Contents

CMBS

NPL issues

Bad debt securitisations gaining traction

The first post-financial crisis non-performing loan CMBS - Rialto 2012-LT1 and S2H 2012-LV1 - have proved popular with investors looking for short duration, high coupon bonds. However, the growth of the sector is expected to be limited by the paucity of distressed assets coming onto the market at present.

William O'Connor, partner at Thompson & Knight, reckons that the current crop of non-performing loan CMBS represent a return to 'old school' bad debt securitisations. "NPL CMBS were originally created to move distressed assets off the books of federal receiverships and reset the capital base by restructuring or liquidating them. The new NPL deals provide a partial exit from distressed debt funds, but they essentially remain a high yield product."

The structure of the new and 1991-1995 vintage NPL CMBS deals are remarkably similar, according to Tad Philipp, Moody's director of research for commercial real estate. Both types of transactions are liquidating trusts and pay down the notes before the sponsor receives anything back, thereby aligning them with investors.

"This is a powerful proposition for investors. Both the Rialto and S2H deals are performing well, with the former already having paid down significantly," Philipp observes.

Joe Baksic, vp and CMBS new ratings team leader at Moody's, adds that both the Rialto and S2H deals were arranged by JPMorgan and have similar structures. "There was significant investor appetite for the first transaction, so the second was structured along similar lines. The difference lies in their portfolios."

The Rialto collateral has an average loan balance of under US$1m and generally consists of esoteric NPLs. Most of the Square Mile assets, on the other hand, are backed by newly constructed hotels and have an average loan size of US$10m-US$20m.

"The S2H transaction has higher quality assets, but is more concentrated than the Rialto transaction. There are also more opportunities with the former to work with the borrower to reposition the loans, thus reflecting the different motivations of the sponsors," Baksic observes.

Like the RTC-era NPL CMBS, the Rialto and S2H deals are expected to help in the process of returning the CRE market to a more stable capital base by reducing time-to-recovery. But an important difference with the new NPL transactions is that the collateral had already been managed by the sponsors for six months before being securitised and so has a track record.

"Both Rialto Capital Management and Square Mile Capital managed the assets into their respective CMBS robustly," O'Connor confirms. "Not only does this maximise the sponsors' return, but it also provides investors with more transparency around the assets. In addition, there is the advantage of having an experienced distressed debt investor at the helm."

Although Rialto's asset selection criteria is proprietary, the portfolio is said to exhibit an even-handed blend of assets - most are valued at 80%-90% of par, but a small portion is at zero. The aim is to play towards 60%-70% in order to produce high IRRs.

O'Connor anticipates NPL CMBS volume to increase significantly as the FDIC share programmes run into road-bumps and banks need to unload assets once again, together with the emergence of more bridge and rescue funds needing a securitisation exit. These portfolios will likely comprise combinations of B-piece acquisitions and NPLs.

However, this does not necessarily spell the end of CRE CDOs. O'Connor believes that both CRE CDOs and NPL CMBS will, in time, be used to recapitalise stressed commercial real estate assets.

Baksic agrees that both CRE CDOs and NPL CMBS are a form of portfolio financing for sponsors, but says the difference is that a variety of collateral is allowed in CRE CDOs and the manager has more flexibility during the reinvestment and wind-down periods. By comparison, NPL CMBS essentially begin at the wind-down period.

Moody's, for one, has a handful of NPL CMBS is in its ratings pipeline. Players said to be looking at such transactions include Jefferies and Cantor. Oaktree Capital Management, meanwhile, is rumoured to be working on a US$400m CRE CDO with JPMorgan.

These aren't necessarily traditional CRE sponsors, hence why NPL transactions are only making a come-back now. The CMBS asset class is currently dominated by investors seeking triple-A ratings, so a push was needed from distressed investors searching for yield.

But this brings its own potential issues, according to one consultant in the CRE space. "Given current regulatory and accounting uncertainty, shadow banking - where the more exotic assets are financed by non-banks via fund structures - is rising. The sponsors of CMBS-type transaction are increasingly not banks, which could drive adverse selection of assets to enable them to cover their funding costs. The danger is that NPL deals could end up financing the worst assets, albeit generating plenty of cashflow in the meantime."

He argues that, unlike after the US savings and loan crisis, there has been no reset in the basis of the assets post-crisis. This is creating opportunities for large private equity shops to step in, acquire distressed notes and foreclose on the property - possibly to the detriment of CMBS refinancings.

However, Philipp believes that the growth of the NPL CMBS sector will naturally be limited by the paucity of assets coming onto the market. "Fewer distressed CRE portfolios are being unloaded these days, whereas such collateral fuelled the market 10 to 15 years ago. Many funds raised money in the expectation that banks would dump assets within a 2-3 year window, but the tidal wave never came. Banks are eager to hold onto their yieldier positions and are trying to work them out themselves, rather than passing the opportunity on to private equity firms."

He adds that it is a different environment this time around. "The FDIC, for example, is trying to sell banks including their collateral and create public-private partnerships, rather than simply liquidating the collateral. It's a game of singles rather than home runs: each initiative aimed at tackling the distress and the asset overhang is helping to re-liquefy the US CRE market, but doesn't necessarily have an overwhelming impact in its own right. The market has so far broadly recovered about 50% of the value it lost."

CS

CDO

Pre-auction CDO buzz

BWIC supply was very strong yesterday, with SCI's PriceABS data showing a record 473 line items. The data includes several of the names slated for sale in tomorrow's Maiden Lane III auction (SCI 10 August).

The New York Fed has 14 ABS CDO tranches up for bid in the auction. Of the ones that appeared on bid-lists yesterday, the highest price talk was for SCF 5A A1, with the US$64.89m tranche being talked in the mid-90s.

Several other names - such as CAMBR 3A A1, DUKEF 2004-7A 1A1, DUKEF 2004-7A 1A2 and DUKEF 2004-6A A1S - were each being talked in the mid-20s, with DUKEF 2004-7A 1A2V being talked lower at low/mid-20s. The largest tranche, the US$479.57m DUKEF 2005-8A A1S, was talked the lowest of all at the low-teens level.

Other names of interest ahead of tomorrow's auction include COOL 2005-1A A1 (talked at mid-30s) and GLCR 2005-3A A1 (talked at mid-40s), as well as HUNTN 2005-1A A1A and HUNTN 2005-1A A1B (each talked at high-70s/low-80s), according to SCI's PriceABS service.

JL

CMBS

Tight CMBS market trading up

Buyers outnumber sellers in the European CMBS secondary market at present. Given recent spread tightening, investors have started working harder for yield.

"There is very good demand for CMBS senior second-pays and quality third-pays, but there are not very many sellers around. It feels very positive, but there is limited paper so trading has been less active than it could have been," reports one trader.

He adds: "The real money guys have stepped in more and they have been actively buying. That has pushed the seniors tighter than they were before. Senior levels now appear too tight for hedge fund appetites."

Those hedge funds are now spending more time looking at second- and third-pays, but the trader notes that there is a limited supply of "decent quality" second-pays. While this is the case, names have been trading up for the last few weeks.

"TMAN 7 is probably the most liquid bond at the moment. Last week it was trading at around the high 89s or very low 90s and is now at a low/mid-90s handle," he says. SCI's PriceABS data confirms this: it shows that the TMAN 7 A tranche was covered on 8 August at 89.95, having previously been covered at 88.27 on 23 July and 86.62 on 29 June.

What selling there has been has largely come from bad banks selling legacy assets, the trader reports. However, he notes that there are fewer of those legacy positions remaining. The main tightening driver has been the Bank of England's funding for lending scheme (SCI 17 July), he argues.

"The real money investors who traditionally stayed in the non-conforming and prime RMBS space are now moving to CMBS as a result of that scheme. It has made people think there will not be as much new issue in UK prime, so there has been a lot of tightening on the back of that," the trader explains.

He continues: "That has also led to UK non-conforming and CMBS tightening. There is really not that much paper paying a decent DM anymore and CMBS looks cheap by comparison. It still feels like spreads can tighten a bit further, so next we will see what happens when everyone comes back in September."

JL

RMBS

Agency, non-agency take turns in spotlight

US RMBS has been prominent on the week's early bid-lists. SCI's PriceABS data shows 119 RMBS line items for Monday, including a good number of non-agency bonds after supply had slowed last week.

Both LMT 2007-5 3A4 and LMT 2007-8 2A1 were covered yesterday - at 94 handle and 80 handle respectively - at the upper-end of the ranges they had been talked at. The likes of AMSI 2004-FR1 M5, ARSI 2003-W8 M1, DBALT 2007-OA4 1A1A, JPALT 2008-R² A1 and SAMI 2006-AR3 12A1 were also being shown. AMSI 2004-FR1 M5 was yesterday variously talked between the mid- and high-teens, having been talked around the low/mid-20s on 26 July.

While last week saw lighter non-agency secondary supply, it was a good week for the agency market, as Babson Capital notes in a client memo. "Buyers outnumbered sellers two to one and included the Fed and money managers. The market continues to believe that a QE3 with agency MBS purchases is a base case, unless the August non-farm payroll report comes out stronger than expected."

The memo adds: "Mid-week there was some profit taking, but overall MBS spreads ended the week tighter. Even if the Fed does not buy MBS, REITS have been raising equity and have about US$25bn to put to work, which will be supportive of the sector. Prepayments were released this past Monday and were largely in line with expectations."

JL

Structured Finance

SCI Start the Week - 13 August

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

Pipeline
A number of US transactions entered the pipeline last week, only to rapidly price. European deals remain thin on the ground.

Pricings
The week's pricings were dominated by CLOs and auto ABS. But two RMBS, a student loan deal and a CMBS printed as well.

Five CLOs hit the market last week: US$362m ACAS CLO 2012-1; US$359m Halcyon Loan Advisors Funding 2012-1; US$362m ING IM CLO 2012-2; US$400m Schackleton CLO; and US$160m TICC CLO 2012-1. The auto ABS prints comprised US$1.274bn Ally Auto Receivables Trust 2012-4, US$175m First Investors Auto Owner Trust 2012-2 and US$1.025bn Santander Drive Auto Receivables Trust 2012-5. In addition, the US$600m North Carolina State Education Assistance Authority Series 2012-1 student loan ABS priced.

The £482m Albion No. 1 and A$300m FirstMac Mortgage Funding Trust Series 1-2012 RMBS rounded out the issuance, along with the US$1.32bn COMM 2012-CCRE2 CMBS.

Markets
US CMBS secondary market activity stayed at the same level as for the last few weeks, report Deutsche Bank analysts. "Spreads ended the week tighter and significantly so for legacy AMs and AJs. The high point of the week was undoubtedly the COMM 2012-CCRE2 transaction, which reset pricing in the new issue market," they note.

Citi securitised products analysts note that US RMBS was quieter. Lower-coupon agency RMBS strongly outperformed treasuries, while dealers were able to place non-agencies with bond prices flat to higher for the week.

Meanwhile, US ABS investors are expected to shift their attention more firmly to the secondary market over the coming weeks, according to strategists at Barclays Capital. "The tone in the secondary market remained firm this week, as investors eagerly scooped up any offerings with a hint of yield. As the new issue market cools over the next few weeks, we expect investors to turn to secondary to source paper. However, given the historical slowdown in activity in late August, volumes are likely to be low," they say.

The US CLO market saw only US$3.6m of triple-As offered on BWICs last week - although about US$50m of mezzanine tranches were out for bid, as well as a lot of equity. Bank of America Merrill Lynch securitised products strategists report that secondary mezzanine spreads tightened by about 10bp for legacy double-As and by about 25bp for triple-Bs and double-Bs.

Finally, the European CLO market tightened quickly early in the month, as SCI reported on Wednesday (SCI 8 August). One trader says that even "average" deals are being covered "very, very tight".

Triple-B tranches are around 1150-1400, which the trader notes is as tight as they have been for almost a year. A bumper BWIC on Thursday saw several names circulated, with SCI's PriceABS data showing strongly elevated supply (SCI 10 August). 

Deal news
• Shanghai Pudong Road & Bridge Construction Co, Ningbo Urban Construction Investment Holding Co and Nanjing Public Holdings (Group) Co have become the first Chinese local government infrastructure firms to issue asset-backed notes (ABNs) under the country's revived pilot securitisation programme.
• The first post-financial crisis non-performing loan CMBS - Rialto 2012-LT1 and S2H 2012-LV1 - have proved popular with investors looking for short duration, high coupon bonds. However, the growth of the sector is expected to be limited by the paucity of distressed assets coming onto the market at present.
• Redefine International has reached an in-principle agreement to restructure and extend the £114.6m Government Income Portfolio loan, securitised in UK CMBS Windermere XI, ahead of its October maturity. The move is viewed as positive, albeit it is likely to result in a principal loss.
• The latest Maiden Lane III sale - which saw US$4.45bn of current face across nine high grade ABS CDOs trade (SCI 1 August) - was met with strong demand from retail accounts looking to add exposure to the sector, especially given the recent rally in non-agency RMBS. AIG has also emerged as a large acquirer of assets from the sales.
• The New York Fed has scheduled two Maiden Lane III auctions for August, comprising 35 ABS CDO tranches. Barclays Capital, Citi, Credit Suisse, Guggenheim Securities, Bank of America Merrill Lynch, Morgan Stanley and RBS have all been invited to bid for the assets.
• The August GNMA issuer report could mark a high watermark for pre-May 2009 prepayment speeds. Several factors indicate that pre-May 2009 speeds should moderate going forward.
• Fitch has downgraded 10 tranches from six Irish RMBS transactions and affirmed a further 29 tranches from nine transactions. The downgrades affect Celtic 11, Emerald 4, Kildare, Pirus and Lansdowne 1 and 2, given that more recent deals benefit from higher levels of credit enhancement.

Regulatory update
• US banking regulators have extended the comment period on three notices of proposed rulemaking on capital rules (SCI 8 June) until 22 October. Comments were originally due by 7 September, but this has been extended to allow for more time to evaluate and prepare comments on the proposals.
• The Federal Housing Finance Agency has sent to the Federal Register a notice indicating its concern with the proposed use of eminent domain to restructure performing home loans and inviting public input. The agency says it has significant concerns about the use of eminent domain to revise existing financial contracts and the alteration of the value of the companies' securities holdings.
• Goldman Sachs has disclosed in its latest 10-Q filing that the SEC has dropped its investigation of the bank's role in selling US$1.3bn of subprime mortgage securities.
• ISDA has published its Recommendation for FpML version 5.3, with the aim of establishing a robust technical framework for global regulatory reporting requirements. The focus in this version is coverage of the CFTC reporting requirements to swap data repositories and for real-time reporting purposes.

Deals added to the SCI database last week:
Civitas 2012-2; Creso 2; Discover Card Execution Note Trust 2012-5 ; Discover Card Execution Note Trust 2012-6 ; Flexi ABS Trust 2012-1; Iowa Student Loan Liquidity Corp series 2012-1; JFIN CLO 2012; Morgan Stanley Capital I Trust 2012-STAR; New York City Tax Lien Trust 2012-A; Nissan Auto Receivables 2012-B; North Texas Higher Education Authority series 2012-1; Ocwen Servicer Advance Receivables Funding Co II series 2012-1; Queen Street VI Re; Symphony CLO X; & Vita Capital V Series 2012-I.

Deals added to the SCI CMBS Loan Events database last week:
BACM 07-2, BSCMS 07-PW16, MSC 07-IQ14 & 07-HQ12, WBCMT 07-C31 & 07-C32 ; BSCMS 2005-PWR10; CD 2006-CD2; CSMC 2006-C4; CSMC 2007-C1; CWCI 2007-3; DECO 2007-C4; DECO 9-E3; ECLIP 2006-1; ECLIP 2006-3; ECLIP 2007-2; EMC 4; EPICP DRUM; EURO 19; EURO 21; EURO 24; FLTST 3; GCCFC 2005-GG3; GCCFC 2007-GG9; GSMS 2005-GG4; GSMS 2006-GG6; INFIN SOPR; JPMCC 2005-LDP4; JPMCC 2006-LDP7; LBUBS 2007-C6; NEMUS 2006-1; PROMI 1; PROMI 2; TAURS 2006-1; TAURS 2007-1; TITN 2007-2; TITN 2007-CT1; WBCMT 2003-C9; WBCMT 2005-C18; WBCMT 2006-C25; WINDM VII; & WINDM XI.

Top stories to come in SCI:
July EMEA CMBS maturity outcomes
CLO documentation

CDO

CDO supply still running high

Yesterday proved to be another busy session for BWICs. Supply has remained elevated across asset classes, with SCI's PriceABS data showing 133 CDO line items on Wednesday and 136 on Thursday.

A few familiar European names were circulated, such as Wood Street CLO II. The WODST II-X D tranche, which was covered at 50 back on 16 May, was yesterday talked variously from the low-50s to 57 and was covered at mid-50s.

LightPoint Pan-European CLO 2007-1, which was attracting interest when it circulated last week, was being shown again yesterday. The LIGHP 2007-1X B tranche was covered at high-70s, while LIGHP 2007-1X C was covered at low/mid-70s, having been talked from 66 to the mid-70s.

S&P's recent ABS CDO criteria update, meanwhile, has also had an impact. Carnuntum High Grade I had its top-rated tranche downgraded from double-A to triple-B plus and yesterday the CARN 2007-1 A3 tranche - which was covered at 18.63 on 31 May - was being talked at between the mid/high-teens and 20.

JL

CMBS

GIP restructuring on the cards

Redefine International has reached an in-principle agreement to restructure and extend the £114.6m Government Income Portfolio (GIP) loan, securitised in UK CMBS Windermere XI, ahead of its October maturity. The move is viewed as positive, albeit it is likely to result in a principal loss.

Key terms of the proposed restructuring include the borrower repaying £33.5m of debt, in return for seven of the 23 properties being released from the portfolio. The repayment is expected to be funded by a £100m capital raise in September.

Under the proposed restructuring, the loan will be extended by 2.5 years to April 2015, in tandem with annual disposal targets. The loan margin will remain unchanged at 0.75% and the loan interest rate will revert to floating after October.

A valuation in May assessed the market value of the 23 UK regional office properties mainly let to the UK government at £82.3m, which is 50% lower than the October 2010 valuation and implies an LTV of 139%, according to CMBS analysts at Barclays Capital. They suggest that if the £33.5m repayment represents the allocated loan amount of the seven properties to be released plus a release premium, the restructuring could be a positive development.

The allocated loan amount of the property that is specifically mentioned to be released (Lyon House) is £12.3m, compared with an updated valuation of £5.8m. Hence, a release of the property by paying the allocated loan amount plus release premium would result in a declining LTV for the whole loan.

In aggregate, the Barcap analysts believe that the potential restructuring could be positive for WINDM XI, given the sharp value decline. However, they remain unconvinced that the sale of the remaining property portfolio will generate the aggregate allocated loan amount. They anticipate a £15m-£20m principal loss, after taking a potential cash sweep of excess rental income into account.

Meanwhile, discussions with the servicer in connection with Windermere VIII - which has a £199.7m GIP exposure - are ongoing. Redefine anticipates that a workable solution will ultimately be negotiated, but this is unlikely to happen before September.

The analysts forecast a £30m ultimate principal loss for the loan securitised in WINDM VIII, taking into account their property value estimate, a potential repayment of the borrower and rental cash sweep post-default.

CS

CMBS

Interest shortfall hits CIB4 X1 note

For what is believed to be the first time in conduit CMBS history, a tranche at the top of the cashflow waterfall has suffered an interest shortfall. The X1 interest-only class in JPMCC 2002-CIB4 was impacted after a loss of 120% on the largest loan in the deal wiped out all available cash.

The loss was triggered after LNR liquidated the Highland Mall in Austin, Texas for US$1.5m in proceeds. The property secured a US$61m loan that had been in special servicing since June 2009 and REO since May 2010.

The sale price not only failed to recoup any principal, but also failed to fully repay US$7.9m in advances due to the servicer, US$2.2m of ASER and liquidation costs, according to CMBS analysts at Barclays Capital. The total loss to the trust was US$73m, with a US$61.3m loss applied to the trust principal, which wrote off the F through to K tranches and 71% of the E tranche. Additionally, as the servicer was not repaid for advances, it recouped all interest and principal payments and no bond in the deal was paid any cash this month.

The servicer is still owed US$6.9m in advances and is expected to use all incoming principal and interest to repay its advances due. This month's scheduled P&I payments only totalled about US$570,000. As such, it is likely to take many months before any cash is received by the outstanding B to E tranches. Interest shortfalls will therefore continue to accrue on all outstanding notes during this time, with losses applied to the bottom of the waterfall.

The mall was originally jointly owned by Rouse (GGP) and Simon, but lost three anchor tenants and was sued for neglect by the fourth anchor. Austin Community College began buying the empty anchor tenant portions of the mall in 2010, which were outside the trust, with the intention of converting them to classrooms. It completed the mall acquisition by acquiring the securitised portion of the collateral this month.

CS

ABS

Asian access

Gregory Park, managing partner at Harvest Northstone Capital, answers SCI's questions

Q: How and when did Harvest Northstone Capital become involved in the Asian structured credit market?
A: Harvest Northstone Capital is a joint venture between Northstone Peak, the fund I established in 2011, and Harvest Alternative Investment Group. Harvest Alternative Investment is a wholly owned subsidiary of Harvest Fund Management Co, the second largest fund house and the largest JV fund house in China. It is minority owned by Deutsche Asset Management (Asia).

Recognising the emergence of credit as a core asset class for its clients seeking stability, Harvest wanted to add an innovative manager with solid experience. Over the past 15 years as head of securitised products Asia for Credit Agricole, Credit Suisse and then Deutsche Bank, I was fortunate to have arranged several pioneering ABS deals in the region. I was excited to contribute my experience to the Harvest platform and in 2012 Harvest Northstone Capital was established.

Over various cycles in Asia, all of my structured credit transactions performed as expected. For example, the US$144.36m KDBC Leasing Receivables Corp 1 and €605m Korea First Mortgage No. 3 transactions from 2000 and 2004 respectively all paid off in full. The €292.8m Hsinchu International Mortgage Loan 2 deal from 2006, meanwhile, remains outstanding but performing.

Our partnership with Harvest creates synergy because the joint platform combines the relationship, compliance and legal oversight that we need as a going concern with the intellectual property the management team offers. Harvest Northstone Capital has the ambition to be a premier Asian credit player offering a high quality product to a global client base.

Q: How do you differentiate yourself from your competitors?
A: Harvest Northstone Capital is the only dedicated Asia-focused structured credit fund. Our vision is to source and structure unique, high quality Asian assets into instruments that can provide stable cashflow-generative returns for the decades to come.

Our aim is to capture the opportunity that arises from the growing imbalance between the demand from Asian SMEs, corporates and consumers for funding and the shrinking supply of credit available from banks due to capital constraints. This dislocation creates a credit vacuum and offers unique investment opportunities in a number of jurisdictions and asset classes.

There has been somewhat of a lag-effect in the region. While investors understand that Asia is the fastest growing region in the world, there has been a lack of available products for investors to evaluate.

Q: What are your key areas of focus today?
A: As yields continue to compress, there is an opportunity to fill a void where well-structured and high quality investments are in demand. There is an abundance of cash-flowing assets in Asia and a growing, highly consumptive middle class.

We are evaluating hundreds of clients throughout the region to find the best asset pools - that is our focus every day. We dive into multiple jurisdictions, cultures and languages - these are high barriers to entry that benefit our Asian platform.

Q: What is your strategy going forward?
A: We're currently marketing our Asia Investment Grade Credit Opportunity Fund I, which will invest in a diverse portfolio of privately-negotiated US dollar-denominated high grade (triple-B or above ratings) structured debt financings in Asia, as well as handling specific separate managed account mandates.

Q: What major development do you expect from the market in the future?
A: I believe alternative investments and shadow banking will become more commonplace as funds replace banks as traditional lenders. At the same time, there will be increasing demand for high quality, transparent and stable investments. Looking ahead, we hope to take advantage of the uncertainty in the global markets by promoting our expertise in the Asian structured credit markets.

CS

Structured Finance

TCW buyout agreed

The Carlyle Group and the management of The TCW Group have agreed to acquire TCW from Société Générale. Equity for the investment will come from two Carlyle investment funds - Carlyle Global Financial Services Partners and Carlyle Partners V - and from TCW management.

David Lippman, previously group md and head of fixed income at TCW, becomes president and ceo of The TCW Group. He succeeds Marc Stern, who will become chairman of the new management board.

The transaction will increase TCW management and employee ownership in the firm to around 40% on a fully diluted basis. The transaction is expected to close early next year.

Structured Finance

Bank boosts credit team

James Dougal and Zaman Khan are joining HSBC's European credit trading team in London. Dougal takes up a post as senior corporate credit trader while Khan becomes head of financials special situations.

Dougal was most recently at RBS. He will mainly focus on trading investment-grade and crossover in both corporate bonds and CDS, reporting to Claus Jorgensen.

Khan was most recently at Abaci Investment Management. His focus will be on special situations in the financial capital structure space and he will report to Mark Wade.

Structured Finance

SEC's ABCP charge settled

The SEC has charged Wells Fargo's brokerage firm and a former vp for selling ABCP structured with high-risk RMBS and CDOs without fully understanding their complexity or disclosing the risks to investors. Wells Fargo has agreed to pay more than US$6.5m to settle the charges.

Wells Fargo sold the ABCP to municipalities, non-profit institutions and other customers without getting sufficient information about the investment vehicles, instead relying almost exclusively on credit ratings, says the SEC. The firm is accused of having "abdicated its fundamental responsibility as a broker" in failing to fully understand the products it was recommending.

The improper sales occurred between January 2007 and August 2007. Shawn McMurtry has been charged along with Wells Fargo as he exercised discretionary authority in violation of the firm's internal policy and selected the particular issuer of ABCP for one long-standing municipal customer.

Wells Fargo and McMurtry consented to the SEC's order without admitting or denying the findings. Wells Fargo agreed to pay a US$6.5m penalty, US$65,000 in disgorgement and US$16,572 in prejudgement interest. McMurtry will pay a US$25,000 penalty and be suspended from the securities industry for six months.

CDO

SEC CDO dispute continues

Appointed counsel for the US District Court for the Southern District of New York has filed a brief in support of US District Judge Jed Rakoff's decision to reject a proposed US$285m settlement between the SEC and Citi. The dispute concerns SEC allegations that Citi sold the US$1bn Class V Funding III CDO without disclosing that the bank bet against US$500m of the assets in the deal (SCI 20 October 2011).

Judge Rakoff rejected the parties' proposed settlement in November 2011 on the basis that the settlement was not in the public's interest, particularly because the SEC permitted Citi to neither admit nor deny wrongdoing as part of the settlement. The SEC appealed this decision to the Second Circuit, which - in a subsequent proceeding - stated that it is not the proper function of federal courts to dictate policy to executive administrative agencies and found that Judge Rakoff did not give proper deference to the SEC's judgment on discretionary matters of policy.

A recent Lowenstein Sandler client memo notes that appointed counsel for the district court argued in its appellate brief that Judge Rakoff had a responsibility to make an independent assessment of the fairness and reasonableness of the settlement, and that the SEC and Citi did not provide the district court with enough evidence for the court to make its assessment. According to the brief, Judge Rakoff's rejection of the settlement expressed an "inability to apply the basic standard of review to the matter before it, given the total absence of any evidence on which a ruling could be based".

The brief further stated that, following the conclusion of the trial of Citi's Brian Stoker (at which he was cleared of wrongdoing in connection with Class V Funding III), the district court now has a substantial evidentiary record upon which to assess the settlement.

In other RMBS-related litigation news, the FDIC has filed five lawsuits in Alabama, New York and California, seeking US$741m in damages in connection with the sale of RMBS to Colonial Bank. The complaints allege that offering documents for the deals contained material misrepresentations regarding LTV ratios, owner occupancy rates, compliance with appraisal standards and loan issuance practices. The named defendants include Bank of America, Barclays, Citi, Credit Suisse, Deutsche Bank, HSBC, JPMorgan, Morgan Stanley, RBS, UBS and Wells Fargo.

CMBS

CRE lawyer snapped up

Mark Foster has joined Sabal Financial Group as general counsel. He will be responsible for all legal and regulatory aspects of Sabal's business operations, focusing on issues surrounding real estate transactions and distressed loans.

Foster has broad CMBS and CRE experience, including involvement in acquisitions, dispositions, leasing, entitlements, real estate licensing and title insurance issues. He was most recently vp and senior counsel at The Rockefeller Group and has also worked at Toll Brothers and Allen Matkins Leck Gamble and Mallory.

ABS

Chinese trio hit the market

Shanghai Pudong Road & Bridge Construction Co, Ningbo Urban Construction Investment Holding Co and Nanjing Public Holdings (Group) Co have become the first Chinese local government infrastructure firms to issue asset-backed notes (ABNs) under the country's revived pilot securitisation programme (SCI 12 June). The move follows the release of new guidance by the National Association of Financial Market Institutional Investors on 3 August that allows non-financial institutions to issue ABNs.

The three firms will offer up to RMB2.5bn in ABN with maturities from one to five years in private placements, with 4.88%-5.85% interest rates that are lower than benchmark loan rates, according to Moody's latest Credit Outlook publication. The agency believes that ABN issuance will provide an additional funding channel for corporations with lower credit ratings but with assets that have strong cashflows.

The ABN guidance states that underlying collateral can be assets with predictable cashflows, property rights or a mix of both. Moody's suggests that assets in transportation and logistics, power generation and supply and public utilities, and infrastructure projects are most likely to back ABN issuance owing to their relatively predictable cashflows - at least in the beginning phase of this market development.

ABS

Consolidation loans criticised

Consolidation loans are credit negative for private student loan securitisations, Moody's notes in its latest Credit Outlook publication. Because prepayments by high-quality borrowers will increase, the amount of excess spread available to cover loan losses of poorer-quality borrowers will decrease, the agency suggests.

SunTrust Bank has this month begun rolling out a loan product that consolidates a borrower's private student loans. Wells Fargo and numerous credit unions have also started offering private consolidation loans.

If new consolidation loan offers draw high-quality borrowers out of existing private student loan securitisations, their loans will no longer produce excess spread to cover loan losses of poorer quality borrowers. Moody's expects securitisations that contain loans originated during the credit crisis to suffer the most because of the high interest rates lenders assigned to loans during that period.

For example, borrowers of loans from that period - which constitute most of the loans in Sallie Mae's 2009-2012 securitisations - are currently paying variable interest rates at an average of 6%-8% compared with 4%-6% for borrowers of loans in Sallie Mae's 2002-2007 securitisations. SunTrust is offering loans with variable interest rates of 4%-8%. The magnitude of loan consolidation will be highly dependent on how tight SunTrust's underwriting is for the more attractively priced loans, Moody's notes.

Consolidation lenders are anticipated to seek borrowers with good payment behaviour, employment and low debt-to-income ratios. And because consolidation loan lenders will target lower-risk borrowers, these lenders can offer lower rates than borrowers are currently paying.

Of the high-quality borrowers, lenders are expected to target those with high interest rate loans because of the borrower's strong incentive to refinance. With lenders offering fixed-rate consolidation loans in addition to variable-rate loans, borrowers who want to protect themselves against rising interest rates will likely want to consolidate their variable-rate loans to fixed-rate.

Excess spread is a large component of credit enhancement for private loan securitisations, typically constituting 15%-60% of the total credit enhancement for A to Aaa rated senior bonds in the ABS that the agency rates. The average annual excess spread per year expected for Sallie Mae and First Marblehead private loan securitisations ranges between 1.5%-6%.

Structured Finance

Capital rule comment period extended

US banking regulators have extended the comment period on three notices of proposed rulemaking on capital rules (SCI 8 June) until 22 October. Comments were originally due by 7 September, but this has been extended to allow for more time to evaluate and prepare comments on the proposals.

One NPR - the Basel 3 regulatory capital reforms - would strengthen minimum requirements for the level and quality of financial institutions' capital. The second proposes changes to the agencies' advanced approaches capital regulation to reflect other aspects of Basel 3 and would apply the agencies' market risk capital regulations to thrift institutions. A third NPR - the standardised approach - proposes changes to the calculation of risk-weighted assets that address issues identified in the financial crisis and removes reliance on credit ratings consistent with the Dodd-Frank Act.

Structured Finance

Counterparty linkage analysed

Moody's has disclosed that during the last quarter it downgraded most of the 114 European banks and 17 securities firms with global capital markets operations that it placed on review in February. Many of these entities were downgraded below the P-1 short-term rating level, which is a common rating trigger in structured finance transactions.

The agency has subsequently identified 420 RMBS and 235 ABS where one of the three most significant rating triggers - in other words, if it reduces the linkage to a counterparty performing a vital role in a given transaction - have been breached following the recent bank downgrades. Of these transactions, 358 have ratings on review that could result in a downgrade if remedies to increase counterparty linkage are not put in place.

Most triggers breaches occurred in transactions exposed to banks downgraded below P-1. Issuer account bank and swap first-level triggers have been hit in 383 RMBS and 190 ABS transactions respectively.

The majority of RMBS transactions reporting trigger breaches are domiciled in Spain (181), with a significant number of deals also affected in Italy (63), the UK (69) and the Netherlands (49). The geographic distribution for ABS transactions is similar, with transactions reporting trigger breaches mostly concentrated in Spain (129) and Italy (46).

Structured Finance

Korean SF set for mild rise in delinquencies

High household debt will contribute to a rise in delinquencies and defaults among South Korean securitisation transactions, but the increase will be mild and remain within expectations, according to Fitch. This is reflected in the agency's stable outlook for the ratings performance of Korean structured finance (SF) deals in 2012.

Unemployment rates and interest rates remain the key drivers of Korean SF performance, and both have been benign. Unemployment was just 3.2% at end-1Q12 and the benchmark rate was reduced to 3% in July. This has offset persistently high household debt and kept debt-servicing burdens manageable so far, Fitch notes.

However, a dip in house prices and slowing growth in household disposable incomes suggest that payment ability for highly indebted households may fall. The agency therefore expects increasing pressure on all asset types, causing delinquency and default rates to pick up. Borrowers' tendency to default on unsecured rather than secured debt means that performance pressure is likely to be felt more keenly in credit card ABS than RMBS.

This should not have ratings implications, however. Default rates among Fitch-rated RMBS have never been above 0.6%, while delinquency ratios have not exceeded 0.6% in any credit card ABS deals since closing. For auto loan ABS, the figure is 0.05%.

The main reason for this strong performance has been the country's economic resilience. In addition, SF deals benefit from transaction-specific eligibility criteria and performance triggers. Structural features and healthy payment rates also support Korean deals.

Nevertheless, Fitch believes that high household debt in the country could amplify the negative impact of any sharp increase in unemployment and/or interest rates, and result in future performance under stressed conditions being worse than the historical data may indicate. While a near-term sharp increase in Korean unemployment or interest rates is not the agency's base case, the resultant volatility associated with any such movements is embedded in its investment grade ratings.

CDO

PF CDO criteria replaced

Fitch has withdrawn its global rating criteria for project finance (PF) CDOs, to be replaced by its corporate CDO criteria with certain sector-specific amendments.

The agency will model portfolio performance using the portfolio credit model (PCM) as described in the corporate criteria, but apply specifically calibrated correlation assumptions. It defines five main sectors for project finance: public-private partnerships (PPP)/public finance initiative (PFI); regulated utilities; power; energy; and transport (non-PPP/PFI).

Within these main sectors, Fitch defines between two to eight sub-sectors. Correlation levels are differentiated based on the sub-sector and country of the individual projects.

Generally, pair-wise correlation levels are higher for projects in the same sub-sector and/or same country. Higher correlation reflects the potentially higher volatility of portfolio default rates. Depending on the sector, the pair-wise correlation between two projects within the same sector and country ranges between 7% and 30%.

The credit quality of each loan in terms of default probability and recovery prospects will be based on individual credit opinions and recovery estimates provided by the agency's global infrastructure team. These credit opinions and recovery estimates take into account whether projects are in their construction, operation or wind-down phase. Generally, construction and wind-down are considered to represent greater risks, Fitch notes.

The obligor correlation stress described in the corporate criteria, which aims to ensure a minimum coverage of the largest obligors, is not be applied to PF portfolios because the correlation for PF portfolios is higher compared to corporates and thus provides sufficient coverage without additional stress.

CDO

ML3 auctions announced

The New York Fed has scheduled two Maiden Lane III auctions for August, comprising 35 ABS CDO tranches.

The first sale - due on 16 August - will include CAMBER 3 (US$219.3m face value), Coolidge Funding (US$140.17m), Duke Funding VI (US$87.88m), VII (US$276.99m) and VIII (US$479.57m), Fortius I Funding (US$277.41m), Glacier Funding CDO II (US$70.71m) and III (US$170.05m), Huntington CDO (US$165.64m), Palisades CDO (US$107.14m), South Coast Funding V (US$64.89m), VII (US$312.51m) and VIII (US$229.35m), and Whately CDO I (US$105.95m) assets.

The second sale - due on 23 August - consists of Ayresome CDO I (US$48.17m), Bluegrass ABS CDO II (US$92.5m), Diogenes CDO I (US$168.39m), Dunhill ABS CDO (US$91.38m), Gemstone CDO III (US$68.2m) and IV (US$229.98m), Ischus CDO II (US$171.15m), Independence VI CDO (US$338.68m), Lexington Capital Funding (US$122.45m), MKP CBO IV (US$78.92m) and V (US$369.64m), Montauk Point CDO (US$222.63m), Neptune CDO 2004-1 (US$154.18m), Neptune CDO II (US$132.75m), Pine Mountain CDO (US$154.92m), River North CDO (US$82.09m), Sherwood Funding CDO (US$204.5m) and II (US$275.61m), Straits Global ABS CDO I (US$30.37m), TABS 2005-4 (US$200.7m) and Vertical ABS CDO 2005-1 (US$192.52m) collateral.

Barclays Capital, Citi, Credit Suisse, Guggenheim Securities, Bank of America Merrill Lynch, Morgan Stanley and RBS have all been invited to bid for the assets.

CDS

Dodd-Frank Protocol launched

ISDA launched the August 2012 Dodd-Frank Protocol, which is designed to allow swap market participants to simultaneously amend multiple ISDA master agreements for the purpose of facilitating compliance with Dodd-Frank regulatory requirements. The protocol consists of a series of amendments to existing documentation, as well as standardised questionnaires that must be completed by counterparties to satisfy new regulations.

These questionnaires must be delivered to each relevant counterparty for the amendments and compliance to be effective. To facilitate these bilateral delivery requirements, ISDA and Markit launched ISDA Amend, a solution that automates the information-gathering process and provides sharing of submitted data and documents to permissioned counterparties.

"The Dodd-Frank rulemakings impose new obligations in a range of areas focused on enhancing customer protection," comments Robert Pickel, ISDA ceo. "The ISDA August 2012 Dodd-Frank Protocol provides an industry standard roadmap for updating swap documentation to comply with these regulatory requirements. ISDA Amend helps make the Protocol process more efficient."

ISDA envisions the possibility for multiple protocols to the extent future final rules may require documentation amendments. The association says it will work with its members to develop a coordinated and efficient process to amend documentation in a timely manner. It also expects to conduct similar reviews for documentation changes mandated by legislative developments in other countries and regions as these develop.

The protocol will be open until ISDA designates a closing date.

CMBS

Call for operating advisor standardisation

Two key issues must be resolved if the role of CMBS operating advisor is to flourish and fulfil its intended purpose of attracting a wider range of investors to the sector, according to Morningstar. These are: how operating advisors are compensated; and how their duties are defined.

Morningstar research has uncovered a range of operating advisor fees, varying from a low of 25bp to a high of 40bp on the original transaction balance. The average fee in recently closed transactions amounts to about US$15,000 per annum because most transactions are less than US$1bn.

These fees may appear adequate in the early stages of a transaction, where performance is strong and delinquencies are relatively low. However, the economic feasibility of this model begins to falter as transactions season and delinquencies begin to rise, Morningstar warns.

Experienced asset managers command higher overhead costs than other mortgage-related employees and, as demand on their time for advisory services escalates with rising defaults, the business may soon find its costs outstripping its income. This, in turn, could lead not only to a failure of the advisor to effectively perform its duties but also result in there being no willing successor to assume the advisor role given the economics involved.

The rating agency suggests that one way to ameliorate this problem would be to establish a lower stand-by fee paid annually to the trust advisor during the early stages of a transaction. Then, as delinquencies begin to mount and a control termination event occurs, a per-loan fee could be paid to the advisor for the review and analysis done on workouts and dispositions.

Meanwhile, another concern lies in the lack of standardisation in what is required of a trust advisor from one transaction to another. It appears that while transaction documents indicate that borrowers are expected to pay for trust advisor reviews, there are no mechanisms in place to enforce payment, other than the incentive a borrower has to close an assumption or other request type if the operating advisor's lack of consent could prevent the request from closing. In addition, the advisor's duties should generally be similar in all transactions, thus providing some predictability for market participants wishing to fill this role.

A number of real estate asset managers are said to be considering entering the CMBS trust advisory space. Morningstar says all of them have communicated that the biggest challenge they face in undertaking this initiative is projecting and justifying the initial costs involved in ramping up technology, personnel and infrastructure for this business given the low fee structure and potential volatility of future transaction performance.

"Yet we believe it is healthy for the industry as a whole to have a large number of competent participants vying for this work," the agency adds. "Unfortunately, as volume amasses in a relatively small number of early entrants, it becomes increasingly difficult for new players to overcome ever higher barriers to entry. This, in turn, will lead to fewer choices for investors and a narrower field in which to benchmark advisor performance."

Pentalpha captured the leading operating advisor market share in 2011, according to Morningstar, with approximately 41% of the market by deal count. Trimont followed, with roughly 36% market share. Pacific Life came next, with 18% market share, followed by Blackrock with approximately 5% market share.

Pentalpha once again leads the pack thus far this year, with a 40% market share by deal count, followed by Trimont and Park Bridge with 20% each. The number of entrants operating as trust advisors has increased from four firms last year to five, as of August 2012.

CMBS

GSI loan restructured

Berwin Leighton Paisner (BLP) has disclosed that it advised Hatfield Philips International on the restructuring of the German State Income (GSI) loan securitised in the Windermere XIV CMBS (see SCI's CMBS loan events database). The restructuring involved the sale of the Justizzentrum in Halle (Saale), Germany.

Specifically, Ebertz & Partner (E&P) acquired 93.86% of the Wichford Group's interest in the property under the restructuring. The Wichford Group had taken over this share in 2007 from the fund E&P Sachwert Fonds 072, which initially bought the building newly-built in 1998.

Together with the entire share capital of the general partner of the GSI borrower being transferred to E&P Fondsverwaltungen, the security over the majority interest in the GSI borrower, the accounts of the GSI borrower and the shares in the general partner were replaced to reflect the new ownership structure. The managing agent of the property was also replaced with CmDE Centermanager und Immobilien.

In addition, a €250,000 holdback amount was applied in repayment of the GSI loan at the July interest payment date. Also commencing from last month, the loan will be repaid by €164,286 on each IPD, with the final repayment instalment due on the January 2014 IPD.

In connection with this complex restructuring of the borrower group, BLP advised Hatfield Philips on amending the loan and security documentation, as well as on tax law-related issues. London-based partner Eleanor Hunwicks and Frankfurt-based partner Thomas Prüm led the mandate. Hunwicks was supported by associate Simon Reynolds, while Prüm was supported by partner Fabian Hartwich and associate Philipp Johannes Schäfer.

CMBS

EMEA CMBS resilience underlined

Fitch reports that a severe ratings stress test of EMEA CMBS underlines the considerable resilience of triple-A rated tranches in the face of a funding shock. The stress involves sharply higher inter-bank interest rates and property yields, two variables that closely chart funding conditions.

In Fitch's analysis, rates are assumed to rise by 4% while yield would increase by over 5%, causing significant downgrades of triple-A tranches but few losses, with only 3% defaulting. The severe scenario is defined by the degree of stress required to move the majority of the agency's triple-A rated tranches to below investment grade.

The scale of the stress needed to achieve this - especially in light of the remaining life of most EMEA CMBS - suggests that this outcome is remote, according to Fitch. It would take a marked deterioration in financial market confidence and bank credit quality to increase inter-bank rates by 4% without any relief from recession conditions. The agency would expect property investors to treat such a harsh funding shock as a game-changer, however, driving commercial property values through an unprecedented peak-to-trough decline.

Fitch also subjected its ratings to a moderate stress scenario, reflecting a more modest escalation in the current financial crises. The hypothesised scenario contemplates a partial withdrawal of banks from wholesale funding markets upon fears of counterparty risk.

Inter-bank rates rise by 2%, while only a limited and temporary response is observed in the property markets. The consensus view that central banks would aggressively prioritise financial stability limits the increase in property yields to 0.25% in this scenario.

The moderate stress was calibrated for the level required before the majority of triple-B rated CMBS are downgraded. Fitch notes that only 2% would go all the way to distressed levels under these conditions.

CMBS

US CRE prices inch up

US commercial real estate prices, as measured by Moody's/RCA Commercial Property Price Indices (CPPI) national all-property composite index, were up by 0.5% in June. Core commercial property prices increased by 1%, while apartment prices dropped by 0.7%.

The strong apartment price appreciation that led the recovery has stalled, says Moody's, with apartment prices down 0.8% over the last three months. Among the different property sectors measured by the CPPI, the central business district (CBD) office sector has had the largest gain over the last three months, at 3.5%.

"Acquisition demand for CBD office remains strong among institutional investors, particularly in gateway cities," says Tad Philipp, Moody's director of commercial real estate research.

The suburban office sector, however, has posted the smallest gains. Suburban office prices have increased by 0.3% over the last three months and 3.2% over the last 12 months.

The national composite index has now regained slightly less than half of what it lost between the market peak in December 2007 and the trough in January 2010. But Moody's notes that the pace of recovery for non-major markets continues to lag that for major markets. Non-major markets have recovered 31% of their peak-to-trough loss, while major markets have recovered 64.8% of their loss.

"Although major markets have recovered more since the trough, non-major markets have seen greater price appreciation over the last month, three-month and 12-month periods as investors continue to look beyond gateway markets in their quest for higher yields," says Philipp.

CMBS

Pecanland Mall on watchlist

Morningstar has added the US$51.6m Pecanland Mall, securitised in the CGCMT 2004-C1 CMBS, to its watchlist for a decline in occupancy.

For the 12-month period ended 31 December 2011, the net cashflow DSCR was 1.90x, with NCF of US$7.3m. Occupancy was reported at 87%.

The NCF DSCR and NCF for the 12-months ended 31 December 2010 were 1.84x and US$7.1m respectively. Occupancy was reported at 77%.

Occupancy in the first quarter of 2012 was again reported low at 75%, which triggered the inclusion of this loan on Morningstar's watchlist. A December 2011 rent roll review also found that leases for roughly 17% of the net rentable area (NRA) are scheduled to expire throughout 2012. Leases for an additional 11% of the NRA will mature throughout 2013.

General Growth Properties (GGP) sponsors the debt. The loan will begin amortising according to a 25-year schedule in January 2013, which could negatively impact the NCF DSCR if net cashflow does not increase.

Despite the decline in occupancy and expected increase in annual debt service in January 2013 based on the new amortisation schedule, Morningstar consider this to be a low near-term default risk. Its analysis of the collateral suggests a value of about US$81.3m (US$233/sf), yielding a 63% LTV.

CMBS

CMBS late-pays fall again

Increased loan workouts have led to a second consecutive month of decline in US CMBS delinquencies, according to Fitch's latest index results for the sector. CMBS late-pays fell by 14bp last month to 8.48% from 8.62% in June.

Helping to drive the downward movement were two large loan modifications, involving the US$305m Schron Industrial Portfolio (securitised in GCCFC 2007-GG9) and the US$210m Savoy Park (CSMC 2007-C1). Both loans were bifurcated into A and B notes (see SCI's loan events database).

One large multifamily portfolio joined the delinquency ranks in July. The US$297m Bethany Maryland Portfolio (LB-UBS 2007-C1) became newly delinquent during the month. The loan was modified in 1Q10, but subsequently transferred to special servicing in February 2011 for imminent default.

Loan resolutions outnumbered new delinquencies for most of the property types in July. The modification of the Schron Industrial Portfolio loan and the resolution of nine other industrial loans totalling US$47m led to a 125bp improvement in the industrial delinquency rate. The multifamily rate improved by 75bp with the modification of the Savoy Park loan and the resolution of 75 other multifamily loans totalling US$335m.

Although the office sector is expected to continue to face stress, its delinquency rate improved by 15bp as a result of 42 office loans totalling US$512m returning to performing status. This compares to 23 office loans totalling US$372m becoming newly delinquent.

Similarly, the retail rate improved by 27bp, driven by 51 retail loans totalling US$404m returning to performing status. This compares with the 31 retail loans totalling US$258m that became newly delinquent during the month.

Conversely, the hotel rate dropped by 24bp, with 11 new loans totalling US$280m becoming newly delinquent. This compares to only 10 hotel loans totalling US$123m being resolved this month. Contributing to the rise in delinquencies was the US$78m JW Marriott located in Tucson, AZ (CSMC 2006-TFL2), which is the second largest loan addition to the index this month.

Current and prior-month delinquency rates for each of the major property types are: 10.89% for multifamily (from 11.64% in June); 11.46% for hotel (from 11.22%); 8.68% for industrial (from 9.93%); 8.43% for office (from 8.58%); 7.40% for retail (from 7.67%).

Risk Management

Collateral optimisation reviewed

An estimated 40%-50% of OTC contracts are expected to be cleared by the end of 2013, leaving a US$2.5trn collateral hole to fill (SCI 26 September 2011). This will drive firms to optimise their internal inventory while simultaneously engaging with collateral transformation services, according to a new Celent report.

Many organisations - including custodians, dealers and settlement houses - are looking to offer collateral transformation or collateral upgrade services to their clients. However, these external service providers will have to ensure they are optimising their assets against their own requirements, as well as having the infrastructure in place to support optimisation services offerings via client clearing services.

Indeed, current-generation approaches to collateral optimisation and hard-wired optimisation algorithms will no longer suffice. When done correctly, firms can optimise collateral across often-siloed front office units, Celent suggests.

It says that the two main collateral management issues firms face today are collateral allocation and collateral optimisation. Firms have collateral held in different offices, through various instruments, by different people with divergent agendas.

This process can be overcome by collateral allocation, which is achieved by taking an inventory of all collateral the firm has in place and integrating it with an enterprise infrastructure across the front, middle and back office. The more challenging issue that firms face is internally planning the best value decision process for the collateral.

Celent describes strategic collateral optimisation as internally planning the best value decision process for the collateral pledged and held. This can be done through credit support annex renegotiation, improvements in inventory management to identify the cheapest-to-deliver assets or much more refined initiatives where firms have clearly identified an opportunity in which strategic margin management can contribute to the front office's P&L.

Risk Management

Clearing connectivity standard launched

Sapient Global Markets has unveiled a new industry standard for cleared OTC derivatives-related activity reporting for asset managers, futures commission merchants (FCMs) and custodians. The Clearing Connectivity Standard (CCS) is a standardised connectivity format that can be used by the FCM community to transmit OTC clearing-related information on behalf of their asset manager clients to custodians.

As industry regulatory reform emerges, both the volume of cleared derivative trades and the number of relationships between market participants is growing. The absence of a formal standard for formatting or transmitting data between entities can create delayed on-boarding and increased operational risk, as well as cost of interface development and maintenance with each custodian.

Sapient Global Markets collaborated with most of the leading FCMs and custodians to develop the CCS, which has been adopted by the original project group of participants representing more than 12 firms and hundreds of end-users in the buy-side community. Overcoming the challenges faced by reading, interpreting and managing files sent in different file formats, the CCS is designed to simplify integration with data systems and automate reconciliation in order to make clearing and communications more concise and efficient.

It provides standardised connectivity and reporting initially for central counterparty-eligible interest rate and credit default swap products in the US through LCH.Clearnet SwapClear and the CME Group. There are plans to expand the service to include additional products, participants and geographies over the next year and beyond.

Future enhancements are expected to include a conversion of the standard to FpML on a real-time basis under the guidance of FpML Working Groups.

RMBS

Wide-scale PIA take-up unlikely

The publication of the Irish Personal Insolvency Bill in late June has clarified certain operational elements of the Personal Insolvency Arrangement (PIA) process, which is expected to be implemented towards end-2012 (SCI passim), according to Fitch. The agency says it has gauged views from Irish banks on the impact the legislation would have on their mortgage portfolios and it believes that PIAs would not be an appropriate solution until existing forbearance measures that banks currently employ are exhausted.

For this reason and also due to the ability for banks to vote against proposed PIAs if they view them to be an inappropriate solution, Fitch does not expect a wide-scale take-up of PIAs for delinquent borrowers. Further, the PIA process will not be an easy way out for borrowers, which should limit the scope for borrowers to use PIAs strategically.

A PIA application is only open to distressed borrowers, who can demonstrate that they are insolvent and that their position is unlikely to improve over the next five years. The PIA will be continually monitored and borrowers must periodically provide updated financial statements and abide by the terms of the PIA. If a borrower was to fail in their PIA commitment, the arrangement could be terminated, leaving the borrower liable for all debts covered under it.

The PIA can be varied, should the borrower's circumstances change during the period of the arrangement. Furthermore, lenders would have powers to 'claw back' additional amounts from a borrower if they sold the secured property and achieved a sale price that exceeded any write-down value.

Fitch does not expect the recent bill to have an immediate impact on Irish RMBS ratings. The bill states that any debt write-down proposed under a PIA would not be lower than the market value of property. Therefore, the agency anticipates the loss suffered in a debt write-down to be lower than if a lender repossessed a property, as lenders would not need to provide for any legal or property sale costs that are necessary to execute a repossession order.

PIAs may result in increased defaults. However, Fitch already assumes that more than 20% of mortgages will default for standard RMBS portfolios, reflecting the collapse in property prices and macroeconomic stress. In addition, the borrowers likely to be eligible for PIAs will already be in arrears, so a high probability of default is already assumed for their loans.

But risks still remain in connection with the implementation of PIAs, the agency warns. There are risks that some borrowers may be unwilling - rather than unable - to meet mortgage payments, in the hope of achieving partial debt forgiveness. Uncertainty also remains on how Personal Insolvency Practitioners and lenders will agree on the value of the property securing the mortgage debt and how mortgage affordability is assessed.

RMBS

Countrywide schedule agreed

An agreed schedule for the US$8.5bn Countrywide RMBS case has been released. The final hearing is set for 2 May 2013, with fact discovery and depositions to begin on 14 December.

The schedule has increased the certainty on timing somewhat, according to MBS analysts at Barclays Capital, who believe that the cash will most likely be paid out in late 3Q or 4Q13. However, they point out that at least three issues could delay this.

First, AIG or other intervenors could file an appeal, which could delay the process by another year or more. Second, the New York and Delaware Attorneys General strategy remains unclear, although they appear to have been quieter in recent months.

Finally, the settlement requires Internal Revenue Service and New York/California state tax authority approvals before the cash can be paid out, which are to be requested within 30 days of signing the settlement. After all these approvals have been received, Bank of America has a further 120 days to disburse the cash.

RMBS

ResiEMEA tool extended

Fitch has extended its European residential mortgage risk analysis tool, ResiEMEA, to cover Germany.

ResiEMEA is an analytical model that assesses the credit risks of loan-by-loan residential mortgage portfolios in accordance with Fitch's published RMBS criteria. The tool will be used to determine weighted average expected default probability, loss severity and recovery at various rating categories during the agency's rating analysis for German RMBS and covered bond transactions. The outputs from the model are used as inputs for RMBS cashflow modelling.

The flexible interface allows users to adjust the agency's criteria assumptions and stress the loan, borrower and property-specific factors that most influence default probability and loss severity. Investors will also be able to input post-closing pool-cuts into ResiEMEA for surveillance purposes.

RMBS

GNMA prepays to moderate?

The August GNMA issuer report could mark a high watermark for pre-May 2009 prepayment speeds, according to MBS analysts at Barclays Capital. They point to several factors indicating that pre-May 2009 speeds should moderate going forward.

Over the past two months, pre-May 2009 GNSF voluntary speeds increased by 34/18/9/5/2 CRR to 51/34/26/19/13 CRR for 4.5-6.5 coupons respectively. But the Barcap analysts suggest that VA speeds provide one benchmark as to where pre-May 2009 FHA speeds could settle going forward. Relative to VA, FHA loans are of worse credit quality and have experienced significant tightening in underwriting.

The August report shows that, for certain cohorts, FHA pre-May 2009 speeds are paying faster than their VA counterparts. In particular, GNMA 4.5 FHA speeds are 10 CPR faster than VA.

"This differential is unsustainable and we would expect those speeds to moderate closer to VA levels in the coming months," the analysts explain.

Meanwhile, Bank of America Merrill Lynch focused its buyout activity on GNMA 5/5.5s in the August report. By dollar volume, it bought back US$260m in GNSF collateral (US$175m in 5.5s and US$70m in 5s).

"At this rate, it should take four to six months to clean up the GNSF 5.5 coupon. Its total delinquency pipeline remains elevated, at 4.72% by loan count. As a result, we believe Bank of America will need to increase its rate of buyouts soon to remain under the 5% delinquency cap," the analysts note.

RMBS

RMBS criteria update hits

Fitch has updated its criteria for estimating losses on US mortgage pools for RMBS transactions, as part of its annual criteria review. Less than 10% of all ratings are expected to be affected by the model enhancements, with the impact varying by sector and vintage.

The core principle of the framework remains the interaction between borrower equity and market value declines in determining expected loss for each loan. In addition, the methodology accounts for both loan-level attributes and macroeconomic factors in deriving loss expectations.

Fitch's criteria report includes several enhancements from the previous version. While the basic framework remains unchanged, the model has been expanded to analyse Alt-A and subprime collateral.

In addition, the agency's sustainable home price (SHP) model has been enhanced to provide home price forecasts at a more granular level. The SHP model now produces forecasts for several hundred metropolitan statistical areas (MSA) in addition to state-level forecasts.

Fitch has also made several enhancements to its loss severity assumptions to better reflect empirical data.

REREMICs issued in 2009 or earlier and collateralised with 2005-2007 vintage Alt-A RMBS will likely be affected by the new model's more severe treatment of underwater borrowers and more conservative rating stress scenarios. Additionally, although prime mortgage loss projections are not expected to change materially, the ratings on prime classes issued prior to 2005 are expected to be more sensitive to the model changes due to the higher number of remaining investment grade ratings and the lower credit enhancement levels.

Ratings expected to be affected by the model revisions will be identified and placed on watch in the coming weeks.

RMBS

Legacy RMBS criteria revised

S&P has published revised criteria for monitoring the performance of existing US RMBS transactions. Specifically, the agency will use the updated criteria to re-rate RMBS backed by collateral originated before 2009.

The criteria incorporates updated assumptions about collateral performance, revised pool-level credit and cashflow analysis, and applies new methodologies for capturing risks associated with a transaction's mortgage pool that contains fewer than 100 loans. Over the next six months, S&P intends to review all in-scope transactions, including first-lien prime, subprime, Alt-A and negative amortisation collateral.

The criteria include updated base-case lifetime default and loss projections for mortgages included in transactions and updated cashflow scenarios that provide stronger differentiation throughout the rating scale. Additionally, the agency has updated the framework for projecting loss estimates at each rating category, incorporating specific stability tolerances into the stress multiples for ratings in the single-A category and higher.

"The events in the US over the last few years have caused many in the mortgage market to re-think their approach to assessing RMBS," comments Vandana Sharma, md and lead analytic manager for US RMBS ratings at S&P. "We have been monitoring developments in the market, changes in borrower behaviour and collateral performance, and changes in the mortgage servicing sector closely. The updated criteria incorporate those changes and reflect our performance expectations for legacy RMBS. Based on what we've seen, there are significant differences in performance across sectors, driven by the underlying collateral and the timing of mortgage origination."

As a result of the new criteria, the agency expects a significant number of rating actions on US RMBS backed by pre-2009 collateral. Overall, the application of these criteria are anticipated to result in proportionately more rating downgrades than upgrades. The rating actions for this sample are likely to exhibit a more negative bias than for the portfolio as a whole, S&P notes.

An impact study of 512 transactions representing approximately 10% of the rated transactions for which the criteria apply suggest that the majority of the ratings (approximately 68%) remain within three notches of the current rating, approximately 2% of ratings will be raised by four or more notches and approximately 30% of ratings will be lowered by four or more notches. Approximately two-thirds of the upgrades involve movements to triple-C from double-C.

RMBS

Goldman probe dropped

Goldman Sachs has disclosed in its latest 10-Q filing that the SEC has dropped its investigation of the bank's role in selling US$1.3bn of subprime mortgage securities. The SEC issued a Wells notice to Goldman in February, concerning disclosures contained in offering documents from 2006 for a US$1.3bn RMBS that the bank underwrote. Goldman states in the filing that the investigation has been completed and the SEC staff does not intend to recommend any enforcement action against it with respect to the offering.

RMBS

Greek rating actions announced

Fitch has affirmed 23 and downgraded six tranches of Greek RMBS. It has also maintained three tranches on rating watch negative (RWN).

The downgrades reflect the performance of the collateral and the deteriorating Greek mortgage market, as well as the existing moratorium on foreclosure activity in the country, which has lengthened foreclosure timings and is limiting the level of recoveries the transactions are able to generate. The affirmations are mainly a result of active portfolio management by the originators.

Greece's mortgage market remains in difficulty as the ongoing recessionary environment, fiscal austerity, rising unemployment and the lack of credit continue to affect borrower affordability within RMBS transactions. In addition, the mandatory freeze on auctions of properties that are the main residences of debtors with values of up to €300,000 has led to a large portfolio of defaulted mortgages and extended the timing for receipt of recoveries that can be expected in these deals.

Fitch has consequently downgraded six tranches from the Byzantium and Estia Mortgage series. As of the most recent interest payment dates for these transactions, the portion of loans in arrears by more than three months stood at between 3.7% and 13.2% of collateral balance compared with a range of 3% to 6.5% 12 months ago.

Due to the weaker performance, these transactions have all drawn on their reserve funds in the last few quarters to provision for defaulted loans. With the pipeline of potential defaults now greater, given the adverse macroeconomic environment, the agency is concerned that further provisioning will be required and expects to see further draws on reserve funds, as well as a build-up in the principal deficiency ledgers.

The affirmations of the Themelion series and Kion are mainly due to the active portfolio management within these deals. The originators in these transactions have engaged in a large volume of repurchases and substitutions of non-performing loans. This has suppressed the arrears levels in these deals, despite the deteriorating macroeconomic conditions.

The agency has also affirmed Lithos. This transaction has reported significant amounts of excess spread, which is provided by the swap and has allowed the deal to provision for all defaulted loans without utilising its reserve fund.

Fitch has maintained the RWN on Grifonas as it awaits further details regarding the extent of the excess spread compression that may take place. On 25 May the liquidity facility provider - JPMorgan - notified the issuer that following the introduction of the Basel 2 requirements and the downgrade of the class A notes, the risk weighting of the liquidity facility applied in determining the capital charge is consistent with capital deduction treatment. As a result, in order for the liquidity facility provider to continue to maintain its commitment, the liquidity facility fee will increase to 10.26% per annum compared with the 0.26% previously paid.

RMBS

Eminent domain RFC issued

The Federal Housing Finance Agency (FHFA) has sent to the Federal Register a notice indicating its concern with the proposed use of eminent domain to restructure performing home loans and inviting public input. The agency says it has significant concerns about the use of eminent domain to revise existing financial contracts and the alteration of the value of the companies' securities holdings.

FHFA has determined that action may be necessary on its part to avoid a risk to safe and sound operations at its regulated entities and to avoid taxpayer expense. Additionally, it has concerns that such programmes could negatively affect the extension of credit to borrowers seeking to become homeowners and on investors that support the housing market.

SIFMA has welcomed the move, commending the agency for recognising the serious concerns that market participants have voiced over the proposed use of eminent domain. The association believes that this plan would likely significantly harm mortgage finance markets and reduce access to credit for mortgage borrowers.

"This proposal also raises serious legal and constitutional issues," notes Kenneth Bentsen, SIFMA evp for public policy and advocacy. "From a market perspective, if performing mortgage loans are taken from their holders, this will cause significant losses which will be borne by the pension plans and individual citizens who are invested in the securities. The use of eminent domain will do more harm than good and the worst harm will be felt by future borrowers, who will inevitably pay higher rates for home mortgages."

The association remains firmly opposed to the plan and says it will share its concerns in detail with the FHFA in the coming month. Submissions from the public are invited by 7 September.

RMBS

Greek resi criteria updated

Fitch has updated its criteria assumptions for assessing credit risk in Greek residential mortgage loan pools. While the move isn't expected to impact the current ratings of Fitch-rated transactions, the agency expects negative rating actions based on performance seen to date.

The main changes relate to worsening house price and default expectations, reflecting the significant deterioration of employment and growth outlook since the last update of the Greek RMBS criteria addendum in August 2011. Furthermore, Fitch has lengthened its recovery timing to four years.

House prices in Greece have declined by 20% on average from their 2008 peak. The agency expects Greek house prices to suffer a further decline of almost 17% over the medium term, in the context of the debt crisis and associated austerity measures, which has resulted in subdued mortgage lending and heightened financial pressure on potential house buyers as well as existing mortgage borrowers. Fitch's average peak-to-trough house price decline (HPD) expectation for Greece has been revised upwards, from 24% to 33% in nominal terms.

Due to the sharp decline in property transactions and the property price index since 2008, as well as the lack of data on foreclosures after 2008, Fitch has also increased the average quick sale assumption (QSA) to 38% from 35%. The increase in HPD and QSA assumptions resulted in an average increase of the market value declines to 47% from 43%.

Fitch has also revised its illiquid property adjustments assumptions in light of the most recent property price developments and increased the servicing costs to 0.4% from 0.3%, due to a high level of arrears and lack of third-party servicers.

Frequency of foreclosure assumptions for a single-B rating have increased to 7% from 6%. Post-2005 vintages continue to perform substantially worse than seasoned ones. Therefore, Fitch will apply vintage adjustments to the lifetime default expectation of a standard Greek mortgage loan after 2005, typically ranging between 1.5x and 2.5x.