Contents

Regulation

Long road ahead

Loopholes remain in GSE reform proposals

Amid what works and doesn't work in reforming the GSEs, one thing remains certain - the US government's firm grasp over the entities is not likely to loosen anytime soon. But whether that remains at an arm's length or not is open for debate.

"When you look at the liquidity function the GSEs apply to the market, in a distressed market, we think policymakers are very reluctant to try to take away what is effectively working in the market," said Ken Bruce, director of specialty financial services at Bank of America Merrill Lynch, on a conference call last week. He expects the government will still run the GSEs, with policymakers determining what level of subsidy they will provide.

Indeed, when all the smoke clears, the government guarantee or wrap on the GSEs is what will likely remain. "The administration will look to pursue a structure that really tries to retain the valuable liquidity features of the government-backed MBS market," Bruce added.

David Min, associate director for financial markets policy at the Center for American Progress (CAP), agrees. "We had something close to a private market in this country prior to 1930s, but what happens is the tail risk is too long for private capital to really come in and fill the housing needs of the country," he says.

From solely government-run institutions to cooperatives and utilities, the future of the GSEs could take many forms. Staff members at the Federal Reserve Bank of New York maintain that a "private lender cooperative utility may provide the best overall solution", according to a paper put out earlier this month. Since cooperatives typically seek to provide a service to their members, with losses and gains shared, it would seem to be a plausible scenario.

They say each member should be required to provide equity capital to the cooperative. Specifically, members' contributions to the mutualised loss pool would depend on the volume of mortgages securitised.

Only members would be eligible, however, to sell mortgages to the securitisation cooperative. It goes without saying that each member would hold an equity stake in the coop.

According to one MBS investor that backs the coop idea, the GSEs should be designed as more of a public utility; for instance, like an electricity company. "The easiest way to transfer risk is to make it more like a utility, which is why electricity doesn't cost that much a month," he says. "With Fannie and Freddie, there was way too much of the subsidy going to the shareholders and not to the homeowners."

But not all are in favour of the coop or utility plan. "I'm not sure if a cooperative-based entity that buys insurance from the government is the right answer or whether it has its own set of problems. For example, does it tend to limit the number of participants in the mortgage market, since you have to buy into this cooperative in order to get the insurance. That would seem to put more systemic risk on those entities that can afford to do it," notes Jeremy Diamond, md of Annaly Capital Management.

Min also questions the coop model's membership design. "They are good for some purposes and bad for others. The inherent member-owned structure tends to be pro-cyclical if those members are banks or other financial institutions. A coop structure is less likely to have a lot of losses, but it strikes me as a poor public policy structure," he adds.

Talk has also emerged about combining Fannie Mae and Freddie Mac into one entity. Such a combination could help ease the financial burden somewhat, since both are in dire need of reform. Just last week, Freddie Mac asked for an additional US$1.8bn from the US Treasury, which was on top of asking for an additional US$10.6bn last May.

With or without any combination of the entities, there is likely to be an intense revamp of the GSEs' portfolios, which are likely to be very curtailed or limited. As the MBS investor notes, the GSEs should have either no portfolio or some sort of backstop portfolio.

Underwriting is also a crucial area of reform. "Underwriting standards (and whatever replaces the current housing system, if indeed there is a replacement) have to be at first and foremost part of the incentives that are set up. Clearly there was a disincentive to good underwriting during the bubble years," Diamond notes.

Despite the Treasury-HUD discussions this week and the House Financial Services Committee meetings slated for September, talks are likely to be long and arduous (see also separate News Round-up story). Actual reform is still likely to be about 5-10 years away, noted Chris Flanagan, head of securitisation research at Bank of America Merrill Lynch on its call.

"This process that is starting is largely irrelevant to today's MBS market. Most of the mortgages that are outstanding today will eventually be extinguished by the time any meaningful change is introduced to the housing finance system in the US," he said.

But to some the housing system is still salvageable. "The misalignment of incentives led to a lot of the problems that we are dealing with now," says Diamond. "But if you can correct those incentives in some way, you will go a very long way to a housing finance system that is stable and equitable and protects the tax payer."

KFH

CMBS

Taking control

New structural features boost US CMBS

A pair of new US CMBS transactions priced over the last fortnight (see also last issue). The structural innovations of one in particular - the US$788m GSMS 2010-C1 - caught the market's attention.

The GSMS 2010-C1 deal, via Goldman Sachs and Citi, showcases a change-in-control feature whereby the most junior investor no longer has the ability to appoint or direct the actions of a special servicer in the event of an underlying loan becoming distressed. This right is conveyed from the outset to the most senior certificateholders, who are the largest investors in the transaction.

In addition, the CMBS features a cap on special servicing fees, a new application of modification fees and the introduction of an operating advisor to consult with the special servicer on major decisions on behalf of all the certificateholders. The arrangers have also made available a deal website that provides the status of and updates on specially serviced loans.

"Goldman Sachs has the right idea about giving triple-A CMBS noteholders more control in distressed periods," says Amy Levenson, md at NewOak Capital. "They are the most senior notes and receive the least amount of risk compensation, and this is exactly how CMBS should have been structured all along."

She points out that triple-A CMBS noteholders traditionally receive significantly less risk compensation than the lowest rated tranches receive because they are supposed to be taking less risk. Yet, when a CMBS loan begins experiencing delinquencies, each party has a diametrically opposed motivation in how to treat the underlying asset. By giving senior noteholders more control in such circumstances, the transaction is leading the way for a fairer structure going forward, Levenson notes.

Analysts at Annaly Capital Management suggest that these changes reflect the balance of power in the CMBS sector. "First, structurers are clearly listening and reacting to investors' concerns about control features and special servicing, as worst-case outcomes have pushed the envelope of the traditional structures and found them wanting," they explain. "Of course, time will tell whether these new control features represent a better solution for dealing with problem loans and the resultant conflicts. Second, there is significant demand for the higher yielding opportunities of the mezzanine and junior tranches."

However, MBS strategists at Deutsche Bank note that while giving triple-A investors the majority of control should all but eliminate the potential misalignment of interests between market participants, effectively stripping control rights from B-piece investors could have an adverse impact on the marketability of future transactions. "Currently, with a relatively limited supply and strong demand, this issue in isolation is not likely to have a material impact, but assuming the new deal pipeline continues to grow, the market might have a hard time finding enough B-piece buyers willing to participate without some control rights."

The Deutsche Bank strategists indicate that the additional layer of an operating advisor could also lead to some delays in the decision-making process. In addition, they view the cap on special servicing fees at US$125,000 for loans with an unpaid principal balance under US$25m and US$300,000 for all others as a slight negative.

"If fees are capped, special servicing rights become much less valuable and could lead to a degradation of service," they explain. "In our view, a better approach would be to provide servicers a small fixed fee at the time of transfer and then have a variable fee that would be tied to the length of the workout and the type. This approach would reduce the incentive to keep loans in special servicing longer than is necessary and the higher level of transparency from the new disclosures would give investors an enhanced ability to spot abuses."

The GSMS 2010-C1 structure builds on control features that were introduced in June with the JPMCC 2010-C1 CMBS (SCI passim), according to the Annaly analysts. This deal initially granted approval rights to the B-piece buyers, thus establishing change-of-control abilities at the outset and limiting them to subordinate investors.

A change-of-control occurred not only with realised losses, but also with unrealised losses through appraisal reductions. The latter mechanism enabled the removal of 'zombie' entities that had no further economic upside by holding the position.

Finally, a 'control event' concept was introduced, which means that if losses wiped out the initial B-piece buyers and junior participants then a new directing certificateholder would then be selected by senior certificateholders. This served to align the remaining economics of the deal with the senior certificate holders, the majority of which would be at the triple-A level.

Such changes, combined with the launch of the new transactions this month, prompted S&P to publish a report claiming that the US CMBS market is slowly coming back to life. The rating agency points to other key changes that have taken place in the sector since October 2009, including: new transactions consisting of smaller pools, larger loans, fewer bond classes and primarily of retail properties; issuers using either a bifurcated interest-only class or none at all; underwriting and loan structuring standards becoming stricter and cash management features becoming tighter; and borrowers taking more responsibility for additional trust expenses.

"Toward the end of last year, we believed that, while the CMBS market was facing an uphill battle heading into and through 2010, it still had a pivotal role to play in the commercial real estate sector," says S&P credit analyst Brian Snow. "And we still believe this today."

The agency believes that the retooling of the CMBS market will be an ongoing process. This is due to market constituents continuing to experiment with new investor-friendly provisions, while balancing investor preferences with CMBS loan borrowers' practical and economic requirements. Nevertheless, the changes that the sector has already incorporated are the first steps toward greater stability in the future, it states.

Rated by DBRS and Moody's, GSMS 2010-C1 comprises US$232m 4.96-year AAA/Aaa rated class A1 notes (that priced at 125bp over swaps), US$410.62m 9.86-year AAA/Aaa class A2s (135bp over), US$27.6m 9.9-year AAA/Aa2 class Bs (190bp), US$35.48m 9.9-year AA/A2 class Cs (265bp) and US$35.48m 9.9-year BBB(high)/Baa3 class Ds (400bp). All tranches priced tighter than guidance, except the class D notes.

The other US CMBS to price recently is the US$660m Vornado DP Trust 2010 through JPMorgan. Rated by S&P and Fitch, this consists of US$140m triple-A rated class A1 notes (that priced at 110bp over swaps), US$304.3m triple-A class A2 fixed rate notes (120bp over), US$60m triple-A class A2 floating rate notes (135bp over Libor), US$38.7m double-A class Bs (195bp), US$57m single-A class Cs (250bp) and US$60m triple-B minus class Ds (360bp). The A1 notes have a 5.5-year WAL, while the remaining classes have a 10.1-year WAL.

CS

Legislation and litigation

Non-agency MBS alternative?

US covered bond developments debated

Congress is set to debate the Covered Bonds Act next month - a move that has been welcomed by investors looking for an alternative to non-agency RMBS. However, issuers appear to be less convinced about the development of a covered bond market in the US.

According to one RMBS investor, it's premature to expect the buy-side to re-enter the US private label RMBS market because it remains tainted by subprime associations. "Rather, the industry should be focusing on establishing a decent covered bond market. The product requires banks to retain the risk on their books and that's what investors want to see at the moment," he remarks.

Jerry Marlatt, senior of counsel at Morrison & Foerster, agrees that investor appetite for non-agency RMBS is extremely limited at present. In contrast, covered bonds look attractive because they offer dual recourse to the underlying assets and the issuing bank, and the assets are refreshed every month. This is evidenced by the more than US$15bn in covered bonds issued into the US market this year by foreign banks.

"Covered bonds are a more secure investment than RMBS," he notes. "Additionally, prepayment speeds are a significant factor in RMBS pricing, but you don't see this in covered bonds."

Steven Miller, partner and md at Odeon Capital, says he understands why investors would currently prefer covered bonds over structured deals in the US. But he points out that from an issuer's perspective, a traditional RMBS structure both addresses customer needs and generates income via fees. In comparison, covered bonds arguably limit issuers' ability to manage their investible cash.

Additionally, while most RMBS qualify for off-balance sheet treatment, covered bonds are held on-balance sheet. "This dictates how much capital an issuer retains and, therefore, how much they have to charge a consumer to compensate for it," Miller explains. "Ultimately, I believe the lack of a fully-functioning RMBS market will drive up the cost for consumers and so we need to come up with viable alternatives until it returns. Covered bonds go some way towards this, but they aren't a replacement."

From an issuer's perspective, the all-in cost of funds determines whether they opt for a securitisation or a covered bond, Marlatt concurs. Bank of America and Washington Mutual issued covered bonds in 2006, but no other US transactions have been issued since then partly because of the financial crisis and partly because the existing structure is expensive.

Under the existing structure, the entire collateral pool has to be liquidated immediately if a bank becomes insolvent, with the decision about alternative reinvestment made at issuance. Marlatt points out that it's hard to find an entity willing to take up to US$20bn of assets at one time and so the reinvestment collateral has to be low yielding. Consequently, the difference between the low yield and the bond's coupon has to be made up with swaps, which are typically off-market and thus expensive.

Another issue with covered bonds is the uncertainty around what the FDIC will do in an insolvency. It can find another bank to take over the bonds; repudiate the bonds; or take no action and allow a payment default, which means the trustee can foreclose.

Nevertheless, the adoption of a statute is expected to facilitate covered bond issuance in the US. The Covered Bonds Act is likely to be debated by the House in September (see separate News Round-up story). It provides for a more typical European structure, whereby the cover pool is separated from the bank in a bankruptcy and therefore doesn't have to be liquidated or reinvested.

But whether a flood of covered bond issuance occurs as a result is debatable. "Covered bonds in the US to date haven't had strong political backing: the current focus on the bill is more of a technical movement," explains Marlatt. "Many participants believe that covered bonds would be a helpful financing alternative in the US and support is slowly developing among smaller regional banks that need to fund their commercial mortgage portfolios, for example."

Miller adds: "The real issue is that there has been a breach of faith among all constituents in the US RMBS market, with good reason. So, the question is how to restore trust in this market?"

He suggests that this process needs to begin on a macro basis by creating an economic environment where house prices stop sliding. Once the housing market has stabilised, the next step is to introduce accurate, high quality reporting.

"Private label RMBS continue to pay down - either by voluntary prepayments or defaults - meaning that there is dramatically less paper outstanding each year, yet a significant number of investors need to be invested in the sector. It is the only mortgage sector where people are finding value at the moment," Miller observes.

Elton Wells, head of SecondMarket's structured products group, indicates that concerns about a double-dip recession are preventing the private label RMBS market from returning just yet. He believes that activity in the sector could have potentially restarted before the Greek volatility began, however.

"Originators realise that simpler structures, better collateral and underwriting standards, and greater credit enhancement are necessary in the post-crisis non-agency RMBS sector," he concludes. "A couple of deals have been completed privately this year - such as the Kondaur Capital transaction - which have enough credit enhancement and a decent spread. But investors generally remain cautious on the sector and will continue to do so until unemployment figures begin improving."

CS

Advisory

Independent insight

New service to address audit and corporate governance issues

As the degree of challenge that auditors and financial institutions' audit committees are able to bring to in-house valuations of complex securities is being questioned, Green Street Capital believes it can provide the market with a solution. The advisory firm has launched a new independent valuations service for structured credit investment portfolios.

Green Street says its new service is needed by the market because auditors have not been challenging management's decisions enough. It intends to provide an additional pair of eyes, working alongside audit committees or external auditors to provide independent valuation analysis.

Dean Atkins, a principal of Green Street Capital, explains: "The focus of this new venture is really on adding some independence and market expertise to the audit process. What we have heard is increasing discussion on the nature of the audit role and a reappraisal of that whole relationship."

He adds: "The audit process tends to focus on checking assumptions made by the institution being audited, but that is where it stops. It just makes sure that what is reported is in line with accounting rules. It is a fairly benign process, which is now not seen as an effective check on management, at least with regard to illiquid asset valuations."

Espen Robak, president of Pluris Valuation Advisors, agrees that there is merit in Green Street's new venture. He says: "It is a viable business and it is a growing business. The need for outside, independent valuations is growing."

Robak explains: "The first factor driving that growth is the increased amount of investment capital held in pools of assets that are quite illiquid. Hedge funds have gradually migrated into more and more illiquid strategies. Instead of playing in very liquid markets, they are now buying a lot of illiquid stuff which is hard to price but which needs to be priced." The second factor driving the valuations business has, of course, been the push - both under IFRS and US GAAP - towards fair value accounting.

The charge that auditors have not been challenging management's decisions is a serious one and it has divided opinion. While Atkins is bullish about the need for Green Street's new offering, Robak believes auditors are doing a better job than they are credited with. He says: "I do not think that auditors are not challenging enough. I think it is a process more than an event."

He continues: "It used to be a very closed, clubby relationship between auditors and their clients - when you have a client the inclination is to never say 'no' because they pay your bills - but that is changing rapidly. Auditors are becoming more and more independent and more and more willing to challenge their clients."

Atkins remains firm, though. He says regulators are concerned about the current auditing process and want to see greater scrutiny, which is precisely what Green Street would offer.

"It is not that auditors have failed. It is more a reappraisal of what the role should be and what skills are required," says Atkins. "I suppose one way of looking at it would be to ask why they should be challenging more, because it is not part of their role. They are hired to make sure accounts adhere to the proper standards; policing above and beyond that mandate is not their role. Furthermore, they have not had the expertise to put forward an alternative view of illiquid asset valuations or approaches to modelling."

The fact that auditors are not required to offer more of a challenge does not mean that more of a challenge is not required, though. This is where Atkins believes Green Street has a role to play.

He adds: "Regulators have seen that they are not getting much of a challenge or a robust check, or even consistency. They want to see the role strengthened, partly so that more can be understood from the accounts than is currently the case. It has taken the crisis to put that into the limelight. The audit role needs to be updated to reflect current markets and current situations."

Indeed, regulators are becoming increasingly vocal. Calls for more stringent auditing are not the only demands the regulators are making and the regulatory push is expected to impact the market in more ways than one.

"There will be more transparency, which will be a good thing. That makes it much easier to understand what an institution's accounts actually mean. It also increases the chances of being able to regulate effectively," says Atkins. "Anything that moves in the direction of greater transparency has to make for a healthier financial sector."

But it isn't just regulators that will see the benefits of greater transparency. It will help senior management within institutions to make better decisions and exercise greater control over their organisations, according to Atkins. "It does not do anyone any good to have large pools of Level 3 assets modelled in a very opaque way, when it is your responsibility for valuing them."

Robak is also expecting changes, but he says it will be accounting rules and auditor independence requirements rather than regulation that will have the most impact on valuations. He concludes: "We have seen so many new valuation standards, but to me the bottom line is we have to get to fair value. Fair value is the standard and that is how securities have to be priced. Other standards are helpful, but fair value is what we have got to get to, where the standard is exit price."

JL

CDO

Standing firm

CLO spreads hold amid more liquidations

The majority of recent BWICs, when they do trade, transact between one or two participants until a few noisy market-wide liquidations whet appetites. But, after last month's much-ballyhooed Stanton CDO-squared auction and another liquidation on 5 August, most secondary spreads were standing firm by that day's close.

The reason has more to do with the kind of paper that's available and whether or not the lists are actually marked to trade. Several BWICs lately have stalled amid a lack of interest, particularly from those participants that are just shopping around to see values, or if there are restrictions placed on the list to be sold in its entirety for one price. Others do not trade as much if there are too many small-sized pieces for sale, leaving large institutional funds skipping the auctions entirely.

But some BWICs, notably the Stanton CDO-squared liquidation (see SCI issue 195), featured several qualities that other lists did not have. Having multiple super seniors on the list helped to sell it, notes one CLO investor.

"There wasn't just one super senior that was controlling it; there were multiple, so it made it more likely to trade. Everybody knew that," he says. All of the US$489m BWIC - which also included CSOs, ABS, Trups and CRE collateral - traded.

Unique seasoning on the Stanton deal also helped the list trade. The collateral was from 2004 and 2005 and featured shorter bonds, whereas typical BWICs lately have featured 2006 and 2007 collateral.

But the CLO-starved market easily absorbed the paper. "We didn't think the Stanton BWIC would be a negative for the market, but we didn't know how positive it could be...when levels came out, they were slightly better than maybe people were thinking," says the investor. Before the Stanton liquidation, triple-B CLO tranches from the 2006 and 2007 vintages traded in a dollar price of low- to mid-50s and during the Stanton liquidation they traded in the mid-50s.

The liquidation of Menton IV, a European synthetic CDO, on 5 August also is not expected to move secondary spreads much. The CDO, which consists of US$250m floating rate notes, unloaded US$200m of senior mezzanine CLOs featuring double-A, single-A and a couple of junior triple-A pieces. The average size of the positions available for sale is US$8.4m.

Spreads in the secondary market for CLOs are considerably wider than the primary market - which creates more of an opportunity, according to Gibran Mahmud, portfolio manager and head of structured products investments at Highland Capital Management. This is particularly noticeable in the higher rated tranches. Triple-A rated CLO paper in the secondary market is trading between 250bp and 350bp, which is almost double where the primary market is pricing, he says.

The difference is not as pronounced in the lower rated tranches, adds Paul Roos, portfolio manager at Highland. For example, double-A spreads in the secondary market can be anywhere from 450bp-550bp compared to 350bp in the primary market.

Similarly, triple-B CLOs on average have been yielding between 12%-14% since June with a 50 to 60 dollar price, depending on the coupon. But the disparity is widespread for equity investors.

If a new deal that has some equity gives a return from 10%-12% and has some upside to 15%, this is compared with buying equity in the secondary and making 30%, adds the investor. "There's a little bit of a challenge on relative values when you go further down the capital structure. Why buy new when I can buy used," he says.

Still, if a large enough new issue triple-A rated deal hits the market, few investors will sneeze at it. Secondary paper will be 22bp-25bp over Libor for that, compared to 150bp over for the new paper, the investor says.

"There's going to be a natural technical that may result in the new issue triple-As coming in at a tighter yield, but it's not apples to apples since structurally they are different," he adds. New triple-B issuance is not the same as triple-B paper in the secondary market, which is more like a double-A of 2006, he says.

To jumpstart the new issue market, however, spreads will have to tighten. For CLOs to be issued again, investors would need a more attractive return profile than is available with current spread levels, according to Mahmud. Given the current loan market, triple-A spreads would have to tighten in to about 125bp to 150bp, he notes. The primary market is currently somewhere between 170bp-190bp.

KFH

CLOs

New breed of CLO prepped

Fitch and Moody's have assigned expected ratings to the class A and B notes of a European arbitrage CLO, ICG EOS Loan Fund I. Unlike more traditional CLOs, reinvestment of unscheduled principal proceeds is not permitted after the reinvestment period, so this transaction will de-lever comparatively quickly.

ICG EOS Loan Fund I will be managed by Intermediate Capital Managers (ICM), with net proceeds from the issuance used to purchase a portfolio of about €1.4bn European leveraged loans from the initial sellers, which are affiliates within the RBS group. The sale of the initial portfolio is subject to a limited failed settlement risk as the portfolio will be purchased at closing, but not settled. If an initial asset fails to settle within 90 days of closing, the investment manager can purchase an alternative asset offered by RBS or use the cash to purchase other assets from other sellers.

The €790.7m class A non-deferrable notes have been rated AAA/Aaa. The €49.5m class B deferrable notes have been rated AA/Aa2, while the €514.62m class S preferred notes and €57.18m class S subordinated notes have not been rated. All of the notes are due in 2024.

The agency says the class A and B notes are able to sustain a robust level of defaults. Fitch assumes that more than 65% of the portfolio could default and average recoveries for senior secured loans could be lower than 35% under a triple-A stress test scenario.

Overcollateralisation and reinvestment tests were not modelled for the investment period as the agency believes the tests may not trap excess spread efficiently enough to protect the class A and B notes. This is because assets purchased at a discount but above 80 cents in the euro can be marked at par for the calculation of the reinvestment test ratios.

Fitch says that at the effective date in December 2010 the portfolio par amount is expected to at least equal the target par amount of €1.412bn. Should this not be the case, then the class A and B notes may be redeemed from interest proceeds and ICM will have to present a plan on how to proceed.

The CLO has a two-year investment period expiring in August 2012. During this period the manager can sell assets and reinvest proceeds into substitutes.

Reinvestment is subject to the eligibility criteria and the maintaining or improving of portfolio concentration tests, collateral quality tests and coverage tests. The portfolio can consist of non-euro denominated loans and the investment manager should in the majority of cases enter into perfect asset swaps for these loans.

Intermediate Capital Group (ICG) has disclosed that the acquisition of the €1.4bn loan portfolio from RBS will be financed by both equity and debt, with the equity to be provided by ICG and two of its funds - ICG European Fund 2006 and ICG Recovery Fund 2008. The firm will manage the portfolio alongside its other senior loan and high yield investment vehicles in its credit fund management business, which currently manages over €4.7bn of assets. The transaction is expected to complete by the end of August 2010.

JL & LB

CLOs

Macro CLO hedges suggested

The hedging of CLO risk continues to be challenging, given the absence of a specific instrument that can be used as a perfect hedge. Structured credit analysts at JPMorgan consequently analysed the historical correlation between triple-A and single-A CLO tranches and the LCDX and CDX.HY indices to determine which index represents the best macro hedge.

"A good hedge should have similar sensitivities as the CLO to the overall market moves and to the different events that can affect its value, such as loan defaults and losses," they observe. "First, the price of a good hedge should be significantly correlated with CLO prices. A priori, loan and high yield instruments should be good hedging candidates as loan issuing companies are mostly rated high yield."

The JPMorgan analysts first calculated the correlation between triple-A CLO tranches and the LCDX index, the LCDX 30%-100% tranche, the CDX.HY index and the CDX.HY 35%-100% tranche since the beginning of the year. They found that the CDX.HY super-senior tranche has had the highest correlation during the period, followed by the CDX.HY index, the LCDX index and the LCDX super-senior tranche.

The analysts note, however, that triple-A CLO and CDX.HY super-senior tranches tend to be sticky (reflecting the latter's poor liquidity), which artificially increases their correlation. Consequently, many CLO investors hedged with the more liquid CDX.HY and LCDX indices.

Turning to single-A CLO tranches, the analysts evaluated correlations with the LCDX index and 15%-30% tranche, as well as with the CDX.HY index and the 25%-35% tranche. These tranches were chosen because they match the typical attachment/detachment points in single-A rated CLOs when the difference in recovery rates between loans and bonds is taken into account.

The LCDX 15%-30% tranche was found to have the highest correlation with single-A CLOs, with the 25%-35% CDX.HY tranche and the LCDX index close behind. The analysts therefore suggest that, from a liquidity perspective, the LCDX index appears to be an attractive hedge for single-A CLOs - despite the slightly lower correlation compared to the senior mezzanine LCDX tranche.

Indeed, they point out that motivations to hedge will be investor-dependent, with hedging costs and liquidity of tranches compared to the underlying indices playing a role. While LCDX tranches represent the best intrinsic hedge for CLOs, they are still not perfect hedges, according to the analysts.

"Therefore, we believe other instruments should be used in combination with the LCDX tranches. For instance, the CDX.HY tranches are also a good CLO hedge for overall moves in the HY credit market, even though difference in default sensitivities between CLOs and HY products are particularly salient if defaults pick up again," they conclude.

CS

CMBS

CMBS loan liquidations set to rise

CMBS analysts at Deutsche Bank suggest that LNR's recent liquidation of a US$1bn portfolio of 270 distressed CMBS loans for about 40c on the dollar could set a template for other US-based special servicers to follow. Faced with limited resources, a continued influx of new loan transfers and a limited number of property trades in smaller markets, it is likely that more special servicers will bring similar transactions in the months ahead.

The Deutsche Bank analysts estimate that of the US$90bn of CMBS loans currently with the various special servicers, only 62% would be potentially eligible for such a liquidation. However, in the LNR transaction the average outstanding loan balance was US$3.8m, which - if adopted in future transactions - would eliminate many of the loans they consider to be eligible. In fact, if a cap of US$5m were put in place, only 6% of loans would qualify.

Consequently, the analysts anticipate that the use of bulk loan sales may come in three phases. Portfolios sold during the first phase are likely to be primarily comprised of loans with a balance of less than US$5m. As the process becomes smoother for sellers and buyers, the upper limit will likely increase to US$10m in the second phase and to US$25m in the third phase.

Over the next few months, CMBS investors could expect approximately US$3.5bn of bulk loan sales during phase one. Only four out of every ten loans would come from the 2006 and 2007 vintages and nearly as many from the early 2000s.

In phase two, the larger balance 2006-2007 loans would comprise a much higher number of loans compared to their share in phase one. But the more seasoned vintages would have a significantly higher number of loans resolved through the use of bulk portfolio sales, according to the analysts. For example, one in three specially serviced loans from the 2000-2002 vintages could be resolved through bulk loan sales compared to only 8% for the 2007 vintage.

Over the first five months of 2010 the average monthly net inflow of US CMBS loans transferred into special servicing grew at a rate of US$2.8bn, according to Trepp. In contrast, June saw a moderate increase of US$700m, while the figure for July was US$120m.

In total, the US$88.49bn in special servicing represents 12.6% of the CMBS universe, as of July 2010. The office sector accounts for US$21.7bn (or 24.6%) of this total, followed by retail (US$18.6bn, or 21%), multifamily (US$17.7bn, or 20%) and lodging (US$17bn, or 19.3%). These four sectors equal 85% of the special servicer loan volume.

Fitch expects the volume of specially serviced loans to pass the US$100bn mark before year-end. This comes even as over US$20bn in loans transferred out of special servicing during H110, compared to just under US$9bn for all of 2009. Additionally, assets-per-asset-manager also increased to 17 through H110, compared to 16 at the end of last year.

However, this figure is heavily skewed for one particular special servicer - LNR - which has about 36 assets in special servicing. The industry average ex-LNR is 14.

The three leaders account for around 65% of the overall special servicing market by balance. LNR holds 26.4%, while CWCAM and C-III account for 24.8% and 12.4% respectively.

"Keeping up with the rapid influx of delinquent loans has been a real struggle for servicers," says Fitch md Stephanie Petosa. "While the increase in loans transferring out of special servicing is encouraging, the volume of large transfers must be taken into account - plus only time will tell if the modifications will stick."

Closer evaluation is showing that smaller balance loans are being resolved via foreclosure, DPO or note sales, while larger loans - mostly from recent vintage CMBS - are being modified and\or extended and returned to master servicing, the agency notes.

CS & LB

CDS

Re-thinking valuation - part 2

In this second column in a series of articles on structured credit valuations, R² Financial Technologies ceo Dan Rosen discusses further the importance of understanding the meaning and use of a "price" and the importance of a model risk framework

Valuation and model risk
What is the price of a security?
In a formal sense, a price is the exchange value at which buyers and sellers agree to trade a security. In an open market, we generally refer to this value as a market price.

When we are pricing a portfolio, ideally we are attempting to estimate the portfolio's price, should it be bought or sold. The process of price discovery is, of course, more transparent when there is liquidity in the market.

But what is a security's price when the market is illiquid and there is little or no trading?
The meaning of a price depends largely on its application. We may distinguish, for example, between a fair price, a liquidation price, a theoretical price (in a normal market) and a fundamental price. In this case, we must largely rely on models to guide us.

Pricing models, and their calibration, may vary depending on their application: marking a book to market, estimating a liquidation value, defining trading opportunities, hedging or managing risk (see Figure 1). For example, marking-to-market a book requires models that satisfy the applicable accounting principles.

In contrast, a pricing model for identifying trading opportunities purposely looks for "mis-pricings" in the market and bets on their subsequent correction. Understanding that a price has different meanings in different contexts is crucial to decision-making, especially when it involves measuring and managing model risk.

Model risk can be loosely defined as the risk associated with using models to value and measure the risk of financial securities and portfolios. Depending on the application, there are several possible definitions of model risk¹.

For example, in its most common use, derivatives traders refer to the risk that different models, calibrated with the same data (e.g. prices for the underlying and hedging instruments) produce different prices for a given non-traded, bespoke product. This exposes the trader to the risk of using a mis-specified model. Similarly, one can have the risk that the same model produces different results with different calibration data curves (e.g. different quotes or curves).

From the perspective of marking-to-market a trading desk or an entire institution's portfolio, model risk refers to the use of models for pricing products which are not reliably observed in the market, or which exhibit no liquidity at all. Essentially, the value at which an instrument would trade in the market cannot be readily determined via screen or broker quotes, looking at market transactions, etc.

A model is required in order to associate a value to these instruments for marking purposes (depending on the institution on a daily, weekly or monthly basis). 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.

For this case, Rebonato (2003) provides the following definition:

"Model risk is the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market."

The need for marking a portfolio, together with institutional and regulatory constraints, has important practical implications for pricing. Model risk arises not because the model value for an instrument is different from its "true" value (if one existed at all), but because of a discrepancy between the model value and the value that must be recorded for accounting purposes. In this case, there is no model risk if reliable market prices are observable (even if these prices seem unreasonable).

Given the complexity of structured credit portfolios, the limitations today of our models, the uncertainty in the underlying data and prices, and the illiquidity in the market, it is important to develop a systematic approach for capturing and communicating model risk.

In the next column in this series, I will discuss the various valuation models for structured credit securities. Later articles will further develop the concept of a model risk framework as well as several other best-practices for structured credit portfolios.

Notes:
¹See, for example, Rebonato (2003).

Investors

Delivering premium returns

Sander Nieuwland, ceo of IMC asset management (IMCam), answers SCI's questions

Q: How and when did IMCam become involved in structured credit?
A: The asset management activity of IMC began in 1998, focusing initially on distressed debt and quickly expanding into ABS, with the launch of a number of funds and CDOs. The IMC Group was founded in 1989.

IMCam was established in its present form two years ago when IMC bought out the minority shareholders and took full control. IMC implemented a strategic review in 2008 and identified asset management activity as a core focus. It turned out to be a good time to embark upon a plan of growing the business, with seed capital available for certain strategies and the opportunity to hire people with strong skills and a proven track record.

We're headquartered in Amsterdam and have an office in New York, where in late 2008 we hired Greg Drennen from the Clinton Group and prior to that Goldman Sachs to run our US ABS strategies.

In total, we cover five product areas: European ABS, European investment grade and sub-investment grade corporate credit, all three run out of Amsterdam - as well as US ABS and our behavioural strategy, which are managed out of New York. We have a quantitative analysis team that supports all of these product areas.

We're a specialised, focused team. We have launched funds in each of the five product areas, but also manage structured products and offer separate account management and advisory services to clients.

One of our recent hedge fund launches, the IMC Distressed European ABS Fund, invests in mispriced ABS assets across the capital structure and targets a 15% net return. These sorts of attractive returns are still within reach if you do the necessary work.

We have an advantage because we've been in the European ABS market since its early days and we now know and have modelled most of the assets. Prices have generally picked up, but we're still finding value in some of the more junior RMBS tranches and selective SME and consumer ABS deals.

Q: What are your key areas of focus today?
A: We launched the IMC US Mortgage Fund on 1 September 2009 (see SCI issue 152) and it's up by 20% in its first 10 months, without using any leverage. It focuses on senior tranches of the US non-agency RMBS market.

Although it was a hard sell at the time, the decision to enter the market last September was driven by the recognition of an opportunity in a severely dislocated market. Securities were cheap relative to fundamental value because of their complexity and illiquidity. While we have seen a recovery in valuations, we still see a significant opportunity in this sector.

More recently, we have hired an investment grade corporate credit team (see SCI issue 185) as an important complement to the existing business. The team brought with them a strong and extensive track record, having managed a long-only strategy during two boom-and-bust cycles and a successful long/short strategy during the recent credit crisis.

This product could not have been stress-tested more severely! It is a pure relative value Euro credit play and we believe there aren't many funds displaying such a skill-set.

The strategy is diversified, but put together with conviction. We begin by looking for the most interesting ideas and then adjust it to control risks and exposure. The team has already won its first mandate and is in the process of launching further products, both in long/short and long-only form.

Q: What is your strategy going forward?
A: In terms of the US, we will remain focused on the same RMBS and ABS space, but we will also launch a new fund to provide the portfolio management team with more tools to generate returns. Our existing fund is still attracting interest; however, given how the market has rallied, it now has a return target of around 10% compared to the original target return of around 15%.

We are in the process of launching a second fund designed to capture 15%-18% by broadening the opportunity set. For example, by introducing the flexibility to invest in different parts of the capital structure and in additional ABS sectors.

One area we have done a lot of work on is the behaviour of mortgage loan servicers, which today has a much greater impact on RMBS cashflows than it had in the past and therefore on their valuation. There are significant differences between servicers in how they deal with the various programmes the US government has introduced in response to the housing crisis.

In general, we expect the coming period to be quite volatile and so our second fund will also be able to hedge market risk while retaining the idiosyncratic risk.

Likewise in Europe, we will launch several credit funds to be managed by both our investment grade and sub-investment grade team to exploit the opportunities we see in the markets going forward.

Q: What major development do you need/expect from the market in the future?
A: The financial crisis caused a lot of pain in the credit and structured debt markets; however, we believe the capital markets will continue to play an important role in the financing of corporate and consumer activity. Banks have taken hits in capital and are less levered. When the market comes back though, it will look significantly different because of the lessons learnt from the past - structures will be more transparent and less levered, issuers will have to retain "skin in the game" and they will be based on different economics.

So, while many risky assets have rallied and spreads have narrowed considerably, the ABS sector can still deliver attractive premia. We expect investors to seek more specialised expertise when trying to extract returns from these complex securities.

At the same time, we expect a fair amount of volatility in the coming years and we believe that the most effective way to generate returns is by recognising and capturing relative value opportunities through the active management of portfolios, both in ABS as well as corporate credit.

CS

ABS

Takeover boosts SF valuations practice

Houlihan Lokey has acquired Red Pine Advisors, a New York‐based advisory firm that specialises in the valuation and pricing of illiquid structured product portfolios.

The transaction adds Red Pine's three principals and 20 employees to Houlihan Lokey's portfolio valuation & advisory services practice. The team brings experience in structured products, real estate loans and illiquid corporate credit instruments.

"Red Pine has developed a compelling platform and a strong reputation for the valuation of structured products, particularly in the banking, insurance and asset management industries," says Michael Fazio, md and head of Houlihan Lokey's portfolio valuation & advisory services.

ABS

Broker-dealer adds in ABS trading

Eric Londa has joined Ally Financial as head ABS trader in New York, reporting to Tom Marano, chief capital markets executive at the firm. Londa was previously md and head of structured products trading at PrinceRidge Group. The move is part of Ally Financial's efforts to develop its broker-dealer capability.

ABS

Portfolio manager joins distressed specialist

Scott Burg has joined Deer Park Road as associate portfolio manager. He will report to Michael Scheckman, portfolio manager and owner of the Colorado-based firm, which specialises in distressed real estate and asset-backed investments.

Most recently, Burg was principal at General Capital Partners in Colorado, where he evaluated strategic solutions for distressed companies. He was also responsible for the firm's development of mergers and acquisitions, reorganisations and capital investments.

ABS

EMEA ABS head hired

Cecile Houlot has joined Morgan Stanley as md and head of its European securitisation effort within the global structured solutions group (GSSG). Based in London, she will report to David Moffitt, global head of GSSG in New York, and locally to European FICM head Claus Skrumsager and European FIG capital markets head Shyam Parekh.

Houlot will be responsible for all primary and secondary securitisations within EMEA and will advise institutional clients and help develop asset-backed finance solutions and related hedging strategies.

Prior to joining Morgan Stanley, Houlot spent 14 years at JPMorgan, most recently as Northern European head of structured finance derivatives. Here, she originated financing and derivative transactions associated with securitisations, covered bonds, structured financings and repos.

ABS

Americas SF head appointed

BNP Paribas has appointed Dan Cozine as head of structured finance for the Americas. He reports locally to Everett Schenk and globally to Dominique Remy, global head of structured finance at the bank.

Cozine returns to New York to run the structured finance business, after spending two years in London as head of loan syndications and trading for EMEA at BNP Paribas. Prior to that, he held positions as co-head of energy and commodities, structured debt and head of project finance in the Americas.

ABS

Boutique finds UK trading partner

Odeon Capital Group and Hobart Capital Markets are forming a new joint venture division in London, Odeon Hobart Partners (OHP). The partnership allows Odeon to expand its trading, research and sales capabilities, which span traditional and esoteric debt classes.

Through the partnership, Odeon aims to offer institutional clients in the UK and throughout Europe the ability to execute high yield transactions, while providing specific analysis across a variety of interest-based instruments.

Odeon ceo Evan Schwartzberg says: "By using Hobart's systems and market presence as an established London-based broker-dealer, we believe that Odeon will be better equipped to provide best-of-breed execution in overseas markets."

Advisory

London hire for advisory firm

StormHarbour has hired Thierry Sciard as managing principal, based in London. He will be responsible for driving the firm's European operations and will also implement strategies for a global alternative asset management business.

His previous role was with Fortis Investments' alternatives and solutions division. Prior to Fortis, Sciard was head of investment management for Europe and the Middle East at Lehman Brothers. He has run global capital markets and fixed income divisions for a number of investment banks during a 25-year banking career.

CDO

Trustee adds CDO svp

US Bank Corporate Trust Services has appointed Joseph Giordano as svp and manager of its CDO business. Based in Boston, he will report to Bryan Calder, president of US Bank Corporate Trust Services.

Giordano has over 30 years of experience in the corporate trust and financial services industry. He has managed financial services business for Bankers Trust, JPMorgan and most recently Fidelity Investments.

CDPCs

CDPC acquired

AGH Acquisition Partners, which is owned by funds that are managed and controlled by EBF & Associates, has purchased Athilon Group Holdings. All of the rights previously held by Lightyear/Athilon Holdings, including managing the Athilon CDPC, have been transferred to AGH under an assignment and assumption agreement.

The actual day-to-day management of Athilon is not expected to materially change, as the staff currently managing Athilon's business will remain in place.

Moody's has determined that the move will not at this time cause the counterparty and debt ratings currently assigned to Athilon to be reduced or withdrawn. However, the agency does not express an opinion as to whether the amendment could have non-credit related effects.

The new follows S&P's downgrade of Athilon Capital Corp/Athilon Asset Acceptance Corp's issuer credit rating from triple-B to double-B and Athilon's senior subordinated note issues from single-B to triple-C. It has removed these ratings from credit watch negative, where they were placed on 21 June 2010. The agency has also affirmed the ratings on Athilon's subordinated and junior subordinated note issues and states that the outlook on the CDPC is stable.

S&P says that the rating actions follow the scheduled implementation of its updated criteria for rating CDPCs with corporate credit exposure. The downgrades reflect the increased capital amount required on the corporate tranches at the applicable rating levels pursuant to the criteria.

The agency concludes that its outlook on Athilon is stable based on the stress default scenario on corporate CDS tranches and the lifetime loss projection on the ABS CDO tranches, together with the timing of potential credit events for the CDS on the ABS CDO transaction.

CDPCs

Strategic alternatives sought for PAM

Primus Guaranty has disclosed that during Q210 it retained Berkshire Capital Securities to advise on strategic alternatives for its asset management business, Primus Asset Management (PAM). It expects this process to be completed by the end of 2010.

PAM managed funds totalling US$17.4bn at 30 June 2010, including US$3.3bn of third-party assets. It also managed Primus Financial and other structured credit vehicles totalling US$22.8bn, including US$1.5bn of third-party assets.

The notional principal of Primus Financial's consolidated credit swap portfolio for Q210 totalled US$14.1bn at 30 June 2010, down from US$16.4bn at 31 March. This also compares with US$21.3bn for the portfolio at 30 June 2009.

Primus said its CDS portfolio had experienced no credit events during the quarter, though it had a net unrealised mark-to-market loss of US$194.8m. The CDPC also terminated US$25m of exposure to Ambac Financial Group and MBIA.

Additionally, the firm reported its CLO interest expense for the three months ended 30 June as US$8.2m.

CDS

US fixed income solutions head hired

BNP Paribas has appointed Matt Salvner as head of fixed income solutions for the Americas. He will report to Kip Testwuide, head of origination and distribution of fixed income products, Americas.

Testwuide says: "Matt will lead the solutions team working closely with the credit and FX/rates structuring teams, and we are confident his expertise will help provide valuable products and advice to our clients."

Salvner joins the firm from Morgan Stanley, where he was head of capital markets products & solutions. Prior to this, he spent seven years on the credit derivative and structured finance teams at JPMorgan.

CDS

AIGFP records gain on super-senior CDS

AIG Financial Products (AIGFP) has reported unrealised market valuation gains related to its super-senior credit default swap portfolio of US$161m in Q210. This compares with unrealised market valuation gains of US$636m in Q209.

The company also reported that interest expense on intercompany borrowings and the effect on operating results related to the continued wind-down of AIGFP's portfolios were lower during Q210 versus the same period in 2009. It cites positive results related to the net effect of changes in credit spreads on the valuation of its assets and liabilities.

Overall, the financial services unit reported pre-tax income of US$42m for Q210 versus a pre-tax loss of US$103m during Q209. AIGFP reported a US$132m operating loss in Q210.

CDS

Two new global heads for Aussie bank

HSBC Australia has appointed Chris Russell and Gavin Powell to its executive committee.

As head of global banking, Russell will be responsible for the firm's corporate and institutional client base in Australia, as well as its corporate financing offering, including syndication, advisory and project export finance. Powell, as head of global markets, will oversee the firm's Australia sales and trading operations, including credit and structured derivatives, as well as its debt capital markets business and balance sheet management.

Russell was previously director, multinationals for HSBC Australia. Prior to this, he worked at the National Australia Bank for 15 years in a range of roles, including state manager for Western Australia.

Powell was head of trading for HSBC Australia, where he ran the A$/NZ$ interest rates risk for the group, as well as managing the balance sheet management team. Prior to this, he managed the firm's interest rate derivatives unit.

Paulo Maia, Australia HSBC ceo, says: "Global banking will expand its client base among multinationals and large corporates, with a focus on building out our global corporate financing capabilities with syndication, advisory, export credit and project export finance. Global markets will increase its penetration of Australia's institutional sector, expanding its sales and trading operations to take advantage of Australia's position as the fourth largest managed funds pool in the world, as well supporting as rising trade and investment flows with the emerging markets of Asia."

CDS

Risk specialist moves

Kinetic Partners has appointed Isabelle Tykoczinski as a member of the firm. She joins the London risk team from Measurisk, where she was head of Europe for the risk transparency and risk measurement service, specialising in hedge funds.

Tykoczinski has worked for Indosuez, JPMorgan and Morgan Stanley, specialising in structured products. Before Measurisk, she worked at Reech Capital in the client services group, focusing on pricing complex derivatives structures and portfolio risk management analysis. She has also worked in ABN AMRO's structured risk interface division.

Julian Korek, founding member of Kinetic Partners, comments: "We are very excited to welcome Isabelle to the team and look forward to continuing to grow and strengthen our risk and valuation services offering. Investors and regulators are demanding not only the appropriate technology tools, but also the expertise to implement them, and our highly skilled team demonstrates our commitment to meet the needs of our clients in this area."

CLOs

Tetragon eyes buys away from CLOs

Tetragon Financial Group, the closed-ended investment company that recently bought GreenOak Real Estate (see last issue), is seeking out acquisitions beyond the CLO market.

The company has the potential to be a broad-based financial services firm, according to Michael Rosenberg, principal of Polygon Credit Management, Tetragon's investment manager, on a 9 August conference call. This would include multiple asset classes and opportunities around the world, he said.

There are currently widespread distressed opportunities for investment and advisory, he added.

Tetragon also confirmed that it is exploring a new issue CLO (see SCI issue 195) based on the attractiveness of just the arbitrage, but it would not elaborate on any further details. The deal, LCM Asset Management's US$300m CLO via Bank of America Merrill Lynch, is currently marketing.

Tetragon purchased the newly renamed LCM Asset Management last November (see SCI issue 161). On its call, the firm said the LCM acquisition was successful from a financial perspective. "Our desire to grow LCM continues to interest us," noted Rosenberg.

Tetragon's CLO investments represent approximately US$720m. Its portfolio composition is comprised of over 70% in US loans, 6.9% in European loans and 19% in US middle market loans. The company added that the European CLO market is not a good fit for it at present.

CLOs

Stanfield CLO transfers completed

The Carlyle Group says it has completed the purchase of the management contracts on US$4.2bn in CLO assets from Stanfield Capital Partners (see last issue). Financial terms weren't disclosed.

The transaction, part of a broader strategy to expand the scope and depth of the firm's global credit alternatives business, increases Carlyle's credit AUM to US$16.8bn. The 11 CLOs are invested primarily in non-investment grade corporate loans.

Mitch Petrick, Carlyle md and head of its global credit alternatives and capital markets group, says: "Linda Pace and her team have done an extraordinary job of swiftly closing all of these contracts. With this consolidation, Carlyle is now one of the world's largest structured credit managers and we continue to make scale and diversity the hallmark of our product offerings."

Pace, md and head of portfolio management for Carlyle's structured funds, adds: "We are pleased with how smoothly the consent process went. By working together with Stanfield, we closed on all 11 funds ahead of schedule and with overwhelming support from debt and equity investors. With a focus on risk management and client service, we will strive to maximise returns and protect investors' capital."

CMBS

Acquisition creates US CMBS platform

MountainView Capital Holdings has acquired Capmark Securities and hired a fixed income team from Madison Williams. The acquisition of Capmark, renamed MountainView Securities, and the key hires broaden the capabilities of the firm's mortgage pipeline hedging and trading of fixed income securities, including MBS.

In addition to providing institutional fixed income trading, MountainView Securities is now offering trading and hedging lines to loan originators in the mortgage banking industry. The new team from Madison believes that pipeline hedging will continue to be a growing service segment in the mortgage market.

The new fixed income sales team, all based in the firm's Texas office, includes: Ansel Eshelman, md and head of fixed income trading; William Sias, md; Robert Fuchs, svp; David Senich, svp; Scott McGowan, md; and Conrad Gerard, md.

Prior to joining Madison, the team was part of the institutional fixed income sales and trading group at Sanders Morris Harris. Sias, Fuchs and Senich will focus on mortgage pipeline hedging and the remaining sales members will focus on institutional fixed income.

CMBS

New CRE investment banking model created

Cantor Fitzgerald and CIM Group have formed a real estate financing business, Cantor Commercial Real Estate (CCRE). Cantor Fitzgerald and CIM will serve as co-general partners to the firm.

The CCRE management team will be led by Anthony Orso, executive md of Cantor Fitzgerald and ceo of CCRE. The firm will originate competitively underwritten fixed- and floating-rate mortgages and mezzanine loans secured by diverse real estate assets in predominantly urban communities and major US markets. It will also engage in securitisations of these loans.

"By partnering with CIM, we are creating an entirely new investment banking model in the commercial mortgage business and are initially targeting annualised loan production of approximately US$5bn," says Orso.

Howard Lutnick, chairman and ceo of Cantor Fitzgerald, adds: "With our partner, we have created an exciting new platform in the CMBS origination and structuring business, something that was traditionally kept in-house by Wall Street. It's a defining moment in commercial real estate lending."

CMBS

New director for CMBS advisory team

Brookland Partners has appointed Prabjot Mann as director and senior member of its real estate investment and debt/CMBS advisory teams. Mann will be responsible for investment analysis, transaction execution and project management, as well as the acquisition or disposal of different types of debt.

Mann joins Brookland from European Credit Management, where she acted as the firm's sole CMBS analyst for its exposure in over 80 European CMBS transactions. Prior to this, she was vp at Merrill Lynch Real Estate Finance, where she worked on its CMBS conduit programme, loan syndication and asset management desks.

CMBS

Broker enhances CRE finance team

Knight Capital Group has appointed Barry Funt and Winston van Buitenen as mds in its CRE finance team. The new hires will help leverage the firm's institutional fixed income platform to originate real estate loans for leased-backed and project financings. The team provides structuring advice on transactions that seek to achieve both the economic and qualitative project goals of participating landlords and tenants.

Prior to joining Knight, Funt spent nine years at Natixis Real Estate Capital, where he helped build the firm's commercial real estate finance unit. Prior to Natixis, he was at Nomura Securities International as general counsel for the firm's commercial real estate group.

Buitenen was previously the co-founder and md of Allegiance Investment Advisors, which specialises in credit-based real estate lending. Prior to this, he was a founding member of The Norseman Group, a structured finance firm that provided debt solutions.

CMBS

CMBS strategist appointed

Richard Parkus has joined Morgan Stanley as CMBS and CRE debt strategist. He is based in New York and will report to Vishwanath Tirupattur, md of the firm's structured credit strategy group. Parkus moves over from Deutsche Bank, where he was head of CRE debt research.

CMBS

CRE firm finds NY president

Peter Hennessy has joined Cassidy Turley as president of its New York tri-state region and will serve as a member of the firm's executive committee and board of directors. He will join the present leadership team of Mark Boisi, chairman of the firm's New York tri-state region, and Richard Bernstein, executive vice chairman.

Hennessy will focus on expanding the firm's commercial real estate services in the Northeast region while overseeing the tri-state team, which includes almost 400 people. In this role he will assume responsibility for the overall strategic focus, growth and profitability of the business unit.

With over 20 years of experience in real estate brokerage, Hennessy most recently served as international director for Jones Lang LaSalle Americas in New York, focusing primarily on representing tenants in their leasing, subleasing and sales requirements.

CMBS

CMBS research analyst hired

Christian Aufsatz is joining Barclays Capital's London research team. He comes from Moody's, where he was a commercial real estate vp, and will cover floating-rate CMBS research in his new role.

CMBS

REIT discloses role in CMBS deal

Starwood Property Trust has announced its participation in a recently completed CMBS transaction, which generated non-recourse match funded financing of approximately 3.5%.

The transaction involved separating five mortgage loans with an aggregate face value of US$178m into senior and junior loans. The five senior loans - comprising either senior A notes or senior participations, with a face value of approximately US$84m - were contributed to the securitisation and received approximately US$92m in proceeds.

The REIT retained the remaining US$94m of junior interests, with a weighted average levered return of approximately 16%. This increases the levered return on its portfolio by 12%.

The loans are secured by office, retail and industrial properties and have remaining maturities of between four and seven years. Goldman Sachs, Citigroup and Wells Fargo Securities acted as initial purchasers. Each of the five loans were either originated or acquired by the firm as part of a first mortgage loan.

Investors

New funds management team announced

BlackRock Advisors has made a number of new md-level appointments within its portfolio management teams. It has also appointed Rick Rieder as cio of fixed income, fundamental portfolios.

James Keenan and Matthew Marra have been assigned to BlackRock's Core Bond Trust and Income Opportunity Trust funds. John Burger, James Keenan, Thomas Musmanno, John Vibert and Mark Warner will now be working on the Fixed Income Value Opportunities fund.

Burger is a senior portfolio manager and head of credit in the financial institutions group within the fundamental fixed income team. He joined BlackRock in 1986, including his time with Merrill Lynch Investment Managers (MLIM), which merged with BlackRock in 2006.

Keenan is a portfolio manager in the corporate credit group within the firm's fundamental fixed income team. He is head of leveraged finance portfolios and investments, overseeing global high yield, leveraged loans and distressed products. Prior to joining the firm in 2004, Keenan was a senior high yield trader at Columbia Management Group.

Marra is a portfolio manager in the multi-sector & mortgages group within the firm's fundamental fixed income team. He is deputy head of retail and mutual fund products and co-head of mutual fund multi-sector portfolios. Marra joined the team in 1997 and began his career at BlackRock in 1995 as an analyst in the portfolio analytics group

Musmanno is a member of the multi-sector & mortgages group within the firm's fundamental fixed income team, as well as a portfolio manager on the short duration portfolio team. Musmanno joined the firm in 1991, including his years with MLIM, where he was a fixed income and money market portfolio manager.

Vibert is a member of the securitised assets investment team within the firm's fundamental fixed income group. Prior to joining the firm in 2008, he was md, head of adjustable-rate mortgage trading, and co-head of non-agency mortgage trading at Credit Suisse.

Finally, Warner is also a member of the securitised assets investment team within the fundamental fixed income group. Prior to joining the firm in 1993, he was director in the capital markets unit of Prudential Mortgage Capital and was initially responsible for asset/liability strategies.

Meanwhile, Reider will continue as head of corporate credit at the firm and will assume responsibility for its multi-sector and mortgage group. He reports to Peter Fisher, head of fixed income, and will be supported by Scott Thiel, deputy cio of fixed income and fundamental portfolios, and head of European and non-US fixed income.

Rieder joined BlackRock and the fundamental fixed income leadership team in early-2009 in a transaction that brought the investment leadership of R3 Capital Partners to BlackRock. In addition to serving as head of corporate credit at the firm, he previously worked as deputy cio of fixed income and fundamental portfolios.

Rieder succeeds Curtis Arledge, cio since Q110, who has accepted a position as ceo of BNY Mellon Asset Management.

Monolines

FGIC Corp files for Chapter 11

FGIC Corp has filed a voluntary petition for relief under Chapter 11 of the US Bankruptcy Code in the Southern District of New York. The company expects the Chapter 11 filing to enable it to deleverage its balance sheet and restructure more than US$300m of debt.

As part of the filing, FGIC submitted a plan of reorganisation and disclosure statement. It expects to progress quickly through the Chapter 11 case.

None of its subsidiaries or affiliates, including its monoline subsidiary, are part of the Chapter 11 filing. The company has been engaged in ongoing efforts to restore FGIC's surplus to policy holders (SCI passim).

The company has hired Kirkland & Ellis to assist in its restructuring efforts.

Separately, the FGIC-related entity Sharps SP I has announced the results of its offer to exchange RMBS and ABS insured by the monoline and the status of certain discussions with holders of eligible insured securities. As of 28 July, eligible insured securities representing US$2.5bn in current unpaid principal balance have been tendered into the offer. Non-binding agreements have also been reached between FGIC and the holders of the eligible insured securities to tender totalling US$121.8m in aggregate current unpaid principal balance. Finally, letters of transmittal have been completed, although the securities have not yet been delivered, with respect to US$846.9m in current unpaid principal balance.

The aggregate current unpaid principal balance of the eligible insured securities represents 37.2% of all securities subject to the exchange offer. The tender expiration date has been extended to 10 August.

Real Estate

Broker adds US real estate head

John Ockerbloom has joined Jefferies as md and US head of real estate investment banking.

With over 13 years of real estate investment banking experience, Ockerbloom was most recently head of real estate and lodging investment banking at Morgan Keegan. Prior to this, he was md in the real estate investment banking groups at Wachovia Securities and BoA.

"Providing Jefferies' full range of financing, M&A and distribution capabilities to corporate real estate clients and real estate private equity firms represents one of our largest opportunities in investment banking," comments Benjamin Lorello, global head of investment banking and capital markets at Jefferies. "We are excited to have John join our team, as he brings the experience and client relationships to lead this effort for our firm."

Regulation

FDIC makes changes for Dodd-Frank

The FDIC Board of Directors approved a new office and division that will help it carry out its responsibilities under the Dodd-Frank Act and provide increased visibility. The FDIC's Office of Complex Financial Institutions (CFI) will review and oversee bank holding companies with more than US$100bn in assets, as well as non-bank financial companies designated as systemically important by the new Financial Stability Oversight Council.

CFI will also be responsible for carrying out liquidations of bank holding companies and non-bank financial companies that fail. "The absence of such authority exacerbated the recent financial crisis, when AIG, Lehman and Bear Stearns became insolvent," the FDIC notes in a press release.

The FDIC's new division, the Division of Depositor and Consumer Protection (DCP), will provide increased visibility to the FDIC's compliance examination and enforcement program.

RMBS

Permacap seeks new name, investment focus

Queen's Walk Investment Ltd (QWIL) is proposing to change its name, conditional on the approval of shareholders at an upcoming EGM, to 'Real Estate Credit Investments Limited' to reflect its intended new investment focus. The permacap vehicle wishes to take advantage of price dislocation opportunities in the European real estate debt market.

Indeed, its investment manager Cheyne Capital Management believes that real estate debt investments offer a more favourable risk-return profile, greater liquidity and improved price transparency than the residual income positions QWIL holds at present. Consequently, QWIL intends to re-direct the focus of its investments on discounted real estate debt, including RMBS and CMBS. Accordingly, the company is proposing to change its investment policy, with the net proceeds of a new capital raising to be invested in real estate debt.

QWIL is planning a capital raising of approximately €26.64m by way of a placing and open offer at €2.00 per new ordinary share. Qualifying open offer shareholders are being given the opportunity to apply to subscribe for one new ordinary share for every two existing ordinary shares held at the close of business on 13 August 2010.

Each of the directors of QWIL intends to take up their pro rata entitlement under the open offer. In addition, placees procured by Liberum Capital have conditionally committed to subscribe for all the new ordinary shares at the offer price.

After close of the first day of trading of the new ordinary shares, the company also proposes to make a bonus issue to qualifying bonus issue shareholders of fixed income preference shares on the basis of 1.25 preference shares for every one ordinary share held at the close of business on 16 September 2010.

However, Cheyne ABS Opportunities Fund has agreed in writing to not take up its open offer entitlement and may also seek to dispose of its holding of preference shares on or shortly following the bonus issue admission.

Tom Chandos, chairman of QWIL, comments: "The fundraising will allow the company to re-focus its investment strategy on real estate debt investments and, through the bonus issue of the preference shares, will give investors an attractive and stable income return. The increased liquidity, price transparency and favourable risk-reward profile of the company's new investments should benefit investors and further our aims to increase NAV and reduce the discount to NAV at which the ordinary shares trade."

RMBS

Reps and warranties figure in Wells action

A class action has commenced in the US District Court for the Northern District of California on behalf of purchasers of bonds issued by the Wells Fargo MBS 2006-AR15 Trust. The complaint charges the trust, Wells Fargo, Deutsche Bank and certain other individuals involved.

The complaint alleges that the trust's registration statement, prospectus and prospectus supplement contained materially false and misleading statements regarding the underwriting standards and loan origination processes. Specifically, the complaint alleges that the registration statement and related documents warranted that the mortgages were made in conformity with applicable laws and that the mortgages underlying the bonds issued by the trust were underwritten pursuant to specific guidelines established by Wells Fargo Bank.

It claims that these standards were disregarded in the actual mortgage loan underwriting process, leading to inadequate collateral securing these bonds and a corresponding loss in value to the bonds. The complaint further alleges that Deutsche Bank failed to perform an adequate "due diligence" investigation prior to underwriting the bonds.

The plaintiff seeks to recover damages on behalf of all purchasers of bonds issued by the trust pursuant to, or traceable to, the trust's registration statement.

RMBS

Broker names RMBS trading head

KGS-Alpha Capital Markets has recruited Brian Bowes as head of non-agency mortgage trading, as it builds out its MBS-focused fixed income trading desk. He was previously part of the residential mortgage trading & sales group at Hexagon Securities.

Technology

Firms collaborate on real estate valuations

FNC has entered into a partnership with Integrated Asset Services (IAS) to offer FNC's servicing clients an option for procuring next-generation real estate valuations.

With IAS already integrated into FNC's Collateral Management Systems (CMS) platform, clients can order broker price opinions (BPOs) or appraisals as part of FNC's collateral risk management solution. IAS' product combines hard data with both comparative and predictive analytics to bring a level of granularity to value estimates. The process creates trend lines that better enable users to predict local area real estate values.

"We believe IAS's next-generation BPO and appraisal technology will give our clients a cutting edge option for better collateral transparency and more accurate decisions," says Mike Mitchell, FNC's chief strategy officer.

ABS

Subordinate ABS relative value touted

ABS strategists at JPMorgan maintain that the best relative value in the US market can be found by "going down in credit". This is because subordinates continue to lag the rally observed in senior ABS and the credit curve remains steep.

"Given the increased credit enhancement available across asset classes, declining loss trends and diminishing seller/servicer event risk, we find the risk/return trade-off worthwhile in subordinates," the JPMorgan strategists note.

They point to the credit card sector as an example, where DCENT triple-B subordination is currently set at 10.5%, versus only a spread account that funds according to excess spread levels in the past. In addition, the three-month average excess spread across the bankcard sector stood at a high of 9.22% in June.

Equally, improved seller/servicer conditions are evident in the prime auto sector as automakers and captive finance companies return to profitability. "We like subordinates in prime auto and bankcard ABS and believe that those segments should lead the tightening in higher yielding ABS. We recommend investors expand into those first, before moving into more off-the-run sectors," the strategists conclude.

ABS

Private SLABS market-weight recommended

ABS analysts at Bank of America Merrill Lynch recommend a market-weight to the private student loan ABS sector. More recent deals should fare better than their seasoned counterparts due to tighter underwriting standards and more conservative structures, they note. At the same time, the potential for continued ratings volatility on seasoned deals and headline risk related to issuers and the industry - along with relatively strong spread performance since mid-2009 - should keep spreads range-bound.

The BAML analysts expect new issue volume to continue at a steady pace, as private student loan lenders tend to rely on the securitisation markets as their primary source of funding. Higher enrolment and college costs, as well as limited Federal aid will likely contribute to demand for private student loans.

The ability of the sector to move to tighter trading levels will depend upon general market conditions and expectations for credit performance, according to the analysts. Indeed, credit performance statistics for private student loan ABS are showing early signs of stabilisation.

ABS

J.G. Wentworth expects one more before year-end

Specialty finance firm J.G. Wentworth intends to issue at least one more ABS transaction by the end of the year, according to Stefano Sola, cio at the firm.

The private placement issuer brought a US$115m ABS offering last week via UBS and Jefferies & Co. The deal was split between US$97.2m class A notes and US$8.9m class B notes. The deal also included one residual class of US$8.9m, which was retained by the company.

Going forward, the size of its deals are likely to be less than the first transaction the issuer came with this year, says Sola. "The last one we did came after a year where we hadn't securitised," he notes.

The specialty finance company brought a more sizable US$252m structured settlement and annuity receivables deal last April (see SCI issue 183). Coupons this time around, however, were more attractive.

The class A notes have a coupon of 4.07% and the class B notes have a coupon of 7.45%. Its last offering in April had coupons of 5.56% for the A tranche and 9.31% for the B tranche.

"Our rates did tighten. We saw strong demand from investors. The coupon rates just reflect that," adds Sola.

The class A tranche was rated triple-A by Moody's. The offering uses a turbo structure, whereby all collections from the receivables are first used to meet interest payments on the notes and then used to pay down the notes' outstanding principal balance until paid in full.

J.G. Wentworth sees a steady supply of structured settlements and fixed income annuities in the market. "We're very active buyers," he says.

ABS

Emirates auto loan ABS prices tight

Emirates NBD and Citi have closed the Y19bn Aa2 rated Emirates NBD Auto Finance (see SCI issue 193) transaction. This is believed to be the Middle East's first true-sale securitisation of a revolving pool of auto loans granted to private and commercial clients in the UAE.

The deal is guaranteed by the Japan Bank for International Cooperation (JBIC) and involves two SPVs: APC, to which the auto loans are transferred; and Repack, which purchased a portion of the APC notes as collateral and benefits from the JBIC principal guarantee.

This dual SPV structure allowed JBIC to participate as both a guarantor of the repack notes and partial investor in the unguaranteed APC notes. The yen-denominated repack notes were marketed primarily in Japan and Asia and were ultimately substantially oversubscribed. They priced at the tighter end of the indicated range at 100bp over one-month Yen Libor and were placed with Asian institutional investors.

Atiq Ur-Rehman, ceo of Citi's Middle East division, says: "As the markets in the US and Europe also pick up, Citi is seeing a resurgence in interest for Shari'ah-compliant and conventional securitisation, and secured finance across the region and across asset classes."

ABS

July credit card ABS performance positive

A credit card performance report by Bank of America Merrill Lynch ABS analysts has found that delinquency and charge-off trends both remained positive in July. Defaults and delinquencies were down, while payment rates, yield and excess spread were all encouraging.

Most credit card trusts saw fewer defaults year-over-year. This trend was bucked by HMNT, which increased year-over-year by 159bp, but it did see defaults decrease month-over-month. The BAML bank card index declined by 135bp year-over year to 8.68% and 92bp month-over-month, which compares to a 442bp year-over-year increase and 29bp month-over-month decrease for July 2009.

Delinquencies also decreased on a month-over-month basis, but unlike last year this was accompanied by a year-over-year decrease too. Late-stage delinquencies continue to decline and the BAML bank card index declined 12bp month-over-month and 70bp year-over-year to 4.86%.

The analysts say payment rate results for reported trusts were mixed, but there were more trusts with higher payment rates than lower ones. The bank card index declined 3bp month-over-month and increased 151bp year-over-year to 19.72%.

Yield increased for the portfolio yield of individual trusts and the BAML card index because of discounting, which the analysts say added between 137bp and 965bp to portfolio yields. Excess spread levels also increased for most trusts due to lower defaults and higher yield.

The analysts remain marketweight to triple-A rated credit card ABS classes and overweight subordinated classes. They expect continued improvement in credit performance and limited supply.

ABS

Stable trend for global SF ratings

Fitch says that the ratio of affirmations to downgrades in its global structured finance ratings improved in Q210, demonstrating an overall continued stabilisation in rating trends for the sector. However, the agency notes that the number of downgrades increased last quarter compared to the first three months of the year.

Downgrades continue to be driven by the number of rating actions taken in the US RMBS sector, most notably from the completion of a review of subprime transactions. Although APAC rating actions were in line with Q110, EMEA saw a decrease in the number of downgrades across all asset classes apart from CMBS.

Following its EMEA SME and large loan CLO reviews in Q110, which mark the completion of substantial portfolio-level reviews, the agency expects CDO ratings to be much more stable.

EMEA RMBS downgrades were concentrated on Greek, Irish and Spanish transactions. The agency says that although Irish RMBS repossessions and losses remain very low, this is driven by lender forbearance and is not a true reflection of the level of stress in the Irish mortgage market. Its expectations over the longer term are for higher losses to be realised, driven by its expectations for further falls in house prices and a continued weakening economic background.

EMEA ABS saw upgrades to a number of German auto transactions following strong performance and amortisation driving increased credit enhancement. Downgrades remained focused on Spanish and Italian auto and unsecured loan transactions.

Meanwhile, US downgrades increased by number in Q210 and continued to be dominated by the subprime RMBS sector, while US auto and credit card ABS ratings were relatively stable. Downgrades were primarily a combination of private student loan deals and tobacco settlement ABS following reduced cashflows from the settlement payment.

The US CMBS sector remains vulnerable to further negative rating migration if more loans enter special servicing or crystallised losses are greater than expected. With US CDOs being the worst affected asset class, the agency does not expect any significant improvements in performance over the coming months.

The number of downgrades in APAC in Q2 was consistent with that in Q1 and related specifically to Japanese CMBS and synthetic corporate CDOs. Latin American rating actions were limited and generally stable compared with previous quarters, with any upgrades and downgrades driven by credit linkage to specific entities.

ABS

'Seasonal effect' to hit timeshare ABS performance

According to Fitch's latest timeshare ABS indices, US timeshare ABS delinquencies and defaults are down for the second straight quarter, although the trend will not last if seasonal patterns take hold.

"The seasonal effect will fade in the latter half of the year, leading to modest increases in delinquencies," says Fitch director Brad Sohl.

Nonetheless, year-over-year improvements will continue to hold. Given the expected stable collateral performance and ample credit enhancement levels, Fitch's outlook for timeshare ABS remains stable.

Sohl adds: "Timeshare delinquencies and defaults have returned to levels consistent with previous recessions. Despite the improvement, current and emerging timeshare performance still illustrates a stressed US consumer."

Total delinquencies for Q210 were 3.61%, down from 4.64% at the end of Q110. Meanwhile, delinquencies decreased by almost 25% from 4.79% in Q209.

This drop is somewhat exaggerated due to the addition of certain recently issued securitisations to the index. These transactions generally experience lower delinquency rates during their first several months. However, absent these transactions, the index still indicates a drop in delinquencies of approximately 15%.

Monthly defaults dropped to 0.71% in June 2010, down from 0.83% at the end of both Q110 and Q409. On an annualised basis defaults were 9.07% for the index in March, down from the 9.53% observed in Q110. The annual default rate has dropped steadily after hitting its all-time peak of 9.57% in January of this year.

ABS

German performance lifts EMEA auto ABS

According to Moody's latest sector review, strong auto loan performance in Germany has enabled auto ABS to remain stable in the EMEA region. Outside of Germany, performance deterioration has been more pronounced, especially in Spain and Portugal where labour market pressure has been more acute, the agency says.

"The German labour market is relatively stable and German borrowers have a generally low level of indebtedness," says Moody's economist Nitesh Shah.

"Auto loan ABS originated by captive finance companies has continued to out-perform auto loan ABS originated by non-captive originators. This long-running trend is because captive originators finance new car sales, which are typically higher priced and therefore require a more creditworthy borrower. The relatively better performance is also due to the larger representation of German transactions in the captive market," adds Shah.

Between January 2009 and May 2010, Moody's downgraded 15 auto ABS deals and upgraded three. Most of these downgrades were driven by the change in the local currency ceiling in South Africa, while operational risk concerns were the second largest driver of downgrades. Three deals, all German, saw upgrades following better-than-expected performance.

Between January 2009 and May 2010, 76% of notes in EMEA auto ABS rated triple-A maintained their ratings, while 22% of these notes were downgraded to double-A.

ABS

Euro SF proves resilient through crisis

S&P has published a ratings transition study which shows that over the last three years - since the beginning of the recent financial downturn - the creditworthiness of European structured finance has generally proved resilient. The sector has shown a relatively low cumulative default rate of just 0.65%.

S&P credit analyst Andrew South says: "Our study shows that only €12.2bn of European structured finance notes - from a total original outstanding of €1,863bn -defaulted over the past three years, resulting in a cumulative default rate of just 0.65% on this basis."

Rating downgrades have unsurprisingly been more widespread than defaults. However, according to South, the three-year cumulative downgrade rate for European structured finance between mid-2007 and mid-2010 was 17.4%. "This means that nearly 83% of ratings were stable or upgraded since the beginning of the financial crisis," he adds.

CDO

Unusual liquidation decision for CDO

BlackRock, the CDO manager for LEAFS 2002-1, has voluntarily auctioned off the transaction's underlying collateral. The liquidation was not forced and the collateral is still performing, but the transaction's mandatory auction redemption was scheduled for this year, rather than the more usual 10 years after close.

Barclays Capital ABS analysts note that many CDOs have been issued since 2002 with mandatory auction redemption clauses set for 10 years after their close, which will come into effect in the coming years. They believe this will make such mandatory auctions more commonplace.

The unusual move to liquidate the deal voluntarily was made possible by the ability to collect enough proceeds to cover the collateral at par and cover legal and trust expenses, as well as other costs specified in the indenture. The BarCap analysts do not think this will always be possible, particularly if the underlying collateral does not perform as well as it did for the LEAFS transaction.

Meanwhile, BNY Mellon is holding an auction on 24 August for Topanga CDO II, involving an original face value of almost US$30m of collateral. It has retained Fixed Income Discount Advisory Company (FIDAC) to act as liquidation agent.

Longshore CDO Funding 2006-2 is also being liquidated by its trustee, Deutsche Bank. Unlike the LEAFS transaction, neither Topanga nor Longshore is a voluntary liquidation.

CDO

Trups CDO defaults continue to escalate

According to Fitch's latest default and deferral indices for the sector, defaults on US bank Trups CDOs eclipsed the 14% mark on 11 new bank defaults. July's new defaults totalled US$129.5m and affected 16 CDOs.

Additionally, 22 banks began deferring interest payments on roughly US$302.5m of collateral in 23 Trups CDOs. Fitch director Johann Juan says: "All defaults that took place this past month were among previously deferring banks. The escalated rate of defaults in July did stem bank deferrals slightly."

The 11 new bank defaults bring the total to 134, affecting 82 CDOs. The 357 banks now deferring are affecting interest payments on US$6.5bn of collateral held by 83 Trups CDOs.

CDO

Repurchases lift CRE CDO delinquencies

US CRE CDO delinquencies decreased slightly last month as asset repurchases slowed, according to Fitch's latest delinquency index results for the sector. Delinquencies dropped from 12.2% in June to 12% last month.

"Despite the slight overall decline in recent months, asset defaults will likely rise as the credit cycle progresses," says Fitch director Stacey McGovern, who also believes the delinquency index understates the full extent of credit risk assets. She adds: "Asset managers have been actively trading out distressed and defaulted assets, often at significant losses to par."

Asset managers are continuing to repurchase defaulted and credit-impaired assets from CDOs, but such activity slowed in July. Only two assets were repurchased last month, as opposed to seven in June.

Other new delinquent assets included three term defaults, five matured balloons and one credit-impaired security. There were 37 loan extensions reported last month, one of which consisted of a former matured balloon loan.

The highest percentage of delinquent loans is those secured by interests in land, which account for 26.4%, up from 20.9% a month before. More than a third of all land loans in Fitch-rated CDOs are currently delinquent.

Around US$75m of realised losses were reported in July from the disposal of distressed assets. The highest asset loss to a CDO was US$16.7m from the sale of a poorly occupied office property near San Diego, where the whole loan defaulted in December after the depletion of its debt service reserve.

Last month 34 out of 35 Fitch-rated CRE CDOs reported delinquencies, ranging from 1.2% to 39.8%. Overcollateralisation tests were being failed by 16 CRE CDOs, which the agency says leads to cut-off of interest payments to subordinate classes.

CDS

DTCC gets Euro repository go-ahead

The DTCC's new European subsidiary, DTCC Derivatives Repository, has received UK FSA approval to operate as an FSA-regulated service company. This new subsidiary will jointly house the global equity derivatives repository and will maintain global credit default swap data identical to that maintained in its New York-based Trade Information Warehouse.

The move is, in part, intended to help ensure that regulators globally have secure and unfettered access to global CDS data by establishing identical CDS data sets on two different continents. "It is very common for counterparties to be located on different continents and to trade on underlying securities issued across borders," comments Stewart Macbeth, md and general manager of the Trade Information Warehouse. "We felt that steps needed 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."

CDS

RFC issued on Indian CDS guidelines

The Reserve Bank of India (RBI) has released for comment a draft report on the introduction of CDS in the country. Draft guidelines were first issued in 2003 and then in 2007, but the issuance of final guidelines was deferred due to the status of risk management practices then prevailing in the banking system and the experiences relating to the financial crisis.

An RBI Internal Group, in consultation with market participants and after taking into account international experience in the working of CDS, has now finalised the operational framework for introduction of CDS in India. The Group's recommendations include:

• CDS shall be permitted only on corporate bonds as reference obligations and the reference entities shall be single legal resident entities.
• While the reference entities are required to be rated, no minimum rating is stipulated. However, keeping in view the need for development of the infrastructure sector, CDS shall be permitted to be written on corporate bonds issued by SPVs of rated infrastructure companies.
• Permitted participants have been categorised into market makers and users.
• Users cannot purchase CDS without holding the underlying exposure and the protection can be bought only to the extent (both in terms of quantum and tenor) of such underlying risk.
• For users, physical settlement is mandatory. Market-makers can opt for any of the three settlement methods (physical, cash or auction settlement), provided the CDS documentation envisages such settlement.
• Standardisation of CDS contract has been proposed in terms of coupon payment dates, maturity dates and coupons.
• A centralised CDS repository with reporting platform on the lines of the DTCC's Trade Information Warehouse would be set up for capturing transactions in CDS and it may be made mandatory for all CDS market-makers to report their CDS trades on the reporting platform within 30 minutes from the deal time.
• While a gradual approach may be adopted for setting up a central counterparty for guaranteed settlement of CDS transactions, to begin with, a system of non-guaranteed settlement may be set up.

CDS

SEF core principles draft released

The Wholesale Market Broker's Association, Americas (WMBAA) has released for comment a draft of its 'Core Principles for Swap Execution Facilities', which it recently submitted to the Commodity Futures Trading Commission (CFTC) and the US SEC. It intends to the draft as a starting point for a dialogue with the various regulatory and industry participants that will be affected by the new Dodd-Frank legislation.

The Dodd-Frank bill is precise about the responsibilities and requirements of being a SEF through the various 'core principles' included in the Act. The WMBAA's proposed core principles rely heavily on the CFTC's existing guidance for compliance with the core principles for designated contract markets, but are modified to reflect the specific legislative requirements for SEFs and the unique structure of the interdealer-brokers that operate at the core of the existing swap market.

The highlights of the WMBAA discussion draft include:

• Establishing core principles that reflect the statutory definition and requirements of swap execution facilities (SEFs) as set forth in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
• Core principles allowing SEFs to only permit trading in swaps that have not been determined by the CFTC to be readily susceptible to manipulation.
• SEFs must monitor trading to prevent manipulation, price distortion and disruptions of the delivery or cash-settlement process.
• SEFs will enforce CFTC-established position limitations based only on readily available information where necessary and appropriate.
• SEFs will make public timely information on settlement prices, transaction price range and volume and other transaction data on swaps actively traded on the SEF.

"The definition of SEF in the Dodd-Frank Act, combined with the requirement that cleared trades be executed through an exchange or SEFs suggest that dealers and other market participants will need to look to the intermediation services provided by wholesale markets brokers to meet the requirements of this new law," says Julian Harding, chairman of the WMBAA.

CDS

IG and HY CDS moving 'in tandem'

Fitch expects that the new derivatives legislation for 'riskier trades' will not impact liquidity for investment grade exchange cleared CDS names, as they will continue to be well utilised by banks. However, the impact on CDS liquidity for non-investment grade non-exchange cleared names remains unclear at this stage, the agency says.

The derivatives section of the Dodd-Frank Act states that riskier trades - defined as non-exchange cleared and non-investment grade CDS - must be pushed out into a separately capitalised affiliate or the bank will lose Federal assistance, including FDIC insurance. Less risky trades - bona fide hedging and traditional bank activities - such as cleared investment grade CDS and hedges of the bank's own risk, can remain in the depository institution.

"Fitch Solutions' global investment grade and high yield CDS liquidity indices have continued to move in tandem since the passing of the Dodd Frank Act, with the high yield index maintaining a consistent liquidity gap over the investment grade index," says Fitch md Jonathan Di Giambattista.

Since the second half of this year, both indices have remained broadly stable, with the investment grade index closing at 9.60 on 6 August and the high yield index closing at 9.21 for the same period.

CDS

Impact of CDS margining explored

Fitch has analysed how the use of leverage by investors in credit default swap transactions - particularly through margining - magnifies credit exposure, variability in return on capital and broader market cyclicality. There has been renewed focus on the leverage obtainable through CDS, given the relatively low level of 'down payment' or margin needed to take credit positions in this market.

The leverage of CDS, coupled with the trading orientation of some market participants such as hedge funds, has the potential to distort pricing and could result in disconnects between CDS spreads and market fundamentals. Since CDS spreads are often used as credit risk indicators, spread volatility could create a negative feedback loop for some issuers, particularly during stress conditions, the agency says.

"Fitch uses CDS spreads as one of many tools to analyse corporate access to funding," says Robert Grossman, Fitch group md. "Fitch may need to revisit the manner in which it views CDS spreads for this purpose as the market evolves."

CLOs

Second-priority US CLO risk recommended

The yield pick-up for second- versus first-priority CLOs is one of the most compelling opportunities in the US CLO market at present, according to structured credit analysts at JPMorgan. There appears to be a 2%-3% difference in yield between AA/mezzanine AAA tranches and pass-through triple-As, they note.

"We believe this premium is too extreme, given the seniority of second-priority risk..., and is largely because second-priority risk sits in an awkward place: returns are too low for hedge funds and seniority too low for super-senior and first-priority triple-A benchmarked investors. We acknowledge the limited carry (40bp-60bp for double-As), but seethe principal-based return (7%-8%) as attractive in the context of the significant level of credit protection," the JPMorgan analysts explain.

They note, however, that liquidity may be challenging, with actual buying opportunities likely limited to a small amount of the circa US$17bn outstanding US double-A market. "Investors who are more risk-averse could instead focus on shorter-duration/higher-priority bonds, given the pick-up to triple-A ABS and MBS, where yields are as low as 2.2% for credit cards and 3.6% for agency MBS respectively."

CLOs

Golub sees appeal of one-stop assets

Golub Capital is in favour of more one-stop assets, or having control over the assets from sourcing to closing, than just mezzanine, says ceo David Golub. But he anticipates having a mix of the two going forward.

"If we go through a period where we see a lot of one-stop opportunities, we're not going to turn them down because we want to achieve a particular portfolio mix," Golub said on a 9 August conference call. His optimum asset mix includes a small amount of equity and a small amount of straight seniors.

Golub said it would not surprise him over the course of the coming quarters to see a larger mix within new originations of one-stops relative to mezzanine. He sees an interesting mix of attractive one-stops and attractive mezzanine opportunities right now in the market.

The company also said high prepayment rates in its portfolio will help the firm accelerate the shift in its asset mix to higher yielding one-stops and mezzanine debt, but it doesn't expect the 50% annualised rate to continue. Golub said prepayments for fiscal Q3 exceeded its expectations. The company experienced US$35m of payoffs at par during the quarter.

Its US$300m CLO (SCI passim) offering, which featured a US$174m triple-A rated tranche, represents the lowest cost middle market CLO done since April 2008, when it did its last securitisation, according to Golub. The company says it used the proceeds to pay off its existing credit facility.

"Securitisations are much better for the company than the bank facility," added Golub, due in part to lower fees and longer maturities.

Its total pro forma cash for this securitisation at 30 June was US$153m, which is now available for investment.

CLOs

Negative outlook for Euro SME CLOs

Fitch has maintained its negative outlook for European SME borrowers - supported by the release of an updated version of the agency's SME CLO Compare tool. The data shows that delinquencies and defaults remain at elevated levels, and have even stabilised in many cases. Uncertainty still remains regarding recoveries from secured loans and the agency continues to benchmark monitored recoveries against its assumptions.

The delinquency ratios within Spanish deals that are between 90 and 180 days past due (DPD) continue to stabilise at around 3% and 1.5% respectively, while the rollover from delinquent borrowers to defaulted borrowers continues to rise. So far, realised recovery rates remain low and below the agency's expectations.

The picture in the German market shows that defaults and the lowest-rated buckets of SME transactions are stable; however, continued transaction amortisation has led in some cases to a higher percentage of negative performance indicators. Recoveries of recent defaults have still yet to materialise and the schuldschein transactions remain the main underperformers of Fitch-rated German SMEs.

Elsewhere across the region, three Italian transactions showed a further rise in delinquency and default rates, which is reflected in agency's ratings for these deals. The default performance of two Fitch-rated Portuguese SME transactions - Douro SME Series 1 issued in 2005 and Lusitano SME No1 issued in 2006 - are stable in absolute numbers.

The Netherlands market was characterised by stable performance and high recoveries, and the default and lowest-rated bucket performance are also stable. Realised recoveries are comparatively high with an average of 85% to date, and all Dutch asset pools continue to amortise at a steady pace.

Three transactions have been added to the SME CLO Compare report, including two Spanish SME transactions (AyT Andalucia FT EMPRESAS Cajamar FTA and AyT Andalucia FT EMPRESAS Cajasol FTA) and one Portuguese transaction (Pelican SME No 1). Fitch has additionally assigned final ratings to Belgian Lion SME I and Sandown Gold, both of which will be included in next month's SME CLO Compare update.

Four transactions have been removed from SME CLO Compare, including three deals that have been paid in full - RCL Securitisation, Geldilux-TS-2005 and AyT FT GENCAT I FTA. The surveillance of the remaining transaction, Lancelot 2006, has been transferred to Fitch's CMBS group.

CLOs

Criteria review to affect Euro SME CLOs

S&P is conducting a review of its assumptions and methodologies used to rate securitisations of loans to European SMEs. The agency says that the scope of the review may include its default rate stresses, correlation assumptions, recovery levels and timing, event risk and model risk.

The review may also include the application of the agency's different rating approaches. The current rating criteria apply either an actuarial approach or a stochastic modelling approach, depending on its assessment of various characteristics of the loan portfolio. This determines the levels of expected defaults for SME asset pools.

The agency states that the review may result in notable changes to the assumptions and methodologies it uses to assign ratings to European SME CLOs. The effect that these potential changes could have on a particular security's ratings will depend on the final criteria that S&P adopts and its analysis of the credit quality of the underlying portfolio of assets, as well as the transaction's structural features.

CMBS

Innkeepers bankruptcy to set CMBS precedent

MBS strategists at RBS have analysed the largest Innkeepers loan - the US$825.4m Innkeepers Portfolio, which was securitised in LBUBS 2007-C6 and 2007-C7 - following its bankruptcy last month. They find that the total combined loss to the two trusts may be in excess of US$300m when additional costs and expenses are considered, which is sufficient to nearly wipe out the junior 6% of each deal.

The RBS strategists point out that this is the first loan of its size where the borrower has proactively filed for bankruptcy rather than making a good faith effort to work out the loan with the special servicer. Consequently, they believe that the proposed bankruptcy may set a precedent for other underwater borrowers representing billions of dollars in CMBS loans.

The outcome of the bankruptcy will ultimately depend on the determination of the value of the properties by the court. "Should the servicer believe that the value determined by the court maximises recovery value to the CMBS trust, they will consent to the proposed plan of reorganisation. Otherwise, we believe they will attempt to negotiate a more acceptable plan or seek relief from the automatic stay in order to foreclose and either liquidate the properties immediately or manage them in the hope that values improve in the future," the strategists note.

CMBS

Interest shortfalls reaching higher up CMBX

US conduit CMBS interest shortfalls rose by 60% in the first half of this year, after nearly doubling in H209, according to MBS analysts at Bank of America Merrill Lynch. These shortfalls are impacting increasingly higher up the capital stack.

For example, this month shortfalls hit the AM tranche on one deal (MSC 2006-IQ12) and continued to eat into the AJ tranche on another (JPMCC 2008-C2). The BAML analysts note that 71 deals referenced in CMBX are taking some shortfalls to at least the double-B level, with 51 of those reaching up to the investment grade class. These transactions are fairly evenly distributed between the CMBX 2 through to the CMBX 5 indices (with 9-12 deals each) and lightly concentrated in CMBX 1 (seven deals).

"We think shortfalls will continue to rise along with delinquencies, specially serviced loans and modifications," the analysts suggest.

In terms of delinquencies across indices, CMBX 1 showed the biggest increase this month, rising by 66bp on the month. The index, which still maintains the lowest delinquency of all the CMBX series at 6.9%, has closed the gap with most of the other indices since the start of the year.

Meanwhile, an all-time high of 72 loans from CMBX deals were reported as liquidated in the July period, surpassing the previous high of 29. In the first half of the year, the number of liquidated CMBX loans totalled126.

"To date we count a total of 267 loans, from CMBX deals, that have left the transactions at a loss," the analysts observe. "Of these, 56 and 58 loans have come from the CMBX.1 and CMBX.2 series. Series 3 has the most at 73 liquidations. The rest come from CMBX.4 (with 52) and CMBX.5 (with 42), where more liquidations have taken place over the past few months."

CMBS

Backstop to Euro CMBS loan extensions?

The special servicer for the Castlegate loan (the last remaining within the Ursus 1 CMBS) has announced that, even if it considers it appropriate, it is unable to provide an extension of the loan without the consent of each class of noteholders. The maturity date of the notes (July 2012) is now less than two years away and any extension into this tail period is not permitted by the structure, according to European asset-backed analysts at RBS.

"In order to preserve a sufficient time to work out defaulted loans, CMBS structures prohibit the extension of loans to within 2-4 years of the legal final of the notes, depending upon the transaction/jurisdiction," they explain. "We consider this rating-driven structural feature will be welcomed by investors as providing a backstop to prohibit continual extensions at historic margins. Recent news flow - notably in relation to Fleet Street 1, but also on Windermere IX/Fleet Street 3 - suggests that note maturity extensions in multi-borrower transactions may be tested in the near future; something to date limited to single borrower deals."

Changes to the legal final constitute a basic terms modification and generally requires all classes of notes to consent and, consequently, will likely require a significant increase in the running margin to incentivise investors. Such changes will be more straightforward in transactions that have effectively become single-borrower deals, with modifications in transactions that remain multi-borrower having to factor in the impact on other loans remaining in the pool.

Meanwhile, a second relatively unusual event occurred last week when the collateral (1 Trafalgar Square in Eclipse 2005-4) backing a performing loan was sold significantly ahead of loan maturity and without negotiating a change of control, such that the sale will trigger repayment of the loan. However, the sale was generally expected, given a combination of the sponsor (ultimately Dubai World) looking to dispose of non-core assets and the prime London location and the quality of the property. As a result, the RBS analysts suggest that the sale was already largely priced into the notes.

CMBS

Small rise seen in US CMBS delinquencies

The delinquency rate on loans backing US CMBS increased by 18bp in July to 7.89%, according to Moody's delinquency tracker (DQT), marking the smallest rise in the CMBS delinquency rate since February 2009.

Moody's md Nick Levidy says: "Although the monthly increases in the DQT have trailed off since March, we do not expect this trend to continue unabated for the rest of the year. The fact that the portion of loans in special servicing exceeds by over 300bp the portion that have so far actually gone delinquent suggests that there are still plenty of delinquent loans in-waiting that can cause the rate to spike in any given month."

In July, 309 loans became newly delinquent, increasing the delinquent balance by a net US$760m. In the US, 3,952 loans are now currently delinquent with a total balance of US$50.6bn.

Retail was the only sector to have a net increase: with 89 loans newly delinquent and 87 worked out or disposed, it saw the largest delinquency rate increase during the month - gaining 33bp to end at 6.51%. But the hotel sector continues to have the highest delinquency rate, ending July at 13.91% after increasing 16bp during the month.

The industrial sector had the smallest increase among the five major property types, rising only 4bp in July. It also has the lowest rate of the major property types, ending the month at 5.49%.

Regionally, the Midwest saw the steepest climb in its delinquency rate, rising 47bp in July to 8.59%. The South had the smallest increase with a rise of only 10bp, but still continuing with the highest rate among the four regions at 9.73%. The West is the second worst performing region, with 9.04%, while the East continues to be the best performer with a rate of 6.18%, but with the second steepest increase with a rise of 26bp.

Meanwhile, the agency also reports that the severity of losses on liquidating loans backing CMBS exceeded its historical average in the second quarter. The 342 additional loans liquidated for a loss had a weighted average loss severity of 42.8%, 740bp higher than the current 35.4% weighted average.

"We anticipate that the cumulative loss severity rate will continue to rise from 35.4%, as more loans from the 2006-2008 vintages of CMBS are liquidated at relatively higher loss severities," says Moody's vp and analyst Keith Banhazl.

He adds: "For loans from these vintages, lax underwriting standards, the absence of amortisation and other loan structural features, historically low capitalisation rates, current reduced market liquidity and the general impact of the economic downturn will likely fuel higher loss severities."

CMBS

Singapore CMBS stays strong

Singaporean CMBS are showing strong cashflows from their underlying properties, according to a quarterly report on the sector by Moody's. The agency says there will be no rating implications on outstanding transactions based on the performance of their portfolio.

The Q210 report says transactions continued to enjoy at least three times actual debt service coverage ratios (DCSRs), while appraisers' LTV ratios were in the 16%-32% range. This performance has not changed in a year.

The economy grew strongly in the quarter, with GDP 18.8% higher than a year previously. Such record-breaking Singaporean growth has outpaced recovery in the rest of the world.

"The strong economic performance has improved market sentiment. The vacancy rate of those securitised office buildings, which were previously over 10%, improved to below 10% in June 2010. Even though the general market's office rental rates and occupancy rates are still soft, such a situation largely reflects abundant supply," says Marie Lam, Moody's vp and senior credit officer.

"In the retail sector, supply of prime retail space is supported by good demand. Although pressure on city fringe malls should remain, the suburban shopping malls in the securitised pools show stable rental rates and low vacancy rates," adds Jerome Cheng, also a Moody's vp and senior credit officer.

Securitised industrial buildings' rental rates in Q210 were all within Moody's stabilised assumptions. However, vacancy rates in certain buildings have increased in recent few months.

The Autron Building, a light industrial building in the Ruby Assets deal, was repossessed by the property manager as the tenant had been in arrears since Q409. Around 40% of the repossessed space has been re-let. Moody's believes there should be no negative impact on note ratings, however, as it contributed only 2.4% of Ruby's portfolio.

CMBS

Euro CMBS remains vulnerable

European CMBS remains vulnerable to further note losses, according to S&P. July's loan performance data for the sector indicates the following issues: an increase in loans not paying at maturity; a material rise in loans in special servicing; and property disposals at prices considerably lower than closing values.

"We expect borrowers to continue to struggle to repay loans at their maturity, given declining asset values and limited financing options," says S&P credit analyst Judith O'Driscoll. "This is borne out by the July loan maturities: of the 19 loans scheduled to mature, only three are reported to have repaid in full."

These latest maturity payment breaches have contributed to a sharp increase in the number of loans going into special servicing. O'Driscoll adds: "Loans in special servicing have cost implications, which, if not absorbed, can translate into interest losses on junior notes. In fact, our data shows that special servicing fees contributed to at least 10 out of 23 tranches defaulting."

S&P credit analyst Robert Leach continues: "Property disposals in July reinforced our loss expectations when properties in the White Tower 2006-3 transaction were sold at values as much as 45% below their value at closing, despite their location in and around the city of London, an area often cited as a bright spot in commercial property."

The agency concludes that although loan losses have only effected two transactions so far, it expects further note losses in European CMBS.

CMBS

US CMBS loan pay-offs improve

According to Trepp, 49.9% of the US CMBS loans that reached their maturity date last month paid off on their balloon date. That is slightly over 10 points better than June's number and is the highest level since December 2008.

Over the last 12 months, the average percentage of loans by balance paying off each month has been 33.2%. Prior to 2008, the payoff percentages were typically well above 70%.

This latest number reinforces the notion that the recovery in commercial real estate lending is still in the embryonic stages, according to Trepp. "In order to feel truly confident that lending for maturing CMBS loans is gaining traction, we would want to see this percentage exceed 50% for a period of three to four months."

Insurance-linked securities

ILS indices launched

Aon Benfield Securities has launched the Aon Benfield ILS Indices, which will provide a quantitative view of monthly ILS returns since December 2000. The indices track the performance of catastrophe bonds in each of four portfolios: all bond, double-B rated bond, US hurricane bond and US earthquake bond.

Each index is a total return index representing what an investor would have achieved by allocating an amount of capital weighted to each catastrophe bond available in the market at a certain point in time. The indices have been calculated by Thomson Reuters.

The all bond index posted a return of 12.85% for the 12 months ending on 30 June, compared to just 2.94% the year before. The double-B rated bond and hurricane bond indices showed returns of 12.95% and 15.18% respectively, while the earthquake bond index gained 7.04%.

Aon Benfield says the indices also allow for comparison with other financial market measures, representing increased transparency of returns for the ILS sector. Despite continued uncertainty and volatility in the global capital markets, the firm says the global ILS market continues to provide capital value to investors.

Paul Schultz, Aon Benfield Securities president, says: "The launch and ongoing administration of the Aon Benfield ILS Indices demonstrate the firm's continued leadership in the insurance-linked securities market. Additionally, we believe the added data and transparency will lead to new investment in this market and provide greater capital alternatives for our clients."

Operations

Survey suggests easing lending standards

The US Federal Reserve Board has released its July 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices. The survey addresses changes in the supply of, and demand for, bank loans to businesses and households over the past three months.

The July survey indicates that, on net, banks had eased standards and terms over the previous three months on loans in some categories, particularly those categories affected by competitive pressures from other banks or from non-bank lenders. While the results suggest that lending conditions are beginning to ease, the improvement to date has been concentrated at large domestic banks. Most banks reported that demand for business and consumer loans remain unchanged.

However, this is the first survey that has shown an easing of standards on commercial and industrial (C&I) loans to small firms since late 2006. Significant net fractions of domestic banks reported that their pricing of C&I loans has eased to firms of all sizes.

Banks pointed to increased competition in the market for C&I loans as an important factor behind the recent easing of terms and standards. However, there was only a small change in demand for C&I loans from large and middle-market firms and from small firms, on net, over the survey period. This was after declining over the three months prior to the April survey.

On net, large domestic banks reported an easing on standards and terms on almost all of the different categories of loans to households. Other banks showed either a smaller net fraction having eased lending policies or a net tightening of lending policies. Regarding residential real estate lending, a few large banks reported having eased standards on prime mortgage loans, while a modest net fraction of the remaining banks reported tighter standards on such loans.

Banks reported an increased willingness to make consumer instalment loans, on balance, for the third consecutive quarter, and a small net fraction of banks reported having eased standards on both credit card and other consumer loans. By contrast, a small net fraction of respondents reported tighter terms and conditions on credit card loans.

The survey is based on responses from 57 domestic banks and 23 US branches and agencies of foreign banks.

Ratings

Federal agencies seek ratings comments

In a joint release, the Board of Governors of the Federal Reserve System, the FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision agreed to publish an advance notice of proposed rulemaking about alternatives to the use of credit ratings in their risk-based capital rules for banking organisations. The notice is in response to section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted on 21 July.

The advance notice describes the areas in capital rules where the federal banking agencies rely on credit ratings, as well as the Basel Committee on Banking Supervision's recent amendments to the Basel Accord. The advance notice is soliciting comments on alternative standards of creditworthiness that could be used in lieu of credit ratings.

Specifically, it requests comments on a range of potential approaches, including basing capital requirements on more granular supervisory risk weights or on market-based metrics, as well as on how these approaches might apply to different exposure categories. It also seeks comment on the feasibility of and burden associated with alternative methods of measuring creditworthiness for banking organisations of varying size and complexity.

The notice addresses only the references to credit ratings in the agencies' capital rules. Proposals for removing references to credit ratings in other parts of their regulations will follow separately, the federal banking agencies say. Comments are solicited for 60 days after publication in the Federal Register, which is expected shortly.

Regulation

Covered Bond Act implications weighed

Moody's outlines in its latest ResiLandscape publication the positive and negative aspects of the US Covered Bond Act (see also separate News Analysis), which has been approved by the House of Representatives Financial Services Committee and is now awaiting a House vote.

If the bill becomes law in its current form, it will establish investor-friendly procedures following an issuer default, according to the rating agency. However, it provides for overcollateralisation levels that will not address market value risk and may also lead to different standards for different types of issuers.

The bill protects investors in both existing and new covered bond transactions by establishing a mechanism for transferring the cover pool following issuer default. Under the bill, following its appointment as receiver of a failed bank issuer of covered bonds, the FDIC has the option to sell the covered bond programme to a solvent issuer within 180 days. During this time, the FDIC must continue to make scheduled payments on the covered bonds.

For non-bank issuers (and, if the FDIC doesn't sell the programme or make the scheduled payments, for banks also), the bill requires the automatic transfer of the cover pool to a separate legal estate. An administrator would manage the estate in an orderly manner over time to make scheduled payments to investors, selling assets only when the natural amortisation of the assets is insufficient to make scheduled payments to investors.

Further, the bill protects investors by providing protections to the administrator designed to minimise disruption by immunising the administrator from lawsuits by covered bondholders. It also preserves investors' potential deficiency claims against an issuer's estate, allowing them to make those claims in the future if the cover pool turns out to be insufficient. Without the bill's protections, investors would have to wait for the cover pool to pay off and for a claim to materialise before they can file.

Moody's concedes that such a gradual wind-down approach mitigates market value risk better than in the current regime, which exposes investors to the risk of having to liquidate the entire cover pool in the market within a short time following issuer default. However, it points out that while the bill requires covered bond regulators to set minimum overcollateralisation levels, it specifically directs them not to take into account liquidity (i.e. market value) risk.

"Since the bill also does not require issuers to match maturities of assets and liabilities, the bill does not address the risk for investors if a sale of part of the cover pool to pay off the bonds occurs in distressed market conditions," the agency notes.

The bill may also lead to inconsistency between the rules for different types of institutions, as - unlike previous iterations of the proposed legislation - the current version appoints the issuer's primary regulator as the covered bond regulator. "Different issuers will have different regulators, depending on their charters," Moody's explains. "Since the regulators are in charge of setting standards, this feature could lead to inconsistency between programmes and reduce transparency for investors. It could also lead to a conflict of interest, since the goals of the issuer's primary regulator may not always be aligned with covered bondholders."

Regulation

Capital reform costs estimated

The Financial Stability Board (FSB) and Basel Committee on Banking Supervision (BCBS) have prepared their reports for the calibration of the new bank capital and liquidity standards. The two reports provide an assessment of both the net economic impact of stronger capital and liquidity reforms and the macroeconomic implications during the transition.

The Basel Committee's assessment of the long-term economic impact finds that there are clear net long-term economic benefits from increasing the minimum capital and liquidity requirements from their current levels, in order to raise the safety and soundness of the global banking system. The benefits of higher capital and liquidity requirements accrue from reducing the probability of financial crisis and the output losses associated with such crises.

The FSB-BCBS assessment of the macroeconomic transition costs, prepared in close collaboration with the International Monetary Fund, concludes that the transition to stronger capital and liquidity standards is likely to have a modest impact on aggregate output. If higher requirements are phased in over four years, the group estimates that each one percentage point increase in banks' actual ratio of tangible common equity to risk-weighted assets will lead to a decline in the level of GDP relative to its baseline path by about 0.20% after implementation is completed.

In terms of growth rates, this means that the annual growth rate would be reduced by an average of 0.04 percentage points over a 4.5-year period, with a range of results around these point estimates. A 25% increase in liquid asset holdings is found to have an output effect less than half that associated with a one percentage point increase in capital ratios. The projected impacts arise mainly from banks passing on higher costs to borrowers, which results in a slowdown in investment.

Mario Draghi, FSB chairman and governor of the Bank of Italy, says: "The analysis shows that the macroeconomic costs of implementing stronger standards are manageable, especially with appropriate phase-in arrangements, while the longer-term benefits to financial stability and more stable economic growth are substantial."

A final report will reflect the fully calibrated global capital and liquidity standards, which are to be delivered in advance of the Seoul G20 leaders summit.

RMBS

Housing finance, GSE reform on the agenda

The Obama administration's Housing Finance Reform Conference convened yesterday (17 August). Other than cooling some of the overheated sentiment that has developed in recent weeks, it was essentially a non-event for today's MBS market, according to MBS analysts at Bank of America Merrill Lynch. They expect housing reform to be a slow process that is unlikely to impact the MBS market in the near term.

Although some anticipate a major government initiative relating either to refinancing or partial forgiveness of underwater mortgages to be announced (SCI passim), the BAML analysts believe that this is unlikely to occur. They suggest that a more likely outcome is the conference being no more than a first step of the Treasury's plan for housing finance reform by early 2011.

The analysts note that they are concerned about the timing of reform and the disposition of the GSE portfolios (see also separate News Analysis). They indicate that housing finance reform will be slow as the housing and financial crises have exposed several flaws in the system, which will take years to address.

The analysts believe housing finance reform will not be ready for implementation until after most of the mortgages currently outstanding have been extinguished, which means a wait of between five and 10 years. Therefore, they say, the reform discussion will not impact today's MBS market.

A subtext to the housing finance reform discussion will be the disposition of the GSE portfolios. Based on the imposition of declining portfolio limits (down 10% per year) on the GSEs by Congress, the analysts believe it is unlikely that they will be part of the framework for the longer-term future, despite their current importance. The GSEs are believed to own over 30% of the 5%-plus universe of MBS and are expected to earn their way out of credit problems.

The GSEs are not expected to loosen risk-based pricing adjustments that have kept good quality borrowers trapped in high coupon mortgages due to negative equity. A period of tighter credit is anticipated, which was the outcome of financial reform legislation.

Finally, the Fed's policy shift of reinvesting into Treasuries is seen as a significant and potentially problematic development for agency MBS. The analysts believe the announcement will lead mortgage bankers to finally ramp up capacity and lower primary mortgage rates, which means the risk of a refinancing wave is considerably greater than it was a week ago.

RMBS

GSE buyout impact on prepay speeds to lessen

GSE buyouts are expected to remain a component of prepayment speeds going forward, but the impact on speeds will likely be lower in coming months. This is because newer vintages display much stricter underwriting standards, according to analysts at FTN Financial.

They note that speeds increased across all product types except five-year GNMA II, which decreased to 6.2 CPR from 8.7 (-28.7%). Realised Fannie Mae and Freddie Mac products increased speeds for those lower in the coupon stack, primarily the 4.5%-5.5% range. Higher coupon speeds were slightly slower than the previous month, the analysts add.

The rate for Fannie Mae prepayments increased from 17.5% CPR to 18.5% CPR. This increase in aggregate speed was expected, but Bank of America Merrill Lynch MBS analysts suggest that 2008/2009 4.5s and 5s came in higher than expected while other cohorts were slower than anticipated.

The analysts say 2008/2009 borrowers have shorter refinancing lags than other borrowers and recent vintage large loan borrowers have shown the highest propensity to refinance because of their high credit quality. Aggregate FNCK pool speeds increased to 33.1% CPR with 2008 FNCK 5s prepaying at 64.2% CPR.

Freddie Mac prepayments increased even more for 30-year mortgages, moving from 17.2% CPR to 19.7% CPR - a 15% increase, which outstrips the 10% rise the analysts had been expecting. In line with Fannie, Freddie saw recent vintage creditworthy borrowers exceed prepayment speeds, while credit-impaired borrowers from older vintages lagged behind.

Freddie had a greater increase in speeds for 2008/2009 4.5s and 5s than Fannie. It also saw newer vintage creditworthy borrowers prepay at higher speeds than its fellow GSE.

Meanwhile, July saw aggregate hybrid ARM prepayments halve for Fannie Mae - dropping from 49% CPR to 24% CPR - and dip from 28% CPR to 26% CPR for Freddie Mac. The analysts explain that Fannie's prepayments were impacted by a sharp decline in buyouts of seriously delinquent loans, while Freddie's change is consistent with the slower-than-expected prepayments for its credit-impaired cohorts.

The BAML analysts expect aggregate 30-year speeds to increase by 15% in August due to the higher refi index and the fact that the month is one business day longer. Hybrid ARM speeds are expected to increase by 10%, with the largest gains for recent cohorts such as 2008.

A new round of speculation on 5 August caused up-in-coupon agency MBS to underperform, following the nervousness exhibited in the market the previous week (see last issue). It was triggered by a press report suggesting that the Obama administration could have a dramatic announcement ahead of the upcoming elections to forgive principal for underwater borrowers.

Subsequently, the US Treasury department released a statement saying that it is not considering allowing Fannie Mae and Freddie Mac to forgive residential mortgage debt that exceeds the current market value of a property. "Given current historically high dollar prices of agency MBS, the nervousness in the market is fairly high that something dramatic could happen ahead of the election season, leading to a repricing of the MBS coupon stack due to policy changes such as these. We warn investors not to overreact to news articles about changes that are already planned," the BAML analysts conclude.

RMBS

New housing programmes to have minimal impact

New programmes are being launched by the US Treasury and Department of Housing and Urban Development (HUD) to provide more support for targeted foreclosure prevention programmes. MBS analysts at Bank of America Merrill Lynch note that the two programmes are complimentary, but doubt their effectiveness.

The Treasury programme injects an extra US$2bn into 17 states and the District of Columbia through the existing Housing Finance Agency. It is the third extension of the Hardest Hit Initiative, which was launched in February. Under the programme, states must submit proposals to the Treasury on how they will spend before they are given the funds and how the cash is used varies from state to state.

The US$1bn HUD programme is different and will provide non-recourse subordinate loans to assist with monthly PTI payments. It will be available in states where the Treasury programme may not reach. To use the programme, a borrower must be at least three months delinquent.

The BAML analysts believe the total size of the two programmes is too small, however. They calculate that, should an average borrower receive US$20,000, the US$3bn could be used for only 150,000 borrowers. Given that there are more than seven million borrowers delinquent, the analysts suggest that the programmes will not make a noticeable difference to the housing market outlook or MBS valuations.

No incremental refinancings are expected for agency MBS, but the analysts do believe the programmes will fuel speculation of a major announcement in the run-up to elections. No near-term housing policy overhaul is expected as the analysts predict the Obama Administration will stick to its original plans.

Non-agency securities will receive a slight boost as incentive payments or additional monthly payments from subordinate loans and assistance will flow to non-agency investors. This slight positive will not have much of an impact though, as the analysts say the programmes are "way too small" to make a noticeable difference.

RMBS

Upsized Aussie RMBS prices

Bank of Queensland (BOQ) has priced its Series 2010-2 REDS Trust RMBS, after the deal was upsized from A$750m to A$1.6bn due to strong investor demand. National Australia Bank is the arranger of the transaction, with National Australia Bank, Deutsche Bank and RBS acting as joint-lead managers.

Rated by S&P and Moody's, the A$960m triple-A rated 1.5-year class A1 notes came at 100bp over one-month BBSW, while the A$497.6m triple-A 6.2-year class A2s priced at 110bp over. The class AB notes priced at 160bp over BBSW, with the class B1 and B2 notes pricing remaining undisclosed.

BOQ md David Liddy says: "In total, 14 investors - including the Australian Office of Financial Management - participated in the deal... The AOFM participated with an investment of A$497.6m in the class A2 notes."

RMBS

Mortgage/Treasury basis to underperform

The decision by the US Federal Reserve to keep constant its holdings of securities at their current level by reinvesting its MBS portfolio paydowns into longer-term US Treasuries has prompted Barclays Capital MBS analysts to move to an underweight position on the mortgage/Treasury basis. They expect the basis to underperform in the near term.

Re-emerging overseas demand and limited origination has tightened the mortgage basis. At current levels, the BarCap analysts note that valuations are expensive, with the coupon to 10-year Treasury spread at 66bp. The fact that prices on higher coupons are already at all-time highs compounds the issue, with any upside hard to see at this point.

The analysts believe mortgages are coming under supply pressure. Paydowns from the Fed's portfolio are becoming increasingly important as a source of supply for the agency MBS market as 10-year Treasuries have reached 2.76%.

The no-point mortgage rate is estimated at 4.60%, leading the analysts to expect Fed MBS portfolio paydowns to run at around US$270bn over the year. Lower rates will mean the Fed's increased pace of portfolio paydowns will make it increasingly more difficult for investor demand to keep up.

Finally, the analysts suggest that the Fed's decision will create strong support for mortgage spreads to widen relative to Treasuries. In addition to mortgage paydowns, there is US$50bn in maturing agency debt, growing the estimated amount of reinvestment in Treasuries to US$320bn.

This represents 15% of expected Treasury coupon issuance, but the analysts say Fed purchases are likely to be concentrated in the five- to 10-year sector. Lower coupons are likely to be most affected.

Should mortgage rates rise and concerns over Fed paydowns and dollar prices ease, the analysts anticipate strong support for mortgages, however.

The Fed's latest data show that outright holdings of domestic securities in the System Open Market Account totalled US$2.05trn. The open market trading desk will look to maintain the face value of the outright holdings of domestic securities at around this level.

RMBS

Permanent loan mods near one million mark

HOPE NOW estimates that the mortgage industry has completed approximately 975,000 permanent loan modifications so far in 2010. It also reports that from January 2010 through to June 2010, approximately 78% of mortgage servicers' proprietary loan modifications included principal and interest reductions.

Proprietary modifications follow Home Affordable Modification Program (HAMP) modifications in foreclosure prevention. When a homeowner does not qualify for HAMP, mortgage servicers determine eligibility for a proprietary loan modification that may help a homeowner stay in their home.

In June, the industry completed about 123,000 proprietary loan modifications for homeowners, representing a 10% increase from the previous month. Mortgage servicers also completed 51,205 HAMP modifications in June.

Almost 3.4 million homeowners have saved their homes via permanent loan modifications since July 2007. This total reflects the combination of proprietary loan modifications plus those completed under HAMP.

Total industry workout solutions for distressed homeowners now top 10 million since 2007. These totals include repayment plans, forbearance and other foreclosure prevention options.

Faith Schwartz, senior advisor for HOPE NOW, says: "We saw significant increases across the board in permanent loan modifications as well as other solutions. Most importantly, servicers were able to offer principal and interest reductions in nearly 80% of their proprietary loan mods."

RMBS

Subprime RMBS index stabilising

Prices continue to stabilise in Fitch Solutions' Subprime RMBS Total Market Price Index, though the momentum of monthly price increases may be hitting a plateau.

The index increased 1.5% this past month to stand at 9.88 at of the end of July. While still 30% higher than levels at the end of last year, the levelling off in performance is notable following almost 7% month-over-month increases on average from February through to May, as well as a 3.9% rise in June.

The 2004 vintage increased by 2.7% and the 2006 vintage rose 12.9%. However, these increases were offset by price drops in the 2005 (-1.4%) and 2007 (-6%) vintages.

Of note, the 2007 vintage experienced consecutive declines (-4.3% and -6%) over the past two months after considerable appreciation of 7.1% and 12.2% in April and May. In contrast, the 2006 vintage continues to show strong growth, albeit at a slower rate than last month (20.1% in June and 12.9% in July).

"While positive momentum still supports the index, high delinquency roll-over rates on the 2006 and 2007 vintages may be reflected next month," says Fitch director Kwang Lim.

Fitch's ongoing monthly loan-level analysis of the index constituents had illustrated positive signs from subprime asset performance over March through to May. However, CPRs and CDRs continue to rise, along with a first-time appreciable increase in the 30-day delinquency levels across vintages in June.

"Current default trends appear to support the market's cautious optimism," says Fitch senior director Alexander Reyngold. "Going forward, low delinquency cure rates and the jump in the 2006 vintage CPR may result in a lower credit quality pool in aggregate."

RMBS

Bank MBS holdings drop

Second-quarter bank holding company (BHCs) consolidated financial statements released by the National Information Center (NIC) indicate that the top 50 US BHCs shed US$32bn of RMBS during the period. MBS analysts at Barclays Capital notes that this decline was led by the top four banks by total assets, whose net position in RMBS declined by the same amount.

The NIC figures show that agency MBS holdings declined by US$30bn, mainly because one bank shed US$22bn, predominantly in conventional pass-throughs. Non-agency and CMBS holdings declined by US$2.2bn and US$2.3bn respectively for the top 50 BHCs.

Although conventional MBS pass-through holdings fell by about US$34bn, GNMA holdings grew by US$4bn and agency CMO positions increased marginally.

The BarCap analysts note that Q3 BHC data will likely show MBS additions, however, given recent indications that banks added US$40bn-US$50bn in MBS over the past month.

RMBS

Spanish RMBS reviewed on reporting error

The share of written-off loans has been understated in recent investor reports for most of the transactions managed by Gestión de Activos Titulizados (GaT). Loans subject to 'compra-venta' (sale of mortgage properties to real estate companies with funds flowing back to the SPV) or 'cesión de remate' (third-party assignment in an auction) were not reported within the cumulative write-off figures. Loans subject to compra-venta and cesión de remate were, however, correctly accounted for in terms of notes amortisation and trigger computation.

Moody's understands that the error was limited to the write-off amount in the reporting module of GaT's application, with the accounting module correctly reporting all written-off loans. GaT intends to rectify the investor reports by the next payment date of each of the transactions currently reporting understated cumulative write-offs.

In some of the transactions the preliminary restated amounts of defaulted loans are significantly higher than previously reported figures, indicating a deterioration in asset performance not reflected in the current loss assumptions for these portfolios. As a result, Moody's has placed on review for possible downgrade the ratings of the class Ds issued by Hipocat 8, the classes A2 and B issued by Hipocat 10, and the classes A, B and C issued by Hipocat 17. Approximately €1.9bn of securities are affected.

The rating agency notes that all classes of notes in Hipocat 9 and the class A3 and A4 notes in Hipocat 10 are already on review for possible downgrade because of worse than expected performance. In all other transactions managed by GaT and not affected by this action the underlying assumptions are still well positioned in relation to preliminary restated numbers.

Moody's is waiting to receive final figures for all the deals, which may result in additional revisions should these be higher than the preliminary numbers provided by GaT.

RMBS

Mexican RMBS shows 'lacklustre' performance

S&P says that despite diminishing borrower credit risk, it expects the Mexican RMBS market's overall performance to remain lacklustre for the remainder of 2010. This, the agency notes, is due to higher defaults, increasing foreclosures and macroeconomic factors that have reduced borrowers' purchasing power and increased their debt-to-income ratios.

Defaults for the aggregated Mexican RMBS market rose during the first half of 2010 to 6.7% as of 30 June 2010, from 5.9% as of year-end 2009. In addition, the total inventory of foreclosed mortgages is still increasing and servicers are not monetising these mortgages rapidly enough to stem losses. As a result, the agency expects the pipeline of future RMBS loan defaults to increase further by the end of this year.

As of July 2010, S&P downgraded 34 RMBS series from five institutions based on the transactions' diminished credit strength. Most of the downgraded portfolios have common characteristics, such as Mexican inflation-linked unit (UDI)-denominated mortgages, a high concentration of loans in Northern Mexican states and a high concentration of loans with borrowers who earn income in the informal economy.

In addition, the downgraded portfolios include transactions that have servicers whose ability to collect payments have weakened as a result of their fragile financial condition, which, in turn, resulted in higher delinquency rates. However, the agency predicts that Mexican RMBS performance will improve in 2011.

RMBS

US prime RMBS delinquencies 'slowing'

According to Fitch's latest performance metrics results, the slowing rate of US prime RMBS serious delinquencies - though still rising - may signal a nearing high-water mark.

Prime delinquencies rose for the 38th consecutive month, while alt-A (fourth month in a row) and subprime RMBS (fifth straight month) delinquencies continue to drop. Fitch md Vincent Barberio notes that the rate of increases has slowed considerably since April due to numerous factors, chief among them the increased liquidation rate of delinquent loans.

"Prime delinquency increases have averaged 12bp a month since April, which compare favourably to 44bp monthly averages between April 2009 and March 2010," adds Barberio. "While increased liquidations of distressed properties are helping to stem the rise in delinquencies, it also means that realised losses are rising."

The monthly annualised net-loss rate for prime RMBS has more than doubled from 0.8% to 1.7% over the past year. Prime jumbo RMBS 60+ day delinquencies rose to 10.6% for July, up from 10.4% for June and 6.9% a year ago. The delinquency rate for loans originated prior to 2005 was 4.9%, while the rate for 2005-2008 vintage loans has more than doubled at 12.5%.

Subprime RMBS delinquencies fell again in July, down to 43% from 43.7% the prior month. They remain above the 41.8% rate of a year ago. Alt-A RMBS delinquencies decreased to 33.6% in July from 33.7% in June (up from 29.7% in July 2009).

RMBS

Criteria review hits 10 South African RMBS

Fitch has placed 10 South African RMBS transactions on rating watch negative (RWN), reflecting its revised rating criteria for South African RMBS transactions and performance concerns in the sector.

The agency says that under its revised rating criteria and to estimate expected foreclosure frequency, it expects to receive data covering loan-by-loan performance or aggregate static pool performance information. This will cover an economic cycle for mortgage products that are part of the securitised pools and will enable the agency to apply frequency of foreclosure assumptions for each transaction.

The agency has also revised its assumptions on parameters that affect recoveries for South African mortgage portfolios, which are the key drivers for placing the rated RMBS notes on RWN. The key changes are the forced sale adjustments to property values for repossessed properties and market value decline. The impact of these changes will vary and, for some transactions, the negative effect on recoveries may be mitigated by the amortisation of the outstanding notes after the end of a revolving period.

The combined effects of the revisions on foreclosure frequency and recoveries for mortgage portfolios will be used to assess the impact on existing rated notes. In the absence of amendments to the transaction structures, Fitch expects that - for a typical mortgage portfolio with LTVs between 50% and 60% - the ratings for both the senior and mezzanine notes will be downgraded by approximately two rating categories.

South African originators, particularly where the originator is a bank, typically have the right to repurchase loans from the securitised pool of assets. If this is exercised, the securitisation regulations in South Africa allow up to 10% of the aggregate balance of the closing asset portfolio to be repurchased by the originator. This would be at a 'fair market value', determined by the originator's valuation models and procedures.

RMBS

Short sales process speeding up

ServiceLink reports that its short sale business model is resulting in dramatically reduced short sale approval and closing timelines. The company says it completes package and contract acceptance in less than 30 days from receiving the file assignment from the servicer. This compares with a year ago, when the process could take as long as three months.

The firm also reports that the timeline from contract approval to closing has been reduced to less than 45 days, providing for a total short sale completion time of less than 75 days. Jane Johnson, svp of loss mitigation at ServiceLink, says: "The biggest difference we're making in the industry is our streamlined asset management approach."

Amid the growing number of short sale transactions, ServiceLink Loss Mitigation Services has seen its short sale inventory increase by over 35% in the last quarter. The firm says it began expanding its loss mitigation operations early this year in anticipation of an increased number of short sale transactions. Unlike the traditional outsourcer model, it employs dedicated closing teams that support the servicer from initiation through liquidation with an emphasis on the closing process.

Trading

Trading ideas: wind at its back

Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a negative basis trade on Windstream Corp

Aggressive high yield bond buying came back in fashion recently as bond inflows shot upwards and Windstream's 2016 bond offers a great opportunity. Fundamentally we have been bullish on Windstream's credit spread for some time now and believe the best place to express that view is in a negative basis trade. The company's 8 5/8s of August 2016 bond trades at a substantial discount to its five-year CDS and we recommend buying the bond hedged with its CDS with a negative basis of -233bp.

Windstream raised its free cashflow forecast for the year when it reported second-quarter earnings last month and, after reviewing its numbers, we find Windstream's five-year CDS trades around 150bp wide to fair value. The company's tight equity-implied spread, increasing revenues, high operating margins (greater than 60%) and stable interest coverage drive our stance on the credit.

Windstream's interest coverage remained between 3.5-4.0x for years and continues to do so. Also, though recent acquisitions certainly helped, revenues increased sequentially for the past three quarters and are up 25% year-on-year, while margins remained well above 60% (Exhibit 1). As long as the economy avoids a double dip, we believe Windstream will continue to perform admirably.

That said, the size of the negative basis and reduced exposure to credit spread fluctuations make the combined bond-CDS exposure more attractive than an outright position. Thus, we believe alpha is best generated through a negative basis trade with Windstream's 5 5/8s of August 2016 bond.

Windstream's 8 5/8s of August 2016 bond CDS-implied fair value is US$115, which makes its offer US$11 cheap. Exhibit 2 compares the bond z-spreads with the CDS term structure and shows that the recommended bond is indeed trading wide of the closest-maturity CDS with a basis of -233bp.

The combined position is default-neutral; however, there is a slight maturity mismatch because the bond matures on 1 August 2016 and the CDS expires on 20 September 2015. We expect to be able to exit the trade with a profit from carry and convergence to fair value before either instrument matures.

The underlying idea of the negative basis trade is that credit risk is overpriced in the bond market relative to the CDS market. The investor buys a risky bond - and thus is paid to take credit risk on the issuer - while paying for credit risk in the CDS market by buying protection on the issuer.

There are many drivers of the basis, both technical and fundamental, which we explain in our Trading Techniques articles. Eventually, the prices for credit risk in the two markets should converge, resulting in an arbitrage-like profit. In the interim, the investor earns positive carry because the credit spread that is collected in the cash market is greater than the spread that is paid in the CDS market.

Position

Buy US$10m notional Windstream Corp 5 Year CDS protection at 355bp.

Buy US$10m notional (US$10.4m proceeds) Windstream Corp 8 5/8s of Aug 2016 at US$104.00 (T+600 bp; z-spread of 618bp) to gain 263bp of positive carry.

The appropriate interest rate is dependent on the portfolio in which the trade is held.

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

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

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