Contents

CDS

Playing safe

Investors repositioning as credit market turmoil continues

As market volatility persists and participants try to predict when the bottom will come, the need to position structured credit portfolios properly becomes more pressing. Several CDO and CDS strategies are possible, with basis trading touted as a particularly attractive option.

The strong market reaction to S&P's downgrade of the US triple-A rating and ongoing uncertainty about European sovereigns are two key factors contributing to the lack of market stability. Michael Hampden-Turner, Citi structured credit strategist, notes for example that the iTraxx volatility started on the day after the US was downgraded (5 August).

He says: "There was also the slightly disappointing summit in Europe. When you add the bad macro data that has been coming out on top of that, everyone is revisiting their assumptions about growth and default rates and what that might mean for their positions."

Investors are rotating from risky assets into safer ones as the Euribor markets are predicting a cut in short-term rates, rather than the increase of a few months before. "Essentially there has been a change in the way the market perceives growth in Europe over the next 6-12 months," says Hampden-Turner.

He adds: "People are less optimistic about avoiding a double-dip recession. Under those conditions, you tend to see everyone readjust their positions; selling cash positions and rebalancing CDS hedges."

Much of the volatility is because of uncertainty as market participants try to second-guess when it will reach its bottom. Up until a few months ago, it was thought that problems would arise in the long term but that the short-term picture was clear. That has changed, as issues such as European sovereign debt now seem far more immediate.

Hampden-Turner believes the situation still has to look a little bit worse before it starts to get better. He says: "I think we have to get to a stage where policymakers get really scared and stare into the abyss and they come up with the goods from a policy decision before the market reaches a bottom. We are not there yet. In Europe we seem to be more reactive than proactive and each reaction seems to be just enough to tide the market over until the next crisis."

Despite the changing economic conditions, structured credit remains an arena with plenty of opportunities. Moving up the capital structure could be one option for the defensively minded, sacrificing a little yield for a gain in subordination.

Hampden-Turner says: "All the strengths that made structured credit attractive in the first place - such as diversity and subordination - should come in to play again. Senior tranches of CLOs and CDOs should be attractive at wides and should be more protected going through the dislocations that we are seeing."

He reports interest all along the capital structure from equity to senior. "A lot of structures since 2008 have rebalanced; they have built up their OC structures and the synthetics are a lot closer to maturity now and looking attractive. Some of these assets should prove their value in the next downturn and should be more stable."

Relative value can be a more prudent approach than taking outright views, so Hampden-Turner also recommends looking at curve shape. He comments: "When Société Générale was going crazy a while ago, for example, it was a great opportunity to go long on Société Générale against France. There are other ways to do similar things now, as well."

Another approach could be to look at basis trades. In times of volatility the relationship between CDS and bonds can often become skewed, offering good opportunities to find value.

Jochen Felsenheimer, md at Assenagon Credit Management, believes basis trading is a particularly attractive strategy. "There are many interesting opportunities in structured credit, but basis trading is a very smart strategy in times like these. The huge volatility means there are many forced sellers in the market. There are a lot of anomalies in the market right now, because it is driven by panic and not by rational investment."

Basis trading is reliant on market segmentation, so the current relationship between CDS and bonds provides a good opportunity to source basis. Felsenheimer says: "In European peripheral countries real money accounts normally dominate the cash market, while the CDS market is dominated by different investors like CVA desks, banks and hedge funds. That means you see completely divergent developments between cash and the CDS side."

Not everybody will be able to pursue the most attractive basis trades though. Banks or insurance companies, for example, may be limited in what they can invest in, but this is not an obstacle for all investors.

Felsenheimer explains: "As a bank you have different regulatory treatment of CDS and bonds, where one might trigger mark-to-market and the other does not. They have limits of buying into basis besides pure economics."

He adds: "When we look at this stuff, we just want to source the biggest basis we can get, while excluding any legal risk. There are always some tail event risks, such as succession events, but you often get compensated very well for taking this kind of risk."

The focus for basis trading in the last few months has been on Europe, with banks and sovereigns such as Greece, Ireland and Portugal most popular. US basis, meanwhile, has not been very attractive, with Europeans facing the additional burden of having to pay the basis swap between euros and dollars.

"If you compare the US and Europe, then Europe is definitely the place you have to be right now. The further development of the basis market in Europe will be driven by the progress of the Greece bailout," Felsenheimer explains.

He continues: "The next tranche must be approved by the end of the month and I expect they will find a solution." The outcome of that bailout could significantly influence basis opportunities.

Felsenheimer believes the opportunities in basis trading will be around for a while yet. He says: "The market will provide many opportunities over the next couple of years, but there will also be more demand for such strategies, simply because more real money accounts have now realised that the traditional approach to asset management is not the best one."

The best approach to take will vary between portfolios. As volatility persists and the market bottom appears closer, now is the time many investors should look to reposition themselves.

"Although we are expecting a crisis, we are not expecting a disaster. Confidence is at rock bottom, which leaves spreads highly leveraged to headlines in either direction. On the bright side, the significant negative surprise to the US economic growth outlook finally appears to be subsiding," notes Hampden-Turner.

He continues: "However, both the political and the economic situation in Europe are likely to deteriorate further over the next few months before things get better. As things get wider, I would long to get long in some select areas of leveraged loans or structured credit as much bad news is already priced in."

JL

CLOs

Euro CLO activity re-emerging

August was a quiet month for the European CLO market, although a couple of "good-sized" bid-lists emerged at the end of last week. This could mark the slow restart of activity in the sector, says one European trader.

"There have been one or two sales here and there. A couple of junior triple-As traded late last week, for example. They traded at around 500DM-600DM. At the tightest, around February or March earlier this year, you were probably talking 300DM-350DM for that type of bid," he adds.

The trader continues: "That was quite a good bid, so we were a little surprised at that. There must have been a customer on the end of those, because the Street bid would definitely have been back from that. Hopefully more deals will follow now."

These bid-lists mark highlights for what has otherwise been a muted market. "We are looking at a percentage of something like 30% of BWICs that have been trading. It seems dealers are generally quite long paper and the offer levels have progressively got cheaper and nobody has been listing bonds in any size," says the trader.

He believes that interest in the market seems to have waned, with participants perhaps becoming a bit fatigued. "People are just a little bit tired. Until the macro picture gets a little bit more transparent and stable, we are going to see our market drift. Nobody has the conviction to go out there and buy a few hundred million dollars worth of bonds, which would make all the difference."

However, as the August holiday season has now ended, many market participants are now returning to their desks, which should bring fresh energy and drive to the market. The trader concludes: "A lot of people are returning to work this week. The market has been so thin up until this point; although we have had some enquiries, the depth is still missing. As people get back in the office, that should help kick things on again."

JL

ABS

Correlation examined between ABS ratings, prices

Investors are justified in using ratings as an initial indication of quality, according to a new report from European ABS strategists at RBS, in which the correlation between ABS ratings and their pricing is explored. However, this should only be an initial indication, given the high standard deviation in pricing for a given rating.

"I think ratings have lost a lot of relevance over time, as evidenced by this high variation on pricing for a given rating," says Krishna Prasad, head of mortgage-backed strategy for Europe at RBS. "More and more investors are making up their own minds about what current rating levels really mean."

The research - based on the current pricing of over 2200 ABS bonds, as well as their current and original S&P ratings - shows that bonds with higher current ratings are, on average, priced higher but there is a substantial deviation around the mean. "A linearly fitted trend regression indicates that each notch is worth about 3.25 points in current markets," says Prasad. "However, the standard deviation of the price is high, suggesting to us that the price difference per notch is not statistically significant. Also, the number of bonds with notched ratings is small, with most bonds concentrated at the un-notched points."

Prasad suggests that the level of dependence of pricing on current rating is as much a function of risk aversion in the market as of rating dependence. "In other words, the slope of the credit curve is quite steep currently, indicating a high level of risk aversion. Before the crisis, this would have been almost flat," he says.

Original ratings also play a role in pricing. While bonds currently rated triple-A trade at very similar levels irrespective of their original ratings, for lower rated bonds, the original rating is more relevant.

"No matter what the current rating, the prices are higher if their original rating was triple-A, but often only by a point or two," says Prasad. "We find this somewhat surprising, since an original triple-A rating indicates that it is a senior bond and hence is likely to get much better recoveries in the event of default. We believe that this is an externality caused by factors such as risk weighting and other regulatory factors."

Upgrades and downgrades also take their toll on pricing, although the research shows that upgrades have a bigger impact than downgrades. Each notch of downgrade is shown to decrease the value of a bond by around two points. On the other hand, bonds that have been upgraded generally price close to par.

"We believe that this is largely because bonds get upgraded only when the deal has de-levered appreciably. But this also shortens the spread duration, causing the price to converge to par, irrespective of the rating or credit performance," says Prasad.

Finally, the study shows that on average the cash price of CMBS bonds is higher than that for RMBS for a given credit rating. This difference can be as large as 10-12 points. At the same time, the study highlights that the average spread for CMBS is also wider compared with RMBS.

"We attribute this to a much shorter pricing duration, although - given current conditions in the commercial loan market - refinancing is very difficult to predict," notes Prasad. "Strikingly, even D rated bonds in CMBS trade at prices averaging 48, while D rated RMBS average only 10."

AC

CDS

Option, tranche trade ideas touted

Implied volatility for both European and US credit indices is currently close to the peak realised volatility experienced during the financial crisis. Against this backdrop, dealers have been selling volatility - whether opportunistically in Europe or to exit overbought long positions in the US.

"The implication is that buyers of volatility are counting on monetising the long-vol positions by unwinding before expiry as realised volatility may not be high enough. Alternatively, they are expecting a major move in spot, but even there the breakeven levels are so wide as to render upside from long-vol strategies unappetising," note credit derivative strategists at Morgan Stanley.

They consequently recommend two strategies with a short volatility bias: covered shorts as a way to monetise index hedges and provide mark-to-market cushion in a tightening environment; and buying 1x2 receiver spreads as a way to position for a rally and decline in volatility. In particular, the strategists highlight selling wide-strike strangles on credit indices - which provide for a variety of hedges, including short-dated x-100% and mezz tranche hedges - combined with outright puts or put spreads in FX/equities/rates.

"In Europe, we particularly like pairing XOver straddles with OTM puts or put spreads on EUR/USD. In US, we like pairing CDX HY straddles with OTM put spreads in equities, where skew is still high," they explain.

With the credit indices also trading at historic wides, tranche market activity has been subdued. Risk takers have typically been focusing on short-dated mezzanine risk, while protection buyers have been focusing on systemic risk hedges using senior tranches.

The strategists suggest that performance deterioration in growth-sensitive sectors and assets implies the market is concerned about a turn in the cycle for the worse. They therefore put forward tranche trade ideas that involve: buying short-dated x-100% tranche protection on legacy portfolios (iTraxx S9 and IG9) as a contagion hedge; and buying protection on iTraxx S9 seven-year 6%-9% and CDX IG9 seven-year 7%-10% (with light delta) as cyclical hedges.

CS

ABS

Paris partner appointed

Linklaters has appointed Patrice Doat partner in its Paris office. He joins from Gide Loyrette Nouel, where he started in 1994 and became partner in 2004. He brings expertise in French and pan-European securitisation and structured products.

ABS

Connemara duo recruited

MHT Partners has recruited John Mullen, md, and Taylor Curtis, director, to lead its financial institutions coverage and private placement units. They are joined by three analysts, who will focus on providing advisory and transaction execution services to technology-enabled service, education, business services and consumer-focused companies.

Prior to joining MHT, Mullen was managing partner of Connemara Capital, a boutique financial advisory firm headquartered in Dallas, where he focused primarily on capital raises for private equity-owned portfolio companies. Among his previous roles, Mullen was global head of structured credit at ABN AMRO in London.

Curtis was formerly a partner with Connemara Capital and co-founder and cfo of Connemara Bancorp. Mullen and Curtis founded Connemara Bancorp in 2009, for the purpose of buying failed banks from the FDIC.

ABS

ABS trading md added

RBS Securities has recruited Pat Beranek as an md on its ABS trading desk, where he will be responsible for trading non-mortgage ABS with Alan Johannsen. Beranek will report to Adam Siegel, co-head of US ABS, MBS and CMBS trading, and will be based in Stamford, Connecticut.

Beranek has 20 years of experience across the securitisation markets. He joins RBS from Mizuho Securities, where he was head of ABS trading for the past two years. Prior to Mizuho, he was with Bank of America Securities, where he served as head of ABS trading and syndicate.

CDS

Iberian valuations partnership formed

Pricing Partners and Siag Consulting International have formed a partnership covering Iberia and Latin America. The two firms say that Siag's expertise in market and credit risk management provides deep domain expertise to partner with Pricing Partners in advising and supporting client valuation methodologies, given the increased requirement for accurate asset valuations, regulatory compliance and correct risk-adjusted capital management for the revised Basel capital standards. The Iberian markets comprise many smaller financial institutions that may not have in-house quant teams to advise on correct methodology and models.

CDS

Algorithmics acquired

IBM has acquired Algorithmics - a member of Fitch Group - for US$387m, subject to price adjustments at closing. The acquisition is intended to expand IBM's business analytics capabilities in the financial services industry.

"Today's economic environment demands that financial institutions have more cash on hand, a better understanding of their financial standing and the ability to deliver more transparency to stakeholders," comments Rob Ashe, IBM general manager, business analytics. "Combining Algorithmics expertise with IBM's deep analytics portfolio will allow clients to take a more holistic approach to managing risk and responding to economic change across their enterprises."

Algorithmics risk advisers will enhance IBM's business analytics and optimisation practice. With the closing of this acquisition, approximately 900 Algorithmics employees will join the firm.

CDS

Credit derivatives pro moves on

Kai Liu has joined Bridgeway Capital Management's investment team and will be responsible for conducting statistical research to develop future investment models. Prior to joining Bridgeway, Liu served as director, quantitative research at Chicago Equity Partners. Before that, he was an associate, credit front office at Citadel Investment Group, where he designed and implemented a security valuation library for credit derivatives.

CMBS

Investment management director hired

LNR Partners Europe has appointed Derek Rich as its new director of investment management and business development. He will report to Matthias Schlueter, coo and md, and will be assisting in the expansion of LNR's loan and asset services platform across Europe.

Rich has over 13 years of experience in the CRE and CMBS industry, of which eight years were spent in Europe where he served as a founding member of Deutsche Bank's CRE and DECO CMBS platform. Subsequently, he served as head of distribution for CRE products at UBS.

Prior to moving to Europe, Rich worked for Deutsche Bank and Goldman Sachs in New York, focused on CMBS loan origination and syndication.

CMBS

Pru JV hires second CMBS originator

Prudential Mortgage Capital Company has hired Scott Heath as a loan officer covering the mid-Atlantic, southeast and southwest regions from the firm's Atlanta office. He will originate commercial mortgage-backed loans for securitisation by Liberty Island Group, the JV between Prudential Mortgage Capital Company and affiliates of Perella Weinberg Partners' asset-based value strategy. His appointment follows the hiring of a CMBS loan originator for the Western region - Curtis Brunton (SCI 24 August).

Heath previously spent 11 years as a CMBS loan underwriter and originator with JPMorgan Chase in Atlanta. Prior to that, he held various financial positions at companies including Citi and Goldman Sachs. Heath will report directly to Mark Gleason, a principal in the Atlanta office.

Investors

NGAM bolsters alternatives business

Natixis Global Asset Management (NGAM) has acquired a controlling interest in Darius Capital Partners, an investment advisory and research firm that provides customised hedge fund solutions to address institutional investors' growing needs for transparency, liquidity and risk management. The firm uses a broad range of products - including UCITs, managed accounts, hedge funds and fund of funds - to deliver alternative investment solutions to its clients. It is headquartered in Paris, with offices in New York.

The acquisition will help further expand NGAM's alternatives' range in Europe. Like all affiliates in NGAM's multi-boutique model, Darius remains independent in its solutions design and investment approach. But it will rely on NGAM's international distribution and marketing capacities.

RMBS

FHFA probe targets 17 more firms

The FHFA, as conservator for Fannie Mae and Freddie Mac, has filed lawsuits against 17 financial institutions, certain of their officers and various unaffiliated lead underwriters. The suits allege violations of federal securities laws and common law in the sale of residential private-label MBS (PLS) to the GSEs.

Complaints have been filed against: Ally Financial, Bank of America, Barclays Bank, Citi, Countrywide, Credit Suisse, Deutsche Bank, First Horizon National Corporation, General Electric Company, Goldman Sachs, HSBC, JPMorgan, Merrill Lynch/First Franklin Financial Corp, Morgan Stanley, Nomura, RBS and SG. The complaints were filed in federal or state court in New York or the federal court in Connecticut.

The complaints seek damages and civil penalties under the Securities Act of 1933, similar in content to the complaint FHFA filed against UBS Americas in July (SCI 28 July). In addition, each complaint seeks compensatory damages for negligent misrepresentation. Certain complaints also allege state securities law violations or common law fraud.

The complaints filed reflect FHFA's conclusion that some portion of the losses that Fannie Mae and Freddie Mac incurred on PLS are attributable to misrepresentations and other improper actions by the firms and individuals named in the filings, the agency says. Based on its review, FHFA alleges that the loans had different and more risky characteristics than the descriptions contained in the marketing and sales materials provided to the GSEs for those securities.

RMBS

MBS litigation taskforce established

Pangea3 has established a taskforce dedicated to MBS-related document review. It says the Pangea3 Mortgage-Backed Securities Taskforce will provide clients with "unsurpassed experience, acquired first-hand through work on dozens of MBS-related litigation and investigations".

The Taskforce is spearheaded by senior US litigators with experience managing complex securities litigation at top law firms and is supported by over 200 full-time attorneys. Since 2010, members of the Taskforce have conducted well over 200,000 hours of review in MBS-related litigations and investigations, as well as over 100,000 hours of review in other complex financial matters.

"The surge in private MBS lawsuits and the sheer volume of associated documents to review has overwhelmed in-house counsel and their outside law firms," says Greg McPolin, vp and md, Global Litigation Solutions. "We have listened and responded to the needs of our clients and the legal industry by dedicating a team of attorneys experienced at working hand-in-glove with top outside counsel to provide efficient and cost-effective MBS-document review, while reducing risk."

RMBS

Analytics firm considers its options

CoreLogic's board of directors has formed a committee of independent directors to explore a wide range of options aimed at enhancing shareholder value, including cost savings initiatives, an evaluation of the firm's capital structure, possible repurchases of debt and common stock, the potential disposition of business lines, and its potential sale or business combination. The board has retained Greenhill & Co to serve as a financial advisor to assist in this evaluation.

Since its June 2010 separation transaction, CoreLogic says it has taken significant steps to strategically reposition itself and streamline its operating structure. These actions have included the divestiture of its employer and litigation services businesses, the outsourcing of its India operations to Cognizant, the acquisition of RP Data and aggressive cost cutting and streamlining initiatives.

While the firm says it continues to make significant progress on these initiatives, in light of the challenging economic environment and current market conditions, the board has determined to look more closely at a range of alternatives with the assistance of a financial advisor.

RMBS

BAML to exit correspondent mortgages

Bank of America has confirmed it is to exit correspondent mortgage lending, as part of its ongoing alignment of the Bank of America Home Loans business with the bank's customer-driven strategy. It intends to sell the correspondent mortgage lending division or, if a suitable deal is not identified, to consider other options, including winding down the correspondent lending business in an orderly manner. At this time, the correspondent lending operations continue business as usual.

RMBS

Litton enforcement action announced

The US Fed has begun a formal enforcement action against Goldman Sachs to address a pattern of misconduct and negligence relating to deficient practices in residential mortgage loan servicing and foreclosure processing involving its former subsidiary, Litton Loan Servicing. Goldman Sachs sold Litton to Ocwen Financial Corporation yesterday (1 September) and has ceased to conduct residential mortgage servicing.

The action orders Goldman Sachs to retain an independent consultant to review foreclosure proceedings initiated by Litton that were pending at any time in 2009 or 2010. The review is intended to provide remediation to borrowers who suffered financial injury as a result of wrongful foreclosures or other deficiencies identified in the foreclosure process. The review will be conducted consistent with the reviews currently underway at the 14 large mortgage servicers that consented to enforcement actions brought by the banking agencies on 13 April (SCI 14 April).

If Goldman Sachs re-enters the mortgage servicing business while the action is in effect, it will be required to implement enhanced corporate governance, risk-management, compliance, borrower communication, servicing and foreclosure practices comparable to what the 14 mortgage servicers are implementing.

The Fed believes monetary sanctions are appropriate and plans to announce penalties in due course. These monetary penalties against Goldman Sachs will be in addition to the corrective actions that the bank will be taking pursuant to this latest action. Goldman Sachs has acknowledged that it will be responsible for satisfying any civil money penalty that the Board of Governors could have assessed against Litton for its conduct.

ABS

REIT rethink underway

The US SEC is requesting public comment on the treatment of asset-backed issuers, as well as REITs and other mortgage-related pools under the Investment Company Act. Through an advance notice of proposed rulemaking, the agency is seeking public input on possible amendments it might consider proposing to Rule 3a-7, which excludes certain ABS issuers from having to comply with the requirements of the Investment Company Act.

Through a separate concept release, the SEC is also seeking public comment on interpretations of a provision in the Investment Company Act - Section 3(c)(5)(C) - that may be used by some companies engaged in the business of acquiring mortgages and mortgage-related instruments, such as some REITs. "We are inviting public comment in light of the significant developments in the asset-backed and mortgage markets. We want to assure that our regulatory approach is updated to reflect the current market environment while still meeting our investor protection goals," comments SEC chairman Mary Schapiro.

Public comments should be received within 60 days from the date of publication in the Federal Register.

ABS

FSB to dig deeper into shadow banking

The Financial Stability Board's Shadow Banking Task Force reports that it has developed general principles for designing and implementing regulatory measures for strengthening the oversight and regulation of the shadow banking system. It has also conducted a regulatory mapping exercise to take stock of existing national and international initiatives on the four broad categories of possible regulatory measures set out in its April background note.

As a result of this, the Task Force has identified five areas where more detailed work is warranted to help gauge the case for further regulatory action. Among these are: the regulation of banks' interaction with shadow banking entities, in particular, examining consolidation rules for prudential purposes and implementing risk-based capital requirements for banks' exposure to shadow banking entities; and the regulation of securitisation, in particular with regard to retention requirements and transparency.

In order to make progress, the FSB has decided to set up dedicated work streams to focus on each area. In some cases the work streams will be undertaken by the relevant international standard setting bodies, while in others work will be carried forward under the guidance of the FSB Task Force. The work streams will develop preliminary work plans shortly, and report their progress as well as the proposed policy recommendations to the FSB by July 2012.

ABS

EMEA ratings migration examined

The ratings of the majority of EMEA structured finance (SF) bonds that were outstanding in July 2007 have been stable, according to Fitch. The ratings migration differs across the asset classes within SF, with the ratings for transactions backed by consumer assets showing greater resilience.

In the four years since the onset of the credit crisis, approximately 40% of the 5,025 Fitch-rated tranches have been downgraded, with negative rating actions concentrated in lower-rated tranches. Nearly one-third of tranches have paid in full, with the remainder having either been affirmed or upgraded from their rating in July 2007.

"Where there have been downgrades, the main drivers have been asset underperformance and - in the case of structured credit - criteria changes," says Gioia Dominedo, senior director in Fitch's EMEA structured finance team. "A smaller number of downgrades have been triggered by downgrades to sovereigns and transaction counterparties."

Asset underperformance has been particularly pronounced in later-vintage transactions. The average rating of triple-A tranches has fallen most significantly for 2007-vintage transactions to single-A plus.

"Transaction performance and, therefore, ratings migration has varied significantly across asset classes and jurisdictions," says Andrew Currie, md in Fitch's EMEA structured finance team. "In particular, securitisations of European consumer assets have generally shown strong performance: tranches that were rated triple-A in July 2007 have, on average, maintained their ratings."

In contrast to these consumer asset-backed transactions, the performance of commercial assets has been weaker. This is reflected in the fact that the triple-A rated tranches in July 2007 have seen an average downgrade to double-A minus.

Of the four asset classes, CMBS has had the lowest proportion of tranches repaid in full and the highest proportion of tranches downgraded. This reflects the low redemption rate of the underlying loans and the extent of capital value declines of the underlying property collateral.

Structured credit transactions have also been downgraded more than average; however, the average SC ratings migration is heavily skewed by the SF CDO sub-sector. The average ratings migration for other triple-A SC tranches - that include CDOs of Cedulas, IG corporate CDOs, CLOs and SME CDOs - has been less pronounced.

ABS

Counterparty criteria dominate Q2 rating actions

Credit watch resolutions linked to S&P's 2010 counterparty criteria dominated the agency's European structured finance rating actions in 2Q11. The total number of downgrade actions accelerated during the quarter, outpacing the number of upgrades sixfold.

"To put this in perspective, we took 937 rating actions in the quarter, comprising 812 downgrades and 125 upgrades, compared with 240 downgrades and 72 upgrades in the previous quarter," says S&P credit analyst Sabine Daehn.

She continues: "Most rating actions were related to our 2010 counterparty criteria update, with about 13% of ratings lowered as a result. Downgrades were concentrated toward the top of transaction capital structures, especially among tranches we had previously rated in the triple-A and double-A categories. Almost half of the downgrades were in RMBS."

S&P also highlights the effect of ongoing sovereign-related pressures in peripheral European countries on the performance of structured finance transactions in 2Q11. Added to this, weak collateral performance drove the downgrades in selected Spanish and Italian transactions.

"Performance will likely continue to differ across asset classes and countries, due to the varying pace of economic recovery across Europe. We believe that growth prospects may well continue to be weak for the rest of the year," Daehn adds.

Both the number of upgrades and downgrades increased significantly compared with the previous quarter. Although collateral performance played a minor role in the downgrades, it remained the key reason for upgrades in 2Q11. RMBS and CMBS were the most affected asset classes under the 2010 counterparty criteria update, given the importance of swaps and often large liquidity facilities in these asset classes.

"In our view, the 2010 counterparty criteria update will continue to influence rating migration in 3Q11. However, we expect the focus of rating activity, particularly in the case of CMBS, to shift back to underlying collateral performance," concludes Daehn.

ABS

Japan ABS stabilising on household debt decline

Moody's expects the ongoing decline in Japanese household debt levels to help stabilise ABS asset performance in Japan. The country's consumer credit balance decreased significantly to ¥26trn in 2010 from ¥39trn in 2005 - a credit positive for consumer ABS in Japan, according to the rating agency.

The trend is expected to result in less burdensome repayments for many underlying borrowers and smaller repayment sizes. Moody's attributes the decline to tightening lending criteria, falling consumer confidence and lower spending, as well as Japan's changing demographics.

ABS

Subprime auto ABS criteria explained

S&P has updated the market on its rating approach for subprime auto loan ABS transactions, given the new originators entering the market and the re-emergence of others that remained inactive during the credit crisis.

"We believe this is particularly important now due to the absence of bond insurers, who had previously provided a significant portion of credit enhancement to this market, were instrumental in structuring these transactions and acted as a single control party," says S&P credit analyst Amy Martin.

The agency generally characterises subprime auto loan pools as those with an expected cumulative net loss of at least 7.5%. Most of the loans in these pools have FICOs below 620.

Many aspects of S&P's subprime auto loan ABS analysis are similar to its approach for prime auto loan ABS, but the agency more closely assesses servicer-related issues for subprime because continuous and proactive servicing is key to mitigating increased defaults that are endemic to this segment of the auto ABS market. Its analysis of subprime auto ABS also considers the sponsor's management, track record and financial viability.

S&P continues to refine its process for reviewing transactions by existing and new subprime issuers, based on its observations of companies that were unsuccessful during the past two contraction periods.

ABS

'Tapable' WBS upgraded

In what has been described as an unprecedented move for the agency, Fitch has upgraded a tapable transaction, raising both the class A and B notes of Dignity Finance a single notch to A plus and triple-B plus respectively. The upgrades are mainly driven by the deal's strong performance to date, the agency says.

Fitch's adjusted 52-week ending 1 July EBITDA for the transaction came in at £70.5m, growing by 5.8% versus its assumed run-rate at tap in September 2010. Although expected by management, this positive set of results - with EBITDA margin mildly increasing to 35% - are viewed positively by the agency, especially in light of the challenging economic environment and the observed temporary slowdown in the number of the deaths in the UK.

CDO

ABS CDO auction scheduled

Stone Tower Debt Advisors is to act as liquidation agent on the Newbury Street CDO. The collateral will be auctioned via four public sales in New York on 14 September.

CDS

Correlation pricing tool enhanced

Pricing Partners has extended the Price-it language to enable faster pricing of correlation and dispersion swaps. The firm says it has developed specific tools to rapidly price these products and to cope with exotic correlation and dispersion swaps with a dedicated correlation keyword.

CDS

OTC valuation service enhanced

CMA has released a new version of CMA NAVigate, its web-based workflow solution that aims to bring transparency and independence to the valuation of OTC positions.

CMA NAVigate 1.6 introduces an intuitive user interface that provides the tools, pricing transparency and real-time support required to manage the pricing process, CMA says. The service handles valuations across multiple asset classes, making reconciliation and price-challenge resolution straightforward.

Clients can now schedule valuation times, run ad-hoc valuations and manage the distribution of reports. The firm says the service addresses the growing requirement from regulators, investors and auditors for funds to demonstrate that their process for valuing OTC portfolios is truly independent. For example, access to all the valuation inputs gives clients the clearest possible view of how the values were obtained.

CLOs

CLO loan maturity profiles analysed

Codean has released its annual update on the maturity profile of leveraged loans underlying CLO deals. The analysis indicates an upcoming peak in the amount of loans reaching maturity, albeit a comparison between this year's and last year's maturity profiles illustrates that refinancing efforts already made have resulted in a significant reduction in the value of loans due in 2012-2014 and a corresponding increase in the volume of collateral maturing in 2016, 2017 and later.

Indeed, the peak of refinancing pressure is expected between 2013 and 2017, according to the Codean study. Nearly 80% of European and nearly 70% of US loans will mature during this period.

However, US loans have a flatter maturity profile (over 90% of collateral will mature in 2012-2018), with the maturity profile of leveraged loans being more concentrated in Europe (over 90% of collateral maturing in 2013-2017). Reinvestment windows of the majority of the CLOs issued during the market boom of 2005-2007 will close in 2012-2013, just before the peak in the loan maturity profile of the underlying collateral.

Nevertheless, changes in the maturity profile over the last year illustrate issuer efforts to circumvent the critical period of 2013-2017. The trend is more significant for US loans, where the maturity wall has been extended substantially, resulting in a more equally distributed maturity profile.

However, the gap in years 2014-2016 equals approximately 55% of the total value of the examined CLOs. As a result, further refinancing will ultimately need to be supported by new CLO issuance and other investors, in order to avoid a maturity crunch.

CMBS

GGP CMBS rating action averted

S&P says that its ratings on five CMBS will not be affected by the recent interest shortfalls caused by the payment of workout or corrected loan fees, following the full repayment of five modified General Growth Properties (GGP) loans that were previously with their respective special servicers. The five transactions (and the related GGP loans) are: COMM 2001-J2 (Rivertown Crossings), GCCFC 2003-C1 (Oxmoor Center Mall), GCCFC 2004-GG1 (Deerbrook Mall), LBUBS 2005-C5 (Providence Mall) and WBCMT 2004-C14 (Park Place Mall).

According to the April 2011 through August 2011 remittance reports for the five deals, the workout or corrected loan fees collected by the respective special servicers for the GGP loans following their full repayment caused the interest shortfalls during that period. S&P did not lower its ratings on the affected classes from these transactions because the interest shortfalls were caused by non-credit-related circumstances - these five GGP loans are part of a group of performing GGP-sponsored loans that were transferred into special servicing as a result of GGP's bankruptcy.

S&P explains that in transactions where the corrected loans' outstanding principal balances are relatively large, as was the case with these five transactions, the shortfalls may affect several classes of the rated securities. The interest shortfalls also impacted various levels of the transactions' priority waterfalls. The extent of the impact was primarily driven by the amount of the workout or corrected loan fee, available funds to the trust and whether the respective servicer elected to allocate the fee in its entirety within one remittance pay period or spread it throughout several remittance periods, thereby limiting the impact on more senior classes of certificates.

For two of the loans, S&P says the full workout or corrected loan fee was charged to its respective trust during the remittance period in which the respective GGP loan paid off. This caused interest shortfalls for certificates subordinate to and including the deal's class C.

Subsequently, the accumulated interest shortfalls for the class C and D certificates were fully repaid in the July remittance period, but the remaining certificates subordinate to and including the class E certificates continued to experience interest shortfalls during the August remittance period. S&P expects the accumulated interest shortfalls affecting those classes to be repaid over the next few months, provided that the transaction does not experience credit-related events that affect interest available to the trust.

In the other three transactions, the agency says the workout or corrected loan fees were allocated over consecutive remittance periods. As a result, certificates subordinate to and including class D experienced interest shortfalls. While the accumulated interest shortfalls affecting several classes in this deal will not be repaid in the near future, S&P does expect them to ultimately be repaid, again, provided that the transaction does not experience any credit-related events that affect interest available to the trust.

CMBS

CMBS loan resolutions slow again

Just over US$1bn in CMBS conduit loans were resolved with losses in August, according to Trepp, as the rate of loan resolutions slowed for the second consecutive month. However, the average loss severity was up sharply from the July reading.

In total, 159 loans were liquidated in August compared to 175 loans and US$1.3bn in face amount in July. The losses on the August liquidations were about US$505m - representing an average loss severity of 49.9%. In July, the average loss severity was 40.2%.

The August loss severity average is well above the average loss severity of 42.2% over the last 20 months. "Special servicers have been liquidating at a rate of about US$1.01bn per month over that time - so the liquidations this month are right at the average over the last 20 months," Trepp says.

CMBS

Euro CMBS maturity repayments improve

Fitch's European CMBS Maturity Repayment Index materially improved during August, increasing to 40.9% from 34.9% in the previous month due to full and partial redemptions totalling €348.1m. This also resulted in the outstanding matured loan balance decreasing by 2.2% to €9.62bn. Of the 182 loans that have matured since 2007, 73 have been repaid in full and 12 have realised a loss.

Eight loans were originally scheduled to mature in August 2011, according to Fitch. Of these, one loan has been repurchased by its originator and two prepaid more than six months ahead of their maturity dates.

Of the remaining five loans, two were repaid shortly before their maturity dates: the two participations in the GSW loan, securitised in Fleet Street Finance Three and Windermere IX CMBS. A further two loans are in standstill - the Henderson 1 (Oberursel) loan, EuroProp (EMC-VI) and the Senior & Junior Monaco loan (JUNO (Eclipse 2007-2)) - and one loan is in workout - the Beacon Doublon loan, Vulcan (European Loan Conduit No.28).

Partial and full repayments totalled €348.1m during the month. The largest principal distribution was for £267.5m, on White Tower 2006-3, following the sale of the last remaining property in June 2011. The proceeds were allocated to the outstanding notes at the July 2011 payment date.

Other partial redemptions included a £4.7m distribution on the Lloyds Portfolio loan - Indus (ECLIPSE 2007-1) - due to the sale of five properties and minimal scheduled amortisation and a £2.7m distribution on the Milton & Shire Houses loan - Radamantis (European Loan Conduit No. 24) - through the full cash sweep that was implemented in the restructuring of the loan.

CMBS

CMBS delinquency rate recedes in August

The delinquency rate for US CRE loans in CMBS fell 36bp in August to 9.52%, according to Trepp's latest delinquency report. This is the second largest drop since the beginning of the credit crisis in 2008 and the third time the rate has dropped in the past four months.

Trepp says that as with July (CRE Finance 2 August 2011), a big part of the change in the rate was the result of the way some special servicers have been reporting data. In July, special servicers started to flag many 'dual-tracked loans', those in which the special servicer was pursing both a modification and a foreclosure strategy, as having a workout code of 'in foreclosure'. This caused the rate to spike sharply in July. However, in August, the special servicer walked backed many of these reclassifications, putting some downward pressure on the rate.

The percentage of loans seriously delinquent (60+ days in foreclosure, REO, or non-performing balloons) is now 8.79%. By that measure, the rate was down 35bp.

Investors

Credit opportunities fund closed

Tennenbaum Capital Partners (TCP) has closed the Tennenbaum Opportunities Fund VI. With capital commitments of US$530m from new and existing limited partners, the fund will focus on discounted and debt-for-control oriented market opportunities as well as complex, directly-originated financings.

Limited partners in the fund include both public and corporate pension funds, insurance companies, other financial institutions, foundations, endowments, family offices and high net-worth individuals. Skadden, Arps, Slate, Meagher & Flom served as counsel, while Greenhill & Co served as the fund's exclusive global placement agent.

TCP invests primarily in private and public companies across a broad range of industries. Since its founding, the firm has invested approximately US$10bn in almost 200 companies where it can play a meaningful role.

RMBS

Aussie RMBS criteria updated

S&P has updated its methodology and assumptions for analysing credit risk associated with housing loan portfolios underlying Australian RMBS.

The criteria update is in line with S&P's global ratings framework and definitions, including adopting a globally consistent analytical framework for RMBS and calibrating the Australian RMBS to consistent hypothetical stress scenarios to further promote global ratings comparability. It also draws on the agency's observations of performance and behavioural trends underlying residential housing loan markets globally that may be relevant for future Australian RMBS performance.

"While the Australian housing loan market has performed strongly, it may become more exposed to stresses, given the increasing level of financial vulnerability arising from higher household indebtedness, higher living costs and stronger property price appreciation trends that have characterised the Australian economy since deregulation of financial markets in the late 1980s," S&P credit analyst Vera Chaplin says. "In our view, this means that if Australia were to experience a recession in the future, the country's housing loan performance may be worse than experienced in an equivalent recession in the past."

The updated criteria article includes some changes from the criteria proposed in S&P's 10 August 2010 request for comment after consideration of feedback from market participants. The levels of credit enhancement that result from application of the final criteria are broadly consistent with those contained within the RFC.

The criteria apply immediately to all new and existing Australian RMBS backed by prime, subprime and non-conforming mortgages. S&P intends to complete its review of all affected transactions within six months, but expects a limited impact on outstanding ratings.

RMBS

UK sustainable housing model developed

Fitch has developed a model for the UK that determines sustainable house prices given certain key economic indicators. The agency believes that the estimation of sustainable house prices based on macroeconomic variables is a useful tool to benchmark expected and stressed house prices.

This follows a similar exercise in the US, whereby a sustainable house price model was incorporated into the default rate and loss severity determination in Fitch's US residential mortgage loss criteria. "The UK model is based on three main macro variables. These are used to determine a real house price level that appears sustainable compared to the experience during the 1990s," explains Atanasios Mitropoulos, senior director in Fitch's structured finance team.

"The model is deliberately kept simple to provide a transparent and intuitive benchmark. It is not a predictive tool," adds Ketan Thaker, senior director and head of UK RMBS at Fitch.

He continues: "Our current expectation for nominal house price declines is at around 10% rather than the model-implied gap of 15% to sustainable levels after taking account of three years of inflation. Fitch additionally takes into account economic prospects, such as GDP growth, credit availability, the low interest rate environment and continued limited housing supply, among others."

The model is aimed at supporting Fitch's residential mortgage criteria development process. The scope of the UK model is currently limited by data constraints as regional data only reach back to 1991. However, the agency believes that its calibrated sustainable house prices are a useful tool to compare expectations and stresses against an intuitive and stable long-term indicator of average real house prices.

RMBS

Euro RMBS interest rate impact examined

Fitch has examined the expected relative impact of rising interest rates on European RMBS asset performance. The heterogeneity of mortgage markets across the region means that RMBS is more exposed in some countries than others.

"Euro zone peripheral countries Greece, Ireland and Portugal, as well as Spain, are most vulnerable to increases in interest rates. In all four countries, at least 80% of borrowers have floating-rate mortgages and are undergoing significant economic adjustment and fiscal consolidation. In addition, with the exception of Ireland, the practice of stressed affordability tests in mortgage underwriting was limited prior to the credit crisis," says Gavin Crawford, an analyst in Fitch's RMBS team.

Factors that influence RMBS exposure to rate rises are generally at a country level, reflecting both the mortgage market profile and the macroeconomic environment, as well as social preferences for certain mortgage types. Fitch considers key factors to be the percentage of mortgages on a variable rate, household debt and income, and stressed affordability underwriting practices.

Italy shares some of the same attributes as the peripheral countries, but fares better in certain areas, such as having lower household indebtedness. The UK also has a sizeable exposure to floating-rate mortgages, but benefits from the more robust stressed affordability tests put in place prior to 2007.

"In terms of exposure to interest rate rises, Fitch considers the northern continental nations the most insulated. This is due to the predominance of long-term fixed-rate loans in the Netherlands, Belgium, France and Germany and - with the exception of the Netherlands - low household debt-to-income ratios," concludes Carlos Masip, director in Fitch's RMBS team.

RMBS

EMEA RMBS loan mods analysed

Fitch says that data it has received suggests that EMEA loan modifications programmes are currently not providing benefits to all parties to RMBS loan transactions. Loan modifications are becoming prevalent across the major European residential mortgage markets following the formal introduction of the programmes into UK RMBS in January 2008.

From the data provided by mortgage servicers and banks across Europe, Fitch notes that 52% of UK loan modifications are in the form of capitalisation of interest arrears, increasing the outstanding mortgage balance. Furthermore, 17% of modifications represent a transfer of the loan type from a repayment loan to interest only.

Throughout Europe, Ireland has seen the most widespread use of loan modifications, with over 8% of outstanding loans being modified. More than half of these modifications are for performing borrowers who anticipate future payment problems. Of the total loans being modified, around 80% of those actions are aimed at reducing borrowers' monthly payment amount, with the rest being a temporary payment holiday or capitalisation of arrears.

Italian banks, meanwhile, use loan modification schemes for RMBS transactions, within the limitations of the transaction documents and government schemes are available which offer aid to borrowers. In Spain, 3.2% of loans in RMBS transactions have been modified; however, in the Netherlands, loan modification programmes are virtually non-existent, with traditional resolution methods remaining preferable.

"Europe is experiencing a low interest rate environment that effectively provides the biggest 'loan modification' of all to borrowers, but it also creates challenges for lenders and servicers in developing effective modification strategies for loans in arrears," says Mark Wilder, associate director in Fitch's operational risk group. "The agency notes that potential loan modifications are being declined by the borrower, implying that they are finding sufficient relief from low interest rates."

Fitch believes that in the current environment, utilising a loan modification programme and not transferring delinquent loans to foreclosure may benefit some parties. However, while a transaction servicer's ultimate role is to maximise recoveries and minimise losses through loan management, an implemented loan modification programme could increase stress for a transaction, putting the interests of the senior and junior noteholders at odds with each other.

"If house prices increase, the appetite for loan modifications reduces and ultimately the banks' economic best interests may be to implement foreclosure," notes Ketan Thaker, head of UK RMBS at Fitch. "This could be implemented, providing it is in line with regulatory guidelines and all other workout strategies have been assessed fairly. However, in the longer term, loan modification programmes should prove valuable to some if they are successful in rehabilitating borrowers and preventing defaults rather than merely postponing the default."

RMBS

Greek RMBS affirmed

Fitch has affirmed 34 tranches and downgraded one tranche of 13 Greek RMBS transactions. The agency has also removed 32 tranches from rating watch negative (RWN).

Although the Greek sovereign situation remains uncertain, in Fitch's view a further downgrade would not necessarily imply an increase in the risk associated with RMBS transactions, which would instead be impacted by deterioration in the transactions' performance and counterparty exposure. With regards to counterparty risk, the agency believes that all transactions should have specific features in place to mitigate the exposure toward the various counterparties, such as servicers, collection accounts and cash managers. In addition, the transactions' increased exposure to operational risks due to downgrade of the vast majority of Greek banks below investment grade rating has been assessed to test the transactions' ability to timely fulfil the obligations under stress conditions.

The RWN has been maintained on all tranches of Estia I, however, pending the resolution of amendments to the latest four investor reports in which material information concerning defaults has been incorrectly reported.

RMBS

Peripheral recovery rate assumptions analysed

Fitch has analysed the foreclosure frequency and recovery rate assumptions applicable to the analysis of residential mortgage portfolio across the various European jurisdictions. The study shows how the agency's most conservative expectations are associated with peripheral countries - Portugal, Greece and Ireland.

The foreclosure frequency and recovery rate assumptions for Germany, Belgium, the Netherlands and France are best placed among all European countries, according to Fitch, as these economies and their underlying housing and mortgage markets have been the most resilient over the past couple of years and are expected to remain so. Conversely, foreclosure frequency and recovery rate assumptions for Portugal, Greece and Ireland are among the most conservative, with the agency's view of Portugal and Greece reflecting its view of future negative growth associated with austerity measures and resulting high unemployment.

With the biggest fall in house prices in Europe and a sharp increase in number of mortgage borrowers in distress, Ireland is also expected to have high default and low recovery rates. Meanwhile, Italy, UK prime and Spain are placed in the middle of the European spectrum due to Fitch's forecast of underlying macroeconomic and unemployment and - specifically for the UK and Spain - continued house price falls from inflated peaks.

Fitch expects the updated assumptions to affect ratings assigned to RMBS in periphery countries, mainly at lower rating categories.