Contents

ABS

ABS decoupling

Market appears resilient to sovereign troubles for now

The European ABS market has remained fairly resilient in the wake of three sovereign downgrades. While benchmark UK and Dutch bonds moved slightly wider and Greek, Portuguese and Spanish bonds have all traded down by several points, investors appear to be in no great rush to offload the affected paper. However, analysts warn that further volatility in credit markets will test the buoyancy of the ABS sector.

"In the long term the sovereign downgrades and the current risk-aversion against sovereigns is not constructive for the securitisation market, with originators being under pressure, the risk of potential selling pressure - which would be definitely a killer in Spanish RMBS and covered bonds - and downgrades being extended due to sovereign downgrades and domestic bank downgrades," says Markus Ernst, structured credit strategist at UniCredit. "But we do not see a lot of trades actually being done as investors remain in waiting mode and potentially do not want to sell in the middle of a panic - there is no fire-sale."

He continues: "Most investors are waiting for the dust to settle. We are seeing an increasing number of offers for Portuguese deals. Clearly, the overall situation is tense, considering the fact that there are more than 627 deals in total outstanding since 2000 with more than €550bn of paper outstanding in countries like Portugal, Italy, Spain or Greece."

Greek, Spanish and Portuguese structured finance bonds have traded down by approximately 10 points, three points and four points respectively since S&P's sovereign downgrades last week. Meanwhile, benchmark Dutch and UK RMBS spreads have also moved out, but by just 10bp to 15bp on average.

One ABS trader notes that one exception to this rule would be the recently-launched Dutch RMBS STORM 2010-1, which has traded down from par 10 early last week to just below par today (5 May). "At the same time, investor appetite for structured finance is still there," he says. "The five-year bonds from Arkle 2010-1 are bid 4bp-5bp higher than where they launched on Friday [see News Round-up] and the news has not stopped Santander from announcing its second Fosse RMBS of the year either."

RBS securitisation strategists suggest that the noteworthy resiliency of the ABS market brings back memories of 2001/2002, when this asset class was notably immune to the corporate sell-off, benefiting from the flight to credit quality. Indeed, after a short-lived reduction in activity in the second half of March, the European structured finance market has had almost a full month of price improvement across various asset classes, with mezzanine bonds in particular benefitting from increased investor appetite.

One portfolio manager indicates that this improvement has, however, been supported by a thin real-money investor base. With the exception of very short-dated senior bonds, the bulk of the remaining trading has been driven by dealers' business and spread buyers - the latter supporting the long-duration mezzanine bonds the most.

The RBS strategists expect any further volatility in credit markets to test the apparent resilience of the broader ABS market, however. "Our caution about the scope for continued outperformance stems from the recent weakness seen in early warning indicators, such as short-term bank liquidity indicators (Libor/OIS)," they say. They also suggests that senior triple-A Portuguese ABS ratings are now also at direct risk of any further sovereign downgrades, following the lowering of Portugal's rating to single-A minus by S&P.

ABS analysts at Wells Fargo, meanwhile, point to sovereign downgrade risk being reflected in the direction of swap spreads over the past three months and note that swap spreads have been creeping higher over the past two weeks from recent lows in the mid-teens. "The primary near-term risk to consumer ABS valuations, in our opinion, would be a rapid widening of swap spreads," they say. "Even a return to the long-run average would have an adverse impact. However, it is difficult to determine what the new equilibrium level of swap spreads will be as the markets readjust from the support given them."

They conclude: "In our opinion, ABS investors should be mindful of the direction of swap spreads."

AC

ABCP

Ripe for resurgence?

New conduit launches, growing demand to boost Euro ABCP

The European ABCP sector looks set for resurgence, following a decline in volumes and the unwinding/consolidation of a number of programmes in recent years. New conduit launches, combined with growing opportunity to tap US demand, have proven to be a boon to the market.

Lloyds TSB Bank last week launched a new A-1 rated hybrid multi-seller ABCP conduit - dubbed Argento Variable Funding - which is said to have been well-received due to the bank's solid reputation and good relationship with investors. The programme has been established with two issuing entities, which will issue ECP to the European market and US CP to the US market.

The maximum amount of ABCP that the programme may issue is US$10bn. The initial transfer of assets will be of rated structured finance securities purchased from subsidiaries of Lloyds Banking Group.

John Spedding, md at Bank of New York Mellon and coo of QSR Management, says the move represents a positive development for the market. "It will likely encourage other sponsors to consider launching new conduits or revitalising their existing programmes," he explains. "As well as providing diversity of funding for issuers, investors are achieving exposure to the asset classes they're comfortable with. Multi-seller and hybrid conduits have generally been better received than pure securities arbitrage conduits."

Other programmes that have fared well in recent months are the Belgian Royal Park Investments vehicle - which has so far issued US$6bn and could expand on this figure - and the Straight-A Funding student loan conduit sponsored by the US Department of Education. "Straight-A Funding has a federal guarantee and has been very successful, reaching US$20bn of issuance within its first couple of months and is now around US$30bn. It is possible that a similar programme could be extended to the US mortgage market to help clear loans of loan originators and/or federal balance sheets," Spedding confirms.

He suggests that the new FASB accounting rules could open up the US conduit investor base for European issuers, if US sponsors - such as Bank of America and Citi - have to bring their conduits back on balance sheet. One potential alternative could be to set up a structure that avoids consolidation by syndicating the assets across a number of sponsors - essentially diluting their positions and at the same time diversifying their portfolios. Certainly, Moody's says its discussions with US banks affected by the new regulatory capital requirements indicate that they will be much occupied in 2010 dealing with these issues.

But increasing issuance in the US CP market by EMEA conduits is also being driven by the perception that the Euro CP market is less robust than its US counterpart. More favourable hedging conditions, higher yields and the greater appetite of US investors for ABCP has led to an increasing proportion of US CP issuance by EMEA conduits, standing at 67% of total issuance at year-end 2009, according to Moody's.

Masako Oshima, vp-senior credit officer at the rating agency, notes that the US market has always been relatively important for EMEA sponsors, with the level of US CP issuance remaining relatively high over the last few years. "The impact of new conduit launches on issuance levels is unclear, but we'd expect the trend to continue," she says.

Indeed, the opportunity for new sponsors to enter the market seems compelling. The average ABCP outstandings across the largest 20 programme administrators in Q409 is estimated to be US$594.3bn, of which Citi accounts for US$54.4bn and BoA US$31.8bn.

"The momentum is changing and there is appetite for programmes that are structured well. Secondary markets for CMBS and ABS have come back and investor comfort with ABCP is increasing as a result," Spedding notes.

In particular, appetite from money market funds (MMFs) is poised to increase dramatically as a function of regulatory change and product shortage. For example, the requirement to hold repos for less than seven days - in order for them to be treated as liquid assets - is serving to reduce the types of products and tenors MMFs can invest in to meet their liquidity requirements, while new liquidity requirements and concentration limits mean that some funds are tight against their thresholds because there isn't enough product to invest in. They typically manage to a 5% exposure to a given name.

Rules are also being introduced to keep MMF duration down, whereas banks are looking to issue long. SIVs would have traditionally helped bridge this gap, given that up to half of the vehicles' assets could be term bank debt.

Additionally, MMFs tend to lag other money market products in a positive rate environment, given the typical WAM of 60-90 days. "If the yield curve turns positive and we're in a rising rate environment, their strategies will have to change in search for yield. Bank-issued paper doesn't necessarily provide a good return for MMFs in this scenario," Spedding remarks.

However, the European ABCP sector is expected to continue to be characterised by conduit mergers in 2010. Rachael Purchas, avp-analyst at Moody's, explains that certain large conduits are being consolidated for rationalisation purposes - as a result of bank mergers and restructurings or the fact that two conduits may be performing the same functions, with potentially declining outstandings. She predicts that more mergers will have occurred by the end of the year.

The latest such example is the consolidation of RBS' Thames Asset Global Securitization No. 1 (TAGS) and Tulip Funding Corporation/Tulip Euro Funding Corporation multi-seller ABCP programmes. Under the merger, Tulip will cease issuing rated CP to investors to fund assets purchased by its asset purchase company, TAPCO, following a one-month transitional period during which all Tulip's outstanding CP will be redeemed. By the end of this transitional period, all existing Tulip assets purchased by TAPCO will be funded via commercial paper issued by TAGS.

There have been no changes to the underlying transaction structures, although some amendments have been made to transaction documentation in order to reflect the new funding source. Outstanding ABCP levels for the merged conduit at the end of May 2010, following the transitional period, are expected to be around US$11.5bn, with PWCE at US$575m.

Moody's has affirmed the Prime-1 rating of both conduits, but will withdraw its rating on Tulip once its CP has been redeemed.

CS

RMBS

Upward ascent

US RMBS market activity in the weeks to 4 May

The US RMBS market has maintained its upward ascent over the past few weeks, showing little of the disruption expected due to the principal forgiveness programmes announced in late March. In addition, positive market sentiment has been bolstered by liquidations of seasoned mezzanine bonds and the introduction of high quality new issuance.

Due to positive market technicals, secondary RMBS prices have held up well over the past week, despite relatively light volumes. A trader describes market sentiment as being strong over the previous weeks.

Furthermore, the trader adds: "There doesn't seem to have been too much affect by the principal modification programme on the market - it has only continued its upward trend."

He points out that some of the indices within the newly launched PrimeX have gained seven points over the past week. "Surprisingly, it hasn't really been that much of a topic of conversation," he says.

However, one dealer, focusing specifically on subprime bonds, notes that the effect of principal forgiveness on the market has been mixed. On the one hand, he agrees that the market has been up fairly significantly over the past month due in part to the increased certainty that the programme gives for the market moving forward. However, for front-sequentials he believes it has been more of a negative impact, while last-cashflows have rallied.

The dealer adds that subprime performance has improved this week off the back of Citi's recent liquidation of subprime bonds. "These were mostly seasoned 2004/2005 mezzanine bonds, which traded well to a mix of dealer and retail hands."

He continues: "Week-over-week we're probably up one to two points on the non-agency side."

The dealer points out that this development has been particularly well-received by investors as seasoned mezz bonds are one of the last few categories where a double-digit yield can still be achieved. "Clients are definitely interested in those coming out of the Citi liquidations and yields continue to grind tighter," he says.

Elsewhere in the market, the pricing of Redwood Trust's Sequoia Mortgage Trust (SCI passim) has generated much interest among investors. With a coupon of 3.75%, the trader is unsurprised that the deal was reportedly five-times oversubscribed.

"It is fresh-rated triple-A and the collateral is pristine. It's really hard to find newly rated triple-As off new loans. It just doesn't exist. I think there's a huge demand for rated securities now in a market where there are barely any triple-As left," he says.

While the demand for similar products is undoubtedly there, the trader does not expect further such deals in the near future. He explains: "I think people are trying to put together similar deals, but it's hard to find loans of that quality at the moment. However, sentiment is extremely positive at present and we expect that to continue."

JA

RMBS

Positive sentiment

European MBS market activity in the week to 29 April

European MBS trading volume has remained thin over the past week off the back of further news from Greece. However, spreads have generally held up well in both the RMBS and CMBS markets, and participants remain positive about the week's performance.

"In RMBS people have been focusing on the news from Greece and are in a wait-and-see mode," says one dealer. "But things are holding up well across the capital structure."

Although market sentiment has remained stable for the RMBS market generally, this has not been the case for Greek transactions and other countries at risk of sovereign volatility. "There's more of a general worry from people over potential exposure to those types of countries that might be in trouble. The few Greek RMBS transactions that are around are obviously performing weaker, in line with sovereign performance, and we've also seen some potential weakening in Spanish and Irish transaction due to fear of contagion," says the dealer. "But there hasn't been much trading and I don't think things have widened significantly."

The dealer explains that some spreads within Greek RMBS have widened, but adds that it is difficult to generalise in a market that is as illiquid and deal-specific as the Greek market. He does say, however, that at the tight end spreads that may have been from 400bp-500bp before the latest Greek headlines are now approximately 700bp-800bp.

Meanwhile, the dealer points out that Granite paper, which rallied over the previous couple of weeks, has widened by approximately half a point over the past week from 94 cash price to low 93s. He explains that overall levels are holding up surprisingly well.

"There hasn't been too much widening in prime stuff and we haven't seen any forced panic-selling from anyone. In general, we're slightly positive that things haven't been affected that much by the Greek crisis," he adds.

Another trader points out the majority of activity has been in prime paper due to its greater liquidity. "I would say 95% of what we've seen over the past couple of days has been triple-A. Although in previous weeks we had an increased interest in mezzanine paper and it did rally, you tend to see less of that going through when things are moving."

Moving forward, pricing of the Arkle deal (SCI passim) is due this week and seems likely to enjoy a good reception from investors. "I've heard that the Arkle deal is at least one times subscribed, so it'll place well," says the trader. "We're seeing decent spreads for most of the new issues, so I would expect it to trade strongly."

The last week in the CMBS market has been quiet, despite strong activity in previous weeks, particularly in the senior part of the structure. "As is the case whenever there's a big crisis people tend to take a step back and assess what's going on," explains the dealer.

The dealer believes that although activity has slowed, this is not indicative of the interest in the CMBS space at present and predicts that strong activity is likely moving forward. "There is still strong interest - there are just fewer trades being done at the moment," he explains. "Sentiment is positive in the CMBS market. While RMBS and Granite showed weakening, the CMBS market has held up well."

Sentiment is expected to remain strongest at the top of the capital structure. "I think that people are starting to realise that senior CMBS paper looks cheap compared to not only the mezzanine paper, but also to other paper out there in other sectors," the trader concludes.

JA

ABS

J.G. Wentworth plans regular securitisations

Specialty finance company J.G. Wentworth is planning to access the ABS market about every quarter to six months, depending on market conditions, according to Stefano Sola, chief investment officer at the firm. The company issued its largest securitisation last month when it brought a US$252m structured settlement and annuity receivables offering.

The light supply of ABS deals created a new issue opportunity for a less frequent asset class such as structured settlements, Sola says. The deal consists of a US$208 class A tranche which had a fixed coupon of 5.56%, a US$26.5m class B tranche that had a coupon of 9.31% and a residual class of US$17.2m which the company retained.

"We had been monitoring the market for a while and noticed a general spread tightening in the last year, with a good stabilisation within the last six months," Sola adds.

Insurance companies have been some of the main investors interested in structured settlement and annuity deals. The J.G. Wentworth transaction was well received due to the rarity of the company name and due to the kind of collateral backing the deal, according to a syndicate source.

"Investor interest was high. We saw very strong demand from insurance companies, as well as money managers and some hedge funds," Sola confirms.

J.G. Wentworth was a regular issuer of structured settlements and annuities receivables offerings prior to the credit crisis, having issued over US$2.3bn in total. The borrower tends to keep the offerings typically around the US$100m size, but it has completed a US$200m offering in the past. Prior to its US$252m offering, it came to market in December 2008.

KFH

Insurance-linked securities

Cat bond activity increases

More catastrophe bonds have begun marketing, joining the growing deal pipeline (SCI passim) ahead of the 1 June start to the hurricane season. Meanwhile, the latest deal to close was upsized and priced at the tight-end of guidance.

Aon Benfield and BNP Paribas have started showing Lodestone Re to investors. The three-year US hurricane and quake deal on behalf of ceding insurer National Union Fire Insurance Co of Pittsburgh, a Chartis US subsidiary, is initially aiming for two tranches of U$125m each.

S&P has assigned preliminary ratings of double-B plus and double-B respectively. The only difference between each class of notes is the covered layer. The deal's collateral will be invested in Treasury money market funds.

The Class A notes cover losses in excess of US$6.5bn up to US$7.5bn and the Class B notes cover losses in excess of US$5bn up to US$6bn, each on a per-occurrence basis. The trigger for calculating covered losses to Lodestone Re is based on the sum of PCS-reported insured personal and commercial line losses (automobile lines, workers' compensation lines, ocean marine lines, offshore energy lines and loss-adjustment expenses are excluded) per state, multiplied by predetermined state payout factors.

For a hurricane event, Lodestone Re will cover losses in the District of Columbia and the following states: Alabama, Connecticut, Delaware, Florida, Georgia, Hawaii, Louisiana, Maine, Maryland, Massachusetts, Mississippi, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Rhode Island, South Carolina, Texas, Vermont, Virginia and West Virginia. For an earthquake event, the covered area is all 50 states and the District of Columbia.

At the same time, the US peril-related Caelus Re II is being brought by Goldman Sachs and Aon Benfield Securities on behalf of Nationwide Mutual and has been assigned a preliminary double-B plus rating by S&P. The US$200m three-year transaction will cover losses - plus loss reserves, if applicable - of Nationwide and certain of its subsidiaries on a per-occurrence basis due to hurricanes and earthquakes in the covered areas (selected US states).

There will be two annual resets, effective in 2011 and 2012 respectively, and will be based on Nationwide's exposures as of 30 September of the previous year. On each reset date, the attachment point for the notes will be reset to keep the probability of attachment at or less than 0.88% and the expected loss at or below 0.79%.

The notes will cover, assuming an issuance amount of US$200m, 70.7% of losses between the initial attachment point of US$2.245bn and the initial exhaustion point of US$2.528bn. The attachment and exhaustion points likely will be adjusted to reflect changes in the underlying subject business that Caelus Re II covers. The calculation and reset agent is AIR Worldwide.

Much less further advanced in terms of the marketing process is Munich Re's Eos Re, which will provide investors with exposure to both US and European wind risk. The deal is currently targeting a US$100m issue size, with no further details yet publicly available.

Meanwhile, Assurant's Ibis Re II cat bond offering upsized at closing to US$150m from US$100m due to increased demand, according to syndicate sources. The class A and B tranches increased to US$90m and US$60m respectively, from US$50m each.

Spreads also came in further after the deal marketed. The A tranche priced at 620bp and the B tranche priced at 925bp over treasury money market funds. Price guidance on the offering originally tightened to 640bp over Treasury money market funds for the class A tranche and 950bp on the class B tranche from wider price talk indications, according to investors.

MP & KFH

RMBS

PrimeX sees flow from ABX accounts

The first two trading sessions of Markit's PrimeX indices have consisted of flow from a base of accounts that trade the ABX index, according to dealers. However, they suggest that a more diversified investor base would be needed to see more growth in the product.

The trades so far are two-way in nature, with no particular bias to either buy or sell protection on the index of prime RMBS collateral. Sizes of trades have been light, ranging from US$25m to US$100m.

All four indices have seen trades. "I've seen inquires on all of them pretty equally," says one dealer, who considers the trading in line with the ABX index. "It's healthy in the sense that there's good two-way flow," he adds.

Most of the accounts interested in the product so far do not appear to own a lot of the prime underlying collateral, according to dealers.

The PrimeX.ARM.1 closed at a price of 106.16 on 29 April, up from 105.68 on its first day of trading (28 April), while the PrimeX.ARM.2 ended at 99.39, up from 97.72. The PrimeX.FRM.1 closed at 108.5, up from 107.22, and the PrimeX.FRM.2 finished at 103, up from 101.6.

Both the PrimeX.FRM and PrimeX.ARM indices consist of equally weighted deals. The minimum deal size at issuance was US$250m. The reference obligations in the index amortise as a function of prepayments and write-downs as opposed to dropping out of the index.

On an investor call earlier this week, Markit officials said about 120 deals met the criteria initially, which were then segregated down to the current names in each index. Of the 80 deals suggested, 10 were also excluded and then others inputted.

The final deals have a combined LTV of less than 85%. All REMICs, net interest margin securities (NIMs) and synthetics were eliminated.

Operationally the PrimeX indices are similar to ABX, but a key difference is that the index has the potential for multiple bonds being included. In the fixed rate indices, there are 40 deals and approximately 150 bonds.

The indices reference vintages from 2005, 2006 and 2007, with the cut-off date being 1 July 2006.

KFH

Technology

Achieving accurate VaR calculations

Richard Bennett, EMEA president of Razor Risk Technologies, outlines the role of VaR in a holistic approach to risk management

Following the financial crisis of 2007/2008, the Value at Risk (VaR) calculation method - arguably the most broadly utilised method of risk management - has come under increasing levels of scrutiny for its failure to provide accurate results. This paper examines the reasons behind the perceived failure of risk management up to and during the economic downturn. It also outlines how VaR can be a highly accurate measure if it can measure and factor in dynamic changes in the underlying portfolio holdings, ensuring that 'non-normal' events and cyclical macro-economic issues are taken into account. This paper will then explain why VaR is simply one of many measures of risk that should be used when aiming for best practice risk management, which ultimately demands a holistic approach.

What is VaR?
VaR is a mathematical methodology, based on a number of assumptions. Its usefulness depends upon the degree to which these assumptions hold: one of the largest assumptions in traditional VaR calculations is that a portfolio is static over the calculated period of time, which of course in reality it is not.

The financial crisis and risk management: what went wrong?
The scale of financial losses in the past three years has led investors, senior board executives and the general public alike to reconsider their previous confidence in risk measurement and risk management. Both the models used to calculate risk and the regulatory standards that were supposed to ensure a conservative risk approach have been called into question, seriously undermining the credibility of risk management methodologies.

Since VaR was the most widely touted method of risk calculation prior to the financial crisis, it is no surprise that VaR is also the measure that has come under the highest level of scrutiny. In January 2008, VaR models reported that Merrill Lynch's highest one-day VaR in the third-quarter of 2008 was US$92m, indicating that the firm's maximum expected cost during the 63 trading day period would be US$5.8bn.

In fact, according to Bloomberg, the firm wrote down US$8.4bn from the value of CDOs, subprime mortgages and leveraged finance commitments. This was 45% more than predicted. The error in the VaR measure at Merrill Lynch, and indeed at many other institutions, was due to a number of simplifying assumptions in the calculation methodology that were simply not true, leading to an incorrect risk assessment and catastrophic results.

There are a number of reasons behind the perceived failure of risk management, including:

• In many instances, the financial institution's appetite for risk was not effectively set nor communicated down to employees by the Board
• Assumptions used in risk models were driven by regulatory requirements, not real world risks
• Different job functions had different 'wants' within each institution - e.g. traders versus business analysts versus risk analysts. This cultural mismatch resulted in a risk management mismatch
• Executives who did not fully understand how VaR is calculated just looked at the single number the models generated, ignoring the base assumptions.

This leads to the question: what should and what realistically can be done to improve risk management? Industry executives rightly expect more regulation and increased investment in risk management. However, instead of focusing on compliance-driven risk management, companies should look to implement a holistic risk management approach that can restore stakeholders' trust and drive business value for the long term.

VaR as part of holistic risk management
The recent financial crisis has shown that in the world of finance, what does not get measured does not get managed. Most firms continue to measure risk in silos and therefore total enterprise risk exposure is not transparent.

Consequently, senior management within a financial organisation are unable to obtain an overarching view of how credit, liquidity, market and other risks are interacting and potentially compounding exposures throughout the firm - leading to crippling losses or outright firm failure. It is therefore vital that a single coherent, or holistic, approach to risk management is taken.

Another vital element of best practice risk management is the deployment of a range of risk measures. Alongside accurate VaR, other risk measures, such as stress testing, must also be used.

Recognising this, regulators around the world have begun to instigate changes towards an improved, more holistic approach to risk management. In Australia and the UK, the Australian Prudential Regulatory Authority and the Financial Services Authority made liquidity stress testing mandatory for banks and many different types of financial institutions.

Stress testing assumptions and correlations can be particularly important when seeking a single view of the bank or firm. Key to the success of this measure is the ability of the risk manager to seek out potential crises and then to accurately describe them, in order for them to be meaningfully incorporated into the stress testing.

Any risk measure is based on some assumptions. The more widespread the use of the technique, the more likely human nature will lead financial institutions to seek 'work-arounds' or forget the assumptions that the chosen technique is based upon, as was the case with VaR. A holistic approach helps avoid over-reliance on just one measure, providing a more balanced guide.

Achieving accurate VaR calculations
There are some major discrepancies in the approach to calculating VaR in different financial institutions, resulting in varying degrees of accuracy. So, how can firms obtain the best accuracy from VaR models?

There are three key ways in which risk professionals need to adjust their calculations:

1. Move to a forward-looking VaR calculation over a multi-period basis, allowing for dynamic changes in the underlying portfolio holdings, like trades maturing, cashflows reinvested or options being exercised - the characteristics of any portfolio changes with the passage of time. Bonds are a very pertinent example of this. As they approach maturity, their value approaches face value and their volatility diminishes and disappears altogether at maturity, when the bond can be redeemed at face value. Options - another example - behave differently. They tend to lose value as they approach expiration, all other things being equal. Therefore, any VaR calculation looking to provide greater accuracy should take into account these changes.

2. Extend market risk VaR models to incorporate credit defaults as these best capture 'non-normal' events faced by institutions today. This extension to the VaR model to cover default, migration, spread and equity risks - including correlations within and across those risks - is an instrumental step in managing the real risks of today, by ensuring a holistic approach.

3. Incorporate cyclical macroeconomic stress test factors into the risk process to avoid having a 'Charles Prince'¹ moment.

In addition, the assumptions built into the VaR models must be communicated at all times to traders, analysts and senior management and the models themselves must be independently reviewed.

Conclusion
Instead of focusing on compliance-driven risk management, financial institutions should look to implement a holistic risk management approach that can restore stakeholders' trust and drive business value for the long term. Firms and regulators need risk measures that not only work today, but can also act as a guide if markets suddenly change as they did in 2007 and 2008. Ensuring accurate VaR plays a key role in achieving this.

Changing VaR to a multi-period, default-adjusted calculation taking into account dynamic changes in the underlying portfolios, while incorporating macroeconomic stress events, will help rebuild the confidence of investors and other stakeholders of the world's financial services companies. They must be confident that robust risk management capabilities are in place to mitigate the kinds of risks that have undermined the global economy. These improvements in the accuracy of VaR models will help to deliver this confidence.

Footnotes
¹ Charles Prince, former ceo of Citigroup Inc, famously said "...as long as the music is playing, you've got to get up and dance. We're still dancing." to the Financial Times in July 2007, in response to queries about the risks and dangers of MBS and CDOs. Prince resigned in November 2007, after Citigroup posted a 57% drop in quarterly profits, caused by losses in the subprime mortgage market. Citigroup went on to report a US$40bn loss caused by the subprime crisis, the most of any bank.

ABS

Bank hires for strategic implementation

Amsterdam Trade Bank has hired Hans Tamm as its head of corporate finance. The bank says Tamm will be responsible for trade finance services and implementing its new strategies for asset-backed finance and structured commodity finance.

He reports directly to recently appointed ceo Martin Czurda. Tamm joins from Al Rajhi Capital in Riyadh and has previously headed the loan syndication desk at HSH Nordbank in London.

ABS

Securitisation specialist hired

Securitisation lawyer Andrew Jinks has joined Clayton Utz as a partner. He has 20 years of experience in legal practice and specialises in international and domestic securitisation and capital markets transactions. The firm says Australia's securitisation market is showing signs of a resurgence and believes Jinks joins at a time when credit markets are stabilising and economic confidence is returning.

CDS

Distressed debt head moves on

Derivatives dealer Conduit Capital Markets has appointed James Moylan md and head of non-investment grade credit trading. Moylan was formerly md and head of European high yield/leveraged loans and distressed debt at Barclays Capital.

CDS

Credit strategy team head resigns

Barclays Capital has confirmed that Robert McAdie has resigned. The former head of European credit strategy is replaced on an interim basis by New York-based Ashish Shah, who will not come to London but will rather run the team from the US.

CDS

Kamakura-Reuters cooperation grows

Kamakura Corporation has expanded its relationship with Thomson Reuters. Last year Reuters began distributing a small subset of Kamakura Risk Information Services (KRIS) default probabilities (see SCI issue 153) and from May onwards KRIS default probabilities for the 1,700 public firms with traded CDS will be available on the Reuters 3000 Xtra service, along with KRIS sovereign default probabilities for 100 countries.

Kamakura says this expanded service will allow Reuters 3000 Xtra subscribers to make daily comparisons between CDS quotations from Reuters and Markit with the KRIS default probabilities, which will help investors make fully informed judgements about whether the risk premiums implicit in CDS spreads are sufficiently high to induce the investor to provide credit protection on that corporate or sovereign credit.

"In the early days of the CDS market, traders believed that the CDS spread equalled the default probabilities times (1 minus the recovery rate)," says Kamakura president Warren Sherman. "Now it is well known that there is a substantial premium in CDS quotations, above and beyond expected loss, because the basic laws of supply and demand prevail in the CDS market just as they do across the financial markets as a whole. Our default probabilities help market participants understand the liquidity premium that results from the intersection of supply and demand."

CLO Managers

Stanfield CLO business sold

Private equity firm Carlyle Group is to purchase the management contracts on US$5.1bn in CLO and other credit assets from Stanfield Capital Partners, a fixed income asset manager based in New York. The transaction will increase the firm's credit AUM to US$18.1bn from its current US$13bn.

The transaction is subject to investor consent and is expected to close in the third quarter of 2010. Financial terms were not disclosed.

Mitch Petrick, Carlyle md and head of the global credit alternatives and capital markets group, says: "Scale is critical to the CLO business. With this purchase, Carlyle would become one of the world's largest structured credit managers and an industry consolidator."

He adds: "As we grow and expand our credit alternatives business, we will continue to look for additional opportunities to enhance the scale and diversity of our product offerings."

The US$5.1bn transaction consists of US$4.2bn in CLOs and US$950m of managed account assets, all of which are invested primarily in non-investment grade corporate loans. The US$4.2bn in CLOs would grow Carlyle's CLO AUM from US$10.2bn to US$14.4bn, a 40% increase.

Dan Baldwin, ceo of Stanfield Capital Partners, comments: "The decision to sell your business is a very difficult one to make. However, we believe the marketplace for credit managers is consolidating, as investors in credit place their money with firms that possess the broad array of resources found at large global asset managers."

He adds: "We chose to sell to Carlyle because they not only have a strong investment platform, but possess a comprehensive infrastructure focused on risk management and client service. We believe our clients will continue to benefit from a consistency and quality of management and service that they have been accustomed to."

CLOs

ACA Euro CLO transfer confirmed

Avoca Capital has confirmed its appointment as investment manager of the €400m ACA Euro CLO 2007-1 (see SCI issue 176) as of 30 April, following approval from the voting noteholders and rating agency consent. This transaction represents Avoca's third successful replacement manager mandate, having been appointed to manage the €840m CLIO European CLO in July 2009, replacing Lehman Brothers International (Europe), and the €350m Lombard Street CLO I in December 2009, replacing KBC Financial Products UK. Avoca's total AUM is now approximately €6bn.

ACA Euro CLO was the sole CLO managed by Nomura Corporate Research & Asset Management Europe Limited (NCRAME). As part of the transaction, Terry McCabe (portfolio manager) has transferred from NCRAME to Avoca.

Alan Burke, chief executive of Avoca, says: "The transfer of ACA Euro CLO to Avoca is consistent with our objective to grow both organically and through acquisition. We have increased our AUM by over 40% in the past 12 months and will continue to take advantage of ongoing growth opportunities. We expect to see our industry continue to consolidate in 2010 as new and existing mandates move increasingly to scale players with strong track records through the current cycle."

CLOs

Transferred Callidus CLOs named

MAPS CLO Fund I and the Callidus Debt Partners CLO Fund II to VII transactions are among the nine CDOs that GSO/Blackstone Debt Funds Management has taken over from Callidus Capital Management (SCI passim). Some minor changes were made to the collateral management agreement for a number of the deals, which Moody's says are not inconsistent with its rating methodology.

Moody's has determined that the assignment and assumption agreements will not result in the withdrawal, reduction or other adverse action with respect to its current ratings (including any private or confidential rating) for any of the transactions.

CMBS

CMBS trader joins Cohen

Veteran trader Rob Cestari has joined Cohen & Company as md from boutique investment bank Maxim Group. He will specifically focus on CMBS in his new role.

Speaking exclusively to SCI, coo Ted Kallina says: "Cohen & Company hired Rob to bolster our existing CMBS trading effort. We believe that the trading of CMBS securities offers one of the best growth opportunities in the fixed income markets over the next two to three years. Rob joins Jon Devirian, trading Cohen & Company's CMBS book."

Cestari worked for Nomura, Sinjin Fixed Income Advisers, Apollo Real Estate Advisers and Winthrop Realty Partners before joining Maxim last year.

CMBS

New CRE broker-dealer minted

NorthStar Realty Finance's wholly-owned subsidiary NRF Capital Markets has been registered with the US SEC and approved as a member of FINRA. The new broker-dealer is based in Denver, Colorado and will distribute certain NorthStar offerings, including the non-traded commercial mortgage REIT NorthStar Real Estate Income Trust, which will focus on commercial real estate debt investments.

Investors

Fund appoints investment counsellor

Eaton Vance Investment Counsel, a division of Eaton Vance Management, has appointed Duke Laflamme as vp investment counsellor. He moves from the group's fixed income team, where he was also a vp and portfolio manager. Laflamme now reports to Westy Saltonstall, Eaton Vance Investment Counsel president.

Laflamme's previous responsibilities included managing investment grade fixed income and money market portfolios, and he will continue to create and implement income strategies in his new role. His portfolio management responsibilities have been taken over by other members of the fixed income team.

Before joining Eaton Vance in 1998 he worked for Norwest Investment Management, where he was responsible for the corporate, Treasury and asset-backed portions of several investment grade mutual funds.

RMBS

Ambac tapped for RMBS workout hire

Assured Guaranty has hired Gregory Raab as senior md, RMBS workouts. He reports directly to Dominic Frederico, the monoline's president and ceo.

In his new role, Raab will lead the group responsible for RMBS loss mitigation and risk remediation, including enforcing Assured's rights to submit or 'put back' mortgage loans that have breached representations and warranties for repurchase and supervising the obligations of servicers of RMBS transactions that Assured has insured.

Most recently, Raab was cro and senior md of Ambac, where he led all restructuring, loss mitigation and risk management initiatives. He joined Ambac from General Electric, where he was a senior md and portfolio manager for GE Equity, identifying low-risk complex assets at deep discounts for purchase by GE. From 2000 to 2004, he held a series of positions at FGIC, including md, structured finance business leader and cro, structured finance, public finance and capital markets.

During his tenure at FGIC, Raab repositioned the structured finance business away from subprime mortgages towards prime mortgages and other asset classes and helped manage owner GE's sale of FGIC to an investor group.

"I look forward to joining forces with the surveillance and legal teams at the Assured Guaranty companies to maximise recoveries in the RMBS portfolio," says Raab. "We are currently evaluating a number of alternative approaches to effecting recoveries on our RMBS transactions and I believe there are a number ways we can intensify this effort."

RMBS

US bank expands RMBS team

Wells Fargo Securities has expanded its RMBS group with several new appointments. It now provides a full suite of advisory, structuring, research, distribution and trading services.

Mike Buttner has been appointed the head of RMBS. A 19-year veteran of Wells Fargo, Buttner was most recently responsible for managing the hedging activities of Wells Fargo Home Mortgage (WFHM)'s servicing rights and pipeline/warehouse assets. He reports jointly to Tim Mullins, head of fixed income trading, and Julie Caperton, head of asset-backed finance and securitisation - two divisions within the bank's securities and investment group.

Reporting to Buttner are Doug Lucas, head of residential mortgage trading, and Dash Robinson, head of residential mortgage finance structuring and lending. Lucas has more than 20 years of experience managing residential risk and most recently ran structured products trading in London for Bear Stearns, where his team set up a mortgage company in Europe. Robinson was previously responsible for the execution, surveillance and restructuring oversight of Wells Fargo's structured finance transactions.

RMBS

Mortgage recovery fund closes

Invesco has held a final closing for its Mortgage Recovery Fund, with total commitments of more than US$1.46bn. Invesco's offering invests in its Public-Private Investment Fund and provides exposure to mortgage loans and securities.

The fund is managed by Invesco Fixed Income, Invesco Real Estate and WL Ross & Co. Invesco says the fund has been designed to invest in the mortgage market broadly, including PPIP-eligible MBS and mortgage-related loans.

"The Treasury Department's PPIP initiative of partnering with private investment firms like Invesco re-established a market for mortgage-related securities in 2009 by providing much-needed stimulus to this distressed market," comments Mark Armour, senior md and head of Worldwide Institutional.

RMBS

REIT plans further MBS purchases

Invesco Mortgage Capital has completed its public offering of nine million shares of common stock for gross proceeds of US$186.75m. The REIT expects to use the net proceeds from this offering to make additional acquisitions of RMBS, CMBS and mortgage loans.

Credit Suisse Securities (USA) and Morgan Stanley acted as joint book-running managers for the offering. Keefe Bruyette & Woods, Stifel, Nicolaus & Company and JMP Securities served as co-managers.

SIVs

SIV-lite case dismissed

Oddo Securities' lawsuit against Barclays Capital and Solent Capital Partners has been dismissed by the New York Supreme Court. The case - originally opened in 2008 - arose from the collapse of SIV-lites Golden Key and Mainsail, which were arranged by Barclays and managed by Avendis.

Oddo, which invested US$50m in the vehicles, claimed among other things that Avendis and Solent conspired with Barclays in early 2007 to transfer subprime RMBS into Mainsail and Goldenkey, knowing that the value of those assets was dropping. However, the court dismissed the case last week on the grounds that Oddo is a "sophisticated entity in the position of appreciating the inherent risks associated with debt securities, including the fact that, under certain circumstances, interest payments may cease and principal may be lost".

The motions by each of the defendants were granted and the action dismissed, with prejudice and without costs or disbursements. Oddo has since filed a notice of appeal.

Technology

IDC acquired

Interactive Data Corporation is to be acquired by investment funds managed by Silver Lake and Warburg Pincus in a transaction with a total value of US$3.4bn. The move follows a review of strategic alternatives undertaken by the firm.

Under the agreement, Interactive Data's stockholders will receive US$33.86 in cash for each share of Interactive Data common stock they own. This represents a premium of approximately 32.9% over the closing share price on 14 January 2010, the last trading day before the review was announced. Completion of the transaction is expected to occur by the end of Q310, following regulatory approvals and other customary closing conditions.

Rona Fairhead, chairman of Interactive Data's board of directors, comments: "This transaction enables Interactive Data's shareholders to realise substantial value and provides the company with partners who are committed to supporting its global expansion. Interactive Data has an outstanding team of more than 2,400 people and the Board thanks them sincerely for their skill and commitment in serving our customers and building the Company over many years. With the support of Silver Lake and Warburg Pincus, I am confident that Interactive Data will take full advantage of its strong market position and the changes in technology and regulations that are shaping its industry."

Following the completion of the transaction, Interactive Data will remain headquartered in Bedford, Massachusetts, and maintain its offices around the world. The firm will continue to be led by its senior management team and expects to continue expanding its workforce over time.

ABS

Moody's updates on SEC rule implications

Moody's has decided how it will conform to the amendment to Rule 17g-5 for credit rating agencies registered with the US SEC as Nationally Recognised Statistical Rating Organisations (NRSROs), which the agency began assessing in March (see SCI issue 178). Compliance with the amended rule is required from 2 June 2010 and the agency says it will comply with the rule with respect to new structured finance (SF) transaction where the rating process begins on or after that date.

Moody's says any product or transaction to which it has already given a rating will not be classed as new and that it is assessing whether rolling or continuous issuance of obligations from 2 June from programmes such as ABCP conduits that already have a Moody's credit rating are affected by the rule change.

For SF products, Moody's believes the rating process starts when sufficient written information is supplied for analysis and the arranger or agent asks Moody's to begin that analysis, but only if the agency agrees. Moody's says it will respond to anything submitted by 28 May with its opinion on whether the rating process counts as being initiated before 2 June for the purposes of its obligations under the amended rule. Any SF transaction for which Moody's receives the information after 28 May will be considered to have had its rating process initiated on or after 2 June.

Specific information sufficient for the analytical process to begin is defined by Moody's as either written descriptions of specific collateral characteristics to be analysed or a written term sheet or email that contains transaction terms to be analysed, or both. A discussion of the agency's methodological approach or about whether Moody's is able to rate a transaction are not considered sufficient for the analytical process to begin, nor is an oral description of collateral or transaction terms or a discussion or correspondence about rating fees.

The agency says it is continuing to assess which types of securities and money market instruments count as SF products, with its current view being that covered bonds generally would not constitute SF products within the meaning of the amended rule.

ABS

SEC revisions to benefit student loan analysis

Moody's believes that the US SEC's proposal to require the disclosure of loan-level data and a computer programme that can be used to model securitisation cashflows would be helpful in the analysis of student loan ABS. The proposal would mean issuers having to provide loan-level data at the time of offering and periodic updates of loan-level performance (SCI passim).

"The loan-level information would be required to be presented in a standardised format," says Tracy Rice, Moody's avp. "In addition, issuers would be required to provide a model of the contractual cashflow provisions of the securitisation. The extent of the benefit to investors would depend on whether they would have the resources to effectively analyse and interpret the loan-level information and model the cashflows of the securitisations to make investment decisions in a timely manner."

The new disclosures are expected to be particularly useful in the credit analysis of private student loan ABS, where Rice says the risk is related to net losses on the underlying loans. Since FFELP student loans are government guaranteed, net losses are minimal. Moody's says the proposed loan-level credit characteristics for private student loan ABS at the time of offering would probably improve an investor's ability to assess the credit quality of the pool's borrowers, better understand the quality of the loan origination process and track changes in issuer's underwriting policies.

The standardisation of data as proposed would enable investors to compare and analyse student loan pools. "Currently, there is no market standard for student loan data as there is for other asset classes," says Rice. "At the pool level, the many differences in the calculation and reporting of performance metrics make surveillance as well as comparisons of student loan pools difficult."

ABS

Auto ABS criteria to reflect residual value volatility

Fitch says it has revised its rating criteria for US auto ABS to reflect the residual value volatility seen over the last two years. The new criteria now places more emphasis on performance during historical downturns rather than the total historical experience in deriving stressed residual loss levels.

Auto lease ABS residual realisation began to improve late last year and Fitch says that trend has continued into 2010. Most ABS portfolios have exhibited gains on lease-end vehicle dispositions through Q110, the rating agency adds.

The rating agency's updated methodology includes changes to the residual loss derivation methodology and the addition of rating sensitivity analysis. Fitch says the incorporation of the updated criteria will not impact its outstanding auto ABS ratings, nor will it result in credit or residual loss assumptions that are materially different to recent practice in most transactions.

Changes to the residual loss derivation are intended to account for the elevated residual loss levels recently observed, as well as the incremental risks that material model, segment and residual maturity concentrations present to auto lease ABS. The agency says current loss protection levels on rated transactions are consistent with those derived under the new criteria.

Auto lease ABS residual value performance was severely impacted by fuel price increases and deteriorating macroeconomic conditions in 2008 and early 2009. Fitch observed increasing monthly residual losses in the 10%-15% range through most of 2008 and its updated criteria accounts for this period, as the stressed residual loss derivation now focuses on times of historical stress.

Fitch's current outlook for asset and rating performance in auto lease ABS is stable, reflecting the expected stability of the wholesale vehicle environment in the near term. Significant changes in automotive market conditions, rapid increases in fuel costs and further deterioration in the US economy could affect the agency's view on the sector, however.

CDO

Retranched CDOs rated

Two CDOs - Gale Force 2 CLO and LCM II - have been retranched and renamed Gale Funding and Liston Funding 2009-1 respectively.

S&P has assigned AAA/AA+ ratings to Gale Funding's US$68m class A and US$12m B floating-rate notes. The transaction is a retranching of Gale Force 2 CLO's class A first-priority, senior secured, floating-rate notes due 2018.

The rating on Gale Funding's class A notes is not hard-linked to the rating on Gale Force 2 CLO's class A notes due to the additional subordination. However, the rating on Gale Funding's class B notes is hard-linked to the rating on Gale Force 2 CLO's class A notes, which means that the rating on the class B notes will mirror the rating on Gale Force 2 CLO's class A notes.

Among other things, S&P says its ratings reflect the expected commensurate level of credit support in the form of subordination, which will be provided by the junior notes in the Gale Force 2 CLO transaction.

S&P has also assigned a double-A plus rating to Liston Funding 2009-1's US$13.6bn class B-2-A floating-rate notes, which retranched LCM II's class A floating-rate senior secured notes. Consequently, the rating is linked to the double-A plus rating on LCM II's class A notes, with subordination also provided by the junior notes in the LCM II transaction.

CDO

Sovereign obligor concentration analysed

S&P has reviewed the synthetic CDO (SCDO) transactions it rates as part of its investigation into the impact of the current credit environment's potential impact on US SCDOs. The review aimed to identify the most widely referenced sovereign entities in each transaction.

The rating agency's review covered approximately 800 corporate US SCDOs and found that about 430 of them reference one or more sovereign entities, but that those sovereign entities make up less than 1% of all the reference assets. S&P says its study only takes into account SCDOs which reference sovereign entities, since it corporate cashflow CDO exposure to these entities is statistically insignificant.

Approximately 56% of the 430 corporate SCDOs reference the Republic of South Africa, which is the most widely referenced sovereign entity in the sample. The Republic of Korea is a reference obligation in nearly 39% of the corporate transactions and the United Mexican States is a reference entity in approximately 36%.

S&P says a more granular data review shows that sovereign obligors in the triple-B rating category are the most frequently referenced sovereign entities. Last year's review showed 580 transactions referencing one or more sovereign securities and the agency believes this year's lower figure of 430 is due to the smaller universe of outstanding SCDO transactions rather than to a change in sentiment on sovereign debt.

CDO

CDO Evaluator error disclosed

S&P says it has become aware of an error in its CDO Evaluator 5.0 credit model. The error is in connection with the recovery rates used for certain sovereign debt when assessing whether the credit enhancement for applicable CDO tranches satisfies the rating agency's criteria for triple-A and double-A liability ratings.

S&P's published criteria provides that the recovery rates for triple-A and double-A rated sovereign debt are 37% and 38% respectively; the incorrect recovery values in CDO Evaluator 5.0 are 30% and 35% respectively. The agency says it has tested its rated global synthetic CDO transactions that reference sovereign debt and has determined that this error had no impact on current outstanding ratings.

A new version of CDO Evaluator with corrected recovery rates will be released in the coming weeks. But in the meantime S&P suggests that users manually override the recovery rates for sovereign assets when running triple-A and double-A analyses.

CDS

Ambac auction scheduled

The auction to settle Ambac Assurance CDS is scheduled for 2 June.

CDS

Sharp rise in government risk index

While markets focused their attention on Greece, Portugal and Spain following S&P's downgrades this week, the systemic threat of a risk repricing in sovereign balance sheets was much clearer, according to Credit Derivatives Research (CDR). CDR's Government Risk Index (GRI) - comprised of seven of the largest government debt issuers in the world - rose over 25% this week, testing February 2010's riskiest levels. These levels correspond to the same risk repricing that was evident in the midst of the crisis in Q109.

Germany's sovereign CDS level reached 10bp more than the USA's levels for the first time as the two nations diverge in terms of economic and currency strength and European investment grade credit spreads trade wider than US. "There are many structural factors that are at play to drive this, but the virtuous cycle of government risk transfer from financials has clearly started to unwind as European financials decompressed dramatically," comments Tim Backshall, chief strategist at CDR.

Meanwhile, CDR's Counterparty Risk Index (CRI) - comprised of 14 of the largest OTC derivative dealers - rose by 30% this week alone and now trades back to its widest levels since July 2009. "It is clear that the sloshing of risk off bank balance sheets and into government balance sheets did not hide the risk and now it is sloshing back out, with dire consequences for any hopes of a robust European economy recovery," says Backshall.

Credit markets are repricing sovereign risk to reflect the liquidity and leverage that exists there. This repricing raises the floor on financials that are implicitly backstopped in many cases and explicitly interconnected via large government bond holdings.

"While Portugal and, to a lesser extent, Greece do not have critical impacts on the euro, any further weakness in Spain (the most interconnected and contagion-prone) will lead to significantly more pro-cyclical deterioration on both euro financials and non-financials as austerity slows growth, credit expansion is minimised and political infighting becomes rife," adds Backshall.

CDS

Troubled companies index maintains improvement

The Kamakura index of troubled public companies improved in April for the twelfth time in the last 13 months, declining to 9.46% from 9.69% in March. Credit conditions are now better than credit conditions in 74% of the months since the index's initiation in January 1990, and the index is 4.23 percentage points better than its historical average of 13.69%.

Kamakura's president Warren Sherman says: "The rated firms showing the largest increase in one-month default risk in April included National Bank of Greece, Bank of Ireland and SAS AB of Sweden. Over the entire KRIS portfolio of 29,200 firms, however, the trend in default probabilities was strongly down again this month."

Kamakura defines a troubled company as one whose short-term default probability is in excess of 1%.

CDS

New OTC data platform prepped

CME Group has selected the XigniteOnDemand platform to support new on-demand OTC market data products and services. The new on-demand platform will launch in Q310 and enable CME Group to distribute OTC data offerings quickly and cost effectively, the exchange operator says.

"With the ongoing development of our multiple OTC product and service offerings, and the need to deliver this data to customers with continued market transparency, the Xignite platform will be a quick and cost-effective way to get OTC pricing and reference data to our global market participants," says Brian McElligott, CME Group information products md.

CME Groups says it intends to offer on-demand access to end-of-day OTC settlement, volume and open interest data to support markets available through CME ClearPort, which currently clears more than 500,000 contracts daily, including CDS, energy, metals, agricultural commodities and foreign currencies.

"Xignite is excited to be working with an innovative industry leader like the CME Group," says Stephane Dubois, Xignite ceo and founder. "Traditional files and feeds no longer solely address the data delivery requirements of the market. Firms need data that is easier to integrate and more cost-effective to manage."

CMBS

New cell tower deal surfaces

New Secured Cellular Site Revenue Notes 2010-1 and 2010-2 are marketing from Unison Ground Lease Funding, according to an investor and a syndicate source. The deal consists of US$154.5m seven- and 10-year fixed-rate tranches split evenly between 2010-1 class C notes and 2010-2 class C notes. It also has a US$41.5m 10-year fixed rate class F tranche.

Price guidance on the seven-year notes is 225bp over treasuries and guidance on the 10-year notes is 250bp over. The class F tranche is expected to yield 9.75%-10%. Deutsche Bank is the sole bookrunner.

The offering is different from other cell tower deals that have been securitised lately since, unlike typical cell tower securitisations in which the towers serve as collateral, the collateral for this securitisation is mainly from easements on the land where the tower resides and on the rooftops and structures. The deal, which consists of notes backed by mortgages on real estate, follows a US$1.23bn SBA Tower Trust offering that came to market earlier this month via Barclays and Deutsche Bank and a Global Tower Partners CMBS cell tower deal earlier in the year.

One structured finance lawyer says the cell tower sector as a whole provides some benefit to investors that want a wide dispersal of values in the collateral. According to an asset manager, there will likely be more cell tower deals coming to the market since it doesn't require too much to get the deals done.

However, the main buyers of the SBA deal, in particular, were not typical investors looking for securitised products. In these offerings, investors tend to look at the deal as secured corporate credit not typical securitised products, says the asset manager.

"The company (SBA) was happy with the execution that it got. But it's really not attractive relative to a securitisation," he says.

The SBA deal and the new Unison Ground Lease Funding deal are lower rated than some traditional securitisations that have included triple-A rated tranches. "There's not a ton of structure around that," he says.

Other cell tower companies in this space - such as Verizon, American Tower and Crown Castle International - may not immediately follow the lead of SBA and Unison in securitising and could instead seek out cheaper alternative funding in the unsecured markets, notes the asset manager. Earlier in the year, American Tower issued US$500m 5.5-year unsecured debt, while Crown Castle Tower also launched a US$1.9bn unsecured debt issue.

Unison is expected to use the proceeds to refinance its existing private debt facility, according to the syndicate source.

CMBS

Further Euro CMBS experience write-offs

Junior tranches from a further two European CMBS have experienced write-offs: the class H and J notes of Cornerstone Titan 2006-1 have been written off in full, with the class G notes subject to a partial write-down; while the Windermere XI class E and D notes have been subject to full and partial write-offs respectively. These deals follow the Epic Industrious and Titan 2007-3 transactions in becoming the first few CMBS to witness write-offs.

The Cornerstone and Windermere write-offs are a result of the application of losses incurred on property disposals - the Peacock Place shopping centre in the Cornerstone transaction and the Shrewsbury loan in Windermere XI. In both cases, the updated valuations resulted in securitised LTVs in excess of 100%, indicating that losses were likely to occur.

As S&P notes in its recent monthly update, these actions illustrate that special servicers may not be deterred from disposing of properties if they believe such accelerated actions optimise the value extraction from the assets compared to a more prolonged management of the property.

CMBS

CMBS delinquencies reach record high

The delinquency rate for commercial real estate loans surpassed the 8% mark for the first time, according to Trepp. Delinquencies rose by 41bp in April to reach 8.02%; however, Trepp notes that the delinquency rate does show signs of easing, as the April increase was 40bp lower than the increase for March.

The percentage of CRE loans considered to be seriously delinquent or more than 60 days late, in foreclosure, REO or non-performing balloons was up by 48bp in April at 7.14%. Trepp points out that the delinquency rate stood at 2.45% one year ago, while the seriously delinquent rate was 1.78% a year ago.

Trepp notes that the highest delinquency rates were noted in the hotel sector, where the delinquency rate increased by 27bp to 17.16%. The multifamily housing sector had the second highest delinquency rate at 13.06%; however, this represented a 13bp decrease from April's rate. The retail property sector increased by 41bp to 6.44%, while the industrial sector jumped 5bp to 5.44% and the office sector spiked by 64bp to 5.37%.

CMBS

US ...

Fitch says cumulative default rates for US CMBS now stand at 8.15% through to the end of Q110. There were 487 newly defaulted loans totalling US$8.43bn, with large loan underperformance.

"Large loan defaults will continue to escalate, with the majority coming from recent vintage CMBS," says Fitch md Mary MacNeill. She also warns that high unemployment will cause limited demand for office space, which will lead to an uptick in defaults.

Multifamily loans are far exceeding the default percentage by dollar balance due to the developments surrounding Stuyvesant Town/Peter Cooper Village in New York, which is in special servicing. Average loan sizes were US$35m for multifamily, US$14m for retail, US$13m for office and US$11m for hotel.

CMBS

... and European CMBS loan defaults climb

Fitch says the number of defaulted Euro CMBS loans is likely to increase, despite improving sentiment on the commercial property market. The agency says over 10% of loans in non-granular European CMBS rated by the agency are now in some form of default, and it has launched a monthly loan maturity bulletin covering the factors which influence the likelihood of upcoming balloon payments being made.

"The improved sentiment in the commercial property market has yet to flow through to CMBS performance," says Fitch European SF associate director Mario Schmidt. "Although the values of some commercial properties now appear to have stabilised, many borrowers have little or no equity left in these loans and hence limited incentive to support them or proactively seek ways of making the balloon repayments."

Over 20% of the 73 non-granular loans in default in Fitch-rated European CMBS transactions have reached their scheduled maturity dates. There are 111 loans scheduled to mature in the next 12 months and Fitch expects a significant proportion of them to default. The agency says only the values of the most prime commercial property assets have increased significantly from their lows and warns that, without rapid improvement for lower-quality assets, the number of loans defaulting will increase.

A small number of loans in special servicing were repaid or successfully restructured in Q110 and there are only a few loans that have been through a full workout process with recoveries allocated to noteholders. Fitch says that if noteholders believe recoveries will be maximised by restructuring, then there may be more cases such as Fleet Street Finance 2, where noteholders voted to extend not just the loan maturity but also the note maturity.

The agency's CMBS Maturity Repayment Index was up at 17% in May from 16% in the previous month, due to the repayment of five loans. Gioia Dominedo, senior director in Fitch's European CMBS team, explains: "The loans that are able to successfully repay, either at or after their scheduled maturity dates, continue to exhibit the same strong credit characteristics of low loan-to-value ratios, high interest coverage ratios or early origination dates."

Dominedo adds: "While one 2006/7 vintage loan did successfully repay in the last month, its moderate LTV makes it an outlier and Fitch does not expect many loans from those vintages to follow suit."

In the May issue of its 'European CMBS Loan Maturity Bulletin', the rating agency says maturity extensions remain common, although the percentage of loans (by current balance) in this situation dropped significantly during the month primarily due to the failure of the €344.7m Project Christie loan, securitised in Titan Europe 2007-2, to exercise its remaining extension option.

"The percentage of the matured loan balance in some form of standstill or workout increased this month to 69% from 58% in the previous month," says Charlotte Eady, director in Fitch's CMBS team. "With the perceived improvement in commercial property market conditions, servicers appear to be less reluctant to place matured loans in workout, although maturity extensions remain common and Fitch expects this to remain the case."

Indices

New indices to set consumer default benchmark

S&P and Experian have announced a partnership to launch a series of consumer credit default indices in the US. The indices will be launched on 18 May and seek to measure the balance-weighted proportion of consumer credit accounts that go into default for the first time each month.

There will be four headline indices determined by loan type, as well as a composite index. The indices will be called S&P/Experian Auto Default Index, S&P/Experian First Mortgage Default Index, S&P/Experian Second Mortgage Default Index, S&P/Experian Bankcard Default Index and S&P/Experian Consumer Credit Default Composite Index.

The balance-weighted composite index will measure default rates across all four loan types, and there will also be granular indices by geography and custom indices for clients. The index values will be published on the third Tuesday of each month.

"Built from the monthly payment data generated by the lenders and aggregated by Experian, these indices will provide a timely, detailed look into the actual payment behaviour of US consumers," says David Blitzer, S&P Indices md and index committee chairman. "In addition, since the indices will allow us to get a pulse on the current default profile of consumers, they could also serve as a leading indicator on the direction of the US economy."

RMBS

Arkle priced, Spanish Driver awaited

Lloyds Banking Group launched the Cheltenham & Gloucester-originated Arkle 2010-1 RMBS late last week via joint book runners Lloyds, Citi and RBS. The £3.4bn transaction comprised nine sterling-, US dollar- and euro-denominated tranches, of which a couple were publicly placed. The closely-watched 4.78-year triple-A rated notes priced at 125bp over three-month Libor, in line with guidance.

The spread levels closely mirror the prime RMBS issued by Lloyds' other securitisation vehicle, the HBOS-originated Permanent, which issued 5.19-year triple-A notes in January at 125bp (sterling) and 130bp (euros) over three-month Libor.

One ABS portfolio manager suggests that 125bp for Arkle 2010-1 seems fairly tight, given the volatility in the wider market. However, while secondary ABS spreads widened in line with equity and credit markets at the beginning of last week - especially in southern European paper - the mood seemed to improve by Friday, with benchmark Granite triple-As trading at 93.50/93.75.

Driver Espana One - a VW-originated auto ABS - remains in the European primary pipeline as Citi and JPMorgan await CNMV approval for the transaction. Guidance for this deal is whispered at low- to mid-100bp for the 1.65-year triple-As and in the mid-200bp area for the 2.16-year single-As.

RMBS

Mortgage REIT preps debut securitisation

PennyMac Mortgage Investment Trust (PMT) has begun working on its first securitisation to provide additional capital and increase its investment capacity. PMT says there is no guarantee the securitisation will be successfully completed, but targets completion in Q210. The REIT has also reported net income for Q110 of US$1.3m on total net investment income of US$3.9m.

The company acquired five residential mortgage whole loan pools in the first quarter, valued at US$115m in aggregate with unpaid principal balances at the time of purchase of US$208m. In April PMT closed a transaction to purchase an additional mortgage whole loan pool of non-performing loans valued at US$71m with an unpaid principal balance of US$141m.

Stanford Kurland, PMT chairman and ceo, says: "Market activity for non-performing whole loans accelerated throughout the first quarter and continues to accelerate into the second quarter of 2010.

"In addition to our acquisition of distressed whole loans, we are moving forward with our prime agency conduit, having purchased our first loans into the conduit in April," continues Kurland. "We expect to proceed gradually with our conduit business throughout the rest of 2010."

PMT says its investment holdings in short-term money market investments shifted to longer-term residential mortgage whole loans. Most of the acquisitions were completed late in Q110, so the company says quarterly results may not reflect the assets' full potential yield. During the quarter PMT recognised an annualised yield of 8.82% on its residential whole loan portfolio.

Alongside the planned securitisation, the company says its mortgage whole loan portfolio will continue to produce cashflows as current loans pay down and non-performing loans become resolved. Its short-term MBS may also be re-invested into higher yielding, longer-term residential whole loan opportunities as they arise.

"As we look forward, we continue to see attractive opportunities in the marketplace," Kurland concludes. "We are starting to see a stabilisation of real estate values, with the economy showing some signs of improvement. The securitisation market is starting to make a comeback as well, with a recent announcement of the first newly originated jumbo securitisation in approximately two years."

RMBS

GSE to no longer securitise balloon loans

As part of its new criteria for purchasing and securitising ARMs, Fannie Mae says it will no longer purchase or securitise balloon loans as it did in the past. The agency is also putting new standards in place for interest-only mortgages (IOs).

The changes show more stringent criteria and a focus on sustainability to make sure when borrowers get these loans, they will be able to keep these loans, according to a spokesperson at Fannie Mae. "So, going forward, borrowers will have to be qualified, not at the initial rate, but at the initial rate plus 2% or the fully indexed rate - the maximum or whichever is the greater of the two," she says.

The criteria will apply to any ARM with a fixed-rate period of five years or less. Fannie Mae will continue to make an IO loan product available, though with some caveats.

"For the IO loans, Fannie Mae will purchase them only up to 31 August 2010 and accept for delivery into MBS pools only up to 1 August 2010," says the spokesperson. For the IO loans, the agency will also no longer accept cash-out refinances and no longer do IOs on investment properties or on 2-4 unit properties.

Borrowers in IOs will also face tougher qualifications. A credit score of at least 720 is needed, as well as a minimum reserve of 24 months of liquid asset reserves. The maximum LTV also cannot exceed 70%.

RMBS

Agency fires warning shot over Redwood collateral

Redwood Trust's new private-label RMBS - Sequoia Mortgage Trust 2010-H1 - officially closed yesterday (28 April), having launched and priced late last week (see last issue). However, S&P - which did not rate the transaction - has issued a note in which it warns on various characteristics of the underlying pool and implies the deal would not necessarily have gained its top rating, had it been involved in the rating process.

"We chose to comment on this transaction - which appears to be one of the first private-label US RMBS transaction containing newly-originated loans offered this year - because we believe the transaction is important to the marketplace and that our views can add value for investors," the rating agency says.

Among other things, S&P highlights several risks in the transaction, including credit enhancement levels, concentration risk and borrower refinancing risk. The rating agency notes that the pool consists of 255 residential mortgage loans with relatively high balances. As such, the default of one loan may have a greater impact on overall credit enhancement than for a pool that contained a greater number of loans or loans with lower current balances, it says.

It also notes that if 33 average-sized loans or the 19 largest loans in the pool were to default at a 50% recovery (the weighted average original LTV ratio is 56.57%), it estimates that either scenario would result in the complete write-down of all the subordinate classes, which provide 6.5% credit enhancement to the senior class.

The agency further highlights that the pool consists entirely of five-year adjustable-rate mortgage loans and nearly 74% of these loans contain 10-year interest-only periods. "All borrowers will experience reset risk after five years, when their initial fixed rates become adjustable, and 74% of borrowers will experience an additional reset when their loans become fully amortising," S&P says. "If mortgage rates rise, property values remain flat and the extension of credit is limited, we believe borrowers may face difficulties refinancing."

The Sequoia 2010-H1 collateral pool is not completely consistent with S&P's archetypical pool assumptions for US RMBS. For example, 17.55% of the loans were newly originated (within the past six months); 81.53% of the loans are secured by single-family detached residences; 19.41% of the loans are for home purchase; 26.26% of the loans are fully amortising; 0% of the loans are fixed-rate; 72.84% of the loans have no simultaneous second liens; 83.75%-93.55% of the loans appear to have FICO scores greater than or equal to 725; and 87.35% of the loans appear to have an original combined LTV of less than or equal to 75%. S&P says in each category, a value of 100% would indicate complete consistency with its criteria.

In addition, the collateral pool for Sequoia 2010-H1 is not as geographically diverse as S&P's archetypical pool, with 46% of loans coming from California and 16% from New York State.

"For transactions with pools that are completely consistent with our archetypical pool criteria, credit enhancement at the triple-A rating category would begin at 7.5%," says S&P. The triple-A notes, as rated by Moody's, have a credit enhancement level of 6.5%.

RMBS

Foreclosures, delinquencies still loom large

A new report by Lender Processing Services (LPS) shows a mixed picture for the US home loan market in Q110, with reductions in total new delinquencies and improvements in the number of loans curing to current being overshadowed by a large US$7.39m pool of non-current and REO loans.

Many of the nation's most populous states showed foreclosure inventories at a higher percentage than the average national foreclosure rate of 3.27%. Although 16 states showed an increase in the number of non-current loans, LPS says the number across the nation did decline over the past six months. Delinquencies excluding foreclosures decreased by 10.3% from February to March 2010, but that total represents a year-over-year increase of 15.7%.

March's foreclosure rate stands at 3.27% - a month-over-month decrease of 1.2%, but a year-over-year increase of 32.9%. The number of loans moving from seriously delinquent into foreclosure rose again in March after hitting historic lows in February.

LPS says the federal government's Home Affordable Modification Program has improved the level of loan cure rates as trial modifications are converted to official loan modifications. There has also been an increase in the levels of early-stage cures.

RMBS

NAIC RMBS analysis assessed

A study of the National Association of Insurance Commissioners' (NAIC) RMBS Initiative results by Fitch has found that mortgage assumptions used to derive risk-based capital (RBC) charges are similar to those used in Fitch's US RMBS recovery rating analysis. The rating agency does not anticipate making significant adjustments to insurers' reported RBC amounts as part of its insurance company rating analysis.

Fitch's analysis follows the introduction of NAIC's new approach, which is effective for year-end 2009 statutory reporting purposes. The new approach uses a financial model developed by PIMCO Advisory to calculate RBC amounts for RMBS bonds (see SCI issue 162). The new methodology utilises an expected bond loss approach and factors in the statutory carrying value of the bond.

"A key component of Fitch's analysis of insurance companies is a consideration of capital levels," says Fitch md Doug Meyer. The agency was able to simulate the results of the NAIC's new RMBS RBC calculation methodology using analysis the agency currently employs in assigning recovery ratings to distressed RMBS bonds.

Fitch says it analysed 2,639 RMBS bonds held by life insurance companies that had been recently assigned an RBC designation based on the new methodology. The sample's par amount was US$19.8bn, a little over 10% of total insurance company RMBS holdings. The study found the NAIC RBC designations assigned with PIMCO Advisory's assumptions appear consistent with Fitch assumptions.

The agency notes that additional disclosure regarding mortgage pool loss amounts, timing and prepayments would be beneficial. "Since RMBS valuations are often highly sensitive to a variety of assumptions, investors and other interested third parties would benefit from greater transparency in regard to the 'RMBS Initiative' valuation methodology," says Grant Bailey, Fitch RMBS surveillance senior director.

RMBS

Eurosail case highlights currency swap risk

The Class A3 noteholders and the trustee on Eurosail-UK 2007-3BL look set to end up back in court to determine whether an event of default has occurred on the transaction. Asset-backed analysts at RBS suggest that if the ruling goes in favour of the Class A3 noteholders, it would almost certainly result in junior note payments being suspended and the Class A note principal payments switching to pro rata. The trustee is seeking an expedited court hearing in order to resolve the issue before the next interest payment date in June.

According to the RBS analysts, the crux of the case for Class A3 noteholders seems to hinge on whether the issuer is able to pay its debts - as defined in section 123(2) of the Insolvency Act 1986 - when considered in conjunction with the post-enforcement call option agreement. Without the benefit of a currency swap, at current exchange rates the Class A3 notes look set to take a partial loss and the more junior notes to suffer complete loss of principal. On the other hand, the issuer is only obliged to make payments up to amounts available, except for senior note interest - hence the need for an official decision on the correct course of action.

The court ruling could impact other transactions where there has been a failure of the currency swap counterparty. "However, it is not clear to us that this would necessarily push the transaction into enforcement because there would still be the requirement in the documentation (under Condition 11(e)(iii)) to get approval of the Class A1 and Class A2 noteholders, who would be disadvantaged by the change in the cashflow waterfall," the analysts note.

RMBS

Timing changes aid Aussie ADIs

S&P says Australian authorised deposit-taking institutions (ADIs) are modifying expected maturity dates to when the balance of their RMBS falls below 10% of the initial transaction balance. The rating agency says in a new report that this change in redemption timing would enable the ADIs to avoid holding additional capital if the current balance exceeds 10% of the initial balance when the assets are redeemed.

"Although our ratings assume that the call date is not exercised by issuers and that the notes will amortise until their legal final maturity dates, we believe it would be useful for investors to know the possible redemption timeframes for the rated ADI-originated RMBS to reach this 10% trigger," says S&P credit analyst Alisha Treacy. "As a result, we have conducted a scenario analysis on the likely redemption timeframes of 131 ADI-originated transactions by applying three hypothetical repayment rates under certain assumptions to the outstanding portfolio balances."

The agency believes most ADIs would be able to redeem their RMBS when the securitised assets amortise to 10%, and that some are aiming to redeem the notes on their date-based call dates by refinancing through warehouse facilities or issuing new securities.

RMBS

Analytics platform updated

Interactive Data Corporation's fixed income analytics business has released BondEdge Version 3.2, which it says will better help institutional investors assess prime and subprime RMBS risk, including fixed and adjustable mortgage pools, CMOs and ABS.

The release has a new model to compute analytic risk measures and provide interest rate and credit spread simulation analysis on prime and subprime RMBS, and enhanced collateral detail on non-prime RMBS. Also included is a security-specific BondEdge prepayment model scaling tool for prime RMBS and a capacity to automate the provision of security-specific base-case prepayment, default and loss severity assumptions for prime and non-prime RMBS.

"This new release extends BondEdge's analytic capabilities to institutional investors having RMBS exposure within their fixed income portfolios," says Keith Webster, fixed income analytics md at IDC.

Technology

Peer group benchmarking tool introduced

S&P Valuation and Risk Strategies has launched a new credit evaluation benchmark called the Credit Health Panel. It provides a quantitative credit perspective on over 3,000 rated and 23,000 unrated non-financial public companies.

The Credit Health Panel is designed to give investors a dashboard view of the credit health of a corporate entity relative to a broad set of entity peers, allowing for extensive and efficient counterparty and portfolio risk analysis. The Panel is targeted at commercial lending, corporate treasury and risk management professionals. It provides an instant peer comparison and a rapid, market-wide perspective on income, operational, liquidity and probability of default estimates, according to S&P.

"With the Credit Health Panel, we've created an extensive heat map of corporate credit health that allows investors to quickly evaluate entities relative to their peer groups," says Lou Eccleston, executive md and head of S&P Valuation and Risk Strategies. "By expanding well beyond the Standard & Poor's rated universe, we are giving investors of every size the tools intended to help them conduct truly robust risk-driven investment analysis."

S&P says the Credit Health Panel includes an overall credit health score, which is an analysis of an entity's cash generation capabilities, a probability of default score to allow users to asses default risk within the next 12 months and a credit model score based on historical default frequency. "The Credit Health Panel analyses 33 key financial metrics across three risk categories (income, operational and liquidity) to give investors a quantitative view of credit performance versus a peer group," says S&P Valuation and Risk Strategies md Sonia Kim. "We've made it possible for all investors to conduct a level of analysis in minutes that would have previously been cost- and time-prohibitive for the most sophisticated credit analysts."

Whole business securitisations

Change of focus for Punch investors

WBS investor focus appears to be shifting from the Spirit to Punch A and B securitisations, following the recent publication of Punch Tavern's interim results. Disappointing trading results were set against management actions illustrating how the pub operator intends to avert near-term financial default in Punch A and B, while also indicating that future growth in the managed business should raise Spirit out of its current difficulties.

According to asset-backed analysts at RBS, the announcements redirected investor concerns from around whether/when the Punch A and B deals would default and the consequences thereafter to whether the underlying assets are capable of returning to long-term growth and whether the group has adequate resources to sustain the transactions until that time. Uncertainty over whether Punch will dispose of the managed business (accounting for 65% of the Spirit transaction's EBITDA) and the implications for the Spirit deal have also reduced, as it increasingly appears that time - coupled with modest inflation - will be sufficient to resuscitate the transaction.

Although the majority of investors will likely have viewed positively management's actions with regards to Punch A and Punch B, the RBS analysts caution that the actions do not represent a fix to the fundamental issues facing these deals, but rather provide the company with further time to address them. "We consider that management need to articulate a long-term solution before investors will gain greater comfort. Whilst the outlook for Spirit appears clearer, there remains considerable execution risk attached to the rehabilitation of the Spirit managed business," they add.

S&P last Friday (30 April) took negative rating action on bonds issued by Punch Taverns Finance and Punch Taverns Finance B. The rating agency appears to have turned negative on the deals, cutting some tranches by three notches.

CMBS

Learning lessons from the past

Anne Horlait, credit analyst at S&P, explores what "CMBS 2.0" might look like in Europe's future commercial property markets

The European real estate sector hasn't left its recent difficulties behind just yet, in S&P's opinion: it remains under severe pressure from the twin problems of depressed property values and a dearth of new credit for all but prime real estate. And the securitisation market - previously a key funding source for commercial real estate - continues to be caught up in this distress and public new issuance of CMBS remains a rarity. Added to this, regulators may make CMBS more costly for banks to hold, heaping yet more pressure on this fragile sector.

Despite this, we believe that commercial property securitisation will return in future, but it is likely to be in a different form: "CMBS 2.0", if you will.

What will future CMBS structures likely look like? Well, in our opinion, much like they used to when they first came to Europe. To look to the future, we believe the sectors' participants might first look to the past.

Tranched structures attract some criticism, but in our opinion are likely to stay
CMBS structures have received much criticism recently from some commentators. Much of it has centred on what is seen by some as the implausibility of any tranched structure addressing the complexity of a severe correction in real estate debt and equity capital markets.

In particular, a small number of commentators have questioned whether the tranched structure creates a conflict of interest between noteholders to such an extent that renders the structure unfair. However, we believe the tranched structures seen by us typically address this issue and will continue to be relevant in future CMBS structures. To see why, we look to the past.

The origins of CMBS structures in the US are to be found in the savings and loan crisis of the late 1980s. CMBS structures gained widespread use to finance purchases of commercial loans from the Resolution Trust Corp, which the US government set up to manage the failed savings and loan associations' assets. CMBS' birth was in circumstances not dissimilar to the landscape in parts of the structured finance market today, as governments and institutions try to identify and isolate the financial system's bad assets.

In designing tranched structures, the initial architects of CMBS put in place a servicer, a special servicer to manage the loans in a distressed environment, and - importantly - a servicing standard to ensure management of the loans was not dissipated to a committee of noteholders with varying levels of seniority. The servicing standard in CMBS is typically broadly defined as a prudent lender standard and, in our opinion, is a key feature that allows tranche structures to deal with conflicting investors' interests in a tranched debt structure. Quite apart from realising credit losses in different orders of seniority, initial CMBS also gave the right to appoint or change a special servicer to classes of notes that retained an ongoing economic interest in the loan, frequently referred to as the "controlling class".

In bringing the model to Europe, perhaps the most important variant in our view was a decision to give material rights to holders of the junior debt - the unsecuritised portion of the loan also called the "B-note" - above those typically seen in the US. We commented on the increased risk of this strategy in "A/B Structures Have An Effect On European CMBS Subordination Levels," published on 14 July 2005.

Given the unsecuritised junior debt was typically destined for banks' balance sheets, we believe the banks wanted to retain greater control over the whole loan, not just the junior portion they held. Indeed, given the relatively low coupon on the junior debt and taking account of its first-loss characteristics some increase in control was perhaps inevitable.

Looking at a number of recent examples, we can see how tranched structures have addressed differing investor interests.

Taking time to complete loan workouts is often seen as the most effective option
CMBS structures typically delegate the effective management of defaulting loans to a special servicer. In our experience, servicers and special servicers usually do consult noteholders, but noteholders don't get a veto on a servicer's decision if it follows the transaction's servicing standard.

The usual banking practice of extending loans in return for an increased margin has also occurred in European CMBS. The servicer can agree changes to loan documentation in most cases without requiring a noteholder vote. But when it comes to changes to note documentation the picture is often different: paying an increased coupon (most CMBS noteholders are receiving floating-rate coupons below 3% per annum) or extending the legal final maturity date of the notes usually require a noteholder vote as the changes affect not only the borrower's loan, but also the terms and conditions of notes.

European CMBS structures we have rated allow an average of five years between loan maturity and note maturity. For instance, while £45bn of large loans in UK CMBS that we rate will mature in the next four years, less than £2bn of that amount has a legal final maturity date before 2014. Real estate workouts take time, so this tail allows a prolonged period in which the special servicer may not be forced to sell the property if it isn't able to work out the loan.

In our experience, swift enforcement at the bottom of the cycle rarely maximises recoveries for noteholders for income-producing real estate. Indeed, the buyer of the Epic (Industrious) property recently noted that his purchase had been "ludicrously cheap" and that if he had bought it today it would have cost 40% more.

We understand that most European CMBS investors are European financial institutions, the majority of which are banks. Consequently, when asked for their view on CMBS structures, in our opinion it is no surprise that these investors adopt a similarly cautious approach to their CMBS exposure as they do to their other commercial real estate debt exposure; avoiding unnecessary losses is the order of the day. This is sometimes referred to as "the rolling loan gathers no loss" principle.

Examples of where tranched structures addressed conflicting interests
Generally speaking, we believe the inherent conflict of interest in tranched structures was successfully managed when the servicer made decisions in a loan workout in accordance with the servicing standards. We see this is at the heart of CMBS structures and expect this will likely continue to be the case in any CMBS 2.0 structure.

In recent materially stressed scenarios in Europe, we have seen servicers take a variety of approaches to work out a loan within a CMBS transaction's servicing standards. For instance, Eurohypo as servicer agreed to loan changes in the Opera Finance (Uni-Invest) and Epic Opera (Arlington) transactions, as we understand in accordance with the servicing standard. In maintaining our CMBS ratings, we generally assume servicers and special servicers - in common with other transaction parties in structured finance - perform their contractual roles and do not seek to abdicate decisions to other parties.

Other examples where the servicer is allowed to make calls within a servicing standard include the White Tower 2006-3 transaction, in which CB Richard Ellis Loan Servicing, appointed by a controlling class of noteholders, is selling the transaction's assets at a time when demand for the underlying properties is likely to be reasonably strong. Hatfield Philips International too is continuing to deal with the Four Seasons loans in Titan Europe 2006-4 FS, where seven tranches of debt outside the CMBS structure showed to us some of the challenges facing junior bank and shadow bank debt.

Furthermore, the majority of noteholders in CPUK Mortgage Finance agreed to a proposal from a Blackstone entity for a loan extension in return for an increase in the coupon paid by investors, among other things. And lastly the noteholders in Fleet Street Finance Two recently agreed material changes to both the loan and note documentation, including extending the legal final maturity by three years, with Capita Asset Services Ireland acting as servicer.

Securitisation loan workouts versus bank workouts
We believe that these and other CMBS workouts generally get more media attention than workouts for non-CMBS loans in part because they are made in public. This transparency may be desirable to allow public scrutiny, although we observe that many non-CMBS workouts in Europe seem to have eschewed the publication of loan-by-loan valuation information, and we believe disclosing a vendor's distressed asset valuation to prospective purchasers is likely to maximise losses in any workout situation. We understand that regulators are faced with the challenge that even the current level of information on CMBS can often exceed the information they have on balance-sheet loan exposures.

Banks' own commercial real estate loss models and scenarios under Basel 2 seem to have understated risks in several cases relative to actual outcomes. For commercial real estate, our experience of loss numbers to date is that they are usually well above those of our estimates.

Basel 3 will likely see regulators take more prescriptive approaches and we see it as probable that the capital that banks hold against commercial real estate loans will rise materially, given the financial travails of the past few years. Indeed, the creation of non-bank and insurance company lenders to the sector may be an important part of commercial real estate finance in the future, even if securitisation doesn't return.

Learning lessons from the past
Any CMBS 2.0 structure will, in our opinion, be expected to have considered the levels of risks that the recent global financial distress has unearthed.

The risk of property value declines is a pertinent case in point to us, as European commercial property values have fallen by 25% on average. To anticipate this risk in our ratings, by mid-2007 our subordination assumptions for newly originated commercial real estate loans in European CMBS pools approached almost 40% in an extreme stress and almost 10% in a mild stress.

At the time, we noted that commercial real estate values could drop by more than 50% in our AAA scenarios from then-prevailing levels in a period of very severe stress in major European markets. In our opinion, the actual outcome three years later has been very poor in several European markets.

Consequently, we believe that widespread losses to notes initially rated up to A are likely in the severe circumstances we currently see in some markets, while the effect on AAA and AA rated notes is likely to be limited. We believe that where a senior loan suffers a loss, the repayment of the junior debt outside European CMBS structures, typically also held by banks, looks uncertain.

Another risk that the recession and related events have brought into stark focus is the difficulties servicers have faced refinancing loans in a distressed economy. We wrote extensively on the refinance risk challenge as early as 2006 in two articles entitled 'European CMBS Refinance Risk Part I: Storing Up Trouble For The Future' (published on 15 June 2006) and 'European CMBS Refinance Risk Part II: Using Financial Covenants To Mitigate The Risk' (published on 7 September 2006).

And in an article entitled 'Has Risk Taken An Extended Vacation?' (published in mid-2007 in "CMBS World Fall 2007") we commented that: "We can say that risk has taken an extended vacation in many global commercial real estate debt and equity capital markets. But as we know all too well, vacations come to an end. Risk is back and risk like we have never seen it before cannot be entirely discounted."

Notwithstanding our comments, banks lent at least a further £30bn of debt to UK commercial real estate borrowers in the 15 months from June 2007; none was financed by securitisation.

CMBS 2.0 might need to retain the simplicity of European secured loan CMBS structures
Reported secondary market pricing of CMBS plummeted in 2008, but recent rallies have resulted in CMBS notes being one of the top performing (in terms of total return) fixed income classes over the past 12 months in both the UK and the US. Like the underlying real estate market, we believe that it is probable the rally may have gone a little far. But we understand that hopes of those who bought senior bonds at 70 pence in the pound and who thought they could force liquidations that would see them recover a swift £1 in a one-year forced sale have not prevailed.

CMBS debt is clearly under pressure, particularly as capital market funding of real estate debt remains unlikely in the near term in our observations, and the absolute amount of finance for commercial real estate may shrink by perhaps one-third as banks delever and accommodate the as-yet unknown capital requirements coming from the EU's Capital Requirements Directives 2, 3 and 4, plus the Basel 3 rules for banks and Solvency 2 for life insurers. These requirements may make commercial real estate exposure through CMBS notes rather than loans more expensive for banks to hold.

With a likely burgeoning issuance of government paper in Europe in the years ahead, it is probably unsurprising that regulators will in future require much of banks' capital to be held in government bonds and not in senior tranches of European structured finance instruments, which have exhibited default rates of less than 0.5% to date. The predominantly five- to seven-year CMBS market - which is seen to have both prepayment risk in the "good times" and extension risk in the "bad times" - may in future be a 15- to 25-year market, given current investor preferences.

We believe that securitisation will have its role to play in financing Europe's real estate markets. But for this to happen, we anticipate that CMBS 2.0 might need to retain the simplicity of European secured loan CMBS structures.

This might mean an end to pro rata pay features, interest-only strips, certain servicer advancing structures, in our view opaque "if this then that" payment structures and limited availability of borrower, loan and tenancy information. We also consider that future investors might be looking for structures in which the whole loan is securitised, where there is a funded reserve for costs, a clear responsibility on transaction parties for payment mechanics, where the servicing standard is reinforced, in which it is clear who is responsible for replacing counterparties, and where the role of trustees and, in particular, trustee indemnification issues are re-evaluated.

In conclusion, existing European CMBS debt accounts for probably less than 10% of outstanding commercial real estate debt.

Tranched CMBS structures have generally been shown to us to provide a means for servicers to deal with loan workouts and defaults in very challenging environments. Because European CMBS investors mostly hold both direct loan exposure and indirect exposure through CMBS, we believe they are likely to be able to minimise losses on their total real estate exposure. Even where a noteholder decision is either sought or required - whatever the motivation may be - we believe investors are generally able to reach a rational decision based on events over the past 12 months.

© 2010 Standard & Poor's. All rights reserved. This Research Note, entitled 'What Might "CMBS 2.0" Look Like In Europe's Future Commercial Property Markets?' was first published by S&P on 27 April 2010.