Contents

ABS

Punchy proposal

Mixed implications for pub paper

Punch Taverns last week announced proposed amendments to the capital structure of both its Punch A and Punch B securitisations, with mixed implications for the bonds. Elsewhere, the pub sector continues to offer good value, with managed pubco paper looking most attractive.

Punch's restructuring proposal looks positive for Punch A junior bonds, but could be negative for Punch B. Barclays Capital MBS analysts note that the proposal's priority appears to be creating as sustainable a capital structure as possible for Punch B, while preserving the option value in Punch A.

The proposals have apparently been compiled by Punch and a group of equity investors, who hold over 50% of the Punch equity, as well as a majority of the Punch B junior debt. However, it appears that the proposals were not discussed with the majority of debt holders.

The proposals would re-profile the Punch A notes and replace existing financial covenants with a leverage covenant, with excess cash being swept to repay debt and step-ups to be removed from the floating rate notes. The Punch B class As would also be re-profiled (targeting a 1.4x DSCR), while the class B1, B2 and C notes would be repaid at a discount to par, with a new B3 bond forming part of that consideration.

"Paradoxically, whilst equity is being injected into Punch B, we think the current proposal - if agreed - would make the Punch B bonds overvalued. The Punch B class A bonds, we think, have been bid up recently on the expectation that they would have received the prepayment rather than the juniors, while the offer price on the juniors is below current market prices," the Barclays analysts note.

The Punch A classes B, C and D look more attractive, however, and are expected to be the main beneficiaries of the move. Deferred amortisation for the class As and Ms will lengthen the period where debt service is received on the junior bonds and provide higher potential recoveries.

Prior to the announcement, the Punch A class Ms were where the value was seen to break in the transaction. Debt-to-EBITDA is 7x-9x and the M1s have been offering 10% yield.

The Barclays analysts argue that bond prices in Punch B across the capital structure will become overvalued if the proposal is agreed, with current pricing producing class A yields of 6%-7%. Punch B class Bs also look overvalued, with the proposed consideration for the B1s and B2s slightly lower than the current market price.

Elsewhere in the sector, managed estate operating performance is expected to continue to grow this year. Junior managed pub bonds - as well as Spirit's class A4 and A5s - have the most attractive risk-adjusted total returns, reckon the analysts. They expect high-teen returns, driven by spread tightening, which would still leave bonds at cheap levels relative to the rest of the market.

Spreads of the managed pubcos barely participated in the recent rally and the hunt for yield is likely to push investors into managed pubs. Having underperformed during the rally, the bonds should outperform in a downturn.

Leased pub bond returns were "exceptionally strong" last year, meanwhile. Unique paper showed capital returns of 40%-140% for the class A to class Ns. The analysts point to reasonable value here, with a 7% yield-to-maturity, but believe that upside is limited from this point onwards.

"We see better risk-adjusted returns in the managed pubcos junior and Spirit class A4 and A5 relative to leased. In a risk-off environment, we would expect the leased bonds to underperform managed," say the Barclays analysts.

They conclude: "The junior and mezzanine bonds in the leased pubs (except for Punch A class M and Unique class M) are exposed to volatile returns and recoveries, and we prefer to stay senior in the capital structure in leased."

JL

CDS

Expropriation example

SNS could set 'dramatic' CDS precedent

The expropriation of subordinated bondholders at SNS Reaal has implications for the entire CDS market. The move has engendered questions about the value of sub protection and concern that CDS liquidity could be hit unless these issues are addressed.

"If any bank bondholders had not previously noticed that the rules were being rewritten on them, then the 80-point drop in SNS subordinated debt ought to have served as a wake-up call. Yet to our minds, the implications for CDS may be almost as dramatic," observe Citi credit strategists.

Since CDS contracts were designed before bail-ins were a consideration, situations could occur in which CDS protection is worth much less than protection buyers expected, either because the contract isn't triggered or because there is a lack of deliverable obligations. The case of SNS Reaal could set a difficult precedent.

"The Dutch government's decision to expropriate subordinated bondholders at SNS but leave senior bonds whole has implications far beyond the €1.6bn of sub debt concerned. The most obvious concern is the likelihood that it may encourage, or be used as a template for, bail-ins elsewhere - quite likely long before European bail-in legislation takes effect," the Citi strategists explain.

The first question to be considered is whether expropriation is deemed to be a credit event, as it is unclear whether it falls under the three recognised triggers (bankruptcy, failure to pay or restructuring). ISDA's EMEA Determinations Committee last week voted to defer a resolution, pending further clarification of certain issues. But the DC is expected to eventually deem the move as either a restructuring or failure to pay credit event.

The second question concerns the deliverable obligations outstanding. In the SNS case, it seems most likely that expropriation means there will be no subordinated bonds outstanding - although this should be clearer after a court ruling due by 25 February. Given that the only remaining deliverables could be senior bonds, both senior and subordinated CDS will have to be settled using these as deliverables.

"Because senior bonds have not been bailed in, these are now trading close to (or even above) par. As such, while it may be in CDS buyers' interest to have them delivered simply in order to close out the contract (and avoid making further protection payments), their recovery will be zero (or potentially even negative)," the strategists note.

Regardless of whether other governments use expropriation, many of the same issues are raised by bail-ins more generally. European legislation for bail-ins is currently expected to be introduced in 2015 and 2018 for sub and senior debt respectively, although several countries have already established different resolution regimes to implement bank bail-ins.

The Citi strategists believe it is highly likely that bail-ins will be used sooner rather than later, given that the political appetite for them is increasing. This could happen not only at the subordinated level, with recent suggestions that a bail-in might be used in Cyprus for either junior debt holders or at junior and senior level.

For CDS protection buyers to be paid out, a bail-in must constitute a credit event and leave sufficient deliverable obligations with which to settle the CDS contracts, with a resultant market price of these deliverable obligations being in line with the losses that bondholders suffered in the bailed-in bonds. Both expropriation and conversion to equity would likely fail to leave deliverable obligations.

Even if expropriation is not used by any government other than the Dutch, conversion to equity is present in almost all the draft bail-in legislation. Unless the write-downs or conversions are designed so as to leave some form of bond outstanding, a lack of deliverables will be problematic here too.

There could even be problems with write-downs. The strategists note that if the newly reduced face value means that all bonds start trading significantly closer to par, then protection holders will face a reduced recovery.

However, they believe that these potential pitfalls could be avoided if governments take action. For example, bail-ins should be possible in such a way that a credit event is triggered and deliverable obligations remain, such as when the Irish authorities deliberately delayed settlement on some of the sub bond write-downs for AIB so that they could remain outstanding for settlement of CDS contracts.

If lawmakers do not take steps to consciously trigger CDS as part of their bail-ins, it may be necessary to redraft CDS contracts. New contracts would have to explicitly incorporate bail-ins in their credit event language and allow for deliverable obligations.

"These issues over triggers and deliverables could all too easily jeopardise the validity of the CDS market as a hedge. If it were accidentally 'killed off', the consequences for the bond market would be severe," say the strategists.

They conclude: "Unlike in sovereigns, where the underlying cash market has normally been more liquid than CDS, in the corporate market liquidity is heavily fragmented. Without the signalling and hedging role of an active CDS market, bond transparency would fall, trading would become more lumpy and ultimately the cost to bank issuers would increase, as an increased illiquidity premium became factored into spreads. This hardly seems a desirable outcome."

JL

ABS

Strong demand for Euro auto paper

A flurry of European ABS activity emerged yesterday, with auto paper helping to drive the secondary market. SCI's PriceABS data shows that a number of names were covered above par during the session, with this proving true even beyond the auto space.

The highest cover recorded yesterday - at 100.98 - was for the GLDR 2010-A A tranche, just over two weeks after being covered at 101.055. Covers in June and August of last year were at 101.18 and 101.49 respectively.

A couple of Santander-originated deals were also circulating, with tranches from SC Germany Auto 2010-1 and Motor 2012-1 both attracting covers. SCGA 2010-1 A was covered at 100.54 and MOTOR 12X A2 was covered at 100.34.

The SGCA tranche was previously covered at 100.592 and talked at 100.59 on 8 January. The tranche was covered at 100.6 in December and at 100.54 back in June, the same level as yesterday.

Of note, a slice of the VCL 13 A tranche was covered at 100.19, having attracted a cover at 100.21 last month. The tranche was talked variously between 100.34 and 100.385 in August and its earliest recorded cover comes from 14 May 2012, when it was covered at 100.291.

Pieces of the CAR 2011-G1 and DRVON 8 A tranches were covered at 100.312 and 100.33 respectively, but a 100.39 cover for TTSOC 2011-1 A also attracted attention. The tranche was previously covered at 100.54 on 30 August, with price talk since then moving to 100.46. Yesterday's cover brings the tranche closer to the levels seen in June last year, when it was covered at 100.35.

Finally, auto ABS wasn't the only sector to see covers above par during the session. HCARD 2011-1X A - a credit card bond - was covered at 100.755.

JL

CLOs

Seniors scarce in US CLO secondary

US CLO secondary supply has been strong all week, but peaked in yesterday's session. SCI's PriceABS data shows 268 CLO line items for the session, with more than half of those from US deals.

Junior and mezzanine paper proved the flavour of the day, with the amount of senior bonds circulating noticeably down on the prior session. Among the junior names out for the bid on Thursday was a handful of subordinated tranches, most of which were covered.

Among those sub tranches, a US$5.9m piece of MTWIL 2007-2X SUB was covered in the low-120s, with talk as tight as 112. A US$7.75m piece of GARDN 2005-1A SUB was also talked at around 112 yesterday, the same level as it had been talked in the prior session.

PRSP 2006-1X SUB was covered at 78.57, while DRYD 2006-16X SUB was also covered. In addition, a US$2m piece of PCDO 2004-3X SUB covered in the mid-20s - with talk in the mid/high-20s - after talk in Tuesday and Wednesday's sessions had been in the mid/high-20s.

At the other end of the spectrum, a US$6.71m piece of CIFC 2007-1A A3L was talked between the high-80s and low-90s, but did not trade. Talk in the previous session had been at 88.04.

There was a range of available sizes out for the bid yesterday. The largest piece to be covered was a US$16.5m slice of INGIM 2006-3A B, which was covered at 91, with talk ranging from the high-80s to the low-90s.

Other sizable slices included a US$12.37m piece of HLCNL 2006-1A C, which was talked in the mid/high-80s and at 86.16, and a US$14.5m piece of KATO 2007-10A D - which was covered in the high-80s, with talk reaching up to 90.16. At the other end of the scale, US$725,000 of ARES 2007-11A E was covered in the high-90s, with talk also at around 100.

Another noteworthy name from the session is T2CLO 2007-1X C, following the transaction's recent failure of a portfolio percentage limitation test. The T2CLO tranche attracted a cover at 93.65, with talk also at 94.21 both yesterday and the day before. Its first recorded cover in PriceABS comes from 25 May 2012, when it was covered at 85.

JL

RMBS

Healthy mix in quieter RMBS session

US RMBS is not the only market to have gone quiet in the wake of the heavy snow in the north-eastern US and Canada, but the sector still saw adequate supply during Monday's session. Agency activity remained moderate, while non-agency activity was more noticeably decreased, with Interactive Data figures putting BWIC volume for the two sectors at around US$600m.

Agency RMBS dealer levels were unchanged to wider yesterday. SCI's PriceABS data shows a few names from the session, with FNR 2012-19 JS covered at low-27 and FNR 2012-30 MS covered at low-24. FNR 2011-101 MG was also out for the bid, with price talk about 5bp wider than on Friday. The FHR 3984 SA tranche was traded at mid-25, while FHR 4016 SL was covered at low-25.

Non-agency supply was more limited, although a good mix of names remained available. The range of vintages on offer stretched all the way to 2002, with the US$5m CWL 2002-S3 A5 tranche talked at low-par. In addition, more recent paper was circulating, with tranches such as BCAP 11-RR5 7A2 and BCAP 11-RR5 9A2 talked respectively in the low-single and low-double digits.

BCAP 2009-RR13 20A2, meanwhile, was talked in the mid-70s. 2005-2008 vintage paper was the most prevalent in the session and a couple of names of note include ARMT 2005-7 2A21 (which was talked between the mid/high-70s and 80 area) and RALI 2007-QO4 A1 (which was talked in the very low-80s, in line with talk from earlier in the month).

JL

Structured Finance

SCI Start the Week - 11 February

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

Pipeline
Many of the deals that entered the pipeline last week went on to price by the end of Friday, with only three remaining. These transactions were a US$585m auto ABS (Ally Master Owner Trust 2013-1), a US$604.3m consumer loans ABS (Springleaf Funding Trust 2013-A) and a US$498.5m CMBS (GSMS 2013-KING).

Pricings
There were 11 ABS prints last week, as well as one RMBS, one CLO and three CMBS. Of the ABS, four were auto transactions.

The ABS deals comprised: US$723m Avis Budget Series 2013-1; US$1.045bn CarMax Auto Owner Trust 2013-1; US$200m Navistar Financial Dealer Note Master Owner Trust II Series 2013-1; €600m Red & Black TME Germany 1; US$800m Discover Card Execution Note Trust 2013-1; US$900m Discover Card Execution Note Trust 2013-2; US$375m GreatAmerica Leasing Receivables Funding series 2013-1; US$563.8m Kentucky Higher Education Student Loan Corporation Series 2013-1; US$400m PFS Financing Corp 2013-A; and US$1.24bn SLM Student Loan Trust 2013-1.

The RMBS was A$709m TORRENS Series 2013-1 Trust, while the CLO was US$310m Race Point VIII. The CMBS consisted of: US$1.1bn GSMS KYO, US$1.36bn MSBAM 2013-C8 and £494m Tesco Property Finance 6.

Markets
The European ABS market appears to be entering a period of consolidation, according to ABS analysts at Deutsche Bank, as evidenced by the thin new issue pipeline and recent widening in senior UK prime RMBS spreads. HMI 2010-1X A4 and ARKLE 2010-2X 2A, for example, have widened by up to 5bp this month.

European auto paper was doing the rounds in the middle of the week, as SCI reported on Thursday (SCI 7 February 2013). SCI's PriceABS data shows a number of European auto names covered above par, with credit card paper also in demand.

Real money investors remain on the sidelines of the European CMBS market, as reported last week (SCI 5 February 2013). BWIC supply remains fairly steady as hedge funds continue to sell. One trader suggests that real money investors will wait until primary issuance picks up before they step back into the market.

Meanwhile, the US CMBS market weakened over the week. Strong institutional demand is keeping new issue cash strong, according to Barclays Capital CMBS analysts.

The analysts note: "Generic 2007 dupers gapped out another 10bp this week, to finish at S+110bp; AMs were similarly wider, ending at S+225bp. 2007 AJs, which had enjoyed a 7-10 point rally in the first two weeks of the new year, have now slipped 2-3 points from their highs. Much like last week, the widening trend was not reflected in new issue deals, where spreads continue to hold in."

The US ABS market was mainly focused on the primary space, where almost US$6bn of deals priced. Securitised products strategists at Bank of America Merrill Lynch note that secondary spreads were unchanged over the week, remaining generally tighter than levels at the beginning of 2013.

Secondary supply for the US CLO market was strong last week, spiking on Thursday (SCI 8 February 2013). Senior paper was more popular earlier in the week, but by Thursday junior and mezzanine dominated supply.

A handful of subordinated tranches circulated, such as MTWIL 2007-2X SUB and GARDN 2005-1A SUB, which PriceABS shows were respectively covered in the low-120s and talked at around 112. Another noteworthy name from the session was T2CLO 2007-1X C, following the transaction's recent failure of a portfolio percentage limitation test.

Finally, Wells Fargo US RMBS analysts report that the non-agency market appeared to take a breather last week, with spreads 25bp wider. "Investors are more cautious with high-yield bonds selling off, the 10-year Treasury yield moving higher (hovering close to 2%) and ABX prices drifting lower. BWIC supply trended higher on the week, with more than US$5bn out for bid," they observe.

Deal news
• The restructuring of the €4.33bn German Residential Asset Note Distributor (GRAND) transaction, the largest CMBS ever issued in Europe, is noteworthy for being implemented via a solvent scheme of arrangement (SCI 24 December 2012). But it is also being hailed as the forerunner for restructurings that take the cash price of senior bonds to par in the secondary market, with more examples expected as the year progresses.
• Embedded call features in SNS Bank RMBS are ultimately expected to be honoured, following the nationalisation of SNS Reaal last week. However, two transactions face elevated risks of at least initial redemption interruption.
• Cairn Capital North America is replacing Aladdin Capital Management as collateral manager on Altius III Funding, Altius IV Funding, Fortius I Funding and Fortius II Funding. Cairn took on three other Aladdin CDOs - Altius I Funding, Altius II Funding and Citius I Funding - last year (SCI 21 December 2012).
• Laguna ABS CDO noteholders are seeking to replace the deal's collateral manager, PIMCO, with Dock Street Capital Management.
• BNP Paribas has replaced Bankia as investment manager on Neptuno CLO I.
• The subordinated noteholders of Sorin Real Estate CDO III are proposing to appoint Collateral Management, a wholly owned subsidiary of Torchlight Investors, as successor collateral manager on the deal. At the same time, the issuer is proposing to appoint Collateral Manager as the successor advancing agent.
• Investors who held Federation CDO notes and used ANZ as custodian were last month informed that Lehman had 'joined' ANZ with end holders and investors which Lehman had initiated legal action against in September 2010. End holders will consequently be required to indemnify ANZ in respect of any legal costs and other liability.
• Moody's has downgraded from Aa2 to Aa3 the Euro and US MTN programmes of Links Finance. The ratings remain under review for possible downgrade.

Regulatory update
• Representatives from Calypso Technology and Deloitte discussed Basel 3 and liquidity risk management in Asia Pacific during a live webinar, hosted by SCI in December (view the webinar here). Topics included the impact of the LCR and NSFR on banks, as well as how to align strategy with compliance.
• The US Department of Justice has filed a civil lawsuit against S&P in the District Court for the Central District of California. The complaint alleges that the rating agency engaged in a scheme to defraud investors in RMBS and CDOs by issuing inflated ratings that misrepresented the securities' true credit risks.
• McGraw-Hill and Standard & Poor's Financial Services have filed for declaratory relief in federal court in South Carolina, petitioning the court to declare that the state is precluded on First Amendment grounds from suing S&P for allegedly inflating its ratings of MBS leading up to the financial crisis. The complaint was filed a day after the US Department of Justice sued the rating agency in federal court in California.
• New documents have been filed in New York State Supreme Court claiming that the proposed US$8.5bn figure for the 2011 Bank of America settlement is too low. The submission was made by Triaxx, as well as the Federal Home Loan Banks of Boston, Chicago and Indianapolis.
• Spanish Minister of Economy and Competitiveness Luis de Guindos last week proposed changes to the country's mortgage market that, if implemented, have implications for Spanish RMBS. The proposals chiefly pertain to providing aid to borrowers that are struggling to meet mortgage payments and follow on from the mortgage foreclosure moratorium announced in November last year.
• RBS and its subsidiary RBS Securities Japan will pay around US$612m in penalties and disgorgement as a result of its Libor breaches. The figure includes £87.5m to the UK FSA, US$150m to the US Department of Justice and US$325m to the CFTC.

Deals added to the SCI database last week:
Affinity Water Programme Finance; Cavalry CLO II; MCF CLO I; and WFRBS 2013-C11.

Deals added to the SCI CMBS Loan Events database last week:
BSCMS 2007-PW16; CD 2006-CD3; CD 2007-CD5; CGCMT 2007-C6; COMM 2005-LP5; CSFB 2003-CK2; CSFB 2004-C2; CSMC 2006-C4; CSMC 2007-C2; CSMC 2007-C3; CSMC 2007-C4; CWCI 2007-C3; DECO 7-E2; EMC VI; EPICP CASP; GCCFC 2006-GG7; GECMC 2005-C4; GECMC 2007-C1; GMACC 1998-C1; GMACC 2003-C3; GSMS 2004-GG2; JPMCC 06-LDP7 & 06-CB16; JPMCC 07-LDP11 & GSMS 07-GG10; JPMCC 2005-LDP2; JPMCC 2005-LDP4; JPMCC 2006-LDP7; LBUBS 2003-C1; LBUBS 2003-C3; LBUBS 2003-C5; LBUBS 2003-C7; MESDG CHAR; MSC 2005-T17; MSC 2006-HQ9; MSDWC 2002-IQ3; OPERA CMH; TAURS 2006-3; TAURS 2007-1; TITN 2006-1; TITN 2006-3; TITN 2006-5; TITN 2007-1; TITN 2007-2; TITN 2007-3; TITN 2007-CT1; TMAN 3; TMAN 6; UBSCM 2007-FL1; Various; WBCMT 2003-C5; WBCMT 2005-C19; WBCMT 2006-C24; WBCMT 2006-C26; WBCMT 2006-C29; WBCMT 2007-C30; and WINDM VII.

Top stories to come in SCI:
Outlook for the pub sector
Relative value in US CLOs

CMBS

MSBAM 2013-C8 prepay assumptions eyed

Several noteworthy price points were observed on the XA and five-year A2 tranches of the recently-priced MSBAM 2013-C8 CMBS. The unusual call protection provisions on two large loans securitised in the deal - the Boston Park Plaza and the Hyatt Regency Hill Country Resort - are said to have driven the move.

MSBAM 2013-C8 printed roughly in line with the previous WFRBS 2013-C11 transaction. Levels were unchanged on the duper tranche at swaps plus 72bp, but the senior interest-only class closed at 75bp - compared with 150bp on the WFRBS deal - while the A2 widened by about 6bp to 45bp.

The Boston Park Plaza and Hyatt Regency Hill Country Resort loans, totalling US$156m or about 14% in outstanding balance, have long 24-month open periods at the end of their five-year terms. Given that the IOs are priced off a 100 CPY convention, the 75bp level on the MSBAM deal in effect assumes that the loans pay off at the end of three years, according to CMBS analysts at Barclays Capital.

But they point out that there is considerable upside potential if prepayments are slower than the 100 CPY assumption. Indeed, the MSBAM XA tranche could yield as much as 5.5% in a 0/0 prepay scenario, compared to about 3.7% on the WFRBS deal. Assuming that the prepay-adjusted yields on the two IOs are equal, this suggests that the market is pricing in a roughly 80 CPY assumption.

Prepay uncertainty also explains why the MSBAM second cashflow A2 tranche priced wider versus the WFRBS deal. However, the breakeven CPY rate for the A2 class appears to be closer to 90 CPY, the Barcap analysts observe.

"In effect, the IO appears to pricing the collateral at somewhat slower speeds versus the A2," they explain. "Purely based on fundamentals, we think the IO should be trading wider, or the A2 should be trading tighter. There are, of course, vastly contrasting supply-demand dynamics on these tranches that could overcome this relatively small conflict in fundamental assumptions."

Both hotel properties were underwritten at relatively conservative LTVs of about 46%. The Boston Park Plaza pays a 4.4% coupon, while Hyatt Regency pays 5.6%.

CS

CMBS

Increased focus on 'drop dead' provisions

The expiration of temporary rate reductions is emerging as a key driver of re-defaults of large modified US CMBS loans. Focus on 'drop dead' provisions is increasing as a result.

The recent re-defaults of the US$89.25m Denmark MHC Portfolio (securitised in JPMCC 2007-LD11) and US$85m Allanza at the Lakes (CSMC 2007-C5) assets appear to be directly related to the expiration of temporary rate reductions on these previously modified loans (see SCI's CMBS loan events database). Other large loans whose modified coupons are set to increase this year include the US$186.6m Four Seasons Aviara Resort (WBCMT 2007-C30), the US$123m Bethany Phoenix Portfolio A-note (LBCMT 2007-C3) and the US$106m Trilogy Apartments A-note (BSCMS 2005-PWR16).

About US$2.3bn of modified loans are due to mature in 2013, according to Citi figures. The past year saw 87 re-defaults, compared to an average of 18 during 2010-2011. Retail properties accounted for 30% of the re-defaults, while office properties represented 23%.

So far, most re-defaults have happened between 13-24 months after the modification date, with only 35% of the re-defaults occurring upon the modified maturity date. CMBS analysts at Citi expect these figures to change, however.

They point to a "non-negligible" number of re-defaults that occurred in short order following a loan's mod. For example, while the US$68.7m Coventry Mall (MSC 2005-TOP17) loan has not re-defaulted yet, it was transferred back to the special servicer in December for imminent default.

The mall's top tenant is the bankrupt Boscov's and Sears is its second largest tenant. The latter's lease expired in early December, which may have triggered the transfer to special servicing.

"Of course, if the lease expiration indeed triggered the transfer, investors may wonder why such an event was not anticipated and dealt with in a timely fashion - perhaps at the time of the fairly recent mod," the analysts observe.

They note that such cases underscore the need to track large outstanding rate-reduction mods, as well as focus on the provisions that determine what happens when a modified loan re-defaults ('drop dead' provisions) - particularly as some borrowers will seek second modifications. Certainly the growing number of re-defaults is expected to provide the market with examples of how re-default provisions are enforced and what happens when the provisions are not included in mod agreements.

CS

Risk Management

Taking control

Liquidity risk management practices discussed

Representatives from Calypso Technology and Deloitte discussed Basel 3 and liquidity risk management in Asia Pacific during a live webinar, hosted by SCI in December (view the webinar here). Topics included the impact of the LCR and NSFR on banks, as well as how to align strategy with compliance. This Q&A article highlights some of the main talking points from the session.

Q: What are the main sources of liquidity risk that Basel 3 is designed to address?
David Little, director of strategy and business development, Calypso Technology: The liquidity risk that Basel 3 addresses is the one that was most prominent during the financial crisis: the risk of wholesale funding sources drying up. Many business models were predicated on funding being permanently available at very short notice, but those funding avenues dried up during the crisis.

What regulators are trying to achieve with Basel 3 is to strengthen the controls and resilience that financial institutions have with regard to potential future liquidity crises. To this end, the Basel Committee has introduced two measures - the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR).

The LCR is a short-term measure, spanning a 30-day horizon. It measures net cash outflow under severe stress scenarios and requires banks to hold enough high quality liquid assets (HQLA) to enable them to go to the central bank or other funding source to keep themselves operational for a minimum of 30 days.

The NSFR is a longer-term measure that requires funding between assets and liabilities to be matched over a one-year time horizon.

Q: What is the impact of the LCR and NSFR likely to be on banks?
Alec Kourloukov, director, risk consulting at Deloitte Enterprise Risk Services: Depending on the sophistication of a financial institution's infrastructure and the availability of data, the LCR and NSFR can become key risk indicators. Both ratios have predictive power because they draw lots of information from core banking systems, especially transaction systems related to cash inflows and outflows.

The LCR is a simple ratio measuring a bank's stock of HQLA over net cash outflows. These cash outflows have to be modelled under acute scenarios; for example, a three-notch downgrade or a partial run on deposits.

The definition of HQLA is specific and categorised into Level 1 and Level 2 assets. Level 1 assets are defined as central bank reserves, marketable securities issued by sovereigns that are traded in a deep market and so on.

However, this is a difficult definition to meet - especially from a Southeast Asian perspective, because the market may not be deep enough. For example, the Singapore government doesn't run a deficit and so there is a limited pool of government securities to choose from in that jurisdiction. If, therefore, you invest in Philippine or Malaysian sovereign debt, you need a clear assessment of whether that market is considered to be deep enough and whether such a move drives an institution to take new risks - such as country and political risk - as well as a potential increase in foreign currency exposure.

Level 2 assets include government bonds and double-A plus rated corporate bonds. Again, there are strict definitions around availability, and there may not always be the requisite market depth or volume of readily available assets.

Given the assets have to be high quality, the yields are relatively low, so there is a direct impact on bank profitability.

The NSFR ratio remains under discussion, since the implementation isn't until 2018. The measure is designed to promote medium- to long-term funding stability and reduce incentives for short-term wholesale funding.

It is defined as the amount of available stable funding over the required amount of stable funding over a one-year horizon. The available amount equates to the carry value of funding times a given adjustment factor.

Tier 1 and 2 capital, preferred stock, retail deposits and secured and unsecured borrowings can be included as available stable funding assets. Cash, money market instruments, loans and gold and so on can be included as required stable funding assets.

There is a stress-testing component to the NSFR, which will inevitably become an important part of the liquidity management framework. The idea is to strengthen liquidity management frameworks to make them more robust and advanced to meet the rapidly changing funding environment. But stress testing is another area where further guidance is needed.

Q: How should intraday stress testing be undertaken following the latest BIS consultative document?
Little: There is not much detail in the paper about exactly how the stress tests should be conducted, or how severe the stress should be. There is recognition that different stresses will be applicable to different banks, so I assume that there will be a significant amount of interpretation by each regulator and significant differences from bank to bank.

The consultation paper has attracted a lot of comments, many of them publicly available on the BIS website. But it is only a consultative document and we await the final paper.

Q: How should banks conduct the scenario analyses necessary under the LCR and NSFR?
Little: Because the traditional ALM function has a cash-oriented view of the world, it's proving difficult to undertake these calculations. Liquidity stress ratios require scenarios where business is projected forward to gauge what may happen to future cashflow under stressed scenarios.

To do this, you need to be able to model and price real transactions that are underlying those cashflows. Traditional ALM solutions don't typically have such functionality.

Henry Kemp, senior market specialist at Calypso Technology: Sophistication and flexibility are important attributes when conducting scenario analyses. Overlapping the stress-test requirement is the requirement to monitor liquidity more effectively than in the past. Again, institutions need to be able to price/model underlying data in a sophisticated way to achieve this.

Q: What sort of strategies should banks adopt to manage liquidity risk?
Kourloukov: It's essentially a compliance exercise. The two questions I'm often asked are: what the impact will be on business strategy and can we get something out of it in terms of improved cost structure.

The fundamental principle behind the LCR and the NSFR is robust governance of liquidity risk management. This has driven many banks, especially in Southeast Asia, to establish what their liquidity risk appetite and risk tolerance is.

Embedded in risk tolerance metrics should be a top-down/bottom-up approach, cascaded down from the board. In such a scenario, the asset-liability committee becomes more prominent in terms of managing risk and providing advice to the board.

On the treasury side, a funding strategy needs to be established, with effective diversification of resources and tenors. This, in turn, feeds into the institution's contingency funding plan.

HQLA are relatively rare, but the business impact of holding them is significant because it impacts profitability. Institutions may potentially have to reduce costs as a result, becoming 'lean and mean'. It requires a significant rethinking of business models.

Little: Given that the cost of doing business is likely to rise, there is also the potential for liquidity premiums to be applied to the P&L of different business lines. Combined with increased regulatory capital as margin is called, these costs will threaten the viability of some business streams, which will force strategic decisions to be made.

But there is opportunity here too, because the investment in new tools can provide powerful strategic chances to model new business openings or to change tactics. It allows senior management to take control of the business and differentiate their firm. We're already seeing this differentiation occurring across certain business models.

Kourloukov: Certainly in Southeast Asia a trend is emerging where banks are moving more into treasury operations in anticipation of significant draws on their trading books. With relatively low interest rates and the squeeze on margin, new capabilities with respect to data aggregation are valuable and should extend beyond Basel 3. I believe the build-up of the treasury function is a long-term trend.

Q: Because of its reliance on data, shouldn't there be a graduated requirement for compliance by banks operating under different economies/environments?
Kemp: Although a phased build-up of the liquid asset buffer has been introduced by the BIS and that will ease the funding burden as the liquid asset buffer only needs to be 60% initially, it does not change the requirement to be able to calculate the LCR and manage the liquid asset buffer. In fact the data challenge remains the same and banks will have to have systems in place for both the calculation and the management of the buffer by 2015.

Q: How can banks ensure compliance with the new liquidity rules?
Kemp: It's about empowering management by increasing transparency throughout the organisation. Compliance requires banks to have a flexible infrastructure, so that they can respond to the varying demands of individual regulators.

In Asia, because there is a shortage of high quality sovereign and Tier 1 debt, we're seeing different responses emerging from regulators. For example, the Australian authorities are developing a central bank facility for this reason.

Q: What is the best-practice approach in respect of intraday liquidity monitoring?
Kemp: Best-practices require looking at liquidity risk across the entire organisation, on an intraday, daily, 30-day and yearly basis. It involves a change in mindset around determining what's due at what time and where, towards a more granular and real-time approach.

Little: One area related to intraday liquidity monitoring that is at the forefront of people's minds is sequential duty. In response to the collapse of Lehman, the Bank of England reviewed the ways that banks transfer cash around the world.

Historically, the BoE provided a float for payments and settlements, and the end-of-day float could be transferred to another jurisdiction where necessary. This provided additional liquidity, but introduced risk.

While sequential duty systems are now date-stamped, they aren't time-stamped. It would be useful to know the exact moment when the impact of liquidity hits, so the challenge is to introduce time stamps.

There is also a temptation to start managing payments too actively. This could lead to the system jamming up, with payments leaving before another payment comes in.

Q: What is the role of funds transfer pricing in liquidity risk management?
Little: The challenge in funds transfer pricing is to bring all the elements together and produce a comprehensive set of price components that a business will end up being charged for. FTP is an increasingly important discipline, given that costs are rising.

Technology can provide transparency and timeliness around FTP. Business managers should expect information in real time, so that they can manage FTP within understandable terms.

Q: Why is the implementation of Basel 3 being delayed?
Little: Part of the reason why Basel 3 is being delayed is a shortage of expertise and skills necessary to deal with all the different requirements. To manage these demands, firms will need to undertake a combination of buying, building and outsourcing various systems. Ultimately, it will require combining the talents of banks' internal IT resources with what vendors and service providers can provide.

Structured Finance

Fixed income, EM sales head added

Peter Albano is joining Oppenheimer & Co as md and head of taxable fixed income sales. He takes responsibility for the sales departments for institutional emerging markets, high grade corporate credits and RMBS, reporting to senior md Robert Lowenthal.

Albano joins from BNP Paribas, where he was head of the US institutional client relationship management team. He had similar responsibilities at RBS and previously held strategic management roles at Bear Stearns, including running US credit sales.

Albano also becomes co-head of emerging market sales with Greg Fisher, who he previously worked with at Bear Stearns. He will be based in the firm's New York headquarters.

Structured Finance

RBS settles Libor charges

RBS and its subsidiary RBS Securities Japan will pay around US$612m in penalties and disgorgement as a result of its Libor breaches. The figure includes £87.5m to the UK FSA, US$150m to the US Department of Justice and US$325m to the CFTC.

The FSA charged RBS £125m, with a 30% discount for settling early. The charge relates to misconduct between January 2006 and November 2010, involving individuals in the UK, Japan, Singapore and the US.

RBS' misconduct included: making Japanese yen and Swiss franc Libor submissions on the basis of its derivatives trading positions; allowing derivatives traders to act as substitute submitters; derivatives traders colluding with other Libor panel banks to influence Japanese Libor submissions made by those banks; and RBS derivatives and money market traders colluding with individuals at other panel banks and brokers who sought to influence RBS' Japanese and Swiss Libor submissions.

The FSA notes 219 documented requests for inappropriate submissions and says at least 21 individuals were involved. RBS failed to identify and manage the risks of inappropriate submissions and had inadequate systems and controls in place.

RBS has also agreed to plead guilty to charges in the US of felony wire fraud. It has signed a plea agreement with the government admitting criminal conduct and agreed to pay a US$50m fine. A deferred prosecution agreement requiring the bank to admit and accept responsibility for its role in manipulating Libor and to pay a further US$100m penalty has also been filed.

Finally, RBS has paid US$325m to settle with the CTFC. The bank must also take specified steps to ensure the integrity and reliability of future benchmark rate submissions, including improving internal controls.

Structured Finance

UBS fined for AIG fund failures

The UK FSA has fined UBS for failures in the sale of the AIG Enhanced Variable Rate Fund, which led to UBS customers being exposed to an unacceptable risk of an unsuitable sale of the fund. UBS also failed to deal properly with complaints from customers about sales of the fund, the FSA says.

Between 1 December 2003 and 15 September 2008 UBS sold the fund to 1,998 high net-worth customers, with initial investments totalling approximately £3.5bn. The fund invested in financial and money market instruments, but - unlike a standard money market fund - it sought to deliver an enhanced return by investing a material proportion of its assets in ABS and floating-rate notes.

During the financial crisis, the market values of some of the assets in the fund fell below their book values. Following Lehman Brothers bankruptcy and a sudden fall in AIG's share price, there was a run on the fund.

As a result, the fund was suspended, with customers prevented from immediately withdrawing all of their investment. At that point, 565 UBS customers had approximately £816m invested in the fund.

A sample review by the FSA of sales of the fund to 33 customers found that 19 were mis-sold and a considerable risk that 12 of the remaining 14 may have been mis-sold. The FSA also reviewed 11 complaints made by these customers and found that all 11 had been assessed unfairly (albeit that six had been upheld by UBS).

UBS has agreed to conduct a redress programme for those customers who remained invested in the fund at the time of its suspension. It is estimated that compensation payable to customers will be around £10m.

UBS agreed to settle at an early stage, entitling it to a 30% discount on its fine. Were it not for this discount, the FSA would have imposed a financial penalty of £13.5m on the bank.

Structured Finance

ABS trading exec recruited

KNG Securities has appointed Armando La Morgia to its fixed income team, as the firm builds its presence in the ABS market. He will play a key role in developing the firm's capabilities within the ABS trading and client solutions business.

La Morgia was previously senior portfolio manager at Hemera Capital Management, where he focused on UK, European RMBS and consumer ABS. Before that, he was a director within Merrill Lynch's global proprietary trading group in charge of ABS portfolio management and also headed the principal investment team within the bank's global structured finance group.

CDO

Dock Street adds to ABS CDO roster

Laguna ABS CDO noteholders are seeking to replace the deal's collateral manager, PIMCO, with Dock Street Capital Management.

Under the collateral management agreement (CMA), the collateral manager may be removed upon not less than 45 days prior written notice as long as any class A1S, A1J or A2 notes are outstanding and if the class A2 overcollateralisation ratio is less than 100% for more than 90 consecutive days. Holders of two-thirds in aggregate outstanding principal amount of these notes, voting together as a single class, have provided notice to PIMCO of its termination.

The effectiveness of the termination is conditional upon the agreement of a successor manager to assume all of the original manager's duties and obligations under the CMA, as well as satisfaction of the rating condition. The replacement also requires that holders of at least a majority of the controlling class have not objected to the replacement manager within 30 days' notice (4 March).

PIMCO has waived the 45-day notice period with respect to its termination.

See SCI's CDO manager transfer database, for other recent CDO manager replacements.

CDO

Project finance CDO transferred

TCW Asset Management Company (TAMCO) has assigned its rights and obligations under the investment advisory agreement for TCW Global Project Fund III to EIG Management Company, effective from 31 January. The transaction is a project finance CDO.

For other recent collateral manager replacements, see SCI's CDO manager transfer database.

CDO

Four more ABS CDOs transferred

Cairn Capital North America is replacing Aladdin Capital Management as collateral manager on Altius III Funding, Altius IV Funding, Fortius I Funding and Fortius II Funding. Cairn took on three other Aladdin CDOs - Altius I Funding, Altius II Funding and Citius I Funding - last year (SCI 21 December 2012).

Moody's has determined that the assignment of the collateral management agreements for the ABS CDOs will not impact any current long-term rating on the notes. In reaching its conclusion, the agency considered the experience and capacity of Cairn to perform duties of collateral manager to the issuers.

For other recent CDO manager transfers, click here.

CDS

European evaluated pricing team established

SIX Financial Information has expanded its evaluated pricing business by building a new valuation team in Frankfurt. The local team enhances SIX's ability to react quickly and effectively to the needs of its European clients.

The Frankfurt team is responsible for assessing OTC products, carrying out market conformity checks and valuing financial instruments in the fixed income and derivatives segment. It will also work alongside the team based in Stamford, Connecticut to support European clients.

The new team continues the expansion of SIX's evaluated pricing service into additional asset classes and regions, following on from its recent partnership with Numerix (SCI 12 November 2012). It will be led by Thomas Stumpf, head of evaluated pricing valuations, Europe.

CDS

Structured expansion for pricing service

SIX Financial Information has entered into an agreement with Derivative Partners Research to produce and distribute independent valuations for structured products. The move further expands SIX's evaluated pricing service, which recently established a European team based in Frankfurt (SCI 7 February 2013).

The global agreement with Derivative Partners Research means SIX's evaluated pricing service will cover a wider range of structured products and complex derivative instruments. The current service combines result sets for various asset classes, including equity, indices, FX and commodities.

CLOs

Ex-Goldman duo move on

CVC Credit Partners has hired two former Goldman Sachs credit traders. Mark DeNatale becomes partner on the firm's operating board, senior portfolio manager and global head of trading, while Scott Bynum becomes md and portfolio manager.

DeNatale was md and head of loan trading at Goldman Sachs, managing risk across distressed, stressed and performing credit. He has experience investing and trading across the capital structure, including loans, bonds, equities and derivatives.

Bynum was vp in the bank loan distressed investing business at Goldman Sachs, managing research coverage for a variety of sectors and leading investments across the capital structure in both public and private companies. He also led the hedging effort for the investing portfolio consisting of loans, bonds, equities, derivatives, trade claims and private financings.

CLOs

Neptuno CLO transferred

BNP Paribas has replaced Bankia as investment manager on Neptuno CLO I. Moody's has determined that the move will not cause the current ratings of the notes to be reduced or withdrawn. The agency does not express an opinion as to whether the amendment could have other, non credit-related effects.

See SCI's CDO manager transfer database for other recent CDO manager replacements.

CMBS

Real estate vet hired in Euro expansion

Carlton has recruited Fernando Salazar to open and run its new office in Frankfurt, Germany. He was formerly head of real estate and commercial banking at Eurohypo, and has 30 years of experience in German and Spanish real estate.

Salazar has been involved in over US$10bn of loan originations and restructurings, and is an acknowledged expert in European real estate valuation, underwriting and financing. At Carlton, he will be responsible for originating and closing new transactions on behalf of financial institutions and borrowers, and assisting in the de-levering process of legacy loan positions. Also on a selective basis, he will represent borrowers to restructure or raise capital along with other key Carlton members.

Salazar will work closely with Carlton chairman Howard Michaels and the other key senior members of Carlton's European team, including Massimo Cecchi (head of Carlton Italy) and Javier Beltran (head of Carlton's Spain and Portugal office). The firm is presently executing over US$3bn of investment sale and debt and equity transactions throughout the region.

RMBS

ResCap liability questioned

The official committee of unsecured creditors in the Residential Capital Chapter 11 proceedings last week filed an objection to the proposed US$8.7bn settlement with 392 RMBS trusts. The committee believes that ResCap's potential liability is less than half of the proposed amount and is alleging that Ally Financial drove up the price of the settlement as a way to absolve its liability to the estates and third parties. The hearing on the settlement - which was originally scheduled to begin in early November - is now scheduled to begin on 18 March.

RMBS

Flagstar first for warranty cases

The US District Court for the Southern District of New York last week ruled that Flagstar Bancorp was liable for representation and warranty breaches on two HELOC RMBS that had been guaranteed by FSA. The decision is the first final court judgement in a rep and warranty case and is expected to influence other court decisions, including MBIA's case against Countrywide.

Under the ruling, Flagstar is required to reimburse Assured Guaranty by approximately US$90m plus 2% contractual interest. The bank will also have to pay for the legal and administrative expenses that the insurer incurred when litigating the case.

Barclays Capital MBS analysts point out that the judge ruled that the rep and warranty breaches did not actually have to cause the loan to default; they simply had to increase the risk of loss on the securities. Even loans that had made on-time payments for 12 months after being originated or where a 'life event' caused the default could be eligible for a repurchase.

"While the ruling is clearly beneficial for other monoline insurers in their rep and warranty cases against the banks, it is important to note that judges in other jurisdictions are not required to follow the district court's decisions," the Barcap analysts observe. "Furthermore, Flagstar has already announced that it will be appealing the judgement and it remains to be seen whether the appeals court will uphold the verdict. That said, the decision marks a victory for monoline insurers and - to some extent - for RMBS bondholders in their rep and warranty lawsuits, and could motivate some banks to engage in settlement talks."

RMBS

Arch makes US mortgage insurance foray

Arch US MI, the US-based subsidiaries of Arch Capital Group, have entered into a definitive agreement to acquire CMG Mortgage Insurance Company from PMI Mortgage Insurance and CMFG Life Insurance Company (CUNA Mututal) for US$300m. Arch US MI also agreed to acquire PMI's mortgage insurance operating platform and related assets.

PMI has been in rehabilitation under the receivership of the Arizona Department of Insurance since 2011. The transaction allows Arch Capital to enter the US mortgage insurance marketplace and will broaden its existing mortgage insurance and reinsurance capabilities.

Arch US MI will also enter into distribution and reinsurance agreements with CUNA Mutual, which will continue to serve credit union customers on behalf of Arch US MI. The transaction is expected to close within 12 months, subject to approvals.

PMI's senior management team and staff are expected to join Arch US MI. All mortgage insurance and reinsurance staff will ultimately report to Marc Grandisson, chairman and ceo of Arch Worldwide Reinsurance Group.

RMBS

McGraw-Hill seeks First Amendment relief

McGraw-Hill and Standard & Poor's Financial Services have filed for declaratory relief in federal court in South Carolina, petitioning the court to declare that the state is precluded on First Amendment grounds from suing S&P for allegedly inflating its ratings of MBS leading up to the financial crisis. The complaint was filed a day after the US Department of Justice sued the rating agency in federal court in California (SCI 6 February).

South Carolina is not among the states that has joined the DOJ's lawsuit, a Lowenstein Sandler client memo notes. However, the state's Attorney General notified S&P on 20 December that his office is contemplating pursuing claims against the agency for "unfair and deceptive practices" relating to ratings issued for RMBS and CDOs.

RMBS

RMBS fund debuts

Morgan Stanley Investment Management (MSIM) has launched a global mortgage securities fund. The fund seeks to provide an attractive rate of return through investment in a portfolio of mortgages and securitised debt instruments issued by government agencies and private institutions.

A thematic bottom-up investment approach will be applied, combining global macro fundamental analysis, thorough research and analysis of industry trends to create a diversified portfolio of securitised instruments. MSIM's global mortgage research teams aim to identify potential value opportunities in all areas of the securitised market, with portfolio construction taking place over three key stages - value identification, implementation and evaluation.

RMBS

Countrywide settlement 'too low'

New documents have been filed in New York State Supreme Court claiming that the proposed US$8.5bn figure for the 2011 Bank of America settlement is too low. The submission was made by Triaxx, as well as the Federal Home Loan Banks of Boston, Chicago and Indianapolis.

The filing reportedly argues that Bank of America continued to put its own interests ahead of investors as it modified troubled mortgages, in light of which the submission contends that the settlement to resolve claims over Countrywide's RMBS is too low. The settlement is awaiting the approval of judge Justice Barbara Kapnick.

"The new allegations in the filing add to the uncertainty around whether the settlement will be approved and when investors will ultimately receive settlement cashflows. While this filing could increase the prospect of a larger settlement than previously agreed to, it also has the potential to prolong the timeline of settlement cashflows," observe MBS analysts at Morgan Stanley.

ABS

Slight increase expected for UK card charge-offs

In its latest quarterly UK Credit Card Index, Fitch notes that credit card ABS produced the strongest performance on record last year. Performance for UK credit card trusts continued to improve throughout 4Q12, with charge-off and delinquency rates decreasing even further from their historical low levels reached in 3Q12.

Given the decreasing late delinquencies and signs of improvements in the UK economy, the charge-off index is expected to stay stable or improve slightly in the coming months. However, Fitch expects delinquencies and charge-offs to start increasing slightly in 2H13, given that a triple-dip recession is a risk for the UK economy.

Current levels in delinquencies and charge-offs are - in Fitch's view - unsustainable in the long term. However, yield and payment rates are expected to remain fairly stable in 2013.

The three-months rolling charge-off index improved to 4.4% in 4Q12 compared with 5.8% in 3Q12. The three-months rolling 60-180 Day Delinquency Index declined to 1.8% in 4Q12 from 1.9% in the previous quarter.

The Gross Yield Index value for December 2012 remained almost stable at 20.7%, representing a slight quarter-on-quarter decrease of 30bp. The Monthly Payment Rate Index increased to 19.3%, slightly above the range of 16%-19% broadly seen in the past 10 years and confirming the consumer trend of deleveraging.

ABS

Subprime auto ABS warning

Fitch believes that recent strength in the US subprime auto ABS market is leading to increased competition among lenders, which could result in looser underwriting practices. The agency also believes that the recent improvement in the stability of asset performance may indicate that future loss performance is more closely tied to new jobless claims than overall unemployment.

The US subprime auto ABS market has, overall, recently been driven by strong 2009, 2010 and 2011 vintages - which have benefitted from comparatively strong credit quality and loan terms during a solid market for used vehicles. During this time, the financial condition of the borrowers in the pool has improved as the less creditworthy ones defaulted.

Fitch notes that these changes have contributed to a continued decoupling of subprime auto ABS from the overall employment rate beginning in 2010. "In our view, trends in new jobless claims may provide a better leading indicator going forward because it more closely tracks the financial condition of borrowers remaining in the pools," it explains.

Performance in subprime auto ABS is anticipated to tail off for 2012 and 2013 vintages. Fitch expects 2013 securitisations to include weaker collateral quality than in prior years, including extended loan terms and weaker credit tier distributions.

"Over the longer term, this factor is viewed as a potential risk to the market. Should the positive performance in the market continue and attract more participants to it, the subsequent increase in competition could result in looser underwriting standards and exaggerate expectations. And, if another recession or downdraft in the market coincides with this expansion, we would expect a significant challenge to many vintages," the agency observes.

Structured Finance

Euro ABS consolidation on the cards?

The European ABS market appears to be entering a period of consolidation, according to ABS analysts at Deutsche Bank, as evidenced by the thin new issue pipeline and recent widening in senior UK prime RMBS spreads. HMI 2010-1X A4 and ARKLE 2010-2X 2A, for example, have widened by up to 5bp this month.

The Deutsche Bank analysts note that the balance of secondary activity seems to be tilting towards higher supply. BWIC volumes reached some €1.1bn this week, compared with the average €620m seen in January, with knock-on softer pricing implications.

"Given the rally experienced so far this year in European ABS, a pull-back in line with broader markets should not come as much of a surprise," they observe. "We see such bouts of spread widening as potential opportunities to add selected risk and believe they will be shorter in nature than previous sell-offs. CLOs (€522m in BWICs this week) and potentially UK non-conforming RMBS (€171m in BWICs this week) look to be sectors where widening will be most pronounced, in our view."

Structured Finance

Commerzbank SME covered bond analysed

Fitch says that programme features rather than the nature of the underlying assets were the key factor in determining how it approached Commerzbank's SME structured covered bond programme. The agency applied its covered bond criteria rather than structured finance criteria when rating the programme, despite it not being governed by the German Pfandbrief regulation due to the ineligibility of the underlying SME loans for inclusion in Pfandbrief cover pools.

Fitch assigned the programme AA/stable ratings in December. Even though a number of the programme's features are new compared with the German Pfandbrief market, they are used in covered bonds elsewhere and most of the structural elements have been seen in other jurisdictions, the agency notes. Most important for its classification of the programme as a covered bond programme is that the bonds are issued by the bank rather than an SPV, as well as the fact that investors have dual recourse to the bank and - should it fail - against the underlying loans.

As is common in covered bond programmes, Commerbank must maintain a certain level of overcollateralisation. This contrasts with structured finance deals, where credit enhancement will typically not be increased by the originator after the transaction is launched. In addition, issuance is untranched and the loan portfolio has to be supported by the bank if the credit quality deteriorates.

Another important feature - the switch to pass-through mechanism - is also not new in covered bonds. Bonds issued under the Commerzbank programme would switch to pass-through payments if the issuer defaulted and the guarantor (the SPV that owns the cover pool) did not have enough cash to repay a maturing bullet bond at its expected date. While pass-through payments from the start are common in structured finance transactions, Fitch has rated covered bond programmes with a switch to pass-through redemption in countries such as the UK.

Other elements typically seen in structured finance - such as the contractual rather than legislative basis for the programme and the presence of an SPV, albeit not as issuer - have been seen in covered bond programmes in other jurisdictions, such as Canada and New Zealand.

CDO

ABS CDO on the block

An auction will be conducted for RFC CDO II on 1 March. The collateral will only be sold if the proceeds are enough to cover the redemption amount.

CDS

SEF accesses connectivity platform

Javelin Capital Markets has joined IPC System's Connexus Financial Extranet service, with the aim of enabling its customers to not only comply with the Dodd-Frank regulations but to also capture liquidity and achieve best execution. The service will provide reliable and secure connectivity for a diverse pool of market participants seeking direct access to the Javelin SEF, the firm says.

"As the market structure for OTC derivatives continues to evolve, IPC is providing its customers with solutions that help their clients seize alpha generation opportunities," comments Joe Pickel, vp, network services product management at IPC. "As electronic trading in interest rate and credit default swaps flourishes, having Javelin Capital Markets as a liquidity venue destination on Connexus will provide market participants with the flexibility required to trade these rapidly growing asset classes."

IPC's OTC derivatives market community includes broker-dealers, inter-dealer brokers, derivative execution venues and major institutional investors.

CDS

Equity tranche trade touted

The credit market is currently characterised by two prominent themes - demand for yield and fear of rising rates - which have turned year-to-date performance negative in the face of strong equity market returns. Against this backdrop, subordinated index tranches are being put forward as a natural way to avoid rate risk, generate additional yield through increased credit exposure and build a cushion against potential LBO risks.

Credit derivative strategists at Morgan Stanley note that while they have a preference for taking credit and structural risk rather than duration risk, a potential rising LBO environment could make credit selection tricky. To that end, they recommend pairing a long position in CDX IG9 10-year equity with a maturity-matched short in CDX IG19 five-year equity.

The Morgan Stanley strategists suggest that CDX IG9 equity tranches are attractively priced, despite the fact that a tail has already formed. At the same time, if credit-negative corporate actions rise, dispersion could increase among CDX IG19 constituents.

"We have a preference for thicker mezzanine tranches on healthy portfolios, such as 7%-15% on CDX IG19, as a positive carry and roll-down trade that will have a cushion against LBO-related dispersion. In addition, we retain our preference for CDX IG9 10-year 3%-7% risk, given favourable comparisons to high yield risk," they conclude.

CMBS

Treveria work-out agreed

CR Investment Management has been awarded the asset management mandate for the Treveria D-Silo facility backing the Treveria II/Sunrise II loan respectively securitised in the DECO 2006 E4X and EMC VI CMBS. The firm will advise and work with Treveria on the implementation of the business plan, which will create value by selling-down the portfolio over time.

The portfolio comprises 48 retail assets across 250,000sqm and was originally financed by a loan of €230m. CR's strong track record and experience in the retail sector, combined with its independence are said to be the critical factors in their selection for the mandate.

Similar to the Treveria C-Silo facility - which CR has been managing since early-2010 - the Treveria D-Silo was financed by loans from Citi and Deutsche Bank. Situs Asset Management is the special servicer on both facilities. With respect to D-Silo, it has entered into a four-month standstill, which is intended to extend on a rolling four-month basis, providing there are no breaches to the agreement.

The addition of the mandate brings the Treveria assets managed by CR to in excess of €750m and total retail assets under management to in excess of €1.5bn.

CMBS

Poor performance expected for Euro CMBS

Moody's expects loans backing European CMBS to perform poorly over the next two years because of the prolonged financial stress in the region and the continued euro area crisis, which is affecting all areas of the commercial real estate markets. The rating agency bases its view on several assumptions that are broadly similar to those in its 2012 European CMBS central scenarios update.

Moody's updated central scenario assumptions are that: 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. Oliver Moldenhauer, a Moody's vp - senior analyst, explains: "Refinancing prospects among CRE loans maturing over the coming years will differ significantly, depending on the quality of the underlying properties and the leverage of the loans. Only loans that are moderately leveraged and secured by prime properties are likely to be able to refinance."

Other factors, such as the avoidance of asset fire-sales and an investment focus on prime properties, are also expected to drive CRE loan performance. CRE capital values should be stable for prime properties overall, but will continue to fall for non-prime properties due to lack of investor demand, especially for low quality secondary and tertiary assets. Servicers and balance-sheet lenders will likely increase the number of loan enforcement actions and forced sales of non-prime properties over the next years, which will bring evidence of further capital value deterioration, according to Moody's.

While rating volatility is anticipated to remain high in 2013, ratings will experience 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 - especially when combined with non-sequential allocation of repayment proceeds - can change the rating of the notes. Similarly, final recovery proceeds significantly below Moody's expectations can lead to further downgrades.

CMBS

Promising start for CMBX.6

CMBX.6 index activity appears to have had a promising start, based on DTCC figures. Total CMBX volumes in the index's first week of trading surged by 30% to over US$4bn, with trading on series 6 accounting for almost half of the activity.

CMBS analysts at Deutsche Bank note that the AAA.6 sub-index made up half of all triple-A trading, as investors rolled their legacy hedges into the new series. While series 1 remains the index with the most outstanding contracts and net notional traded, they believe that series 6 will continue to make up ground.

CMBX prices fell across all series last week, with AJs falling the furthest in the legacy space. Net dealer positions declined by over US$300m as new issue desks added to series 6 shorts.

Although the TRX.II index is eventually expected to fade away, given the superior hedging available via CMBX.6 (SCI passim), volume has surged in recent weeks. It remains to be seen whether the activity is just closing out of positions to roll into series 6.

CMBS

CMBS late-pays hit 2010 lows

US CMBS late-pays declined by 8bp in January to 7.91% from 7.99% a month earlier, according to Fitch. This marks the eighth straight month of declines and the lowest level since October 2010, when the index stood at 7.78%.

In January, resolutions of US$1.4bn outpaced additions to the index of US$1.1bn. However, Fitch-rated new issuance volume of US$600m fell short of US$2.9bn in portfolio run-off last month.

Offsetting the positive movement in overall delinquencies is Georgia, which continues to be a problem spot, according to the agency. The two largest loans entering the index last month - the US$71.1m Millennium in Midtown (securitised in GSMS 2006-GG6) and US$67.7m Southlake Mall (BSCMS 2007-PWR18) - are both located in Atlanta, helping to push the delinquency rate for Georgia to 20%. This represents the second-highest rate of any state, with at least US$5bn in CMBS outstanding (behind Nevada at 20.7%).

Fitch took a closer look at Atlanta office loans greater than US$10m that were REO, as of the start of last year. Of those, four loans totalling US$88m were disposed of. It took an average of 18.2 months for those properties to be sold from the time they were foreclosed upon, with an average loss severity of 78% of the original balance.

Additionally, loss severities for another six Atlanta office properties that were REO at the start of last year and remain outstanding would be 52% based on recent appraisals. However, the agency expects actual severities to be higher.

Current and previous delinquency rates for Fitch's index are: 9.73% for multifamily (from 10.12% in December); 8.76% for hotel (from 8.87%); 8.69% for industrial (from 8.61%); 8.33% for office (from 8.41%); and 7.43% for retail (from 7.14%).

CMBS

CMBS pay-offs jump

The percentage of US CMBS loans paying off on their balloon date has exceeded 60% for the fourth time in the last five months, according to the Trepp January Payoff Report. In January, 66.9% of loans reaching their balloon date paid off - an increase of more than 12 percentage points from the December reading.

The total was also the second highest total over the last four years: only September's 68.2% reading is higher. The January rate of 66.9% is well above the 12-month moving average of 49.2%.

By loan count, as opposed to balance, 62.6% of loans paid off. The 12-month rolling average on this basis is now 57.9%.

Risk Management

EMIR intelligence solution debuts

OpenLink Financial has launched an intelligence solution designed to address the European Market Infrastructure Regulation (EMIR). The new online analytical processing-based cube offering provides financial institutions and other organisations participating in bilateral OTC derivatives trading a speedy and cost-effective way to comply with the new clearing and reporting requirements, the firm says. The OpenLink EMIR Cube enables organisations to: generate daily regulatory reports for trade repositories; calculate and record the sum of the absolute values of the notional outstanding portions of current sales; view the EMIR values for the entire firm and also drill down into trade-level detail; and run 'what if' scenarios.

RMBS

Spanish debt forgiveness 'should be manageable'

Spanish Minister of Economy and Competitiveness Luis de Guindos last week proposed changes to the country's mortgage market that, if implemented, have implications for Spanish RMBS. The proposals chiefly pertain to providing aid to borrowers that are struggling to meet mortgage payments and follow on from the mortgage foreclosure moratorium announced in November last year.

Deutsche Bank ABS analysts highlight one proposal that is concerning: partial debt forgiveness from the fifth year onwards from foreclosure. Debt forgiven is the debt remaining after the debtor pays (within five years) 65% of the post-foreclosure loan amount.

The post-foreclosure loan amount is defined as the loan amount less foreclosure value. Debt forgiven reduces to 20% of the post-foreclosure loan amount in the tenth year onwards from foreclosure.

"We estimate on average across the RMBS market that some 5.28% of loans are in arrears, not too far off the 3.63% given by the Bank of Spain for the residential mortgage market at large," the Deutsche Bank analysts note. "Therefore, when allied to the constraints imposed on the quantum of debt permitted to be written off - we estimate, for example, an 80% original LTV loan would see debt write-off of just 8.75% under the scheme after five years - the impact is likely to be negligible. Nonetheless, the proposal is a further step towards more comprehensive formalised non-voluntary mortgage debt forgiveness."

They suggest that by limiting mortgage debt forgiveness to a share of the post-foreclosure loan, the amount written off as a proportion of the original loan amount should be manageable. While it is unclear if this applies to existing repossessed loans, it is unlikely to be retrospective, in their view.

RMBS

Mortgage insurance recommendations issued

The Joint Forum has released a consultative report entitled 'Mortgage insurance: market structure, underwriting cycle and policy implications'. The report examines the interaction of mortgage insurers with mortgage originators and underwriters, and includes a set of recommendations directed at policymakers and supervisors that aim to reduce the likelihood of mortgage insurance stress and failure in tail events.

The report sets out the following recommendations: policymakers should consider requiring that mortgage originators and mortgage insurers align their interests; supervisors should ensure that mortgage insurers and mortgage originators maintain strong underwriting standards; supervisors should be alert to - and correct for - deterioration in underwriting standards stemming from behavioral incentives influencing mortgage originators and mortgage insurers; supervisors should require mortgage insurers to build long-term capital buffers and reserves during the valleys of the underwriting cycle to cover claims during its peaks; supervisors should be aware of and mitigate cross-sectoral arbitrage that could arise from differences in the accounting between insurers' technical reserves and banks' loan loss provisions, and from differences in the capital requirements for credit risk between banks and insurers; and supervisors should apply the FSB Principles for Sound Residential Mortgage Underwriting Practices to mortgage insurers. Comments on the consultative report should be submitted by 30 April.

RMBS

New agency derivative indices debut

Markit has launched IOS, PO and MBX indices referencing 3% and 3.5% Fannie Mae pools issued in 2012. MBS analysts at Barclays Capital suggest that the closest comparable index for the 3.5 2012 cohort is the 3.5 2010 index, albeit the 2012 cohort is expected to pay slower and thus trade better than the 2010 cohort.

They note that this is because the 2012 cohort: is lower in the aging curve at 8 WALA; has an average WAC that is about 12bp lower than that for the 2010; has a lower share of TPO loans (at 43%) than the 2010 (63%); and has about 14 points lower FICO.

Further, both new IOS contracts appear attractive relative to their counterparts on a hedged-carry basis, according to the Barcap analysts. 2012 IOS 3.5s offer 7.3 ticks of carry per month, compared with the 6.4 ticks of carry on 2010 IOS 3.5s. The former also offer attractive carry of 8.5 ticks, as they are even further down the aging ramp.

RMBS

RMBS interest shortfalls increasing

Morningstar Credit Ratings has reviewed monthly occurrences of interest shortfalls in US RMBS across the second half of 2012. The data shows a steadily increasing trend in shortfalls across different collateral types, tranche types and vintages.

As of the December 2012 remittance cycle, approximately 21.8% of the deals in the Morningstar sample experienced a shortfall in at least one tranche. The month-over-month increase in shortfalls occurs in nearly every subcategory.

Prime deals have seen the largest jump from July 2012 based on collateral type (68.7%), but interest shortfalls are still more likely to occur in subprime deals. Junior tranches had the largest six month increase (45.4%) when analysing by tranche type and their overall prevalence is still the highest when compared to senior and mezzanine tranches. The most recent vintages experienced a large increase in occurrences of interest shortfalls, but this category also had the smallest sample size of only 138 classes.

With respect to the bonds that repaid their November 2012 interest shortfall in December 2012, the likelihood of repayment was found to be impacted by both the amount and duration of the shortfall. To analyse the effect that time can have on curing interest shortfalls, Morningstar reviewed the performance of the 1,140 classes of RMBS securities that experienced an interest shortfall in July 2012 by looking at their status in December 2012.

Of the sample, 78.6% continued to have an interest shortfall in December. Of the 21.4% that cured, 3.9% had a principal write-down and 0.6% had an unrealised write-down.

In order to examine more closely the month-over-month changes, the same exercise was undertaken for the 1,398 bonds that had shortfalls in November 2012. Here, 88.2% of the shortfalls remained in December.

To learn more about what drives the repayment of interest shortfalls, 9.4% of the classes (132 tranches) that had an interest shortfall in November and fully recovered in December with no principal write-down were examined. The 132 bonds that repaid had an average interest shortfall of US$15,987, while the classes that did not repay had an average interest shortfall of US$95,631 - suggesting that the amount of shortfall has an impact.

The length of the outstanding interest shortfall also plays a role. On average, the tranches had 1.8 consecutive months of shortfall before being repaid and a total of 3.4 instances of interest shortfalls throughout their overall history, according to Morningstar.

Of the 132 tranches that repaid in December, 68.2% (90 tranches) had only one month of shortfall preceding the repayment. For 40.9% (54 tranches), the November shortfall was the first and only occurrence of interest shortfall throughout the tranche's history.

The analysis focused on a subset of 21,000 bonds from over 2,000 deals from the Morningstar database.

RMBS

FHA reform gaining momentum?

FHA reform discussions gained momentum last week, with the House Financial Services Committee holding the first of two meetings scheduled for February to discuss changes to the FHA programme. Testimony at the hearing stressed that the FHA should focus on its original core mission: insuring mortgages for low- and moderate-income borrowers and first-time home buyers.

Two methods for reducing FHA loan limits were proposed during the meeting: accounting for regional home price differences; and setting a declining hard dollar cap. The former proposes setting loan limits at 100% of county median prices for most home buyers, with first-time home buyers' loan limit set at something less than 100%. Repeat buyers would be subject to a limit of 80% of county median home prices.

The latter suggestion involves reducing the FHA loan limit immediately to US$625,000, with subsequent annual reductions of US$100,000, subject to a floor of US$350,000 after the third year. An alternative proposition would be to eliminate loan limits altogether and target the FHA programme at borrowers based on income, according to MBS analysts at Barclays Capital, thus more closely aligning the programme with its original mission.

To improve the quality of loans insured by the FHA, it was suggested that the agency's full faith and credit guarantee be scaled back. Further, several specific underwriting criteria changes were discussed.

Other options likely to be under consideration are those that were included in last year's FHA Solvency Act, including enhancing the FHA's indemnification authority, easing its ability to remove originators, raising the maximum MIP and limiting seller concessions to 3%.

New proposals on loan limit reductions, increased down-payment requirements and more conservative underwriting standards enjoy some level of bipartisan support. Equally, there appears to be bipartisan concern regarding the financial condition of the FHA. The Barcap analysts consequently believe that some type of reform will pass the House in 1H13, albeit specific details still need to be worked out.

RMBS

Resi idiosyncratic risks eyed

Fitch says that prime residential mortgage portfolios with low expected loss levels need an additional level of scrutiny to ensure that idiosyncratic risks are adequately mitigated. This applies to portfolios securing either RMBS or mortgage covered bonds (MCB).

The agency will conduct an additional level of review for portfolios where expected losses, when applying a triple-A level stress, are below 4%. It may also perform additional analysis on portfolios with triple-A level loss expectations in excess of 4%, where the expected loss is low compared with peer transactions in the same country or for a sector outside of prime.

While such instances are relatively infrequent, they can arise where portfolios consist of mortgage loans with exceptionally strong credit characteristics, according to Fitch. Given tighter post-crisis underwriting limits across the globe, it is likely that portfolios with stronger credit profiles will feature more frequently and the 4% loss expectation could be tested more often. Depending upon the outcome, this additional analysis could result in an increase to expected credit protection supporting ratings on bonds against idiosyncratic risks.

The specific drivers of these idiosyncratic loss outcomes are difficult to determine in advance, the agency notes. For example, the loss may result from unforeseeable factors affecting a property's value. Servicers could also choose to prioritise higher LTV loans for workout, meaning that low LTV loans could see a longer workout period and incur greater carry costs prior to security being enforced.

Fitch says it would expect to receive supplementary historical performance data and foreclosure history specific to loans with strong credit characteristics over a period of economic stress, specifically with regard to loans that defaulted - as well as those that experienced unexpectedly high LS. The agency may then choose to apply specific deterministic stresses or sensitivities to model-derived loss rates.

This supplementary analysis will be performed, where applicable, when a new rating is assigned. However, the risks involved and the extent of credit protection will also be considered at the surveillance review for existing transactions and programmes. If the analysis for an existing rating suggests that credit protection may be insufficient due to increased idiosyncratic risk, Fitch may downgrade the affected bonds.