Contents

CMBS

Keep on keeping on

Cautious outlook for the global CMBS and CRE markets in 2012

At best, expectations for the US CMBS and CRE markets in 2012 are for more of the same - there appears to be little hope for a sudden upsurge in activity next year. However, there are some pockets of positivity and ultimately, it is argued, the market simply has to keep going. (For more on European CMBS, see boxed out section below.)

Consensus among bank research analysts appears to be that the three main preoccupations of 2011 - macro-driven volatility, refinancing and regulation - are likely to weigh heavily on the US CMBS market in 2012 as well. While there are hopes that volatility could reduce by the start of H2, the other two factors will be felt throughout the year and beyond.

Volatility was a major hurdle for CMBS issuance in the second half of 2011 and it is expected to hold volumes in 2012 to something around this year's levels. Broadly, bank researchers and rating agencies are predicting non-agency volumes in the US$30bn-US$40bn range.

"The primary market is still in suspended animation," confirms one US CMBS investor. "At the moment, high quality commercial mortgage loans are getting very competitively bid by life insurance companies, so they're getting relatively aggressive yields. However, when you factor in what the current market volatility is doing to the bond market in terms of the yields on offer there, it is uneconomical for CMBS issuers to produce end product."

He continues: "That lack of arbitrage has made it very difficulty for primary issuers and we expect that to continue. At the same time, there also isn't a viable hedging vehicle for them to hedge volatility as they build their loan pipeline to put into a new deal at the moment."

The investor notes that TRX II could become that hedging vehicle but is not quite there yet. "It hasn't gained significant momentum yet. But if the impetus for CMBS issuance came back, there would be a little more market acceptance."

However, for the time being only a limited number of market participants are willing to enter into the trade. "That too is partly a result of volatility, which - given the time-tenored nature of the contract - leaves you heavily exposed to a major blowout if it happens at the wrong time," the investor adds. "I could, for example, see us getting involved and talking the other side to the Street. But, again, there would have to be less volatility around for it to be attractive."

Supply has been further damaged by a noticeable pullback from market participants this year and the investor does not expect the trend to be reversed next year. "2011 began with reports of firms coming back into the CMBS and CRE lending market, but in the summer and autumn we've heard of drastic cutbacks in certain groups and some have exited completely."

However, he adds: "On the demand side, it's still very strong - as evidenced by the very tight spreads seen in recent triple-A CMBS, which were several times oversubscribed."

Those spreads will likely narrow further, according to US CMBS strategists at RBS. They say: "We believe volatility is likely to remain elevated in the first half of 2012, but may eventually begin to subside thereafter. This is likely to lead to tightening CMBS spreads as investors become comfortable re-allocating to the asset class. As a benchmark, we believe the TRX.II index will be flat through the first half of the year at approximately 165bp, but will tighten by year-end to inside of 145bp."

Citi securitised products analysts agree that general market volatility will likely continue to be the key driver of spread directionality in 2012. With this in mind, they have developed spread forecasts under three scenarios: 'stability returns', 'vol persists' and 'liquidity crisis II'.

They explain: "Our most likely scenario, 'vol persists' (which we've assigned a 60% likelihood) has most spreads tightening moderately in 2012 from their recent levels. Generic dupers would reach the 230bp area under this scenario from their current level of 280bp. In our upside scenario, 'stability returns' (with a 35% likelihood), generic dupers could tighten to 135bp, as market vol is assumed to dampen. Under our unlikely downside scenario, 'liquidity crisis II' (with a 5% likelihood), these spreads could widen to the mid-800s area, as another financial sector meltdown is assumed to occur."

Meanwhile, structured products analysts at Wells Fargo see 150bp of spread-tightening potential generically for legacy AMs to bring the super-senior-to-AM spread relationship from the current 300bp back to 150bp, where it stood in December 2010. "Our target spread of 475bp for AM tranches is 280bp wide of the five-year triple-B rated corporates," they add.

In terms of flows in the secondary market, the investor is equally as cautious as he was over primary volumes. "Secondary flows have been light since the summer, averaging US$1.5bn a week, as opposed to the first quarter where a typical week was US$2bn to US$2.5bn. That said, for high quality bonds and - given the interest rate environment we're in - there has been decent demand for paper. But it's been difficult to find - a lot has been tucked away by investors who are keen to hold on to it. For the moment, I don't see that changing."

Also, he says: "The Street hasn't been using their balance sheets the way they used to - what used to happen was that when bonds came out, the Street would buy them, hope they tightened a little and resell them or even just to build up an inventory. But since H2, it's been flow trades only."

That new dynamic is unlikely to change in the near future. In a market where flows are relatively light, this isn't expected to be a big issue. However, it would be more problematic if some European banks or others began flooding the market with big portfolios of CMBS.

Certainly the huge wave of loans that will require refinancing in 2012 - after what had been a difficult year in 2011 - is an issue. The investor says: "I expect the refinancing situation to perhaps get a little bit worse in 2012, given the relatively big pipeline of 2007 loans - which can be characterised as aggressively underwritten - maturing next year. Larger loans can be extended, but there will be less opportunity to do the same on smaller loans, which will impact the market heavily and so we're watching that aspect closely."

US CMBS research analysts from Barclays Capital say: "Overall, for the entire CRE space, we forecast about US$300bn in loans set to mature in 2012. Only US$135bn in new loans is expected to be originated, implying a funding gap. As such, we expect CMBS delinquencies to step up again in 2012, driven by an increase in maturing loans not able to refinance. In addition, we expect some period IO loans to have trouble switching to their full debt service payment."

Based on the results of their most recent analysis of the conduit universe and their proprietary credit model, Deutsche Bank CRE debt analysts estimate that more than half of maturing loans in 2012 will be able to refinance in the current environment. "CMBS liquidation volumes reached new highs in 2011; however, as liquidations rose sharply this year, the amount of modifications has not kept up pace. We expect the mix between liquidations and modifications to be more heavily skewed towards liquidations, but in any given month a large loan mod could change that. CMBS investors will gain much more clarity on the value of their investments as distressed loans work through the pipeline and either become liquidated or modified," they add.

For its part, Moody's expects the proportion of specially serviced and delinquent CMBS loans to remain within a few percentage points of their respective current levels of 12.1% and 9.3% during 2012. The current delinquency rate is near the high-water mark the agency expects for this cycle.

Loans entering and leaving special servicing will remain roughly balanced during 2012, the agency suggests. The delinquency rate will then transition downward until the problematic 2016-2017 refinancing years cause it to reverse, although not back to current levels.

MBS analysts at Bank of America Merrill Lynch observe: "For CMBS investors, interest shortfalls should remain a focus point, as we expect they will continue to increase as a result of loan modifications - particularly within deals issued during the market peak. Over the past two years interest shortfalls have crept steadily higher in the capital structure. We expect this will continue next year, making mezzanine conduit bonds issued into the peak of the market extremely difficult to value."

The BAML analysts continue: "As a side effect of additional sizeable modifications, loan losses will be delayed, which may keep investors sceptical as to what the eventual outcome will be. So while we expect losses will also continue to migrate up the capital structure, the pace should be considerably slower as modifications effectively delay, minimise or eliminate altogether losses that would have otherwise occurred."

Overall, the Barcap US CMBS research analysts suggest a number of negative technical factors are likely to weigh on CMBS performance in 2012. These include: increased correlation with macro indices, lower liquidity, additional supply, a decreasing contribution of CMBS to the US Agg index and persistent high premium dollar prices due to low interest rates.

There is more than those factors to concern market participants, however, according to the US CMBS investor. "There is also the unforeseen impact of the regulatory environment," he says. "If you look at the interaction of all the different US regulatory bodies as are proposed, it really is an unbelievably confusing mix and match of conflicting organisations with conflicting requirements and rules."

He continues: "I think that could have a really big impact on all structured finance, not only CMBS. If I was a chief risk officer at an investment bank thinking about whether I want to be in the structured finance market, I'd take some great pause, just because now people can so easily get caught off-guard from a regulatory standpoint when purely doing regular day-to day business. You could easily go awry of one of the myriad of institutions aiming to regulate you."

The BAML MBS analysts concur that the unintended consequences of upcoming regulatory changes - including Basel capital requirements, Dodd-Frank risk retention and the Volcker rule with respect to positioning bonds -could hurt the CMBS market. For example, they say: "As the Volcker rule is written, dealers will no longer be able to position bonds and benefit from any appreciation in value. Instead, regulated dealers will only be able to trade bonds without positioning them, which is likely to hamper liquidity, result in less price transparency and possibly increase the cost to investors as a result."

Although few of the impending regulations have been implemented, the market is already beginning to feel their effects. For instance, as Basel regulatory capital requirements gain focus, dealers have been less willing to provide liquidity to clients or to hold large positions in the securitised products space - especially away from bonds at the top of the capital structure. Additionally, in a more highly regulated environment, conduit origination and portfolio lending could potentially decline, which would result in a decrease in credit availability.

However, despite all the potential negative factors impacting the US CMBS market, there is still room for optimism. The investor says: "Generically our feeling is that the CMBS market has to come back. When you look at the amount of CRE that was financed in the CMBS space, even if all the insurance companies and all the banks turned their loan volumes up to the maximum, there is still a massive gap in the amount of refinancing of commercial mortgage loans that needs to occur over the next several years."

The Deutsche Bank CRE debt analysts are similarly positive for the long term. As they conclude: "Our bottom line recommendation is to stay the course, be comfortable with the inherent risk of owned CMBS bonds and be cognisant of the embedded risks both at a deal level and a portfolio level, given an economic outlook with more questions than answers."

MP 

Structured Finance

Forging ahead

US ABS continuing to battle headwinds

The US ABS market continued its post-crisis recovery in 2011, achieving decent issuance despite some battering headwinds. Those same headwinds are expected to impact the market again in 2012, although issuance and performance should both remain strong, with more esoteric ABS set to prove popular.

Ongoing regulatory wrangling, legislative issues and macroeconomic factors, such as the European sovereign debt crisis, have impacted the US ABS market and will continue to affect it in 2012. Barclays Capital consumer ABS analysts calculate that non-mortgage ABS primary issuance stands at US$108.4bn in 2011 and predict US$100bn-US$115bn in 2012, with more than half of that likely to be auto-related.

Theresa O'Neill, md at Bank of America Merrill Lynch, says that autos and credit cards both performed relatively well in 2011, with spreads widening far less than in other markets. She notes: "From an excess return perspective or from a spread perspective, we saw a lot less volatility in these markets than the non-agency RMBS or certain corporate markets. They are traditionally viewed as safe-haven markets and they have performed that way."

O'Neill believes performance in 2012 should also be positive. She says: "We continue to be overweight the ABS sectors, with a few exceptions. Given the volatility, we would anticipate that most investors are going to want to stay higher up in the capital structure and look for products that are going to have a fair amount of liquidity, but we expect performance will be relatively good."

The Barcap analysts expect US$65bn-US$70bn of auto issuance in 2012. Credit card and student loan ABS are each expected to contribute around US$11bn, with equipment and other non-mortgage ABS each contributing around US$9bn.

Non-prime is starting to account for a greater proportion of auto issuance and the sector as a whole remains solid. Credit card ABS activity is a long way down on pre-crisis levels, but has more than doubled year-over-year to US$12bn in 2011.

Student loan issuance is down on 2010, decreasing from US$19.5bn to US$15.2bn. FFELP issuance is dwindling as there is a finite supply of loans available for securitisation, with private credit transactions increasing market share next year.

Equipment ABS volumes have been fairly stable around the US$7bn mark since the crisis hit in 2008 and reached US$7.4bn in 2011.

As with 2011, regulation is expected to be a major market driver in 2012. Although it is likely to be at least another year before the full effect of the delayed implementation of the Dodd-Frank Act is fully felt, the uncertainty that persists as the market waits is certain to have an effect.

Ron D'Vari, ceo at NewOak Capital Management, believes regulation is going to be a hindrance next year, particularly for RMBS. He says: "In general we are still fairly negative on non-agency RMBS securitisation. There are still some big issues in terms of Dodd-Frank in representations, conflict of interest and skin-in-the-game, so those will remain a concern. Because of those issues the market is going to struggle to get going, as much as we wish that was not the case."

O'Neill agrees that the uncertainty that the pending regulation is causing is not helpful. She says: "There are a lot of costs associated with interpreting and implementing changes. Ultimately these costs will be passed along to borrowers."

Risk retention is a central issue, but it is not the only one. "There are also other aspects of Dodd-Frank that need to be interpreted. In the consumer space, that slows down the origination process. When the rules are finally written, people will have to think through documentation issues and operational aspects that have to change," O'Neill says.

She adds: "From our perspective, we would not anticipate the market shutting down. Auto companies continued to access the market even throughout the crisis. The TALF programme was important in kick-starting that, but as far as risk retention is concerned, for example, most of the issuers retained first loss positions. They might have to hold more in the future, but they will manage to do so quite easily."

Indeed, D'Vari is confident that sectors such as auto ABS should be fairly robust. He says: "The more standard ABS sectors should perform pretty well. Obviously, the European situation is a concern and there are fears that it could kill the golden goose over in the US. But fundamentals in the US appear to be OK for the time being - barring global financial dysfunction created by a euro break-up. Issuance in 2012 should resemble issuance from early 2011, as opposed to how it has been towards the end of the year."

Although regulatory uncertainty remains and macroeconomic influences are inescapable, the US ABS market should weather those storms. Previously niche sectors that are less impacted by Dodd-Frank requirements such as risk retention should prove particularly popular.

Esoteric ABS, where skin-in-the-game is generally not a pressing concern, could be a strong growth area, particularly as investors hunt for yield. Rental car ABS could be one such sector set to see increased activity.

"Rental car transactions would certainly be an option. In the commercial and consumer space, a lot of the issuers have skin in the game, including rental car companies. They are securitising their fleet, so it is almost whole-business securitisation. Those esoteric sectors will perform well," says O'Neill.

She continues: "However, if volatility declines and concerns about the wider economy subside, then you will not see the same incremental yield in esoteric ABS as you would in certain mortgage products."

O'Neill believes esoteric ABS should do well in the current environment, but the upside is more limited. While rental and other esoteric ABS might outperform auto loan ABS, they would not outperform a sector such as CMBS.

D'Vari agrees that rental car ABS could be attractive. He says: "We believe things like auto rentals may come because it is an issuer-sponsored transaction where they are looking for funding and keeping most of the first-loss risks. We are also seeing activity in the speciality finance area in the multi-lateral private transaction form, which is akin to a securitisation, but is actually a good way to address Dodd-Frank."

He continues: "It is not strictly a security, so the regulations do not all apply. We are seeing US$50m-US$300m sizes there. That is one area that is under the radar and we are seeing these are transactions being originated and put together by boutique firms like ours that are working with smaller issuers."

In RMBS, the market will be clearly split between investment grade and non-investment grade. Ankur Makhija, svp at Odeon Capital Group, believes US investment grade RMBS will fare well in 2012.

He says: "We anticipate robust demand for investment grade non-agency RMBS as the universe for quality investment bonds shrinks. US non-agency investment grade RMBS is a very good alternative to sovereign and other ABS bonds because of the upfront nature of cashflows in the pass-through structure. A lot of those bonds have very strong internal credit enhancement relative to delinquencies."

Non-investment grade RMBS is another matter. Fundamentals may have a negative impact on pricing, although technical factors will limit this.

Makhija explains: "We anticipate depreciating short-term cashflows in highly delinquent subprime, Alt-A and option ARM pools. The crux to valuation of these securities is to understand the nature and repercussions of restructuring of underlying pools."

He continues: "The underlying borrowers in those pools are going through restructuring in terms of modifications, delinquencies and liquidations of delinquencies. I think institutional investors are still grappling with the full repercussions of all of that."

The limited availability of non-investment grade RMBS should act to limit the downward pressure on prices. The increasing scarcity of non-investment grade non-agency RMBS should provide a level of pricing support.

Makhija says: "For the 2006/2007 vintage non-investment grade bonds, we expect cashflow challenges to continue in 2012. That may push the prices down, but we do not expect a strong downward price movement because of limited availability of this product."

Front-ended cashflows in highly delinquent pools has been decreasing and this trend is expected to continue in 2012. There may be a rally for non-investment grade bonds if the US economy shows a strong sign of recovery, but Makhija believes that this is very unlikely, at least for the first half of the year.

Ultimately, the US structured finance market in 2012 will face many of the same issues that it faced in 2011. Performance and issuance should also be similar. O'Neill is fairly optimistic for the market's prospects: while she expects consumer ABS issuance for 2011 to total US$120bn, she believes 2012 will comfortably top that.

She says: "We expect US$140bn of issuance for 2012. I would expect credit to continue to improve in the first half of the year, albeit at a slower pace than we have been seeing."

JL

CDS

Facing a watershed

Challenges remain as CDS market prepares for central clearing

Next year is shaping up to be a watershed for credit derivatives in terms of regulatory change. But the market continues to face a number of challenges, not least of which is finalising the framework for central clearing.

"2012 will be a watershed year for credit derivatives in terms of regulatory proposals taking their final shape and being implemented," says David Rubenstein, managing principal and ceo of BlueMountain Europe. "But, while most of the necessary infrastructure to support the different environments - cleared and electronic - has been built, it will likely be of little use to the buy-side in the first half of 2012 due to regulatory challenges that have delayed the implementation of mandatory buy-side clearing."

One of the biggest issues outstanding from a buy-side perspective is around resolution of portfolio margining rules, he notes. "It's vital that regulators understand that cross-margining between cleared and uncleared positions makes sense when the risk between the two kinds of positions is offsetting; otherwise, it will be a painful transition into the new environment. So far, very little has been resolved: policymakers are working on so many fronts that it's somewhat difficult for them to focus on a single one to any great degree."

Segregation of client accounts is another important issue that is yet to be resolved satisfactorily for the buy-side. "Assuming the cost of implementation is not too great, we need to ensure that buy-side collateral is safe when held by a CCP. This has been given even more impetus by MF Global's recent collapse," adds Rubenstein.

John Wilson, former global head of OTC clearing at RBS, cites the beginning of mandatory clearing and the advent of SEFs as the main regulatory developments for credit derivatives in the US next year. "We'll definitely see CDS indices being included in mandatory clearing, but the universe of single names will be more challenging, given that they're not homogeneous," he says. "Equally, by end-2012 we may see many SEFs teeing up to launch. Currently under the CFTC rules, SEFs should consider up to eight factors when deciding what should trade on their platform."

Central clearing isn't expected to have much of an impact on CDS trading, however, until the capital implications for non-cleared products are clearer. "The number of names eligible to be cleared has increased, but no explicit statement has yet been issued about what happens if a name isn't cleared. There are suggestions that capital requirements will be calculated based on a gross basis, which could render some business models impractical. Consequently, some participants have ignored the clearing issue to a certain extent: there are too many other things to worry about at the moment, but it will happen," explains Michael Hampden-Turner, structured credit strategist at Citi.

But tension in relation to capital charges and their application to cleared activity is only expected to increase next year. How the default fund will operate is one such area of tension because Basel 3 rules inflate the exposure that a CCP would normally consider to be reasonable, leaving a permanent capital shortfall.

Wilson suggests that punitive capital charges, together with significant default fund contributions - the CME, for example, requires a US$50m minimum amount per product - could put many clearing members off. "Along with other regulatory requirements, this business isn't likely to generate much profit, so how will the returns on capital to cover the shortfall be generated?" he asks. "Clearing members strongly argue that the balance should be added to initial margin, but this would make clearing CDS prohibitively expensive for many end-users."

From a CVA perspective, banks will likely end up buying ineffective hedges for sovereign debt, for instance, in order to realise capital benefits. "Ultimately, participants will reassess the costs versus the benefits of centralised clearing. It may be that policymakers are trying to kill off the CDS market, but if people can't hedge, they'll reassess buying bonds," warns Wilson.

The environment is also driving greater contemplation about which counterparties to trade with to the extent a product isn't eligible for central clearing. US regulators require any entity within a US banking group to collect initial margin on uncleared obligations, but there are no corresponding demands on European groups as yet.

"This could make US entities unattractive to trade with," Wilson explains. "We may see the market bifurcate due to the different timings of regulations, with participants choosing what and with whom to trade more carefully. The caveat is that further clarity about extraterritorial provisions is needed from US regulators."

Dodd-Frank and potential new legislation such as the Tobin tax - which essentially weigh more heavily on prop trading - provide other regulatory headwinds that will likely impact liquidity in the CDS market. The extent of the impact depends on the way these new rules are precisely defined, according to Hampden-Turner.

"The detail of such regulation is critical," he observes. "It all equates to additional costs for and restrictions on banks, which are positioning for leaner times in anticipation. A combination of regulation and the need to deleverage and adjust business models will cause the negative mood to persist."

In comparison to the US, the implementation of European credit derivatives regulatory requirements are lagging. Nevertheless, Wilson suggests that MiFID's pre- and post-trade transparency requirements will have a profound effect on traded notional sizes.

The requirement to advertise interest to the market via a RFQ, disclose execution data and the publication by clearinghouses of open interest data is expected to diminish the number of dealers willing to trade in size. One possible outcome is that single trades will be sliced into many smaller ones to reduce market impact. While the traded notional won't increase under this scenario, transaction volumes will.

The knock-on impact is that the infrastructure previously used to support 1500 trades will then have to deal with 15,000 trades. "A lot of work is going into ramping up infrastructure to cope with this, but increased volumes don't necessarily translate into increased revenue - if it costs too much money, this may dampen demand," observes Wilson. "On the other hand, smaller trade sizes could be more palatable and thus attract smaller players to the market, which may boost liquidity."

He points out that electronic markets play to the strengths of high frequency traders (HFTs). "Regulators don't like HFTs, but they are creating conditions for them to operate in. Their advent should increase the overall traded notional and volumes of credit derivatives. Additionally, given that HFTs aren't subject to capital rules but their dealer counterparties would be, two HFTs trading together would have an advantage."

To cater to these new markets, banks will establish connections to multiple execution venues to enable clients to achieve best execution. "Banks could also begin offering smart aggregation services or services that slice orders up into smaller sizes and then apply algorithmic smart routing, spreading the trades across venues to hit liquidity in a number of areas. These sorts of facilities have already been developed for the fx, equities and futures markets, so it could be a case of refining existing infrastructure for a new asset class," argues Wilson.

Meanwhile, the long-awaited European ban on shorting sovereign CDS will likely be implemented at the end of next year. "The text of the ban is yet to be finalised, but it is assumed that the list of exceptions will be relatively generous and not directly affect that many investors. For example, CVA, hedgers and market makers will have a carve-out. It's deliberately aimed at prop desks and hedge funds, but many of these are based in the US and so aren't affected by it," notes Hampden-Turner.

However, he expects the psychological impact to result in a drop in liquidity in some names. "If CVA desks can't trade then they will likely short bonds or equities as proxies for a hedge. It's unclear what percentage of the market is reliant on liquidity from hedge funds, but typically many participants are the same way around, so it could be harder to find the other side of a trade as a result."

Equally, some less liquid CDS will continue to become increasingly less liquid due to their lack of clearing eligibility. These CDS entities will become even less liquid as large numbers of CSOs mature between now and 2017.

"Some of the iTraxx IG9 tranches - the most traded European index tranches - only have 18 months left to run and may become extremely illiquid as they approach maturity," Hampden-Turner says. "Volumes in credit swaptions are likely to benefit as liquidity decreases as investors look for alternative methods to get leverage and convexity on investment grade."

Interest in simple CLNs is also likely to pick up as investors search for yield. In addition, Hampden-Turner reports some interest in more sophisticated CLNs; for example, products that pay a return based on the skew.

Rubenstein maintains that liquidity is primarily a reflection of demand for a product, not the venue in which it is traded. He says that indices remain very liquid and continue to be a great way to hedge credit exposure.

Indeed, credit derivatives strategists at Morgan Stanley expect the role that credit derivatives played in offering a liquidity avenue in challenging markets to be reinforced next year. "2011 proved to be mostly about capturing the asymmetric downside in risk markets and we think 2012 is likely to be increasingly about the asymmetric upside - whether isolating and monetising elevated fears of defaults via the tranche markets or monetising excessive credit volatility and skew in options," they note.

As the market moves forward into 2012, the metrics that the Morgan Stanley strategists are watching comprise: volatility, the basis, correlation, options skew and curve shape. Against this backdrop, their best trade ideas are hedges, including ATM payers, X-100% tranche trades and trades that monetise high skew or high volatility to fund hedges in other asset classes. Their remaining trade ideas are divided into one of three categories: index replacement strategies, curve trades and trades that have outsized convexity in a particular scenario.

Looking ahead, the sovereign debt crisis will likely continue to cause distress and may even trigger some bank failures over the next six months. "The complete dominance of the macro theme relative to bottom-up bond picking based on fundamentals goes against the grain for many portfolio managers and adjusting to it has been a painful process," comments Hampden-Turner. "Many on the buy-side are wondering how to make money in the current environment, given how irrationally the market is behaving - they've been frustrated by the linkage between corporates and sovereigns."

Certainly rising defaults, bank debt burden-sharing and contagion risk are three themes that will drive European markets next year, according to Alberto Gallo, senior credit strategist at RBS. "The first two will likely remain in place, even if the ECB intervenes strongly. So far, intervention has focused on liquidity, while doing little to address the solvency issue and the fact that the banking sector is unsustainable at its current size."

Gallo explains that banks will have to refinance a quarter of their debt next year and although liquidity injections limit the fall-out, they don't address the macro impact, which is negative growth and rising defaults. RBS forecasts that defaults will rise from 2.6% this year to 5.6% in 2012.

"Bank lending will dry up because banks will be forced to de-lever their balance sheets by at least 20% of assets or €5.1trn over the next three to five years, bringing the European banking sector in line with Japan, at 190% of GDP," Gallo says. "Banks won't necessarily be able to sell these assets, so they'll need to run them to maturity. Government guarantees could help, but ultimately allocation of credit still has to go through banks and we're already seeing some starting to convert sub debt into equity or senior debt."

The third theme is based on the premise that contagion risk in Asia and Australia hasn't been priced in. Australian banks, in particular, have significant exposure to Europe in terms of lending or owning assets at almost 20% of GDP.

In line with these themes, Gallo recommends three macro strategies: going short Crossover risk/long CDX HY risk; short iTraxx Sub Financials/long iTraxx Senior; and short a basket of Australian and Korean bank CDS. The first two trades are non-directional, while the third is directional.

"Generally, in terms of asset allocation, investors should be relatively conservative and overweight corporates over banks, prefer UK or Scandinavia banks over eurozone banks, US credit over European credit and senior to subordinated debt. The idea is to position for changes in the structural landscape over the medium term," he notes.

Given the current uncertainty, Rubenstein recommends that investors should be cautious and build balanced portfolios that are hedged against unpredictable macro-driven downside. "The macro environment is very difficult at the moment because so many political forces are at work," he notes. "Redenomination of underlying obligations is one possible outcome, for example. Most participants believe that New York law wouldn't allow redenomination, but are unsure about the law in the UK."

Rubenstein points out that some of the best investment opportunities tend to be less liquid and so, in order to take advantage of these particular investments, investors ought to have longer investment horizons. "While the average investor's time horizon has shortened considerably over the last few years, many of BlueMountain's investors are thinking longer-term. We see lots of assets with great fundamental value, but which need a longer investment timeframe," he says.

Other institutional investors are also coming to this conclusion and establishing funds with three- to five-year locked capital. While investors may experience some mark-to-market volatility in the short term from such strategies, they are expected to gain in the long term.

CS

Structured Finance

Expanding opportunities

Growth continues in APAC securitisation markets

Asia-Pacific structured finance has enjoyed a good year in 2011 and is expected to see even more activity in 2012. Despite a number of challenges, issuance and performance in mainland Asia, Japan and Australia continues to be robust.

Warren Lee, global head of structured finance solutions at Standard Chartered, says 2011 has been one of the better years for Asian structured finance since the financial crisis began in 2008. He notes: "We have seen transactions come out this year. We have seen consumer credit receivables, such as credit cards and auto loans, being done. There was a US$300m Korean Airlines ticket receivables deal done just last month."

Collateral asset performance for Japanese ABS and RMBS was very stable in 2011. Koji Kumamaru, Moody's structured finance md, says there were no downgrades in these sectors caused by poor collateral performance except for a few buy-to-let RMBS.

The Tohoku earthquake and tsunami had only a modest impact on Japanese structured products. "There was some impact from the earthquake in that particular region, but we checked what portion of deals were affected by this and it was less than 2% with almost all deals," explains Kumamaru. "The affected area and particularly the area impacted by the tsunami is a coastal area with quite a low population, which is why the impact on the performance of collateral pools was very limited."

Jennifer Wu, Moody's vp and senior credit officer, notes that Australian market activities in 2011 were more affected by events in the eurozone. "There was a definite global contagion effect and Australia is impacted by that," she says.

Despite the eurozone issues, one Australian banker says that 2011 was a good year for structured finance and he expects overall volumes by the end of December to surpass those of 2010. "We are continuing to rebuild in the aftermath of the financial crisis. In RMBS we are getting close to the local market absorbing new issuance equivalent to that just before the crisis hit in 2008, so the picture is improving."

Domestic primary issuance is back to the levels seen around 2007, although the market is still struggling to tap the international investor base. "While the domestic side of the market has re-established itself, issuance to international investors is still the missing piece," the banker notes.

The desire to tap the international investor base is strong, however. "We continue to promote the product in international markets, particularly in Asia, because we believe there is a latent investor base in those markets. We have heard that the American market is hungry for Australian RMBS and ABS because of the strength of the underlying economy here and good historical credit performance of Australian deals. They are looking at Australia as particularly interesting for diversification," the banker adds.

The Australian RMBS market has been boosted by the number and variety of issuers coming to the market, although conditions in the second half of the year have been tough. Issuers that had not been active for a few years returned to the market early in the year, but funding markets became more challenging in H2 and will continue to be at the start of 2012.

Nevertheless, Wu believes that 2012 will be another good year for Australian securitisation. She says: "We have seen a very high issuance this year and a lot of the deals have been placed offshore with strong investor demand. We see that continuing, especially as lenders are looking to diversify their funding portfolio and use securitisation as a possible tool of funding."

The banker agrees that the prospects for next year are good, although they are tempered slightly by regulatory uncertainty. He says: "Leading into 2012 there are still challenges for the market to address. While the Australian market is one of the most active in terms of volumes and number of issuers, rating agencies have introduced a large number of changes to criteria and those have affected the market."

He is concerned that changes to rating criteria, particularly to how much credit agencies give in a transaction to lenders' mortgage insurance, will provide challenges for the market. He believes subordinated tranches will need further enhancement in the future if they are to achieve investment grade ratings, which will add to the cost of issuance.

Since the credit crisis, Australian transactions have had cleanly delineated senior, mezzanine and subordinated tranches, with conservative credit support provided to the senior tranches. Although that should continue to be the case, the level of support may start to soften.

"We think it will probably continue but to a lesser degree. In the last few years there has been a lot of buffer provided by the mezzanine and junior tranches, mainly because of investor preference. We expect that trend will still continue, but maybe the buffer provided to cover subordination will be less," says Wu.

However, RMBS will remain central to Australian structured finance going forward. House prices are expected to stabilise, but with a downward bias. A housing shortage remains in the country, which should help to stabilise the downward pressure.

Arrears are also expected to stabilise, mainly due to recent interest rate cuts. A further rate cut from the RBA could be on the cards early in 2012.

Meanwhile, the jurisdiction is set to see a greater variety of transactions as investors seek greater diversification. The banker says: "We take heart from a trend of asset-backed deals being done in the market."

He continues: "While they have always been dwarfed by RMBS, we are still seeing auto loan, equipment lease and equipment loan deals being placed by a small number of issuers. Investors are attracted to those issues because of the shorter tenor and because they provide yield pick-up and diversification away from purely residential mortgage assets."

Other transactions, such as trade receivables deals, could also become more prevalent. Wu explains: "The Australian ABS market is largely auto loans and commercial equipment leases. I think we may see some other asset types, such as trade receivables, being added to that mix in 2012."

The banker agrees that trade receivables transactions would be well received, although rating agency criteria could be a challenge for first-time issuers. "There is some potential for that; however, the agencies do like to see a reasonable period of history. One of the issues that many corporates face with those types of receivable is that they do not retain data in a way that aids rating agency analysis or provides the necessary information for capital market investors."

He adds: "Corporates are interested because it is a way to diversify their funding. With Basel 3 coming into play, the availability of credit for small businesses will be a little more difficult, so that does make the costs of securitising trade receivables look more attractive. It is not completely out of the park, but it is a challenge in the current environment."

Wu also predicts that 2012 might see more of a balance between RMBS and covered bond issuance. She says: "Of course a lot is dependent on market conditions in Europe, but we have seen covered bond issuance this year and I expect that will continue next year, so there should be a slight balance between RMBS and covered bonds in that sense. It is something not so much reducing the issuance activity, but it will probably act as a balance."

The mainland Asian covered bond market could also be set to expand. Lee explains: "The Korean government has been trying to push out a covered bond market for a while now. There have only been two deals so far, so hopefully next year we will see other banks tapping the covered bond space to supplement the liquidity."

Away from covered bonds, Lee expects 2012 to see even more Asian securitisation activity than in 2011. "Liquidity is going to be paramount in the Asian market. We are seeing some of the European banks exiting the market, so liquidity will be tight," he says.

He continues: "Asia has historically been very liquid, even in the Hong Kong market where a bank's loan-to-deposit ratio is usually in the 60% range, but now is in the 70%-75% range. With liquidity so tight, I think issuer companies are going to definitely look at alternative funding sources."

Many companies are in need of significant refinancing, so in 2012 some of that refinancing will have to be done in the securitisation market. Several CMBS, for example, will have to be refinanced out of Singapore next year.

In Japan, Kumamaru expects the stability seen in RMBS performance to continue. Although the macroeconomic condition is "severe" and the employment market is not healthy, tight underwriting standards should keep performance stable.

Kumamaru says: "Our RMBS observations are mainly focused on the private banks, which are the relatively larger banks in Japan. Their underwriting policy is strict, so the obligors' average credit quality is much better than the national average. Even with stressed economic factors, performance should be stable."

The main sector for issuance and activity in the country will continue to be RMBS. Although Moody's does not rate public sector RMBS in Japan, where the Japan Housing Finance Agency (JHF) purchases residential mortgages and securitises them, Kumamaru expects JHF will be the top issuer in the market as was the case over the last couple of years.

He says: "Many obligors go to the JHF because it provides long-term fixed-rate residential mortgages with a low interest rate and it provides a discount. That is why they are dominating the securitisation market in Japan."

That discount ended in September, but the government subsequently announced a new discount programme which started this month. The new discount is related to energy efficiency and qualifying property collateral can receive a 70bp discount for the first five years. Kumamaru expects this programme to underline the JHF's dominance of the RMBS market in 2012.

As with 2011, in Japan credit card and auto loan ABS are expected to be the most active sectors outside of RMBS next year. ABS performance should remain stable in 2012.

"Loan originator underwriting policies are relatively strict and performance is not worsening. The consumer finance sub-sector performed quite badly over the last couple of years, but originators' tighter screenings contributed to better collateral quality, so credit performance next year should be stable," Kumamaru continues.

Finally, a particular growth area for Asia next year could be in CLOs. Standard Chartered has been active in issuing its line of Start CLO deals and it is a template Lee believes other banks could follow.

He says: "Our bank is very proud of the Start series of regulatory capital CLOs we have done. We did four transactions last year, and just this month we did Start CLO VII, which is one of our biggest."

Lee concludes: "Hopefully we will continue to issue a regulatory capital trade, so we can redeploy capital more efficiently. A lot of the Asian banks are also analysing why we are doing this and hopefully next year, with Basel 3 kicking in, perhaps they will consider doing their own programme."

JL 

ABS

CoActiv appoints credit svp

CoActiv Capital Partners has promoted Robert Levitsky to credit and risk management svp. Levitsky will lead the small ticket and structured finance credit underwriting teams, as well as overseeing risk management interaction with CoActiv's parent, Marubeni America Corporation.

Levitsky has thirty years of experience in the industry and was most recently credit and risk management vp, having previously been CoActiv's workouts and restructures vp. He has also held positions at Siemens Financial Services, Fleet Capital Leasing and CIT Group/Equipment Financing.

Structured Finance

FIG ceo takes leave

Daniel Mudd is taking a leave of absence from his role as Fortress Investment Group ceo. Randal Nardone, currently Fortress principal and co-founder, becomes interim ceo.

Mudd says he is taking the leave of absence to ensure the attention he is focusing on matters outside of Fortress do not affect the company's business or operations. The US SEC announced earlier this week that it is charging Mudd, who is the former ceo of Fannie Mae, and five other former GSE executives with securities fraud (see SCI 19 December).

Structured Finance

Law firm names SF head

Reed Smith has appointed Tamara Box as head of structured finance. Previously head of international structured finance at Berwin Leighton Paisner, Box joins Reed Smith's London office as a partner in the financial industry group.

Box is qualified in both England and New York and specialises in securitisations, derivatives, debt capital markets and debt restructurings. She also has significant experience with emerging markets and Islamic finance.

Structured Finance

CRE lawyer hired

Krieg DeVault has appointed Ross Taylor as of counsel in its commercial and real estate lending practice. He specialises in secured and unsecured lending, structured finance and lease financing.

Taylor joins the Chicago office from Kelley Drye & Warren, where he was a partner. He has been in the industry for over twenty years and has also served as partner at Schiff Hardin and at Chapman and Cutler.

Structured Finance

Tech firm recruits Euro md

Jamie Harper has joined Vichara Technologies as European business development md. He is based in London.

Harper's most recent post was as vp for EMEA at Lewtan Technologies. Previous roles include svp at Demica and a business development position at Moody's RMS.

CLOs

CLO manager resigns

Nomura Corporate Research and Asset Management has given notice of its resignation as investment manager on the Clydesdale Strategic CLO I and Clydesdale CLO 2005 transactions. The manager proposed to assign the investment management agreements for the deals to Ares Management (SCI 5 October).

CMBS

CRE advisory hires for DCM

American Realty Capital (ARC) has hired Andrew Winer to lead a number of the firm's strategic debt initiatives.

Reporting directly to Nicholas Schorsch, ceo, and Bill Kahane, president, Winer will be charged with advising ARC, its affiliates and subsidiaries in connection with debt capital markets. He will be responsible for arranging corporate lines of credit and other loan facilities for all of ARC's investment programmes, participating actively with rating agencies on securing corporate credit ratings for all of ARC's companies and designing investment strategies for both commercial debt and structured debt products.

Winer's experience includes 20 years in CRE finance, including 17 years at Credit Suisse and its predecessors. Most recently, he oversaw pricing, hedging and execution of commercial securitised real estate debt at Credit Suisse.

RMBS

Brazilian bank buys securitisation firm

Banco PanAmericano, a division of BTG Pactual, is to purchase Brazilian Finance and Real Estate (BFRE). A non-binding memorandum of agreement has been signed for a R$940.3m acquisition of all BFRE companies, including its mortgages and securities divisions.

The purchase marks a repositioning for PanAmericano as it reorganises and diversifies its business. BFRE has been a market player for 12 years, specialising in the securitisation of real estate receivables. Brazilian Securities focuses on RMBS, but in 2010 it also structured the Brazilian market's largest CMBS issuance, backed by sale-lease back agreements within Oi Group.

RMBS

RMBS trader joins Stifel

RMBS trader Eric Daouphars has joined Stifel Nicolaus. He was most recently md at Citadel Securities and previous positions include md at ICP Capital and Bank of America, as well as director at UBS Investment Bank and vp at Salomon Smith Barney.

RMBS

Bank's RMBS rap from regulator

FINRA has fined Barclays Capital US$3m for misrepresenting delinquency data in connection with subprime RMBS it issued and also fined it for inadequate data supervision. In settling, Barclays has neither admitted nor denied the charges.

Subprime RMBS issuers are required to disclose historical performance information for securitisations with similar mortgages to those in the RMBS being offered to investors. FINRA found that from March 2007 until December 2010 Barclays misrepresented the historical delinquency rates for three subprime RMBS it underwrote and sold.

FINRA says the inaccurate data posted on Barclays' website was referenced as historical data in five subsequent RMBS investments and contained errors significant enough to affect an investor's assessment of subsequent securitisations.

The regulator says Barclays also failed to adequately supervise the maintenance and updating of relevant disclosure on its website. It says there was no system to ensure data posted was accurate.

ABS

Stable auto ABS performance predicted

With small declines in both delinquencies and losses in November, stable asset performance for US auto ABS will likely stay the course in 2012, according to Fitch's latest index results for the sector. US prime and subprime auto loan ABS continued to show performance stability during the month, posting marginal improvements in both delinquencies and losses month-over-month (MOM).

Asset performance will likely stay on track in 2012, with continued low prime annualised net losses (ANL) next year. Fitch expects the auto ABS rating outlook to stay positive, following a similar 2011. Year-to-date, the agency has issued 75 rating upgrades in 2011 through November, versus 61 for the same period in 2010.

Key areas of focus next year for auto ABS performance will be the state of the US job market and the health of the wholesale vehicle market. Fitch will also be closely watching ongoing volatility in the global geopolitical climate to determine if there are any inlays on auto ABS asset performance.

Fitch's prime 60+ days delinquency index dropped 4.2% to 0.46% in November over October. November's delinquency rate was well within levels recorded in 2005-2007 and 14.8% improved over November 2010.

ANL dropped by 7% in November versus October to 0.53%. Year-over-year (YOY), losses were 36% lower in last month compared to 0.83% recorded in November 2010.

In the subprime sector, 60+ day delinquencies dropped to 3% in November. This represents a 2.6% improvement over October and a 3.9% improvement from a year earlier. ANL dropped 3.7% to 6.69% in November MOM, and were 5% lower YOY versus a year earlier.

ABS

Card charge-offs increase

US credit card charge-offs increased by 17bp in November to 5.38%, according to Moody's latest credit card indices. With other key performance measures remaining strong in November, the agency continues to expect the overall trend in charge-offs to be downward, with the rate eventually falling below 4% by the end of 2012.

"The charge-off rate index is more than three percentage points lower than it was a year ago, as the credit quality of securitised receivables is exceptionally strong," says Jeffrey Hibbs, Moody's avp and analyst. "The increase in November is not unexpected, as weaker charge-off rate performance during the month is consistent with seasonal patterns."

More positively, the delinquency rate index remained stable in November - down only 1bp from October, at an all-time low of 3.03%. The rate of early-stage delinquencies was also unchanged in November, although five of the six largest trusts posted monthly declines, says Moody's.

Although dropping a bit for a third consecutive month, the card payment rate remained near its all-time high. Specifically, the payment rate declined in November to 20.56%, still close to the record 21.91% rate it posted in August.

"Historically low delinquencies and high payment rates reflect the improved borrower mix in credit card trusts today as weak borrowers have charged off at record levels in the recent recession and originators have added few new accounts to the securitisations," says Hibbs.

As expected, the yield index resumed its downward trend in November, reversing the 8bp gain in October with an eight point decline, as the benefit of principal receivables discounting continues to decline. The yield index ended the month at 19.21%.

Finally, excess spread ticked lower in November, moving down to 11.03% from 11.30% in October. It remains extraordinarily high, however.

ABS

Vecta 1 closes

Vecta 1, Aurigen Reinsurance's embedded value life securitisation (SCI 19 December 2011), has closed at C$120m, paying an 8% fixed coupon. The deal has been rated triple-B plus by S&P.

The subject business consists of 447,444 term, permanent, and universal life (UL) policies on Canadian lives with aggregate face amount of approximately C$22bn, average face amount of C$49,779 and aggregate annual premium payments of approximately C$65m in 2010. Highlights of the securitised business profile are as follows (% by face account): 59.7% issue age 30-49 and 99.8% issue age <70; 39% UL, 18% 20-year term, and 43% 10-year term; and 99.59%

Joint bookrunners were Credit Agricole Securities (USA), the structuring lead, and Swiss Re Capital Markets.

Structured Finance

Volcker Rule comment period extended

The comment period on the proposed Volcker Rule (SCI passim) has been extended by a month until 13 February 2012. The extension forms part of a coordinated interagency effort to allow interested parties more time to analyse the issues and prepare their comments.

Kenneth Bentsen, evp, public policy and advocacy at SIFMA, notes that the extended comment period will allow commentators sufficient time to adequately address a "very complex rule proposal that includes nearly 1,400 questions". He adds: "This extension also allows commentators the time to provide regulators with the necessary information to ensure crafting a rule that does not unnecessarily impede liquidity in capital and credit markets at the expense of capital formation and economic growth. We also appreciate the regulators' approach to this extension, which will facilitate better coordination with the CFTC as they look to publish their own proposal in the near future."

Structured Finance

Stable outlook for LatAm SF

Fitch's credit outlook for Latin American structured finance (SF) transactions in 2012 is stable. This view is consistent with most of the outlooks for the sovereigns in the region.

The agency highlights that while most of the world continues to feel the effects of the global credit crisis, Latin American ratings continue to be fairly resilient. The stable outlook is based on the continued recovery and growth of Latin American sovereigns, which foster improved asset performance. Improving economic conditions in the region exerted a stabilising influence on the credit quality and collateral performance of the majority of SF portfolios.

Affirmations constituted the majority of rating actions in 2011 for both cross-border issuances and transactions issued in their respective local markets. The exception remains Mexican RMBS transactions backed by portfolios originated by non-bank financial institutions, which continue to suffer from mounting non-performing loans.

Structured Finance

Sovereign-linked deals on review

Fitch has placed 40 tranches of 23 Irish, Italian and Spanish structured finance (SF) transactions on rating watch negative (RWN) following the rating action taken on the sovereign IDRs of these countries. In addition, the agency has revised the outlook on two tranches - Harvest CLO IV class Ms and Exfin Capital class As - credit-linked to government bonds issued by France to negative.

The tranches of Irish RMBS transactions that have been placed on RWN are those that are rated at, or a notch below, the cap on ratings for Irish SF transactions of double-A. If Ireland's sovereign is downgraded, it is likely that the cap applied to Irish SF ratings will also be lowered.

The ratings of both tranches of FIP Funding, meanwhile, rely on the strength of the Italian sovereign as the guarantor for the sole tenant of the properties and so Fitch has placed these tranches on RWN. The single tranche of Astrea is also credit-linked to the Republic of Italy and so placed on RWN. Similarly, Italian state entities provide the majority of the rental income supporting the Patrimonio Uno CMBS.

Finally, the RWN on the Spanish transactions are the result of the RWN on the Kingdom of Spain's ratings. Although explicit government guarantees do not exist in all of these cases, the transactions' ratings are more closely related to the sovereign rating than would be the case in a typical securitisation.

Similarly, the RWN on the class A of Santander Publico 1 is the result of the public sector borrowers in the portfolio being highly correlated with the credit quality of the Spanish sovereign. The five tranches of five other SME CLOs that benefit from a guarantee from the Spanish sovereign have also been placed on RWN.

Fitch expects to complete the review of the sovereign ratings by the end of January 2012 and therefore resolve these RWNs shortly thereafter. If the sovereign review concludes that a downgrade is warranted, it is likely be limited to one or two notches.

CDO

Marginal rise in Trup default, deferral rate

New deferrals for US bank Trups CDOs declined again this past month while defaults rose slightly, leading to a marginal increase in the overall rate, according to Fitch's latest index results for the sector.

Bank defaults for Trups CDOs rose by 0.09% to 16.71%, while new bank deferrals fell 0.06% to 15.42% from 15.92%. The drop in deferrals was due primarily to three banks transitioning to default from deferral status on their Trups CDOs. The November defaults totalled US$33.5m of collateral in seven CDOs.

The combined default and deferral rate for banks within Trups CDOs increased by 0.03% and now stands at 32.13%. Through the end of November, 195 bank issuers were in default (affecting US$6.3bn held across 83 Trups CDOs), while 375 bank issuers deferred on interest payments (accounting for US$5.8bn held by 84 Trups CDOs).

CDO

ABS CDO tender announced

Faxtor ABS 2005-1 class A1 noteholders have been invited to tender their notes for purchase for cash. The maximum proposed spend amount is €22m at a maximum purchase price of 80%.

Originally sized at €227m, the outstanding principal amount of the class A1 notes is €169.72m. All responses are to be submitted by 20 January, with settlement expected on 26 January.

CDS

ISDA OTC stats released

ISDA has published its analysis of the OTC derivatives market based on 30 June statistics. They show that the notional amount of OTC derivatives outstanding increased by 18% from US$416.7trn at year-end 2010 to US$491.3trn.

This increase in notional outstanding reverses declines in 2008, 2009 and 2010. From year-end 2007 through year-end 2010, the OTC derivatives markets decreased in size by approximately 12%.

With regard to credit default swaps (CDS), the analysis shows modest progress in clearing in the first half of 2011. Nearly 13% of the CDS market is cleared.

The analysis indicates that while notionals rose in the first half, gross market values and gross credit exposures declined during this time period. Gross credit exposure after netting and collateral measured 0.1% of notional outstanding at 30 June, compared to 0.2% at 31 December 2010.

Portfolio compression reached US$130.1trn as of 30 June, including US$22.1trn in the first half of 2011 alone. For CDS, compression by TriOptima exceeds US$71.4trn, including US$3.2trn in the first half of 2011. Compression of CDS from other vendors is approximately US$7.4trn as of June, with compression in the first half amounting to US$500bn.

In addition, the analysis shows the risk mitigation benefits of netting. In the first half of 2011, gross market value declined from US$21trn to US$19.5trn, while gross credit exposure declined from US$3.5trn to US$3trn. At 30 June, netting reduced gross market value by 85%, a 1% increase from year-end 2010.

CMBS

Euro CMBS loan warnings issued

According to the latest European CMBS monthly bulletins from S&P and Fitch, January is going to be a testing month for loan maturities.

Although recent data show that some delinquent European CMBS loans have cured, the poor loan performance looks set to continue undeterred in 2012, according to S&P. This, the agency says, is all the more troubling considering that in January alone borrowers will need at least €3bn in aggregate to refinance their maturing loans.

"As property values continue to fall, we are likely to see more appraisal reduction mechanisms triggered in the CMBS transactions that we rate and, depending on how the appraisal reduction mechanisms are structured, subsequent interest shortfalls on notes," says S&P credit analyst Judith O'Driscoll.

Fitch notes that January 2012 will see the largest monthly volume of debt falling due since the onset of the financial crisis. It reports that a total of €2.6bn (36 loans) is scheduled to mature, which adds to Fitch's concerns about special servicers' capacity to handle growing loan portfolios.

The majority of the loans maturing in January are backed by non-prime assets, Fitch adds. Availability of debt on such assets remains scarce, indicating that restructuring and work-outs will ensue.

Another concern the rating agency highlights is the sheer size of the loans scheduled to mature - six of the 36 due to mature in January have loan balances in excess of €100m. In Fitch's view, these larger loans will suffer from increased financial strains on lending institutions.

At 39.1%, the December Fitch repayment index was broadly unchanged from the previous month. This is largely due to the small number of loans that were scheduled to mature in the month, Fitch says, but nonetheless underscores the lack of debt availability for the majority of borrowers.

Looking ahead, the agency concludes: "A weighted-average Fitch LTV ratio of 98% suggests that most of the 2012 loan maturities will not result in timely principal redemption. Over time, smaller loans backed by higher quality collateral have been repaid with greater frequency, reducing the average credit quality of the remaining CMBS portfolio."

RMBS

PEARL RMBS restructured

SNS Bank has restructured PEARL Mortgage Backed Securities 1, 2 and 3, following the update to Fitch's criteria for rating RMBS transactions backed by the Nationale Hypotheek Garantie (NHG).

Under the restructuring, the proceeds of a partial redemption of the class A notes were used to issue mezzanine class S notes. The class S notes rank senior to the class B notes, but junior to the class A notes, resulting in an increase in credit enhancement. The margins on the class S notes are equal to the unchanged margins on the class A notes.

Fitch has affirmed the class A notes of all three deals at triple-A, downgraded the class B notes and assigned ratings to the new class S notes. At the same time, all existing class A and B notes have been removed from rating watch negative. The affirmation of class A notes reflects the increased credit enhancement provided by the newly created class S notes.

RMBS

AG servicing settlement nears

It appears that the state attorneys general and the five largest mortgage servicers - Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial - may have reached an agreement, after more than a year of negotiations over servicing and foreclosure abuses (SCI passim).

DBRS notes in its latest US structured finance newsletter that the proposed settlement would require the servicers to commit US$5bn in cash, US$3bn in refinancing and US$17bn in principal forgiveness, in addition to adhering to tougher standards for loan servicing and foreclosures. In return, the servicers would be released from all claims against them by the states and federal government, including any claims for fraudulent originations.

The settlement does not grant immunity to the servicers for any individual cases brought against them by homeowners, however. Nor does it force borrowers who accept compensation under the settlement to give up their rights to sue the mortgage companies independently.

Of the US$5bn in cash, US$1.5bn will be allocated to people who were foreclosed upon and were abused in some way during the process. The compensation payment to each borrower will range between US$1,500 and US$2,000.

US$2.75bn will go to state programmes for foreclosure mitigation efforts, such as counselling, legal aid hotlines and mediation between the homeowners and banks. US$750m will be given to the federal government for foreclosure mitigation programmes.

Refinancing will be undertaken for underwater mortgages for borrowers who are not behind in their mortgage payments but have been unable to refinance because the value of their home has declined. The refinancing will consist of reducing the interest rate charged on the loan.

If agreed to, the proposed settlement is expected to reduce the principal balances on approximately one million underwater loans by US$17bn-US$20bn. DBRS points out that although the cost of the principal write-downs are not supposed to be borne by RMBS investors, many in the industry believe this will not be the case.

The agency cites three reasons why. First, loans that have principal forgiven and then ultimately wind up in foreclosure will likely result in higher loss severities, particularly on the subordinate tranches.

Higher delinquency rates may also occur because some borrowers will intentionally stop paying their mortgages in an effort to have a portion of their principal forgiven. Finally, servicers will reimburse themselves for advances when they 'modify' the loans to a current status as they forgive the principal, which will cause greater losses to security holders.

Given the magnitude of this proposed settlement and the fact that some states - such as California and New York - have dropped out of the settlement, it could take several more months of negotiating before a final settlement is put into place.

RMBS

Second-lien RMBS criteria reviewed

S&P has issued an advance notice of proposed criteria change regarding its methodologies and assumptions for analysing US RMBS backed predominantly by second-lien mortgage loans. Transactions for review include those in which most loans in the mortgage pool are second-liens and classified as home equity line of credit (HELOC), closed-end second-lien, second-lien high-combined-loan-to-value (HCLTV) or home improvement.

The agency says it is reviewing its methodologies and assumptions for the sector in light of the ongoing seasoning and increased longevity that some of these transactions are experiencing. Although overall delinquencies for mortgage pools consisting predominantly of second-lien loans have declined over the last year, S&P believes these transactions could be susceptible to future losses.

As such, it intends that the updated methodology and assumptions will address the magnitude and timing of potential losses under different economic stress scenarios. The agency expects to publish the updated methodology and assumptions in the next few months. At that time, it plans to review the applicable RMBS transactions to determine the impact of the update.

RMBS

US resi outlook assumptions updated

S&P has updated its outlook assumptions for the US residential mortgage market, which will apply to new US RMBS backed by prime, Alt-A and subprime mortgage collateral. The assumptions support the agency's view of base-case loss projections for an archetypal mortgage loan pool, as defined in its US RMBS criteria.

Specifically, S&P's outlook assumptions reflect its view of expected losses for archetypal mortgage loans, its growth expectations for the US economy and its view that home prices will decline by an additional 5%-7.5% over the next 18 months due to a significant backlog of distressed loans. The agency also maintains a 30% market value decline assumption underlying its 0.5% single-B credit-enhancement level.

In addition to considering the economy and mortgage markets, S&P's outlook assumptions consider certain trends in the mortgage market, including declining delinquencies among agency loans and RMBS.

RMBS

Chapel deals downgraded

S&P has lowered and removed from credit watch negative its credit ratings on all classes of notes in Chapel 2003-I. At the same time, it lowered and removed from credit watch negative ratings on the class A2, B, C, D, E and F notes, and affirmed and removed from credit watch negative the rating on the class A1 notes in Chapel 2007. The downgrades reflect what the agency considers to be the transactions' deteriorating credit performance and its analysis of set-off risk as a result of duty of care claims (SCI passim).

Chapel 2003-I's reserve fund is believed to stand at zero, resulting in a cumulative uncleared principal deficiency ledger of €4.5m. Chapel 2007 continues to draw on its reserve fund, which currently stands at €6.88m - 33% of its target level.

Longer-term arrears continue to accrue in both transactions, according to S&P. The agency says it has taken these factors into consideration in its downgrade decisions and has removed the ratings from credit watch negative as a result of its analysis, which includes an expectation of a reduction in the balance of the asset pool through set-off risk arising from duty of care claims relating to over-extension of credit and the mis-selling of insurance by the insolvent originator.

Consumers who are affected are expected to exercise the rights of set-off, as provided under the framework agreement reached with DSB, during 2012. S&P assumes set-off risk amounts of 21.2% of the current pool balance in Chapel 2003-I and 16.67% in Chapel 2007.

Noteholders are understood to have voted in favour of Quion Services assuming the role of servicer to the transactions by May 2012. Under the sub-delegation agreement, Quion will service DSB Bank's portfolios for an initial period of five years.

RMBS

Servicer compensation proposals slammed

SIFMA has filed a comment letter on the FHFA's Alternative Mortgage Servicing Compensation Discussion Paper (SCI 28 September). The association says that although it respects the FHFA's interest in aligning servicers' financial interests and incentives with those of other pertinent parties, particularly those of investors, it has not seen any effort by FHFA to prove that case.

"The servicing industry compensation model, a subject critical to the soundness of housing and the more general economy, should not be subjected to radical change without strong research and proof," the association notes. "That has not been shown. Accordingly, SIFMA very strongly believes that changes to the structure of mortgage servicing compensation should not increase the cost of credit for mortgage borrowers and is concerned that each of the fee-for-service and reserve fund approaches proposed by the FHFA proposals would do that."

SIFMA believes the FHFA should not implement either of the proposals it outlines in its discussion paper at this time. Instead, the association encourages the FHFA to work more closely with the securitisation industry to determine if there is a need to make changes in markets for Fannie Mae and Freddie Mac MBS and, if so, what the most effective changes would look like.

In particular, the association stresses that the proposed fee-for-service approach would make mortgages more expensive for nearly everyone in the country. Under this approach, servicers would receive a set dollar fee per loan for performing loan servicing and separate compensation for distressed loans. This approach would severely impair liquidity in the TBA markets for Fannie Mae and Freddie Mac MBS and therefore would increase borrowing costs for consumers, SIFMA says.

As an alternative, the FHFA proposes a regime whereby servicers continue to be compensated with a strip of income based on the balance of the loans in a pool and a reserve account would be created, intended to cover costs for servicing non-performing loans. This proposal would represent a less dramatic change from the current regime, but SIFMA believes this approach would still reduce TBA market liquidity and increase costs for mortgage borrowers.

RMBS

FSA proposals credit negative for NC RMBS

Moody's says that the UK FSA's revised proposals for tighter rules on mortgage lending will be credit neutral for UK prime RMBS but credit negative for UK non-conforming RMBS. The proposed measures are less prescriptive than the previous consultation in July 2010, but are still designed to ensure that any borrower taking out a new mortgage can meet the associated repayments.

Moody's believes that the revised rules will be credit neutral for UK prime RMBS as the affordability criteria laid out in the revised rules will likely be looser than the original proposals and the revised proposals contain a new planned measure to mitigate the impact of the rule change on existing borrowers. However, new mortgages that are added to substituting deals will still benefit from the increased checks on income verification that were a significant driver for defaults.

But the revised rules will be credit negative for UK non-conforming RMBS as it will be difficult for weaker borrowers to take advantage of proposed waivers on affordability checks. As such, borrowers will continue to have extremely limited refinancing options in the medium term.

According to the FSA, a clear link existed between overstretched finances and mortgage arrears and repossessions. Even with interest rates at historic lows, the FSA found that 46% of all households either had no money left, or had a shortfall, after deducting mortgage payments and living costs from their income.

The revised proposals are subject to a consultation period that runs to the end of March 2012. Following this, the rules will be finalised in the summer of 2012, although implementation will not be before 2013.

RMBS

Updated LMI criteria hits

Fitch has downgraded the ratings of 46 tranches of 43 Australian RMBS transactions, following the implementation of its updated Australian RMBS and Lenders Mortgage Insurance (LMI) criteria. The agency has now completed its review of all Australian RMBS transactions, with the ratings of 308 tranches in 117 deals not being impacted.

The affected tranches are made up of 41 equity notes that had no credit enhancement other than LMI and excess spread, plus five mezzanine notes that had insufficient enhancement to sustain their rating under the new criteria. Twelve notes remain on RWN pending the outcome of restructuring and/or imminent issuer call option dates. The RWN on these notes will be resolved by 10 February 2012.

"Rated notes with no subordination other than LMI and excess spread are exposed to the tail risk associated with a small transaction size beyond the clean-up call. These risks include a less diversified collateral pool, a higher weighted average liability margin and lower excess spread, impacting the transaction's ability to cover a large LMI unpaid claim or denial," comments Ben Newey, director in Fitch's Sydney-based structured finance team.

Tranches with no hard subordination were downgraded to triple-B, double-B' or single-B'. Subordinate tranches from transactions that continue to perform well, with large remaining size at call, adequate excess spread to cover possible LMI non-payment, a sponsor with an investment-grade credit rating and a strong history of calling transactions were downgraded to triple-B.

Subordinated tranches from transactions that are performing well, have a sponsor with a history of calling transactions, but do not have significant excess spread were downgraded to double-B'. Tranches from transactions where the sponsor does not have a history of calling transactions were downgraded to single-B.

Five of the affected issuers have elected to modify transactions within the criteria review period before 10 February 2012. Should the modifications not be completed before that date, the affected notes will be downgraded.