Contents

ABS

Limited demand

European ABS market activity in the week to 1 June

Although European ABS had previously remained stable in the face of sovereign concerns, over the past week the market has begun to show signs of increased strain - most evident in the limited demand for and wider pricing of the recent Fosse deal. In addition, trading volumes are reportedly down from the previous month and largely confined to inter-dealer selling.

One ABS trader describes the space as a "sidelined market", currently dominated by dealers. "They've been flipping bonds between themselves, but there hasn't been much end account activity," he says.

A dealer adds that the volumes he has seen are still light and show a definite decrease month-on-month. "The market had an initial delay where it was holding up well against the sovereign news, but finally ABS has reacted and volumes have dipped," he says. Furthermore, pricing has remained largely unchanged, with Granite RMBS paper shifting only slightly from mid-91 to its current position of high-91.

An ABS investor notes that the market operates more in concert with the broader credit risk markets now than it did pre-crisis. "Sovereign news is part of it," he says. "But there is also talk of a double-dip recession, there's oil spewing into the Gulf of Mexico, potential war in the Korean peninsula... it's just weighing on the ABS market as much as it's weighing on the equity and broader credit markets."

The trader explains that many investors have realised some of the previous year's losses during the run-up in prices seen at the beginning of the year, and are in a more comfortable position to wait for an improved market tone. "This pull-back in activity that we've had just shows that we don't have the same degree of leveraged players in the client base that we had back in 2008," he says.

"Market participants consider the current environment to be a temporary storm rather than a permanent impairment to the value of their collateral - so they're happier to wait. They're more patient players," he explains.

An asset manager notes that the spread compression has been a result of the cheapening of offers in the better quality paper. He was therefore unsurprised by the wider spreads seen in the pricing of the Fosse RMBS last week (see separate News Round-up story).

"140bp is considerably wider than the previous Arkle deal and also has half the life," he says. "That gives an idea of the weaker tone that there is in the tighter and better quality paper in the space."

The trader points out that the pricing of the Fosse transaction is also indicative of how thin demand is at the moment. Nonetheless, the Gracechurch Card and Moorgate 2010-1 deals are still marketing (see last issue).

The investor notes that current issuers are less concerned by the unfavourable economic environment. He explains: "The people who are issuing now understand the importance of securitisation as part of a broader diversified funding strategy. They aren't operating on an opportunistic basis in order to continue funding themselves and they aren't only going to issue securitisations when the market is in good shape or when spreads are particularly tight."

Despite the pause in trading activity, most agree that market sentiment is cautious but resilient. A recent informal survey which ran through Bloomberg found that the majority were either in 'buying opportunity mode' or a 'wait-and-see mode', explains the trader.

The dealer notes that there is no sign of forced-selling and it is unlikely to occur moving forward. The asset manager believes that this stable market sentiment is due to the collective confidence in the absolute credit value of assets in the sector.

"Even if we do have a double-dip recession, we aren't going to get to a point where every asset is in danger of suffering principal losses. We're so far away from that point that it's almost unthinkable," he concludes.

JA

CMBS

Returning interest

European CMBS market activity in the week to 27 May

Although European CMBS markets have slowed due to eurozone contagion, the impact on pricing levels has been limited. Interest is now returning to the sector and the previous few days have seen an increase in activity.

One trader notes that the CMBS market has slowed in line with the rest of the ABS market. He says: "When there is distress in other markets, people tend to shift their focus, so they don't get involved as much in CMBS. As a result, bids have been pulling back in the last few weeks when the focus has been on Greece, Ireland and Spain."

Although the decrease in trading volumes has helped to limit the impact on spread levels, a dealer confirms that there has still been softening. "Generally, for the first time this year, dealers are lightening up and being more apt to sell rather than buying," he says. "This has really tested the depth of the bid and it's held up fairly well, although it is clearly a little softer."

He explains that high-grade senior paper is 50bp off from its previous levels, while weaker bid lists are 4bp off. Similarly, in the mezzanine space bids are off by approximately 5bp, while better names are off only one or two points.

Overall, the dealer explains that UK CMBS has outperformed European paper, the majority of which is German. "Some of the worst technicals we've seen in the market are being reflected in paper like Talisman 7 A, which got as high as 80 and then fell as low as 72 cash price two days ago," he says. "There has been some drastic price action in more liquid names, but most names have not moved with that sort of volatility."

He explains that the majority of selling has been from dealers looking to reduce their balance sheets. "There's not been a lot of client selling going on," he says. "But the clients have then taken the opportunity to soften up their bids, so they're still getting trades done."

The trader believes that the last few days have seen market participants show renewed interest in the CMBS space as the focus shifts away from eurozone volatility. "People are beginning to look at what they were doing before and starting to focus on the cheaper sectors," he says. "I think senior CMBS is one of those sectors that's cheap at the moment, and we certainly have investors who agree with that."

The problem, according to the trader, is that investors are hesitant to move into the CMBS space again while it lacks liquidity. "It's difficult for people to get a clear understanding of where things are at the moment in terms of when to get in and at what levels, so they're cautious," he explains.

Moving forward, the trader believes that cheap paper still exists at the junior tranche level, but points out that this space requires a greater certainty in terms of understanding when liquidations might take place and what prices are achievable. "For the senior parts, it's mainly a case of how long the notes will be. But with juniors you have to also account for possible losses on those, so the analysis is a bit more complicated," he explains. "There has already been a rally in the junior tranches this year, so it's harder for people to step in there, but there are still good opportunities."

JA

ABS

BWIC trading stalls amid inventory rethink

A growing percentage of BWIC lists that are making the rounds lately are not trading, say investors. The stall in trading began last week as dealers evaluate inventory levels heading into month end.

"Dealers are unwilling to bid more bonds from customers unless they sell some of their inventory. They are trying to get their inventory down," says one structured finance investor. "Trading started to taper off last week."

CDO liquidations continue, but starting last week those have also quieted down. Those aggressive buyers that had money to put to work and would buy US$100m clips off a particular dealer earlier in the month have also arrested their buying, says the investor.

The size of what is being offered has also shrunk compared to earlier lists months ago. A BWIC that circulated midday on 26 May, for example, included a US$280m mezzanine portfolio liquidation, US$40m and US$50m bond lists, along with smaller amounts of US$2m to US$10m paper.

Participants typically use the lists to do some price discovery, but they are currently opting to wait and buy at their own terms. "People are either having trouble meeting reserve levels or bids are just so far back that it's just not worth even trading them," says the investor.

The active selling from the BWICs that occurred earlier this month put pressure on ABS spreads. Off-the-run and subordinate consumer ABS spreads are 15bp to 75bp wider.

Leveraged money accounts have been unloading the paper that has widened the most, says another investor. After a recent bout of tightening, spreads on liquid triple-A consumer ABS spreads are 10bp wider from the week's tightest levels.

KFH

CDS

Macro concerns reflected in index-intrinsic basis

Credit strategists at Barclays Capital have analysed the historical performance of both the CDX index and the underlying single names at times when the basis becomes substantially positive or negative. They found that a positive basis tends to preface both index tightening and single-name widening. However, large negative bases were found to have limited implications for the index, but are a stronger signal for single-name tightening.

The BarCap analysis indicates that a substantial portion of volatility in the derivative and cash credit indices year-to-date has been due to a combination of sovereign risk and concerns about financial regulatory reform. Because of the macro nature of these concerns, the index intrinsic basis has also been volatile and has absorbed a meaningful amount of volatility.

Based on closing levels, the CDX.14 index has traded in a 45bp range since inception in March 2010, reaching a tight of 82bp in early April and a wide of 127bp on May 6. The intraday ranges have been even more extreme, with recent trades as high as 140bp. Since inception, the index is nearly 30bp wider, after opening in March at 90bp.

Although it is also wider on the year, cash has outperformed CDS - a holdover from the rally over the first four months of the year. The option-adjusted spread (OAS) of the US Credit Index is wider by only 15bp year-to-date, leading to -82bp excess returns.

When the strategists backed out the changes in the on-the-run CDX index related to the SovX index and CDS spreads of large US banks, the CDX index was flat on the year. "This indicates, in our view, that the risks in the market are macro in nature, rather than associated with individual credits - in particular, the deteriorating sovereign situation in Europe and financial reform...in the US are increasing risk aversion and concerns about the sustainability of the global recovery, leading to lower valuations," they note.

Although the same factors appear to be driving the cash market, the influence of sovereign and financials risk is less severe than for CDS. The strategists estimate that the two risk factors are responsible for the entire year-to-date widening in both derivatives (by around 50bp) and cash (15bp).

"One obvious explanation for the increased sensitivity of CDS to macro developments relative to cash corporate bonds during the recent sell-off is the concentration of hedging activity in CDS," they explain. "Credit investors may use CDS to reduce risk rather than sell bonds, based on liquidity conditions in the two markets. More important, in our view, macro investors looking to hedge against continued deterioration and/or position on the short side will clearly be drawn to the index, which is a liquid vehicle with relatively limited idiosyncratic risk."

More evidence of the influence of macro hedging on the CDS market is the vacillation of the CDX index-intrinsic basis, particularly during the past six weeks of heightened volatility, according to the strategists. Again, intra-day levels were often more distressed than closing levels indicate.

As investors have looked alternatively to hedge/sell risk and unwind hedges/take risk because of developments in Europe, the index intrinsic basis has moved by more than 15bp over just a few days. The volatility in the index-intrinsic basis is still limited compared with the extremes in late 2008 and early 2009, but the strategists view the recent spikes as another indication of the focus on macro concerns.

CS

CDS

'Anatomy' of recent CDS sell-off analysed

Based on a panel of more than 1000 European and US CDS names, credit strategists at Goldman Sachs have undertaken a series of daily cross-sectional regressions of CDS total return indices since the beginning of the year to estimate the repricing of numerous characteristics across the market. These characteristics include credit rating, sector, subordination, region and the premium (or discount) for on-the-run names.

"These regressions extract factors that represent the price associated with each characteristic," the Goldman strategists explain. "Leaving aside the econometrics, these factors can be thought [of] as the engines that allow some credits to outperform the broader universe. More importantly, their identification allows us to get a more refined sense on the anatomy of the recent sell-off."

They note that two factors are of particular interest. The first is the region factor that allows the relative performance of US, German, core and southern European firms to be quantified. The second is the rating factor, which allows the degree of decompression across the rating spectrum to be evaluated.

The results of the regressions indicate that German firms have not been more resilient to the sell-off than their counterparts in the eurozone core, better fundamentals notwithstanding. Further, Southern European names have - predictably - sold off heavily. And finally, controlling for compositional differences, CDS has sold off as much in the US as in Europe - albeit the analysis ignores the substantial sell-off in the euro against the US dollar.

However, despite the fiscal drag on growth, the strategists believe that German firms remain much better positioned compared to the broader European universe and so recommend going long a basket of German names against the iTraxx Main as a way to exploit the indiscriminate sell-off. "As we continue to think that the crossover space currently offers the best value in credit, we select German names with ratings between double-B and single-A," they note. "Our basket...contains companies with at least 25% of revenue generated from outside of Europe and should thus benefit from a (still) robust global growth outlook. These names have all widened out to above 100bp and should outperform the index as market participants focus again on macro fundamentals."

CS

ABS

Veteran CMBS analyst recruited

S&P has appointed Howard Esaki as md and head of its new global structured finance research department. To further strengthen S&P's analytical work and capabilities, the new research department will produce research and commentary that will complement the work of the structured finance ratings groups, as well as provide additional in-depth structured finance research for the investor community.

"We are very fortunate to have someone with Howard's expertise in the global structured finance markets join us," says David Jacob, executive md, S&P structured finance ratings. "He is extremely well-known by investors in structured finance for the quality of his research and breadth of knowledge. Standard & Poor's is dedicated to raising the bar in providing the most thorough market intelligence to investors and the global community."

Esaki was most recently with Morgan Stanley and previously led the mortgage research team at Moody's.

ABS

TD expects lower securitisation gains

Toronto-Dominion Bank subsidiary TD Bank Financial Group says its securitisation gains will be lower going forward, which will contribute to a higher loss level for Q210 versus Q209 on its 27 May conference call.

TD also reported a loss of C$2m after taxes due to the change in fair value of CDS hedging its corporate loan book. Its Tier 1 capital ratio rose to 12% during the quarter versus 11.5% in Q1.

Volume growth in the Canadian personal and commercial banking division was primarily in real estate secured lending, business deposits and consumer loans. Compared with the second quarter last year, real estate secured lending volume - including securitisations - increased by C$20.9bn, or 13%, while consumer loan volume increased by C$3.8bn, or 14%. Business loans and acceptances volume increased by C$1.6bn, or 5%.

The bank said its consumer lending overall has increased and it is quite comfortable with its exposure to the Canadian consumer. Officials say loan growth may be an issue going forward, particularly with short-term pressure on volumes. As the economy improves, the bank expects to see more loan demand.

CDS

Credit hedge fund adds five traders

PVE Capital has added five new hires to its business on the back of growth in AUM and successful performance.

Loren Remetta, an index trader most recently at UBS in London, joins as a portfolio manager to focus on liquid credit products within the trading platform at PVE.

Alexei Garan, Melody Adams and David Yuen join from Credaris, where they previously worked with two of PVE's founding partners - Gennaro Pucci and Christian Evans. The trio will strengthen the analytical and trading functions in ABS, CDO and financial modelling respectively.

Finally, Helene Schutrumpf also recently joined PVE as a product specialist, with a background in proprietary trading at Merrill Lynch.

The Matrix PVE Global Credit Fund has grown to €130m by the end of May, based on the fund manager's estimate, through a combination of additional subscriptions and performance. The fund is up over 30% year to date after monthly double-digit positive performances both in April and May.

CDS

London finance partner hired

Mayer Brown has hired Chris Arnold as a new finance partner in its London office to strengthen its derivatives and structured products practice. Arnold started on 1 June, joining from Allen & Overy, where he spent eight years in the firm's international capital markets practice in London and New York.

"Chris' appointment marks the next phase in our commitment to building a top city finance practice, following six other finance partner hires in the last 12 months alone," says the firm's London senior partner Sean Connolly.

The firm says Arnold has advised on many complex derivatives issues for leading investment banks and has been involved in high profile industry initiatives, including advising ISDA on the 'big bang' and 'small bang' protocols for credit derivatives. His appointment follows the promotion of Edmund Parker to co-head of the global derivatives and structured products practice in February, when Josh Cohn was also hired (see SCI issue 173).

Parker says: "Chris is an exceptional technical lawyer, with excellent client relationships on both sides of the Atlantic. Chris will give our derivatives and structured products practice depth that few firms can offer."

CLOs

Replacement CLO managers announced

The replacement of three CLO managers has been announced.

WestLB has resigned its position as investment manager on Silver Birch CLO I and Alcentra has been proposed by the issuer as a replacement, in accordance with clause 10.4(a) of the investment management agreement. However, the controlling class and class F subordinated noteholders have the ability to veto this appointment acting independently, each by ordinary resolution within 30 days of 1 June.

Separately, New York Life Investment Management has been replaced as collateral manager on NYLIM Flatiron CLO 2004-1 by Commercial Industrial Finance Corp. A majority of each class of secured notes, voting separately by class, has to approve the replacement within 90 days of 10 May.

Finally, Invesco Asset Management has added another CLO to its roster of Morgan Stanley Investment Management transactions (SCI passim), replacing the manager on the Coniston deal.

Emerging Markets

EM veteran hired as co-head

Gleacher & Company Securities has hired Harry Wool as md. Along with Peter Carril, who joined in November (see SCI issue 161), he will be co-head of the emerging markets group.

Wool joins the debt capital markets division with 23 years of credit trading experience, most recently as md at Miller Tabak Roberts Securities, where he started its EM debt group. He has also held trading and sales positions with the international fixed income and debt groups of Gruntal & Co.

"Harry's track record of success, leadership, strong relationships and market knowledge will allow us to grow our EM team efficiently and effectively," says Gleacher executive md Joseph Mannello, head of debt capital markets. "Combining Harry's experience with that of Peter Carril will create a veteran team capable of rapid expansion into Latin America, Europe and Asia. We also look forward to adding additional talented EM sales and research professionals."

Investors

Asset management team gets private equity boost

Rizvi Traverse Management and the management of Ziegler Capital Management (ZCM) have signed a unit purchase agreement. Under the terms of the agreement, Rizvi and ZCM management have purchased 51% of the outstanding units of ZCM, which is a subsidiary of The Ziegler Companies.

Rizvi co-founders Suhail Rizvi and John Giampetroni say combining their distribution expertise with ZCM's investment management capabilities will make a powerful combination. ZCM president Scott Roberts will become the ceo of the newly structured ZCM.

Roberts comments: "We expect the Rizvi/ZCM collaboration will build a broad based company with increased capacity to introduce new institutional clients to ZCM's high quality products and services."

RMBS

Strategic hires for alternative asset manager

Structured Portfolio Management (SPM) has made four hires to expand its investment team. Mehdi Malaki joins from Glenview Capital Management and Yicheng Zhong comes from Deutsche Bank, while Qian Yang joins from Yale University and Kyle Johnson brings experience from SAC Capital Advisors.

Malaki will concentrate on capital structure transactions as md within the SPM fixed income opportunity fund. He was a senior analyst at Glenview, specialising in European equity and credit investments, and has previously worked for Blackstone Group as an associate and JPMorgan as an analyst. He will work alongside Vishal Bhutani, md at SPM.

Zhong will join the mortgage research team as vp, focusing on SPM's prepayments strategy. He will also help expand the firm's prepayment modelling efforts, previously having modelled both agency and non-agency MBS at Deutsche, Platinum Grove Asset Management and RBS Greenwich Capital.

Yang will join the risk management group as an analyst, while Johnson will become part of the firm's software team.

"These key hires underscore SPM's strategy of building an institutionally-focused asset management firm with the very best talent available," says Don Brownstein, SPM's chief investment officer and ceo. "We are committed to expanding SPM's talent pipeline with employees who possess a wide range of analytical, academic and practical experiences within the financial and mortgage industries."

RMBS

Investment manager adds to MBS fund roster

DoubleLine Funds Trust has launched an open-end mutual fund focusing on US government treasuries, agency and non-agency MBS, CMBS, as well as global developed credit and emerging markets debt. The DoubleLine Core Fixed Income Fund is managed by lead portfolio manager Jeffrey Gundlach, ceo of DoubleLine Capital and adviser to the DoubleLine funds.

Gundlach says: "The investment professionals at DoubleLine have a long history of managing both diversified and sector-centric bond portfolios. Having launched DoubleLine's sector-centric mutual funds in April [SCI passim], we are pleased now to offer our sector-allocation strategy to mutual fund investors."

RMBS

Securitisation director appointed

Allonhill has hired former Fidelity Southern executive Kathy Ireland as securitisations director. She has 30 years of banking and financial services experience and will manage the firm's core securitisation solutions.

"Kathy's expertise in the challenges of securitised pools, working with ratings agencies and supervising loans reviews - all with a heightened focus on integrity and independence - will play an instrumental role in the continued success and growth of Allonhill," says the firm's ceo Sue Allon.

The firm released a complete securitisation solution for RMBS issuers and underwriters in January (see SCI issue 170), offering issuers a turn-key solution by meeting the requirements of all four major credit rating agencies for third-party review firms. It also hired Ross Gammill as head of commercial due diligence last month (see SCI issue 186).

Trading

Credit trading business continues expansion

Samantha Wessels has been appointed as md and senior credit analyst at Jefferies. She is based in London and will work closely with Tom Jenkins, who joined in March as a senior credit analyst.

Jefferies' global head of fixed income Tim Cronin and head of European credit sales and trading Jon Pliner comment: "Her significant experience in credit analysis, financial advisory and restructuring will add immediate value to Jefferies' efforts to serve institutional clients globally."

Wessels has over 14 years of industry experience, most recently at BlueRay Asset Management, where she was a credit analyst for distressed credit. She has previously been an svp at Houlihan Lokey Howard & Zukin, where she spent 11 years.

She joins a global fixed income group focused on the sales and trading of investment grade corporate bonds, high yield bonds, government and agency securities, repo finance, MBS, ABS, municipal bonds, whole loans, leveraged loans, distressed securities and EM debt.

ABS

Poll predicts pain for sovereigns

A Fitch survey of senior European fixed income investors, conducted before the recent EU/ECB/IMF support package was announced, has revealed rising eurozone concerns. Respondents believe the bedrock asset class of eurozone sovereigns will have the most difficulty refinancing borrowings, against a backdrop of widening budget deficits and rising debt. Governments are also expected to face higher funding costs amid rising concern over future defaults and losses.

"Respondents signalled intensified concern over developed market sovereign issuers, with the proportion expecting significant credit deterioration nearly doubling from the previous quarter to 19%," says Monica Insoll, Fitch credit market research md. "Expectations for financial institution credit strength also deteriorated, partly driven by concerns relating to the impact of new regulation."

The sovereign borrower pessimism contrasts with the enthusiasm for most other asset classes, such as investment and speculative grade corporates and emerging market issuers. Credit profiles are predicted to strengthen further and confidence is building that losses are a past issue. However, Fitch notes that survey participants expect the 14-month credit really to continue to falter as a result of the contagion risk of sovereign concerns.

The corporate sector is expected to continue hoarding cash and repaying debt, with capex being viewed as a low priority. There is an increased expectation that there will be merger and acquisition activity, although investors expect deals to be financed by a mix of debt and equity to protect credit profiles.

Issuance is expected to rise across the board, with the exceptions of investment-grade corporates, emerging market sovereigns and structured finance. In the year to date, European capital market activity has lagged 2009 by 25%, with issuance totalling US$1.73trn.

ABS

RFC issued on counterparty risk criteria change

S&P is requesting comments on the proposed changes to its methodology and assumptions for assessing counterparty risk, to be received before 30 June 2010.

The ability to replace a counterparty in a structured finance security remains the overarching principle behind S&P's counterparty criteria. S&P believes that a counterparty rated below triple-A could support a security rated triple-A to varying degrees in certain circumstances if the counterparty agrees to replace itself with another, should its financial condition weaken. The proposed changes to its criteria focus on revised minimum counterparty ratings and higher collateral levels for when the counterparty's rating falls below the minimum.

Furthermore, the proposed changes will see the discontinuation of Japan-specific counterparty criteria to be replaced by new global criteria. The four specific criteria include:

• The use of S&P's bank survivability assessment for counterparty eligibility;
• The criteria whereby S&P assumes that commingling risks at an unrated servicer are mitigated, without additional credit enhancement, by the existence of a certain relationship with a rated parent;
• The criteria whereby S&P assumes a bank deposit account for transactions rated triple-A can be held with any bank, regardless of the rating on the bank and without any trigger for mitigation if the full amount of such a bank deposit account is protected under Japan's deposit insurance system;
• The criteria whereby S&P assumes commingling risks at an originator bank are mitigated, even for triple-A transactions, without additional credit enhancement and trigger for mitigation, due to the Japan-specific deposit insurance system.

S&P points out that if it adopts the proposed criteria, this may result in significant rating actions on outstanding securities, with between 25%-35% likely to be affected. The greatest impact would be on securities with derivative obligations, it notes.

ABS

Card charge-offs reach 'inflection point'

Moody's reports that US credit card charge-offs declined month-over-month in April, finishing 30bp below March's level at 10.91%. The decline is seen as strong evidence that the charge-off rate peaked for the current cycle in Q110, with gradual improvements now expected throughout the year.

"April's improved charge-off rate, combined with our base-case expectation for the unemployment rate to plateau at 10.1% in the second half of the year and steadily improving delinquencies, support the long-awaited call that credit card charge-offs have indeed reached an inflection point," says Moody's analyst Jeff Hibbs.

During April, the delinquency rate fell for the sixth consecutive month to 5.54% - the lowest monthly rate since November 2008. The early stage delinquency rate also fell, reaching 1.35% - its lowest level since the summer of 2008.

The yield index slipped more than a percentage point from March's 23.54% record-high back down to 22.39%. Moody's says the surge of the last year has mainly been caused by principal discounting on the part of the card companies. The agency also notes that a decline in yield in April is typical as the gains from finance charges on holiday purchases decrease.

Excess spread continues at high levels. It has declined by 86bp to 8.72%.

ABS

RFC issued on Australian servicing risk

Moody's has published a report detailing its proposed approach to assessing servicing risk in structured finance transactions in Australia and is now calling for comment from market participants. The report examines the appropriate level of liquidity required to mitigate cashflow disruptions to bondholders as a result of a servicer transfer event for typical RMBS and ABS transactions.

Richard Lorenzo, a Moody's vp and senior credit officer, says: "The report for the Australian market is a follow-up to the recently released Moody's global request for comment on operational risks and which provides a framework for explaining which transactions could reach triple-A. Our key findings include the conclusion - assuming the absence of any preparations before a default - that if a servicer transfer takes place, then normal operations could take up to a year to resume in a stressed situation."

"However, in other cases, a transfer could take only a few days - depending on the extent of advanced preparations and the prior existence of adequate systems," adds Lorenzo.

Moody's invites participants in the structured finance market to review and comment on the approach to operational risk until 16 July. The rating agency expects the final report to be released publicly in August.

ABS

Auto RV risk approach explained

Moody's has issued a new rating methodology report explaining its approach to rating UK auto lease securitisations exposed to residual value (RV) risk. The report examines the types of auto financing arrangements available to UK consumers and the key risks in those contracts exposed to RV risk.

"The RV of a lease is defined as the initial financed amount, less any scheduled capital repayments over the term of the lease," explains Nicholas De Swardt, Moody's vp, senior analyst and report author. "The lessee must pay this amount in order to complete the purchase of the vehicle. Our focus in the new report is on contracts where the lessee has the option - but not the obligation - to purchase the vehicle for this amount. These contracts are exposed to RV risk."

The agency says it has seen increased activity in this UK sector in recent years. Moody's says the sector is dominated by captive lenders, although a small number of transactions relate to independent finance companies. It also notes that differences in the data available in the UK and US necessitate a different methodology.

De Swardt comments: "The methodology presented here is constructed around the data currently available in the UK and may be extended to other EMEA jurisdictions where similar data is available."

ABS

SME ABS sweep shows significant stress

Despite the number of transactions recently reviewed for possible downgrade and revised rating assumptions, after conducting a study of European ABS backed by loans to SMEs Moody's has noted the sector's resilience. The agency believes the sector will experience a sluggish economic recovery in 2010, with high business insolvencies remaining in line with 2009.

Moody's conducted a comprehensive rating review of ABS SME after deteriorating performance and methodology refinements. Key rating assumptions for SME portfolios were revised to reflect the credit deterioration in the underlying assets of the SMEs, as well as anticipated stress throughout this credit cycle.

Moody's vp Ariel Weil says: "The sweep resulted in a large number of rating downgrades on ABS SMEs, particularly in Spain. However, Spanish Aaa ratings showed a higher resilience compared to the EMEA average."

Weil notes performance has deteriorated in many ABS SME transactions in recent years, as SMEs tend to perform in a pro-cyclical fashion. Ludovic Thebault, Moody's associate analyst, says: "The unfolding of real estate crises in several countries such as Spain placed further stresses on these transactions, often highly exposed to the real estate sector. As we amended our rating methodology to take into account risks not reflected in the available historical data, Moody's put more emphasis on a top-down approach to expected default rates."

The agency believes there are two key factors influencing performance levels for this asset class, which are originator or servicer quality and the concentration in the real estate sector. "While broad performance trends look similar for most transactions, there are vast differences in performance when aggregating transactions by originator/servicer," Weil comments. "Meanwhile, transactions most exposed to the real estate sector have been performing worse than others since the beginning of the crisis. This is evidenced when looking at delinquencies as a function of transactions' real estate exposure."

Significant areas of uncertainty remain. Very limited data has been received on recoveries, and Moody's believes other areas of rating pressure may arise due to credit deterioration in the credit profile of key counterparties, resulting in increased operational and sovereign related risks.

The aggregate outstanding balance for ABS SME transactions at the end of Q110 was €134bn.

CDO

Spanish CDOs hit by sovereign downgrade

Fitch downgraded 10 classes of CDO notes and affirmed 14 last week, following its downgrade of Spain's long-term foreign and local currency issuer default ratings (IDR) from triple-A to double-A plus. All notes are covered by an irrevocable and unconditional guarantee by the Kingdom of Spain.

The agency downgraded the notes that did not have sufficient standalone credit protection to withstand a triple-A stress without relying on the Kingdom's guarantee, and affirmed those that did have sufficient credit enhancement to maintain a triple-A rating without the guarantee. Spain's country ceiling remains at triple-A.

"The sovereign downgrade reflects Fitch's assessment that the process of adjustment to a lower level of private sector and external indebtedness will materially reduce the rate of growth of the Spanish economy over the medium term," says Brian Coulton, Fitch's head of EMEA sovereign ratings.

"Despite government debt and associated interest costs remaining within the triple-A range, Fitch anticipates that the economic adjustment process will be more difficult and prolonged than for other economies with triple-A rated sovereign governments, which is why the agency has downgraded Spain's long-term IDR to double-A plus," Coulton adds.

Fitch acknowledges the rebalancing of Spain's economy is well underway, but believes the pace of adjustment will be hindered by the inflexibility of the labour market and the restructuring of regional and local savings banks. The agency has also said the downgrading of Spain's IDR will have no direct rating impact on ABS and RMBS transactions that include Spanish collateral.

CDO

CDOROM v2.6 released

Moody's has released an updated version of its CDO modelling tool CDOROM. The new v2.6 includes updates to assumptions used for analysing CDOs backed by corporate and structured finance assets, and improved tools for analysing CLO portfolios. The latest modelling tool for Trups CDOs has also been included.

CDOROM v2.6 uses Moody's updated Trups CDO modelling methodology to reflect changes in its analytical assumptions adopted since the recent market turmoil. Indicative rating and Moody's metric outputs in CDOROM have been made approximately half a notch more conservative at the Aaa level in order to bring them in line with expected loss levels typically sought by rating committees to assign Aaa ratings over the past year.

Assets with a simulated default probability of 100% are excluded from correlation-related 'industry overconcentration' calculations and are assumed to default immediately for the purpose of calculating the WAL of synthetic tranches.

In addition, the portfolio summary worksheet in CDOROM now includes several key metrics used in CLO analysis, including diversity score, weighted average rating factor and portfolio recovery rate measures. It can be used to calculate these metrics for CLO portfolios.

Finally, the new version also includes the GetRating tool used to benchmark combo notes.

CDS

Report examines cost of derivatives reform

Greenwich Associates has released a new report on derivatives reform, examining the consequences of trying to eliminate systemic risk. The firm says that new regulations will impose costs with a far-reaching impact on banks' ability to lend, the price and availability of credit for companies and consumers, and on companies' ability to protect their bottom lines against volatility in commodities and financial markets.

The firm says the costs are not reason in themselves to oppose the legislation - which it says includes some constructive changes to make markets more robust - but an objective look is needed at what costs will be imposed on markets and the economy in exchange for tighter regulation.

Most market participants believe centralised clearing and exchange trading, intended to move risk from the balance sheets of individual banks and market participants to central entities where it can be aggregated, would be a constructive step in managing systemic risk. However, Greenwich says it will also require unprecedented standardisation in derivatives contracts, preventing companies from tailoring agreements to the precise specifications of their liabilities.

Standardisation could create mismatches that increase risk and volatility in company P&L by reducing the effectiveness of hedges. Creating such mismatches could also prevent some derivatives from qualifying for treatment as hedges under US accounting rules, making them subject to mark-to-market accounting standards, introducing volatility to corporate P&L and effectively preventing their use.

The report also suggests that the move to central clearing and exchange trading would reduce activity and liquidity in the OTC market. New costs will be added for all participants if banks are forced to use centrally cleared and exchange-traded derivatives to lay off risks incurred in the facilitation of OTC trade for exempt end-users.

Greenwich also highlights the ambiguous language of both US derivatives reform bills, which will give great leeway to regulators interpreting them. The Senate bill empowers the US SEC to set position limits, but a lack of specificity on how position limits should be determined and implemented "could devolve into government price fixing".

A Senate proposal requiring derivatives brokers to act as fiduciaries in transactions with municipalities and other government agencies "seems just short of non-sensical" because the two sides of a swap transaction, by definition, have conflicting interests and Greenwich says it is impossible to envision how such a requirement would work.

Finally, the proposal to force banks to establish separate subsidiaries for derivatives trading is not expected to be included in the final law.

CDS

SN CDS clearing-eligibility to be assessed

The DTCC has published data compiled from CDS trades registered in its Warehouse Trust Company at the request of market participants who will use it to assess which of the various single reference entities might have sufficient liquidity to be cleared through a central counterparty (CCP). The information includes market activity from 20 June 2009 through to 19 March 2010 for all single name CDS reference entities.

Market participants requested the data in keeping with the commitments they made to global regulators to continue strengthening the operational infrastructure and mitigating risk in OTC derivatives trading (SCI passim). As part of this commitment, the signatories pledged to increase the range of products eligible for CCP clearing.

While DTCC compiled and provided the basic data requested by industry firms, the analysis of the data and subsequent assessment of which reference entities might be best suited for clearing will be conducted by market participants, including various members of ISDA's Credit Derivatives Steering Committee and the relevant CCPs.

CDS

LCDX illiquidity drives underperformance

Leveraged loans lost 2.63% last month (as at 26 May), albeit the asset class has been more resilient than high yield, which has lost 4.13%. Cash loans have also outperformed derivatives, with LCDX returns down 5.13%, compared with a 6.32% loss for CDX HY.

Credit strategists at Barclays Capital indicate that while loan returns have tracked high yield with a beta of 0.5 over the past month, LCDX has been unfairly punished, with a beta of 0.8 to CDX HY. "We believe that the underperformance has been caused by the comparative illiquidity of LCDX and its underlying instruments, coupled with the lack of index arbitrage support. While arbs help keep CDX HY close to intrinsic, LCDX lacks this natural check. We believe that LCDX 14 currently looks cheap to CDX HY 14 and has a better convexity profile, given higher recovery expectations," they note.

HY/LCDX 14 spread ratios show that LCDX 14 is the cheapest it has ever been compared with CDX HY 14, according to the strategists. "Furthermore, the HY/LCDX 13 spread ratio has been steady, which is unexpected, given that LCDX 14 has a better convexity profile than LCDX 13 because of its lower coupon and dollar price," they conclude.

CLOs

CCP default guidelines published

The European Association of Central Counterparty Clearing Houses (EACH) has published guideline default procedures to help its members prepare their own internal procedures and disclosure documents. EACH says the document is the result of work by its risk experts and serves as a response to calls for greater transparency.

EACH supports the ESCB/CESR default procedures disclosure recommendation, noting that transparency of procedures provides certainty and predictability for market participants. The association believes it facilitates an orderly process in the event of a default and helps members make fully-informed assessments of risk. Presenting default procedures in a standard format across all member CCPs should make procedures as transparent as possible for the benefit of all market participants, it says.

The new guidelines published by EACH detail which points it believes should be covered by a disclosure document. It does not take into consideration the event of default of a linked CCP, which the association believes to be only a very remote possibility and would have different implications to the default of a clearing member.

The association says that disclosure documents will be for general information purposes only and non-binding in nature. Government laws and CCP rules and regulations should prevail over and above any disclosure document, it concludes.

CLOs

CLO haircut amended

The ratings on the Neptuno CLO II deal will not be downgraded or withdrawn due to the issuer's entry into a second supplemental trust deed dated, according to Moody's. However, the rating agency does not express an opinion as to whether the amendment could have other, non credit-related effects.

The amendment agreement includes a change to the definition of par value test excess adjustment amount to make it consistent with Neptuno CLO III. It affects the way the overcollateralisation test haircut is applied with respect to assets rated Caa1 or lower, in excess of 7.5% of the aggregate principal balance. This haircut is now equal to the difference between the par amounts and the market value of those assets rated Caa1 or lower.

This transaction is a high yield CLO related to a collateral portfolio comprised primarily of European senior and mezzanine loans and high yield bonds that closed in December 2007. The portfolio is managed by Caja de Ahorros y Monte de Piedad de Madrid.

CMBS

Multifamily housing deal in works

A multifamily CMBS offering, which is considered a "baby CMBS deal" since it is backed by collateral from a low number of units from apartment buildings, is marketing via Barclays. The deal, called Impact Funding Affordable Multifamily Housing Mortgage Loan Trust 2010-1, is coming via Impact Community Capital.

A roadshow for the 144A deal occurred last week, while pricing is expected this week, according to one investor.

The offering includes US$269m class A pass-through certificates, which are backed by affordable multifamily housing mortgage loans acquired by wholly owned subsidiary Impact from Bank of America and California Community Reinvestment Corporation. The class A tranche is expected to be rated triple A by S&P.

Certificates will be issued under a real estate mortgage investment conduit structure. It will have subordinate and senior classes, as well as unrated tranches.

Similar to prior offerings from Impact, the loans in the deal are secured by affordable housing projects located throughout the US. About 98% of the loans in this offering were constructed with 9% federal low-income housing tax credit.

Deals from Impact in the past have had diverse collateral as well. Impact Funding commercial mortgage pass-through certificates series 2001-A, for example, included 84 diverse loans on properties in 14 states. A little over half of the loans in that deal, however, were originated in California, with the rest from other parts of the US.

CMBS

No rating impact for Tahiti restructuring

Tahiti Finance's restructuring proposal, published on 27 May, will not have an immediate rating impact on the transaction's outstanding CMBS tranches, says Fitch. The loan is in standstill until 1 July so that noteholders can consider the proposal, which will be voted on at an 18 June EGM.

The Tahiti A and B facilities had been scheduled to mature on 24 May. The borrower has a two-year extension option, subject to a step-up in margin, extension fees and the fulfilment of certain criteria.

One criterion says the facility A1 and term loan LTVs should be no greater than 55% and 65% respectively. Fitch says that, based on a revaluation in December 2009, the term loan does not comply with this and so the borrower would have to make a voluntary prepayment in order to exercise the extension option.

An extension of the term loan maturity date by two years to 24 May 2012, with the option to extend a further year, is one of the key proposals. Final legal maturity of the bonds is 24 May 2015, which means the further extension would shorten the tail period to two years. Fitch says the proposal, if accepted by noteholders, would not result in any note tranches being downgraded due to other positive changes proposed by the borrower.

Proposals such as a voluntary prepayment of the facility A1 loan, £29m of which has already been repaid using funds held in the borrower's dividend ledger, an ongoing cash sweep after payments on the term loan and senior expenses, and increases in the extension fees and loan margin are all held to be in the borrower's favour. Fitch says the voluntary prepayment and cash sweep will improve the loan's exit position, despite the shortened tail period, which should still be long enough to work out the loan if it should become necessary.

The rating agency notes that the failure of Tahiti Finance to repay at its scheduled maturity date was the predominant driver of a decline in its European CMBS Maturity Repayment Index in May. The index declined to 15% from 17%, offsetting the slight improvement seen in the prior month.

Of the total £493.5m balloon balance for the Tahiti deal, only £29m was repaid using funds held in the borrower's general account and the dividend ledger.

None of the loans represented in Fitch's index that matured in previous months were repaid in full, increasing the total outstanding matured debt balance to €5.3bn at the beginning of June from €4.2bn in the previous month.

CMBS

'Consistent' rise in CRE loan delinquencies

Trepp's latest Monthly Delinquency Report indicates that the delinquency rate for commercial real estate loans in US CMBS continued to move higher in May, with the monthly rate of increase demonstrating remarkable consistency. For the last eight months, the rate of increase in delinquencies has been between 37bp and 49bp (after backing out the Stuyvesant Town impact in March). The only exception was February of this year, when the delinquency rate nudged up only 22bp.

Overall in May, the percentage of loans 30 or more days delinquent, in foreclosure or REO jumped by 40bp, putting the overall delinquency rate at 8.42%. The percentage of loans seriously impaired remains almost in lockstep with the headline number. Finally, the percentage of loans seriously delinquent (60 days +, in foreclosure, REO or non-performing balloons) jumped by 41bp.

Trepp analysts note that US CMBS spreads gave back some of the gains that had been booked from January through to April. "For the first time in 2010, CMBS spreads were wider over the course of the month," they explain. "Overall, spreads spiked 70bp for the month of May for recent vintage super-senior bonds - more for bonds backed by weaker collateral; less for stronger names. The spread increase comes after a rally that saw levels on super seniors drop about 160bp from the beginning of the year through the end of April."

For example, the benchmark GSMS 2007-GG10 A4 bonds began the month at 315bp over swaps. It underperformed the broader market, finishing the month at 420bp over swaps.

CMBS

Fleet Street 2 controlling creditor changed

An appraisal reduction notice has been issued by UK CMBS Fleet Street 2, which is based on a revised valuation it has held since February. The €486.5m appraisal reduction results in the class A noteholders becoming the controlling creditor and, consequently, the only class to vote on any further restructuring of the transaction.

European asset-backed analysts at RBS suggest that the timing of the announcement clearly pre-empts the receipt of restructuring proposals from the parties bidding for Karstadt, the German department store and sole tenant in the Fleet Street 2 deal. The competition to acquire the bankrupt business is now between private equity company Triton, Goldman Sachs' Highstreet partnership and a joint venture between investment company Berggruen and fashion retailer BCBG.

"While we see risks of a further extension to the bid timetable, the wider interest is still positive for creditors, who had previously been facing the receipt of only one bid at best. In further constructive developments, sufficient cities agreed to waive tax claims against Karstadt, making the sale possible," the RBS analysts note.

CMBS

Strong Singaporean CMBS cashflow reported

Singaporean CMBS transactions are enjoying strong cashflow from their underlying properties, according to a quarterly Moody's report on the sector. The agency notes no rating implications on any outstanding Singaporean CMBS based on the performance of the underlying properties. The Q110 report says the transactions continue to enjoy at least three times actual debt service coverage ratio, while appraisers' loan-to-value ratios are in the 16%-32% range.

Moody's did, however, place three transactions on review for possible downgrade on 1 March due to lack of liquidity coverage (see SCI issue 174). The notes issued by Orion Prime have been confirmed as Aaa, while the other two transactions remain on review.

Meanwhile, two transactions are scheduled to be refinanced in 2010 - one in June and the other in September. Both already have refinancing plans in place.

The high supply of office and industrial space is keeping rental and occupancy rates down in the CRE market, according to Moody's. Jerome Cheng, vp and senior credit officer at the agency, says: "For the office buildings in the CMBS transactions, actual vacancy rates ranged from 2%-14%. The high vacancy rate is caused by tenants moving out since the beginning of 2009. However, this should improve as vacancy rates on a committed basis improved in Q110."

Cheng adds: "Office rental rates in the transactions have been higher than our stabilised assumptions, providing a cushion for downward rental rate adjustment, especially for the leases expiring in 2010 and 2011."

Fellow Moody's vp and senior credit officer Marie Lam says rental rates for prime and suburban retail properties in the CMBS transactions have exceeded expectations, and that there are also low vacancy rates. She comments: "There is also an abundant supply of retail space in the market. Two integrated resorts have partly opened in early 2010. But take-up for retail space in the market has been encouraging thus far."

Finally, securitised industrial building rental and vacancy rates are very close to Moody's stabilised assumptions. Emerald Assets, a transaction with industrial buildings as underlying assets, is enjoying a strong debt service coverage ratio, for example.

LSS

LSS note ratings raised

S&P has raised its ratings for 11 spread-trigger leveraged super senior (LSS) notes and removed them from credit watch negative. Ratings for two LSS notes have also been affirmed, with one removed from credit watch negative.

The rating actions follow positive movements over several months in two key transaction variables - weighted-average spread (WAS) and trigger spread level. The WAS of the portfolio of reference entities has tightened and the time to maturity has reduced, causing an increased trigger spread level. S&P believes these factors lessen the probability of the transactions breaching their portfolio spread triggers.

Ratings have been raised for four notes to investment grade. Each has a scheduled maturity date in 2010 and significantly higher spread triggers than the other LSS spread transactions.

The remaining notes are deemed speculative grade, either because of a smaller difference between the portfolio WAS and trigger spread, a longer maturity or a lower trigger spread level. They are also thought more likely to breach their portfolio spread triggers and could be vulnerable to spread widening before maturity.

S&P has affirmed its double-B rating for Calyon CDS, while Eirles Two series 341 has had its single-B rating affirmed and been removed from credit watch negative.

Ratings have been raised and credit watch status removed for Chess II series 22 (from triple-C to double-B), Midgard CDO 2005-14 (triple-C to single-B), Omega Capital Investments series 12 (from triple-C to double-B for C7E-1, and triple-C to triple-B for B5E-1 and B5E-2), Sceptre Capital 2005-5 (triple-C to single-A) and Eirles Two series 207 (triple-C to double-B), 213 (triple-C to double-B), 337 (triple-C to double-B plus), 340 (triple-C to single-B) and 342 (triple-C to triple-B).

Real Estate

Distressed loan levels hamper stabilisation

Lender Processing Services has released a mortgage monitor report suggesting that signs of stabilisation in US home loan delinquency and foreclosure rates remain largely neutralised by the more than seven million loans in distress. The report says the number of loans 90 or more days delinquent declined from 4,186,627 to 4,074,443 between March and April, with the total number of non-current US loans plus REO just over 7.3 million.

Deterioration ratios remain high, with two loans rolling into a worse status for every one which improves. The overall volume of loans moving from delinquent to current status declined to a three-month low supported primarily by 'artificial cures' associated with HAMP modifications. Newly delinquent loans, which were current at year-end but 60 or more days delinquent as of April, have declined from the 2009 levels but still remain historically high.

The total US loan delinquency rate is 8.99%, the foreclosure inventory rate is 3.18% and the non-current loan rate is 12.17%. The states with the most non-current loans are Florida, Nevada, Mississippi, Arizona, Georgia, California, Illinois and New Jersey.

Regulation

Fair value accounting standards update proposed

The FASB has issued an exposure draft of a proposed accounting standards update intended to improve accounting for financial instruments (see also separate News Analysis). The proposals seek to bring more transparency to financial statements by incorporating both amortised cost and fair value information about financial instruments held for collection or payment of cashflows.

The proposal also aims to provide more timely information on anticipated credit losses to financial statement users by removing the 'probable' threshold for recognising credit losses. The results of asset-liability management activities at financial institutions are also intended to be better portrayed.

Non-public entities with less than US$1bn in total consolidated assets would be allowed a four-year deferral beyond the effective date from certain requirements relating to loans and core deposits. Other proposals include a single credit impairment model for loans and debt securities, and simplifying hedge accounting criteria to improve consistency in reporting.

FASB chairman Robert Herz says: "The changes we are proposing are aimed at improving the accounting for financial instruments in a number of ways. The proposal would impact the reporting by financial institutions and all other entities that have financial instruments as the goal of greater transparency in financial statements is pursued. We encourage all interested parties to carefully review the proposal and provide us with your comments. Through its due process, the FASB will ensure that it obtains and considers a broad range of input on this important proposal."

The comment period for the proposed update ends on 30 September. The FASB will also hold additional public roundtable meetings in October to collect further input.

In a separate accounting standards update, FASB has also proposed that total comprehensive income and its components in two parts - net income and other comprehensive income - be displayed in a continuous statement of financial performance.

RMBS

'Credit burnout' to improve subprime forward defaults

Subprime and Alt-A current to delinquent roll rates have improved substantially versus their peaks in December 2008, according to ABS analysts at Barclays Capital. However, they point out that the improvement in jumbo performance has been marginal.

The analysts note that a large part of the improvement in performance is due to better collateral composition of, and positive self-selection among, remaining current borrowers. However, performance has improved beyond that which their model can explain by changing macro trends, compositional changes and payment reductions due to modifications.

They explain that the unexpected improvement is likely a combination of an abnormally bad performance at the end of 2008, as well as additional 'credit burnout', since that is not captured using observable variables in LoanPerformance.

In its latest report on the sector, BarCap lays out a methodology to identify and project the effects of credit burnout on forward defaults, across residential mortgage markets. The analysts find that credit burnout may result in an 8% point improvement in forward defaults for subprime collateral.

Furthermore, they point out that the biggest beneficiaries of credit burnout will be performing cleaner borrowers in subprime and Alt-A. As a result, while current-to-delinquent roll rates will improve the most for subprime, a much higher share of performing borrowers in Alt-A will ensure a bigger decline in future defaults. The analysts add that, compared with the base, they expect Alt-A pools to experience 11% less forward defaults in a credit burnout scenario.

The analysts add that in a more optimistic scenario, in which credit burnout is accompanied by a larger-than-expected improvement in mortgage credit availability, the improvement could be as much as 9% points for subprime and 13% for Alt-A. In addition, they expect prime roll rate performance to start improving over time, but that will likely be driven by a better economy and an improving employment picture rather than credit burnout.

RMBS

Increased verification requirements hit mod rates

The number of newly started trial residential loan modifications dropped again in April to approximately 57,000 from 81,000, according to ABS analysts at Bank of America Merrill Lynch. They attribute this slowdown in part to the HUD supplemental directive 10-01, requiring increased documentation and verification, which took effect on 1 June (SCI passim).

However, the BAML analysts note that at this point, based on the US Treasury's estimate of 1.7 million eligible HAMP borrowers, trial plan offers have already been extended to almost 90% of the eligible universe. Given declining current-to-30 roll rates, they anticipate the number of trial modifications starting to remain relatively muted going forward. In order for the administration to reach additional homeowners at risk, it may need to examine expanding the scope of the HAMP programme, they note.

The pace of conversions continued to climb in April, with over 68,000 permanent modifications completed. This brings the total number of permanent modifications started to 299,000, representing 24.6% of all trial modifications started, according to the analysts. Furthermore, conversion rates varied considerably across servicers, with those utilising verified income having higher success.

As servicers continued to work through the backlog, cancellations rose significantly in April. Through to the end of April, over 277,000 trial modifications were cancelled, representing 23% of all trials started. Going forward, the analysts believe that cancellations will drop as income will have to be verified prior to the start of the trial.

The BAML report notes that modification rates were flat for most sectors except for Alt-As, which were slightly down. Cumulatively, 6.8%, 1.6%, 6.1% and 28.2% of Alt-A, jumbo, option ARMs and subprime loans have been modified respectively.

The analysts expect to see a rise in modifications reported in May securitisation data, reflecting the increase in HAMP conversions completed in April. Modified loans have increasingly been coming from the 90+ delinquency bucket, they add.

Meanwhile, principal forgiveness and forbearance continue to be used primarily in the option ARM sector, comprising approximately 17% of option ARM modifications. Capitalisations, as a percentage of modifications, rose across sectors - contributing to an increase in the portion of modified loans having either no change or an increase in payments.

RMBS

Fosse prices wide

Santander's second Fosse issuance this year has priced - after a two-week delay - at significantly wider levels than Lloyds Banking Group's Arkle RMBS a month earlier. In addition, it required substantial support from JPMorgan, which committed in advance to US$1.5bn worth of its class A1, A2 and A3 notes.

While the £3.4bn-equivalent Arkle 2010-1 priced with spreads ranging between 115bp-125bp, the US$2.1bn-equivalent Fosse 2010-2 deal came at 140bp-143bp. Barclays Capital arranged the transaction, while Bank of America Merrill Lynch, BarCap, Citi, JPMorgan, RBS and Santander were joint leads.

Fosse 2010-2 comprises three triple-A rated tranches denominated in dollar, euro and sterling. The spread on the US$1.2bn A1 tranche was 143bp over three-month Libor, the spread on the €500m A2 tranche was 140bp over three-month Euribor and the spread on the £210m A3 tranche was at 140bp over three-month Libor.

The notes are secured by a portfolio of UK prime, first-lien, owner occupied residential mortgage loans. The weighted average LTV is 57.42% and the weighted average seasoning is 66 months.

ABS strategists at UniCredit suggest that the focus on the dollar tranche is not surprising, given that demand from US accounts was the main target in the current environment and as the deal-related roadshow took place in the US. "However, the print on the US dollar tranche was 3bp wider than on the other tranches and the euro-US dollar basis swap was also considered tricky for pricing," they note.

The strategists point to deterioration in the primary market environment, with secondary UK prime RMBS paper widening by up to 170bp on the back of the EMU sovereign crisis, as the reason for the transaction's triple-A notes pricing roughly 20bp wider than the Fosse 2010-1 transaction. "But the deal was priced in line with indicated levels at around 140bp and also priced aggressively inside of comparable secondary spreads, which - on the other hand - underlines that investors are convinced of the very good performance and fundamental track record of the Fosse programme," they observe. "Nevertheless, the current environment is anything but supportive for primary issuance. It will remain extremely difficult to come to the market if the current risk aversion were to persist for longer, in particular with respect to less straightforward transactions than the Fosse 2010-2 transaction."

RMBS

Continued support for Australian RMBS

The Australian Office of Financial Management (AOFM) has issued a letter of support for the proposed APOLLO Series 2010-1 Trust RMBS issue, arranged by Suncorp-Metway. Suncorp submitted an issuance proposal to the authority in May, to which the AOFM replied asking Suncorp to consider modifying the capital structure of the proposed issue to assist the objectives of its RMBS investment programme.

It is anticipated that the revised structure will allow the AOFM to invest at tighter levels in a way that complements a high proportion of private sector participation in the issue. The AOFM expects to bid for all the APOLLO Series 2010-1 Trust class A2 notes at an indicative range of 1.10% to 1.30% over BBSW and will not invest in notes that it expects to be well subscribed by other investors, including the class A1 notes.

Under its RMBS investment programme, the AOFM invests at pricing levels that support competition for residential mortgage lending and to support lending to small business. The programme has invested around A$8.7bn in 27 transactions since its inception.

The AOFM says market conditions have improved since the RMBS programme began, which has resulted in reductions in issuance costs and relatively high private sector investor participation. Primary and secondary RMBS pricing appears to have stabilised around current levels for an extended period, it notes. Consequently, the AOFM is willing to invest at tighter levels due to the high credit quality of Australian RMBS and the programme objectives, but this will be balanced against encouraging continued private sector participation.

There is a further A$7.3bn available to be invested under the programme, of which A$3.14bn has been allocated to future issues under serial arrangements.

RMBS

Ginnie Mae details pool programme changes

Ginnie Mae released further details of the operational changes it is introducing to Ginnie II multiple-issuer pools. The programme changes, initially announced by Secretary of Housing and Urban Development Shawn Donovan in April, include enhancements aimed at minimising financial risk for warehouse lenders and making the programme more efficient for all lenders.

"These programme changes reflect one more step in Ginnie Mae's continuing efforts to bring greater stability to the housing market by minimising financial risk on warehouse lending lines," says Ginnie Mae president Theodore Tozer. "As we've become a larger piece of the housing recovery puzzle, the housing industry has looked to Ginnie Mae to lead and this is one example of how we've responded quickly to the challenging business needs of our issuers."

Beginning this autumn, issuance for Ginnie II multiple-issuer pools can occur on a daily basis, rather than once a month. "Lenders will be able to better utilise warehouse lending lines and reduce interest costs associated with carrying loans until they can be securitised and settled," Tozer adds.

Under the second programme change, lenders will be able to securitise a single loan in Ginnie Mae multiple-issuer pools, thereby eliminating the current three-loan minimum requirement. The change is designed to enable small lenders to more easily participate in multiple-issuer pools.

Additionally, the programme enhancement helps to accommodate "orphan loans" or individual loans that cannot be securitised because the interest rate differs significantly (at least 50bp) from other, more similarly characterised loans in the pool. Ginnie Mae expects to begin accepting single loans into multiple-issuer securities in July.

RMBS

Tougher approach brings re-REMIC rating stability

Fitch says its rating stability for re-REMICs rated triple-A has improved significantly. After the mortgage crisis, the agency increased the amount of loss protection needed to achieve triple-A ratings and has declined to assign ratings to entire categories of re-REMICs or has put in place rating caps below the triple-A level because it says the risks in the collateral or structure were deemed inconsistent with high investment grade ratings.

Over the past year Fitch has implemented limits on rating certain re-REMICS and, as a result, it does not issue new ratings for re-REMICS backed by subprime or Alt-A collateral because of volatility in the underlying collateral and security performance. The agency does not issue new ratings on re-REMICS backed by the subordinate classes of RMBS securities, nor will it assign triple-A ratings to re-REMICS backed by pools with less than 300 current pay loans or in cases where the pool's combined LTV ratio is greater than 100%.

The criteria revisions mean Fitch now rates less than 10% of the re-REMIC transactions it is presented to review. The agency has rated more than 1,800 re-REMIC classes triple-A since the start of 2008, of which over 95% retain their original rating or were paid in full (PIF) and 98% remain investment grade or were PIF. Of those rated triple-A since the start of 2009, 99% retain that rating or have been PIF, while 100% remain investment grade.

20 ratings were originally rated triple-A in 2008, but have since been downgraded to below single-B. These were transactions backed by Alt-A or prime collateral whose performance deteriorated sharply following the Lehman bankruptcy and unemployment surge in late 2008, particularly in California and Florida.

Fitch has increased the average loss protection on triple-A rated prime re-REMICs from approximately 8% in early 2008 to around 28%. Alt-A loss protection was increased from 11% to over 40% in Q309, which is when the agency ceased rating re-REMICs backed by Alt-A collateral.

The agency says that although its re-REMIC rating stability has improved significantly, some of these ratings - particularly those issued prior to the various limitations put in place - still remain vulnerable to downgrade risk. However, it believes the number and magnitude of those rating actions will be muted by the steps taken to identify and discontinue issuing ratings on many re-REMIC product types.

RMBS

Australian RMBS delinquencies rise in Q1

The ability of Australian borrowers to repay their mortgages - as measured by delinquencies rates - started to experience some constraint in Q110, according to Moody's. Specifically, prime mortgage delinquencies greater than 30 days increased to 1.34% from 1.10% in Q409. Meanwhile, non-conforming mortgage delinquencies greater than 30 days continued to rise to 13.02% from 12.13%.

Ryan Lu, a Moody's avp/analyst for the structured finance group in Sydney, says: "Since October 2009, six consecutive 0.25 percentage point rate rises have started pressuring mortgage payments, reflected by the increase in arrears over the course of this quarter. At the same time, seasonal upward trend in delinquencies - due to holiday spending during Christmas and the New Year - is also pushing the arrears level up."

"However, the delinquency levels are not expected to increase significantly as official interest rates return to 'neutral' levels," Lu explains. "Stable collateral performance is expected to continue in 2010 in light of the improved forecast for the Australian economy and the rating performance of the RMBS sector is expected to be stable."

Technology

Loan analytics platform enhanced

S&P has made changes to its structured finance and whole loan analytics platform, ABSXchange, which it believes will allow European ABS market participants to perform more robust transaction analysis. More than 200 new cashflow models have also been added across EMEA ABS, CMBS, RMBS and CLOs and Australian RMBS.

ABSXchange's latest amendments introduce enhancements to the platform's portfolio analysis capabilities and a new collateral analytics module to allow users to edit deal collateral within existing securitised transactions, or upload custom securitised or unsecuritised pools. The module will also facilitate pool stratification and loan level valuations. A series of workflow improvements, such as the ability to stress triggers in the portfolio analytics module, have also been made.

"The introduction of a powerful collateral analytics module to ABSXchange demonstrates S&P's commitment to support growing demands for the ability to analyse loan level data in the securitised and whole loan markets. The new module will allow users to perform statistical and time series analysis and run cashflow projections on a pool of individual loans, providing a more accurate picture of the value of the underlying collateral," says S&P valuation and risk strategies director David Pagliaro.

CDS

Trading idea: halitosis

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright short on Halliburton Company

Halliburton's latest results show a change of tide with regards to its fundamentals. Cashflows, interest coverage and margins are all below multi-year trends, indicating momentum heading in the wrong direction for the company.

Tack on event risk from the Gulf spill and a short credit recommendation on Halliburton is an easy call. At 90bp, the downside risk to the trade is minimal.

The overarching theme emanating out of Halliburton's latest earnings call is that of change for the worse. Halliburton's operational cashflows are off its trend, coming in at just US$317m last quarter, which is half of its two-year quarterly average.

LTM interest coverage is now below 9x, as the company's quarterly interest expense nears US$80m (Exhibit 1). This, combined with a massive capex bill (US$400m per quarter) and an equity quarterly dividend of US$81m, leaves the company with total yearly expenses in the US$2.4bn range (Exhibit 2).

Though it maintains plenty of cash on its balance sheet, the pressure to generate such massive amounts of cash is not fully priced in its 100bp credit spread. As the exhibit demonstrates, the difference between its cashflow and expenses collapsed and most recently turned negative. Pricing pressure also forced its latest earnings margins (EBITDA/Revs) to fall below trend.

We see a 'fair spread' above 150bp for Halliburton based upon our quantitative credit model, due to its equity-implied factors, margins, change in leverage, interest coverage and free cashflow factors. Unlike using rates of change for valuation, the model relies on absolute levels relative to peers. The recent 30% drop in the company's stock price pushed its equity-implied spread significantly higher, resulting in a notable jump in expected spread (Exhibit 3).

Though not the motivating factor for the trade, as Halliburton remains embroiled in the gulf disaster, we cannot ignore the additional event risk. Halliburton conducted the cementing work on the well and its workmanship has been called into question.

Though its chief executive recently announced that the company would not incur any damages from the clean-up, we feel it is prudent to assume that there is still significant event risk surrounding all companies associated with the spill. Given the increasingly uncertain regulatory/governmental environment, the fallout is anything but certain. Public outrage could easily spur Congressional action.

Though Halliburton's CDS spread widened post-spill, a substantial portion of the widening can be attributed to overall market weakness (both the CDX IG and HAL's spread are 30bp wider since its latest earnings call). With weakening fundamentals, hammered equity and an environmental disaster, Halliburton's credit profile is facing more downside than upside and we recommend shorting the credit.

Position
Buy US$10m notional HAL 5 Year CDS at 90bp.

This Trading Idea was originally published on 27 May.

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