Contents

RMBS

RMBS alpha

Hedge fund appetite hinges on security selection

Relative value opportunities in legacy US non-agency RMBS remain for credit hedge funds, despite significant price appreciation in the sector. Complexity of individual bonds means that security selection still offers a significant source of alpha.

"Much of the beta in mortgage securities has disappeared since 2010, as the distressed sector has seen significant price appreciation. But the market is complex, so opportunities remain for alpha generation, albeit based on conservative assumptions," explains Tim Beck, senior research analyst at Stenham Asset Management.

He continues: "For much of the sector, prices are approaching fair value, with yields in the mid-single digits. This doesn't represent much of a return for hedge funds, so they're targeting individual securities driven by idiosyncratic risks rather than broad allocations to the sector."

Different sub-strategies are emerging within this opportunity set, including taking advantage of representation and warranty-driven put-backs. Again, the optionality within the impacted bonds is less dependent on beta. This sub-strategy also provides access to wrapped securities, given the recent monoline settlements (SCI passim).

In these scenarios, hedge fund managers sometimes hedge via the ABX index. But, given that technical factors often drive index performance, they may try to mitigate tail risk elsewhere with macro hedges using a broad range of instruments.

Distressed strategies have also evolved over the last year. "The de-levering of European banks has begun to increase, with assets being disposed of or restructured quite regularly, and this provides strong opportunities," Beck observes. "The key driver of being able to capture this opportunity is the ability to leverage networks and source assets. Disposals may come through complex structures or portfolio sales; the ability to analyse across asset classes is important, to identify which assets are attractive."

Stenham's access to the sector is via its credit opportunity fund of hedge funds, and Beck points to the importance of manager selection in this environment. "Manager selection is increasingly important in driving performance in the distressed space because there haven't been a wave of defaults. Those managers in close dialogue - on a selective basis - with certain banks about their non-core disposals can be expected to outperform. We haven't gone down the route of funds dedicated to the European deleveraging theme; the aim is not to constrain managers' mandates and force them to allocate to a specific asset class or theme, thereby broadening the investment universe."

For the second consecutive month, credit strategies was the only hedge fund segment that saw net investor inflows in April, according to eVestment figures. An estimated US$5.2bn was added during the month, bringing year-to-date 2013 inflow totals to US$31bn for the segment.

MBS strategies accounted for US$1.08bn of the inflow in April, with year-to-date volume of US$4.07bn. And distressed hedge fund AUM increased by US$950m, resulting in year-to-date volume of US$2.38bn.

The distressed segment returned 1.89% last month, as measured by the EDHEC-Risk Alternative Indexes, bringing year-to-date returns to 6.2%.

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RMBS

Ups and downs for US RMBS

The primary focus in the US RMBS market yesterday was on the possible tapering of QE, given Fed chairman Ben Bernanke's scheduled testimony to Congress. The implication that QE will remain in place until year-end has given further impetus to the rally in risk assets, but sparked heavy selling in fixed-rate agency RMBS.

Interactive Data reports that agency mortgage pass-throughs opened well-bid yesterday morning, boosted by overnight buying by foreign investors. But by mid-day spreads reversed course sharply, leaving lower coupons significantly wider versus benchmarks. The top of the stack continues to exhibit less intraday volatility and is outperforming by a large margin, however.

"Flows have reportedly been heavy and skewed toward net selling in 30-year 3% and 3.5% from a broad array of investors, as 10-year US Treasury yields breach the 2% threshold," the firm notes. "Specified activity remains light to moderate and appears to be an afterthought at the moment."

Meanwhile, non-agency BWIC supply remains elevated, with the ARM and subprime sectors driving volumes. In the option ARM segment, for example, the AHMA 2007-1 A1 bond was talked at mid/high-60s during the session. SCI's PriceABS archive shows that the tranche was last talked in the high-50s on 22 February.

Although dealers continue to report strong bid-list execution and broad-based demand for paper, the increase in available bonds appears to be taking a minor toll on sentiment. Interactive Data notes that a large (US$8.7bn) BWIC is scheduled to trade on 28 May, for instance. Lloyds is reportedly the seller.

Bernanke's testimony was said to support a widespread view that QE tapering discussions will only start happening once the government sees improvements in the labour market and growth in inflation.

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CDS

Bail-in credit event takes shape

Unconfirmed details have emerged regarding ISDA's proposals to update the CDS definitions (SCI 21 May). Among the proposals is a new bail-in credit event for financial CDS contracts, which would be triggered by a governmental authority reducing the interest payable or the principal payable on, by deferring the maturity of or subordinating a debt obligation.

BNP Paribas credit strategists indicate that the bail-in credit event would trigger on subordinated CDS contracts if the bail-in action were taken on Tier 2 or more senior debt obligations, but would only trigger on senior CDS contracts if the bail-in action were taken on senior debt obligations. The effect of this limitation is that subordinated CDS could trigger on a bail-in of subordinated debt without triggering senior CDS on bail-in, they observe.

This credit event is expected to be a 'hard' credit event, with no maturity buckets limiting the deliverable obligations. If the bail-in credit event is triggered, it is anticipated that the protection buyer will be able to deliver anything it receives from the governmental authority (at its original principal amount prior to the write-down), providing the affected debt obligation meets deliverable obligation characteristics prior to the bail-in action. Proceeds of bailed-in Coco bonds would be deliverable only if the Coco conversion feature has not yet been triggered.

Successor provisions that dictate how CDS moves when debt obligations are moved from one entity to another are also expected to change, so that subordinated financial CDS will track the movement of subordinated debt obligations and senior financial CDS will track the movement of senior debt obligations. Senior and subordinated CDS move together at present.

Noting that market action indicates a disregard for the protections offered by the current subordinated CDS contract, the BNP Paribas strategists point out that identifying a trigger has not been the challenge in recent bail-in situations. Rather, the level of recovery has proved the issue.

As such, they note that the new contract does not change the probability of an event occurring. "What it does do is alter the recovery levels where deliverable obligations have not been available. This is more acute for subordinated CDS, as the market remains reluctant to believe that politicians will attempt a senior bail-in, fearing contagion to other banks. This may change over time and is dependent on specific situations, so the probability of senior bail-in is not negligible."

The strategists suggest that if there is a bail-in credit event on a new subordinated contract, it would trigger a restructuring credit event on the old senior and subordinated CDS contracts, as well as a restructuring credit event on the new senior CDS contract in most cases. Hence the main factors differentiating fair value between new and existing contracts are: the probability that a bail-in credit event occurs on a subordinated CDS contract with no or only written-down subordinated obligations deliverable; and the expected recovery rate on the existing subordinated CDS contract if such an event occurs.

"The higher each of these two variables is, the higher the ratio we would expect between the new and the existing subordinated CDS contract spreads," they explain.

ISDA has yet to officially publish the definitions. They have been under consideration for a while (SCI 19 December 2012), with draft rules circulating around the market over the last two weeks.

The Markit iTraxx Europe Subordinated Financials index collapsed by 41bp to 177 during the week to 23 May, according to BNP Paribas figures. The index closed yesterday at 190.96, up by 13.21bp from the previous day.

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CMBS

CMBS softening likely post-GSE sale

Fannie Mae is due to sell a US$2.2bn list of legacy CMBS today. Deutsche Bank CRE debt analysts note that the move represents not only the largest transfer of risk since last year's MAX and WAVE CDO liquidations (SCI 2 May 2012), but also the first widely distributed bid-list to include multifamily collateral.

The bid-list comprises 17 senior bonds - with an average balance of US$129m - that are being offered on an all-or-none basis. Eleven of the bonds still retain their triple-A ratings, while the lowest rated bond is the GSMS 2007-GG10 A1A tranche, which carries a triple-B minus rating from S&P.

Deutsche Bank's base-case model results indicate that the bonds extend slightly to 3.34 years on average and the average loss of the deals from each vintage is better than the full vintage average. Only two tranches - the GG10 bond and MLCFC 2007-6 A1A - are performing meaningfully worse than the full vintage projected loss average.

The analysts estimate that if Fannie sells all of the bonds, it would represent more than half of the required deleveraging for 2013. "In addition, by choosing to sell the bonds in a public manner, Fannie is helping to create a more transparent secondary market that should allow themselves and other market participants to more accurately estimate market values going forward. This will become especially useful if, at some future date, the GSEs are required to speed up non-agency bond sales," they observe.

Over the last year secondary CMBS supply has averaged around US$750m per week across private-label LCFs and agency CMBS. The US CMBS market has softened over the last week and the size and uniqueness of this list is expected to put further pressure on spreads, especially for legacy last cashflow bonds. Weakness could also spread to the agency CMBS and new issue duper sectors.

"However, the scope of the potential widening should be limited and short," the analysts note. "After the uncertainty regarding execution passes and fears of another large list in the near future wane, the exercise - assuming it trades well - could form the basis for the next tightening cycle in related subsectors, much in the same way we saw in the AM and AJ markets following the large CDO liquidations in 2012."

SCI's PriceABS data shows a range of talk for the GG10 and MLCFC bonds yesterday. The former was talked at 130 area, 140 area and mid-100s; the latter was talked at mid-90s and mid-100s.

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RMBS

ResCap plan 'net negative' for RMBS

Ally Financial, along with Residential Capital and ResCap's major creditors, has completed the next step in implementing the comprehensive settlement agreement and Chapter 11 plan (SCI 20 May). ResCap filed a motion seeking court approval of the plan support agreement in the bankruptcy proceedings, which includes announcement of the terms of the Chapter 11 plan.

The plan includes releases of all claims between Ally and ResCap - including all representation and warranty claims that reside with ResCap - and all claims held by third parties related to ResCap that could be brought against Ally and its non-debtor subsidiaries, except for securities claims alleged against Ally by the FHFA and FDIC. The Chapter 11 plan terms also confirm that the ResCap estate has responsibility for the costs and obligations associated with the foreclosure settlement with the US Department of Justice and the Attorneys General, as well as the responsibility for all consent order directives originally addressed to ResCap.

As part of the plan, Ally will contribute US$1.95bn in cash to the ResCap estate on the effective date of the plan, as well as the first US$150m from insurance proceeds it expects to receive related to releases in connection with the plan. The agreement also requires that Ally receive full repayment of its secured claims, including US$1.13bn that is owed under existing credit facilities.

Ally expects to record a charge of approximately US$1.55bn in Q2 related to the plan and an increase in litigation reserves.

MBS analysts at Barclays Capital note that although the US$2.1bn contribution is larger than the US$750m that Ally originally agreed to pay into the ResCap estate, the allocation agreed to among creditors appears to be less beneficial for RMBS investors than had originally been envisioned. Under terms of the settlement, RMBS holders will receive an unsecured claim of US$7.1bn against RFC debtors and a US$210m claim against GMAC debtors, while total estimated distributions available to RMBS holders will be US$672.3m. Based on the estimates available, this translates into an 8.6% recovery for the RFC trusts (US$611m) and a 28.9% recovery for the GMAC trusts ($60m).

However, the Barcap analysts point out that the eventual recovery number could be different for two reasons. First, under a separate agreement between the RMBS investors, US$75.3m of the pro-rata share that is due to RFC RMBS holders will be transferred to GMACM RMBS holders. Second, the entities will together contribute a maximum of US$96m (83% from GMAC and rest from RFC), which will be re-allocated back to the entities in a manner that has not yet been specified.

The recovery to RFC bondholders is consequently expected to be significantly lower than originally believed, primarily because of higher monoline and ResCap holdco claims. "As such, the proposed agreement appears to be a net negative for non-agency RMBS, especially for RFC-sponsored deals," the analysts note.

The plan support agreement includes details about how claims will be allocated among the RFC and GMACM trusts. Each trust's claim will be determined by the trustees under the advice of a third-party financial advisor.

The financial advisor will estimate total historical and future losses, as well as the ratio of loans in the trusts that breached rep and warranty provisions (the 'exception rate'). Each trust's allocated share of claims will then be determined by the product of that trust's total estimated losses and its exception rate. The worst-performing deals (2006 and 2007 vintage subprime and second-lien RMBS) are anticipated to receive the largest pay-outs under this methodology.

In addition, the plan support agreement currently estimates that MBIA will receive approximately US$796m on total claims of US$3.6bn against the ResCap estate. This represents about 80% of the US$1bn in remaining rep and warranty recoveries that the monoline had recorded on its balance sheet after its settlement with Bank of America and is enough to add another US$296m to its liquidity pool.

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RMBS

Better RMBS data provides Irish guidance

The European DataWarehouse (ED) is benefitting sectors that had previously suffered from a paucity of information, such as peripheral RMBS. One such jurisdiction is Ireland, where greater access to data is set to facilitate more rigorous fundamental analysis and aid in the trading of bonds.

With late-stage 90-day plus arrears averaging 17.5% for prime Irish RMBS, the sector remains particularly credit intensive for investors. Information asymmetry due to the lack of loan-level data historically meant that many bonds 'traded to worst'. But now that loan-level data on CRSM 9, CRSM 10, FSTNT 2 and EMERM 4 has been made available, the ability to better understand and size where credit risk lies in pools should enable better investment decisions, according to Deutsche Bank European securitisation research analysts.

Based on an analysis of the data, they note that interest rates seem to be a key driver of defaults across Irish mortgage pools. Tracker rate mortgages default less frequently than SVR mortgages, which show a 1.6x higher likelihood of default compared to tracker mortgages, on average.

There is also a low correlation between incidence of negative equity and default, as can be seen in the weak relationship between negative equity buckets and 90-day plus arrears. For FSTNT 2, for example, there is a higher arrears likelihood in the 60%-70% LTV bucket than for the over 100% LTV bucket.

In addition, the loan-level data shows that estimated pool losses vary significantly across deals. For example, if 100% of total arrears were to be liquidated, then expected losses for CRSM 9 and EMERM 4 would be around 4.9% and 3.6%, but would be higher for CRSM 10 at 8.6%. Such analysis provides greater clarity than comparing late-stage arrears alone, since it enables the computation of more accurate cumulative losses from loan-level indexed LTVs.

The Deutsche Bank analysts note that the data also provides insights on credit resiliency. For instance, comparing an aggregation of available reserve funds and 12-month projected excess spread with pool losses in a scenario where 100% of loans are in arrears shows that the cushion available for CRSM 9 and FSTNT 2 is more than the arrears liquidation loss.

Based on the data available, the analysts favour CRSM 9 B over CRSM 10 B as both bonds trade within a two-point range of each other, with significantly different credit risk inherent in the pools. Irish RMBS seniors also still appear fundamentally sound.

"The leakage of interest proceeds to RMBS mezzanine and first-loss pieces due to forbearance for borrowers in distress in the last three years was a prominent concern among investors. However, recent central bank efforts to accelerate arrears resolution and loss recognition should play well into senior RMBS, as reserve funds will increasingly be directed towards repaying senior bonds," the analysts conclude.

JL

Structured Finance

Back to BlackRock

Armando La Morgia has rejoined BlackRock from KNG Securities, having spent five months at the firm (SCI 13 February). He joins BlackRock as director in London.

La Morgia was previously a consultant in BlackRock's financial markets advisory group and has also served as portfolio manager at Hemera Capital Management, director at Merrill Lynch, vp at Morgan Stanley and bond analyst at ING Bank.

CLOs

Permacap proposes structural changes

Carador Income Fund is convening an extraordinary general meeting on 26 June. The company says it intends to invest in primary CLO income notes, which - although permitted under the current investment policy - needs to be considered alongside some other structural features.

The company believes that the opportunity to deploy significant capital in the secondary CLO market at attractive returns will diminish over the next few years. In contrast, primary CLO income notes may now offer higher risk-adjusted internal rates of return than those currently available in the secondary market.

Following a consultation process with its major shareholders, the company has therefore developed proposals to: increase its exposure to primary CLO income notes compared with the current concentration on secondary CLO positions; replace the 2017 continuation vote with a redemption opportunity for investors in 2017 (and every five years thereafter), if the shares have traded at an average discount to NAV in excess of 5% over the 12-month period prior to 30 April in the relevant year; replace the winding-up vote to take place in 2021 with a continuation vote to be held in 2022 (and every 10 years thereafter); amend the distribution policy such that the company not be required to pay out all net income each year and to use this flexibility for the purposes of making more consistent quarterly dividend payments; permit the issue of 500 million shares on a non-pre-emptive basis; and amend the investment manager's performance fee hurdle.

The company has delivered an annualised NAV total return of 26.54% from the launch of the US dollar share class to 30 April 2013.

CMBS

CreXus merger completes

Annaly Capital Management has completed its acquisition of CreXus Investment Corp (SCI 18 April). Annaly's commercial real estate business will now operate under the name Annaly Commercial Real Estate Group.

Under an agreement and plan of merger dated 30 January, CreXus was merged with a newly formed CreXus subsidiary in a transaction in which Annaly became the sole stockholder of CreXus. CreXus common stock holders were entitled to receive cash equal to US$13.05206 for each share they owned immediately prior to the merger.

Risk Management

Chinese expansion planned

Calypso Technology has opened an office in Beijing, to service both domestic and international institutions across the region. The move follows recent client successes and continued growth in Greater China, according to the firm.

The new office will house sales, professional services and engineering teams to support existing and new clients across Greater China. Calypso plans to develop its Beijing team by relocating some key staff to assist with integrating local hires.

RMBS

Origination acquisition eyed

Ellington Management Group has appointed Steven Abreu to a new role as head of mortgage originations. He will lead the firm's efforts to acquire one or more mortgage originators and oversee both agency and non-agency mortgage originations, including refinancings, purchase loans and retention of servicing rights.

Abreu was previously president of GMAC Mortgage from 2009. Prior to that, he was ceo and president of GreenPoint Mortgage Funding.

ABS

Auto ABS performance remains strong

Annualised net losses (ANL) for both US prime and subprime auto ABS dropped in April for the third consecutive month this year, according to Fitch's latest index results for the sector.

Prime ANL dipped by 27% in April over March to 0.24% - the fourth lowest loss rate ever. In the subprime sector, ANL stood at 4.10%, a 12% improvement versus the prior month.

Strong seasonal performance is typical for this time of year for auto ABS, Fitch notes. Overall the agency expects auto ABS performance to remain strong entering the summer months.

ABS

CAA consultation 'credit neutral'

UK airport regulator the Civil Aviation Authority (CAA) last month launched a consultation on initial proposals for regulation of Heathrow and Gatwick airports during the five-year period beginning April 2014 (the so-called sixth quinquennium, or Q6). The Civil Aviation Act 2012 - which became effective in December -introduces a new license-based regulatory regime for Q6, allowing the CAA the flexibility to tailor rules for individual airports (beyond price cap and minimum service level standards) and to revisit the rules over the quinquennium. The CAA will publish final proposals in October, with the final decision on licensing conditions expected in January 2014.

In S&P's view, the initial proposals would be credit neutral for the Heathrow Funding and Gatwick Funding corporate securitisations. The agency believes that their business risk profiles would remain unchanged, without significant additional cashflow volatility.

The CAA's initial proposal is to maintain a regulatory asset base (RAB) framework for capping annual airport charge rises at both Heathrow and Gatwick. The CAA intends to change the annual price cap for both airports during Q6.

For Heathrow, the suggested cap is 1.3% below retail price inflation (RPI) - significantly below both the Q5 cap (RPI plus 7.5%) and Heathrow's proposal (RPI plus 5.9%). For Gatwick, the suggested cap is RPI plus 1% per year in Q6, a modest increase from the cap in the year to March 2014 (RPI minus 0.5%), but below the level of the previous five years (RPI plus 2%).

The CAA is also planning to introduce rules requiring Heathrow and Gatwick to make their operations more resilient to service disruptions. Minimum service level requirements, rebates that Heathrow and Gatwick must pay to airlines for underperformance, and bonuses that they can earn for exceeding targets are largely based on those from Q5.

In S&P's view, it is unlikely that the initial proposals will affect the credit profile of Heathrow Funding, despite the lower price cap. It therefore expects Heathrow's business risk profile - currently "excellent" - to remain unchanged.

"We do not expect the sub-inflation price cap to affect Heathrow's credit quality, as this could be partially offset by lower capital expenditure. Capital expenditure will average £600m per year in Q6 under the current proposals, compared with a £1bn average in the last regulatory period, potentially leading to better cashflow generation," the agency explains.

Based on initial modelling, S&P believes that Heathrow could generate positive free operating cashflow during Q6, which could help to improve its flexibility and offset the changes in pricing structure. The CAA and Heathrow have also found cost savings that, if achieved, should mitigate the impact of the real price decrease on Heathrow's EBITDA.

That said, the lower price cap decreases the transaction's resilience to downside stress scenarios and S&P suggests that there is a higher chance of the transaction breaching dividend lock-up covenants.

Similarly, for Gatwick Funding, the agency expects the new rules to have a limited effect. The business risk profile assessment remains "strong".

However, S&P notes that the consultation leaves open the possibility of replacing RAB-based regulatory price caps with bilateral agreements between Gatwick and airlines. The agency says it would view this development as credit negative for the securitisation.

The RAB represents the value of the securitised assets and provides an important reference point for investors, should the assets need to be sold to repay securitisation bondholders, according to S&P. If the new regulatory framework dispensed with the RAB model - which is not its base-case expectation - the agency would review whether the transaction is subject to significantly higher EBITDA volatility or refinancing risk. If so, this could affect the ratings on Gatwick Funding bonds.

"For both Heathrow and Gatwick, we view the proposed operational resilience regulations as broadly credit positive. Despite likely entailing up-front and ongoing compliance costs, we believe these may be largely offset over the longer term by less severe service interruptions and an increase in passenger confidence," S&P concludes.

Structured Finance

Euro mezz ABS takes a breather

The European ABS sector showed a muted response to the volatility seen in equity markets last week. Granite triple-B prices were down slightly on Thursday and Friday.

"After what seems like a very long period characterised by strong unflinching demand for bonds, very little supply and consequently steadily increasing prices, a slight pause in this dynamic has been notable," ECM Asset Management observes in a client memo. "It remains to be seen if this dynamic is fundamentally altered - most market participants seem to think not - but it seems a reasonable point to reflect back on the significant price increases in mezzanine ABS seen in 2013."

Senior ABS paper remains strongly in demand, with both of last week's UK prime RMBS prints tightening following issue. Santander's three-year Holmes Master Issuer 2013-1 A2 notes priced at 40bp over three-month Libor and is currently bid 5bp tighter in the secondary market. West Bromwich Building Society's Kenrick No. 2 A tranche priced at 65bp over and is currently bid 8bp tighter.

Meanwhile, Clydesdale Bank has announced a new UK RMBS - Lanark Master Issuer series 2013-1 - which is expected to price this week.

Structured Finance

Bondholder communication network unveiled

DealVector has launched a secure electronic communication network that allows fixed income and illiquid asset market players to know 'who's in their deal', thereby improving the efficiency of these markets by facilitating communication. The platform fills a gap in the current DTC/Street name system by offering the ability to directly message the beneficial owners of financial assets on a mutual opt-in basis, according to the firm. In doing so, issuers, investors, advisors, collateral managers and others can efficiently and confidentially come together to address governance and restructuring issues, improve market surveillance and source illiquid assets.

Market participants invested in CDOs, CLOs, fixed income and other alternative investments have historically operated in an opaque, fragmented market, with limited insight into counterparties, transaction volumes and inventory. This lack of transparency makes it difficult to track down the right players in deals and means many claims or restructurings are never brought to a vote because too few holders are aware it is happening. As a result, market participants often incur large costs and high risk with respect to price discovery, governance, consent solicitations, illiquid asset sourcing, creditor class formation and many other common events requiring communication among deal participants.

DealVector's innovative platform solves these problems by using a confidential deal registry and identity-protected messaging service to match alternative asset players according to specific deal, role or pricing preference. Members address messages by defining two 'vectors' of approach: the asset and the type of participant (role). Messages are delivered only to members who match the specified criteria.

All communication takes place under numeric identifiers, preserving anonymity. At the same time, DealVector validates each network participant, meaning that members can also be confident they are communicating with legitimate counterparties.

"Investors in the alternative investment space have long searched for a solution that provides a secure method to pinpoint other holders in a specific deal without having to give away their position or personal information," comments David Delo, chairman at Southport Asset Management. "DealVector has addressed that issue by creating the first social networking platform that preserves privacy while fostering communication between investors in the structured credit and fixed income communities."

Structured Finance

Risk retention consultation begins

The European Banking Authority has launched a consultation paper on draft regulatory technical standards (RTS) to specify the securitisation retention rules and related requirements. It has also released draft implementing technical standards (ITS) to clarify the measures to be taken in the case of non-compliance with such obligations. The consultation runs until 22 August.

The EBA says the key objectives of the draft RTS are: an alignment of interest and information between securitisation sponsors, originators and original lenders and the investors buying securitisations; and the facilitation of the 5% retention requirement and disclosure requirements of the sponsor, originator or original lender and the due diligence requirements of investors in securitisations. The ITS, meanwhile, provides the assessment criteria for breaches of the Capital Requirements Regulation (CRR) and RTS requirements, as well as the implementation conditions and the calculation of additional risk weights to be applied by competent authorities.

The EBA is tasked to submit draft RTS and ITS to the European Commission by 1 January 2014.

Structured Finance

Pfandbriefe amendments welcomed

Amendments to the German covered bond law passed by the German Parliament earlier this month will likely strengthen the country's existing covered bond framework, improve clarity for investors and enhance the quality of Pfandbriefe, in S&P's view. The changes - which will come into force on 1 January 2014 - for the first time state explicitly that accounts with Deutsche Bundesbank are eligible to be used as collateral by issuers of covered bond programmes.

"We believe this explicit recognition could lead to a wider use of Bundesbank accounts by issuers as a tool to mitigate commingling and account bank risk," comments S&P credit analyst Ioan Isopel.

The agency considers the risk of commingling and bank accounts in determining whether, and by how much, covered bond ratings may exceed the issuer's credit rating. In the absence of relevant mitigants, it would generally link its covered bond ratings to the rating of the account bank to reflect bank account risk.

While Deutsche Bundesbank is not rated, S&P currently deems it highly unlikely that a sovereign would exit the eurozone. The agency therefore considers a eurozone country's central bank's credit standing is indistinguishable from that of the European Central Bank.

Other amendments to the German covered bond law include: clarification for the statement of collateral purpose, with regard to land charges and foreign security interests; more transparency with regard to the ratio of the loan in the covered pool to mortgage lending values and arrears levels; and further clarification of the engagement of the cover pool administrator. "Although we believe these changes will improve the quality of information available to market participants, we consider them broadly credit neutral under our ratings criteria," says Isopel.

Structured Finance

Risk-adjusted pricing remains 'challenging'

The development of a genuine market for long-term investments - whether for infrastructure, SMEs or any other sector - requires a well-structured, transparent and stable long-term policy framework, according to S&P. The agency's comments are a response to the OECD's public consultation paper entitled 'Draft High-Level Principles Of Long-Term Investment Financing By Institutional Investors'.

An estimated US$85trn of liquidity is held by institutional investors worldwide. The OECD's draft principles - which focus on eight broad issues, ranging from incentives to prudential regulation - aim to facilitate long-term investment and help offset the increasingly short supply of long-term capital in the market since the financial crisis.

However, while recognising the opportunity for institutional investors to provide long-term capital for sectors such as infrastructure and SMEs, S&P nonetheless expects that pricing transactions appropriately from a risk-adjusted perspective will be challenging. "Even if public authorities were to adopt and implement the principles quickly and in full, we believe that it may take a number of years for the market to build critical mass," comments Peter Tuving, md at S&P.

He adds: "We note that when transaction structures are supported by independent, stable and transparent regulatory frameworks enshrined in legislation, the risk of periodic policy change is reduced. Such policy changes have in our experience discouraged investor participation and, in certain cases, have the unintended effect of being a principal driver of increased default risk on infrastructure debt."

A further draft of the principles is expected to be discussed by the OECD Task Force on Institutional Investors and Long-Term Financing at its next meeting in late May. A final draft will then be submitted to G20 finance ministers and central bank governors at their July meeting for transmission to the G20 Leaders Summit in St Petersburg at the beginning of September.

Structured Finance

APAC ratings remain stable

Fitch reports that Asia Pacific (APAC) structured finance (SF) tranches remained largely stable in 2012, with over 95% of tranches maintaining their ratings or being paid in full (PIF), compared with 89% in 2011. As in previous years, most downgrades (92.8%) were made to Japanese transactions, three-quarters of which were CMBS.

Ratings from two credit-linked notes referencing a Japanese government bond were also downgraded following a similar action on Japan's local currency issuer default rating. All impairments in 2012 came from the triple-C category and were concentrated in Japanese CMBS, which contributed to eight of the nine impairments. The remaining impairment was a New Zealand non-conforming RMBS tranche.

Downgrades outnumbered upgrades for the fifth consecutive year, the ratio being 2:1 in 2012. However, the number of downgrades declined sharply to 28 in 2012 from 66 in 2011 and from the peak of 143 in 2009. Upgrades remain limited due to the fact that 52% of Fitch's APAC SF rated tranches are rated triple-A.

Fitch's outlook for APAC SF remains largely stable. Negative outlooks are limited to three Japanese CMBS tranches and two New Zealand non-conforming RMBS tranches. Distressed ratings, which are expected to contribute to ratings volatility, are isolated in Japanese CMBS and Australian and New Zealand non-conforming RMBS.

CDO

Ambassador CDO sale due

Cowen and Company has been retained as liquidation agent for Ambassador Structured Finance CDO. The collateral will be auctioned via two public sales on 4 June.

The first sale will comprise RMBS assets, while the second consists of credit card ABS, ABS CDO, RMBS, CLO, CRE CDO and Trups CDO assets. The sales are to be held on an 'as is and where is' basis.

Any collateral remaining unsold at the conclusion of the public sales may be sold afterwards in one or more public or private sales.

CLOs

CLO indenture comparisons prepped

Fitch has launched CLO Indenture Abstracts, which will be published for every Fitch-rated US CLO 2.0 transaction. The new reports are designed to provide what the agency believes is unprecedented insight into the key features of the CLO indenture and how those features compare to other Fitch-rated CLOs.

The nuances of CLO indentures can significantly influence investment theses and may ultimately impact performance. Up until now, there has been no easy way to locate and compare these features from one CLO to the next, Fitch notes.

Among the indenture features that the agency reviews and comments on are: collateral quality tests; concentration limitations; coverage tests; priority of payments; conditions to reinvestment; events of default; manager replacement provisions; call provisions; indenture amendments; and reporting requirements.

"As investors continue to deal with rapidly growing CLO volume, their ability to dissect and digest the transaction documents presents an increasing challenge," Fitch explains. "CLO indentures lack uniformity and evolve over time to reflect current changes in the underlying loan market. Fitch's CLO Indenture Abstracts are aimed at easing this burden by highlighting the indenture features that investors have indicated are most critical in their analysis."

The indenture features that investors are most interested in comparing are often the same as those that are factored into Fitch's CLO credit analysis, it says. Consequently, the agency says it makes sense to share this information with investors in the clearest and most timely manner possible.

Going forward, Abstracts will be published on all new Fitch-rated CLO 2.0 transactions at or near the time the transactions are issued. Additionally, the agency is currently back-filling Abstracts on its existing portfolio of rated 2.0 CLOs.

Once it has attained a critical mass of reports, Fitch will consider providing a comparison tool to quickly compare two deals side-by-side. Additionally, the agency will consider providing this analysis for non-Fitch rated transactions subject to availability of information.

CMBS

CRE tap turning back on

UK banks - which remain in a process of rehabilitation - continue to provide new lending into the commercial real estate sector, but in constrained amounts. While conditions are expected to improve, S&P suggests that the market for bank credit is unlikely to return to its 2007-2008 heights.

In the aftermath of the financial crisis, banks - in the UK and elsewhere - have had to radically adjust their finances and their business models. S&P points out that many UK banks started this readjustment back in 2008 or 2009.

As a result, much of the heavy lifting has been done, particularly by Lloyds and RBS. What's more, UK banks once again find themselves able to fund themselves in reasonable volumes at something close to a sensible cost.

In S&P's view, UK banks will have greater confidence and ability to extend credit in greater volume once: their balance sheets stabilise and future requirements become predictable; economic prospects improve; long-term funding markets become reliable; and the likelihood of further declines in collateral values reduces. "Credit conditions may well ease further over the next 12 to 18 months, but we expect that even when the flow of credit from UK banks into the CRE sector returns to normalcy, the cost of that credit may be sustained at a higher price than in years past," the agency adds.

CMBS

Pro forma swipe rebutted

In assessing the value of a CMBS property, using sustainable income is a better approach than relying on only current (in-place) leases or pro forma income, Moody's suggests. The agency's comment comes after Fitch published an unsolicited comment on the CGCMT 2013-375P deal (SCI 14 May).

"Of the methods for determining the income used to value properties from a credit perspective, we consider sustainable income the most accurate," says Tad Philipp, Moody's director of CRE research. "A Fitch report on a CMBS transaction we rated recently used the term 'pro forma underwriting' to call into question the level of credit protection the collateral provides. In our view, Fitch's concern was misplaced, because there was a disconnect between the value of the property based on simply capitalising in-place income and the intrinsic value of the collateral available to support debt."

CGCMT 2013-375P is backed by the Seagram Building at 375 Park Avenue in New York City. "In our view, 375 Park has proven its exceptional ability to attract capital and retain tenants throughout the credit cycle. In this case, capitalising only in-place income ignores the long-term income generating and value preservation ability of this trophy asset, which is currently performing below its sustainable level," adds Philipp.

According to Moody's analysis, the property's value could decline by 74% from the appraised amount - or by 65% from the value a 2011 capital markets transaction assigned it - before resulting in a loss on the portion of the loan the agency rates Aaa. This allows buffers of a respective 29 and 20 percentage points above the 45% peak-to-trough decline in midtown Manhattan office prices stemming from the financial crisis and is consistent with Moody's Aaa rating on the most senior portion of the 375 Park loan.

Relying too much on in-place income can also result in recognising too much income from properties with weak business prospects - such as C-quality malls - whose income could easily decline or disappear, or from properties at a cyclical peak whose fundamentals are on the verge of decline. "Given our holistic approach to credit, the collateral value we assign in the rating process is sometimes higher than what capitalising in-place income would imply, as was the case with 375 Park - although more frequently the value is lower," Philipp concludes.

CMBS

Mall performance examined

With interest rates averaging 3%-4% on regional mall securitisations, retail REITs have been very active in the CMBS space. But as attractive as these rates are, financing in the unsecured REIT market has also been strong, according to S&P.

The agency notes that in deciding which debt market to access, the upcoming mortgage maturity, amount of origination proceeds and investor interest in the underlying mall collateral are considerations. Other factors could include the REIT's unsecured-to-secured debt funding ratio and unencumbered assets-to-unsecured debt ratio.

"Regardless of the REIT's financing choice, the performance of the underlying mall collateral will ultimately determine a financing's success," notes S&P credit analyst Larry Kay.

The agency reviewed various operating and loan metrics for REIT-sponsored CMBS malls from the 2012 and 2013 vintage years. Average mall sales per square-foot was US$553. By contrast, the ICSC's national mall sales productivity index was US$452, as of 2012.

"In our view, concerns about major retailers, such as J.C. Penney and Sears, as well as struggling retail sales have hampered demand for tenant space and kept construction levels low. Consequently, US mall growth in 2012 was the lowest in more than 40 years," comments Kay.

CMBS

REIT liquidity highlighted

Changes in the availability, pricing and underwriting stringency of CMBS financing could affect REITs directly and indirectly, according to Fitch.

"In the near term, the CMBS financing market's acceptance of pro forma assumptions may be indicative of increased risk appetites, improving the already strong liquidity of REITs and driving additional cap rate compression in secondary asset classes/markets that are more dependent upon CMBS. Over the longer term, continued usage of pro forma assumptions will ultimately increase the uncertainty and volatility of CMBS performance and therefore the requisite spread to compensate for the risk," the agency notes.

A boom-or-bust cycle for CMBS loan performance would negatively affect REITs that regularly access the CMBS market, seek to sell to entities that finance the transactions with CMBS and/or increase the volatility of and perception of risk for commercial real estate.

Insurance-linked securities

Combine Re first-loss impacted

Losses resulting from the severe tornado that struck Moore, Oklahoma on 20 May are credit negative for the US$200m Combine Re Series 2012 indemnity catastrophe bond, Moody's notes in its latest Credit Outlook publication. Because of strong subordination, relatively low preliminary loss estimates and the reinsured company's small market share in Oklahoma, the agency does not expect losses to rise to the level where the notes will experience principal write-downs, however.

Moody's currently rates the class A notes Baa1 and the class B notes Ba2. Insured losses from the Oklahoma tornado, together with previously reported losses of US$20.7m from another qualifying event in 2013, are expected to reduce the first-loss layer of protection for the cat bond. However, the deal benefits from strong subordination because the aggregate ultimate net losses were reset to zero on 1 January, the first day of the second annual risk period, so that losses would begin accumulating anew.

The cat bond - which closed in March 2012 - provides retrocessional protection over three annual risk periods against the perils of hurricane, earthquake, severe thunderstorms and winter storms in the US. Swiss Re underwrote the transaction for the benefit of Country Mutual Insurance Company and North Carolina Farm Bureau Mutual Insurance (see SCI's primary issuance database).

The US National Weather Service estimated the tornado's wind speeds at more than 200 miles per hour and rated it EF5, the highest category on the Enhanced Fujita scale. Although damages were severe, losses have not yet been determined.

EQECAT's preliminary insured property loss estimate of US$2bn-US$5bn is high for a single tornado loss event, but relatively low for Combine Re because it has limited exposure in the covered area. NCFB has no exposure to Oklahoma, while Country Mutual's market share in Oklahoma was less than 1% in 2012, with less than US$10m in direct homeowners premiums written and limited exposure to commercial premiums.

Moody's notes that the tornado has no credit effect on the other four cat bonds it rates because it is not a covered peril.

Risk Management

AIMA warns against regulatory overlap

The Alternative Investment Management Association has produced a paper that highlights the key areas where deeper coordination of OTC derivatives regulation is required to achieve the G20 objective of maintaining global markets. The paper provides examples of potential regulatory conflicts or unnecessary overlap between EMIR and the CFTC's derivatives rules in a number of key areas, including clearing obligations, reporting obligations, segregation rules, collateral rules and margin requirements.

AIMA says in the paper that - if untreated - some of the conflicting rules may prevent counterparties from complying with either regime, leading to market fragmentation along geographical boundaries. The association suggests that these effects could be mitigated for cross-border transactions by firms being allowed to follow the rules of the jurisdiction of one, rather than both, counterparties to a transaction under a concept known as 'substituted compliance' in the US or 'equivalence' in the EU.

In the US and Europe, the CFTC, the US SEC and the European Commission respectively will soon determine the scope of their derivatives regulatory regime with respect to cross-border transactions. These decisions - which will address the scope of substituted compliance and equivalence recognition - will have a significant impact on the nature of the global derivatives market, the association warns.

Risk Management

Collateral concerns 'unjustified'

A recent Committee on the Global Financial System report says that concerns about an absolute shortage of high-quality collateral assets appear unjustified, given that the supply of collateral assets has risen significantly since end-2007. The report adds that endogenous private sector responses - such as collateral transformation activities - will help to address supply-demand imbalances, if and when they emerge.

The Committee concedes, however, that demand for high-quality assets that can be used as collateral will increase due to a number of key regulatory reforms and could lead to temporary shortages in some countries. This comes on top of greater demand for collateral assets through increased reliance by banks on collateralised funding, particularly in Europe.

The report identifies implications for markets and policy that warrant monitoring and further analysis. They include: endogenous market responses - while mitigating collateral scarcity - are likely to come at the cost of increased interconnectedness and greater financial system pro-cyclicality; and greater reliance by banks on collateralised funding can adversely affect the residual claims of unsecured creditors during bank resolution, increase risks to deposit insurance schemes and reduce the effectiveness of policies aimed at bail-in.

RMBS

Property price indexing introduced

Fitch is set to introduce property price indexing into its analysis of Australian RMBS in the near future. The aim is to create a more accurate picture for investors of the value of security backing the underlying loans, as well as allow Fitch a more systematic assessment of regional variations in house price changes when it assesses recoveries.

Fitch notes that in a falling market, there is a risk that house prices drop to below the original valuation recorded, which can give investors an incorrect assessment of security and in some cases may result in losses. Indexing would provide a more transparent view and allow both Fitch and investors a more up-to-date picture on which to base their analysis, the agency says. To capture potential losses at all loan-to-value ratio (LVR) levels, it already applies a minimum loss severity to individual loans.

Overall Australian house prices stabilised in 2012, but data shows that price movements are far from uniform across the country. In some areas, particularly non-major city coastal spots, peak-to-trough price movements have been in excess of 20% in the period 2011-2012.

Fitch's analysis will incorporate indexed revaluations at the loan level. It will use separate indices for units and houses in 76 Fitch-defined regions, largely based on the Australian Bureau of Statistics subdivisions. Indices are provided by RP Data/Rismark and will be updated quarterly.

The specific impact on existing Australian RMBS transactions will depend on the seasoning of the underlying loans and their geographical distribution. Preliminary analysis indicates no impact in the sector, where the vast majority of ratings are triple-A.

The rise in Australian house prices in recent years means indexed current LVRs are generally lower than un-indexed current LVRs. Almost all deals benefit from indexation in that more properties have increased than have decreased in value.

Even where that is not the case, the size of the price increases compared with the smaller but more numerous decreases means aggregate property values in the portfolio are higher. Fitch will give 50% credit for price increases and 100% credit for price falls.

Indexing will also be introduced into the New Zealand RMBS criteria. The new criteria will be released within the next two months.

RMBS

Freddie unveils modified PCs

Freddie Mac has begun securitising certain performing modified mortgage loans held in its mortgage-related investments portfolio. To be eligible for securitisation, loans need to be current for at least six consecutive months.

The modified mortgage loans are being pooled into new Freddie Mac fixed-rate modified participation certificates (Modified PCs) with new 'MA-MD' prefixes. They are not TBA deliverable and do not include loans modified through HAMP. The PCs are eligible collateral for new Freddie Mac Giant PC securities.

Freddie Mac will also provide additional pool-level and loan-level disclosures specific to the Modified PCs. Additional disclosures will include mortgage loan attributes at origination before modification, at time of modification and at time of securitisation as Modified PCs. In addition, the GSE will provide pool-level disclosure of payment history covering up to 36-months prior to the Modified PC issuance.

The vast majority of these loans were bought out of their related PCs when the loans were at least 120-days delinquent. When loans become 120 days or more delinquent, it is generally Freddie Mac's policy to purchase the delinquent loans out of the PCs and hold them in its mortgage-related investments portfolio while the company pursues resolutions to the delinquencies.

"Securitising loans that have been modified and are now performing will allow Freddie Mac to better manage its mortgage-related investments portfolio," comments Adama Kah, Freddie Mac vp of distressed assets management.

RMBS

Caution emerging in secondary RMBS?

Further details have emerged regarding the US$8.7bn non-agency RMBS BWIC scheduled to trade on 28 May (SCI 23 May). The list is composed of mostly adjustable-rate collateral, with over half being Alt-A paper. Bidding will be conducted on an all-or-none basis.

Interactive Data notes that although the list comprises similar collateral to the list put out by Freddie Mac on 15 May (SCI 17 May), the overall bond quality appears to be worse. This can be partially explained by an increased proportion of non-investment grade bonds (55% versus 21%), driven in part by the inclusion of option ARM collateral and senior mezz/support structures.

Larger than usual secondary supply appears to be impacting the overall appetite for risk, with dealers said to have generally more conservative expectations. Average price talk levels fall short of evaluated levels by a far larger margin for next week's list, particularly in investment grade bonds, Interactive Data observes.

Elevated ARM BWIC activity was observed yesterday, meanwhile, as subprime and fixed-rate supply dwindles ahead of the holiday weekend. In the subprime segment, the HEAT 2006-3 M1 tranche was talked at low-70s during the session, according to SCI's PriceABS data. It also shows that Alt-A fixed-rate bond BOAA 2006-9 2NC1 was talked at mid-70s.

RMBS

Statute of limitations analysis recommended

Two recent New York State Supreme Court decisions regarding claims arising from US RMBS representations and warranties (R&Ws) breaches significantly differed in their analyses of the applicable statute of limitations (SOL), S&P reports. The agency consequently believes that investors should consider both cases when reviewing such transactions.

The first decision was when the defendant's motion was granted on 10 May to dismiss the action in Nomura Asset Acceptance Corp Alternative Loan Trust Series 2005-S4 v. Nomura Credit & Capital Inc. The case involved HSBC Bank USA, the trustee of a 2005 RMBS, suing Nomura Credit for various breaches of R&Ws made in the transaction's governing documents.

However, the court concluded that the action was barred because the plaintiff initiated it after the applicable SOL for contract claims had expired. The SOL in New York on claims for breach of contract is six years.

The trustee's argument was that Nomura Credit's refusal to repurchase the loans when requested in 2011 constituted a separate event from which the SOL should be measured, but the court rejected this position. The court reasoned that the R&Ws were false when they were made, constituted a breach at the time and that the SOL ran from the time the R&Ws were originally made rather than from the time the trustee demanded repurchase. The court found that the repurchase agreement was solely a remedy, not an independent duty under the contract.

Three days later, in ACE Sec. Corp v. DB Structured Prods Inc, a different judge in the same court reached an opposite decision - rejecting the seller/sponsor's rationale that the SOL ran from the time the R&Ws were made. The court - disagreeing with a 2003 federal decision cited by the seller - determined that the SOL began only when the plaintiff's repurchase demand was refused.

In the ACE decision, the court found that under the terms of the standard securitisation documents, the R&W provider had no duty to ensure that the R&Ws were true. It only needed to follow the applicable repurchase protocol and its failure to do so was the only contractual wrongdoing it could commit. The court further stated that the transaction was intentionally structured to shift the risk of R&W compliance onto the R&W provider and indicated that this 'insurance' was likely priced accordingly.

Based on these decisions, S&P believes that - in addition to considering the substance of R&Ws and any sunset provisions in US RMBS transaction documents - investors should consider any applicable SOLs and the possibility that they could begin as of the date the R&Ws are given. Resolving the SOL question, however, will likely take many years to reach a consensus - if any - since many more cases may be filed as the SOLs expire.

In the agency's opinion, these decisions demonstrate the potential difficulty of pursuing claims arising from breaches of R&Ws in US RMBS transactions and therefore the importance of up-front due diligence and consideration of operational factors.

Currently, the applicable six-year SOL for contractual claims in New York is expiring on the vintages that originated from 2005-2007. Other jurisdictions have various SOLs, but none is over 10 years.

RMBS

Short sales trump loan mods

The remedy of choice for underperforming residential mortgage loans has undergone a sea-change of sorts over the last several months for US RMBS servicers, according to Fitch's latest quarterly index for the sector. Once the norm, loan modifications have slowed notably, while short sales have become the proverbial order of the day.

For non-agency loans, short sales by bank servicers peaked at 51% in November 2012, an increase from 20% two years prior. Short sales among non-bank servicers have also increased, peaking at 16% in October 2012 from 11% two years prior.

"Loan modifications have fallen, due partly to overall declines in mortgage delinquencies," says Fitch md Diane Pendley. "However, they may also have fallen out of favour since many modified loans have already failed and do not qualify for another modification."

Fitch notes that prime borrowers are more likely to accept a short sale, with 64% of recent liquidations being sold as short sales. Alt-A short sales are not far behind, with 53%, and 42% for subprime loans.

The increased use of short sales may also be the result of servicers' efforts to reduce the impact of foreclosure on borrowers who have re-defaulted loan modifications. Currently, the modification re-defaults after 24 months are 24% for prime, 36% for Alt-A and 43% for subprime.

Another interesting trend that has developed is the wide disparity between bank and non-bank servicer practices in numerous areas like loans per employee, use of temporary staffing and staffing levels. Following a marked increase in late-2010, bank staffing levels have declined, with defaulted loans either being resolved or transferred. At the same time, non-bank staffing levels have risen as their portfolios have increased.

"Increased use of non-bank servicers has been particularly evident on subprime loans, due in part to their more aggressive use of loan mods and shorter overall timelines," says Pendley.

RMBS

Weakening enforcement highlighted

The news that a delinquent borrower in a repossessed property belonging to a Spanish RMBS (Mixto III) will be allowed to remain in their home under recent Andalucian legislation highlights the risk of weakening mortgage enforcement in Spain, Fitch says. The Autonomous Community of Andalucia last month approved the legislation (Decreto ley 6/2013), which gives it power to control the occupation of a property for up to three years when the previous owner and current occupant is about to be evicted and is considered on the verge of social exclusion.

The fact that the eviction was halted before it took place suggests that this type of action cannot be taken retrospectively, according to Fitch. The agency notes that a number of uncertainties remain around the application of the Andalucian law. For example, it is unclear who will pay for the recurrent expenses or rent linked to the property during the period that Andalucian authorities determine it should be rented to the occupier.

This type of legislative development and the related uncertainty over changes to the mortgage enforcement process were among the drivers of Fitch's placement on negative outlook of all Spanish RMBS tranches earlier in the year (SCI 21 March). The agency says they also support its decision to extend to four years the time expected to complete the enforcement of defaulted residential mortgages.

RMBS

Dutch RMBS fundamentals eyed

Statistics Netherlands (CBS) has reported a house price decline in April of 1.4% month-on-month and 7.6% year-on-year for the country. Dutch house prices now stand at a 10-year low and 19% below their 2008 peak, with the rate of price declines continuing to accelerate. Combined with the current 17-year high in the unemployment rate, S&P says this suggests that the Dutch RMBS sector's credit fundamentals are turning increasingly negative, even though average arrears and losses remain low so far.

Not all Dutch regions and property types have fared the same in terms of house prices. Kadaster reports that, as of December 2012, house prices in the Zeeland region were down by 12% from their peak, compared with 18% in Friesland. Similarly, Rabobank calculated that apartment prices declined by 16% between 3Q08 and 4Q12, compared with 19% for detached houses.

By year-end 2013, S&P expects overall Dutch property prices to decline by a further 3% and by another 1% in 2014. This would increase the cumulative house price decline to about 23% from its 2008 peak.

In the short term, austerity measures, rising unemployment and various mortgage market reforms may weigh on property prices and transaction volumes. Key mortgage market reforms include a scaling back of tax deductibility on interest payments, a gradual reduction in the maximum loan-to-value (LTV) ratio for new mortgages and a move away from interest-only loans.

Provisional property sales agreements rose in 4Q12, as buyers rushed to the market before the new, less borrower-friendly mortgage lending rules took effect. However, the residential property market is now once again moribund, with transaction volumes dropping to a monthly average of 7,400 between January and April 2013 - barely half of the 4Q08 volume. Meanwhile, the number of houses entering the market for sale has continued to rise, reaching 229,000 in April.

In the long term, however, a shortage of housing stock may support a gradual recovery. For example, ABF Research estimates that there is currently a 150,000 unit shortage of properties, but that this will double by 2020 due to a widening gap between housing completions (averaging 35,000-45,000 per year) and housing demand (80,000-100,000 per year).

Despite deteriorating macroeconomic and housing market conditions, credit performance in Dutch RMBS collateral pools to date remains broadly stable. In S&P's view, this may be due to relatively generous unemployment benefits historically, which likely introduce a significant lag between rising unemployment and rising mortgage arrears.

RMBS

Self-employed IO loan concentration examined

Moody's expects self-employed borrowers' exposure to current UK economic weakness not to have a significant impact on the creditworthiness of UK RMBS, since over three-quarters of RMBS loans are made to employed borrowers. But, in addition to their exposure to current UK economic weakness, self-employed borrowers remain particularly at risk from a potential rise in interest rates because of the higher concentrations of interest-only loans among this group.

"Despite these pressures, however, lower loan-to-value ratios among self-employed borrowers and the greater proportion of them living in the South of England - where the housing market and economy have been stronger - will lessen the impact of the current economic weakness," says Jonathan Livingstone, a Moody's vp - senior analyst.

In Moody's view, self-employed borrowers will remain more at risk of default than employed borrowers with the UK economy currently flat-lining and significant growth not expected until 2014. Self-employed borrowers are more at risk of suffering a drop in income than an employed borrower as they do not benefit from a regular salary to cushion them from the weak economy. The UK economy has experienced very little growth over the past 18 months, with GDP 0.4% higher in 1Q13 compared with 3Q11.

Moody's nevertheless has a stable collateral performance outlook for UK prime RMBS as a result of the low interest rate environment and tight housing supply. However, the agency sees some downside risk, should a triple-dip recession materialise. Such a downturn would lead to further austerity measures, which would cause problems for some borrowers who have until now been able to stay current with their mortgage payments.

While not anticipated, interest rate rises could lead to back-end losses for self-employed borrowers. Levels of interest-only loans are higher for self-employed borrowers, with 62.4% of loans being non-repayment - compared with 45.5% for employed borrowers - reflecting the more stretched affordability of such borrowers. The higher level of interest-only loans among self-employed borrowers may lead to a higher proportion of back-end losses in Moody's adverse scenario, in which there are significant interest rate increases.

RMBS

Home price warning issued

Fitch believes the recent US home price gains recorded in several residential markets are outpacing improvements in fundamentals and could stall or possibly reverse. Many of these areas are in California, which has seen price increases of 13% over the last year.

In many markets, fundamentals are improving as unemployment rates continue declining, while low prices and low interest rates have kept affordability high. However, Fitch notes that rapidly increasing price levels are a potential cause for concern, especially in cities that never fully unwound the mid-2000s bubble.

For example, in Los Angeles prices are up more than 10% in the past year, despite a stubborn unemployment rate that remains above 10% and real incomes that have declined over the past two years. Prices are now more than 75% above pre-2000 levels.

"Several factors are combining to form an environment supportive of brisk home price growth, but few are capable of providing long-term support to sustain the recent pace of improvement," Fitch observes. "Primarily, restricted supply and bolstered demand factors are bidding prices up. The demand is artificially high as borrowers remain on the side-lines waiting for prices to stabilise."

The agency believes that this level of housing demand is likely to abate once the pent-up demand is satisfied. The supply-demand imbalance is even more pronounced in regional markets that are seeing strong institutional and retail bids for rental properties. The low rate and steep drop in prices, coupled with the decline in homeownership, have attracted an estimated US$8bn-US$10bn of new capital to this sector.

RMBS

MILAN methodology updated

Moody's has updated its methodology for rating RMBS using the MILAN framework, including the introduction of a new approach for the analysis of mixed-pool mortgage loan portfolios. At the same time, the agency has updated its related approach to originator assessments.

In EMEA Moody's uses a unified approach when analysing a mixed-pool portfolio (a portfolio comprising two sub-pools of mortgage loans made to individuals and SMEs). This combines the standard EMEA rating methodologies for assessing the loan portfolios of RMBS and SME ABS.

The agency splits the portfolio into sub-components and analyses each sub-pool using the standard EMEA methodologies for individuals and SMEs. It then merges the loss distributions associated with the two sub-pools. In instances where one of the pools is very small (typically less than 5% of the total portfolio), Moody's may adopt a simpler approach, whereby it will apply only the standard methodology of the main asset type.

The first sub-pool includes loans to individual borrowers or small unlimited liability companies that have taken out a mortgage loan to purchase/renovate a residential property. The second sub-pool includes loans to limited liability companies (no recourse to the shareholders) with mortgage loans on either a residential or commercial property or loans to small unlimited liability companies with a mortgage loan on a commercial property or residential property to finance the business activity of the borrower.

Once Moody's has determined the loss distributions on a standalone basis of the SME ABS and RMBS sub-pools, it merges the loss distributions of the two sub-portfolios. The approach used to merge the two distributions has two properties: the resulting loss distribution follows a lognormal distribution; and the approach is relatively simple, so that Moody's can determine the key parameters for rating and monitoring the portfolios.

Other minor changes to the methodology include: the introduction of settings used by the MILAN model for emerging securitisation markets in EMEA; an update to the borrower concentration adjustment, which clarifies that Moody's may apply a lower benchmark in certain circumstances; and the expansion of the House Price Stress Rate (HPSR).

Moody's has also updated its approach to originator assessments. In particular, the rating agency has increased disclosure of its existing criteria to test borrowers' affordability and willingness to pay.

Separately, Moody's has published the settings it uses for rating RMBS in Australia, Hong Kong, Korea, New Zealand and Singapore. The settings are not expected to have any impact on the outstanding ratings of RMBS in Australia, Hong Kong, Korea and New Zealand.

For Australia and New Zealand, there is no change in the settings. For Korea, there are updates to some of the settings, such as the minimum portfolio credit enhancement and the stress rates for house prices.