Contents

ABS

Going green

Securitisation to help fight carbon emissions

The Green Investment Bank (GIB) Commission, set up by the UK government minister for climate change and Chancellor of the Exchequer late last year, has issued a report on how such a green bank should operate. The report includes potential funding strategies, with securitisation key to its approach.

Ultimately the government will decide which proposals to adopt or ignore. But among the strategies included in the report are structuring 'green bonds' for institutional investors, the purchase and securitisation of project finance loans and the securitisation of a levy on energy bills.

The commission says: "The banking crisis has resulted in the virtual elimination of loan syndication markets for large investment projects. Although bank balance sheets are some way to being repaired, it is nearly impossible to raise the large amounts of capital needed for green infrastructure like offshore wind. If the GIB could either purchase and securitise project finance loans or find mechanisms for credit enhancement of publicly traded bonds, it would free up capital that is not flowing to the sector."

The commission suggests the green bonds could take many forms. The GIB could issue green bonds to raise money to finance itself or, in cases where the GIB provides risk mitigation for project debt, the bank could lower debt costs if those projects issued bonds.

Green bonds targeted at institutional investors could be single project bonds to provide exposure to specific projects, bonds directly funding asset portfolios - such as offshore wind or residential solar - and secondary project finance loans, bought from commercial banks. However, despite the bonds' potential, concerns surround the specifics of just how they will work.

"We have been quite concerned about the lack of rating of green bonds; we need to define what a green bond is," says Jon Grayson, director and co-founder of sustainable finance consultancy EnviroMarket.

He says: "Yes, they can raise huge sums and there are a lot of hungry investors who will cry out for them. There are trillions of assets which can be tapped into. What you need is some sort of framework for comparing and assessing the quality of the green bonds. There are not many currently listed and nobody really understands the proceeds of the funds and what they are going to be put to."

Green bonds are already issued by the World Bank, CREB and European Investment Bank. The German Breeze securitisation programme, which provides financing for wind farms, could also be an attractive model for the GIB because wind farms are a relatively mature asset and provide long-term, stable funding.

The proposed levy on energy bills would also provide long-term and stable funding. Grayson believes securitising the levy could raise tens of billions of pounds.

He says: "In terms of what the levy could raise, I think it could be very interesting. Securitising the future flow of those levies would raise a substantial sum, if the authorities get it right."

The GIB Commission proposes the levy could replace the soon-defunct CERT supplier obligation, which is currently around £35 per household. It is due to be phased out two years from now, possibly enabling a smooth transition into a similarly-sized levy.

"As CERT is phased out in 2012-2013, the money it raises could be replaced by a charge set at a similar level to part fund the activities of the GIB," says the commission.

"By providing a guaranteed revenue stream, perhaps ten years plus a ten-year run-off period, the levy could, by securitising these future receipts, provide a substantial upfront pulse of additional funding for investment," the commission adds.

There are risks involved though, Grayson says. He believes that, as the levy is outside the tax framework, it is very much a levy on the utilities which - he cautions - could leave consumers picking up the tab.

How the bonds are structured will be key to how successful they are. GIB bonds backed by the UK government should prove very attractive to institutions, especially pension funds which typically desire long-duration assets.

"I think it is really a viable business model, depending on how the bonds are structured. There has always been a case for a lot of the longer-term investors to get the right kind of structured bonds," says Grayson.

He adds: "If they can be structured as green bonds and be well rated, then institutional investors could be looking at something like US$120trn of assets sitting there. If you can tap into that even in a small way, then I think you can start to finance the country's infrastructure requirements."

There will be obstacles, though, and rapid investment is needed in new projects to maintain momentum. How to best leverage private funds with limited public money is a question the GIB and government will have to tackle, as is how involved the state should be. Interference by either parliament or the civil service could cause problems and the risk-sharing balance between the private and public sector will need to be addressed.

"The GIB idea already has traction, but a decision needs to be made quickly. Anyone making investments will hold fire until they know what is happening. If uncertainty persists, then infrastructure projects could stall. The authorities have to build on what has been put out there very quickly," says Grayson.

By the year 2020, the GIB Commission says £550bn will need to be invested if the UK is to meet climate change and renewable energy targets. Much of this funding can come from winding up existing funds and organisations, but securitisation has an important role to play.

"Securitisations are interesting as they provide ways of structuring products that do not crowd out the private sector and potentially maximise the leverage of public grants or budget allocations," says Grayson. "In a constrained environment where there are very few funds available, then any way of bringing forward future revenue flows is going to be of interest."

The commission blames decades of underinvestment for the scale of spending now needed. It says: "£800bn to £1trn of investment is required by 2030 to replace, upgrade and decarbonise Britain's infrastructure. This £40bn-£50bn annual requirement substantially exceeds the historical average and is on a scale not seen since reconstruction after the Second World War."

JL

ABS

Offshore interest

Demand imbalance to continue for Australian international ABS

The latest offshore Australian transactions - brought by Macquarie Leasing and Members Equity Bank (see last issue) - indicate issuers' increased willingness to cater for different investor appetites. However, a glut of legacy paper outstanding suggests that a demand imbalance in the sector will remain for the foreseeable future.

Ilya Serov, vp and senior analyst at Moody's, points out that Macquarie Leasing's SMART Series 2010-1 US Trust is the first Australian ABS to tap US demand with somewhat longer-dated paper. "The triple-A tranches have different maturities, with both fast- and slow-pay notes, indicating that issuers are trying to structure deals to cater for different pockets of demand," he explains.

The Members Equity deal - SMHL Securitisation Fund 2010-2E - is also structured to be investor-friendly, with scheduled principal. "We didn't see this before the crisis, but issuers are more in tune with investor demand now. It's early days for the international markets for Australian paper, but the fact that we're seeing fairly conservative/customised structures emerge is positive," Serov adds.

There is potential appetite among European investors for offshore Australian issuance, according to RBS securitisation strategist Phil Adams, but at the moment the swaps into euros cost too much. He says: "There is no structural difference between euro and US dollar tranches. However, there is a significant short-dated investor base in US money market funds, which has typically been interested in one-year Aussie paper, while traditionally the longer-dated paper was sold to European investors."

But Serov concedes that international demand for Australian paper is unlikely to reach the same levels as before the crisis due to the disappearance of SIVs. "Nonetheless, there is healthy interest because the jurisdiction has a strong story."

He notes that Australian issuers have several motivations for tapping the international investor base at present. First is that investors are comfortable with Australian paper because there haven't been any credit issues in the underlying collateral. Second, the cost of the basis swap for issuers hasn't been economic, but rates have moved around recently and the economics may work better now.

The final reason is more generally to do with the credit crisis appearing to have abated somewhat, despite some volatility remaining. "There is a sense that issuers and investors are looking longer-term towards their funding platforms," Serov observes.

Adams agrees that it makes sense for Australian issuers to tap the offshore investor base, given the exemplary performance of collateral from the jurisdiction. "There is a disconnect at present in pricing on US ABS and Australian ABS, given that TALF has served to keep spreads tight, which means the latter offers a pick-up while remaining competitive as a funding mechanism in Australian dollars. The Australian investor base is fairly limited and so there is also a danger that it could become concentrated," he explains.

The Australian securitisation market enjoys features that regulators around the globe would like to see in their jurisdictions, which makes the sector best in class, according to Adams. For example, cumulative claims of lenders mortgage insurers (LMIs) in the worst-performing vintage of Australian RMBS are only 20bp and are insured anyway.

In addition, there is a strong diversification argument for Australian paper. Commodities play a significant role in the Australian economy, especially in Western Australia, which means that the country will always be on a different economic cycle to service-oriented economies like in the UK and the US.

SMHL Securitisation Fund 2010-2E's US$282.9m 1.54-year class A1 notes priced at 120bp over three-month Libor, which Adams says seems like a reasonable level in the context of the current market. The deal's Aussie dollar tranches came at 105bp over, but benefitted from investment by the Australian Office of Financial Management (AOFM).

But an imbalance in demand for Australian offshore issues is expected to continue for a while longer. Adams points out that the imbalance is evident in the fact that, however happy domestic investors may be with Aussie paper, it doesn't change the appetite for legacy offshore notes.

"Some bonds will continue to pay down at a reasonable speed, but issuers of other bonds have had difficulties calling them because of an inability to refinance," he explains. "If the new issue market begins functioning properly and then calls in legacy paper are made, the overhang could be worked through quite quickly. But it depends on timing and obviously needs further work."

It is difficult to gauge what the pipeline is like for offshore Australian ABS because of the current market volatility, Serov says. "We're seeing plenty of interest from both investors and issuers across both ABS and RMBS, but it's unclear how much will come to fruition."

Although a dramatic rise in demand for offshore Australian transactions in the near term seems unlikely, there is talk that some reverse enquiry activity is happening behind the scenes, with large, single US investors looking to take down US$150m-US$200m of the right assets.

Indeed, Adams confirms that there appears to be a degree of optimism about Australian ABS issuance. A number of Aussie dollar investors were said to be looking at longer-dated senior tranches back in November - at a time when European investors were still focusing on short-dated paper - in the hope of locking in spreads before they began tightening. "If this is true, it portrays an investor base that's more evolved and an attitude that will also likely become valid at some point in the US and Europe," he concludes.

CS

Insurance-linked securities

Two becomes one

Cat bond closes with one tranche rather than the expected two

The senior tranche of US hurricane catastrophe bond Shore Re has closed. However, the originally anticipated class B tranche for the deal has failed to materialise.

Shore Re's class A notes priced at the top end of guidance at 700bp over Treasury money market funds and demand was sufficient to fulfil the originally targeted size of US$100m. Yet there was not enough demand to provide a class B tranche, which was planned to partially cover losses between a higher attachment level than the class As.

Overall, the deal is thought to have faced the usual challenge of indemnity transactions - investor concerns over how swiftly the sponsor will be able to supply the initial loss reserves. As a result, there is a heavy dependence on the sponsor's ability to provide information and this could lead to an information gap between different types of investors, which may negatively affect pricing of the transaction - and therefore generate higher volatility - in the secondary market.

Such investor concerns have in the past been mitigated in a number of ways. The sponsor could provide greater detail on its loss reserving procedures, including past cat events and how the process went. Or more simply the sponsor could pay more.

But, as one ILS investor says: "While we still have some US wind capacity available, the structure of this deal is not fully satisfactory. Shore Re is priced very competitively - at this moment, we could easily buy cleaner structures at better discount margins in the secondary market. Consequently, we decided not to participate."

Munich Re and GC securities had begun marketing the three-year Shore Re, which covers hurricane-related losses in Massachusetts, with a US$100m class A tranche and an unspecified size class B. S&P assigned preliminary ratings of double-B and double-B plus to the two tranches respectively.

In its presale report the rating agency notes that while the ceding reinsurer is Munich Re America, covered losses will not be directly linked to Munich Re America's exposure in the covered area. Rather, they will be based on the losses of the Massachusetts Property Insurance Underwriting Association (MPIUA). Ultimate net losses will be calculated on a per-occurrence basis and will reflect the actual paid losses (including loss reserves, if applicable, and a loss-adjustment expense factor of 6.0%).

The class A notes were planned to cover approximately 33.3% of losses between the attachment level of US$600m and the exhaustion level of US$900m. The class B notes were intended to cover an unspecified percentage of losses between the attachment level of US$900m and the exhaustion level of US$1.2bn.

S&P says: "The MPIUA maintains other forms of reinsurance for these layers. However, the MPIUA will be required to retain at least 5% of the layer covered by the notes."

The transaction will have two annual resets, effective on July 2011 and 2012 respectively, which will be based on MPIUA exposures as of the applicable date immediately prior to the 1 February reset calculation date. For each annual reset, the model will be replaced with the latest commercially available version of the AIR US hurricane model (including updates) as of the applicable reset calculation date. Each annual reset will adjust the attachment point to maintain the deal's initial probability of attachment and expected loss.

Shore Re's collateral will be invested in US Treasury money market funds.

MP

ABS

Pockets of activity

European ABS and MBS seeing some trading, but still relatively quiet

European ABS and MBS secondary markets are still seeing some pockets of activity, but overall remain relatively quiet. Similarly, there are occasional deals to be looked at in the primary market.

One ABS trader says: "In ABS generally there has over the past few days -Monday excepted - been better activity and client interest than in the previous few weeks. We're seeing more buying interest, but it is still fairly quiet."

In a report published on Monday 5 July Barclays Capital European securitisation analysts concur that there is a quiet tone in the secondary ABS market, with liquidity remaining thin and flows generally muted. "There was, however, a spike in volumes at the end of the second quarter, which we think may have been driven by repositioning as investor focus shifted to risk reduction," the analysts add.

They continue: "Liquidity and volumes are now much thinner than they were towards the end of last year and the beginning of this year, and a few bond holders who were reluctant sellers earlier are now starting to show some willingness to sell at prevailing bid levels - a shift in behaviour that could lead to future price weakening. We do not expect trading volumes to stage a significant rally this month or next and would not be surprised if volumes turned even weaker later in the summer."

Nevertheless, the trader reports a busy Tuesday 6 July. Consequently, he says: "Overall levels are pretty much unchanged week on week; perhaps slightly better. UK prime in particular has improved, but Irish paper continues to decline."

The secondary CMBS market has also been reasonably active. "There are a couple of bid lists out there at present and they look to be trading reasonably well - though not everything is going, as some bids aren't as aggressive as they were. Over the last two weeks in BWICs dealers have been stepping off the levels they had previously bid and we are now at levels that had previously interested clients," the trader says.

He continues: "That's good for those market participants who are trying to engage with clients more, as you can now get customer trades done - it's now possible to buy at prices where clients might want to get involved again."

The previously aggressive bid levels are seen, at least in part, as a function of new dealers coming into the market and bidding higher than was perhaps necessary to accelerate market share. That appetite now appears to have been sated and the market is expected to continue to settle down.

Activity is also quiet in the primary market. "There's nothing of note in the deal pipeline. We, of course, saw Tesco price its non-traditional CMBS last week, but there's nothing else we're looking at right now."

Tesco Property Finance 3's single tranche priced at 165bp over the 4.25% 2032 gilt. Demand is understood to have been strong, with the deal more than twice oversubscribed.

In ABS more broadly, the BarCap analysts also expect public placements to be few and far between. "Given the ongoing concerns over regulations, banking system stability and sovereign risk, we do not expect much appetite for publicly-placed issuance over the summer. It may be September before the next sizeable opportunity for public placements comes to the fore."

However, they add: "The transaction that may yet generate investor interest is the Renault deal, which is currently being marketed. Renault is set to offer €873m class A notes with a WAL of 1.8 years."

MP

CLOs

Slight return

CLO BWIC trading up, but euro loans slowing

CLO BWIC activity has seen some increase over the past week or so on both sides of the Atlantic, most notably in the US thanks to the Axon Financial SIV liquidation (SCI passim). However, the underlying loan market in Europe is showing signs of a summer slow down.

One European CLO manager says: "We've seen plenty of supply from BWICs and for a wider range of names than we're used to. We're not awash with stuff to buy - it's been more of a steady trickle over the last month - but it's better than it was."

A report published 1 July, by structured credit analysts at Citi confirms: "With most real money accounts still on the sidelines amidst the ongoing volatility in markets worldwide, liquidity in the CLO secondary market has remained somewhat subdued. However, the volume in public BWICs has picked up from the levels in May ([a] month over which we saw the lowest total volume and the lowest number of bonds in public BWICs since July 2009), to reach roughly US$1.25bn."

The Citi analysts add that the pick-up in secondary activity over the past couple of weeks shrugs off fears that paper supply has been exhausted. "With the novation of Ambac CDS contracts with its counterparties, we may see significant supply of CLO and Trups CDO paper from more than a dozen HG ABS CDO liquidations."

Meanwhile, the analysts continue: "The liquidation of Axon Financial SIV marks another important milestone in the secondary market. The auction, held on the 30 June, brought a total of about US$630m of senior CLO tranches to market. Contrary to what was feared, a significant number of the CLOs (and other bonds) have traded, spreading hope that the successful auction results will reignite secondary trading much like the liquidation of Whistlejacket SIV did in April 2009."

The driving force of supply in Europe is less clear, according to the manager. "There is some speculation that a chunk of the supply is the liquidation of a more recently done CLO, but that rumour changes in popularity on a daily basis. Overall it's all to do with the ability to sell out at prices that work. We don't sense any element of panic about it; it's just that prices are once again attractive for sellers," he says. The Carlyle Group reportedly liquidated its €1.5bn CELF Partnership Loan Funding 2008 deal last week, after a redemption notice was served on the portfolio.

That is not to say that buyers are thick on the ground. "We talked with a lot of investors at Global ABS and most are not looking to add new money right now. Instead they are just watching how their existing deals are doing," the manager says.

Indeed, the Citi analysts report: "The sentiment among investors still remains mixed, with many bonds failing to trade from bid lists (only three bonds traded in one recent CLO equity list with 19 bonds). Generally speaking, the trading of BWICs was more successful in the top of the capital structure, with most bonds trading around expected prices (mid-80s to low-90s for triple-As, mid-70s to mid-80s for double-As, low- to mid-60s for single-As)."

That trend has also been evident in secondary market pricing more broadly. "CLO spreads in the senior parts of the capital structure have remained relatively unchanged over the last month, while mezz tranches have - on average - traded a bit wider over the month," the Citi analysts add.

Nevertheless, the manager says: "In terms of trading performance, we're seeing a steady improvement across all names. There is no evidence of any kind of double-dip. In fact, we're worlds apart from this time last year - there is just one restructuring of note, whereas a year ago there were a dozen or so."

Genuine new issuance is some way off, however. "Potential new deals are still all about rearranging assets - there's still not enough supply to arrange a fresh CLO," the manager says.

He continues: "There are a few small mid-cap deals still to be syndicated, but overall the loan market is now quietening down for the summer lull from a not very busy year. We expect, like last year it will be a slow July and August in the UK and Europe at least - it's back to the old days."

MP

Secondary markets

Re-thinking valuation

In the first in a series of articles on structured credit valuations, R² Financial Technologies ceo Dan Rosen discusses the challenges and complexities of pricing structured credit securities, and the perils of doing so inadequately

Pricing models for structured credit securities have often been overly simplistic, with many institutions placing too much reliance on dealer quotes, on simple models based on credit ratings and on top-down views of collateral portfolios. As liquidity dried up in the markets, many practitioners were left in the dark, not able to reliably determine the value of their portfolios or to analyse their risk. In this series of articles, I point to the importance of a model risk framework, given the inevitable limitations of industry models, and discuss several lessons and best practices that are being re-learned as the global banking system copes with the legacy of the crisis.

The financial industry just experienced a (hopefully) 'once-in-a-lifetime' crisis, which nearly brought down the entire system. A recent report by the IMF estimates bank write-downs and loan provisions between 2007-2010 at US$2.3trn, with about two-thirds of these losses (or about US$1.5trn) realised by the end of 2009.

Originating first in the US subprime market before spreading around the globe, the credit crisis has highlighted many limitations of the industry's general valuation practices and our understanding and management of risk, particularly as they relate to structured credit portfolios. Market participants clearly misunderstood and underestimated the risks in many securities, especially with respect to systematic risk, default correlation, contagion and liquidity.

Modelling, valuation and risk measurement of structured credit products is challenging, given the complexity of the structures and underlying risks. Investors have in practice generally relied on periodic valuations by dealers or other third parties, or on simple models based on credit ratings and on top-down views of collateral portfolios.

This black-box approach has resulted in a lack of transparency in prices and limited risk capabilities (risk measures, stress testing, concentration risk, etc). During the housing and credit boom of the last decade, structured finance instruments generally performed well.

There was a widespread perception that their risks were small and contained. This view proved to be wrong...and costly.

Valuation and risk solutions for structured credit portfolios are computationally intensive and require important investments in methodology, systems, people and the integration of multiple data sources. Several difficulties in valuing and measuring their risk include:

• Complex risk profiles. Portfolios contain market risk (interest rates and spreads), credit risk and prepayment risk (as well as liquidity risk). These risks are intertwined and it is difficult to capture their interaction effectively. Correlations are very important and difficult to assess, and they are not widely used or standardised. Systematic concentrations have proven to be key drivers of losses, as well as possible contagion (within a market, as well as across markets).
• Complex structures. The cashflow structures are complex and generally opaque for a standard investor. They are difficult to model and are computationally involved.
• Lack of reliable pricing data. Pricing, as well as fundamental credit data, comes from multiple data sources and is often incomplete or unreliable. The lack of liquidity in the market increases this problem.

What is the value of a security and how do we know?
When dealing with complex structures and markets with limited liquidity, it is important to understand the meaning and use of a 'price'. It is vital to acknowledge the sometimes "heroic" assumptions in industry models and the limitation of the information that we can reasonably extract from the market.

When liquidity is thin, dealer quotes are unreliable and model parameters cannot be estimated based only on observed market prices. The crisis has made evident these limitations and has further highlighted the subjectivity of valuation models and their assumptions.

In practice, we must effectively incorporate into the valuation process fundamental credit information, historical data and expert judgment. In addition, it is vital to develop explicit model risk and stress testing approaches, which can help us understand better the behaviour of instruments and portfolios, together with their risks and the 'Knightean' uncertainties we are facing.

A quote by the famous dramatist and poet Oscar Wilde (1854‐1900) comes to mind:

"Nowadays people know the price of everything and the value of nothing."

If Wilde were alive today, his quote might well have read something like this:

"Before the crisis, people knew the price of everything and the value of nothing... now they know neither."

In upcoming articles, I will explore in more detail several lessons and best practices the market is re-learning as it emerges from the crisis, as well as the application of model risk and scenario analysis concepts to structured credit portfolios.

Secondary markets

Secret service

Russel Parentela, md for BNY Mellon Structured Credit, answers SCI's questions

Q: How and when did BNY Mellon become involved with Structured Credit Connection?
A: Structured Credit Connection is a real-time auction marketplace, which allows us to act as agent in the structured credit trading area. We got involved based on the lessons learned from the financial crisis, a strong desire on the part of market participants for transparency and feedback we received helping the US government with its TARP, TALF and PPIP programmes.

We were involved in the early stages when the different government programmes were being created. At first, the initial concept was to have an auction system to auction securities, but while there were benefits to that approach there were also problems, particularly anonymity. Structured Credit Connection allows us to act as an agent in trying to bring back the securitisation market by providing an anonymous marketplace for securities and, in particular, illiquid securities.

Q: What are your key areas of focus today?
A: The initial area of focus is illiquid securities. The first rollout of the system is going to be US dollar-denominated RMBS securities, in which we include prime, subprime and alt-A. We will also handle ABS, CLOs and CDOs.

We eventually plan to expand into Islamic finance and energy receivables, such as carbon credits by early next year and perhaps sooner. We are working with partners at the moment and we are still in the development stages.

One of the key aspects of our system which is unique is that, as assets are put up for sale, we have custody of the asset. For example, as a company, we have a custody business for carbon credits. We are one of the few places with the capability to act not only as agent but to also have custody of the asset.

Q: Which market constituent is your main client base?
A: There is a target audience for traders and there is a non-trading audience.

Our clients are qualified institutional buyers (QIBs) and being a QIB is our first eligibility qualification. We are trying to target everybody from investment banks and broker-dealers to asset managers, hedge funds, insurance companies and pension plans.

The goal is to allow the information to be widely disseminated to allow people to make knowledgeable decisions about the market. That is the target market for people who will be trading with the system.

But we also have a target market including people such as regulators. We think rating agencies, risk officers and evaluation officers will want to see what is going on in the marketplace and use that for valuation purposes. These are people who want to know what is going on in the market.

Q: How do you differentiate yourself from your competitors?
A: BNY Mellon is a triple-A rated US bank counterparty, which is rare. Our large custody book of nearly US$23trn, the robustness of our institution, the strength of our balance sheet and breadth of our capabilities is how we differentiate ourselves.

Our auction system for most asset classes requires that we have custody of the asset while it is available for sale. Also, buyers and sellers remain totally anonymous. That is how we differentiate our product.

We have a specific exemption from the US SEC to make sure our buyers and sellers remain absolutely anonymous. Normally, even with an agent, the buyer or seller has the right to legally ask the identity of other party. We have true anonymity.

Other than that, the largest distinguishing feature is that for assets available for sale we are going to provide a free, detailed data and analytics tool to allow people to form their own opinions about these assets. It is a loan-level, drill-down data analytical system built in direct response to a Bank of England requirement.

The system has all the loan-level information and it also has all the documents associated with each transaction and a public waterfall model. All of this is available to the purchaser to help them make their decision.

It would take people years to build a comparable data and analytics system. We let people have free access to the system for anything available for sale, while it is available for sale and then for 30 days thereafter.

Q: Which challenges/opportunities does the current environment bring to your business and how do you intend to manage them?
A: To get rolling! The largest challenge is whether the market is willing to embrace this level of price transparency.

Right now the regulators are discussing including the concept of TRACE - putting the price of an ABS trade onto a database. This system does that and much more, because in this system every time someone bids they get a bidder number and everyone can see the size of the bid they submitted. You can see the depth of people bidding and you can see at what level they bid.

I can put an asset for sale with a reserve price of 70. Normally, if nobody shows up there is no news and no data which can be taken from that.

In our system you can see, for example, if five people put in bids at 60. Not only do you see what level it was offered at, but you can see the market's level of interest.

You can see how many people were interested and what level they were interested at. It is very transparent.

We are hearing overwhelmingly positive feedback about our transparency. Investment banks are very interested because they like that this is proof that what they are doing is very transparent and that they are adhering to regulations and acting appropriately.

Purchasers like it because it will allow them to have more information before they make their investment decision. Sellers like it because they have no downside; the seller does not pay anything.

If sellers own something on their books at 80 and know they can sell it at 85, they can put it up for 85. If they get 85 then they sell it, but if nobody shows up then that is OK also.

The key is that it is very revolutionary. We think it answers all the criticisms in the system about people lacking information, about not having an easy enough format, about people trying to bid pennies on the dollar if they know the seller is in distress. We have tried to address the system to maximise the execution for the seller.

We will know more in the months ahead when we see how many people sign up.

Q: What major developments do you need/expect from the market in the future?
A: The major development that needs to continue to happen is the development of relationships and communication between buyers and sellers, while at the same time keeping other interested parties informed. It is important to have increased reporting and usefulness of data.

A lot of the initiatives already put forward by the EU, Bank of England and the SEC are on-point. I expect that there will be greater loan-level transparency and publication of waterfall models, so that people can truly assess the risks inherent in what they are buying.

JL

ABS

Illiquid asset advisory formed

G2 Investment Group has entered into a strategic partnership with Asset Oversight Services (AOS), an advisory and asset management firm focused on illiquid, private credit assets. The venture will be named G2 Asset Advisors.

Brian Broesder, president of AOS, says: "Partnering with G2 gives AOS the scale and resources necessary to deliver best-in-class solutions to institutions with exposure to illiquid assets. The experience we possess, coupled with G2's capital markets and real estate expertise, positions G2 Asset Advisors as a market leader in advising institutions with exposure to challenging structured credit assets."

G2 Asset Advisors specialises in advising holders of illiquid credit assets as well as providing customised liquidity solutions, either through disposition to active third-party purchasers through its capital markets division or opportunistic investments made by one of G2's captive fund vehicles. The group is currently advising on the sale of direct debt and equity in highly structured assets, including aircraft, alarm servicing contracts, auto loans, business acquisition loans, credit cards (specialty and distressed), equipment leases and timeshare loans.

ABS

New corporate trust partner recruited

Charles Dietzgen has joined Nixon Peabody's New York office as partner in its corporate trust and global finance practices. He joins the firm from Sonnenshein, which he joined in 2009, having spent his entire career prior to that at Thacher, Proffitt & Wood.

Nixon says Dietzgen is highly sought after by corporate trustees for his experience in structured finance and securitisation transactions, including both ABS and MBS. His practice ranges from representation in new transactions to providing regulatory and compliance advice, to assisting clients in the resolution of problem situations, restructurings and disputes.

Robert Coughlin, leader of the firm's corporate trust practice, says: "Charles' depth and breadth of experience in asset-backed and mortgage-backed securities will be particularly valuable to our clients as they face the challenge of financial reform legislation and SEC regulatory reform over the next few years. Charles will be an important enhancement to our team as we look ahead to the return of active securitisation markets."

CDS

UK to house global CDS data

The DTCC plans to establish a new European subsidiary. The DTCC Derivatives Repository will maintain global CDS data identical to that maintained in its New York-based Trade Information Warehouse.

A regulatory application has been filed with the FSA in London, where the subsidiary will be headquartered. The DTCC says it hopes the move will ensure regulators have "secure and unfettered access" to CDS data by establishing identical CDS data sets on two different continents.

"DTCC has always envisaged a 'global solution' for repository services supporting each OTC asset class," says Stewart Macbeth, md and general manager of the Trade Information Warehouse. "It is very common for counterparties to be located on different continents and to trade on underlying securities issued across borders."

He adds: "This means that repositories for any asset class need to maintain global information to be useful. It also means that steps need to be taken to ensure that the data is always available to regulators globally, regardless of events and circumstances taking place in one location or another."

The subsidiary will also house the global equity derivatives repository being built by the DTCC, which won ISDA's global bid for the service. ISDA mandated that the European global equity derivatives repository had to be in London.

A wide variety of critical functions, such as operational, customer, technical and CDS trade reporting will all be supported by the European-based repository. It is hoped that this will ensure greater public transparency and support the information needs of regulators and supervisory authorities.

CDS

Asia Pacific credit structuring team expands

Stefan Masuhr has joined RBS as head of credit structuring & repackaging, Asia Pacific, as the team continues to expand in the region.

Masuhr will head RBS's credit structuring capabilities throughout Asia Pacific, working closely with sales and trading on the repackaging of assets and liability and asset credit structuring. He will also work in close partnership with RBS' asset class specialist teams within global structuring to develop multi-asset structures for clients across Asia.

Geoffroy Wallier, RBS head of global structuring, says: "Stefan brings 16 years of Asian credit structuring experience, as well as topical repackaging capabilities, which suit our clients' needs. He has an impressive and proven track record and I look forward to having him onboard."

Masuhr joins RBS from Deutsche Bank in Singapore, where he was most recently head of funds and managed investment solutions. While there, he led the bank's fund and trust formation business, headed credit structuring for local markets and hybrids, and was instrumental within debt restructuring for South Asia.

Prior to this, Masuhr worked at HVB from 2002 to 2006 as head of structuring, Asia.

CDS

Complex workout exposures transferred

Natixis says it has sold most of the complex credit derivative exposure held in its structured credit workout portfolio, GAPC, to a bank counterparty. These positions aren't covered by the BPCE guarantee applied to €35bn of the portfolio.

The transaction significantly contributes to the reduction of the risk profile of GAPC and Natixis, in line with the strategy that has been defined by management, the bank notes. This operation is also anticipated to limit earnings volatility.

It is expected to have a slight impact on the bank's H110 results to be released on 5 August 2010.

CDS

Derivatives and funds capability enhanced

James Waddington has joined Dechert's London office as partner. He moves over from Orrick, Herrington & Sutcliffe, where he was partner. Prior to this, he worked as an investment banker at Bankers Trust.

Waddington advises commercial and investment banks and private equity and hedge fund clients in connection with finance and derivative transactions, including credit default swaps, lending and borrowing arrangements, debt and equity offerings, insolvency and restructuring matters as well as fund formation and fund investments.

Co-chair of Dechert's global financial services group, Peter Astleford, says: "Jim's expertise will further enhance our brand as a leader representing clients across the nexus where corporate, finance and fund matters meet."

CLOs

Investment manager adds investor relations md

Steven Delarosa has joined Highland Capital Management as an md. He will be responsible for managing the firm's relationships with existing investors and developing and maintaining relationships with investment consultants across the globe.

This is a newly created position and Delarosa will be based in Dallas, where he will report directly to Kevin Latimer, partner, head of business development for Highland.

Delarosa has over 20 years of client service and marketing experience in the investment industry. He joins Highland following 11 years at Western Asset Management Company (WAMCO), where he held three executive level positions in client service & marketing and helped expand the firm's assets under management from US$24.7bn to a peak of US$628bn.

CLOs

Permacap name change voted in

Carador shareholders approved during the company's recent AGM a change in its name to Carador Income Fund (SCI passim). They also approved an amendment of the company's Articles of Association to change its distribution policy to permit distributions to be made out of net capital gains, as well as the ability of the company to charge fees and expenses to capital.

The change of name is expected to be completed at on 5 July 2010, when the company's stock exchange ticker codes for the euro and US dollar classes will change to CIF and CIFU respectively. The effective date for the changes to the Articles of Association will be 14 July 2010.

RMBS

New Euro RMBS head named

Alex Maddox will join Deutsche Bank in August as head of European RMBS. In this newly-created role, Maddox will report to Doug Naidus, global head of RMBS lending and trading.

Prior to this, Maddox worked at Citadel Investment Group as head of securitised products. He joined Citadel's London office in late 2008, bringing over members of Lehman Brothers ABS trading structuring team that he previously led. He spent fourteen years at Lehman Brothers, where he established the firm's mortgage trading desk.

RMBS

Broker boosts MBS capabilities with acquisition

Knight Capital has acquired Urban Financial Group to strengthen its institutional fixed income MBS desk. Urban Financial will provide a pipeline of home equity conversion MBS.

Urban Financial is an independent mortgage company and originator of reverse mortgages (HMBS) under the FHA Home Equity Conversion Mortgage programme. Unlike conventional private MBS, HMBS pools are guaranteed by the federal government.

"Knight has acquired one of the leading originators of reverse mortgages in the US and created an origination-securitisation-distribution model in home equity conversion MBS," says Thomas Joyce, Knight Capital chairman and ceo. "Considering the relatively low risks, growing demand among institutional investors and Knight's revenue model, the acquisition makes perfect sense."

Urban Financial is based in Tulsa, Oklahoma. It has offices in 10 states and offers or purchases residential mortgage loans in more than 30 states.

Founder and ceo of the firm, Bryan Hendershot, has been appointed Knight Capital md and head of mortgage origination as a result of the acquisition. He will report to Ronak Khichadia, md and global head of ABS and MBS for Knight Capital.

Trading

Broker launches advisor services platform

Knight Capital Group has established Knight Advisor Services to provide fixed income sales, trading and research to the investment advisor community. A team of five experienced traders and relationship managers have joined Knight from Morgan Stanley to form the new platform.

Joshua Zucker, md, leads credit sales and trading for the group, while Bohn Vergari becomes a director in Registered Investment Advisor (RIA) sales. Joseph Miller, vp, is responsible for credit sales and Patrick Moore - also a vp - broker-dealer sales. John Browning, an avp, will lead business development.

"Investment advisors have been left to develop their own networks of trading partners and research providers. Knight Advisor Services addresses the coverage gap by serving sophisticated investment advisors, who seek competitive pricing, deep inventory and service, but who are less active or execute in smaller trade sizes than the average portfolio manager," says Gary Katcher, evp, head of global institutional fixed income at Knight Capital Group.

He adds: "We see an opportunity to better serve this client base by combining the expertise of our new team with Knight's electronic and voice access and trading, deep resources and broad universe of products."

Zucker built Morgan Stanley's special situations group, focusing on providing the top fixed income-producing financial advisors with trade ideas and execution. He has more than 12 years experience in credit trading and sales overall.

Vergari joins Knight after 12 years in dealer and RIA fixed income sales at Morgan Stanley. He managed the bank's internal service desk for fixed income-producing financial advisors and was also responsible for launching its municipal dealer sales group to provide the broker-dealer community with access to the firm's municipal inventory.

Miller spent seven years at Morgan Stanley, where he assisted in providing fixed income sales coverage to the top advisors within the firm's retail brokerage force.

Moore has more than 12 years of experience in fixed income sales. Working for Morgan Stanley in New York, San Francisco and the UK, he assisted the firm's broker-dealers and private bank clients with fixed income solutions.

Browning joins Knight from Morgan Stanley, where he led business development efforts for the RIA fixed income sales desk. Previously, he worked as an investment grade credit analyst with J&W Seligman until 2008.

Knight Advisor Services clients include RIAs and broker-dealers, who serve high net-worth investors, endowments and foundations. The team trades investment grade corporates, municipals and certificates of deposit, among other fixed income securities in demand by investment advisors.

ABCP

ABCP settlement to boost investor protection

The Autorité des Marchés Financiers (AMF) says it plans to use the C$72.8m settlement from its investigation into the Canadian ABCP sector for the purposes of consumer education and investor protection.

The AMF collected C$72.8m in administrative penalties in settlements with National Bank Financial and Laurentian Bank Securities, and will pay 50% of this to the Education and Good Governance Fund (EGGF), which helps to educate consumers and protect investors. It will use the remaining half to develop new initiatives to enhance security enforcement and to prevent offences in the financial market.

The AMF plans in particular to draw on the US Securities and Exchange Commission as a basis for creating a team of financial market specialists dedicated to the latest practices and new products.

ABS

Associations blast safe harbour NPR

The American Securitization Forum, the CRE Finance Council and SIFMA's Securitization Group (SSG) have filed comment letters with the FDIC in response to its proposed safe harbour rule, which addresses the treatment of assets during the potential insolvency of an FDIC-backed institution. The associations agree that the proposals, if implemented, will prevent the securitisation market from reopening and note that certainty for investors remains paramount.

The ASF expresses strong concern in its letter that the agency's safe harbour proposals would prevent the securitisation market from reopening because they would eliminate certainty for investors that they would receive timely payment from their triple-A investments. The FDIC proposals include numerous preconditions, including requirements relating to a transaction's capital structure, disclosure, documentation, origination and compensation. The ASF has proposed that the applicability of the safe harbour not be conditioned upon the numerous requirements set forth in the proposed rules and instead limit any requirements to clear, bright-lined conditions that allow investors to rely upon the safe harbour without fear that its benefits could disappear.

Meanwhile, the CRE Finance Council in its letter urges the FDIC to consider carefully the negative impact that piecemeal reforms would have on providing certainty and confidence for market participants, particularly investors, and supporting a commercial real estate recovery. Lisa Pendergast, Council president and md of CMBS strategies and risk at Jefferies & Company, comments: "The FDIC must be mindful to ensure that investors have confidence in the protections afforded by the safe-harbour framework and that the framework reflects congressional intent on securitisation reform, particularly as it relates to joint rulemaking."

The Council also urges the FDIC - and financial regulators more broadly - to work within the new and coordinated framework directed by Congress in H.R. 4173, the Wall Street Reform and Consumer Protection Act (or 'Dodd-Frank'), which requires regulators to promulgate joint rules by 'asset class' to ensure that securitisation reforms are coordinated and customised. The Council states in its comment letter: "Tailoring regulation is especially important in addressing assets such as commercial mortgage-backed securities, which have innate characteristics that minimise the risky securitisation practices that policymakers wish to address, but could suffer detrimental effects to liquidity and credit availability if reform mandates do not take these unique characteristics into account."

The CRE Finance Council's membership is united in the view that the alignment of the interests of lenders, issuers and investors in the securitisation process is essential.

Finally, the SSG in its letter reiterates its support for coordinated, comprehensive securitisation reform and for an insolvency safe harbour rule that provides the required certainty to investors, rating agencies and other market participants to continue to participate in the securitisation market. However, the SSG finds that the proposal by the FDIC achieves none of these goals.

"Restoring the securitisation market is essential to ensuring consumers and small businesses have access to affordable credit," says Richard Dorfman, head of the SSG. "We believe the FDIC should work in concert with actions currently underway by Congress and other regulatory agencies to ensure passage of consistent regulations that facilitate comprehensive securitisation reform."

In its comment letter, SIFMA notes that the FDIC's proposal addresses many of the issues under consideration as part of the financial regulatory reform bill being crafted by Congress. A proposal for ABS reform by the SEC, which offers sweeping changes to its disclosure and reporting requirements, addresses many of the disclosure issues proposed by the FDIC. SIFMA believes that subjecting securitisations to multiple and inconsistent regulations will impede the goal of successful securitisation reform and may reduce the use of securitisation, thus negatively impacting liquidity and credit availability to consumers and small businesses.

SIFMA also notes that the FDIC's proposed changes to the insolvency safe harbour will not provide adequate assurance with respect to the treatment of assets in the event of the insolvency of an insured depository institution. It is no longer based on traditional legal principles of insolvency laws, but rather on the basis of accounting principles and certain other market conditions that are vague or subjective and create risk to investors by leaving the door open to change or to the reassessment of eligibility for the safe harbor after a securitisation closes, SIFMA notes.

The Association requests the FDIC extend the interim safe harbor, currently in effect until 30 September 2010, until it - in conjunction with the other bank regulatory agencies and the SEC - promulgates final regulations under the financial reform legislation.

ABS

Euro stress tests to support the market

CEBS is expected shortly to reveal the names of the European banks that have undergone the stress tests. The results of the stress tests are slated for publication on 23 July, but their underlying methodology will likely be released before then.

Ollie Rehn, the EU's Economic and Monetary Affairs Commissioner, has confirmed that both national and EU (namely the €440bn European Financial Stability Mechanism and Facility SPV) financial backstops have been put in place to support the banks that look vulnerable after the publication of the results.

One structured credit investor notes that the European stress tests should go a long way towards increasing transparency around the magnitude of the losses in the Euro system. "The results will provide a lever for regulators to force banks to raise new capital with, as well as putting a buffer between the banks and the sovereigns," he says.

He adds: "There is a sense that the market is misjudging the prospects for disaster in the eurozone because it is incorrectly applying the lessons from 2008, whereas there is dramatically less scope for a funding crisis in this case. Sovereigns have more scope for cutting costs and raising revenues than corporates do and the financial stabilisation SPV will provide a backstop where necessary."

Barclays Capital European securitisation analysts agree that, assuming the stress tests are well designed and sufficient detail about the stresses applied are made available, they could help reassure the markets. "If, however, the tests end up falling short of market expectations, the effect could be fairly negative and self-defeating," they conclude. "ABS markets would certainly not remain immune to any escalation of fears about the health of the banking system, given the generally strong relationship between ABS spreads and those on senior financials."

ABS

Sallie Mae brings SLABs deal

SLM Corp has closed its US$1.7bn SLM Private Education Loan Trust 2010-C offering. Underwriters are BoA Merrill Lynch, Barclays Capital, Credit Suisse and RBC Capital Markets.

Five triple A-rated class A tranches priced over one-month Libor. The largest tranche, the A-1 US$451m tranche, has a 0.99-year WAL and came at 165bp over, while the US$209.38m 3.51-year A-2 tranche came at 265bp.

The notes will have initial overcollateralisation of 37%, which S&P expects will grow to a target of 43%.

On its Q110 earnings call last April, SLM Corp said it expected to come in below its initial US$3.5bn guidance for its private student loan origination business. But it expects to securitise assets from its retail deposit initiative that it started in Q1 and from its new origination growth through Sallie Mae Bank.

SLM also said on its April call that it retired US$2.5bn of unsecured debt, including the repurchase of US$1.3bn in notes with maturities from 2010 through 2014. The replacement of its ABCP facility allows it to fund up to US$10bn in the first year, US$5bn in the second year and US$2bn in the third year. It further said it had US$12.5bn in primary liquidity, consisting of cash and investments in committed lines unchanged from 31 December.

ABS

BoE survey points to stabilising performance

The Bank of England's Q210 credit conditions survey suggests that UK consumer-backed assets, such as mortgages and credit cards, have stabilised in performance, according to European securitisation analysts at Barclays Capital. They note that availability of financing appears to be increasing as overall liquidity in the banking system improves and as banks' risk appetite begins to pick up again in certain segments that were shunned throughout the credit crisis.

"We expect prepayments in UK prime RMBS to remain stable for the moment and performance to continue to improve modestly, absent any external macroeconomic shocks," the BarCap analysts add.

Further, the increased availability of credit card lending will likely benefit the sector as more refinancing options become available to borrowers. However, the relaxation of lending standards in the credit card space may lead to a renewed wave of credit card defaults in 2011, the analysts warn.

Finally, the overall improved credit conditions for corporates are a positive overall and should bode particularly well for performance in the balance sheet CLO deals outstanding.

ABS

UK credit card trusts to benefit from extended support

MBNA has extended the use of the discount option of 5% for newly added receivables in its two UK credit card master trusts until January 2011, after which it will start to decline monthly. Introduced in February 2010, the discount was originally going to be applied until July 2010 and then decline by 1% each month until October 2010.

The news is positive for the two CARDS trusts, which will now benefit for a longer time from the increase in yield generated by this measure of support. European securitisation analysts at Barclays Capital note that portfolio yields in the trusts increased markedly following the introduction of the discount option, thereby reducing the likelihood of early amortisation triggers being hit.

ABS

CARD Act to have little impact on ratings

Fitch believes that new regulations restricting US credit card issuer fees are likely to reduce overall gross portfolio yield by approximately 10% from the record highs seen earlier in the year.

The new rules follow the Federal Reserve Board's (FRB) final rule approval of 15 June in its implementation of the 2009 Credit Card Responsibility and Disclosure Act (CARD Act). The new rules will negatively impact gross yield and excess spread cushions on existing credit card ABS (SCI passim), although existing ratings should be well-insulated. A provision targeting interchange revenue could reduce gross portfolio yields even further if the bill is signed into law.

"The operating environment for credit card issuers is significantly more challenging from a regulatory perspective during the past two years," says Fitch md Michael Dean. "That said, credit card ABS still provides sufficient protection to support current ratings."

The FRB started implementing the CARD Act in August 2009 and January 2010. Credit card issuers must now comply with the new standards by 22 August. Issuers have been tightening credit and raising interest rates to offset losses caused by the economic downturn, but the new regulations will limit issuers' abilities to generate fee revenue.

Credit card issuers will not be able to charge late fees of more than US$25 unless the borrower is consistently late or unless the issuer incurred large costs as a result of repeated late payments, nor will they be able to charge multiple late fees for the same payment.

Issuers are also prohibited from charging penalty fees, late payment fees or over-the-credit limit fees that exceed the amount the borrower violated the account terms by. Furthermore, issuers would be banned from charging inactivity fees or fees for closing accounts or declined transactions.

"The most profound implications will be on gross yield and, to a lesser extent, monthly payment rate," says Cynthia Ullrich, senior director at Fitch. "Retail and subprime credit card issuers stand to be most affected since the fee component is typically a significant portion of total revenue."

Late fees currently average US$39, which Fitch expects to shrink by up to 30%. Gross yield is expected to decrease 10% and the agency has started applying haircuts to its gross yield assumption. Gross yield is up 27% year-over-year and Fitch does not anticipate negative rating actions for any credit card ABS.

Finally, Senator Richard Durbin's interchange amendment to the financial reform bill is expected to be incremental to Fitch's estimates. The agency believes the amendment will have a dampening effect on credit card usage with merchants able to enforce minimum dollar amounts for credit card purchases.

ABS

Credit card delinquencies reach 17-month low

Fitch reports that US credit card ABS performance remains stable, with late stage delinquencies improving. Late payments improved for the fifth consecutive month. Fitch's 60-plus day delinquency index fell by 17bp to 4.01% to set a 17-month low in May, dipping below last year's average.

Early stage delinquencies also improved for the third straight month, as 30-plus day delinquencies decreased by 26bp and are now down to 5.27%. Lower charge-offs are expected as a result.

"Seasonal factors are influencing the improvement in delinquencies and could benefit charge-offs in the coming months," says md Michael Dean. "Employment trends remain vital to any meaningful and sustained improvement taking hold."

Fitch's prime credit card charge-off index increased by 3bp to 11.13%, although charge-offs were only 7% higher than a year ago. The 61bp increase of defaults in the BA Credit Card Trust was a major contributor to the rise, Fitch notes.

"Given their resiliency in the face of higher charge-offs and delinquencies, ratings on senior credit card ABS should remain stable," says Cynthia Ullrich, Fitch senior director. "The outlook for subordinate tranches remains negative."

Gross yield resumed its increase, rising to its second-highest total at 22.2%. Yield performance for May was up 26% from a year before, but Fitch expects gross yield to decline by up to 10% in the coming months because of regulatory and legislative changes (SCI passim).

Monthly excess spread increased by 58bp to 8.59%, while the three-month average increased by 29bp to a four-year high of 8.57%. Excess spread has improved four months in a row and is 77% higher than it was a year earlier.

The monthly payment rate improved by 21bp to 19.02%, which is an 11% increase on the same time last year. The rise is due to a high number of collection days during May, consistent with seasonal expectations.

Retail credit card ABS charge-offs remained stable, while late stage delinquencies fell again, as they did in the three preceding months. Charge-offs improved 1bp to 13.22% and remain around 4.5% higher than a year ago. Late stage delinquencies improved by 13bp to 4.8%, while early stage delinquencies were up 3bp to 6.87%.

Gross yield increased by 42bp to 26.08%, similar to the prime index; however, monthly payment performance slumped 65bp to 13.96%. Monthly excess spread increased 137bp to 8.66% and three-month average excess spread fell to 8.63%. Excess spread was flat year-over-year.

CDO

CDO recovery rate criteria updated

Fitch has updated its global rating criteria for corporate debt-backed CDOs. The criteria report outlines the agency's approach to addressing the primary risk drivers of a corporate CDO, in which it considers the following factors as primary risk drivers: asset quality, asset security, portfolio composition and portfolio selection and management.

Fitch's corporate CDO rating methodology is fundamentally unchanged from its April 2008 report. However, one notable update covers its recovery rate assumption framework, which has been changed to reflect the significant compression in recovery rates in the high yield debt market in 2009.

High yield defaults in 2008 and 2009 highlighted the pro-cyclical nature of defaults and recoveries. Fitch recognised the importance of this pro-cyclical relationship in its previous criteria report update in April 2008, explaining that it benchmarked historical peak default rates to its single-A rating stress scenario.

In its updated criteria, Fitch has extended this benchmarking application to its recovery rate assumptions due to the exceptionally low recoveries recently recorded. The agency has therefore reduced its recovery assumptions in rating stress scenarios of triple-B and above.

Elizabeth Nugent, a New York-based senior director in Fitch's structured credit group, says: "More closely aligning Fitch's recovery rate assumptions with historical data makes the agency's rating criteria more transparent for investors and will produce more robust high investment grade ratings."

CDO

Revised criteria impacts Trups CDOs

S&P has lowered its ratings on 63 tranches, with a total issuance amount of US$8.84bn, from 25 US Trups CDOs and removed them from credit watch negative. At the same time, it affirmed the rating on Alesco Preferred Funding XIV and removed it from credit watch negative.

Under the rating action, 12 Alesco Preferred Funding, seven Preferred Term Securities, two Trapeza CDO and the InCaps Funding II deals were affected. S&P says the move reflects three primary factors: the application of its updated corporate CDO criteria; the application of its revised recovery assumptions for trust-preferred securities issued by US banks (SCI passim); and in most cases, significant deterioration in the credit quality of the underlying asset portfolios, due to increased exposure to obligors that have either defaulted or deferred payments on trust-preferred securities, along with an increase in the number of trust-preferred securities that experienced downgrades into the triple-C range.

While the rate of increase in the number of deferrals may have recently slowed, in S&P's view, the economic and regulatory conditions at the root of these deferrals continue to unfold.

The affirmation reflects the agency's view that the tranche has sufficient credit support to maintain its current rating according to its updated criteria.

CDS

Japan set for CDS clearing

Japan Securities Clearing Corporation (JSCC) is to introduce a clearing function for OTC derivatives trades, initially for credit default swaps and interest rate swaps.

With regards to CDS, on 19 May 2010 the financial instruments and exchange act was amended to mandate the use of a domestic central clearing institution for CDS by November 2012. To provide clearing services for CDS trades promptly, JSCC has decided to introduce CDS clearing ahead of IRS trades. The Corporation will continue discussions on detailed operational procedure and other related matters with major market players to commence CDS clearing in the second quarter of 2011.

Meanwhile, JSCC says it would be useful to create a link with LCH.Clearnet for the provision of IRS clearing.

The move follows the establishment of a working group on clearing operations for the sector between Tokyo Stock Exchange and JSCC on 22 May 2009.

CDS

Bankruptcy credit event determined

ISDA's EMEA Determinations Committee has resolved that a bankruptcy credit event has occurred in respect of Truvo Subsidiary Corp, a Delaware corporation that is part of the Truvo Group, which publishes print and online directories. The Committee also voted to hold an auction for Truvo. The firm filed for Chapter 11 protection on 1 July.

Meanwhile, Mitsubishi UFJ Morgan Stanley has requested that ISDA's Japan Determinations Committee rule on whether a succession event occurred with respect to Nippon Oil Corporation. Nippon Oil Corporation and Nippon Mining Holdings last Friday incorporated JX Holdings through a share transfer. JX Holdings shares were newly listed on the Tokyo Stock Exchange, Osaka Securities Exchange and Nagoya Stock Exchange.

The move follows the postponement of a resolution on whether a succession event occurred with respect to Mitsubishi UFJ Securities Co, pending further research by the legal sub-committee for the Japan region. Mizuho Securities Co asked the DC to determine whether a succession event occurred following Mitsubishi UFJ Securities' preparations regarding its planned strategic alliance with Morgan Stanley. The firm has adopted an intermediate holding company structure and a preparatory spin-off company.

CDS

OTC collateralisation best practices issued

Best practices for the OTC derivatives collateral process have been published by ISDA. The collateral management proposals were drafted by a committee of buy-side and sell-side market participants.

"ISDA continues to harmonise practices between market participants in an effort to mitigate risks, set expectations and establish further market standards," says Julian Day, ISDA head of trading infrastructure. "The best practices for collateral are the latest in a series of industry efforts by collateral professionals to enhance the collateral management practice."

The best practices focus on OTC derivative trades collateralised on a bilateral basis under the ISDA English and New York law credit support annexes and English Law credit support deed agreed between two parties. The latest guidance follows earlier contributions by the industry, such as the 2009 recommended practices for collateralised portfolio reconciliation, standards for the electronic exchange of OTC derivative margin calls, 2010 market review of bilateral collateralisation practices and the Independent Amount Whitepaper (see SCI issue 175).

CDS

Platform to increase OTC derivatives transparency

In response to the prospect of increased OTC derivatives regulation, Bloomberg is offering a new valuation service designed to bring transparency. The new Bloomberg Derivatives Valuation Service, an extension of Bloomberg Valuation Services (BVAL), offers end-of-day valuations and risk measurements for OTC derivatives and structured products as well as over six million publicly available securities including bonds, mortgages and equities.

The new service offers pricing for derivatives and structured notes of all levels of complexity. It is fully integrated with the additional analysis tools on the Bloomberg ProfessionalR Service.

"Bloomberg is uniquely positioned to help the financial community better manage its derivatives positions. Our new OTC derivatives valuations provide unparalleled independence, expertise and transparency so critical to investment and risk professionals, regulators and investors," says Tom Secunda, founding partner of Bloomberg and head of the financial products and services division.

Bloomberg's new service uses market-standard quantitative models and a data portfolio that taps advanced validation and cleansing techniques. Users can access their evaluated positions via end-of-day data files and a dedicated portfolio manager on the Bloomberg Professional Service.

"The increasing sophistication of the global marketplace, combined with increasing regulation, means that financial professionals, government agencies and regulatory bodies must have pricing tools that are accurate, reliable and defendable, so they can generate accurate portfolio and risk measures," says Jean-Paul Zammitt, global head of core product development in Bloomberg's financial products and services group.

CLOs

Indian microfinance deal completed

IFMR Capital has completed its second securitisation with Bengaluru-based microfinance institution, Grameen Financial Services Private (previously Grameen Koota). This is IFMR Capital's sixth microfinance transaction as a structurer, arranger and primary investor.

The Rs311.5m securitisation pooled over 27,000 microloan contracts originated by Grameen Koota, issued via the Alpha Pioneer IFMR Capital 2010 SPV. The securities were issued in two tranches, with the P1+(so) rated senior tranche being subscribed by a large Indian mutual fund and IFMR investing in the P4+(so) subordinated tranche.

With this deal, funding facilitated by the Chennai-based firm for the microfinance sector has reached about Rs3bn.

CLOs

Landmark CDO warning issued

Moody's has downgraded the ratings of two tranches of notes issued by Landmark CDO. The rating agency says the move reflects its concerns about a potential event of default.

Landmark CDO, issued in July 2001, is a CLO backed primarily by a portfolio of senior secured loans and managed by Aladdin Capital. In its latest review of the deal Moody's warns of a potential shortfall in the amount of cashflows available to pay the current interest due to the class C-1 and class C-2 notes on the next few payment dates.

"Under the terms of the indenture, a missed interest payment on the class C-1 and C-2 notes, currently the most senior notes in the capital structure, will trigger an event of default, which may then lead to subsequent acceleration and liquidation of the collateral," the agency explains.

Moody's analysis is based on the latest trustee report dated 19 May, which reports the class C interest coverage test at 47.18%, failing the trigger level of 130%. Given a limited amount of scheduled principal maturities over the next six payment periods, interest payments due to the class C-1 and class C-2 notes in the near term will be heavily reliant on principal prepayments on, and/or sales of, the underlying collateral.

The agency also notes that the portfolio includes a large number of investments in securities that mature after the maturity date of the notes. Based on the May 2010 trustee report, such securities represent 33.66% of the underlying portfolio. These investments potentially expose the notes to market risk in the event of liquidation on or before the notes' maturity.

The US$10m class C-1 third priority floating rate notes due 2013 (current outstanding balance of US$9.4m) and the US$16m class C-2 third priority fixed rate notes due 2013 (current outstanding balance of US$15.2m) have both been downgraded to Ba1 from Baa2. Moody's says it has retained the ratings of both classes of notes on review for possible downgrade as it monitors actual developments relating to the risk of missed interest payments and/or potential sales of collateral prior to their maturities.

CMBS

US CMBS delinquency rate moderating?

The delinquency rate for commercial real estate loans in US CMBS showed signs of moderating in June, according to the latest Trepp Monthly Delinquency Report. Although the rate increased by 17bp, it remains the best reading since July 2009.

"For the nine months prior to June, the rate of increase in delinquencies averaged 39bp per month (after backing out the Stuyvesant Town impact in March). The lowest increase prior to June was February's 23bp jump," Trepp explains.

The overall delinquency rate in June for loans 30 or more days delinquent, in foreclosure or REO reached 8.59%. However, the increase for seriously impaired loans was significantly higher than the headline number, jumping by 28bp - albeit this is a marked improvement over May's 41bp increase.

Analysts at Trepp note that if defeased loans were taken out of the equation, the overall delinquency rate would be 9.15% - breaking the 9% threshold for the first time.

US CMBS spreads fell sharply in June after widening significantly in May. Overall, spreads tightened by 50bp to 60bp during the month for recent vintage super-senior bonds.

According to Trepp, June was particularly good for bonds from vintages 2004 and earlier. Many single-A bonds from those vintages are now trading above US$90 - double the price from a year ago in some cases. The market was buoyed by the emergence of new issuance and the refinancing of some large trophy property assets, the analysts note.

CMBS

REIT refinances Grand Central Mall

Glimcher Realty Trust has closed on a ten-year, US$45m mortgage loan secured by Grand Central Mall in Parkersburg, West Virginia. The loan has been originated by Goldman Sachs Commercial Mortgage Capital and structured for sale in the CMBS market.

The new loan has a fixed interest rate of 6.05%. Proceeds were used to retire the US$39.3m secured mortgage debt, which had been scheduled to mature in February 2012, and reduce outstanding borrowings on the company's credit facility.

"This refinancing represents our third CMBS loan since the market re-emerged earlier this year," says Mark Yale, Glimcher evp and cfo. "With all of our scheduled 2010 debt maturities already addressed, we viewed this as an opportunity to secure attractively priced capital to replace shorter-term, recourse financing that was in place on the property."

CMBS

Euro CMBS servicers under increasing pressure

Fitch says that European CMBS servicers will come under increasing pressure as the volume of loans reaching their scheduled maturity dates continues to rise with little improvement in maturity outcomes. Maturity outcomes vary significantly by servicer, as do maturity profiles, the rating agency notes.

"On one side of the spectrum you have the captive servicers, which show extremely positive maturity outcomes," says Gioia Dominedo, senior director in Fitch's European CMBS team. "Royal Bank of Scotland, for example, has only seen one loan mature to date, with a successful refinancing, and has no further loans scheduled to mature until 2011. Barclays Capital Mortgage Servicing also shows a strong trend, with a successful repayment of nearly 90% of its matured loan balance, representing all but one of its matured loans."

Third-party servicers show more mixed outcomes, however. Charlotte Eady director in Fitch's CMBS team says: "Fourteen loans serviced by Capita Asset Services have matured to date and 91% of this balance has not yet repaid. Of the outstanding loans, maturity outcomes are split across extensions, workouts and standstills. A similar situation exists with matured loans serviced by Hatfield Philips International: all but one of these are still outstanding, with just over half going through a workout process."

The 36 outstanding matured loans represent just under 5% of European CMBS loans, according to Fitch. With the number of maturing loans increasing to 54 in H210 and 143 in 2011, and new bank lending remaining tight, the agency expects servicers to come under increasing pressure.

Constant Proportion technology

Short- and long-term CPDO risks assessed

Moody's has taken various rating actions on five CPDO transactions, reflecting its latest assessment of the evolution of the short- and long-term risks of the deals in the recent spread environment. Approximately US$125m of debt securities are affected in the move.

The SURF CPDO Series 2, Thebes Capital Series 2007-1 and Cairn CPDO I Finance Series B1-U1 Turbo notes have been downgraded. The R-Evolution transaction has been upgraded, while ratings on the Thebes Capital Series 2007-2 deal have been withdrawn following the buy-back of the notes. Moody's rating on Cairn CPDO I Finance Series B1-U1 Turbo will also be withdrawn shortly because the notes have been cancelled in accordance with their terms.

In its rating decisions, Moody's has placed varying weights on the short-term risk and long-term risk in these transactions as the spread environment changed over the past two years. The rating agency characterises short-term risk as the possibility of a cash-out event resulting from a significant spread widening over a short period of time.

Long-term risk is characterised by the failure of a CPDO transaction to repay principal and interest due at or before maturity, whether it is due to spreads widening or other events occurring during the life of the transaction that may erode its net asset value (NAV). Other events may include defaults, mark-to-market losses incurred upon rolling the portfolio or the underlying obligors paying a spread too low to cover costs.

Using the frequently reported data on the NAV of the referenced portfolio, the level of cash, the risky duration, the coupon and the swap spread in these transactions, Moody's has calculated the long-term risk measure to be the sum of the marked-to market value of the swap, the cash deposit and the estimation of the proceeds over the remaining life of the transaction less an estimation of the interest costs over the life of the transaction. This measure is used as a proxy for the expected principal at maturity and the use of this measure replaces a more detailed modelling of the future evolution of the NAV from the current level, under specific scenarios that depend on the target rating of the CPDO notes.

Moody's has observed during the recent credit crisis and dramatic spread volatility in 2008 and 2009 that the short-term risk component is a dominating factor in assessing the credit risk of CPDO notes in a volatile spread environment. In the meantime, the long-term risk measure can also be subject to significant volatility, due to the high leveraged nature of these transactions.

After reviewing the historical values for the long-term measure of these transactions, the agency has determined to give some limited benefit to those cases where the value of the long-term measure is above 100% so that ratings fall in the Ba range. For those cases where the value of the long-term measure is below 50%, the ratings would fall in the Caa range. The ranges of possible ratings based on the long-term measure are then used in combination with the rating levels associated with a transaction's short-term spread widening that would trigger a cash-out event in Moody's final rating assessment for these transactions.

In particular, it notes that the R-Evolution transactions currently have a long-term measure of above 100% and can also withstand a short-term spread widening that is consistent with a Ba rating, contributing to an upgrade to Ba3. On the other hand, Surf CPDO Series 2 and Thebes 2007-1 have a long-term measure that is valued significantly below 50%, contributing to a one notch downgrade to Caa2.

Emerging Markets

Aircraft sukuk prepped

Nomura Holdings intends to issue a US$100m two-year sukuk. The bank has appointed Kuwait Finance House (Malaysia) Berhad (KFHMB) as the mandated lead arranger, while S&P has assigned the issuance a preliminary rating of triple-B plus.

"This issuance is part of Nomura's ongoing push to diversify its funding sources to drive growth. Islamic investors and Islamic finance are a very important and rapidly growing sector globally and this transaction is highly significant for Nomura and for corporate Japan," says Takumi Shibata, Nomura Holdings deputy president and coo.

He adds: "Nomura has now opened the way for other Japanese corporations to tap the Islamic finance market and we believe that the transaction will lead to significant benefits for Nomura and for our clients and partners."

The sukuk's assets primarily consist of ownership interests in aircraft assets and rights under the associated lease agreements. NBB Ijarah (NBBI), the special purpose company, will sell its legal interests in two aircraft assets to the trustee and act as servicing agent for the transaction. Nomura will unconditionally guarantee all of NBBI's obligations to the trustee.

"Nomura's guarantee will rank pari passu with the company's other senior unsecured obligations and underpins our equalisation of the rating on the certificates with our long-term counterparty credit rating on Nomura," says Allan Redimerio, S&P credit analyst.

Only two aircraft are involved in the proposed transaction, making the possibility of total loss relevant. Should total loss occur, any shortfall between the required insurance coverage amount and actual insurance proceeds will be the obligation of NBBI and thus come under Nomura's guarantee.

"Other factors that partly mitigate the small number of assets in the transaction include the ability of the transaction to replace a damaged aircraft and the short tenor of the transaction," Redimerio adds.

Regulation

Call for accounting boards to agree on fair value

The proposals issued by FASB and IASB last week, aimed at converging rules for measuring fair value and enhancing related financial statement disclosures, are expected to benefit investors' efforts to assess risk (see last issue). But Moody's points out in its latest Weekly Credit Outlook that although the proposed rules will align the boards' definitions of fair value, the two camps' significantly divergent views on the anticipated utilisation of fair value for financial instruments will limit the proposals' effectiveness at converging US and international accounting standards.

The FASB's current rules on fair value measurement have been in place since 2008 with some revisions. The IASB last year proposed fair value rules that are expected to be finalised in the first quarter of 2011. As part of their ongoing efforts toward convergence, the boards have been working to ensure that fair value has the same meaning in US GAAP and its international counterpart International Financial Reporting Standards (IFRS) and that their respective disclosure requirements are consistent.

Included in the proposals are the following disclosure requirements:

• The FASB would require more information on the uncertainty inherent in fair value measurements of assets classified as Level 3. This is similar to a requirement already included under IFRS, of which the IASB is proposing further refinements in its latest proposal.
• Reporting entities would be required to disclose their use of an asset in a way that differs from the asset's "highest and best use" as determined in a valuation.
• Firms would be required to disclose the level in the fair value hierarchy (Level 1, 2 or 3) for items that are not carried at fair value on a balance sheet, but for which the fair value of such items is required to be disclosed elsewhere in the financial statements.

"The proposals would align fair value measurement guidance and represent an achievement on the overall path to convergence. The significance of this achievement is tempered somewhat by the realisation that although fair value measurements may be aligned, the boards differ significantly on which financial instruments should be carried at fair value," Moody's explains.

The boards' recent financial instrument proposals differ in the treatment of loans and other financial instruments. The FASB proposes nearly all financial instruments be carried at fair value on the balance sheet, whereas the IASB's proposal retains the use of amortised cost for instruments with contractual maturities for which the entity's business model is to hold to maturity. Unless the boards can agree on the usage of fair value, the standardisation of its definition will be of only minor importance in the effort to converge global accounting standards, Moody's warns.

RMBS

Increased convexity demand in CMOs

A drop off of interest-only and principal-only (IO/PO) bonds has occurred in new issue CMOs from the beginning of the year, according to MBS analysts at Wells Fargo. In a research note, they explain that during the month of May new deals consisted mostly of floaters, PACs, accretion-directed and other bonds.

The reasons for the trend could be that investors are demanding floating rate paper in anticipation of higher short-term interest rates and a generally defensive posture, the Wells Fargo analysts note. "We believe that the increased issuance of PACs and accretion-directed certificates may signal that investors are anticipating slower prepayments and wish to have added extension protection."

They further note that in the first three months of the year, Ginnie Mae collateral represented the majority of REMIC issuance, while the past two months have marked a shift to most of the collateral being sourced from Fannie Mae. As of May, the most common coupons backing the new 30-year issuance was 5%, 5.5% and less than 4% net coupon collateral.

RMBS

FHFA releases GSE conservatorship rules

The Federal Housing Finance Agency (FHFA) has proposed rules on the conservatorship and receivership operations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The rules will be open to comment 60 days after being published in the Federal Register.

Similar to the provisions in the FDIC's rules, the FHFA rule seeks to address the status and priority of claims, the relationships among various classes of creditors and equity holders, as well as the priorities for contract parties and other claimants under conservatorships or receiverships.

It specifically clarifies that all claims arising from an equity interest in a regulated entity in receivership would be given the same treatment as the interests of shareholders. It also points out "that the powers of the conservator or receiver include continuing the missions of a regulated entity and ensuring that the operations of the regulated entity foster liquid efficient, competitive and resilient national housing finance markets".

Edward DeMarco, acting director of FHFA, says: "This regulation is designed to provide clarity to the regulated entities, creditors and the markets."

RMBS

Alt-A transactions assessed

Fitch has reviewed all its alt-A transactions and taken rating actions on 760 of them. Total average expected mortgage losses have not changed much from its review a year ago, although some individual pools had significant loss revisions. In addition, home prices are expected to fall by a further 10%.

From the 1,371 classes rated triple-A before the review, 93% were issued before 2005. Of those triple-As, 94 (7%) were downgraded. Meanwhile, ratings have been withdrawn on 848 interest-only (IO) classes under a new rating policy announced last month (see SCI issue 190).

Loss severity assumptions on liquidated loans range between 50%-60% for most pools. The average updated expected collateral losses as a percentage of remaining pool balance are 5% for pre-2005 deals, 13% for the 2005 vintage, 22% for the 2006 vintage and 26% for the 2007 vintage.

Although average expected mortgage pool losses were mainly in line with loss assumptions from 2009, a number of individual transactions deteriorated quicker than anticipated and were downgraded. Almost 90% of downgrades affected classes already rated below single-B.

Some transactions have performed better than expected, but none have been upgraded because of the general volatility of the collateral performance and remaining risk in the housing market. Fitch says classes rated single-B minus or higher may be upgraded in the future if current performance trends continue.

The projected mortgage losses reflect the agency's belief that house prices will drop by 10% over the next year, starting from Q210. The agency says the large number of unresolved distressed loans will continue to negatively affect home prices and distressed property liquidations are expected to increase as borrowers fail to have their loans successfully modified.

Serious delinquencies increased to approximately 26% from around 20% at the time of the last rating review. The roll-rates from performing-to-delinquency have improved notably in recent months, but some of that improvement is likely due to seasonal factors and recent modification activity.

RMBS

Majority of non-bank Aussie RMBS remain unredeemed

S&P observes that 13 out of the 51 outstanding Australian prime RMBS transactions backed by housing loans of non-bank originators have passed their documented call dates and remain unredeemed. This contrasts with the experience prior to the global financial crisis, when almost all Australian RMBS were redeemed on reaching the call dates.

"While the housing loan portfolios underlying Australian RMBS have performed steadily and the ratings on RMBS remained stable through the global financial crisis, the unfavourable market conditions have affected non-bank originators' ability to fund new loans as well as refinance their RMBS on documented call dates," says S&P credit analyst Vera Chaplin.

S&P says it assigns ratings to RMBS assuming that the call date option is not exercised and the notes amortise through to their legal final maturity dates. Most investors, however, generally expect that the notes would be redeemed on the call dates, which often reflect the weighted-average life calculations for the securities.

Ratings

The unrecognised and unaddressed ratings issue

Malay Bansal, md at NewOak Capital, suggests that credit rating agencies' activities should be separated into two distinct roles

The most important and the most basic issue related to ratings and rating agencies has not been recognised or addressed in reforms announced so far. Here's a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.

Rating agencies have been criticised heavily by many for their role in the US financial crisis, in particular over conflicts of interest and their failure to recognise the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.

The US Congress, after resolving the differences between the House and Senate versions last month, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals.

The bill directs the SEC to conduct a two-year study to determine if a board overseen by the SEC should be set up to help pick which firms rate asset-backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company 'knowingly or recklessly' failed to conduct a 'reasonable' investigation before issuing a rating). The compromises are better than the extreme versions of proposals, even though it means that the proposed regulations may not do much to change how the agencies operate.

Earlier, in mid-April, the SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.

The SEC also promulgated Rule 17g-5, which went into effect on 2 June, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognised statistical rating organisations (NRSROs). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products.

To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.

None of these changes are radical overhauls or even proportionate to the amount that Calpers has sued the three major bond rating agencies for - US$1bn - in losses it said were caused by markets reacting violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries.

Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody's. Greece had been 4% of that index but was excluded starting on 1 May, due to S&P's downgrade. That, in turn, likely forced selling from investors tracking that index.

Critics assailed rating firms for fuelling woe in Europe and Europeans criticised debt rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.

There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting a lower rating.

The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle, increasing the likelihood of default.

The downgrade reflects a rating agency's opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury and the hangman for the company.

The real problem that has not been recognised
In the current system, the rating agencies' opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment and do not have any special powers of predicting the future.

Their failures in predicting subprime mortgage performance have been appalling. But, even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome and the predictions themselves change over time, as they should.

So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?

The answer lies in recognising the real problem - one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one.

The first role is to provide a rating based on statistical analysis and past performance of the assets - remember that SR in NRSROs stands for statistical ratings. The second role is that of a research analyst to provide an opinion on what might happen in the future.

Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future.

This allows rating agencies to downgrade companies or countries, even while they are in the process of attempting to improve their financial condition. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in the ratings process that creates perceived conflicts of interest in issuer paid ratings.

The solution
The logical solution is to separate the two roles. NRSROs should be doing statistical ratings - based on past performance of assets, known facts, events that have already taken place and statistical models and methods that are well disclosed.

They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade until the event actually happens. So they will not be precipitating events and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role and should be open to any research provider, including NRSROs. These credit ratings could be designated as 'informational ratings', without any legal or official role impacting investor charters and debt covenants, which will only use the ratings designated as NRSRO ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started - as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.

The conflict of issuer-paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose), which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers, even though the agencies will be indirectly paid by the issuers.

The NRSRO rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.

For more qualitative information and opinions, investors will look to the informational ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivise them to compete with others for investor subscriptions and produce quality results.

Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where it's needed, while encouraging the investors to do more work on their own and look for third-party unbiased research and opinion.