonds. While this approach is also not perfect, as the worst date can move around and there is still duration mismatch risk, this is one way of assessing relative value between HY bonds and CDS.

HY basis evolution
Why is the HY basis more negative than the IG basis today? This wasn't always the case - throughout 2006 and 2007, the HY basis was actually more positive than the IG basis. The prevalence of the structured credit bid helped push IG CDS spreads tighter than HY CDS spreads during 2005-2007 for starters.

Additionally, the difficulty of shorting HY bonds and the relative ease of using CDS to express a negative view meant many investors were running cash portfolios with CDS hedges as overlays. As many of these trades unwound, CDS benefitted from investors unwinding protection, whereas the cash market found it more difficult to find a counter bid early in the crisis. Moreover, as there was a flight to quality away from illiquid assets, HY bonds suffered substantially more than IG.

Although the European HY basis is still negative (-33bp), there are reasons to prefer taking risk via CDS. In European HY, many of the callable bonds are at or close to their call prices and are increasingly facing capped dollar prices.

As the HY primary market reopens and equity market alternatives such as credit-friendly M&A or IPOs become more plausible, we could see bonds taken out at call prices even as CDS rallies substantially on demonstration of access to finance. To the extent that investors share our relatively constructive worldview, many of the callable bonds in the universe offer less upside than the CDS in Europe.

In contrast, US HY universe still trades at a significantly negative basis (-120bp versus -33bp for European HY). We would expect the US HY basis to follow the European HY basis and US IG basis to mid-double-digit levels as the recovery continues (see Exhibit 5).

Courtesy Morgan Stanley: Copyright 2010 Morgan Stanley. This Research Note is an extract from Morgan Stanley's recent Credit Derivatives Insights publication, published on 19 March 2010.

For important information and disclosures regarding specific companies, derivatives, or other instruments discussed in this report, please refer to the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures.