Contents

Risk Management

SEF certainty

CFTC clears up CDS concerns

A perceived regulatory preference for CDS futures over swaps has caused serious consternation in the market. However, the publication of final SEF rules yesterday (16 May) has assuaged most concerns and paved the way for participants to advance.

Bloomberg last month filed a lawsuit to prevent the US CFTC from implementing what it saw as flawed regulation (SCI 18 April). With rules for designated contract markets (DCMs) at that point far more advanced than those for SEFs, Javelin Capital Markets ceo James Cawley believes that Bloomberg certainly had a point.

Legal uncertainty around SEFs and the drawn-out nature of the regulatory process actually caused trueEX to abandon early plans to register as a SEF as well, says its ceo Sunil Hirani. The firm intends to instead create futures contracts based upon S&P's new credit spread indices (SCI 11 April).

A lack of action by regulators to bring clarity around SEF rules was seen to be creating an unfair competitive advantage for DCMs. With the CFTC's release of the SEF rules (see separate article), the mismatch in clarity between the rule sets has now been corrected, although other discrepancies remain.

Another bone of contention has been the VaR difference between swaps and futures. "There is a mismatch on block sizes and there is a major mismatch on margin requirements, not least with one-day versus five-day VaR for IRS and credit indices," says Cawley.

While there is a significant difference in the margin period for swaps and futures, Hirani believes that several factors account for this difference. He says it "should be based on the liquidity, risk, volatility and time for liquidation" but not on the wrapper. With tax, accounting and maintenance cost implications, he says it is more complicated than just one factor.

However, Cawley says the shorter VaR for futures is very much because of predicted liquidity, predicated on the one factor of how quickly portfolios of futures and swaps are expected to be able to be liquidated. This would be more understandable if the swaps market was actually illiquid, but he suggests that there is a very liquid market for both credit indices and IRS.

"This is based on the hypothetical liquidity of swap futures portfolios, which do not exist yet. It is based on a fiction. The IRS market is one of the most liquid and standardised in the world," says Cawley.

While differences between the two products remain, the final rulemaking from the CFTC means that SEFs do now know where they stand as they compete with DCMs for business. Hirani says that ultimately providing choice to the market is the most important factor.

"The world wants swaps and futures, so I think we should let the market decide. Our job is to provide the infrastructure which allows people to trade and that is what we are trying to do," he explains. He points to CME's deliverable swap futures (DSFs) as an innovative solution, which will help both the swaps and futures markets to grow.

The offering from trueEX will be a futures contract based off credit indices derived from the S&P 500. "That will be independently derived and based on debt outstanding, including a financials index component, and on the futures contract the names are going to be known," explains Hirani.

He continues: "The vision is to take the trueEX futures contract on the S&P index and be able to offer it to every single person and institution in the world who trades S&P 500 equity futures. The goal is to exponentially expand the universe of investors who can express views on corporate spreads but does not currently have access to a transparent, regulated, standardised and independent futures contract."

The new market agreed coupon (MAC) standard put forward by SIFMA and ISDA (SCI 24 April) is also a big step forward for the market, says Cawley. The argument against swaps has so far been that they are too bespoke and this goes a long way to negating such criticism.

"As the market begins to trade on SEFs this summer, the time has come for a standardised coupon swap that trades with an IMM date. We expect to see liquidity take off in this new MAC product," Cawley observes.

He concludes: "Now that SEF rules are finally here, thoughts that DCMs have first-mover advantage in the swaps market are unfounded. The fact is that the entire market is readying itself to trade transparent execution venues off the SEF mandate."

JL

CDS

Asian liberalisation?

Signs of CDS gaining ground as Asian markets open up

The OTC derivatives market in Asia continues to be fragmented and largely weighted towards FX and interest rate swaps. However, CDS remains a core constituent and there are encouraging signs that the sector is evolving.

Overall CDS volume in the Asian Pacific region is down on previous years and trading has consolidated around only a few jurisdictions. The majority of trading activity takes place in Hong Kong or Singapore, followed by Australia.

"Australian banks trade CDS out of Australia, which is a significant market. However, most global banks will even trade their Australian CDS out of Hong Kong and Singapore, due to price pressure. Though volumes have decreased, there are still a couple of Asian sovereigns that regularly make the top-20 most actively traded names," says Keith Noyes, Asia-Pacific regional director at ISDA.

One of the markets where CDS has gained ground is China. Although the country remains particularly heavily biased towards FX, CDS has begun to gain a foothold.

"While the Chinese CDS market is not particularly buoyant, some CDS have been packaged into structured products sold as wealth management products. The inter-bank market is small and practically non-existent," says Noyes.

He continues: "However, a number of Chinese banks have structured CDS essentially as CLNs and sold them as wealth management products. That has been a very interesting development."

Another good example of the desire to expand CDS to non-traditional Asian markets is India (SCI passim). Nonetheless, progress in both markets is being hindered by restrictive local regulatory regimes, with onshore CDS markets expected to take time to develop. One example is the Indian market, which only allows CDS for prescribed categories of users and for the purpose of hedging or protecting specified risks.

"We were involved in putting together templates for the Indian market. CDS was not allowed there until 2011, when a statutory change allowed covered credit derivatives to be used. The market there is in nascent stages and has only just started up," says Matthew Hebburn, partner at Allen & Overy.

Ross Stewart, counsel at Allen & Overy, points to the irony that onshore CDS was first permitted in India - albeit in a limited form - after the global financial crisis and the scrutiny that came with it in more developed markets. "One of the drivers for the introduction of onshore CDS in India was to provide liquidity for the local bond market and that still remains the goal, so - although regulators are being restrictive - they do want this market to work," he says.

A further challenge is that CDS trades in India require a separate onshore CSA. Most banks will run one CSA globally with new counterparts, but in India they are required to set up a new one.

"There is also the problem that, due to restrictions on the types of names you can write CDS on, where CDS is available there is not much demand and where there is demand the CDS is not available," says Noyes.

He adds: "Also, the number of participants is still small and while banks are willing to market-make and write protection, they will hit risk limits quickly because products like CLNs are not allowed in India. The natural sellers, such as insurance companies, are not allowed to participate and there is no onshore hedge fund industry."

It is hoped that the tight Indian regulations may loosen up, however. Noyes suggests that Indian regulators have deliberately avoided a 'big bang' and will look to pace the opening up of the market conservatively.

Advancements have also been made in other Asian markets. Stewart points to progress from more developed markets, such as Japan, and less established jurisdictions such as Mongolia. The former is the first Asian market to clear CDS, which is now available for Japanese iTraxx indices.

"There is some appetite to expand and deepen the Asian CDS market. One of the more interesting examples is that we recently looked at writing CDS on Mongolian sovereign bonds," he adds.

Another interesting jurisdiction is South Korea, with discussions underway about a Korean CDS index being developed locally. Noyes notes that regulators in the country are currently more focused on implementing G20 commitments for clearing, but says that CDS remains something they intend to introduce.

While CDS has previously caused controversy - and not just in Asia - Hebburn notes that the product has borne out extremely well throughout various crises. Although he understands regulators' caution about the instrument, he points out that many of the concerns are unfounded.

"From an economic perspective, these are sound financial tools and a good part of any treasurer's toolkit to hedge risk. There is already a relatively developed market in Japan, Hong Kong, Singapore and Australia and - as other south-east Asian economies rise, such as Indonesia - the markets will liberalise," Hebburn concludes.

JL

RMBS

Freddie sale meets strong demand

Further details have emerged on the US$1bn-plus US RMBS non-agency bid-list put out by Freddie Mac earlier this week (SCI 14 May). The collateral consisted mostly of subprime and adjustable rate prime or Alt-A loans, with all of the bonds originated in 2005 or earlier.

The list was announced at the start of the week and scheduled to trade on Wednesday. The day's session saw elevated BWIC volumes for prime hybrid, Alt-A hybrid, option ARM and subprime paper, with around 70% of the US$1bn BWIC understood to have traded to one dealer.

The historical performance of the bonds has been quite strong. Three-month default rates are low and 60-day plus delinquencies are generally below 20%, apart from for 2005 subprime securities. At nearly 2x, the average loss coverage ratio is also solid, compared to broader non-agencies.

Price talk for most bonds averaged mid-90s to low-100s, with the range of talk generally only five to six points. While colour ahead of the bidding cut-off was very transparent, subsequent information has not been so plentiful.

"Initial indications from the Street were that one dealer purchased nearly three-quarters of the list and that execution was thought to be strong. Late [Wednesday], one dealer sent out re-offerings on 15 line items, most at or well above the top end of earlier price talk," reports Interactive Data.

Although the list does not appear to have greatly impacted the total volume of non-agency trading relative to recent averages, there were several more investment grade securities changing hands. After averaging US$77m per day, Wednesday's total was US$623m.

In terms of flows, Interactive Data says that there was a noticeable increase in net dealer positioning. "In aggregate, the Street appears to have gotten long approximately US$730m non-agency CMO bonds."

Freddie Mac is understood to be planning to sell another US$1bn of its RMBS holdings next month. The GSEs are required to sell 5% of their holdings other than agency MBS by the end of the year (SCI 5 March).

Non-agency BWIC volume remained high and was over US$1.5bn yesterday, with ARMs tightening by about two points. 2005-vintage paper was popular yesterday and accounted for the majority of the 162 US RMBS line items in SCI's PriceABS data for the session.

The prime fixed WFMBS 2005-2 1A6 tranche was talked in the mid/high-90s and 101 area and the Alt-A hybrid IMSA 2005-2 A2D tranche talked in the mid-70s, having previously been talked in the low-60s and mid/high-50s last November. The oldest vintage paper was AMRES 1999-1 M1 (talked low/mid-90s), while the most recent was SLFMT 2013-1A B1 (talked 103).

JL

RMBS

Active start for non-agency RMBS

The secondary US non-agency RMBS market has had an active start to the week, boosted by a CDO liquidation containing vintage mezzanine subprime collateral. A drop in supply was observed in fixed rate bonds, however.

One notable subprime name out for the bid yesterday was PPSI 2005-WCW2 M3, which was talked in the high-40s. The tranche last appeared in SCI's PriceABS archive on 28 August, when it was talked at 30 area.

Among the fixed rate bonds circulating were JPMMT 2005-S3 1A9 and CWALT 2005-20CB, which were talked at very high-90s and 80 area respectively. Talk for the former tranche is up from where it was offered on Friday.

In the option ARM segment, meanwhile, the SARM 2005-16XS A1 tranche was talked at mid-90s during the session. This compares with talk of low/mid-90s back on 30 November 2012.

Structured Finance

SCI Start the Week - 20 May

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

Pipeline
A broad range of transactions remained in the pipeline at the end of last week. These deals comprise four ABS, four RMBS and two CMBS.

The ABS currently in the pipeline consists of: €800m Bavarian Sky German Auto Loans 1; US$238m CarFinance Auto Receivables Trust 2013-1; US$599.7m Edsouth Indenture No.4 Series 2013-1; and €300m Volta Electricity Receivables Securitisation. The RMBS include Firstmac Series 1E-2013 and £420.6m Kenrick No.2, as well as two servicer advance deals - HLSS Servicer Advance Receivables Trust series 2013-T2 and 2013-T3 (each sized at US$425m). Finally, a pair of CMBS continues to be marketed - US$510m JPMCC 2013-JWRZ and US$1.47bn WFRBS 2013-C14.

Pricings
The deals that priced last week were even more diversified. The ABS, CLO, CMBS, ILS and RMBS asset classes were all well represented.

No less than 10 ABS printed during the week. These were: A$540m-equivalent SMART ABS Series 2013-2US Trust; US$1.342bn Ford Credit Auto Owner Trust 2013-B; US$800m Nissan Auto Lease Trust 2013-A; €571.4m Red & Black Auto Lease Germany 1; US$526.3m World Financial Network Credit Card Master Note Trust Series 2013-B; US$750m Chase Issuance Trust 2013-4; US$250m Chase Issuance Trust 2013-5; US$512m Hyundai Floorplan Master Owner Trust Series 2013-1; US$150.8m United Auto Credit Securitization Trust 2013-1; and €450m Alba 5.

The CLO new issues comprised: US$500m Cent CLO 18; US$500m CIFC Funding 2013-II; €403m Grand Harbour I CLO; and US$517.5m Octagon Investment Partners XVI. The CMBS were US$1.2bn GSMS 2013-GCJ12 and US$440m CGCMT 2013-375P.

Finally, two RMBS (US$424m Sequoia Mortgage Trust 2013-7 and A$472m Series 2013-1 REDS EHP Trust) and one catastrophe bond (US$300m Long Point Re III series 2013-1) rounded out the issuance.

Markets
European secondary ABS spreads tightened further across the board last week, according to ABS analysts at JPMorgan, although the pace has slowed somewhat. "In absolute terms, peripherals and higher-yielding asset classes tightened the most, as to be expected. Granite remained flat across the capital structure, with the exception of the junior-most bonds, which gained 75bp to close the week at 89.75 cash price," they note.

US CMBS spreads also tightened significantly early last week, with the rally flagging by Thursday. While 2007 dupers and AMs ended the week marginally tighter, the main price action continued to be in the vintage AJ/mezz space, MBS analysts at Barclays Capital observe.

"Prices on these tranches climbed another 1-2 points in the beginning of the week, before a surge in profit-taking caused levels to back off slightly. We estimate that almost US$760m of vintage AJ/mezz was put out for bid [last] week, significantly above the weekly average of about US$385m for much of last year," they add.

Supply in the US non-agency RMBS sector reached roughly US$3bn, meanwhile, boosted by a US$1bn bid-list from Freddie Mac (SCI 17 May) and a number of CDO liquidations. Structured product analysts at Wells Fargo note that the general tone was positive, even with the elevated supply and the velocity of bonds trading in the street increasing.

Secondary US CLO activity also picked up last week, with BWIC volume increasing to over US$900m, according to Bank of America Merrill Lynch figures. In addition to triple-B, double-B and equity tranches - which accounted for most of the sector's BWIC volume in recent weeks - a large volume of triple-A notes were offered.

"Spreads across the capital stack tightened amid the healthy volume of traded line items. Of particular note were two middle-market CLO tranches that ended up trading above par, which surpassed the market's expectations," BAML CLO analysts comment.

Deal news
• Freddie Mac's US$1bn-plus US RMBS non-agency bid-list traded on Wednesday. The day's session saw elevated BWIC volumes for prime hybrid, Alt-A hybrid, option ARM and subprime paper, with around 70% of the collateral understood to have traded to one dealer.
• The risk of equitable subordination has arisen for the first time during insolvency proceedings of German CMBS borrowers. The case involves the Orange loan securitised in Talisman 6, which is sponsored by Treveria.
• Moody's has placed on review for downgrade the ratings of 28 tranches in eight UK RMBS sponsored by Co-operative Bank. The rating actions follow the agency's downgrade of Co-operative Bank from A3/Prime-2 to Ba3/Not Prime on 9 May.
• Fitch has released an unsolicited comment on CGCMT 2013-375P, a CMBS backed by a single loan on the Seagram Building located at 375 Park Avenue in New York. The agency says that the deal contains significant pro forma income that makes the credit enhancement insufficient at the triple-A ratings level.
• HIG WhiteHorse Capital has closed WhiteHorse VII, a term facility - structured like a CLO - to fund purchases of broadly syndicated loans. The facility closed with an initial investment of US$25m from the equity holders, with the class A delayed draw note having sole discretion to advance funds in US$5m increments up to a total of US$141m.
• Fitch has upgraded 24, affirmed five and downgraded one tranche from 12 Greek structured finance transactions. The action follows the revision of the country ceiling for Greece to single-B from single-B minus, after the Greek sovereign was upgraded by one notch on 14 May.

Regulatory update
• The US CFTC has released a final rulemaking on core principles and other requirements for SEFs. The move has been welcomed by many participants, but SIFMA strongly disagrees with the rules and warns they could negatively impact investors.
• ISDA has launched the ISDA 2013 Reporting Protocol, which contains a counterparty's consent to the disclosure of information. It is intended to facilitate market participants' compliance with mandatory trade reporting requirements.
• A borrower in California has successfully obtained an injunction against a foreclosure sale on his property. The borrower alleges that Bank of America, the servicer on the loan, violated the Homeowners Bill of Rights (HBR) ban on dual tracking by filing for foreclosure sale before responding to a request for a loan modification.

Deals added to the SCI database last week:
Apollo Series 2013-1 Trust; Armor Re series 2013-1; Auto ABS DFP Master Compartment France 2013; Benefit Street Partners CLO II; Capital One Multi-asset Execution Trust 2013-2; CarMax Auto Owner Trust 2013-2; Irvine Core Office Trust 2013-IRV; Missouri Higher Education Loan Authority series 2013-1; Neuberger Berman CLO XIV; Santander Drive Auto Receivables Trust 2013-3; and Taurus 2013 (GMF1).

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; BACM 2005-1; BACM 2007-1; BSCMS 07-PW17, BSCMS 07-PW18 & MLMT 07-C1; BSCMS 2007-PW16; BSCMS 2007-T26; CGCMT 2007-C6; CGCMT 2007-C6 & CD 2007-CD4; CSMC 2007-C1; DECO 2011-CSPK; ECLIP 2005-2; ECLIP 2007-1; EURO 25; FORES 1; GCCFC 2004-GG1; GECMC 2005-C3 & GECMC 2005-C4; GECMC 2007-C1; JPMCC 2008-C2; MESDG CHAR; MLMT 2006-2; MLMT 2007-C1; MSC 2007-HQ13; PROMI 2; PROUL 1; TAURS 2007-1; TITN 2005-CT1; TITN 2007-CT1; TMAN 6; TMAN 7; WBCMT 2005-C22; WBCMT 2007-C32 & CFCRE 2011-C1; WFRBS 2011-C5; and WINDM VII.

Top stories to come in SCI:
Hedge fund relative value opportunities
US CLO market update

CLOs

Compelling case for CLO calls

Equity investors in callable 2010 and 2011 CLOs should call them now and take advantage of the low current funding costs in the new issue market, suggest CLO strategists at Morgan Stanley. Many holders of legacy deals would also benefit from exercising call options, although continuing to hold 2006 and 2007 vintage CLOs could offer greater value.

Twenty transactions have been called this year and a further 42 were called in 2012. Of those 62 deals, five are early CLO 2.0 transactions from 2010 and 2011.

Based on an analysis of the legacy deals called, the Morgan Stanley strategists find that the costs of funding prior to call tend to be much higher than their original levels at deal issuance, with the senior debt having typically already been paid down in part or in full before the call. For the 2.0 deals, the costs of funding prior to call were not significantly different from their original levels at deal issuance. This suggests that the motivation behind calling the deals is equity investors looking to re-use collateral to issue new deals that take advantage of lower market levels of funding.

The new issue CLO cost of funding is currently at post-crisis tights. But, as most CLO 2.0 deals have two-year non-call periods, many are unable to take advantage at present. Earlier 2.0 deals may be eligible to be called and the strategists believe it would pay for CLO equity investors of vintage 2010 and 2011 deals to value the embedded optional redemptions.

Besides refinancing, the other common motivation for calling CLOs is monetisation, where equity investors expect the excess interest to decline and want to monetise the current collateral market value after paying down all the debt tranches in full. This is most common when the collateral factor decreases as a deal starts to deleverage or when the coupon rates of collateral decline.

The median collateral factor is lowest for 2004 vintage CLOs at 24%, with 2005 vintage CLOs next at 57%. "With the current level of robustness in collateral re-pricing activities, we expect the collateral factors of legacy CLOs to decrease at a reasonably fast pace, which makes calling the deals more economical than holding them and waiting for the deals to get paid down naturally," note the strategists.

To see where coupon rates might be declining, the strategists examined median CLO portfolio WAS by vintage for legacy and 2.0 deals. CLO portfolio WAS have declined since the beginning of 2013 across all vintages and the levels of Libor floors in the underlying loans have also been declining steadily, lowering excess spread in deals and thus reducing likely future equity distributions.

"Clearly, the asset spread compression increases the probability of CLOs being called. While the prospects for future equity distributions appear to be headed down, the equity tranche liquidation values have been on the rise," the strategists observe.

They add: "The liquidation values of CLO equity tranches have just climbed to the highest levels since the beginning of 2012. In our opinion, the current high liquidation value of CLO equity tranches makes the call options in many deals more in-the-money than before."

A large portion of deals from 2005 or earlier appear likely to be called due to their low collateral factors, low expected future equity cash distributions and relatively higher liquidation value. For 2006 and 2007 vintage CLOs, the value of the call option is more varied, but investors would seem to be generally better off holding the equity tranches for additional cash distributions. For those 2008 vintage CLOs outstanding, the call option is more valuable than for 2006 and 2007 deals.

Finally, debt tranches from legacy CLOs that are still trading at a discount to par can also be attractive in deals where a call is likely. The strategists conclude: "An optional redemption massively accelerates the timeline of their principal cashflow receipts in full and thus is very valuable. In this context, we like mezzanine tranches trading at a discount to par of CLO deals that are likely to be called."

JL

CMBS

Equitable subordination risk rises

The risk of equitable subordination has arisen for the first time during insolvency proceedings of German CMBS borrowers. The case involves the Orange loan securitised in Talisman 6, which is sponsored by Treveria.

An insolvency creditor contested the voting rights of the lenders under the loan. The insolvency court then held that the voting rights of the Orange loan lenders are only 50% of the actual nominal amount of claims, because the extensive consent requirements and covenants under the facility agreement may make equitable subordination applicable to the repayment claims.

"According to the risk factor sections of these transactions, the German rules of equitable subordination apply to claims of a shareholder against the company in which it holds a shareholder interest exceeding a certain threshold (10%, to our knowledge). The rules can, however, also apply to a lender if - under the loan agreement - the lender is granted de facto control of the borrower in respect of its management and/or business decisions," Barclays Capital CMBS analysts note.

In these circumstances, the lender can be treated as being in a situation similar to that of a shareholder, with the result that its claims may be subordinated in borrower insolvency. The insolvency court in the Treveria case has not yet decided on the equitable subordination of the Orange loan, but has reduced the voting rights of the Orange loan lenders.

This reduction of the voting rights should not be overly negative, however, assuming the borrowing entities are SPVs with no substantial debt in addition to the securitised loan. More concerning is the rationale of the reduction, which seems to be based on the principles of equitable subordination.

"We are not lawyers, but we understand that these principles would apply to the entire loan and not to a part of the loan only. In other words, we do not think that the 50% voting right reduction for the Orange lenders implies that ultimately only 50% of the loan could be seen as equitably subordinated," the Barcap analysts explain.

Therefore, if the insolvency court decided that the Orange lender's position should be similar to that of a shareholder, this position would apply to the whole exposure and theoretically result in the Orange loan lenders having no voting rights. The fact that the claim is secured by mortgages does not affect the situation, the analysts add.

Net sales proceeds from the Orange loan are expected to be around €300m-€320m. In case of equitable subordination, the analysts estimate that only €260m could be allocated to the Orange loan, increasing principal loss expectations from €40m-€60m to €90m-€110m. When loss expectations for the other loans securitised in Talisman 6 are also factored in, the analysts change their base case from a 0%-15% principal loss for the class B notes to a 55%-80% principal loss.

A creditor meeting to review the creditors' claims is scheduled for the autumn, with no recovery proceeds expected to be allocated to the loan and CMBS until after that meeting - most likely resulting in the Orange loan not generating any principal recovery proceeds in 2013, even if the underlying properties are sold. The non-payment of interest is also expected to continue throughout 2013, resulting in continuous liquidity facility draws.

TMAN 6 B bonds were talked at mid-60s yesterday, according to SCI's PriceABS data. They were last covered at low/mid-70s on 13 February.

JL

CDO

Zombie deals: the living dead of structured credit

Dave Jefferds, co-founder and COO of DealVector, examines how noteholder communication could help heal the Trups CDO sector

Five long years ago, the global financial crisis hit. Many deals imploded almost immediately, like ABS deals that blew through their event of default triggers. That capital was more or less destroyed.

Other deals, like CLOs, were stretched but did not break at all. Their resilience allowed the structures to recover and that sector is now booming again.

But there are some deals that lived in between - zombie deals, neither living nor dying, the capital tied up and slowly wasting away. Some hedge funds are zombies: they were gated in 2008 and remain gated even today, still charging fees to investors. In structured credit, it turns out that a 'small' backwater (with US$60bn in total issuance) called Trups CDOs (or should we say ZDOs) also is full of zombies.

How can this be, after so long? How do markets heal and what stops them from healing?

Well, of course, the deals themselves matter. But there is a deeper problem. That problem lies at the heart of the financial system and it stops markets from healing efficiently.

The problem for investors is the one described in the movie Cool Hand Luke: "What we have here is failure to communicate." Let's compare the cases of the 'good' structured debt (CLOs) and the Zombie structured debt (Trups). As we will see, despite their differing fates, both would have (and would still) benefit from improved communication pipes in our financial infrastructure.

Let's look first at the ZDO situation. Trups CDOs were structures that took 'trust preferred' securities - usually issued by regional banks - and bundled them into CDOs, which were then tranched and sold. Most of these trust preferreds were issued by small un-rated banks.

The CDO underwriters kept the names of the banks secret (!) from the investors in the CDOs. Ostensibly this was to protect the banking relationship that existed between the big underwriter and the small regional, but it probably (I mean, for sure) also served to disguise the risks in the pool.

In this type of 'blind pool' structure, it turns out that many of the investors that were most comfortable with Trups were those that were most familiar with regional bank risk: the regional banks themselves. So, in the end, many Trups CDOs that held regional bank risk were themselves held by regional banks. Risk was not dispersed; it was concentrated.

When the crisis hit, these structures went south along with the banks. Without getting into too much detail, the structures had a forbearance period of about five years and this window suited policymakers just fine as they attempted to stop a banking collapse.

So far, so bad: this trade was a tragic one. Regional banks have been in a sort of limbo existence, reducing their balance sheets and doing relatively little lending. Holders of the CDO risk have also been in a limbo, with payments cut-off while they hoped for some restructuring or market recovery.

Healing the un-dead, or how do you talk to a zombie?
Still, in capitalism, when prices go down, new investors should appear at the right price. Why hasn't that happened in Trups? The answer is that new actors have indeed entered the market, but they have suffered from a failure of communication.

We are aware that CDO noteholders have reached out to banks with the idea of working constructively towards a more beneficial workout. But in the main these paper-written inquiries have generated no response.

Conversely, some commercial bank issuers have been reaching out to CDO noteholders because they want to repurchase their own Trups out of the CDO. Such repurchases could facilitate the recapitalisation of the bank in question.

The bank has sent notices through the trustee system and DTC. But they have not been able to locate the holders of their liabilities.

So this is a strange situation. Motivated parties on both sides seem to want to find each other but can't. Messages through the trustee system seem to go into a black hole.

Such messages are forwarded to custodial banks, who then forward it to beneficial owners or their representatives. Perhaps such messages are read. Perhaps they sit on a desk unread. Perhaps they are never actually delivered.

The stakes are not small. The potential transactions in question - recapitalisations of regional banks - could reach into the US$100m range or higher. Failure to communicate; in the Google age, it seems crazy.

The Trups market is still truly impaired. But even rebounding markets like CLOs could have recovered more quickly if the central communication system of the financial world were more dynamic.

During the bottom of the crisis, certain buyers of CLO equity perceived that the there was significant value in assets that were trading below liquidation prices. They attempted to find and purchase such assets.

But really only two entities knew where to find them. The first was the trustee. But the trustee is boxed in: if it moves proactively to help in connecting particular affiliates of a deal, it has little upside and potential downside.

The other entity that would know who the holders were is the underwriter. But the underwriter is conflicted because it trades on its own behalf and so any buying inquiry depends on a trust relationship that is fraught because one party holds all the knowledge.

As a result, any interested buyer of assets has to take certain protective steps in this information vacuum. The buyer can't vet the recipients of any notices they send ahead of time, so they may begin with a more conservative proposal than they are really willing to undertake. The risk of this approach is that it makes the sender appear unserious, when in fact it is more in the nature of an opening bid to start a conversation.

The recipient of such notices, in turn, may be reluctant to disclose their identity by responding to an inquiry (especially if it is overly vague or 'low-ball'). Even in the case where both parties want to communicate, the slow turn-around time of such messaging is problematic.

Anecdotally from several sources, the consequence can be a missed vote, or lack of time to truly evaluate a proposal effectively. Such votes are often a reason to send messages through trustees.

The threshold percentage of votes that is desired, depending on the asset class, might be 25%, 33%, 50%, 67% or even 75% of the total votes outstanding. The clunkiness of messaging means that there is a fatal inability to develop the critical mass for such blocks, even when the economic incentives are clear.

So, as the economy continues fighting World War ZDO, perhaps policymakers should focus on the low-hanging fruit. Rather than focusing on top-down legislative reforms, they could simply encourage the development of platforms that make bottom-up communications easier among investor groups and interested participants. That would be the easiest way to wake the undead.

Structured Finance

Cantor eyes primary CDO desk

Cantor Fitzgerald has made four key hires across the CLO, CDO and structured credit segment. Florian Bita joins the team in New York, while Jason Eppleston, Martin Deville and Damian Horton join Cantor Fitzgerald Europe in London.

Bita joins Cantor as md and is responsible for US CLO secondary trading. In addition, he will help build out the firm's primary new issuance capabilities alongside James Keller. Bita recently served as the head of CLO and structured products trading at UBS.

Eppleston joins Cantor as the head of structured credit origination in Europe, responsible for establishing a platform to manage the origination and structuring of CDOs and other securitised products. Previously, he served as a senior banker at Investec Bank, focused on CDO structuring.

Horton joins Cantor as a CDO structurer and deal originator, focusing on the financial analytics of deal origination. He has held senior level positions leveraging his experience in financial modelling across multiple asset classes at Pioneer Investments, Prudential Financial and Bear Stearns.

Finally, Deville joins Cantor as an md and ABS trader, covering UK prime RMBS, European consumer ABS and sterling fixed rate ABS. Previously, he served as an executive director at UBS, focusing on European RMBS and consumer ABS.

Simon Gold, who joined Cantor in September 2012, leads the European structured credit trading desk.

Structured Finance

Senior credit pair leave asset manager

Andy Clapham and Richard Downer are both understood to have left Investec this week. The pair worked together closely and are expected to reunite at another company or to start their own.

Clapham was head of capital markets at Investec and left on Tuesday, having previously worked at Bear Stearns, Nikko Securities and Greenwich NatWest. Downer was head of financial markets and also previously worked at Bear Stearns and Greenwich NatWest as well as a stint at Merrill Lynch.

Structured Finance

Investment manager adds analyst

John Robbins has joined Lucidus Capital. He becomes a research analyst in the investment manager's New York office.

Robbins was previously at Elliott Management Corp, where he served as an analyst. Over the last 15 years he has also worked at Saba Principal Strategies, Morgan Stanley and Banc of America Securities.

Structured Finance

REIT beefs up in operations

Annaly Capital Management has named Glenn Votek as chief administrative officer. He brings over 20 years of financial and operational experience, with particular expertise in risk management, capital raising, liability management and regulatory oversight. He will report to Kevin Keyes, Annaly's president.

Votek joins from CIT Group, where he was an evp and treasurer since 1999 and president of consumer finance since 2012. At CIT, he was responsible for all functional areas of CIT's treasury group, including capital markets and securitisation.

Structured Finance

Mortgage, risk management capacity strengthened

Treliant Risk Advisors has expanded its mortgage and risk management capacity with five financial services hires.

John Ward joins the firm as senior director. He is a risk management consultant with broad experience in building and re-engineering diverse financial services industry businesses. Previously, he worked at Citibank for almost 30 years in the derivatives, loan sales and structured credit markets.

Kevin Dwyer has been appointed senior advisor and brings over 25 years of experience as a senior legal executive at a number of mortgage companies, as well as Freddie Mac. His financial services and mortgage industry expertise includes work on domestic and international capital market transactions, encompassing origination, acquisition, securitisation, sale and servicing of single family and multifamily mortgage loan portfolios.

Benjamin McComas has been named director, having previously worked at the law firm of Gunster, Yoakley & Stewart. He brings a range of expertise in the mortgage industry, including securitisation disputes, high-volume mortgage loan review projects, mortgage insurance rescission disputes and the training of large teams of mortgage underwriting specialists.

Julie Campbell becomes a consultant, bringing over 25 years of experience in mortgage underwriting and loan file audit review. Also an experienced underwriter, Stacy Mullins joins her in the position of consultant.

Structured Finance

Senior appointments made at SIFMA

SIFMA has appointed former three-term US Senator Judd Gregg as ceo. At the same time, the association has named acting president and ceo Kenneth Bentsen as president.

"Judd's experience as both a governor and legislator will be of tremendous value to SIFMA in bridging the gap between the complexities of the financial markets and the positive impact our markets have on every community across America," comments Chet Helck, SIFMA chair and ceo global private client group at Raymond James Financial.

Senator Gregg was the ranking Republican member on the Appropriations; Banking, Housing and Urban Affairs; and Health, Education, Labor and Pensions Committees. Prior to joining the US Senate, he served two terms as governor of New Hampshire and four terms as a member of the US House of Representatives.

Structured Finance

Buy-side vet joins PCS committee

Will Howard Davies has agreed to serve on the Prime Collateralised Securities (PCS) Market Committee. He has worked on the investment side of securitisation for 14 years and is presently portfolio manager at PIMCO, responsible for RMBS and residential mortgages.

Structured Finance

Asset manager beefs up in Korea

Highland Capital Management has appointed Jun Park as director of business development, Korea. He is based in the firm's Seoul office and will be responsible for business development and investor relations support in the country, reporting to Paul Adkins, md of business development (Asia-Pacific region).

Park has more than 10 years of experience in global alternative investments. Prior to joining Highland, he worked at Woori Financial Principal Investment in Seoul, where he was responsible for establishing fund structures and managing over US$1bn in private equity assets in a range of categories, including mezzanine debt, buy-outs, real estate and infrastructure investments in the UK, US and Korea.

Structured Finance

Direct lending fund closed

BlueBay Asset Management has closed the BlueBay Direct Lending Fund, having raised over €800m of commitments from institutional investors. The fund will make investments of €20m-€100m to UK and Northern European mid-market companies, with an emphasis on targeting high-quality businesses representing an enterprise value of less than €500m.

The fund aims to provide primarily senior and subordinated loans for acquisitions, capital growth, restructuring and liquidity situations. To date, over 20% of the fund has been deployed in a number of deals.

Anthony Fobel, partner and head of private lending at BlueBay Asset Management, comments: "The fund will provide much needed growth capital to European mid-market businesses, whether privately or publicly owned, as well as a source of finance to private equity sponsors. The growth in direct lending funds is providing a real financing alternative to companies and private equity firms in an environment of continued retrenchment by banks from mid-market lending and we are seeing a large number of exciting investment opportunities. Similarly, as the search for yield by investors continues, senior credit represents a lower risk but high yielding investment opportunity."

Structured Finance

Markit looks east for growth

Singapore-based Temasek has made a significant equity investment in Markit. The addition of Temasek as one of Markit's largest investors further diversifies the company's shareholder base and increases its links to Asia.

Lance Uggla, ceo of Markit, comments: "Temasek is an expert investor in entrepreneurial growth companies, with a track record in increasing shareholder value. The strength of their position and profile in Asia, an area where we see significant potential and opportunity, will help fuel our growth in the region. We look forward to their participation in our company's strategy."

CDO

Abacus CDO decision reversed

New York's Appellate Division, First Department last week reversed a lower court's order and dismissed ACA Financial Guaranty Corp's lawsuit against Goldman Sachs in connection with the Abacus 2007-AC1 CDO (SCI 7 January 2011). ACA alleged that the bank fraudulently induced it into insuring the transaction by misrepresenting hedge fund Paulson & Co's economic interest, including Paulson's role in the portfolio selection process and Paulson's short position against the CDO.

In denying Goldman's motion to dismiss the fraud claims, Justice Barbara Kapnick found that ACA's complaint contained a "rational basis" to infer that the bank intentionally misled ACA from its silence in the face of ACA's mistaken belief that Paulson was on the same side of the transaction as it was. In reversing Justice Kapnick, the First Department found that Goldman's purported misrepresentation was contradicted by the deal's offering documents, according to a Lowenstein Sandler memo. Furthermore, the court found that Paulson's intentions with regards to the investment were not peculiarly within Goldman's knowledge and that ACA - although in direct contact with Paulson - failed to ask the hedge fund what position it intended to take in the investment.

CLOs

CLO specialist recruited

Lawrence Berkovich has joined Mayer Brown in Charlotte as a partner in the banking and finance practice. Previously, he was a counsel with Dechert in Charlotte.

Berkovich concentrates his practice on complex structured finance transactions, with a particular emphasis on broadly syndicated and middle-market CLOs, CRE CLOs/CDOs and rated/unrated leveraged loan and CRE loan warehouse facilities. In addition, he has extensive experience with derivative products, including credit default swaps.

CMBS

Senior CMBS analyst appointed

Ed Barrett has left Morningstar to take up a role as CMBS director at Kroll Bond Rating Agency. He was structured credit svp at Morningstar and has also worked as a portfolio mananger at Aberdeen Asset Management and as a senior analyst at Deutsche Asset Management and at GMAC Commercial Mortgage Corporation.

Insurance-linked securities

Willis taps Asia head

Willis Capital Markets & Advisory has appointed Michael Guo as md and head of Asia. Based in Hong Kong, he reports to the firm's ceo Tony Ursano and will be responsible for developing its capital markets and strategic advisory business in the region.

Guo has more than fifteen years of experience working with financial institutions. He joins from Boston Consulting Group, where he was a partner and md of the firm's financial services practice, covering insurance, banking, brokerage and fund management. He was also the regional leader of BCG's corporate banking segment in Asia.

RMBS

Mortgage specialist enlisted

Keeyeol Nam has joined Tilden Park in New York as md to lead a team trading agency mortgages and mortgage derivatives. He was previously head of structured products at DB Capital Management and has also worked at RBS, where he was svp.

RMBS

REIT subsidiary spun off

Newcastle Investment Corp has spun off its New Residential Investment Corp subsidiary. New Residential is now an independent REIT trading on the New York Stock Exchange, primarily focused on investing in residential mortgage-related assets. Holders of Newcastle common stock have been electronically issued one share of New Residential common stock for each share of Newcastle common stock held.

ABS

Uncertainty remains for tobacco ABS

S&P has published a report detailing a number of significant developments related to tobacco MSA settlements over the last six months. The agency says that these developments have provided additional clarity around certain aspects of the tobacco securitisation segment, while leaving ambiguity in others.

For example, the release of the term sheet - an agreement between a number of participating manufacturers (PMs) and various states and territories for settlement of the 2003-2012 non-participating manufacturer (NPM) adjustments with those states - in December 2012 raised investors' expectations that a resolution for the NPM arbitration could be imminent, but there was only a partial resolution. A degree of uncertainty persists with respect to the states and territories that did not agree to the term sheet, as well as the potential PMs' future withholding for the NPMs' adjustment, according to S&P.

"Until very recently, there was also uncertainty regarding the release of the proportionate funds in the disputed payment account (DPA), as some states had filed injunctions against the term sheet, which could have delayed the release if they proved successful. Even the decline in consumption rate compared with last year might be a small breath of fresh air for the annual payment numbers going forward, but the overhanging possibility of another excise tax on cigarettes to fund universal pre-school is now looming," the agency adds.

The 2012 tobacco consumption decline was less than 2% for the first time in six years. This decline - combined with the release of a portion of the funds in the disputed payment account to the relevant settled states and territories - resulted in an increase in the overall annual payment to US$7.5bn from last year's US$6.15bn.

Although this is a favourable swing for the states and investors, it is not sufficient to offset the large decline in payments from 2009 and 2010 following the 2009 increase in the federal excise tax. In fact, S&P believes it would take several decades to accumulate the same present value of cashflows as if there had been a 3% decline during the same period.

The large declines in 2009 and 2010 are potentially irreversible, the agency says, unless there is significantly higher inflation combined with a positive shift in consumption. From a securitisation standpoint, the severity of the impact is largely correlated with the year of origination.

Despite this year's overall MSA payment increase - which is mostly due to the release of funds from the DPA for settled states - uncertainty remains for next year, S&P observes. Depending on a number of issues - including the outcome of the remainder of the states/territories that did not agree to the term sheet - and if the PMs continue to withhold going forward, there could be a decline in the overall MSA payment in 2014.

Meanwhile, some positive developments for states and investors might include release of DPA funds from settlement agreements with the remaining jurisdictions that have not previously settled the NPM disputed amounts. If this is coupled with less NPM withholding and the federal excise tax increase does not pass, the MSA payment could be higher than in previous years.

ABS

FFELP SLABS criteria updated

Fitch has updated its criteria for US FFELP student loan ABS. The agency has placed 192 tranches on rating watch negative and 25 tranches on rating watch positive as a result.

The criteria update reflects a new analytical tool Fitch has introduced as part of its rating process. The new tool simulates cashflows based on collateral stratifications and deal structure, and incorporates the stresses for various rating categories.

In taking the actions, the agency has identified trusts most likely to be affected by the implementation of the new analytical tool. Rating watch negative is assigned to deals containing tax exempt auction rate notes, while rating watch positive is assigned to the subordinate tranches - rated double-B or below - of Libor-indexed trusts with a parity of at least 100%.

Fitch says it will conduct individual reviews on each affected trust. The magnitude of the upgrades and downgrades is expected to range from three to six notches in severity. The rating watch status for all trusts is expected to be resolved over the next six months.

ABS

Further container ABS calls anticipated

TAL International has re-priced its TAL Advantage IV Series 2010-1 transaction via an amendment to the structure. The unusual move is expected to trigger more container ABS calls going forward.

Under the amendment, the coupon on the note was lowered from 5.5% to 3.25% and the call date was pushed back from July 2013 to July 2015. "While the coupon on the new structure may appear slightly high compared to recent prints and recent TAL deals, the amendment saves the issuer from the full redemption process. Also, the first deals after the crisis may have had fewer investors, making an amendment easier to execute," structured product analysts at Wells Fargo observe.

ABS

Improvement seen in timeshare ABS

Total US timeshare ABS delinquencies for 1Q13 stand at 3.27%, down from 3.55% in 4Q12 and 3.58% in 1Q12, according to Fitch's latest index results for the sector. The improvement in timeshare ABS delinquencies last quarter is typical of springtime performance, the agency notes.

Defaults for 1Q13 also decreased to 0.72% from 0.75% in 4Q12. Delinquencies are now 0.82% lower than levels seen at the same time last year.

While improvement this quarter is evident across all issuers, some of the overall improvement is attributed to slight shifts in the composition of the index. Transactions from issuers with lower historical delinquency and default rates were added in 2012.

Delinquency trends have largely normalised at their historical levels following the dramatic increases that occurred in 2008 and 2009. However, defaults still remain elevated from pre-recessionary levels.

ABS

Unusual utility ABS prepped

Three Ohio subsidiaries of FirstEnergy Corp - The Cleveland Electric Illuminating Company, Ohio Edison Company and The Toledo Edison Company - are prepping a US$505m utility securitisation dubbed FirstEnergy Ohio PIRB Special Purpose Trust 2013. The trust comprises debt instruments issued by three separate SPVs formed to facilitate the transaction (CEI Funding, OE Funding and TE Funding).

One indication of the complexity of the upcoming transaction is that FirstEnergy will receive two-times the normal fee seen in previous utility securitisations for acting as servicer of the bonds. However, it shares certain features with previous such deals: the imposition of a special ratepayer obligation charge (ROC); a mechanism to adjust the ROC periodically, to ensure payments of interest and principal when due; and legal protections to make the adjustment mechanism irrevocable and enforceable for the benefit of bondholders. The note issuance is expected to receive the highest investment grade ratings from the rating agencies.

The Ohio legislature passed special legislation in 2011 to allow the Public Utilities Commission of Ohio to authorise and approve Ohio utilities to sell bonds to recover certain costs incurred in providing electric services.

Structured Finance

Second agency upgrades MBIA

Moody's has upgraded the insurance financial strength (IFS) ratings of MBIA Insurance Corporation (to B3 from Caa2), National Public Finance Guarantee Corporation (to Baa1 from Baa2), MBIA UK Insurance (to B1 from B3), MBIA Mexico (to B3 from Caa2) and MBIA Inc (to Ba3 from Caa1). The rating action also has implications for the various transactions wrapped by the MBIA group.

The move reflects the overall positive effect that MBIA's recent settlements with various counterparties have had on the group's credit profile (SCI passim). Moody's says that the settlement of put-back recoverables owed to MBIA and of claims owed by MBIA related to insured exposures have, in aggregate, improved the group's liquidity profile and reduced the volatility of its insured risk portfolio. Additionally, the bank-led litigation related to the MBIA group's 2009 restructuring was dismissed as part of these settlements, reducing legal risk.

Specifically, the settlement with Bank of America alleviated liquidity strains that could have triggered regulatory action at MBIA Corp. Proceeds from the Bank of America and Flagstar settlements allowed MBIA Corp to repay and extinguish a US$1.7bn loan that National had extended to MBIA Corp, thereby eliminating a substantial risk from National's balance sheet and a major obstacle to National's payment of dividends to MBIA Inc. The end of the restructuring litigation and the reduced financial exposure to MBIA Corp improves National's prospects for underwriting new transactions.

Moody's notes that National's rating could be raised if the insurer were able to establish a more solid market position, marked by underwriting of high quality risks at attractive prices. Meaningful improvements at MBIA Corp - either through risk reduction or capital enhancement - would also be a positive rating driver for National, as well as for MBIA Corp itself, as those improvements would reduce the contingent risk of a call on National's resources.

The ratings of MBIA Corp could be downgraded if the insurer were to experience greater than expected claims that would cause liquidity stress, but the ratings could be upgraded if there were material risk reduction in its portfolio due to improving credit trends, amortisation or commutations.

S&P raised its ratings on the monoline earlier this month (SCI 13 May).

Structured Finance

Liquid asset analysis outlined

The EBA has issued a discussion paper presenting the methodology and scope of its forthcoming analysis on definitions of highly liquid assets. The proposed methodology is based on a scorecard, which aims at producing an ordinal ranking of assets by combining a set of different liquidity indicators. Following the outcome of the analysis, the EBA will report to the European Commission on appropriate definitions of high and extremely high liquidity and credit quality of transferable assets for the purpose of the liquidity coverage ratio (LCR).

The analysis will involve the assessment of a range of asset classes against the fundamental definitions of liquid assets included in the draft Capital Requirements Regulation (CRR). A detailed quantitative assessment of the liquidity of individual assets will then be performed, with the objective of producing a ranking of the relative liquidity of the different asset classes.

Finally, the analysis will identify the features that are of particular importance to market liquidity. The objective of this last step is to provide definitions of the characteristics assets should have to be qualified as highly, or extremely highly liquid.

Structured Finance

SSFA provision clarified

The OCC has clarified a provision of the market risk capital rule. Specifically, it has addressed the measurement of a parameter used in the simplified supervisory formula approach (SSFA) for securitisation exposures.

When an institution assigns the specific risk capital requirement for a securitisation position, the OCC is clarifying that exposures underlying the securitisation position should not necessarily be considered to be in default solely because the borrower has deferred payments of principal or interest. In limited cases, such a deferral is not a result of a change in the borrower's creditworthiness. Instead, payment deferrals might be a result of provisions in the contract at the time funds were disbursed.

The SSFA takes into account the nature and quality of the underlying collateral. It includes a variable (W) designed to increase the capital requirement for a securitisation exposure when delinquencies in the underlying assets of the securitisation increase. Under the capital rule, an exposure is delinquent if it is 90 days or more past due, subject to a bankruptcy or insolvency proceeding, in the process of foreclosure, held as real estate owned, in default or has contractually deferred interest payments for 90 days or more.

Since the publication of the rulemaking, commentators have noted that the term 'delinquencies' can be read to include deferrals of interest that are unrelated to the performance of the loan or the borrower. The OCC says it did not intend for the term to be interpreted in this manner. Thus, it is clarifying that the meaning of 'delinquency' in the market risk capital rule excludes the calculation of 'W' loans with contractual provisions that allow deferral of principal and interest on federally guaranteed student loan programmes or on consumer loans, provided that such payments are deferred pursuant to provisions included in the contract at the time funds are disbursed and the periods of deferral are not initiated based on changes in the creditworthiness of the borrower.

Structured Finance

Greek country ceiling raised

Fitch has upgraded 24, affirmed five and downgraded one tranche from 12 Greek structured finance transactions (two ABS and 10 RMBS). In addition, the three tranches of Lithos Mortgage Finance have been placed on rating watch evolving (RWE), pending the outcome of investigation into the transaction's recent performance.

The action follows the revision of the country ceiling for Greece to single-B from single-B minus, after the Greek sovereign was upgraded by one notch on 14 May. Consequently, Fitch has upgraded those RMBS tranches that were constrained by the previous country ceiling and have sufficient credit enhancement to withstand the agency's single-B stresses.

The upgraded transactions include New Economy Development Fund (Taneo) and Aeolos. The downgraded transactions include Byzantium Finance, reflecting Fitch's concern over tail risk.

Meanwhile, a deterioration in performance has been observed in Lithos, with the level of three-month plus arrears increasing to 26.8% from 21.1% a year earlier.

Structured Finance

Canadian loss framework finalised

Fitch has finalised its new model framework for estimating losses on prime Canadian residential mortgage pools. This follows the conclusion of the consultation period for the exposure draft that the agency published in March (SCI 5 March).

Fitch will apply the new model to analyse both new and existing ratings for covered bond programmes, as well as those supporting ABCP facilities and RMBS. The agency does not expect any negative rating impact based on the implementation of the new model to existing covered bonds.

Fitch says it received feedback from a number of market participants during the consultation period. Most comments came from issuers who considered the agency's approach to be overly conservative. The model framework described in the final criteria is effectively unchanged from the version contemplated in the exposure draft.

Key drivers of the model include home price projections based on Fitch's proprietary sustainable home price (SHP) model. The agency currently estimates that home prices are overvalued by approximately 20% in real terms across Canada, with regional variations. However, actual nominal declines could be as low as 10% due to the effects of inflation and price momentum.

Structured Finance

RPI ABCP rating intact

Moody's says that the Prime-1 rating of the ABCP issued by Royal Park Investments (RPI) is unaffected by the sale of the entire asset portfolio backing the conduit (SCI 29 April). The decision to take no action reflects the Belgian government's continued full support for the ABCP principal and interest through an irrevocable guarantee, according to the agency.

Following the sale, the guarantee remains in full force and effect until all ABCP has been repaid in full. The guarantee remains available to enable timely payment on any ABCP issued.

RPI had US$4.53bn and £236m ABCP outstanding, as of 14 May, and assets of €6.3bn remaining from €11.3bn.

CDO

Stable performance continues for Trups CDOs

Combined defaults and deferrals for US bank Trups CDOs have remained stable, standing at 28.2% at the end of April, according to Fitch's latest index results for the sector. One new bank - representing US$5m of collateral in one CDO - defaulted during the month, while another bank - representing US$10m of collateral in one CDO - began deferring interest on its Trups. The decrease in cumulative default rate was attributed to the removal of a defaulted issuer from the portfolio in one CDO.

There were no new cures in April. The decrease of US$37.5m in the dollar notional of cures is due to the redemption of cured collateral by three issuers in five CDOs, the agency notes.

Across 79 Trups CDOs, 218 bank issuers have defaulted since the index's inception in 2007, representing approximately US$6.4bn. Additionally, 312 issuers are currently deferring interest payments on US$4.2bn of collateral and 111 issuers representing US$2.4bn of collateral deferred in the past but are currently cured.

CDO

CRE CDO late-pays remain flat

US CRE CDO late-pays remained flat in the month of April, at 13.2%, according to Fitch's latest index results for the sector. Asset managers have steadily reduced the overall balance of delinquent assets through resolutions over the past year, which has helped stabilise delinquencies, the agency suggests.

Only one new delinquency was reported in the month: this newly matured balloon B-note is secured by a full service hotel located in Los Cabos, Mexico. Further, two assets included in last month's index are no longer considered delinquent. These assets include a mezzanine loan backed by a hotel portfolio disposed of at nearly a full loss and a rated security that is no longer considered credit-impaired.

In April, asset managers reported approximately US$70m in realised principal losses from the disposal of three assets. The majority of the reported loss was related to the mezzanine loan disposal.

CDS

Urbi credit event called

ISDA's Americas Credit Derivatives Determinations Committee has resolved that a failure to pay credit event occurred in respect of Urbi Desarrollos Urbanos. An auction will be held in due course for outstanding CDS transactions referencing the entity.

The move follows the expiration of the 30-day grace period on the US$6.4m payment of interest on the company's 2016 bonds. Urbi announced on 20 May that it does not plan to make such payment of interest at this time.

CDS

Electronic trading challenges examined

New research from GreySpark Partners examines the state of electronic trading in fixed income markets for bonds, CDS and IRS. The report - 'Fixed Income Electronic Trading 2013' - analyses how the traditional roles of investment banks and trading venues for these products are changing, driven by a combination of macroeconomic forces and incoming capital markets regulations.

The financial crisis caused liquidity in the fixed income market to fragment across a number of trading venues. New capital markets regulations are changing the fixed income market's structure, forcing established trading venue operators to prepare for changes that will incentivise the emergence of new competitors, according to GreySpark.

The report finds that leading banks must adapt to this changing landscape by differentiating themselves from competitors and become specialist providers of liquidity in the fixed income markets. In order to achieve this, enhancements must be made to their existing sales and trading tools that emphasise cost-effective access to bonds liquidity and IRD liquidity, as well as enhancements to various areas of post-trade functionality.

GreySpark has created a business and technology maturity model that banks can use to prepare for changes to the market structure for bonds and IRD dealing. This model can be used to assess the adaptability of a bank's fixed income dealing business and drive decisions in the development or adaption of technology solutions that will allow that business to grow in an increasingly competitive future landscape.

CDS

Documentation overhaul spooks sub CDS holders

Concern that ISDA's plan to update the CDS definitions (SCI 19 December 2012) could impact the liquidity of current subordinated contracts is believed to have driven compression in the Markit iTraxx Senior Financials and Subordinated indices yesterday (20 May). The latter index tightened by 17bp to 182.5bp, leaving the multiple to the senior index at 1.41. Markit notes that the index has only been lower than this on one occasion - in August 2007.

The firm suggests that question marks remain over whether the new definitions - due to be implemented in the second half of the year - will apply to legacy trades. If not, the current contracts could become less valuable than new deals.

The fact that senior bondholders are also liable to be bailed-in post-Cyprus may also be contributing to the compression in the indices, according to Markit. In addition, single name CDS were affected: for example, Monte dei Paschi subordinated CDS tightened by 76bp to 890bp, while its senior spreads rallied by 11bp to 565bp.

CLOs

Uncovered FX eyed in Euro CLOs

Managers' increasing desire to include sterling assets - funded with either euro or sterling-denominated liabilities - in the new generation of European CLOs may introduce uncovered FX exposure, Fitch warns. The agency notes that managers are trying to access the largest possible asset universe and achieve a desirable level of diversification in their portfolios. But, with the economics of European CLOs still finely balanced, they must be able to ramp up portfolios quickly and with competitive asset pricing.

Legacy CLO transactions with non-euro buckets that were structured before the financial crisis addressed FX risk in a number of ways: perfect asset swaps, macro hedges, out-of-the-money FX options and variable funding notes. Today, many of these would need to be keenly priced to compete with other bank business lines, considering the dual challenges that European banks now face - raising capital (and reducing leverage) and obtaining competitive funding.

"This pricing may have a detrimental impact on the economics of a new CLO and may already be affecting the pricing of sterling assets in a market where most legacy CLOs are required to buy euro assets or hedge non-euro assets on purchase," Fitch reports. "Sterling assets trading at a discount may be all the more attractive to managers, provided the cost of the hedge - whether structural or asset based - is not too high. CLOs may therefore look to match fund or go naked with their sterling exposures."

While it may provide a form of natural hedging, match funding is complicated as there are a number of factors that can reduce the effectiveness of the hedge over time, such as defaults being skewed to sterling assets, a divergence of interest rates and maturity mismatches between sterling assets and sterling liabilities.

CLOs

CLO-like structure minted

HIG WhiteHorse Capital has closed WhiteHorse VII, a term facility - structured like a CLO - to fund purchases of broadly syndicated loans. Arranged by RBS, the facility closed with an initial investment of US$25m from the equity holders, with the class A delayed draw note having sole discretion to advance funds in US$5m increments up to a total of US$141m.

Fitch has assigned the class A notes a single-A rating and expects them to be repaid via a securitisation event within one year of closing. WhiteHorse VII has a maximum two-year ramp-up period and allows discretionary sales or sales of credit risk obligations at any time, providing the advance rate test is satisfied and the eligibility criteria are met. The facility features portfolio concentration limitations that are generally consistent with recent CLO issuance.

The overcollateralisation ratio test of 112.6% must be satisfied prior to any advance. Credit enhancement for the class A notes will vary between 35% and 15% as additional advances are made. Fitch notes that minimum credit enhancement requirements vary depending on predefined diversity, weighted average spread, weighted average recovery and weighted average rating factor limitations for the portfolio.

The average credit quality of the indicative portfolio is B/B-, which is also comparable to recent CLO issuance.

CLOs

CLO pricing tool offered

Thetica Systems has rolled out an enhanced CLO analytics module as part of its ABS Trader Tools structured finance infrastructure. The service integrates pricing data for CLO NAV from Lewtan/ABS.Net, Markit and Reuters.

"Whether for new deals or older vintage bonds, clients can easily run the universe of CLOs through a price/yield matrix, define their scenarios and produce customised reports such as tearsheets for easy use and distribution," comments Thetica ceo Ariel Yankilevich. "This enhanced module enables our users to quickly take advantage of continuing CLO market opportunities and retain full control over the process used to price and analyse CLOs."

CMBS

Apartment, office prices at record highs

US major market apartment and central business district (CBD) office prices continued to set record highs in March, according to the Moody's/RCA Commercial Property Price Indices (CPPI). Apartment prices nationally increased by 1.5% during the month, while core commercial prices were unchanged. The national all-property composite index increased by 0.4%.

The recovery rate for loans resolved with a loss greater than 2% during the first quarter was up by approximately 25 percentage points from the recovery rate near the January 2010 trough. The national all-property price index increased by nearly 35% in that time.

"Since commercial property prices formed a bottom in late-2009/early-2010, they have enjoyed a strong and almost uninterrupted recovery, providing a tail wind for the resolution of defaulted loans in CMBS," comments Moody's director of commercial real estate research Tad Philipp.

Major market apartment prices are 6.9% above their January 2008 peak level, while major market office prices are 3% above their December 2007 peak level. Among the suite of 20 CPPI indices, only major market apartment and major market CBD office have surpassed their 2007/2008 peaks.

Industrial properties saw the biggest price decline among the core commercial sectors during the first quarter, meanwhile, declining by 3.6%.

CMBS

Secondary German CRE demand on the rise

Signs of renewed investor interest in secondary German commercial real estate (CRE) markets suggest some respite from the refinancing challenges facing the sector, Fitch notes. However, significant concerns remain because of the limited time left in which to resolve problem loans.

Property in secondary locations, particularly in office and retail markets, accounts for much of the collateral underpinning German loans packaged in European CMBS. But rising risk appetites appear to be encouraging investors to take exposure to some properties in secondary locations in Germany again.

Jones Lang LaSalle recently reported a 1Q13 increase in acquisitions of CRE in Germany, with overall transaction volumes rising by 35% from a year earlier to €7.1bn. Average yields for prime properties in secondary locations across the 'big seven' German cities fell to 5.54%. Domestic banks with access to deep pfandbrief funding markets are underwriting this renewed interest in German non-core CRE.

With about €7bn of German CMBS loans falling due in the next 12 months, an increase in investor demand for non-core properties is positive for the prospects for refinancing loans and disposing of CRE collateral. With a similar volume of German loans already overdue, it is hoped that improving sentiment will also allow servicers to expedite loan work-outs, particularly given the potential crunch in bond maturities from 2016.

According to JLL, the yield pick-up for prime properties in secondary locations across Germany's 'big seven' above those on prime sites has fallen below 80bp, suggesting a reversal in the tiering that took off in the crisis. However, JLL points out that while investors are more comfortable taking exposure to secondary locations, they are not yet willing to compromise on building or tenant quality.

A preference for lease and building quality over location nonetheless signals growing confidence in the medium-term prospects for German CRE. But it also shows that despite Germany's relative insulation from the eurozone crisis, investors are still demanding income visibility as protection against short-term market volatility, according to Fitch. With time pressure building as bond maturities draw closer and leases roll off, this stance will continue to drag on ratings in the sector.

CMBS

New challenges for Euro special servicers

New challenges are emerging for special servicers working out European CMBS loans with borrowers undergoing insolvency proceedings. Recent court rulings in France and Germany have raised questions over not only the level of control the CMBS lenders have, but also the seniority of their claims within the insolvency estate of their borrowers.

In France, safeguard (or pre-insolvency) proceedings provide insolvency-law protection to borrowers, as they prevent their creditors from enforcing security on the real estate in case of an event of default. Such protection forces their creditors to negotiate a restructuring plan and consequently increase the timing and costs necessary to recover their funds.

In the high-profile case involving the €1.5bn Windermere XII transaction, the Versailles Court of Appeal recently passed two judgements that Moody's views as credit positive for this and other CMBS backed by French loans (SCI 19 March). The first judgement confirmed the enforceability of the security assignments to the issuer, a point of contention since the safeguard proceedings began in 2008. The second judgement put in place a safeguard plan with a loan maturity in July 2014, three years prior to the CMBS legal final maturity date.

The work-out process remains largely uncertain for other French loans in default, however. For example, it is difficult to assess if the special servicer will be able to return the loan principal of the €232m Target loan securitised in Titan Europe 2006-3 to noteholders within the three years remaining until the CMBS legal final maturity date (see SCI's CMBS loan events database).

The borrower filed for safeguard proceedings and the loan was transferred to special servicing last month ahead of its July maturity. But a timely work-out of the loan appears unlikely because the initial observation period before which the French courts put a safeguard plan in place can last up to 18 months and the French courts may restructure the loan term beyond the legal final maturity of the CMBS notes.

In terms of recovery estimates for French loans, Moody's takes into account the limited options of creditors to initiate and control bankruptcy proceedings against the borrowers and assumes stressed recovery rates compared to loans in other more creditor-friendly jurisdictions. "One clear lesson learned is the insufficient tail period available to most securitised French loans," it observes. "The tail period for legacy CMBS French loans is four years on average. A restructuring plan under the safeguard proceedings could extend the period of loan recovery up to an additional 10 years."

The exposure of CMBS transactions to French loans is relatively limited, however, with a total of 28 loans outstanding at end-April. These outstanding loans make up approximately 4% of the outstanding balance of single-borrower and large multi-borrower transactions rated by Moody's.

Loan work-outs in a more creditor-friendly jurisdiction, like Germany, can also be challenging. The sponsor of the €360m Orange loan, securitised in Talisman 6, announced last week that the German insolvency court has recently resolved that the claims under the whole loan could be subject to equitable subordination (SCI 17 May).

Moody's suggests that such a ruling would essentially change the seniority of the securitised loan against other insolvency creditors, lowering the ultimate principal recovery on the loan by an amount that is difficult to quantify at this stage. In a subsequent related announcement, the special servicer clarified details regarding the voting rights granted to the various creditors and confirmed that the merit and rank of the claims were to be determined at a later date.

The agency has also observed work-out complications in loans with borrowers incorporated in jurisdictions with the underlying properties located in another jurisdiction. Disagreements and disputes among different insolvency courts and administrators both prolong the loan work-out process and increase costs for the issuers.

An example is the €149m Karstadt Kompakt loan securitised in Deco 7 - Pan Europe 2, in which the borrowing entities are incorporated in the Netherlands but the properties are located in Germany. As the Dutch administrators over the borrowers did not accept any duty to the issuer, the special servicer had to initiate secondary insolvency proceedings in Germany, which then convinced the Dutch administrators to cooperate in the realisation process.

In smaller and less creditor-friendly jurisdictions - such as Spain, Italy and Bulgaria - servicers avoid enforcement during loan work-out because of uncertainty and unfamiliarity with the insolvency process in the context of CMBS loans. In these regions, servicers and/or special servicers have been following a consensual work-out route with borrowers.

As at end-April 2013, 160 European CMBS loans were in special servicing, according to Moody's. These loans represent approximately 23% of all loans outstanding across single-borrower and large multi-borrower transactions rated by the agency.

Whereas the UK contributes the highest portion (at 45%) to the total in terms of volume of loans, Germany is the jurisdiction with the highest number of loans in special servicing (78 loans, accounting for 49% of the total). The UK follows Germany with 49 loans (30%), France and the Netherlands contribute nine loans each and other jurisdictions including Italy, Spain and Finland contribute three loans or less each.

Of all loans in special servicing, Moody's has identified 58 loans (36%) as undergoing enforcement/forced liquidation. Almost half of these loans are backed by collateral in the UK, the most creditor-friendly jurisdiction in Europe. The number of loans under a standstill and/or restructuring is the next highest (35 loans, accounting for 22%), followed by consensual property sales, which is the case for 20 loans (12%).

Thus far, 89 loans have been worked out, with 52 (58%) having realised principal losses of 36% on a weighted average basis (39% simple average). For loans that have yet to be worked out, Moody's expects principal losses of 43% on a weighted average basis (39% simple average).

Risk Management

Operations tool enhanced

Misys has released Sophis VALUE v5, which is designed to offer increased transparency for traditional and alternative asset managers into their operations. New and upgraded features in the service include: support for compliance with Dodd-Frank derivatives requirements; connectivity to various execution venues; capability to clear and novate new trades.

Risk Management

Final SEF rulemaking released

The US CFTC has released a final rulemaking on core principles and other requirements for SEFs. The move has been welcomed by many participants (see separate article), but SIFMA strongly disagrees with the rules and warns they could negatively impact investors.

SEFs were written into the Dodd-Frank Act three years ago. The final regulations establish procedures for the registration of SEF applicants, clarify execution methods and provide guidance and regulations for SEFs to comply with the Commodity Exchange Act, as modified by Dodd-Frank.

The regulations, guidance and acceptable practices will take effect 60 days after publication of the final rules in the Federal Register. The CFTC has set a general compliance date of 120 days after Federal Register publication.

SIFMA says it will review the new rules but on first read strongly disagrees with them and believes that as drafted they will "negatively impact investors and hinder the ability of American businesses to manage risk". This could discourage responsible capital management, limit job creation and dampen economic growth, SIFMA adds.

The association believes a minimum bid requirement for certain swap transactions executed on SEFs will impair market liquidity. The CFTC's rule for determining block sizes is also seen as too restrictive.

Risk Management

EU asset quality to be reviewed

The EBA has agreed on recommendations to supervisors to conduct asset quality reviews on major EU banks. While banks' capital positions were significantly strengthened under the EBA's recapitalisation exercise, the objective of the asset quality exercises will be to review banks' classifications and valuations of their assets. The aim is to help dispel concerns over the deterioration of asset quality due to macroeconomic conditions in Europe, the authority says.

Since appropriately reviewed balance sheets are a key input to an effective stress test, the EBA has also adjusted the timeline of the next EU-wide stress test. The exercise will be conducted in 2014 once the asset quality reviews are completed. However, to ensure transparency and comparability, the EBA will provide in the second half of 2013 appropriate disclosure on the actual exposures of the EU banking sector.

The EBA notes the importance of alignment in methodologies and timeline with the balance sheet assessment of the Single Supervisory Mechanism (SSM) to be conducted under the aegis of the ECB. Consequently, the set of EBA recommendations and the timeframe for the asset quality reviews and the EU-wide stress test will be published once the timeline of the SSM's balance sheet assessment is known.

RMBS

Spanish RMBS ratings reviewed

Fitch has downgraded 97, affirmed 194 and upgraded three tranches from 80 Spanish RMBS. The agency has also maintained its rating watch negative placement on seven tranches.

The transactions affected by these rating actions were previously placed on rating watch negative, following the publication of revised criteria assumptions for Spanish RMBS (SCI 21 March). During the course of the review, Fitch categorised the transactions into six groups according to the characteristics of their performance, asset portfolio and structures.

Group 1 - representing 26 deals - comprises low risk portfolios, mostly with a weighted average (WA) loan origination date before 2006. The full capital structure of these RMBS have been affirmed, primarily due to their stable performances, as well as adequate levels of credit enhancement available to the tranches to withstand the increased stress assumptions associated with Fitch's latest criteria.

Group 2 - representing eight transactions - is characterised by adverse portfolio characteristics but strong credit enhancement. All of these transactions' tranches have been affirmed, despite the mortgage origination being concentrated around the peak of the market.

Group 3 - consisting of 13 transactions - has solid performance, but insufficient credit enhancement to withstand stresses. The agency has therefore downgraded 21 tranches of the transactions belonging to this group.

Group 4 - comprising 24 transactions - exhibits adverse portfolio characteristics and have insufficient credit enhancement to withstand stresses. The combination of poor performance and weak credit enhancement levels were the key rating drivers for the downgrade of 66 tranches across these structures.

Meanwhile, payment interruption poses a risk for Group 5, representing six RMBS. Fitch says it has taken various rating actions across this group, but maintains a rating watch negative on seven tranches due to concerns over payment interruption in case of servicer default.

Finally, counterparty issues characterise the three Group 6 deals. The bank account roles have been transferred to Bank of Spain (for Hipocat 16 and 20) and BNP Paribas (for IM Caja Laboral 2). The levels of credit enhancement available to the class A notes of the three transactions are sufficient to withstand higher rating stresses and have therefore been upgraded to double-A minus (Hipocat 20 and IM Caja Laboral 2) and single-A plus (Hipocat 16).

RMBS

ResCap plan agreed

Ally Financial has entered into a comprehensive plan support agreement with the Residential Capital estate and its major creditors to support a Chapter 11 plan in ResCap's Chapter 11 cases. The plan will settle all existing and potential claims between Ally and ResCap and all potential claims held by third parties related to ResCap that could be brought against Ally and subsidiaries that are not Chapter 11 debtors, except for securities claims by the FHFA and the FDIC.

The plan support agreement and Chapter 11 plan is subject to approval by the bankruptcy court and definitive documentation. The parties have agreed under the plan support agreement to keep the terms confidential until the debtors file a motion to approve the plan support agreement, which is expected to occur this week. The economic consideration payable by Ally, however, is not subject to further negotiation.

The parties to the comprehensive settlement include: Ally and its consolidated subsidiaries; ResCap and its affiliated debtor entities; the official committee of unsecured creditors; AIG Asset Management; Allstate Insurance Company; FGIC; counsel to the putative class of persons represented in the consolidated class action; Massachusetts Mutual Life Insurance Company; MBIA Insurance Corporation; Paulson & Co; Prudential Insurance Company of America; and certain investors in RMBS represented by Gibbs & Bruns, Ropes & Gray and Talcott Franklin.

RMBS

Specialised depositary 'critical' for Russian MBS

Specialised depositary and management company roles are critical for Russian RMBS transactions, Moody's notes. Failure to adequately perform these functions may lead to losses for the mortgage agent and, in some cases, default under the notes.

"To reflect the importance of these roles, we evaluate the entities acting as specialised depositary and management company as part of our rating analysis," says Olga Gekht, a Moody's vp - senior credit officer. "The financial strength and experience of these entities may affect the highest achievable rating in Russian RMBS transactions."

Moody's notes that the specialised depositary function is positive for Russian RMBS because this entity performs independent checks of the mortgage collateral and monitors the actions of the mortgage agent, which ensures a degree of independence for the transaction from the originator. There is no comparable role to that of the specialised depositary in other jurisdictions; the closest would be the role of trustee.

RMBS

Co-op RMBS on review

Moody's has placed on review for downgrade the ratings of 28 tranches in eight UK RMBS sponsored by Co-operative Bank. The rating actions follow the agency's downgrade of Co-operative Bank from A3/Prime-2 to Ba3/Not Prime on 9 May.

Moody's believes that the affected RMBS transactions are exposed to increased payment-disruption risk, following the downgrade of Co-operative Bank. The ratings in these transactions have been placed on review for downgrade because of insufficient back-up servicing and back-up cash-management arrangements, the agency says. During the review, it will assess this risk and the mitigants that will be put in place in line with its criteria.

Co-operative Bank acts as a servicer and cash manager in Silk Road and Cambric series. Platform Funding, which is part of Co-operative Bank, acts as servicer and cash manager in the Leek Finance series. In the case of Silk Road Finance Number Two, the current servicing arrangement does not sufficiently mitigate the risk of a termination event under the cross-currency swap documentation.

Uncertainty stems from the timing of the necessary servicing and cash-management transfers. The ratings of all the notes would be negatively affected if a servicing transfer takes longer than Moody's would expect, following an operational disruption or the inability to find replacement parties in a timely fashion.

Risk Management

Counterparty credit risk uncovered - part two

Terri Duhon, managing partner at B&B Structured Finance and author of 'How the Trading Floor Really Works', discusses counterparty credit risk on credit default swaps

As explained in the first in this series of articles (SCI 3 May), counterparty credit risk in interest rate swaps can generally be thought of as a symmetric picture of potential future exposure, a fraction of the notional of the trade and non-correlated between the credit risk of the client (counterparty) and the market risk of the trade. In this article, the focus will be on counterparty credit risk in credit default swaps, where none of this is applicable. However, the interest rate swaps framework will still be the starting point: analyse each trade based on the market risk of the product itself to look at potential future exposure, understand the credit risk of the counterparty and then analyse the trade in the context of the overall existing exposure to the client.

Let's start with comparing the interest rate swap and credit default swap picture of potential future exposure from just the market risk. In the interest rate swap world, the picture is symmetric in that the dealer has the same potential future exposure on the trade, whether he is paying fixed or receiving fixed on the interest rate swap. This is because we broadly say it is just as likely for interest rates to go up as it is for them to go down.

Of course, when considering how a new trade impacts the existing risk with a particular counterparty, the direction of the new trade (paying or receiving fixed) is very important to the portfolio exposure but that is a later step. For credit derivatives, the direction of the trade is important in this first step because the potential future exposure profile is asymmetric.

While it may be the case that credit default swap prices have an equal probability of going up as they do of going down, the maximum possible loss is very different whether the dealer pays the CDS premium or receives the CDS premium. When the dealer is receiving the CDS premium (he has sold protection on the reference entity), it has a positive mark-to-market when the CDS spread tightens; in other words, when the credit risk of the reference entity is lower. The lowest that the CDS spread can theoretically go is zero, making the maximum possible positive mark-to-market the PV of the difference between the trade spread and zero.

Similar to the interest rate swap market, the CDS premium is paid over time - which means that by the maturity of the trade, there is only one quarterly premium left to pay. Also - depending on the initial spread, how volatile we assume spreads will be in the future and the confidence level used for the calculations (e.g. 95% or 99%) - it is unlikely that the potential future exposure ever reaches the PV of the difference between the initial spread and zero. In a very simple example, think about how much credit spreads can actually tighten between a reference entity that trades around 50bp versus a reference entity that trades around 450bp.

Now let's look at the trade when the dealer buys protection on the reference entity. The dealer has a positive mark-to-market on the trade when the credit spread widens.

In the extreme scenario, the maximum positive mark-to-market is when the reference entity experiences a credit event and the dealer is owed the contingent payment, which is equal to the trade notional times (1 - recovery rate). Similar to the situation when the dealer sells protection, how close the potential future exposure is to this maximum contingent payment is a function of the initial spread, the volatility assumption and the confidence level used.

The contrast, though, remains between buying protection and selling protection. The picture is not symmetrical (see diagram below). Because buying protection has a larger potential future exposure than selling protection, it is generally the harder trade to get approved when a client's credit lines are full or the client credit quality is low.

This analysis also explains the second difference highlighted between CDS and interest rate counterparty credit risk, which is in the relative size of the potential future exposure and the notional of the trade. In interest rate swaps, the maximum potential future exposure could be on the order of 4% of the notional of the swap. This is similar to the maximum potential future exposure in CDS, when the dealer sells protection.

But when the dealer buys protection, the maximum potential future exposure could be multiples of this up to the maximum of (1 - recovery rate) as described above. As long as there is a recovery rate, it should not be the full notional, but it is possible that it could be very close (e.g. Icelandic bank credit events had very low recovery rates).

Finally, the third point is the correlation of the market risk to the credit risk of the client. The interest rate swap counterparty credit risk is non-correlated because we do not take into account the fact that the level of interest rates could be related to the default of the counterparty. It is possible in times of extreme market stress that there is a correlation, but we generally simplify and assume that there is not a correlation.

In credit default swaps, we cannot make that assumption. We always consider the relationship between the counterparty and the reference entity of the CDS trade. The relationship we theoretically care about is the probability of joint-default.

In other words, we care about the probability of our counterparty defaulting when the reference entity defaults. Intuitively, this is a greater issue when the dealer buys protection rather than sells protection (remember the asymmetry of the potential future exposure graph).

Unfortunately, joint default probability is not observable. For example, when a dealer buys protection on Goldman Sachs from JPMorgan, the dealer can't look at the number of times JPMorgan defaulted when Goldman Sachs experienced a credit event, as it's never happened before. So, we look at other related data - such as equity price moves and credit spread moves - and generally make a lot of assumptions.

Despite having to make a lot of assumptions, we need to take this relationship into account when we think about the potential future exposure in CDS and in extremely correlated situations, we need to consider whether it makes sense to do the trade in the first place. Thus, the closer to default that the reference entity is, there is a higher likelihood that the counterparty will also default when the reference entity and the counterparty are highly correlated (in the example above, Goldman Sachs and JPMorgan are more correlated than say Disney and JPMorgan). This is really where the challenge lies in managing this type of counterparty credit risk.

When we compare CDS counterparty credit risk to interest rate swap counterparty credit risk, we can immediately see these three distinctions: asymmetry of future potential exposure, large percentage of the notional of the trade and correlation between the market risk of the trade and the credit risk of the counterparty. When we look at each of these in isolation, understanding the risk becomes more intuitive. Unfortunately, understanding the risk and managing it are different things and a topic for a later article.

The next article in the series will examine another correlation issue of wrong-way risk.