Contents

CLOs

Regulatory divergence

US CLO issuance accelerates as European market hesitates

A lack of regulatory convergence is creating an uneven playing field for issuers of US and European CLOs. While the US primary CLO market continues to gain momentum, European issuance remains moribund.

June was the most active month since the global financial crisis for US primary CLOs, with new issuance totalling US$2.3bn. Managers including GSO Capital Partners, Carlyle Investment Management, Babson Capital, BlueMountain Capital Management and PineBridge Investments have all launched deals within the last couple of weeks, bringing the total supply of US CLO issuance to US$8bn year-to-date. Several more transactions are joining the pipeline, with Moody's confirming in a recent industry update that it is in the process of rating at least seven new broadly-syndicated CLOs.

Explaining the resurgence in US CLO issuance, Matt Natcharian, md at Babson Capital Management, notes that several triple-A buyers have come back to the primary CLO market and have picked the managers they want to work with. "Given the issuers can now sell the triple-As at a relatively good level and also given that prices on bank loans weakened just a little, the economics work better at the margin," he says.

He continues: "For the first time, we have seen some deals that were either partially ramped or not ramped at all at closing, meaning that the equity took some of that ramp-up risk. This was a little surprising. But given that there aren't a lot of opportunities for low- to mid-teens returns in the wider market at present, CLO managers have been able to attract equity as well as the triple-A buyers. With those two components, they have been able to get a few deals done. "

Wells Fargo CLO strategists believe that US$12bn of primary CLO issuance in 2011 is a reasonable projection - a sharp contrast to the European CLO primary market, in which just a handful of deals are currently undergoing the ratings process. So far, only one deal has publicly launched this year - European Capital's ECAS 2011-1 - which sold €288m of triple-A notes.

According to Elana Hahn, partner at law firm Morrison & Foerster, the mismatch in CLO issuance trends between the two jurisdictions is in part being fuelled by the implementation of the 5% retention rule in Europe - and lack thereof in the US. "European requirements for risk retention were passed with a broad brush in article 122a of the CRD. The minimum 5% retention requirements for risk-weightings apply to any ABS exposure risk - including CLOs, even though this asset class cannot really be compared to other ABS. In Europe there's no obvious solution as to who should take the 5% risk in CLOs and this is hindering new issuance."

In the US, risk retention requirements for securitisations are still a proposal and therefore US issuers are able to launch new CLOs without the headache of who should retain the 5% risk. The earliest that retention rules can be implemented is 2013.

However, Hahn is confident of a European CLO recovery. "We are expecting a revival in the European CLO market," she says. "Banks are warehousing loans for new CLOs and clients are planning CLO issues. Pricing economics is the most fundamental issue, followed by the risk retention rules. I think that if the economics begin to make sense for issuing CLOs, a solution will be found for the risk retention rule."

European CLO market participants are working on a number of ideas to deal with the risk retention problem (SCI passim). One proposal involves a sub-noteholder also being designated as a quasi-manager and therefore satisfying the risk retention requirement through its sub-noteholding.

"If an investor is retaining the risk, however, you have to question how it is that this addresses the underlying rationale of risk retention and whether the regulator and market is moving away from a reasoned approach," says Hahn. "Perhaps the regulators should recognise that CLOs are not based on an 'originate-to-distribute' model, managers and the loan originators have always had 'skin in the game' and the application of a risk retention rule to this product just doesn't make sense."

Should risk retention rules be implemented in 2013 in the US as they are now proposed, then that market too will face significant problems. Many industry participants are currently lobbying for complete exemptions for CLOs from the risk retention rule under the premise that CLOs do not follow the originate-to-distribute model.

"The industry also advocates, as a fallback, the substantial expansion of the very narrow exemption from risk retention for 'qualifying commercial loans' already included in the US risk retention proposal, arguing that the standards set for exemption are so high that very few deals could meet the requirements," says Ken Kohler, a US-based lawyer at Morrison & Foerster.

"It's still unclear what the impact of Dodd-Frank on CLOs will be," concludes Natcharian. "There have been a lot of strong arguments made by market participants through the LSTA and ASF. We are still optimistic that something will be worked out. CLOs have been shown to offer strong performance - the market feels that collateral manager and investor interests have been well aligned through subordinated fee structures, and most think the market should stay this way."

AC

CMBS

Embracing change

DECO paves way for European CMBS revival

The successful launch of DECO 2011-CSPK is expected to mark the start of a revival in European CMBS, with at least four more deals slated for this year. Officially closed at the beginning of July, it is the first publicly-marketed, de-linked European CMBS to be fully placed with investors since 2007 and the first CMBS to comply with new regulatory requirements issued under the Capital Requirements Directive (CRD).

"We are quietly confident that this may be the start of the re-emergence of the CMBS market in Europe, even though it will probably take a while to get to substantial volume and will focus on high quality assets and simple structures in the short term," says Conor Downey, partner at Paul Hastings. He adds that the impact of certain regulatory measures, including the CRD 5% retention rule, is yet to be fully clarified.

"CMBS, under its new '2.0' banner, is coming back to the European market, abandoning many of the now ill-favoured features of its heyday in favour of a simpler, more investor-centric model," notes Darren Davey, md of Solutus Advisors. "The closing of the Chiswick Park Deco CMBS fully subscribed and generally in line with target pricing showed that there is renewed appetite for these bonds - even in the immediate wake of the latest twist in the sovereign debt crises."

The transaction, arranged and originated by Deutsche Bank, is sized at £302m and securitises a single commercial real estate loan that Deutsche Bank made to entities sponsored by the Blackstone Group. This loan was used to finance the acquisition of the units in the Chiswick Park Unit Trust.

Chiswick Park is an office park located in West London, situated between Heathrow Airport and the West End. It provides 1.1 million square-feet of grade A office space within nine leasehold buildings and serves as the global, European or UK headquarters for 26 organisations. Tenants include Tullow Oil, Discovery Communications, Paramount Pictures, Starbucks Coffee and Halliburton.

Rated by DBRS and S&P, the CMBS comprises four classes of notes: £235m triple-A class As, £30m double-A class Bs and £37.24m single-A minus class Cs, as well as a £100m unrated class X tranche. The rated notes priced at 175bp, 275bp and 375bp over three-month Libor respectively.

Deutsche Bank retained 5% of each tranche in the transaction, so that investors were not penalised under new CRD regulatory capital requirements. This is the first instance of a European CMBS complying with the new requirements.

The transaction also has a number of features not seen before in European CMBS. In its presale report, S&P highlights that half of the loan was advanced on a fixed-rate basis, while the half made on a floating-rate basis is hedged against interest rate risks via a prepaid borrower cap.

In addition, the rating agency points out that all of the notes, other than the class X notes, bear interest at three-month Libor plus a margin. For each interest payment date following the expected maturity of the notes (May 2016), the notes will bear interest at the lesser of three-month Libor plus the margin and 8.25% plus the margin.

Furthermore, following the expected maturity date, a loan default or a transfer to special servicing, class X interest payments will be fully subordinated to transaction expenses, repayment of principal and payments of interest on the class A, B and C notes.

Downey explains that one of the features of the Chiswick deal addresses the very problem that the Opera Uni-Invest deal is currently facing with the controlling class of bondholders. "It was assumed that the interests of the different classes of bondholders would always be fairly well-aligned. On the Chiswick deal, the controlling class shifts, depending on where value breaks in the structure," he says.

The servicing arrangements also include new features that aim to improve the operational efficiency of the transaction and to facilitate realisation of funds by noteholders in the event of a loan default. According to S&P, these features include requirements or the ability of the servicer to maximise proceeds with respect to the loan, rather than take into consideration the broader interests of the noteholders. They will also be required to prepare an asset status report in consultation with an operating advisor regarding the loan and the property within 60 days of the loan being transferred to special servicing and call for a valuation within this period.

"This asset status report would contain a description of the status of the loan and the properties, consideration for the effect on net present value of various courses of action - including work-out or realisation - on security for the loan and a conclusion as to the strategy that the special servicer had determined would maximise recovery on the loan on a net present value basis," explains S&P.

The special servicer will also be able to form an ad-hoc noteholder committee in order to allow the servicer and/or special servicer to consult with noteholders on matters, such as modifications, waivers and consents relating to the loan. The special servicer will be able to disregard votes from noteholders that are affiliated with the borrowers in any vote that relates to any modification or restructuring of the loan.

"We've also created a note maturity plan where, if six months before bond maturity there are still assets left, the special servicer is obliged to put forward several different proposals for bondholders," explains Downey. "If the bondholders don't approve any of them, then the special servicer is obliged to appoint a receiver to sell the assets - as quickly as possible."

The transaction also introduces a significant improvement to loan structures for CMBS, relating to the additional leverage on the properties. According to a client alert from Paul Hastings, in prior European CMBS transactions it was not unusual for additional subordinate loan positions to be secured against the property (typically in the form of B loans or mezzanine debt). These subordinate loan positions shared in the first mortgage security of the senior loan.

"Typically, the documentation for these subordinate loan positions provided the subordinate lender with significant rights to limit or otherwise impede the rights of the CMBS transaction in connection with any enforcement on the related property and an extra-contractual ability to threaten to interfere with such enforcement," the client alert explains. "While the DECO 2011-CSPK transaction provides that the related mezzanine debt has the benefit of a subordinate mortgage, as opposed to sharing in the first mortgage, the mezzanine lender does not have the right to enforce on such security."

The note also explains that, in addition, the mezzanine lender's rights to such subordinate mortgage security can be released by the senior lender upon an enforcement on the senior loan - thereby limiting the ability of the mezzanine lender to restrict the manner of enforcement of the senior loan or threaten to interfere with it. Instead, the mezzanine lender's primary means of enforcement is limited to non-mortgage security at a higher position in the equity structure of the borrower, at a level removed from the security held by the CMBS transaction (so-called 'true mezzanine debt').

"This is a significant improvement from the structures seen in older vintage CMBS transactions, where the rights of the senior lender in a work-out or enforcement were significantly limited because of the structure of the security package held by the subordinate lender," the note concludes.

AC

CMBS

New options?

CRE loan refinancing opportunities scrutinised

Recent restructurings of a number of CRE loans (SCI passim) alongside the launch of the first post-crisis CMBS would suggest that the European refinancing environment is improving - at least where prime assets are concerned. However, market participants warn that while there is increasing optimism for the future, the ability to find new debt capital for refinancing in today's market remains tough.

The launch of DECO 2011-CSPK last month has boosted hopes that CMBS may once again become a viable refinancing option. The transaction, sized at £302m and backed by a single loan on Chiswick Park in West London, is deemed to be the first true CMBS to be launched in the European market since 2007 (see separate deal profile).

"The new Deco deal was important for the market for people to believe that CMBS can work again. It will be interesting to see if the market agrees," says Stewart Hotston, director at Hatfield Philips. "It may transpire that it is easier to find banks that can provide the financing directly, such as in the case of Project Isobel at RBS."

Nassar Hussain, managing partner at Brookland Partners, explains that investment banks tend not to hold loans on their balance sheets for long, so will only make new loans if they feel comfortable that a viable distribution market exists. "That's through loan syndication or CMBS and, for investment banks, the most profitable exit route is through CMBS," he says.

He adds: "There are two or three more CMBS planned before the end of this year, but it won't really be until next year that you start to see a market re-emerging more properly. At that point, investment banks will be more comfortable originating loans that they can then securitise."

Darren Davey, md of Solutus Advisors, argues that CMBS, in principle, has always remained viable and will certainly ease - though certainly not carry the burden - of the real estate funding gap. "It's all about balance: so long as the pricing is attractive for all involved, demand will drive the re-emergence of CMBS," he says.

Any loan that has proved problematic in the past will be unlikely to be refinanced in the CMBS market, however. "It's going to take a lot of convincing to get investors to look at anything where we know there are already problems," says Hotston. "I could envisage refinancing where certain loans are refinanced and make up part of the pool in a new CMBS, but I don't see CMBS being used as a refinancing tool in its own right."

It is estimated that around half of the loans coming up to maturity are currently being refinanced, with the majority of those being low-risk and conservatively-underwritten loans. In many cases, borrowers are - where possible - giving up a large amount of equity in order to facilitate the refinancing.

Loan extensions are also popular, while other options include obtaining loans from a traditional balance sheet lender or - when required leverage surpasses 65% - from a mezzanine loan fund. The size of the loan required, the quality and location of loan are all limiting factors, however.

"Location is critical for refinancing. If your property is in central London, you are going to get a more serious hearing than if you are elsewhere," says Hotston. "That applies across Europe: for example, nobody wants to refinance multifamily housing in the East of Germany and the same applies in the south of France or central Spain."

At the same time, Hussein notes that some institutions are having difficulty buying prime real estate assets and are therefore moving into the 'good' secondary sector. "Banks are also struggling to deploy as much capital as they were hoping to - in order to increase their business flows, they may have to become more competitive on financing terms and perhaps be prepared to increase their risk profile a little," he says.

Loan size is also critical. While a €50m-€100m loan is deemed manageable for lenders at present, anything larger presents more of a challenge.

"Even if you can find someone willing to take it on, you then have the challenge of putting multiple lenders together to refinance a loan rather than the single lender, single loan scenario," says Hotston.

A recent example of this is the GSW loan - a €1bn multifamily portfolio - that was refinanced by five different lenders. "None of them wanted to - or could - take on the whole amount alone," explains Hotston. "That changes the dynamics. Those needing to refinance small loans are generally OK, but for the big loans there are a handful of lenders that could consider it but as it stands, it's very difficult to refinance the big loans as they are."

While many balance sheet lenders face the overhang of legacy issues, they also have to contend with Basel 2 and 3 requirements that will push up the cost of riskier lending. Firms such as Pramerica, Duet, LongBow, Lasalle, M&G and Axa have - or are understood to be in the process of - establishing commercial real estate mezzanine platforms to offer financing no longer available from traditional balance sheet lenders.

"Mezzanine finance has, and will continue to, play an important role in filling the funding gap between CMBS and equity, as seen with the loan provided by GIC in the Deco deal and the ever-increasing list of mezz providers in the market," says Davey.

Hotston suggests, however, that the new mezzanine funds appearing in this space will not have a huge amount of influence in refinancings. "For any public deal, there's not a lot that can be done due to the documentation prohibiting unilateral deals with someone that essentially walks in off the street," he says. "You have to run a process to show that you've recovered the greatest amount that could be recovered. A lot of these funds feel they have an angle, but that quite often results in a loss for the borrower and that is a hard sell for a servicer, even if it results in an exit from the loan."

He adds: "In some cases, it might be easier for the big balance sheet lenders to keep the loans on their balance sheet because the cost of the funds is lower than the cost of a loss. Right now, nobody is incentivised to give these mezz funds access."

Insurance and life insurance companies are also looking to step into the space vacated by senior lenders. A number of teams have been set up for this purpose; for example, at Prudential M&G and Aviva. While these firms haven't been as quick off the mark as first anticipated, they are expected to make up a much larger proportion of the market in the coming years.

"On a relative return basis, senior real estate loans offer far stronger returns from a risk/reward basis, especially when compared with corporate loans/bonds. Also, due to Solvency II, the capital requirements for holding hard real estate will increase - thereby incentivising them to get exposure to real estate through debt," explains Hussain.

Opinion is divided on loan extensions in the current market environment. According to Hotston, borrowers often see extending their loans as a route to cheaper funding than a full refinancing.

"Our argument [is] that that is not necessarily the case now," he says. "Where loans are performing adequately, we frequently take the view that it's about the will of borrowers to go and find the refinancing and make the necessary sacrifices."

A significant number of loan extensions are nonetheless going ahead, although - depending on the nature of the underlying assets - banks and servicers are also looking at enforcement, particularly for prime offices in London. For example, the Aviva Tower, Leadenhall Triangle and St Katherine Dock properties were all sold at a price higher than their valuation - thereby encouraging other lenders and servicers to look at this option.

"Loan extensions shouldn't be dismissed completely - and the blanket 'extend-and-pretend' label is not always justified," concludes Davey. "While the requirements on the borrower - debt pay-down, increased amortisation, tighter controls, viable exit metrics - often prove unachievable, there are certain instances where such a route clearly provides the best route to maximum recoveries."

AC

ABS

Counterparty risk

Market concerned criteria changes devalue ratings

Yesterday (18 July) marked the deadline for transactions to comply with S&P's changed counterparty criteria. Consequences for CMBS have been particularly acute, with a raft of deals downgraded, and there is concern in the market that these ratings no longer accurately reflect credit quality.

S&P's new counterparty criteria give greater recognition to structural features, such as swaps and liquidity facilities for securitisation ratings. While previous counterparty criteria only addressed triple-A rated transactions, the changes S&P has made mean that guidance is also given for lower rated transactions.

"In light of our experience with financial institutions through the recent downturn, we felt the need to revisit the issue of counterparty risk in our criteria. We saw it as something that warranted greater scrutiny," says S&P analyst Robert Leach.

Although the criteria changes affect all ABS asset classes, they are of particular significance for CMBS. Unlike an asset class such as RMBS where repeat issuance is commonplace, CMBS sees far more solitary transactions. This lack of repeat issuance means that less action is taken to defend ratings and so downgrades become much more likely.

Paul Crawford, ABS strategist at RBS, explains: "S&P's changes are particularly relevant to CMBS in that there have been a lot of downgrades - some of them quite significant, such as dropping from triple-A down to single-A - and a large part of that is because people are not taking action to avoid those downgrades."

Mathias Herzog, also an analyst at S&P, says that the agency was prepared for this. Even before the six-month process of reviewing transactions began, the expectation was that there would be more rating actions taken for CMBS than other asset classes "because there are fewer incentivised parties to make changes to documents".

He adds: "CMBS transactions tend to be more orphan-style deals without a sponsor who is actively managing them. In many cases, it would take either action by the trustee or noteholder initiative to encourage transaction parties to make changes to documents and that is something which has not happened very frequently for CMBS transactions."

125 CMBS transactions were placed on credit watch negative in January, when S&P started reviewing deals according to the new criteria. The average downgrade within the asset class as a result of the criteria changes has been 2.7 notches. When affirmations are included, the average change has been 2.1 notches.

As ratings have been cut across the board for CMBS, many in the market are concerned that credit quality is no longer being accurately reflected in S&P's ratings. The agency's focus on documentation issues seems to have been detrimental to the relevance of its ratings.

Edward Chai, portfolio manager at Henderson Global Investors, explains: "CMBS is a very good example because if one or two large loans default, then losses will blow through the lowest tranches first. In some CMBS deals, there is a higher probability of some of these large loans going bad than the supporting counterparties going bust, so investors are primarily concerned with the underlying credit risk of these loans and how it affects the bonds."

He adds: "I think most ABS investors look to these ratings to get a sense of the relative credit risk between the classes. To be honest, the revised ratings from S&P are going to be a little less useful than they used to be for this type of credit risk assessment. Unfortunately, I think these ratings are becoming more about documentation than they are about credit."

Chai suggests that carrying S&P's criteria to their logical conclusion leads to a situation where several different classes in a single transaction suddenly have the same ratings. This has already been seen for transactions the agency has reviewed.

"Are we to conclude, for example, that class A and class B from the same securitisation have the same credit risk on the basis that they now carry the same (revised) rating from S&P?" Chai asks.

Crawford believes this change may have upset a few investors. While he says that ratings do still reflect credit issues, they are hindered by a ceiling that has been introduced by documentation issues.

He explains: "S&P would argue those documentation issues are significant enough to put a ceiling on the ratings. However, for investors who invested in triple-A notes that have been downgraded without any deterioration in the credit, the decision might seem to make less sense. I think people are a little disappointed."

Leach does indeed make the point that counterparty risk has an important influence on the performance of transactions, so S&P cannot assign a credit rating without taking it into account. "Clearly we believed a criteria change was warranted. Counterparty risk is a real risk in transactions and one that we believe should be reflected in our ratings," he notes.

Counterparty risk is not the only factor influencing rating changes though; several transactions were downgraded because of liquidity facilities instead. Herzog says: "Our ratings do not just address the recovery of the principal from underlying loans. They also address an issuer's ability to maintain timely interest payments."

He continues: "For that timely interest component, in CMBS perhaps more than in other asset classes, there is a high reliance on liquidity facility providers. Disruptions to individual loan cashflows can affect a transaction's cashflow, requiring an injection of liquidity, even if for only a short period."

The S&P analysts note that the market reaction to the agency's criteria changes has been quiet. They have not seen noteholders putting pressure on trustees to change documentation, although in many cases the changes which would be needed are very simple.

Chai has noticed this too, although he sees expense - rather than simplicity - as a barrier. He says: "I think investors were initially confused by these downgrades, but overall market reaction has been muted. Even as these ratings hit the market there was no big, adverse movement in prices of the bonds that were affected. There are some investors who potentially had to sell because of ratings-sensitivity, but there really has not been much forced selling going on."

Lack of repeat issuance and costly barriers to change mean that the economic incentive to adapt transactions in response to the criteria changes is lacking. Chai notes that to preserve the economics of a deal and still comply with S&P's new requirements is very challenging for an issuer. He cites the higher fees and interest rates charged by potential replacements for a downgraded liquidity provider as just one example.

As the market absorbs this wave of criteria changes and transaction downgrades, yet more may come in the future. The other rating agencies are not expected to take quite the same line as S&P, but Crawford notes that Moody's for one has already started to move in this direction.

"I do not know if it is the end. Moody's came out and did an operational risk review of a lot of deals and we are starting to see that feed through to a couple of transactions," observes Crawford.

He notes that the agency is concerned by the functionality of the liquidity facility in some transactions and intends to take rating actions. "That will not be anywhere near the scale of what S&P is doing though."

Leach is happy that S&P's changes have been appropriate and says the agency will continue to look to improve its ratings. "We continuously analyse the approach we take," he concludes. "While we value rating stability, we cannot ignore what happens in the market. Where we see areas that we think can be improved, we address those areas. There are always lessons to be learned from any down-cycle and that is a fundamental aspect of testing your ratings."

JL

CLOs

US CLO investors return

The US CLO market has been kept busy by a string of BWICs, with softness in the market drawing investors back in. Additionally, a rare upsizing of a deal has occurred, while one upbeat CLO trader also describes liquidations coming back into 'active mode'.

"It has been a noteworthy week, despite the slippage and bad tone in the peripheral countries now bordering on the prime Euro nations. There has been a plethora of bid lists, focusing primarily on equity tranches," the trader explains.

He continues: "The week can be characterised as very busy with BWICs. There were three lists yesterday and four today; there has been quite a bit of trading on the lists, but also a fair few DNTs. Equity continues to trade well, although most bids are off several points from where we were back in May."

Debt tranches also continue to have decent appeal, says the trader. US triple-A tranches remain at around 160-170, while European triple-As are in the low- to mid-200s.

Investment banks still seem hesitant about loading up on mezzanine CLO risk and are not adding a lot of paper. However, the trader notes that there has been better participation from retail, with opportunistic hedge funds and traditional money players continuing to return to the market.

Meanwhile, KKR CLO 2011-1 has been upsized by 50% since closing (see SCI 11 July). The deal originally closed earlier this year, but has just been upsized from US$400m to US$600m, underlining the strength of demand in the market.

"The senior notes will be US$450m and the equity will represent around US$130m. Mezzanine makes up the remaining US$20m. This really shows the strength of the primary market and the fact that there is demand from the conservative money investors," notes the trader.

He adds: "Changes like this rarely take place after the closure of a CLO, but it is not just because of strong demand. It is also because the par-value test requirement was reduced from 133% to 120%, which lowers the leverage and makes the deal a little bit better for investors across the board."

While softness in the market persists, the trader expects the buoyancy it is currently experiencing to continue. He says: "People are crawling back in and continue to watch behind their back to see what is dropping in Europe. Average loan prices have also fallen down to 94.63, so they are down a point or a point and a half in the last couple of weeks".

He continues: "We have softness in the market, which has brought people back in. People are typically lukewarm stepping into these BWICs, but it is a noteworthy sign; you would think there would be a general strike, but I believe true investor clients are coming back."

JL

CLOs

Equity sellers surprise CLO market

While mezz trading has slipped away, the European CLO market has seen a wave of equity sales this week, with mixed trading levels. The reasons behind the spike in activity remain unclear and it has left several traders slightly bemused.

One trader explains: "It has really been quite a hard market to read for the past few days. The main pattern we have seen has been lots of sellers for equity, without any clear reason as to why that should be the case."

The trader says that there have been half a dozen or so small equity lists traded, including blocks of up to around €25m. He adds: "There has been on average seven or eight lines of €2m and €3m of a real mixture of quality; there has been some top-tier equity and there has been other stuff, which is not really cashflowing. Desks have just been inundated with these lists for the past few days - all this week in fact."

What is trading is coming not just from a couple of core accounts putting out lists, but rather from a varied spread of accounts. The trader knows that most of these are not forced sellers - although some may be - which makes the timing of this wave all the more surprising. Generally, they have held the equity for a fairly long time and are simply choosing now as the time to sell, the trader believes.

For all the confusion, trading levels have held up fairly well. The trader notes: "Some of it has traded very strongly and some of it has traded quite weakly. The more cuspy stuff has been trading anywhere from the mid-teens to the 20s, but the more attractive propositions have been trading quite a bit higher, such as anywhere around the 60s and 70s."

All of which has come as some surprise to the market. "A lot of traders have been scratching their heads and wondering whether there is something they should be aware of," the trader concludes.

JL

CMBS

CMBS A/B splits, assumptions increasing

US CMBS loan modification activity continues apace. However, modifications are becoming more sophisticated, with A-note/B-note splits and assumptions gaining in popularity.

Only about 47% of loans modified in the first half of 2011 had their maturity dates extended, according to CMBS analysts at Barclays Capital, compared to as high as 70% a year ago. A-note/B-note splits, on the other hand, account for 26% of all modifications in the first half of 2011 after being in the low single-digits at the beginning of last year.

Another 11% of loans had their amortisation terms modified either as a switch from paying principal and interest to interest-only, or to include a hyper-amortisation feature. In addition, 6% saw changes to their reserve requirements, while 4% saw some principal write-off.

Modifications have typically been executed at the request of the original borrower because seller financing wasn't attractive enough, with potential buyers of distressed assets funding their acquisitions elsewhere rather than assume in-place CMBS debt. However, the BarCap analysts note that a greater number of modifications are now being closed with assumptions, indicating that the underlying properties are changing ownership and that the new sponsors are considering seller financing.

"We believe such assumptions are more likely when large sponsors are willing to give the keys back to the lenders trying to dispose of non-core assets in their portfolios. Typically, modification terms on assumed loans tend to be less favourable to the trusts," they explain.

Larger balance (over US$100m) loans tend to be modified more often, with special servicers liquidating smaller (below US$15m) loans, including through note sales. There have been only two cases over the last year in which loans with an original balance exceeding US$100m have been liquidated: One Park Avenue was disposed of with a 1% severity, while Pacific Arts Plaza experienced a 19% severity. Loans backed by properties in prime locations where commercial property prices are on the rise also tend to be modified more often, according to the analysts.

Recent modifications have often resulted in high interest shortfalls to the trust, in some cases hitting the AJ tranches. While shortfalls in the CMBS conduit universe appear to be stabilising in the range of 4.5%-5% of outstanding balance, their composition keeps shifting. The analysts suggest that ASERs were among the largest contributors to interest shortfalls in the past, but now non-accruing interest B-notes are increasingly contributing to them.

Modifications are generally viewed as positive for interest-only tranches and shorter-duration front-pay tranches that are trading at a premium, because they are expected to remain outstanding for longer. The impact of modifications on junior tranches is less obvious, however.

CS

CDS

Roadmap for adoption

Paul Middleton and Simon Rees-Goddard, vps at Sapient Global Markets, answer SCI's questions

Q: How did Sapient Global Markets become involved in the structured credit market?
SRG: Sapient Global Markets has been working with institutions involved in structured credit for over 20 years. Our unique perspective - born from being closely aligned with both market participants and system providers, intermediaries and regulatory bodies - enables us to provide a differentiated service to clients that spans the entire project lifecycle. Our typical involvement includes advising clients on setting operational targets - often that then need to be agreed with regulators - then determining, developing and implementing the right technology and process to achieve those targets, before measuring the impact and benefit.

PM: The group employs 3000 people across Europe, the Americas and Asia. Our clients include large investment banks, hedge funds, asset managers, utilities, and oil and gas companies, as well as a number of regulatory bodies. We look to engage at the senior level and deploy from a strategic perspective.

Q: What are your key areas of focus today?
SRG: Our business adapts to client and market need. Today, a lot of that stems from changing derivatives industry commitments, which have, over the years, morphed into a roadmap to adoption. The whole market is undergoing a sea-change and our business is designed to help clients meet these challenges, streamline processes to become best in class and help them capitalise on any opportunities that may arise.

PM: Regulatory change has brought an added imperative for clients to understand their portfolios and demonstrate this by transparency of approach. Within structured credit specifically, we have specific service offerings that review complex portfolios for completeness and accuracy of bookings. We combine these services with wider advisory services around, for example, valuations and workflow optimisation.

SRG: The onus is on getting it right first time, which involves beginning with the correct data and then getting the product hierarchy right. Conceptually, it's like an inverted pyramid: if the systems and controls are right, it's possible to do less to the trade as it goes through the trade lifecycle and you end up with a clearer picture on which to report.

This sometimes involves undertaking a detailed root cause analysis to identify any problems in the process. In terms of valuations, for instance, it is possible to take remedial action and ensure that the right checks and balances are in place. But this isn't always the case, and firms should be looking at how best to achieve transparency in order to meet new reporting and compliance requirements.

Q: How do you differentiate yourself from your competitors?
PM: We add value by understanding our clients' critical issues and investing in the appropriate people/knowledge. We've achieved this by developing specific practices with expertise in particular areas of concern to the industry and across the entire trade lifecycle. Today, these are areas such as market initiatives, trade documentation, valuations and risk assurance. Each of these practice groups has the ability to deliver end-to-end projects, including technology, programme management, advisory, analytics and operations services.

As part of this, our staff often chair industry committees and, as certain challenges arise, practices can be established with the relevant expertise to deliver a wide range of solutions and services. The delivery methodology is based on quality control and client feedback.

SRG: Another differentiator is our burst capacity - in other words, the ability to bring additional resources where necessary. Within structured credit, for example, we have teams that are able to support the whole post-trade transaction management lifecycle - delivering either an in-house or outsourced solution. We recognise that we have to be flexible to change with the times and scalable to meet regulatory changes, as well as any up-tick in volumes.

Q: Which challenges/opportunities does the current environment bring to your business and how do you intend to manage them?
PM: Some of the key challenges for the derivatives industry at present are clearing, workflow optimisation and regulatory reporting. The areas where banks are investing significant amounts are market infrastructure and market initiatives. We're spending time with clients, planning their responses to regulatory change across multiple complex projects.

SRG: The 'eureka moment' for the industry was when banks recognised that they are only as good as their counterparty. So we've worked closely with regulators, industry associations, member firms and service providers to firm up solutions to this issue.

Q: What major developments do you need/expect from the market in the future?
SRG: The need for regulatory change has been accepted by the industry, but uncertainty remains about what shape it will take in the future. Compliance to current and future regulatory requirements will be an area that continues to gain momentum and that drives the majority of thinking as the market endeavours to re-establish trust.

PM: Going forward, firms will also look even more closely at trade lifecycles and transaction management. For example, there will be a greater emphasis on identifying portfolios that are in run-off and whose management can be outsourced to create economies of scale. However, as clients seek to drive down cost per trade, there are compelling reasons to outsource any number of trade lifecycle functions or repeatable activities.

CS

ABS

Securitisation vet promoted

Linklaters has named Jim Rice as divisional practice head of finance & projects, for a four-year term, replacing John Tucker. Rice will retain his role as global practice head for capital markets and Tucker is returning to full-time client work. Alongside his new role, Rice will continue to be engaged in client work.

ABS

SF lawyer moves on

Todd Miller has joined Greenberg Traurig as shareholder in its Orlando office, expanding the firm's corporate & securities practice in Florida. Miller's areas of experience include banking, lending and structured finance; mergers and acquisitions; and private equity. His structured finance practice includes credit card, automotive, trade receivable and other asset type securitisations on behalf of originators, underwriters and conduit sponsors.

CDO

ABS CDO transferred

Cutwater Asset Management is set to replace Western Asset Management Company (WAMCO) as collateral manager on Coronado CDO. Moody's has confirmed that the move will not result in the withdrawal, reduction or other adverse action with respect to the ratings on the notes. In assessing the credit impact of the appointment of Cutwater, the agency assessed the history of Cutwater's collateral management of transactions comparable to the issuer, the adequacy of its systems for managing the transaction and the level of active management required for this transactions, which is no longer actively reinvesting collateral debt securities.

CDS

CDS risk manager added

Pierre Bourlatchka has been appointed a director at Kinetic Partners and will join the risk management consulting and monitoring team in London. He joins the firm from F&C Asset Management, where he worked for the alternative investment market risk team, focusing on AI risk management and reporting. Prior to this, he worked within risk management and quantitative analysis at Deephaven Capital Management on its credit derivatives, high yield & fixed income and volatility & convertibles bonds funds.

CLOs

Aladdin to focus efforts on alternatives

Aladdin Capital has announced a strategic reorganisation by downsizing its global capital markets business. The firm says it will now focus its efforts on its alternative credit asset management business, which has been the core area of expertise since it was founded in 1999. Aladdin will continue to grow its established platform of investment products while looking to provide new innovative investment solutions for sophisticated investors.

CLOs

CypressTree CLO offloaded

Acis Capital Management has been appointed successor collateral manager on Hewett's Island CLO I-R. The transaction was originally managed by CypressTree Investment Management, which was acquired from Primus Guaranty last year by CIFC (SCI passim).

Acis is an affiliate of Highland Capital Management and Highland is a sub-advisor to Acis. In this capacity, Highland provides to Acis certain shared services, investment research and analysis and a programme of collateral evaluation, sale and reinvestment support.

A new collateral management agreement is being entered into by the issuer and Acis, which essentially follows the key terms and provisions of the existing collateral management agreement. Moody's has determined that the move will not result in the withdrawal, reduction or other adverse action with respect to its current ratings on the notes.

CLOs

Saratoga management team enhanced

Saratoga Investment Corp has appointed Michael Grisius as md and cio of Saratoga Investment Advisors, the management company overseeing its portfolio. The firm also intends to nominate Grisius to its board of directors.

Grisius was previously co-chairman of the investment committee of Allied Capital, where he worked for 16 years originating and managing more than US$2bn of subordinated debt investments, senior unitranche loans and control buyouts. Before that, he was at KPMG Peat Marwick and Chemical Banking Corp.

Saratoga Investment Advisors last year purchased a minority stake in GSC Investment Corp (SCI 21 April 2010) and has since then strengthened its loan portfolio and expanded its asset base. The appointment of Grisius is part of Saratoga Investment Corp's ongoing enhancement of its management team, the firm says.

RMBS

WesCorp suit filed

The NCUA has filed another suit in California against RBS Securities, alleging violations of federal and state securities laws and misrepresentations in the sale of securities to WesCorp. This law suit follows two similar legal proceedings filed in the Federal District Court of Kansas against JPMorgan Securities and RBS (SCI 21 June).

As liquidating agent for WesCorp, NCUA has a statutory duty to seek recoveries from responsible parties to minimise cost to its insurance funds and the credit union industry. This latest action seeks damages in excess of US$629m, totalling more than US$1.5bn when added to the damages sought in the previous filings.

NCUA's new suit against RBS claims the sellers and underwriters of the securities made numerous material misrepresentations in the offering documents. These misrepresentations caused WesCorp to believe the risk of loss associated with the investment was minimal, when in fact the risk was substantial. The MBS experienced dramatic, unprecedented declines in value, effectively rendering WesCorp insolvent.

Any recoveries from these legal actions would reduce the total losses resulting from the failure of the five corporate credit unions, the NCUA says. The five wholesale credit unions placed into NCUA conservatorship and now liquidated are: US Central, WesCorp, Southwest Corporate, Members United Corporate and Constitution Corporate. NCUA anticipates a total of five to 10 actions overall to recover losses from the purchase of securities that caused the failures of these credit unions.

RMBS

Ex-Freddie Mac counsel recruited

SNR Denton has appointed Robert Bostrom as partner and co-head of its global financial institutions and funds sector. He was previously evp, general counsel and corporate secretary of Freddie Mac, having directed its legal strategy through the financial crisis and recovery.

Bostrom will share leadership of the global financial institutions and funds sector with partner Jana Cohen Barbe. He is expected to lend his experience to the firm's financial regulatory reform special situations team, which helps clients navigate the sweeping changes required by the Dodd-Frank Act. He also will help lead the firm's multidisciplinary corporate governance crisis management team, which draws together the firm's white collar, internal and governmental investigations, public policy, capital markets, SEC enforcement, corporate governance, and state Attorneys General lawyers and professionals.

ABS

Sound supervisory framework recommended

The Joint Forum has released its 'Report on Asset Securitisation Incentives'. The report is based on an extensive literature review, as well as interviews in Europe, the US and Australia with originators, issuers, service providers and investors.

The report analyses the incentives to engage in securitisation throughout the market before the financial crisis, the distortions created by misalignments and conflicts of interest which emerged, and the interplay of incentives in the aftermath of the crisis. It also examines some of the reasons why there has yet to be a meaningful recovery in securitisation activity. The report outlines three recommendations to authorities on the tools and approaches they can employ to promote a sustainable and responsible securitisation framework.

Tony D'Aloisio, chairman of the Joint Forum, comments: "Re-establishing securitisation on a sound basis is a priority for the FSB and part of the G20's push to strengthen the international financial regulatory system. The Joint Forum recognises the important contribution it can make due to its cross-sectoral representation from the banking, insurance and securities sectors. Drawing on an extensive literature review and interviews with market participants in several key jurisdictions, this report provides an important perspective on the dynamics prevailing in securitisation markets and aims to inform the continuing regulatory efforts internationally to facilitate a sound and responsible framework for securitisation markets."

The report confirms funding diversification, risk transfer, revenue generation and regulatory capital benefits as the key drivers for securitisation originators and issuers before the crisis. Investors saw securitisation as a source of high credit quality assets, portfolio diversification and attractive risk-adjusted yields. The key incentives that drove participation in securitisation markets before the crisis remain today, according to the report.

The report recognises that regulators can play a role in establishing a framework for securitisation that ensures it is conducted in a prudent manner, continues to be an alternative funding source for institutions and contributes to the availability of credit to support the real economy. They can do this by building a regulatory and supervisory framework that addresses the misaligned incentives and conflicts of interest and which supports enhanced disclosure and transparency for investors.

ABS

US rating review hits guaranteed ABS

Moody's has placed the US government's Aaa bond rating on review for possible downgrade, given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on US Treasury debt obligations. In conjunction with this action, the rating agency has placed on review the Aaa ratings of financial institutions directly linked to the US government: Fannie Mae, Freddie Mac, the Federal Home Loan Banks and the Federal Farm Credit Banks. It has also placed on review securities either guaranteed by, backed by collateral securities issued by or otherwise directly linked to the US government or the affected financial institutions.

Moody's announced on 2 June that a rating review would be likely in mid-July unless there was meaningful progress in negotiations to raise the debt limit. The agency considers the probability of a default on interest payments to be low, but no longer to be de minimis.

An actual default, regardless of duration, would fundamentally alter its assessment of the timeliness of future payments and a Aaa rating would likely no longer be appropriate, Moody's notes. However, because this type of default is expected to be short-lived and the expected loss to holders of Treasury bonds would be minimal or non-existent, the rating would most likely be downgraded to somewhere in the Aa range.

The specific rating that would be assigned at the conclusion of the review once such a default is cured would depend on: the speed with which the default is cured; an assessment of the likely effect on future borrowing costs; and whether there is a change in process for raising the debt limit that would preclude another default. A return to a Aaa rating would be unlikely in the near term, however, particularly if there were no progress on the third consideration.

If the debt limit is raised again and a default avoided, the Aaa rating would likely be confirmed. However, the outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction. To retain a stable outlook, such an agreement should include a deficit trajectory that leads to stabilisation and then decline in the ratios of federal government debt to GDP and debt to revenue beginning within the next few years.

Among the securities affected by the action are structured finance bonds that hold government-linked debt as their primary collateral. These include transactions defeased by US Treasury strips, transactions backed by FFELP government guaranteed student loans and USRMBS backed by government agency mortgages.

ABS

Portuguese ABS ratings hit

Moody's has downgraded the ratings of 18 tranches of 13 Portuguese ABS and 95 tranches of 29 RMBS transactions. 12 ABS tranches from seven ABS deals remain on review for possible downgrade. The agency has also placed on review the rating of an ABS tranche guaranteed by the European Investment Fund, as the benefit of the guarantee may be conditional to the performance of transaction parties.

The rating actions follow Moody's decision to downgrade the Portuguese government's debt rating to Ba2 from Baa1 on 4 July 2011, as well as its revision of the key collateral assumptions for Portuguese receivables and the ongoing rating review initiated on 9 June of Portuguese banks that are key transaction parties in Portuguese structured finance transactions.

LTR Finance 5 is not affected by the rating action, however, as the originator has announced publicly that it will redeem the transaction on 26 July. For Caravela SME No. 1, the originator is proposing to restructure the transaction by introducing an independent cash manager and increasing the credit enhancement. However, all classes of notes remain on review for possible downgrade pending implementation of the restructuring proposal.

Moody's no longer expects most Portuguese structured finance transactions to retain or achieve a rating higher than A2, which is six notches above the government's rating. This determination reflects the weaknesses in the Portuguese economy and in the government's balance sheet, which together with the changes in the euro area support framework prompted Moody's recent multi-notch downgrades of the Portuguese government's rating.

ABS

Cat bond duo prepped

Two new cat bonds hit the market last week. Munich Re is marketing the third in its Queen Street series, while Swiss Re is offering the latest iterations of its Vita mortality transactions.

The US$50m Queen Street III Capital European windstorm deal has been given a preliminary rating of single-B plus by S&P. It will cover European windstorm in Belgium, Denmark, France, Germany, Ireland, Luxembourg, the Netherlands and the UK between July 2011 and July 2014. The transaction provides protection to Munich Re for Europe windstorm losses above an index value of 10,000 up to an index value of 15,000 on a per-occurrence basis.

Swiss Re, meanwhile, is in the market with US$50m series V class D and US$50m series VI class E notes issued by Vita Capital IV. The bonds have been given preliminary triple-B minus and double-B plus ratings by S&P.

Series V noteholders will be at risk from an increase in age and gender-weighted mortality rates that exceeds a specified percentage of a predefined index in Canada and Germany. Series VI noteholders will be at risk from an increase in age and gender-weighted mortality rates that exceeds a specified percentage of the MIV in Canada, Germany, the UK and the US. The risk period for both series runs from 1 January 2011 to 31 December 2015.

The MIV will be defined on a rolling two-year period, with the probability of a loss attaching and the magnitude of the loss in principal depending on the extent to which the MIV for any country and measurement period exceeds the attachment point for the notes.

ABS

APAC ratings largely stable

Fitch reports that the ratings of structured finance tranches backed by assets in the Asia-Pacific region were largely stable in 2Q11, although there are specific sectors where the agency's outlook is negative.

"The outlook for certain Japanese CMBS remains negative at this time, although an increased proportion of this sector is now on stable outlook as Fitch has downgraded many tranches to levels considered commensurate with the outstanding risks," says Alison Ho, senior director in Fitch's structured finance team and head of APAC SF performance analytics. "As the time to legal final maturity approaches, the possibility of some property sales being completed in time to redeem the outstanding notes diminishes."

All rating actions in Japan during the quarter were on CMBS transactions where a total of 22 tranches were downgraded, three were placed on rating watch negative (RWN), three were upgraded and a further 22 were affirmed. The downgrades resulted from the impact of the remaining time to maturity on the likelihood of full principal repayment, interest deferrals and downwards revisions to commercial property values.

Meanwhile, over 50 Australian RMBS are currently on RWN, pending the publication of Fitch's criteria on the credit given to lender's mortgage insurance in RMBS. This is expected to be published shortly and the agency anticipates reviewing all tranches on RWN within six months of publishing the final criteria.

But over 80 Australian/New Zealand tranches were affirmed during 2Q11 as a result of steady asset performance, while two ABS tranches were upgraded.

Elsewhere, one Taiwanese CMBS transaction remains on negative outlook, with other ratings in the region expected to remain stable. The performance of Indian SF also continues to be stable, with over 20 tranches affirmed during 2Q11.

ABS

Indian counterparty exception made

Fitch says it will make an exception to its counterparty criteria for Indian ABS and RMBS transactions that have an account bank as a single investor with a credit rating of at least A(ind)/F1(ind). The agency draws comfort in these cases from the fact that the investor is in possession of the fixed deposit required to maintain the transaction's rating above the account bank's ratings.

Current structures used in Indian structured finance typically use credit enhancement provided in the form of cash collateral held with a single account bank. "Most Fitch-rated Indian SF transactions are exposed to excessive account bank dependency as the credit enhancement supporting the ratings of these transactions is in the form of cash collateral kept at an account bank as fixed deposits," explains Sandeep Singh, head of Fitch's structured finance team in India. "Fitch's counterparty criteria defines excessive account bank dependency whereby, on the failure of the account bank and consequent loss of the credit enhancement, the transaction's notes could be downgraded by 10 notches or more, and potentially default."

"Securitisation structures have evolved globally, in most cases, to avoid excessive dependency on a single party. The agency expects the Indian market to take similar steps over time," says Ben McCarthy, head of Asia Pacific structured finance at Fitch. "Typically, credit enhancement in global ABS structures is derived from overcollateralisation (an excess of assets over liabilities), as opposed to cash held at a bank, to avoid such a dependency."

Direct assignment transactions which are 'bilateral trades' and 'held to maturity' dominate the Indian SF market, compared to transactions that are widely distributed and traded in the secondary market. In most Fitch-rated Indian ABS and RMBS transactions, the investing party - which is also a bank - is the sole investor and also acts as the account bank to hold the cash collateral account. The agency believes that this arrangement mitigates the excessive exposure of the transaction to the account bank, as the cash collateral is held by the sole investor and can be utilised by it at any time against shortfalls in note payments.

In such cases, Fitch will seek confirmation - as part of surveillance information to be received from the seller - that the investor is unchanged from transaction closing. In cases where the investor is not the account bank, the excessive account bank dependency could be mitigated if more than one bank holds the cash collateral in separate fixed deposits to diversify the risks arising out of dependence on a single entity to support transactions at AAA(ind) rating levels.

However, PTC transactions - where there is a greater possibility of wider syndication and subsequent secondary trading - may have different investors at different times that may not be the account bank. In such cases, Fitch will also seek a confirmation from the trustee on a regular basis and - if the investor and account bank are different - the rating of such transactions would be credit-linked to the account bank's rating.

ABS

US-linked SF ratings on review

S&P has placed its ratings on 604 structured finance transactions on credit watch negative after it placed on CWN its triple-A long-term and A-1+ short-term sovereign rating of the US. Moody's took similar rating actions on 13 July (SCI 14 July).

S&P's sovereign credit watch action reflects the agency's view of two separate but related issues, it says. The first issue is the continuing failure to raise the US government debt ceiling so as to ensure that the government will be able to continue making scheduled payments on its debt obligations. The second pertains to S&P's current view of the likelihood that Congress and the Administration will agree on a credible, medium-term fiscal consolidation plan in the foreseeable future.

The 604 structured finance transactions, which had an original issuance amount of US$373.67bn, on CWN represents approximately 3% of the total structured finance transactions S&P rates globally. Of the affected deals, 39 are RMBS (with a principal amount of US$23.3bn), 46 are CMBS (US$7.5bn), 62 are structured credit (US$39.2bn), 387 are ABS (US$259.1bn) and 70 are ABCP vehicles (US$44.6bn). This list, however, excludes transactions with holdings of US government securities as eligible investments.

Specifically, the negative credit watch placement of the US sovereign rating will affect the ratings assigned to structured finance securities with distinct structural characteristics that typically include direct exposure to US-backed securities. These include principal-protected notes, defeased securities (or transactions with defeased collateral) and transactions with ratings directly or in part linked to the sovereign rating of the US. Transactions with eligible investments composed of holdings of US government obligations are not included in these credit watch placements, however.

S&P says it will continue to surveil the ratings on these structured finance securities and revise them as necessary to reflect any changes in the transactions' credit quality. In addition, it may take further rating actions on pending the resolution of the ongoing credit watch status of the US government ratings.

CDO

CRE CDO hits the market

Deutsche Bank has arranged the first CRE CDO to hit the market post-crisis. The US$670.5m transaction, dubbed Prima Capital CRE Securitization 2011-1, will be managed by Prima Capital Advisors. Amherst Securities, Bank of America Merrill Lynch, Morgan Stanley and Wells Fargo are co-lead managers on the deal.

The collateral pool comprises 57 assets: 22 CMBS certificates from 11 trusts (accounting for 26%); 19 REIT debt securities issued by nine REITs (25.3%); 10 whole loans (24.2%) secured by first priority liens on commercial real estate; two B-notes secured by liens on CRE (10.1%); two mezzanine loans (9.2%); and two credit tenant lease securities (5.2%).

Kroll Bond Rating Agency has rated the deal, along with Moody's. The capital structure consists of US$189m class A-1A notes, US$146.3m A-1Bs, US$67.7m A-2s (all rated triple-A), US$32.8m double-A class Bs, US$21.8m single-A class Cs and US$66.4m triple-B minus class Ds.

CDO

US CRE CDO delinquencies post largest-ever drop

Delinquencies for US CRE CDOs saw their largest decline in almost four years, according to the latest index results from Fitch.

Late-pays declined significantly to 12.6% in June from 14.1% in May, representing the largest monthly drop since Fitch began tracking CRE CDO delinquencies in October 2007. Only two new delinquent assets were reported last month.

"Much of last month's drop in CREL CDO delinquencies is related to the disposal of troubled assets and corresponds to realized losses on the CDOs," says Fitch director Stacey McGovern. "Like CMBS, CREL CDO delinquencies are likely to remain somewhat volatile with significant month to month fluctuations as new loans become delinquent and delinquent loans become resolved."

Fitch's analysis already takes into account expected losses and potential future increases in delinquencies. While new delinquencies included only one matured balloon and one term default, 25 formerly delinquent assets were removed from the index. Many of these resolutions resulted in better than expected recoveries to their respective CDOs.

In fact, Fitch says over half were resolved without losses to the CDOs. Further, some asset managers were able to affect positive outcomes involving partial paydowns or increased reserve deposits as part of a loan restructuring. However, some loans that were brought current or extended may reappear in the delinquency index if these workouts prove to only postpone an inevitable default. This is why Fitch's average modelled default rate continues to be higher than actual.

CDS

Uncertainty indicated ahead of bank earnings

Market uncertainty surrounding major banks continues to increase, as evidenced by their still-widening CDS spreads, according to Fitch Solutions in its latest earnings commentary.

CDS on Bank of America Corporation and Goldman Sachs Group, both reporting tomorrow, have been among the biggest underperformers over the past quarter. BofA's spreads are 31% wider, while Goldman has come out 29%. Both BofA and Goldman are underperforming the broader US banking sector, for which CDS have widened by 20%.

Further signs of uncertainty are evident in the increasing CDS liquidity for both BofA and Goldman, Fitch notes. Though both banks had established triple-B minus trading patterns, on a spot basis CDS on BofA are testing below investment grade levels.

"The market is pricing in more risk for BofA than Goldman, which may be reflective of BofA's mortgage-related legal challenges and increased scrutiny over capital requirements," says Fitch director Diana Allmendinger.

CDS on Morgan Stanley have also underperformed (widening by 24%), while CDS liquidity moved up two rankings to trade in the second regional percentile along with BofA. "Persistently wide CDS spread levels and increasing CDS liquidity point to continued market concern for Morgan Stanley," Allmendinger adds.

CDS

CFTC provides Dodd-Frank relief

The CFTC has issued an order clarifying the effective date of the provisions in the swap regulatory regime established by Title VII of the Dodd-Frank Act. The order provides temporary relief from certain provisions that will become effective as of 16 July, until the CFTC completes the rulemakings specified in the order.

The action is aimed at avoiding disruption in the markets and will provide for the orderly implementation of the new comprehensive swap regulatory regime mandated by Congress. This order is temporary and will expire upon the effective date of final rules or 31 December.

Specifically, the CFTC provided relief from certain provisions of the CEA added or amended by the Dodd-Frank Act that do not require a rulemaking but that reference one or more terms regarding swap entities or instruments that the Dodd-Frank Act requires be 'further defined'. It also provided relief from certain provisions of the CEA that will or may apply to certain agreements, contracts and transactions in exempt or excluded commodities.

CDS

ML2 auctions dampen subprime CDS rally

A modest decline for US subprime CDS prices has effectively closed the chapter on an unprecedented rally, according to Fitch Solutions in its latest commentary on the sector. Subprime CDS prices declined by 1.8% last month, after a seven-month rally that saw prices rise by 126%.

"The modest subprime price weakness last month was driven in part by Maiden Lane II's poor auction performance," says Fitch director David Austerweil.

Not only was June's auction the largest on record, but it was also the least successful with just under 50% of the bid list being sold. "Maiden Lane's sub-par auction results have left an abundance of future subprime supply that will continue to pose as a short-term negative for subprime CDS prices," adds Austerweil.

Since the New York Federal Reserve Bank has not committed to a defined auction schedule in its disposition of subprime assets, uncertainty regarding future Maiden Lane II supply could serve as a ceiling for prices.

The current index level is 12.18, down from a price level of 12.40 at the end of May. Price declines were evident in most vintages, with only the 2007 vintage increasing by 4.6%.

In contrast, the 2004 and 2005 vintages declined by 1.9% and 2.9% respectively. The 2006 vintage declined by a more modest 63bp after last month's 8.4% drop.

The minor downturn also reflected in 30-day and 60-day delinquencies and current to delinquent roll rates, all of which increased modestly last month. The 30-day delinquency rate rose by 2.3% month-over-month, with the 2007 vintage showing a larger month-over-month increase than peers at 3.1%.

The 60-day delinquency rate rose even faster, with a 7.6% increase month-over-month for the overall index. The rise in the 60-day delinquency rate reflects both the recent uptick in 30-day delinquencies and an increase in roll rates from 30-day to 60-day delinquency.

"After several months of stagnancy, the loan delinquency and foreclosure pipeline is beginning to move again," says Fitch senior director Alexander Reyngold.

There was an increase in loans moving to the later stages of delinquency last month. There was also a significant increase in loans moving from foreclosure to real estate-owned.

"If a trend develops where a higher percentage of late-stage delinquency loans become real estate-owned, the foreclosure backlog may begin to clear," concludes Reyngold.

CDS

CDS operations challenges outlined

Citi has released a whitepaper that outlines the top-five issues that OTC derivative investors must plan for in the wake of Dodd-Frank reforms. Specifically, the report describes the challenges facing investment managers across operations and technology infrastructure.

Citi estimates that about 60% of the current OTC derivatives market by volume will be centrally cleared. "Investment managers should expect significant technology and operational challenges and may need sizeable reengineering of their infrastructure to prepare for central clearing, oversight and reporting, and increased reconciliations," comments Neeraj Sahai, global head, securities and fund services at Citi.

The paper highlights that institutions will be subject to mandated central clearing of most OTC derivatives, higher margin requirements for non-cleared swaps, increased margin and collateral complexity, and increased reporting requirements. It points out that although some final rules have not been issued, firms with substantial swap positions, major uncollateralised exposure or that are highly leveraged will likely be required to register as either swap dealers or major swap participants. This would subject them to a number of new requirements, including capital and margin requirements, reporting and recordkeeping requirements, position limits and business conduct requirements.

In this new environment, the report suggests that investors should consider taking the following actions: determining the regulatory classification of their organisation; put clearing relationships in place; establishing trade connectivity; ensuring that internal operations and technology staff can meet the new reporting and reconciliation guidelines; and assessing the impact of central clearing on margin and collateral levels.

CDS

ICE completes Dodd-Frank transition

ICE Trust US completed its transition to a CFTC-regulated derivatives clearing organisation (DCO) and SEC-regulated securities clearing agency (SCA), as required by the Dodd-Frank Act, on 16 July. In addition, the clearinghouse has converted from a New York State Banking Department and Federal Reserve regulated bank and will be known as ICE Clear Credit.

ICE Clear Credit will continue clearing the 168 products it offers for clearing across North American CDS indices (CDX) and single-name instruments as a DCO and SCA. With the transition from Federal Reserve and New York State Banking Department oversight, ICE Clear Credit will be regulated by the CFTC for broad-based index products and by the SEC for single-name products. The DCO and SCA structure also provides full customer protection under the CFTC's and SEC's regulatory framework, including margin segregation and portability.

As of 8 July, ICE's credit default swap clearinghouses had cleared US$20trn in gross notional value with aggregate open interest of US$1.5trn.

CMBS

CMBS pay-off percentage jumps

The percentage of US CMBS loans paying off on their balloon date jumped in June, according to the latest Trepp pay-off report. This jump comes on the heels of two consecutive months where the percentage fell.

In June, 42.4% of loans reaching their balloon date paid off - over seven points above the May reading. The June number was above the 12-month rolling average of 39.6%.

By loan count, as opposed to balance, 56.1% of the loans paid off - also up from May's 48.1% reading. On the basis of loan count, the 12-month rolling average is now 48.2%.

Prior to 2008, Trepp says the pay-off percentages were typically well north of 70%. Since the beginning of 2009, however, there have only been two months where more than half of the balance of the loans reaching their balloon date actually paid off.

CMBS

Further mezz CMBS supply expected

Additional US mezzanine conduit CMBS supply could hit the market, following the US$1bn liquidation of LNR VI 2007-2 CRE CDO last Friday. The liquidation was triggered by an EOD due to the B tranche taking interest shortfalls since April. Increasing modification rates are expected to trigger more interest shortfalls in the future, resulting in further CDOs experiencing EODs.

In the case of the LNR transaction, two-thirds of the controlling class noteholders voted to accelerate principal and interest payments to the trust, through a sale of assets. Given the subordinate nature of the underlying bonds, their value lies in the associated special servicing rights.

CMBS analysts at Barclays Capital note that in the past a number of controlling B-pieces were bought by third-parties via a CDO liquidation, which ultimately resulted in the replacement of the special servicer. "Given that LNR has a faster liquidation pattern, [the] possibility of their replacement certainly deserves attention from a pure modelling standpoint," they observe.

CMBS

EMEA special servicing activity reviewed

Moody's reports in its latest EMEA specially serviced loan update that four loans were transferred into special servicing during June. One loan was removed, bringing the total number of loans in special servicing across EMEA CMBS large multi-borrower and single-borrower transactions monitored by the agency to 104.

Highlights for the month include the restructuring of the €581m Mozart Loan securitised in Talisman - 7 Finance, which was completed such that a costly and lengthy borrower insolvency has been avoided, enabling an orderly loan work-out (SCI 12 July). Contracts were also exchanged for the sale of the office property backing the St Katharine Dock loan, with completion due on or before 8 August. The sale price of £156.3m is expected to fully repay the securitised debt in Taurus CMBS (UK) 2006-2.

Meanwhile, Southern Cross Healthcare Group has announced that all landlords indicated their intention to leave its operating business and that it will cease to be an operator of care homes at the end of the restructuring period (SCI 13 July). The borrower of the single loan securitised in Titan Europe 2007-1 (NHP) and the borrower of the newly transferred Ashbourne loan securitised in both Equinox (Eclipse 2006-1) and Hercules (Eclipse 2006-4) are landlords to Southern Cross. The special servicer of the loans is evaluating all options available to it with a view to the maximisation of recovery on the loans.

Finally, the loss in relation to the last remaining loan of Ursus EPC - the Castlegate loan (originally £36m) - has been determined. The £8.9m loss will be borne by the class C, D and E notes.

The weighted average Moody's Expected Principal Loss for loans in special servicing increased to 37% from 35%, primarily due to increased loss expectation on the loans securitised in Titan Europe 2007-1 (NHP) and Opera Finance (Uni-Invest).

RMBS

Servicing advance recovery policies updated

Ocwen Loan Servicing has updated its servicing advance recovery policies on future servicing acquisitions, including its impending acquisition of Litton Loan Servicing. The firm says that the policy adjustments are intended to minimise cash shortfalls on current investment grade rated non-agency RMBS bonds following a servicing acquisition or transfer.

Ronald Faris, Ocwen president and ceo, comments: "Acquisition opportunities are increasing as major financial institutions divest servicing operations. Ocwen's low operating and advance financing costs, coupled with access to capital, provide a competitive advantage to acquire available non-agency servicing. Our prior experience and proven processes make for operationally seamless servicing transfers of large portfolios, whether they involve acquisitions of entire platforms, mortgage servicing rights only or subservicing arrangements."

The policy adjustments include Ocwen modelling each RMBS deal transferred and deriving the amount of cash needed to maintain sufficient cashflow on highly rated bonds, as well as any required swap payments. To the extent the model shows that standard advance recovery procedures would contribute to a cash shortfall to highly rated bonds or swap counterparties, Ocwen will eliminate the shortfall by deferring recovery of certain advances in that remittance cycle.

The firm will first defer the recovery of any principal and interest amounts over-advanced by the previous servicer. It will next defer recovery of principal and interest advances on completed loan modifications. Finally, it will maintain or increase these voluntary deferrals in subsequent months to achieve the targeted remittance amounts until cashflows are sufficient to allow reimbursement.

Ocwen chairman Bill Erbey notes: "Even though these adjustments are not legally required and will temporarily increase our cost of advance financing, we view them as part of the investment needed to successfully execute on our planned strategy. This updated policy combined with our ongoing success in rehabilitating a greater number of delinquent borrowers through loan modifications should generate more cash and lower overall pool losses, thus benefiting all bondholders."

Ocwen estimates that its advance recovery changes, when implemented upon the Litton transfer, will defer up to US$25m in servicing advance recoveries for a period of approximately four to six months. These changes are not expected to have a material negative effect on Ocwen's advance recovery timelines, liquidity position or financial results.

RMBS

Non-conforming RMBS review completed

Moody's has completed a review of the UK non-conforming RMBS market, noting that performance trends are in line with current expected loss assumptions for the majority of transactions. Furthermore, its ratings are resilient to stressed future loss scenarios, the agency says.

The conclusion is based on stress-testing 75 of the 84 outstanding UK non-conforming RMBS transactions. The review took into account: the effect of potential interest rate increases; the performance of each transaction to date; and the future outlook for this sector.

In particular, Moody's assumed an increase in constant default rates, considering that most of the currently delinquent loans will not be able to cure their arrears in a less benign interest rate environment. This analysis suggests an average expected default rate of approximately 27% for the sector and an average loss severity of 25%. These levels vary for each individual transaction, according to seasoning and performance to date.

As a result of this review, the agency has updated its portfolio loss assumptions in Money Partners Securities 3 and GMAC Securities No.1 NS3s. The collateral performance to date and the negative outlook on the sector going forward suggest higher expected losses than Moody's previously assumed. But the credit enhancement available under the corresponding notes fully offsets this deterioration and so it hasn't affected the current ratings of the notes.

However, Moody's has placed on review for downgrade all the notes issued by Money Partners Securities 4 because of worse-than-expected performance. In this transaction, the credit enhancement available is insufficient to maintain the current ratings with higher loss assumptions.

The remaining 72 reviewed transactions are currently performing broadly in line with Moody's expectations.

RMBS

RMBS recovery service launched

Glass, Lewis & Co has launched a new service designed to help institutional investors and plan sponsors recover their losses on private-label RMBS. Pension funds and institutional investors are believed to have lost more than US$750bn over the past five years.

"Many of our 950 institutional investor clients are participants in the US RMBS market," comments Katherine Rabin, ceo of Glass Lewis. "Our new service will assist them and other investors in getting redress for the losses they incurred when originators, servicers and trustees did not fulfil their contractual and fiduciary obligations."

Glass Lewis' proprietary research and recovery-facilitation service can help institutional investors assess their RMBS investments, identifying securitisations in which there is a high probability that loan origination misconduct has led to investor losses and enabling investors with overlapping holdings to collectively seek recoveries. "We have systems that process thousands of ownership files and millions of transactions a year on behalf of institutional investors," adds John Wieck, Glass Lewis' coo. "Given the significant losses investors have incurred in RMBS, we believe this new service is a great use of that sophisticated technology, especially when coupled with our proven ability to analyse complex governance structures and transactions."

RMBS

Granite hit in counterparty criteria action

S&P has lowered its credit ratings on 91 tranches from Northern Rock's Granite UK RMBS master trust. At the same time, the agency affirmed its ratings on 76 tranches and withdrew ratings on an additional six tranches. The downgrades reflect the application of S&P's 2010 counterparty criteria for structured finance transactions.

The agency placed the senior classes of notes on credit watch negative on 18 January, following the update to its counterparty criteria. S&P has now lowered and removed from credit watch negative ratings on the class A and B notes in the five remaining capitalist issuers - Granite Mortgages 03-2, 03-3, 04-1, 04-2 and 04-3 - to single-A plus from triple-A for the class A notes and to single-A plus from double-A plus for the class B notes.

The agency says it doesn't consider the issuer payment accounts of these issuers to be compliant with its counterparty criteria. As a result, in its analysis S&P linked the ratings to the long-term rating on the bank account provider (Citibank).

However, S&P considers that the bank accounts or the Granite Master Issuer transactions comply with its criteria. But the funding basis swap in these transactions isn't complaint with its counterparty criteria. Therefore, the agency ran its cashflow scenarios without the benefit of this swap.

Separately, given that the notes all pay in a pass-through manner following a non-asset trigger event in November 2008, credit enhancement has been increasing to offset this increase in arrears. As a result, S&P has affirmed ratings on the subordinate classes of notes.

The agency has also withdrawn the ratings on six tranches as the notes have redeemed. Owing to an administrative error, it didn't withdraw these ratings at the time of the note redemptions.