Contents

Risk Management

Swings and roundabouts

DVA best practises still evolving

Debt value adjustment (DVA) became a hot topic when banks announced their 3Q11 earnings, due to the magnitude and direction of the amounts reported. Best practises for pricing and hedging DVA have yet to be established, with swings in this component of bank earnings expected to continue for the foreseeable future.

Under accounting rules, DVA represents the amount added back to the mark-to-market value of a derivative exposure to account for the expected gain from a financial institution's own default. The measure has gained notoriety because it allows institutions to record gains when their credit quality deteriorates, with most banks reporting large DVA gains in Q3 due to significantly wider credit spreads.

Although banks began reporting DVA in 2007, it was really only in Q3 that the market started paying attention to it, confirms Quantifi director of research Dmitry Pugachevsky. "Compared with the previous quarter, bank credit spreads widened significantly in September on Greek rumours and European contagion. In particular, the CDS market questioned the exposure of Morgan Stanley to Italy, with its five-year spread moving from 162 in June to 492 in September. The bank's DVA number also moved because of this swing and it reported a US$3.4bn gain."

Only one bank reported a small change in DVA for the period - Goldman Sachs. This was attributed to the bank's hedging activity.

However, Pugachevsky notes that calculating and hedging DVA isn't straightforward. While there are well-established ways of hedging CVA - by buying protection on the counterparty in question - to achieve the same result for DVA, a bank would have to sell protection on itself, which is impossible.

"Alternatively, a bank could buy back some of its bonds, but they would obviously need to have issued some and this then impacts the ratio of debt and equity on their balance sheet. Consequently, most banks sell protection on a basket of proxy institutions to hedge DVA," Pugachevsky explains.

He adds: "Because of the difficulty hedging DVA, banks argue that they shouldn't have to report it. They always emphasise that it's an accounting measure and analysts tend to not to pay much attention to it."

Meanwhile, banks use credit spreads derived from their bonds - or a combination of bonds and CDS - to calculate DVA because the estimates are generally much closer than using only CDS. But using bond spreads instead of CDS seems to compromise a key benefit of including DVA in the valuation of derivative positions, according to Pugachevsky.

"Including DVA along with CVA results in both parties reporting the same value for the position. Using bond spreads compromises that because each party typically uses the other party's CDS spread to price CVA," he observes.

Recent dramatic widening in the bond-CDS basis compounded this issue during Q4, driving increased interest in pricing liquidity risk via a liquidity valuation adjustment - essentially, the difference between DVA calculated with CDS spreads and DVA calculated with bond spreads.

Pugachevsky suggests that best practises for pricing and hedging DVA will develop quarter by quarter, based on reverse engineering bank calculations of the measure. In the meantime, swings in this component of bank earnings are expected to continue, with significant DVA losses likely once the financial markets stabilise.

"Although Q4 DVA results were relatively small, there could be substantial losses in the future, given the relatively high spreads," Pugachevsky concludes. "For example, if the increases in spreads that occurred during 3Q11 were reversed, large DVA gains would turn into roughly equivalent losses. In a tougher regulatory environment it is reasonable to expect bank earnings to remain constrained and it is possible that future DVA losses could entirely offset earnings, even as credit quality improves."

CS

CLOs

Euro CLO market ignites

There has been a rally in European CLOs over the last couple of weeks. Activity has picked up dramatically after the slow start to the year and one trader believes this could be just the beginning.

"CLO-land has seen quite a bit of activity over the last couple of weeks. In the US there has been activity on BWICs for a while, but Europe is now catching up with that. There is more stuff being shown in Europe and the banks are playing again," the trader says.

He continues: "As well as seeing more paper on European BWICs, demand is still strong on triple-As, double-As and single-As. The single-A space seems to be the sweet spot at the moment and everything there has gone to 800DM handles."

Interest is also beginning to pick up in triple-Bs as buyers look further down the capital structure, although the trader notes that there are still no bids for double-Bs and he has not done any equity trades for a while.

"There has definitely been a rally. I think now there may be some people who are going to want to take advantage of that rally and sell. We are maybe starting to see a few more offers," the trader says.

He adds: "I have a feeling that there is also some kind of bid for the equity. There is some really good equity out there that is not being shown around. There are people who hold good equity paper, but they want to keep it or would want a really high price for it."

What really excites the trader is the fact that the banks seem to be looking to become more involved in the market. After stepping back a little in 2011, he thinks they may now be ready to step up their activity.

He notes: "Barclays has had some activity lately for sure. RBS has also been more active and I think some of the other banks are getting busier again as well. It makes you wonder whether the year has now really begun and maybe banks are going to use their books again to start buying paper."

JL

Structured Finance

SCI Start the Week - 13 February

A look at the major activity in structured finance over the past seven days

Pipeline
Many deals entered the pipeline last week only to price by the end of it. Only two transactions remained on Friday: a £1.01bn whole business securitisation sponsored by Center Parcs (CPUK Finance) and a US$75m ILS from Munich Re (Queen Street V Re).

Pricings
The week saw eleven deals pricing, including two auto floorplan ABS (US$1.6bn Ford Credit Master Owner Trust A 2012-1 and US$747.7m Ford Credit Master Owner Trust A 2012-2) and three auto loan ABS (US$970m CarMax Auto Owner Trust 2012-1, €750m Red & Black Auto Germany 1 and €460m FCT TitriSocram 2012-1). In addition, RBC issued a combined US$950m of credit card ABS (US$500m Golden Credit Card Trust Series 2012-1 and US$450m Golden Credit Card Trust Series 2012-2). One RMBS (€450m Caja Ingenieros Ayt 2) and two CMBS (US$1.02bn Freddie Mac SPC series K-706 and £210m DECO 2012-MHILL) also printed.

Markets
The ABS secondary market remained firm last week, with buyers again outnumbering sellers, according to consumer ABS analysts at Barclays Capital. "Despite some small profit taking in the esoteric space, the general tone of the market remained strong, with secondary positions trading 5bp through new issue levels," they say. "Investors have shown an increasing appetite for short-term paper with some spread as the search for yield continues. Also, interest in FFELP ABS has started to pick up with more investors poking around the sector."
Most CMBS sectors continued their year-to-date rally, according to Citi securitised products analysts. Generic 2007 dupers are now at 205bp (65bp inside of their year-end level), GG10 dupers are at 247bp (28bp tight to year-end), while 2007 AMs are at 510bp (190bp tighter). CMBS 2.0 triple-As are at 130bp (25bp inside of the year-end level), while 10/9.5 DUS and 2.0 super-seniors are at 60bp and 105bp respectively (each 15bp inside of their year-end levels).
"The only major CMBS sector that has not tightened since year-end is CMBS 2.0 triple-Bs, which is now at 685bp, 10bp wider than at year-end," the Citi analysts add.
In RMBS, residential credit analysts at Barclays Capital note: "Technical fears have taken a back seat, at least for now, as sentiment in the broader markets is much improved - especially with respect to Europe. However, the weaker credit sectors (especially subprime LCFs and option ARMs) remain subject to near-term volatility related to sentiment shifts and details of the AG settlement, HAMP expansion and other events."
On the week, non-agency prices rose slightly, with prices up by a quarter point in jumbo hybrids, alt-A and negam. Jumbo fixed prices remained flat.
ABX prices were also marginally higher, with prices up by less than a quarter point. PrimeX outperformed, rising three-quarters to one point week on week.
At the same time, supply surged last week in the CLO secondary market, with BWIC volumes in excess of US$1bn for Thursday and Friday alone, according to CLO research analysts at Bank of America Merrill Lynch. "In particular, the issue of scarcity of supply in CLO equity experienced major resolution to the upside, with around US$250m for the bid in visible volumes. To put things in perspective, this weekly run rate is consistent with the turnover of half of all equity outstanding over one year," they explain.
Triple- and double-A spreads came in by 10bp on the week, while lower down the stack they tightened by around 25p.

Deal news
• The New York Fed sold another slug of assets, with a current face value of US$6.2bn, from its Maiden Lane II portfolio through a competitive process to Goldman Sachs. Proceeds from this sale and last month's (SCI 20 January) will enable the repayment of the entire remaining outstanding balance of the senior loan to ML II on the next payment date in early March.
• CIFC Corp has sold the equity and class D mezzanine tranches issued by DFR Middle Market CLO, together with the rights to manage the CLO, for an aggregate sale price of US$36.5m. This sale represents the completion of the firm's intention to reposition its core business as a fee-based asset manager and free up capital to support further growth.
• In a rare positive turn for the CMBS, Fitch has upgraded REC Plantation Place's class B to E notes. The agency attributes the move to the asset's improving market value since March 2011, which ultimately increases the refinancing prospects of the £421.83m Plantation Place loan at maturity in July 2013.
• Fitch says it continues to monitor Empresas Hipotecario TDA CAM 3, a Spanish SME CLO whose reserve fund experienced a €11.5m drop to €1.3m in October. The deal illustrates that the misalignment of the provisioning mechanism and the default definition may lead to abrupt reductions in the reserve fund balance without a corresponding increase in the defaulted notional, the agency says.

Regulatory update
• European Parliament and Council representatives last week agreed on the text of the European Market Infrastructure Regulation (EMIR), which will regulate trade in OTC derivatives. The rules require OTC derivatives to be cleared through CCPs, with all derivative contracts to be reported to trade repositories.
• Fitch says that although some of the changes to the US residential mortgage market recently proposed by President Obama could be positive, it also believes that some will be neutral and some potentially negative. Most could face fierce political opposition, the agency says.
• New Irish personal insolvency legislation proposed in January and expected to come into force in 2013 will see the introduction of debt forgiveness for borrowers deemed to have unsustainable mortgage debt. Moody's views the proposal as credit negative for Irish RMBS because many mortgage loans will be written down and many borrowers will become discouraged from maintaining their mortgage loan repayments.

Deals added to the SCI database last week:
ALM V
AmeriCredit Auto Receivables Trust 2012-1
Arkle Master Issuer series 2012-1
BAA Funding
Discover Card Execution Note Trust 2012-1
Embarcadero Re Series 2012-I
Kibou Series 2012-I
LCM X
Lowland Mortgage Backed Securities No. 1
Mercurio Mortgage Finance series 2012-7
PFS Financing Corp series 2012-A
SLM Student Loan Trust 2012-A

Top stories to come in SCI:
Emergence of index CCDS
Special servicer fees
Euro ABS portfolio management trends
Difficulties in hedging DVA
RangeMark Analytics profile

CLOs

Record week for CLO BWICs

Last week was one of the busiest the US secondary CLO market has seen since 2Q11. Bid list volume was US$1.3bn, the largest weekly amount in a year.

Trading off the lists was strong and 99% of paper was traded, with the Street taking down about half of the volume. All tranches were represented on the lists, but the highest counts went to triple-A and equity paper.

"CLO equity continues to trade at very aggressive levels, with strong demand coming from investors looking for the cashflow profile produced by CLO equity. Going forward, it will be interesting to see if the CLO rally continues or if supply catches up with demand," Babson Capital states in a recent client note.

Bank of America Merrill Lynch analysts have changed to a more neutral stance on CLOs as a result of last week's activity, advocating staying long on equity but without chasing too aggressively while prices remain as they are. They advise handling CLO equity with care: "We continue to like the remarkable front cash properties and attractive defensive features of the product, but eventually all-in yields do matter."

The analysts suggest that investors who are not too concerned about mark-to-market volatility or current cash profile could rotate into junior debt at a minimal yield differential. Bullish investors could abandon long-dated high payers and move up the yield spectrum.

"We are not that worried about the cashflow profile of legacy CLO equity and remain firm believers in the merit of leveraging quality carry in light of the Fed's low rate promise. But at current prices, the top names reflect very positive expectations in terms of rates, forward defaults - both assumed and realised - and supply/demand technicals," say the analysts.

In particular, they like the look of 'best of breed' European equity pieces with good credit quality, no PIK history in the first round of OC weakness in 2008 and 2009 and above average income trends at 1.5x-2x cashflows.

JL

CMBS

CRE auction activity continues

Large 'geo-series' CRE sales posted on auction.com helped drive US CMBS conduit liquidation volumes in 2011. The signs are that in the first part of this year at least they will continue to have a major impact on the sector.

Auction.com has already listed property-level details for three large note/REO auctions for 1Q12. Scheduled for February and March, they account for close to US$1.2bn in CMBS assets, according to US CMBS research analysts at Barclays Capital.

The first auction, scheduled for 6-9 February, lists 82 notes and REO properties spread across multiple states and property types. The Barcap analysts identified 45 of these as securitised in CMBS trusts, making up nearly US$200m in outstanding balance, with most properties reported in deep delinquency or REO. Some of the largest CMBS loans with exposure to the auction include the US$90m Ariel Preferred Retail Portfolio in GSMS 2006-GG8 and the US$11m 5000 West Roosevelt loan in HFCMC 2000-PH1.

The second auction takes place on 21-23 February and consists of 58 properties in Arizona, Colorado and Nevada. Of these, the analysts identified 32 with CMBS exposure, totalling US$260m. The largest exposures are the US$19m Rustic Hills Shopping Center in GCCFC 2005-GG5 and the US$18.5m Meridian Bank Tower in WBCMT 2005-C21.

The final auction is the largest of the three and is scheduled for 5-8 March. In this multifamily-only auction, the analysts estimate US$720m in CMBS exposure, led by the US$63m Empirian Chesapeake in COMM 2006-C8 and the US$45.6m LeCraw Portfolio in LBUBS 2006-C6.

As has been the case with previous auctions, assets out for bid are tilted towards worse performing geographies, with Nevada, Tennessee, Georgia, Arizona and Texas making up half of the CMBS loans in the auctions. Unlike previous auctions, however, a majority of CMBS properties listed are in REO, while the rest are essentially note-sales on non-performing loans. LNR remains the dominant special servicer, accounting for 80% of the collateral.

The analysts say the majority of liquidations as a result of these auctions should occur in the 2005-2007 vintage deals, with the 2006 vintage alone having US$600m of exposure. They estimate that GECMC 2006-C1, COMM 2006-C8 and BACM 2006-4 will be most affected deals, as each of these deals has more than US$60m of loans participating in the auction.

Looking ahead, auction.com lists six other CRE auctions scheduled through March and April, comprising an estimated US$2bn of assets.

MP

CMBS

First Freddie transfer

The Retreat at Stonebridge Ranch loan securitised in the Freddie Mac SPC Series K-704 CMBS was transferred to special servicing yesterday. It is believed to be the first time this has happened to a large loan securitised in the Freddie Mac K series.

According to an update from Fitch, the US$29.41m multifamily loan transferred to the special servicer following the appointment of a receiver by the SEC. The loan remains current on debt service and the property continues to operate. The property was 92.5% occupied as of June 2011 and had a debt service coverage ratio of 1.25 times at issuance.

Fitch explains: "The assets of the loan sponsor, Wendell A. Jacobson, were frozen by the SEC on 15 December 2011 (Case No. 2:11-cv-01165 BSJ). Mr Jacobson and his affiliates are under investigation for fraud and a Ponzi scheme."

Deutsche Bank CRE debt analysts comment: "As far as we know, this is the first sizeable loan from a K deal to transfer. The reason for the transfer is to monitor the performance of the property while it is in receivership. At this time, we do not expect any losses and the loan should be returned after the investigation concludes and/or the property is sold."

MP

CMBS

Loss severities examined

The elevated levels of liquidation volumes in the US conduit CMBS universe seen last year have continued into 2012 and, at the same time, loan loss severities have been rising steadily since the middle of last year. A new report from US CMBS research analysts at Barclays Capital examines the pattern and factors behind the increase.

The Barcap analysts note that average three-month severities have increased to 47% recently versus an average of 35% in 1Q11. However, they add that the increase would have been even sharper if not for the recent increase in the share of maturity defaults, which tend to pay off with much lower losses. Severities on non-maturity related liquidations are up by 14 points since March 2011 and are currently running at 55%.

Much of this increase (eight of the 14 point rise in severities) can be attributed to the changing composition of liquidations. "A much bigger share is now coming from properties with higher current LTVs and in worse geographies. We estimate that the share of the 25 best performing metro areas in liquidations decreased from 38% in 1Q11 to about 9% most recently," the analysts explain.

Multifamily properties have outperformed other property types, but their contribution to liquidations has declined over the same period. Equally, longer liquidation timelines - resulting in greater ASER and advance reimbursements - also contributed a few points in the severity increase. In addition, losses have been pushed higher by rising servicer expenses on liquidated loans and note-sale related discounts.

"We expect servicers to continue to push liquidations for distressed properties while looking to resolve 'less bad' loans through modifications. As such, term-default severities should remain elevated in the coming months," the Barcap analysts say.

That said, they add: "Headline severities might be tame because of the wave of maturing loans coming due. It is not uncommon for these loans to pay off past their balloon dates and experience a 1%-2% severity due to servicer-related fees and expenses."

MP

RMBS

Servicer advance rates scrutinised

Loss severity varies across US mortgage servicers by about 14 points: servicers with lower advance rates tend to have lower severity prints, while those with longer timelines have higher prints. ABS analysts at Bank of America Merrill Lynch expect loss severity to increase over the next 18 months by roughly 8-10 points, due to a drop in home prices and increased timelines before servicers begin to increase liquidation rates.

The BAML analysts note that determining advancing rates accurately is critical in valuing deals with heavy delinquencies. Lower advance rates reduce cashflow to the trust in the front months and bring down severities in the back months, as less recovery cashflow is allocated to reimbursing servicers.

"There have been several subprime deals where the senior tranches have incurred interest shortfalls or no cash payments to the trust at all in a given month, due to servicing advance recoveries," they explain. "While most of the interest shortfalls are typically made up in subsequent periods, the cashflow discrepancies can occur for several months in a row. They highlight the potential differences between actual and projected cashflows."

Servicing transfers are another variable in understanding servicing behaviour. Several servicing platforms have been sold to smaller servicers recently - notably Ocwen, which recently purchased servicing rights from JPMorgan and bought platforms from Morgan Stanley (Saxon) and Goldman Sachs (Litton).

Upon purchasing servicing rights, Ocwen typically recovers advances from the past servicer aggressively and also implements loan modifications to recover additional funds. Consequently, investors in deals with benign advance rates today should take into account the potential for changing advance rates due to servicing transfers, the analysts warn.

They point out that the average advance rate on the Saxon book dropped from 74% in April 2010 to 36% six months later, following its purchase by Ocwen. Similarly, the average advance rates on the HomEq and Litton books respectively dropped from 81% in September 2010 to 41% six months later and by 57% to 33% from March to September 2011. This compares with an average subprime servicer advance rate of 59.5%.

CS

RMBS

Modest RMBS impact from AG settlement

The US federal government and 49 state attorneys general (all states except Oklahoma) have reached a US$25bn agreement with the nation's five largest mortgage servicers to address mortgage loan servicing and foreclosure abuses (SCI passim). The move is expected to have a limited impact on non-agency RMBS modifications, with foreclosure rolls likely remaining slow for the rest of the year.

Barclays Capital securitisation analysts calculate that the settlement will cost Ally Financial US$310m, Bank of America US$11.8bn, Citi US$2.2bn, JPMorgan US$5.3bn and Wells Fargo US$5.4bn. The US$25bn total could also increase if further banks sign on to the settlement deal, possibly taking the figure as high as US$45bn.

As well as forcing banks to provide financial relief for borrowers by reducing the principal balance on many loans, refinancing loans for underwater borrowers and paying billions to states and consumers, the agreement imposes changes on how servicers can operate in the future.

The joint federal-state agreement requires servicers to implement comprehensive new mortgage loan servicing standards and to commit to resolve violations of state and federal law. Those violations include robosigning, deceptive practices in the offering of loan modifications, failures to offer non-foreclosure alternatives before foreclosing on borrowers with federally insured mortgages and filing improper documentation in federal bankruptcy court.

At least US$10bn will go towards reducing the principal on loans for borrowers that are either delinquent or at risk of imminent default and who owe more than their homes are worth at the time of the settlement. At least US$3bn will go towards refinancing loans where borrowers are current on their payments but still underwater. Up to US$7bn will go towards other forms of relief, such as principal forbearance for unemployed borrowers.

Mortgage servicers are required to fulfil these obligations within three years. There are incentives for relief provided within the first 12 months.

Servicers must reach 75% of their targets within the first two years. Servicers that miss settlement targets and deadlines will be required to pay substantial additional cash amounts.

The servicers also have to pay US$5bn in cash to the federal and state governments, with US$1.5bn being used to establish a borrower payment fund to provide cash payments to borrowers whose homes were sold or taken in foreclosure between 1 January 2008 and 31 December 2011, if they meet certain criteria.

The BarCap analysts point out that Fannie Mae and Freddie Mac pools are excluded from the settlement, but loans in private-label pools will be affected. "We believe that the banks will be required to target the US$17bn in forgiveness and other relief and will receive a 125% credit for every dollar of forgiveness that they apply to portfolio loans, but only a 50% credit for every dollar of forgiveness applied on loans that they service but do not own."

They continue: "From a purely economic perspective, it would seem that banks would try to modify as many non-portfolio loans as possible through this programme since while they only get a 50% credit, they also escape the actual monetary costs of forgiveness."

However, this may not be possible for a few reasons, not least that bank servicers will have to follow certain NPV rules to make a judgement on whether to apply a principal forgiveness modification. As the five servicers are part of HAMP, they have probably already been applying NPV tests to delinquent loans, the analysts suggest.

Investors are better organised than they were a few years ago when Countrywide settlement costs were passed on to them and are now more likely to prevent large-scale modifications if they do not deem them in their interests. Also, the principal forgiveness modifications and other relief will only have a limited effect on banks' financials if they are applied to delinquent loans, because banks have likely already taken markdowns there.

"Overall we expect that this settlement will have a relatively modest effect on non-agencies in terms of the pace and composition of modifications. We think that this, along with the previously announced enhanced HAMP incentives, will increase principal forgiveness modifications somewhat and potentially also lead to a small increase in overall mod rates but is unlikely to trigger widespread mods," the analysts note.

The impact on liquidation timelines is expected to be quite pronounced, with 90-plus day delinquency-to-foreclosure and foreclosure-to-REO roll rates slowing down as servicers take time to adjust to the new servicing standards. In the longer run, however, the analysts expect that those rates will rise to higher levels than have been seen over the past two years.

Finally, they note that several questions regarding the settlement are still unanswered, which could impact non-agency valuations. "We do not yet know what proportion of the US$17bn from the settlement will be applied toward debt reductions on non-agency loans versus debt reductions on loans held by the banks themselves."

The analysts continue: "We are also uncertain whether future principal reduction alternative modifications under HAMP will be credited towards the US$17bn and, therefore, whether non-agency investors will receive some form of reimbursement for these losses. If the HAMP PRA modifications are not applied toward the US$17bn, then the scale of principal forgiveness modifications applied to non-agency loans could be much higher."

JL

RMBS

Non-agency RMBS still rallying

The rally in US non-agency RMBS continued last week, but may now be getting ahead of itself. Subprime prices were up by half a point or a point on the week, while average generic spreads on non-investment grade bonds were between 25bp and 50bp.

RMBS analysts at Bank of America Merrill Lynch put last week's BWIC volumes at US$1.3bn in subprime and US$2.1bn in non-agency RMBS. The market was also boosted by the US$6.2bn in current face value that traded via Goldman Sachs' Maiden Lane II transaction (SCI 9 February).

Dealers are returning to the market and playing a more active role, which is seen as a significant development, considering how strongly they pulled back in 2011. The BAML analysts note that TRACE data on the recent MLII portfolio trade underlines the degree to which dealers are returning; unlike the previous Maiden Lane portfolio sale, it seems the majority of the most recent supply was not then sold on to clients.

"Whereas trading reported 19 January, when the first portion of MLII traded, showed a difference between 'customer buys' and 'customer sells' of only US$1.9bn on US$7bn of face trading, the reports from Wednesday and Thursday showed a difference of US$3.9bn. This indicates much lower turnover on the second portion taken down by Goldman," the analysts note.

The TRACE data suggests that Goldman Sachs retained a large portion of the assets. Non-investment grade trade volume on 8 February showed US$6.9bn in customer sells versus US$0.9bn in customer buys, with another US$2.1bn of customer buys coming through the next day - indicating that the bank still holds at least half of the bonds purchase from the Fed. The analysts note that this is in contrast to the first portion of bonds awarded to Credit Suisse on 19 January, when TRACE data showed US$4.8bn in customer buys versus US$6.7bn in customer sales.

There remains a further US$6bn of non-agency RMBS in the ML II portfolio and no timetable has been given for their sale. Given the success of recent sales, however, other legacy holders could well be tempted to try to sell into the market.

The weighted average price for non-investment grade securities traded on 8 February was 57.8. Using that figure as the approximate price paid for the MLII bonds, it represents an 18% premium to the fair value of 49 reported at end-2011 and a 35% premium to the fair value of 42.7 reported on 19 January.

"Even with the rally in non-agency bonds in 2012, this confirms that the second portion of bonds was higher in quality than the first and likely the remainder of the MLII pool. It also suggests to us that the market rally has gotten somewhat ahead of itself at the moment and gives us some pause on near-term appreciation potential for non-agencies," the analysts conclude.

JL

ABS

Cat bonds on the up

Thierry Berthold, co-head of insurance and European structured credit solutions at Natixis in Paris, looks at what the next 12 months will have in store for the cat bond market

There is good reason to be optimistic for the catastrophe bond market in 2012, particularly in Europe. Asset managers are showing an increasing willingness to accept cat bonds as a viable asset class and the increase in new capital via dedicated ILS funds is likely to continue, as experienced in 2011.

This should maintain the virtuous circle, with more capital leading to more competitive pricing and therefore a higher level of issuance. Indeed, the European cat bond market is currently anticipating the arrival of new sponsors, taking advantage of competitive pricing levels and the increasing capacity for such risks.

This is not to suggest it will be plain sailing - cat bonds are a difficult asset class, carrying a particular risk-reward profile that requires time and experience to understand. But recent evidence suggests asset managers are showing a deepening appetite for this asset class.

Total issuance in 2011, following a number of new deals issued towards the end of the year, was US$4.3bn. The results of rigorous back-tests prove that cat bonds do offer truly uncorrelated risks - witness how well they have performed during the tumultuous past three years. This performance has not gone unnoticed among funds and investors looking for new exposures offering genuine diversification benefits.

ILS specialist funds are now succeeding in attracting new investors, such as pension funds and other institutional investors. Some multi-strategy hedge funds are coming back as well. One of the key questions for 2012 will be around the domination by a handful of ILS funds in terms of deal volume and the impact this will have on the market.

Meanwhile, we can also expect the issuance of more European-sponsored deals, which have traditionally represented a small proportion of the total market when including US deals. Indeed, specialist insurance-linked securities funds will be keen to seize the chance to increase their non-US catastrophe risk exposure.

PERILS, the catastrophe loss information provider, should continue to play an important role in stimulating the European cat bond market. The simpler risk transfer transactions that PERILS enables - considerably reducing documentation and transaction costs - and the good compromise it offers in terms of basis risk/acceptability by investors appeals to existing and new sponsors alike, particularly via private transactions. Second tier insurance companies and bonds hedging against new risk types should emerge - including flood risk in the UK - following new loss data sets introduced by PERILS.

Of course, all this must be considered in the context of the traditional reinsurance market. The virtuous circle scenario mentioned above clearly helps improve the competitiveness of current cat bond spreads and is attractive for sponsors.

Structured Finance

Sovereign concerns

Sovereign default and re-denomination risk remain

European structured finance trading and issuance trends have been impacted by wider concerns stemming from the European sovereign debt crisis - particularly towards the end of 2011, when spreads moved steadily wider and issuers shied away from the primary market. While the market appears to have started 2012 with renewed confidence, several unfavourable scenarios remain possible, such as a sovereign default and currency redenomination within the eurozone.

In the following article - written for SCI's upcoming Pricing & Valuation Guide 2012 - Interactive Data's director of EMEA valuations, Anthony Belcher, examines the impact of the sovereign crisis on the pricing and valuation of structured finance bonds, the practicalities of pricing securities in the event of a sovereign default or currency re-denomination and the benefits of an evaluated pricing approach in times of economic uncertainty. The full chapter can be downloaded here.

According to Belcher, an actual split of the eurozone and the re-denomination of collateral and contracts would be an event of much larger magnitude than a sovereign default. "While current market opinion does not gauge re-denomination as a significant probability, the market believes there is a far greater chance of it happening now than there was a year ago," he says. "In a re-denomination scenario, the challenge for our evaluated pricing systems would come in the form of understanding which securities and which agreements would move to different currencies."

For example, if debt is denominated in euros, would it remain in euros or move to a new currency? This, says Belcher, is where the main source of valuation uncertainty lies: determining if the impact of currency re-denomination on the pricing of specific securities will be correlated with what happens to the denomination of the outstanding debt.

"It is critical in times of economic crisis, such as in the aftermath of the Lehman bankruptcy, to keep lines of communication with clients open to help cope with stress in the marketplace," adds Belcher. "Significant lessons have been learnt from the aftermath of Lehman's default. One of the most significant issues is understanding the current situation by talking to market participants and feeding that data into relevant systems. Interactive Data has prepared for this by increasing the number of our sources and contacts within the market."

Pricing, evaluations and reference data are provided in the US through Interactive Data Pricing and Reference Data, Inc. and internationally through Interactive Data (Europe) Ltd. and Interactive Data (Australia) Pty Ltd.

Limitations
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Structured Finance

Fundamental resilience

Richard Cooperstein, president of RangeMark Analytics, answers SCI's questions

Q: How and when did RangeMark Analytics become involved in the structured finance markets?
A: RangeMark Analytics was formed when I joined RangeMark Financial Services along with my analytics platform - Fixed-Income Valuation Platform (SCI 18 January). The aim is to supplement RangeMark's existing advisory business by licensing the platform and our other applications to financial institutions, institutional investors and government agencies for valuation and risk assessment of mortgage loans, RMBS and CMBS.

I've been building option-based mortgage simulation models for over 20 years, beginning in the White House during the first thrift crisis when we were trying to value the government's exposure to financial guarantees. I've rebuilt the platform four or five times at different organisations during this time.

The theory behind the platform hasn't changed over those 20 years: it is based on finance and consumer economics theory. What has changed since then is computer power, which permits granular analysis at loan level with multiple scenario simulations.

Q: What are your key areas of focus today?
A: We focus on clients with credit-sensitive mortgage-related assets, who lack the requisite analytics to manage and understand their risks as well as they would like to. In the aftermath of the financial crisis, much of the industry's analytics capability was dismantled, yet the risky assets remain. Our clients range from those with orphan portfolios but inactive businesses, to asset managers, domestic financial institutions and even European financial institutions that own US RMBS.

Some clients are fairly small and cannot support a full valuation infrastructure that requires data, sophisticated architecture and models, and thus are ideal candidates for our turn-key solution. Larger clients may have sizeable assets under management and may have their own model but want a second opinion or may not be completely satisfied with their own solution.

Current activity is primarily directed towards distressed or legacy assets, but we will naturally transition to assessing the risk of newly originated mortgages when the non-government market restarts. At present, the government accounts for about 90% of new mortgages. This concentration of mortgage risk to the taxpayers is itself an important risk to consider.

The platform can be used to determine fundamental asset values, as well market-implied values in the portfolio application. Further, our simulation approach is designed to assess extreme risks and capital adequacy, which is especially useful in this time of high uncertainty. While recognising these risks, good returns relative to other asset classes remain.

Q: Which challenges/opportunities does the current environment bring to your business and how do you intend to manage them?
A: We saw an opportunity to launch our licensing business and expand our advisory for CMBS and RMBS because there is so much product at risk and in distress, yet quantitative capabilities have been broadly dismantled. Outside of the top firms with their own research departments, few have the infrastructure to continue managing these assets. Consequently, there is a persistent need for analytic solutions in the market.

Q: How do you differentiate yourself from your competitors?
A: We differentiate ourselves in two major ways. First, with a platform that fully integrates economic fundamentals and consumer behavioural models with a cashflow engine.

The point of this integration is to seamlessly generate value distributions for portfolios of assets quickly and beginning at the loan level. Many inputs are required to achieve this, but most other vendors only provide part of the solution.

The second way we differentiate ourselves is by using thorough scenario analysis. Most vendors build models based on historical data and apply them to a particular scenario or handful of scenarios. But the last decade has demonstrated that there are many potential scenarios to consider: we've had the best and worst of economies during this time, both of which were nearly impossible to predict before they happened.

As a result, thorough scenario analysis must be used to generate the appropriate range of potential future outcomes and deviation of returns. Proper asset valuation begins with expected returns, but requires measuring the variance of those returns.

Thus, we focus on getting the distributions right. To generate expected losses and extreme losses, we benchmark extensively to prices of traded credit assets - highly rated and liquid, as well as unrated and illiquid.

The current innovation in mortgage analytics is the ability to benchmark models against market prices. There was no such mechanism a decade ago - models could be back-tested, but that does not mean such models could adequately price risk.

While some vendors do test their models against traded prices, we make market benchmarking a core part of our fundamentals-based approach. Thus our clients can see how fundamentals drive performance, while simultaneously assessing model value against market. Simply matching historical curves and prepayment/default projections is not sufficient in today's environment.

Q: What major developments do you need/expect from the market in the future?
A: Looking ahead, three factors will presage a recovery of the mortgage market generally and the non-governmental segment in particular: employment growth; resolution of the large 'shadow inventory' of homes with distressed mortgages; and government mortgage agencies charging unsubsidised fees for the credit risk taxpayers bear, so that private executions are again economic.

US jobs peaked at 138 million in 2008 and bottomed at 129 million at end-2009. The country has gained three million jobs since then, so we're on an upward trend, but it will likely be several years until we reach a healthy level of unemployment. We may be about five million jobs below where we need to be.

We're clearly also several years away from resolving the glut of residential mortgage delinquencies. The issue is how fast this inventory can be absorbed.

There are two driving economic policy principles that we should strive for: insuring orderly markets and that financial incentives flow through the system. The US government took extreme measures to recover orderly markets in 2008 and - except for the failure of Lehman - has largely achieved this.

However, financial incentives have not been allowed to flow through the US mortgage market. Foreclosure of the unprecedented inventory of underwater and delinquent mortgages has been constrained for several years. There is a practical limit to the rate that distressed housing can be liquidated.

There is also great political reluctance to permit foreclosure of millions of households and to realise the attendant losses on balance sheets. Finally, home ownership is declining to levels seen in the 1980s before housing was viewed as a 'free lunch' investment that would always rise. Thus, billions in investor financing are needed but not currently available.

The government has not effectively facilitated the resolution of problem mortgages and thus has forestalled housing market recovery. There is no good and quick way out of this situation: on the one hand, delinquent loans have to be resolved at a rate that preserves orderly markets; on the other hand, the rule of law needs to be upheld and existing valid contracts honoured.

Ending the government's current dominance in mortgage origination and re-growing a private sector with appropriate oversight should be accomplished using the market mechanism. We cannot make private sector activity emerge; we need only permit it to do so by the government refraining from financing mortgages more cheaply than the private sector can.

Three years ago I thought the recovery would take three years; that was clearly very wrong. It will likely take three or four more years because of the number of jobs that need to be created and the size of outstanding distressed housing inventory.

Ultimately, the fundamental resilience of the US economy will drive us through. However, the market is still waiting for appropriate regulation and oversight.

CS

Structured Finance

Securitisation lawyer joins Mexico office

Haynes and Boone has recruited Jorge Labastida as a partner in its finance practice group in Mexico City. He joins from Bufete Labastida, where he was the founding partner of the banking and finance practice.

Labastida's practice focuses on structured cross-border finance, including securitisations of a wide variety of asset types, leasing, synthetic leasing and multi-jurisdictional tax-enhanced structures, real estate finance, project finance, debt restructurings and workouts, treasury products, derivatives, factoring and distressed asset transactions.

The firm says Labastida's appointment adds further depth to its project finance and structured securities practices and enhances the firm's ability to compete for infrastructure projects and structured financing in Mexico.

Structured Finance

Legal team moves on

Chapman and Cutler has recruited six partners for its newly-established office in Washington DC. Felicia Graham, Douglas Madsen, Michael Mitchell, Mark Riccardi, Craig Fishman and Rachel George all join from Orrick, Herrington & Sutcliffe.

All six attorneys have significant structured finance practices. Graham represents clients in ABCP transactions, asset-backed financings and structured products. She also has a longstanding practice as underwriters' counsel in tax-exempt housing transactions.

Madsen advises financial institution clients as issuers of ABS with a particular emphasis on unsecured consumer asset and credit card-backed revolving securitisation structures. Mitchell acts as counsel to issuers and underwriters on a variety of ABS issuance platforms and is recognised as an authority on SEC regulations and Dodd-Frank rule-making initiatives.

Riccardi represents financial institutions, investors and other market participants in capital markets and debt financing transactions, including structured products, secured lending, securitisation and related regulatory matters. Fishman represents financial institutions as purchasers, lenders and investors in ABS transactions and as lenders in asset-based lending transactions.

Finally, George represents financial institutions in a range of asset-based lending and ABS transactions and advises clients on SEC regulations and Dodd-Frank rule-making initiatives. The appointments follow those of James Croke and Peter Manbeck, who recently left Orrick for Chapman and Cutler's New York office (SCI 31 January).

Structured Finance

SF vet joins Analysis

John Richard has joined Analysis Group as an affiliate. Richard's investment expertise spans unsecured corporate credit and securitisations. He was a founder of the distressed CMBS Taurus Horizon Fund and previously served at State Street Global Advisors as a senior fixed income portfolio manager.

Structured Finance

Corporate trust business boosted

US Bank Global Corporate Trust Services has added Breige Tinnelly and Emma Hamley to its European corporate trust business in London. Tom Cubitt, svp, has been named as the team's leader.

Tinnelly, svp, will lead the corporate trust sales team and develop the sales and business strategy. She spent seven years with BNY Mellon before joining US Bank last year. Hamley, vp, will work alongside Tinnelly to provide further depth to the team. Her previous employers include Capita Trust Company, BNY Mellon and Bankers Trust.

Cubitt joined US Bank from Bank of America last year as manager of its new London office (SCI 28 October 2011). He is responsible for the securitisation and structured finance trust and agency business, which was bought from Bank of America in late 2010. He is also responsible for growing and diversifying the business and client base.

CDS

Structured credit head appointed

Avoca Capital Holdings has appointed Vaibhav Piplapure as head of structured and illiquid credit. He joins from Credit Suisse, where he was head of asset finance for Europe within the securitised products group.

Piplapure's new role will see him focus on managing allocations to structured credit from Avoca's €500m Credit Opportunities Fund. He is also expected to raise further funds specifically for his management in the short term.

Clayton Perry, Avoca coo, says Piplapure will seek investment opportunities from securitisations to "more complex and illiquid" assets. The appointment follows that of Rachel Black, who joined Avoca last month as head of capital raising for its credit hedge funds (SCI 23 January).

CDS

New credit head to target derivatives

HSBC has appointed Asif Godall as head of European credit trading. He will be based in London and report to both Niall Cameron, global head of credit trading, and Thibaut De Roux, EMEA head of global markets.

The bank says Godall will be responsible for further integrating credit trading into its existing credit franchise by engaging with teams across syndicate, DCM, sales, research and risk management. He will also be responsible for expanding the bank's credit offering and targeting a larger share of the credit derivatives market.

CLOs

Deerfield CLO acquirer revealed

Further details have emerged on CIFC Corp's sale of DFR Middle Market CLO (SCI 9 February). The rights and obligations to the transaction under the management agreement have been assigned to DWM Management, an affiliate of Fortress Investment Group.

See SCI's CDO Manager Transfer database for more recent assignments.

CMBS

Law firm boosts real estate practice

William O'Connor has joined Thompson & Knight as a partner in the firm's New York office. He recently served as chairman of the financial services practice at Crowell & Moring.

O'Connor's practice focuses on the special servicing of CMBS and related aspects of loan workouts. He is a founding member and chairman of the high yield debt and investment forum at CREFC.

Risk Management

Risk analytics firm acquired

S&P Capital IQ has bought R² Financial Technologies. The acquisition of R²'s team of more than 30 financial engineers and technology specialists will strengthen S&P's cross-asset portfolio analytics and offer its clients an integrated view of market and credit risks across asset classes.

R² Financial Technologies offers multi-asset class portfolio and risk analytics delivered in real-time to front and middle offices through two software products: NxR², a front-office pricing, portfolio construction, and risk management software; and R² Capital - a middle-office risk and capital management software solution.

RMBS

Law firm forms RMBS fraud task force

K&L Gates has created a new cross-practice task force to help clients address questions and allegations raised by the recent creation of the RMBS Working Group (SCI 30 January). The firm says it is essential to "respond in kind" to US federal and state governments coordinating their enforcement activities.

The firm's new financial fraud enforcement task force formulates defence strategies to address allegations of RMBS fraud, mortgage fraud and securities fraud. It has a core group of more than 50 lawyers from a dozen of the firm's US offices.

ABS

Latest Queen Street issue marketing

Munich Re is in the market with its latest catastrophe bond - the US$75m Queen Street V Re. Rated single-B plus by S&P, the notes will be exposed to major North Atlantic hurricane risk in selected US states between April 2012 and March 2015 and major European windstorms between October 2012 and March 2015.

Munich Re will be the cedant to the retrocession contract. The notes provide protection to Munich Re for North Atlantic hurricane losses above an index value of 104,000 up to 136,000, and Europe windstorm losses above an index value of 16,400 up to an index value of 19,925 - both on a per-occurrence basis.

AIR Worldwide Corp provided the risk analysis for the transaction and will act as the event calculation agent. Following a qualifying event, AIR will calculate an index value.

Each year, Munich Re can choose whether to reset the US hurricane payout factors, the Europe windstorm payout factors or the foreign exchange rates, subject to certain limitations. It must reset the industry exposure data for both perils.

The proceeds from the notes will be invested in preselected US Treasury money market funds rated triple-A.

ABS

Mystic Re III on the blocks

Aon Benfield Securities and Swiss Re Capital Markets are marketing the third deal from Liberty Mutual's Mystic Re catastrophe bond programme, the first since 2009. The two-tranche deal will be based on the ultimate net losses of the ceding insurer from US hurricanes and earthquakes, including fire following, on a per-occurrence basis.

Mystic Re III's series 2012-1 class A notes will cover a percentage to be determined of losses in excess of US$2.1bn up to US$2.433bn, while the class B notes will cover a percentage to be determined of losses in excess of US$1.3bn up to US$2.1bn. S&P has assigned preliminary ratings to the notes of double-B and single-B respectively.

There will be two annual resets effective 1 January 2013 and 1 January 2014. These will be based on the cedents' exposures as of 1 July 2012 and 1 July 2013 respectively.

ABS

Proprietary credit scores tested against FICO

S&P recently compared the relative value of proprietary credit scores with FICO scores to see which was better at gauging the future performance of subprime auto ABS transactions.

FICO scores are common measures of creditworthiness, but they primarily reflect borrowers' prior credit behaviour. According to Amy Martin, a senior director in S&P's ABS ratings group, many subprime auto finance companies have maintained that their proprietary scoring methods offer a more complete picture for assessing whether a borrower might default.

"Unlike FICO, proprietary scores can incorporate additional variables, such as borrower income, the amount of down payment and loan-to-value ratio," Martin says. "For this reason, proprietary scoring models - like the ones General Motors Financial uses - may be better at forecasting future losses in subprime ABS transactions."

For the study, S&P conducted a statistical analysis to determine if GM Financial's proprietary credit scores have been more powerful in predicting losses on the company's securitisations than FICO scores alone. It also aimed to identify other variables that help explain GM Financial's auto loan performance.

GM Financial's proprietary credit scores were found to be generally stronger indicators of losses than FICO scores for the sample of subprime auto loan securitisations studied, especially for transactions issued between 2006 and mid-2009. There was a particularly strong correlation between the percentage of obligors with a proprietary credit score below 215 and securitisation losses.

Higher loan-to-value ratios from 2006 to 2009 also corresponded with higher net losses. Finally, cumulative net loss rates were shown to be more sensitive to differences in proprietary scores than they are to differences in FICO scores, S&P notes.

"We believe the results of our study underscore the importance of proprietary credit scores in our assessments of the credit quality of subprime auto loan collateral," says S&P credit analyst Erkan Erturk. "While FICO scores are less useful for established players like GM Financial, they still provide relative perspectives on defaults across issuers."

Structured Finance

Conflict of interest rules examined

In a comment letter filed with the SEC, SIFMA expressed its appreciation for the intent of Section 621 of the Dodd-Frank Act and agreed that certain reforms may be necessary to ensure that securitisation transaction parties are not creating and selling ABS that are intentionally designed to fail or default and profiting from the failure or default. At the same time, however, the association urged the SEC to create a framework that still allows for the issuance of ABS without the uncertainty of overly broad or vague regulations or undue restrictions or prohibitions.

"SIFMA's comments reflect its continued goals of restoring capital flow to the securitisation markets and increasing the availability of credit to American consumers and small businesses," comments Richard Dorfman, md and head of SIFMA's securitisation group. "Securitisation is a key component of long-term, stable funding for banks and other lenders and provides investment diversification to investors. Rules should be crafted in a way that does not prevent the recovery of these markets and that presents clear guidance for a pathway to compliance."

SIFMA's comment letter notes that the proposed rule would have a significant economic impact due to the curtailment of securitisation and other risk management activity. The association also believes that the economic analysis set forth is insufficient.

Consequently, it says the SEC should re-propose the rule and provide a thorough economic analysis quantifying and comparing its costs and benefits. In SIFMA's view, the costs of implementation of the proposed rule far exceed the benefits.

Further, it states that intent should be a necessary element in determining the existence of a "material conflict of interest" and that balance sheet transactions should still be permissible. Additionally, the rules should focus on the activities of the business units involved in the structuring of or selection of the assets for the securitisation rather than encompassing all business units, regardless of their knowledge of or involvement in the transaction.

Structured Finance

Flexibility sought for counterparty criteria

Fitch is set to propose enhancements to its structured finance (SF) counterparty criteria. The proposals will build on the existing framework in order to allow more flexibility to keep pace with a rapidly changing counterparty environment.

The proposals will be detailed in a consultation paper in March, with a one-month period for market participants to provide feedback. Fitch expects limited change to its ratings on existing transactions in the event of the proposals being adopted.

Similarly, the agency will not expect documentation changes to be made to existing transactions to maintain existing ratings. Transaction counterparties may elect to incorporate any proposals that are subsequently adopted.

The main areas upon which feedback will be sought are expected to be: extended rating eligibility thresholds, changes to collateral posting calculations and more collateral types examined.

With recent downward migration in bank ratings, fewer counterparties are eligible under current criteria. Fitch's proposals will examine more combinations of rating eligibility thresholds, allowing notes below triple-A to be supported by a wider range of counterparty ratings.

The aim will be to balance extending counterparty eligibility while still mitigating SF rating volatility. For triple-A note ratings, Fitch expects to maintain the existing A/F1 eligibility threshold.

In addition, Fitch will propose new volatility cushions (VCs) for cross-currency swaps, based upon a revised and more transparent methodology that would generally reduce amounts expected to be posted. VCs determine the extent of collateral expected to be posted, as well as mark to market upon breach of rating thresholds.

Greater differentiation in the amount of collateral to be posted by reference to the rating of the counterparty will be proposed. Amended prepayment (CPR) assumptions for determining weighted average lives will also be proposed. The aim will be to balance easing the burden of collateral posting on counterparties, while maintaining sufficient collateral protection to facilitate replacement in the event of counterparty default.

Finally, current criteria specify only cash and highly-rated sovereign bonds as eligible collateral. However, with many sovereigns having been downgraded below eligibility thresholds, options for collateral posting have reduced.

Feedback will be sought on widening eligible collateral types to other asset classes, including corporate bonds, covered bonds and certain SF bonds. In particular, advance rates in light of perceived liquidity issues will be discussed, as well as any conditions that might be attached to posting such collateral. The aim will be to extend collateral posting options for counterparties, while addressing any increased liquidity and volatility risk that new collateral types could pose.

To avoid any potential rating volatility, any SF rating that becomes subject to a rating review as a result of a counterparty not implementing remedial actions upon losing eligibility will now be placed on rating watch negative (RWN) rather than being immediately downgraded. Fitch expects any ratings placed on RWN in this way to be resolved following publication of any final criteria amendments and, if affected counterparties choose to implement documentation changes in accordance with the revised criteria, following any subsequent grace period during which such changes are made.

Following expiry of the feedback period, the agency expects to publish the revised criteria by May.

Structured Finance

Volcker proposals slammed

Yesterday marked the deadline for public comment on the Volcker Rule, which has seen a flurry of criticism from industry players. The final rule - which prohibits institutions from trading certain securities and making certain investments in funds for their own accounts - is set to take effect on 21 July.

Allen & Overy, for one, contends that the Volcker Rule would hamstring non-US banks' operations and significantly curtail revenue. In addition, the Rule is being opposed for its expansion of US law extraterritorially.

Allen & Overy says it has submitted six separate letters to regulators on behalf of some two dozen of the largest non-US banks voicing these concerns. Among them were letters seeking relief for securitisations from the prohibition of fund investments and detailing the inconsistencies between the Volcker Rule and the Title VII derivatives provision of Dodd-Frank.

Douglas Landy, head of the firm's US financial services regulatory practice in New York, has spearheaded the effort for the banks. "In its current form, the Volcker Rule represents a serious over-reach by lawmakers and regulators, extending jurisdiction beyond US borders - and beyond what's reasonable," he comments.

He adds: "In fact, if the Rule were approved as it exists now, no trade anywhere in the world involving a share listed on a US exchange or US fund investment could be executed without being subject to Volcker restrictions. In the face of such extreme restrictions on their daily business, many non-US banks will have no choice but to simply transfer many of their operations to other countries due to the unwarranted application of the rule, which won't benefit anyone."

According to Allen & Overy, the proposed extraterritoriality rules are so narrowly constructed that they would permit non-US banks to trade only in transactions done solely outside of the US - what has become known as the SOTUS exemption. Landy notes that this would impose a disproportionately expensive, ongoing compliance burden upon non-US banks for their trading and fund investment activities.

Structured Finance

Bank tax criticised

SIFMA has criticised President Obama's proposal to include a tax on financial institutions in his budget, under the guise of recouping lost TARP funds. The association says that it is an "ill-considered and ill-timed concept", noting that this latest proposal is nearly double the cost of previous proposals.

"It is important to remember that TARP capital injections into banks have, by and large, been paid back with a significant profit to the taxpayer - over US$19bn by the end of 2011," SIFMA president and ceo Tim Ryan comments. "Imposing a broad-based tax on financial institutions and unfairly tying it to the mostly repaid TARP programme ultimately serves as a tax increase on individual investors."

The association notes that financial institutions already face the burden of higher capital and liquidity standards set by Dodd-Frank and the Basel 3 framework. Adding onto these measures with a bank tax will only serve to impede the ability of financial institutions to provide the necessary capital formation and credit availability to continue to spur economic growth and job creation, it says.

Structured Finance

Euro SF default rate remains low

S&P reports in its latest transition study for the sector that the overall default rate for European structured finance securities has remained low. By year-end 2011, only 1% of the securities outstanding in mid-2007 had defaulted and the 12-month rolling default rate stabilised at 0.5%. In addition, about 54% of the securities are estimated to have redeemed in full.

"Based on our calculations, only €26bn of notes outstanding in mid-2007 had defaulted as of year-end 2011," says S&P credit analyst Arnaud Checconi. "Based on the overall sample's notional value at issuance of €26trn, this gives a cumulative default rate of 1%. By definition, this cumulative measure of default can only increase over time and is up slightly from 0.87%, based on data through the third-quarter of 2011."

The European structured finance cumulative default rate remains low in absolute terms, for example, compared with the equivalent measure for US structured finance. However, many of the ratings transition and default trends vary substantially by asset class and by a note's position in the capital structure.

S&P warns that it may lower some ratings further in the coming months as it factors in revisions to its bank criteria, as well as the ongoing effects of the sovereign debt crisis and a likely economic contraction in several European countries.

CDS

EMIR agreed

European Parliament and Council representatives yesterday agreed on the text of the European Market Infrastructure Regulation (EMIR), which will regulate trade in OTC derivatives. The rules require OTC derivatives to be cleared through CCPs, with all derivative contracts to be reported to trade repositories.

Under the legislation, trade repositories will have to publish aggregate positions by class of derivatives. The European Securities and Markets Authority (ESMA) will be responsible for the surveillance of trade repositories and for granting their registration. It will also provide for binding mediation in disputes between national authorities over the authorisation of CCPs.

CCPs from 'third countries' will be recognised in the EU only if the legal regime of the country provides for an effective equivalent system for recognition. However, this does not set a precedent for other legislation on the supervision and oversight of financial market infrastructures, the European Parliament notes.

In addition, what is described as a "light touch" regime has been secured for pension schemes with regard to the clearing obligation. This will apply for three years, extendable by another two years plus one, subject to proper justification.

The implementation of the legislation is to be evaluated by the European Commission, including the effectiveness of the supervisory framework for CCPs, the respective voting arrangements and the role of ESMA. The Commission will present its findings in a report - accompanied by proposals to Parliament and Council, if necessary - no later than three years after the regulation's entry into force.

The legislation needs final approval from Parliament and the Council. It will enter into force 20 days after publication in the Official Journal.

CDS

Singapore OTC review underway

The Monetary Authority of Singapore (MAS) is conducting a review of the regulatory oversight of the OTC derivatives market in Singapore and is seeking public comments on its proposals. In developing these proposals, MAS says it has taken into consideration international developments - such as the G20 commitments and Financial Stability Board recommendations - to improve the regulation and supervision of the derivatives market.

Under the proposals, MAS will expand the scope of the Securities and Futures Act (SFA), Chapter 289 to include: mandatory central clearing of OTC derivative trades at regulated central counterparties; mandatory reporting of OTC derivative trades to regulated trade repositories; and the establishment of regulatory regimes for market operators, clearing facilities, trade repositories and market intermediaries for OTC derivatives. In addition, the authority is engaging the industry to better understand the costs and benefits of introducing mandatory trading on exchanges or electronic platforms, but will consult on this at a later date.

The consultation period will end on 26 March.

CLOs

CLO operational due diligence recommended

Fitch says that while manager consolidation in the US CLO market may be positive for bondholders, these newly merged companies require investors to consider operational and associated manager factors as they perform their due diligence.

"Managers have purchased or merged with other firms to form larger institutions that now provide transatlantic scope and depth on specific issues for bondholders," the agency notes. "We believe larger firms are generally positive for bondholders. However, investors in CLOs being acquired should only consent to having their investments managed by these new firms following their due diligence process and becoming comfortable with several aspects."

CLO trust documentation varies by structuring bank, vintage and by manager. Investors should therefore consider how the new CLO manager is, or is not, equipped to handle these differences, Fitch says. CLO investors should also be aware of changes to key person provisions: the individual named pre-merger may not join the new firm.

Finally, the new CLO manager may have a different credit opinion on certain assets in the underlying loan portfolio. Investors should understand how the new manager plans to reposition or manage that specific portfolio in the future.

CLOs

Amend-and-extend activity noted

The Aramark (which is the 11th most common exposure among US CLOs), Sabre (12th), Nuveen (57th), Caesars (62nd) and Catalent (69th) loans have all had their maturities extended recently. Research analysts at S&P note that such activity could have negative credit implications, with the lengthening maturities likely to extend the WALs of some CLOs.

"Transactions that are post-reinvestment and mature before the extended loan matures may face additional risk," they observe. "Over 525 CLOs contain one or more of these credits and on average have about 2% exposure."

CLOs

CLO pay-down to support technicals

An aggregate US$30bn US CLO pay-down is forecast this year due to structural amortisation. At least some of this cash is expected to serve as a technical support to the primary and secondary CLO markets.

The average monthly loan prepayment rate fell to as low as 2.3% in 3Q11 and 1.4% in 4Q11. However, during that time 2003-vintage CLO triple-A tranches experienced a 2.4% pay-down per month between mid-July and mid-November versus 1.4% per month from mid-November to end-January, illustrating the rapid pay-down for senior bonds in their amortisation periods.

As the outstanding arbitrage cashflow US CLO universe shrank from US$258bn to US$244bn since July, CDO analysts at JPMorgan estimate that US$14bn has returned to CLO investors during the period via amortisation, including US$9.3bn (or 73%) triple-A pay-down and US$0.6bn double-A pay-down. For 2012, based on prepayment rates remaining at around 4%-6% per quarter, this scenario indicates around US$30bn amortisation proceeds.

"To put this into context, our circa US$20bn gross issuance forecast for 2012 is just two-thirds of the US$30bn pay-down we anticipate from seasoned US CLOs, or -US$10bn net issuance for the year. Given low yields in credit markets and the proven track record of CLO performance, we believe at least some of these proceeds will be invested back in the CLO market and add technical support," the JPM analysts conclude.

CLOs

Provision mechanism warning

Fitch says it continues to monitor Empresas Hipotecario TDA CAM 3, a Spanish SME CLO whose reserve fund experienced a €11.5m drop to €1.3m in October. The deal illustrates that the misalignment of the provisioning mechanism and the default definition may lead to abrupt reductions in the reserve fund balance without a corresponding increase in the defaulted notional, the agency says.

The sudden change in reserve fund balance in this case was due to one bullet loan failing to repay at maturity and therefore becoming delinquent on principal. However, there was no corresponding increase in defaults.

Per the transaction documents, the provisioning mechanism diverts available funds to repay the senior notes so that the balance of the notes after provisioning matches the balance of non-defaulted assets that have not reached maturity. Only loans 12 months or more in arrears are considered in default, according to the transaction documents.

However, the typical provisioning mechanism for Spanish SMEs defines the principal deficiency as the difference between the balance of the notes outstanding and the balance of non-defaulted assets, irrespective of whether they have reached maturity or not. As a result of the specific provisioning mechanism in this transaction, the reserve fund was used to provision for the matured but unpaid principal of the bullet loan, even though the loan was only considered delinquent and not defaulted under the transaction definitions.

Fitch notes that while senior noteholders benefit from earlier provisioning, this feature can potentially reduce liquidity for the transaction.

CLOs

Deerfield CLO unloaded

CIFC Corp has sold the equity and class D mezzanine tranches issued by DFR Middle Market CLO, together with the rights to manage the CLO, for an aggregate sale price of US$36.5m. This sale represents the completion of the firm's intention to reposition its core business as a fee-based asset manager and free up capital to support further growth. The transaction reached the end of its investment period in July 2010.

CMBS

REC 5 upgraded

In a rare positive turn for the CMBS, Fitch has upgraded REC Plantation Place's class B to E notes. The agency attributes the move to the asset's improving market value since March 2011, which ultimately increases the refinancing prospects of the £421.83m Plantation Place loan at maturity in July 2013.

During the past year, a number of investors attempted to acquire the property (SCI passim). While each proposal was either blocked by noteholders or the current owners, the proposed sales prices - ranging from £450m to £500m - would have resulted in a full redemption of the senior loan and thus all tranches of the deal.

Although the loan remains in default due to a breach of its LTV covenants, the leverage has been improving since October 2009 and last month was reported close to covenant compliance. The securitised and whole loan LTVs stood at 81.5% and 86.3%, compared to covenants at 77.7% and 82.1% respectively. The improvement was driven by ongoing amortisation, as well as yield compression, Fitch notes.

The class B notes have been upgraded from double-A minus to double-A, the class Cs from triple-B minus to triple-B plus, class Ds from single-B minus to double-B plus and the class Es from triple-C to double-B.

CMBS

Euro CMBS scenario assumptions deteriorate

Based on updated central scenario assumptions, loans backing CMBS in Europe will continue to perform poorly in 2012, according to Moody's.

Compared to the agency's previous assumption of an improved lending market in 2013, it now expects the recovery to take longer and only start in 2014 due to the prolonged financial stress in Europe and continuing eurozone crisis making lenders risk averse. At the same time, Moody's expects capital values for low quality non-prime properties to fall.

"The updated CMBS central scenario assumptions reflect the deterioration of the macroeconomic environment since Moody's last update in February 2011 and the rating agency's global macroeconomic outlook for 2012 of a continued slowdown in growth globally," says Oliver Moldenhauer, a Moody's vp-senior analyst.

The agency's updated central scenario assumptions are: refinancing prospects will remain tiered; lending will remain subdued; fire sales will be avoided; investment will focus on prime properties; prime property values will remain stable while non-prime property values will fall; and real estate fundamentals will weaken.

Moody's says its current ratings reflect the high refinancing risk of loans maturing in 2012 and also assume some improvement in the lending market starting in 2013. An improvement in lending is no longer expected in 2013 and most loans maturing in 2012 and 2013 will not repay at their scheduled maturity date. CMBS transactions with a larger portion of loans secured by non-prime properties that need refinancing in 2013 and beyond therefore face the greatest risk of further downgrade.

In addition, rating volatility will remain high, with a downward trend over the coming years. Due to the non-granular nature of CMBS loan pools, the outcome at loan maturity for a large loan in the pool can change the rating of the notes. Further rating drivers will be tenant defaults and/or other idiosyncratic events at the loan or transaction level, the agency says.

CMBS

January pay-offs inch higher

The percentage of CMBS loans paying off at their maturity date inched higher in January, according to the latest Trepp pay-off report.

In January, 40.8% of loans reaching their balloon date paid off, up by about three points from December's 37.5% reading. The December reading had been the lowest in eight months. The January number of 40.8% was below the 12-month rolling average of 44.1%, however.

By loan count (as opposed to balance), 51.3% of the loans paid off. This was virtually unchanged from December's reading of 51.2%. On the basis of loan count, the 12-month rolling average is now 50.2%.

CMBS

Office, retail delinquencies hit new highs

Delinquencies for office and retail loans have hit their highest-ever levels while overall US CMBS delinquencies fell for the sixth straight month, according to Fitch's latest US CMBS Loan Delinquency Index.

CMBS late-pays declined by 5bp in January to 8.32% from 8.37% a month earlier. The improvement was driven by multifamily loans, which saw a 165bp plunge in its rate month-over-month to 12.77%. The delinquency rates for office and retail rose to all-time highs of 7.3% and 7.21% respectively.

January marked the first time post-recession that the office delinquency rate surpassed that of retail. Office is the only major property type that Fitch has a negative outlook on for 2012. The agency expects office delinquencies to continue rising as leases made at the height of the real estate boom roll to market, impacting income available to cover debt service.

New delinquencies were led by five-year interest-only loans from the 2007 vintage that failed to pay off at maturity and have subsequently stopped paying interest. Notably, no new loans over US$100m were added to the index in January. In part, this was due to Fitch excluding from the index several large loans (over US$500m in total) that were reported as non-performing matured balloons for the first time in January, but which remained current on interest despite not satisfying their scheduled balloon payments.

Multifamily and hotel loans have shown the best performance rebound over the past 24 months, a trend Fitch expects to continue. In fact, the multifamily delinquency rate has fallen by 4.63% from one year ago to 12.77%.

Month-over-month, the decline was led by the US$375m loan on The Belnord dropping out of the index. Previously, the loan was more than 90 days delinquent, but the borrower was able to use reserve funds to bring the loan current. Based on the remaining reserve balance and in-place cashflow, Fitch expects the loan to remain current for roughly four more months, with the loan likely to re-enter the index sometime over the summer unless cashflow improves.

Current and prior month delinquency rates for the major property types are: 12.77% for multifamily (from 14.42% in December); 12.21% for hotel (from 12.02%); 10.40% for industrial (from 10.25%); 7.30% for office (from 6.84%); and 7.21% for retail (from 6.89%).

CMBS

Maturity defaults drive deterioration in Euro CMBS

Fitch says in a new report that maturity defaults continue to drive deterioration in its European CMBS portfolio. In 4Q11, 22.8% of all loans were in maturity default, a steep increase from 17.5% in 3Q11, it notes.

Due to a combination of standstill agreements, restructurings and loan extensions, the proportion of loans that has been declared in default is slightly lower at 20.2%. However, this also represents a significant increase from 16.3% in 3Q11.

The increase in maturity defaults drove the proportion of fully performing loans even lower, to 62.5% in 4Q11 from 65.4% in 2Q11. Fitch expects this trend to continue.

The increase in the weighted average (WA) reported LTV to 80% from 77% in the previous quarter indicates that future loan repayments will be even more difficult. This is further highlighted by the WA Fitch LTV, which is even higher at 98%.

Rating watches and downgrades in 4Q11 were driven in many cases by downgrades of transaction counterparties or key tenants. However, Fitch also has growing concerns about approaching legal final maturities on CMBS bonds. The majority of CMBS legal final maturities commence in 2014 and peak in 2017, with only a small proportion of bonds maturing in 2012 and 2013.

"The increasing number of transactions moving into their tail periods will result in decreased flexibility for servicers when working out defaulted loans," says Mario Schmidt, associate director in Fitch's European CMBS team. "Loans with significant outstanding balances secured by a large number of assets are particularly at risk, especially if the collateral is of secondary or tertiary quality. It may become increasingly difficult to obtain resolutions within the two- to three-year tail periods typically seen in EMEA CMBS."

Fitch says the most prominent example is the Opera Finance (Uni-Invest) transaction. On 2 December 2011, the agency downgraded all tranches to single-C with a recovery estimate of 0%, reflecting Fitch's expectation that an ongoing loan workout will not be completed by the notes' legal final maturity on 15 February 2012.

CMBS

DECO structural strengths highlighted

Deutsche Bank has priced its new CMBS, the £210m DECO 2012 MHILL (SCI 6 February). Rated by DBRS and S&P, the £145m AAA/AAA class A notes printed at 300bp over Libor, the £30m AA high/AA class Bs at 450bp over and the £35m A high/A class Cs at 550bp. The single-loan deal has a 4.45-year WAL and a legal final in July 2021.

According to structured finance strategists at Chalkhill Partners, term risk is significantly mitigated by the fact that the asset - Merry Hill - is a well-established shopping centre, with a granular and stable rent roll, and a strong ICR (2.4x). Equally, maturity risk is addressed through the conservative leverage (50% LTV) and the long tail period, which allows for deleveraging through a cash sweep (applied sequentially) and factors in a potentially protracted workout due to the lack of a mortgage charge and the split ownership.

The absence of a class X note, meanwhile, appears to be driven by economic considerations. "The excess spread reserve is a positive structural feature for dealing with increased deal costs, but is unlikely to be topped up," the Chalkhill strategists note. "In fact, given the 2.45% loan margin and estimated senior expenses of 18bp, the notes had to print at +2.27% and sell at a discount to achieve the returns required by investors (+3.6% blended). The gap reflects wider return expectations relative to last summer, but also the pricing risk in underwriting loans for CMBS issuance."

CMBS

Japanese recoveries reviewed

S&P has released a report detailing the results of a survey that it conducted on the recovery of defaulted loans backing rated CMBS transactions in Japan, as of the end of December 2011.

From the second quarter of 2008 - when the first underlying loan of a Japanese CMBS transaction defaulted - to the end of December 2011, 129 loans backing rated Japanese CMBS defaulted. With respect to 99 of these 129 loans, one or more collateral properties had been sold (or collection through the transfer of receivables had been made), as of the end of December 2011. Meanwhile, none of the collateral properties related to the other 30 defaulted loans had been sold, as of that date.

Collection operations for 78 of the 99 loans for which collection procedures were undertaken were completed by the end of December 2011. 49 of the 78 loans were fully recovered and the other 29 loans incurred principal losses. The simple average recovery rate for the 78 loans for which collection operations were completed was 90%, while the weighted average recovery rate for the same 78 loans was 89%.

The 129 loans that defaulted were backed by 785 properties in aggregate at the time of default. The simple average ratio of the sales price to the underwriting value for the 407 properties was 66.4%, while the weighted average ratio of the sales price to the underwriting value for the same properties was 59.1%. Both ratios dropped marginally from the levels S&P noted at the end of June 2011.

CMBS

Euro CMBS maturity warning

Fitch says that investment grade European CMBS ratings are becoming increasingly vulnerable to downgrades as legal final maturity (LFM) approaches. This could see Europe follow the Japanese CMBS experience, where most loan maturities have now passed and the majority of loans defaulted. There have been multiple downgrades of Japanese CMBS as the remaining time in tail periods diminishes and servicers seek to work out defaulted loan positions by LFM, the agency says.

Fitch cites Opera Finance (Uni-Invest) as one of the earliest examples of this approaching phenomenon in European CMBS (SCI 14 February). "The LFM of this transaction is today and all remaining notes are expected to default. The class A notes of this transaction were downgraded to distressed levels (to triple-C from triple-B) on 30 June 2011, when it became highly unlikely that the underlying defaulted loan would be worked out by LFM. This reflected that noteholders were unable to reach consensus on bids for the company and its assets," Fitch notes.

All Opera notes were further downgraded on 2 December 2011 to single-C to reflect the inevitable default of the notes at LFM. This followed the suspension of an auction process that had been instigated 3.5 months earlier.

"The key rating drivers were previously overall borrower leverage and debt financing conditions. However, these were supplanted by the illiquidity of the assets, given the short remaining tail period. The erosion of time has restricted the servicer's operational flexibility and weakened its bargaining position with both the borrower and potential external providers of finance," Fitch explains.

While Japanese CMBS loan maturities have passed their peak, European CMBS loan maturities start to ramp up considerably in 2012, peaking in 2013. Japanese CMBS LFMs peak over 2012-2014, with major outstanding transactions well into their tail periods. European CMBS LFMs peak over 2016-2017, with few yet facing the situation of Opera, Fitch says.

It continues: "Operational risk in European CMBS is therefore expected to intensify, as servicer capacity is increasingly put to the test. Some defaulted loans will absorb more servicer resources than others; notes backed by loans that are secured by high quality collateral may find themselves on the backburner, especially if servicers are prepared to place reliance on sponsor-led business plans. Idiosyncratic risk and rating actions can be expected to intensify, as individual loan workouts vary, business plans change over time and refinancing risk grows as note LFM approaches."

The agency says it will look through leverage to broader operational risks as LFM approaches and will cap ratings accordingly. Where transactions approach LFM or are seeing a protracted work-out process, key rating drivers will change, particularly in the final 18 months before LFM.

"In contrast to Europe and Japan, US CMBS transactions do not see loan maturities peak until 2015-2017, with loan tenors generally of ten years. Transaction maturities are generally 30 years or more, providing very long tail periods after loans have matured and allowing considerably more time to work out defaulted positions prior to LFM than European and Japanese transactions," Fitch concludes.

CMBS

OPERA UNI default anticipated

Opera Finance (Uni-Invest) will become the first European CMBS to fail to repay by its legal final, if it defaults - as is expected - tomorrow. A senior noteholder steering committee has been involved in discussions about resolution options, but an announcement on the strategy is unlikely before Friday, according to structured finance strategists at Chalkhill Partners.

They expect that the special servicer - Eurohypo - will be instructed to liquidate the property promptly, with recoveries most likely covering the A notes and the value breaking somewhere in the Bs. The auction process to sell Uni-Invest Holding as a going concern is currently suspended, however, due to severe constraints on the availability of debt finance.

Uni-invest, the only loan in the portfolio with a balance of €603.6m, recently reported a 96% LTV and 1.65x DSCR.

RMBS

Italian RMBS stress tested

Fitch expects that approximately 80% of Italian triple-A rated RMBS tranches would be able to pay in full following a three-year severe recession and collapse of the country's real estate market. The transactions were stress tested against a concurrent doubling of unemployment to around 17%, an increase in interest rates to 9% and residential real estate crash with a 70% drop in the value of foreclosed properties.

Mortgage defaults over the three-year stress period would be expected to reach 17% on average. Such a scenario is far beyond Fitch's expectations.

This severe stress scenario was calibrated to be significantly worse than conditions experienced in any major European market so far in the current crisis. It assumes a more severe and prolonged recession than the one experienced in Italy in 2009, with GDP growth shrinking for the next three years and decreasing on aggregate by 9% from the current level. This would push unemployment to levels of 50% more than the 1990 peak.

The foreclosed houses price decline of 70% implies a general house price decline of around 45% and a further adjustment of 25% to take into account the lower values achieved through forced sales. The 45% house price decline is worse than that seen in Ireland between 2007 and 2010 of 37.7%, which is the worst three-year performance in the eurozone so far.

This scenario does not take into account the unlikely event of Italy leaving the eurozone, however. If the eurozone were to break up, mortgage debt will likely be redenominated in a new national currency. Since a new Italian currency would be expected to depreciate substantially from the outset against the stronger European currencies, the expectation would be that RMBS notes would suffer repayment shortfalls and therefore RMBS default rates would be even higher.

The stress tests were carried out as part of a wider study into how robust Italian RMBS are to a prolonged economic downturn. The analysis also highlights the rating migration of RMBS tranches in such a scenario, as well as the vulnerability of RMBS to a more moderate downturn.

In the moderate scenario, Italian unemployment rises to 10%-12%, interest rates go up to 6% and house prices fall by approximately 18% in the next three years with foreclosure properties declining by 45%. All triple-A rated bonds would be able to redeem in full at their maturity following the three-year stress period. In terms of ratings migration, 82% of triple-A tranches would remain at that level and none would migrate below double-A.

The ratings migration analysis throughout the report does not look at the impact of sovereign or counterparty downgrades. If Italy is downgraded by one rating category, Fitch would expect Italian RMBS triple-A rated tranches to be downgraded to the double-A category.

Fitch expects to conduct similar stress test reports in the coming months for other jurisdictions and structured finance asset classes.

RMBS

AG settlement a 'net positive'

Fitch believes that the final State Attorneys General settlement agreement with US residential mortgage servicers is a net positive that reduces some uncertainty and is likely to be felt industry-wide. The agreement resolves some of the subject servicer's outstanding liability for process errors, provides additional relief to at-risk borrowers and is another step in formalising servicing industry best practices, the agency says.

Fitch has already accounted for the likely increase in servicing costs and continued extension of loss mitigation timelines in its RMBS rating analysis. As such, both servicer and RMBS ratings are unlikely to be impacted immediately by the agreement.

In light of the protracted settlement negotiation process and consent orders announced last year, the agency's RMBS servicer ratings already reflect the increased infrastructure costs, process changes and operational challenges, as well as loss mitigation timeline extensions that were formalised by this agreement. It downgraded the operational risk ratings of several residential mortgage servicers in June 2011, four of whom were named in the AG agreement.

With respect to ratings on RMBS transactions, Fitch had already assumed continued increases in liquidation timelines and loss severities through 2012 prior to the settlement. It is not yet clear how many loans within the transactions may be affected by the principal reductions included in the settlement. That said, the agency currently expects that the overall impact to lifetime projected losses will not be significant enough to affect long-term credit ratings.

While Fitch believes that modification schemes designed to help borrowers avoid foreclosure could improve performance, it warns that indiscriminately applying a wide-ranging programme could raise moral hazard risk. "This scenario may result in higher defaults among borrowers who would otherwise remain current, despite their negative equity position. This in turn would potentially increase total losses to the trusts, particularly if the principal reductions are not effective in reducing defaults."

If implementation of the policies takes longer than expected or prevents timelines from ultimately improving in future years as quickly as currently expected, the agency believes the settlement may have incremental negative rating implications in the long term, however.

RMBS

Irish PIAs 'credit negative' for RMBS

New Irish personal insolvency legislation proposed in January and expected to come into force in 2013 will see the introduction of debt forgiveness for borrowers deemed to have unsustainable mortgage debt. Moody's views the proposal as credit negative for Irish RMBS because many mortgage loans will be written down and many borrowers will become discouraged from maintaining their mortgage loan repayments. The rating agency estimates that a quarter of all Irish mortgage debt is susceptible to a write-down under the proposal.

Moody's notes that, under the proposal, borrowers who are unable to pay their debts when due could be eligible to enter into a Personal Insolvency Arrangement (PIA) with their creditors. Providing at least 75% of secured creditors and 55% of unsecured creditors agree, the PIA could see the mortgage loan reduced to the current market value of the property and the borrower would continue to live in their home.

Precise details of the insolvency tests used to identify only those borrowers truly unable to pay their debts, together with banks willingness to veto an arrangement, will determine the impact on the agency's expected loss assumptions for Irish RMBS.

RMBS

US resi proposals to face 'fierce' opposition

Fitch says that although some of the changes to the US residential mortgage market recently proposed by President Obama (SCI passim) could be positive, it also believes that some will be neutral and some potentially negative. Most could face fierce political opposition, the agency says.

Two of the proposals could have a material impact on the market, but their passage is uncertain. One of these is a refinancing option for current borrowers.

"We would expect it to have a mixed impact on RMBS, should it be made available to the private label sector, as it could remove performing loans as well as those with high LTVs from existing deals," Fitch notes. "The remaining loans could be of yet higher risk. The second of these proposals is that all lien holders, public and private, provide one year forbearance to unemployed borrowers."

This proposal follows the recent announcements for the GSE programmes and suggests that bank and private held loans should follow suit. There is no legal framework for this and Fitch expects it to be fought by several of those lien holders.

Also of concern to the agency are the proposed changes to HAMP that include a new qualification ratio and principal forgiveness. "We believe that using a total debt (instead of only housing) ratio to set the qualification limit presents risk to the first lien investors. It is impossible to gauge the impact of more flexible debt-to-income criteria as there was no limit on total debt in the earlier programme."

The effect of proposed increases in principle forgiveness incentives is also difficult to evaluate as so few of the HAMP loan modifications for private transactions have provided for principal forgiveness.

One proposal that could positively affect the inventory of foreclosed homes would be to create an FHFA REO-to-rental initiative. While Fitch believes that this proposal could improve the inventory and release some pressure on the rental market, it might have unintended consequences for the REO sellers.

Investors are likely to pay less for the properties than other buyers, the agency adds. Also, investors typically require their properties to be in specific geographic areas so that their management costs are consolidated.

RMBS

ML II senior loan repaid

The New York Fed has sold another slug of assets, with a current face value of US$6.2bn, from its Maiden Lane II (ML II) portfolio through a competitive process to Goldman Sachs. Proceeds from this sale and last month's (SCI 20 January) will enable the repayment of the entire remaining outstanding balance of the senior loan to ML II on the next payment date in early March. The original amount of the senior loan was US$19.5bn.

The transaction was prompted by an unsolicited offer from Credit Suisse to buy ML II assets. The five broker-dealers included in the subsequent competitive sale process were Barclays Capital, Credit Suisse, Goldman Sachs, Morgan Stanley and RBS. The broker-dealers were selected based on the strength of each of their recently submitted reverse inquiries for large parcels of the portfolio.

The New York Fed decided to move forward with the transaction only after determining that the winning bid represented good value for the public. Remaining assets in the portfolio will be disposed of in segments over time as market conditions warrant.

Following repayment of the New York Fed's senior loan, additional proceeds will be allocated as per the ML II agreement. Proceeds from additional asset sales that are allocated to the New York Fed will be included in the Federal Reserve's remittances of income to the US Treasury.

RMBS

Subprime principal reduction to proliferate

The Federal Open Market Committee's expectation of low interest rates through 2014 - while benefiting the US prime mortgage sector - will provide little direct help to subprime mortgage borrowers, according to Fitch. Consequently, subprime borrowers are expected to continue to rely solely on loan modifications for any payment relief.

Prime borrowers have benefited more from low interest rates than weaker borrowers: since 2009, approximately 40% of all such borrowers have been able to refinance into lower-rate loans. And although a meaningful portion of the remaining prime borrowers have been locked out of refinancing due to negative equity, an increasing majority of the borrowers currently outstanding with adjustable-rate mortgages has still enjoyed downward rate adjustments (on average from a 5% initial coupon to approximately 3% today).

In contrast, only 5% of subprime RMBS borrowers have been able to voluntarily refinance since 2009. Furthermore, due to initial loan terms that maintain a minimum floor on most subprime adjustable rates, the average coupon rate on outstanding un-modified subprime ARM loans has only declined from 7.8% initially to 7.6% today. Given that approximately 20% of subprime borrowers began with interest-only payments that have now started to amortise, a number of borrowers have higher monthly payments today than they did initially.

The likelihood of expanding HARP to non-GSE borrowers, as currently proposed (SCI 2 February), appears limited. Consequently, loan modifications seem to be the only path of payment relief for subprime borrowers.

To date, almost 50% of subprime loans outstanding have had their loan terms modified at least once, with average rate cuts from 8.24% to 5.03%. However, the pace of new rate modifications has slowed as fewer remaining borrowers qualify for existing modification programmes or are able to provide the needed documentation. In recent months, the percentage of borrowers receiving rate modifications is roughly a third of the pace experienced at the peak in 2010.

Fitch expects principal reduction modifications to make up an increasing share of subprime modifications under the enhanced HAMP. To date, principal reduction modifications have experienced slightly lower re-default rates than rate-modifications, although the agency still expects re-default rates greater than 50% on all modification types going forward.

Although collateral performance in the subprime RMBS sector has improved significantly from the onset of the crisis, Fitch expects the rate of improvement to slow in 2012 as many remaining borrowers continue to struggle with overextended consumer debt and negative equity in their homes. This year the agency anticipates downgrades of subprime RMBS to continue to outnumber upgrades, as almost 75% of subprime RMBS bonds remain on outlook negative.