Contents

Structured Finance

SCI Start the Week - 20 January

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

Pipeline
Additions to the pipeline last week were focused on CMBS and CLOs. In ABS, the €440m E-Carat Compartment No.6 was announced, while Sallie Mae began remarketing the US$1bn SLM 2004-10.

The CMBS joining the pipeline comprised the US$399.5m Annaly 2014-FL1, US$620m DBCCRE 2014-ARCP and US$1.1bn GSMS 2014-GC18. The newly-announced CLOs, meanwhile, consisted of US$411.95m Ares XXIX CLO, €924.7m Atlantes SME No.3, €300m Carlyle Global Market Strategies Euro CLO 2014-1, Harvest VIII and US$518.88m CIFC Funding 2014.

Pricings
The number of deals pricing during the week also picked up. As well as seven ABS deals, one ILS, three RMBS, one CMBS and three CLOs were issued.

The ABS prints comprised: US$1.25bn Capital Auto Receivables Asset Trust 2014-1; US$1.75bn Chase Issuance Trust 2014-1; US$850m Citi Credit Card Issuance Trust 2014-A1; US$800m Discover Card Execution Note Trust 2014-1; US$267.75m DT Auto Owner Trust 2014-1; US$1.577bn Ford Credit Auto Owner Trust 2014-A; and US$994m SLM 2014-1. The ILS new issue was US$200m Vitality Re V Series 2014.

The RMBS pricings were US$750m CAS 2014-C01, US$600m HLSS Servicer Advance Receivables Trust 2014-T1 and US$200m HLSS Servicer Advance Receivables Trust 2014-T2, while the CMBS print was US$535m JPMCC 2014-FBLU. Finally, the US$417m ACIS CLO 2014-3, €413.5m Jubilee CLO XI and US$517m Oaktree CLO 2014-1 rounded out issuance.

Markets
The European RMBS secondary market continued to be supported by strong market technicals last week, according to Bank of America Merrill Lynch analysts. They note: "In core markets, Dutch RMBS started to outperform, as the sector is catching up with UK RMBS. As a result, Dutch RMBS now trade inside UK prime non-master trust RMBS, in contrast to November-December when they were in line with each other. Storm 4.5-year paper is at low-70s versus low-80s in December."

Granite bonds have been grinding tighter, supported by the positive UK housing market. UK non-conforming RMBS spreads continue to contract, with seniors holding steady and mezzanine bonds tightening.

The European CLO secondary market has rallied strongly, as SCI reported on 17 January. Hedge funds have been active in mezz and both bid and offer levels have come in sharply.

The US CLO secondary market, meanwhile, has also been well bid. Wells Fargo CLO analysts note that the credit curve has flattened in 2014.

They add: "Double-A spreads have pushed slightly wider; we believe this may be due to the fact that the triple-A/double-A spread gap had tightened inside of 40bp in late 2013, much lower than the 2013 average gap of 55bp-60bp. Also, the buyer base of double-A is similar to the triple-A buyer base, so the Volcker uncertainty will also affect double-A spreads."

US CMBS secondary spreads tightened slightly last week. Barclays Capital CMBS analysts note that 2007 dupers were unchanged at swaps plus 106bp, while AJs tightened 3bp to swaps plus 849bp.

They add: "The credit curve steepened slightly in the new issue space, with the duper tranche tightening to swaps plus 81bp, while the triple-B minus tranche widened 3bp, to swaps plus 353bp."

US ABS BWIC volume started the week slowly before rising markedly, as SCI reported on 15 January. Auto loan tranches dominated supply on Tuesday, with SCI's PriceABS data showing that offering levels were down slightly.

Deal news
• Results from the US$2.57bn CWCapital CMBS auction are beginning to trickle out. Over 700 potential buyers signed confidentiality agreements in mid-October after the liquidation was announced, with 153 of them eventually lodging bids.
• JC Penney is set to close 33 underperforming stores beginning this year. Nine US CMBS loans have exposure to these properties, the largest of which is the US$115m Centre at Salisbury, securitised in JPMCC 2006-LDP7.
• The Dutch State Treasury Agency completed its second IABF sale on 16 January, with BWIC execution appearing solid. The auction comprised 360 individual securities totalling approximately US$4.27bn current face.
• Punch's restructuring proposal includes a number of modifications from the details outlined in December, including increased PIK coupons on junior notes. The proposal for Punch A is said to represent a transfer of upside in the recovery of the Punch group from the junior bondholders to Punch equity, as a result of the principal write-off in the class B, C and D bonds.
• Fannie Mae's US$750m CAS 2014-C01 transaction is broadly similar to the CAS 2013-C01 issue, but there are some notable differences. Weighted average voluntary prepayments are 41bp lower and cumulative defaults are 3bp higher than in the 2013-C01 transaction.
• FeatherStone Investment Group says it has designed a new class of security that will allow qualified institutional buyers to participate in the equity-like returns of single-family rental securitisations without a long-term capital commitment to the sector. Dubbed a residual tracking tranche (RTT), it is anticipated to have a three- to five-year maturity based on the longest issued debt tranche within a securitisation.
• The issuer and portfolio manager for Harvest CLO V intend to amend the provisions of the portfolio management agreement to replace Paul Carman as a key person with Peter Goody. The trustee has already concurred that the proposed amendments are not materially prejudicial to the interests of any noteholders.
• Hatfield Philips International has agreed the sale of the Margaux portfolio, securitised in the Titan Europe 2006-2 CMBS, for a purchase price of €268m (see SCI's CMBS loan events database). IN-WEST Partners managed the purchase and also co-invested alongside the purchasing institutional investors.
• Sallie Mae has closed a new US$8bn ABCP facility that matures in January 2016. The facility replaces a US$5.5bn conduit that is set to expire in January 2015, with the remainder available for federally guaranteed loan acquisition or refinancing.

Regulatory update
• The US Fed, the FDIC, the OCC, the CFTC and the SEC have approved an interim final rule to permit banking entities to retain interests in certain Trups CDOs under the Volcker rule. The move comes after the American Bankers Association agreed to delay advancing a lawsuit on the issue until 17 January.
• The Loan Syndications and Trading Association, SFIG and SIFMA have submitted a further letter to the US regulatory agencies regarding risk retention as it pertains to CLOs. The associations propose an approach that would create a definition of a 'qualified CLO'.
• The Financial Services Roundtable, the Loan Syndications and Trading Association, SFIG and SIFMA have submitted a letter to the regulatory agencies regarding the definition of 'ownership interest' under the Volcker Rule as it pertains to CLOs. Specifically, the associations request that regulators provide confirmation in a FAQ or other guidance that CLO debt securities that have a contingent right to remove a manager for cause or to vote for a replacement do not constitute an ownership interest.
• The Basel Committee's oversight body, the Group of Governors and Heads of Supervision (GHOS), has endorsed a number of important steps in the completion of the Basel 3 agenda. Although the move entails a dilution of some of the proposed rules, the debate on appropriate capital levels on a risk-weighted and a non-risk based approach is expected to continue.
• The implementation of the US Treasury Market Practices Group's margin practices appears to have met its near-term goal of covering a significant amount of agency MBS trading volumes. However, the broad-based implementation of the guidelines could have an unexpected impact on the structure of counterparty relationships across the Street, as the costs associated with striking a margin agreement with a new counterparty starts to outweigh the incremental liquidity that party might provide.
• The People's Bank of China and the China Banking Regulatory Commission last month jointly updated the 5% risk retention rule on Chinese securitisations. The update expands the types of notes that are part of a securitised transaction that originators must retain beyond just the equity tranches to include potentially 5% or more of all tranches.
• An agreement in principle has been reached by the European Parliament and the European Council on MiFID 2 rules. The rules are designed to close the loopholes in the existing legislation and include proposals to regulate high-frequency trading.

Deals added to the SCI New Issuance database last week:
American Credit Acceptance Receivables Trust 2014-1; COMM 2014-CCRE14; Dryden XXII Senior Loan Fund; FREMF 2014-K714; Santander Drive Auto Receivables Trust 2014-1

Deals added to the SCI CMBS Loan Events database last week:
BACM 2005-3; BACM 2006-4; BACM 2006-5; BACM 2007-3; BACM 2007-4; BACM 2007-4, BACM 2007-5, BACM 2008-1 & MLMT 2008-C1; BSCMS 2004-PWR3; BSCMS 2006-PW11; BSCMS 2007-PW15; CGCMT 2004-C2; CGCMT 2006-C4; COMM 2001-C1; COMM 2005-FL10; CSRELT 2006-A; DECO 2006-C3; DECO 2007-E7; DECO 2013-CSPK; DECO 6-UK2; DECO 7-E2; ECLIP 2005-4; ECLIP 2007-2; EPICP BROD; EPICP MLDN; EURO 25; FOX 1; GCCFC 2004-GG1; GMACC 2004-C2; GSMS 2006-GG6; GSMS 2007-GG10; JPMCC 2006-LDP7; JPMCC 2006-LDP9; MLCFC 2007-8; MLMT 2005-CIP1; MSC 2005-IQ10; MSC 2007-IQ14; MSC 2007-IQ15; MSC 2007-IQ16; OPERA CMH; THEAT 2007-1 & THEAT 2007-2; TITN 2006-5; TITN 2007-1; TITN 2007-2; TMAN 6; WBCMT 2005-C21; WBCMT 2006-C28; WFRBS 2011-C4; WINDM VIII; WINDM X; WINDM XIV

Top stories to come in SCI:
Corporate trust roundtable

CLOs

CLO cushions being squeezed

US CLO 2.0 deals now account for around half of the outstanding market. OC cushions among those transactions have been decreasing as leverage has increased, but structures appear to remain well protected against default shock.

JPMorgan CDO analysts examined 229 arbitrage US CLOs issued from 2Q11 until 3Q13, representing about 70% of the deals in the CLO 2.0 market. The transactions have an average 10.1x leverage and senior OC, mezz OC and sub OC cushions of 10.7%, 8.4% and 5% respectively.

Deal leverage was 9.36x in 4Q11, 9.7x in 2Q12 and rose to 10.81x in 3Q13. The increase has contributed to a 0.6%-0.8% drop in average OC cushions across the capital structure in more recent deals, according to JPMorgan figures.

Debt remains well cushioned to default shock though. Even among the deals issued in 3Q13, senior, mezz and sub OC cushions remained at 10.3%, 7.9% and 4.6% respectively. Asset defaults are close to zero and CLOs have a 3.5% average triple-C bucket.

Average CLO 2.0 OC cushions are also 0.6%-1.4% higher than in reinvesting CLO 1.0 deals, while par subordinations and MVOC are also higher, providing more principal protection. Asset distress is also lower in 2.0s. However, CLO 1.0 debt has convexity upside with high asset prepayment and 2.0s are exposed to call/refinancing risk both in the collateral and debt.

Based on a sample of 82 managers, average debt OC cushions are very close between the bigger and smaller managers. However, there is a degree of OC tiering among those CLO 2.0 managers who have fewer deals, particularly among those who only manage one deal.

"Generally speaking, this OC cushion tiering would have to do with the difference in portfolio construction, management styles, deal leverage and other vintage effects. In addition, CLO managers can add value by trading loan assets in and out of portfolios as loan prices appreciate, which can result in the building of extra par balance and OC cushion from the deals inception. In that sense, other factors - such as deal launching time, warehouse strategy and the size of the CLO manager - could matter too," the analysts conclude.

JL

RMBS

QM rules to limit credit expansion

The continued normalisation taking place in the US housing market provides scope for mortgage credit to expand from its current tight levels. However, Dodd-Frank ATR/QM requirements pose challenges for credit to expand to pre-crisis levels.

Barclays Capital RMBS analysts believe that the majority of credit expansion is likely to come from QM loans, where some flexibility remains regarding FICOs and LTVs. Beyond QM, the area most likely to witness a pick-up in originations is pristine credit IO loans.

Most current originations have a GSE/FHA guarantee and receive temporary QM status, with only around 15% of GSE loans having debt-to-income of more than 43% and therefore not counting as QM. Credit expansion could be constrained by a GSE push to accelerate their conformity with the general rules, although the Barcap analysts believe this course of action is unlikely in the wake of Mel Watt's appointment.

IO loans are expected to perform similarly to amortising loans in the base case, although the analysts note that they are likely to underperform by as much as 40bp in annualised credit costs in a stress scenario. Additionally, while the ATR claims-related cost for IOs is negligible in the base case, it could go up to 10bp-12bp in a stress scenario.

At the other end of the credit spectrum, there is also room for a pick-up in originations as borrowers that do not qualify for GSE/FHA loans might look to traditional subprime mortgages. Depending on debt-to-income, points and fees, these loans may not be QM.

Borrowers would likely treat those subprime-style loans as short-term bridge loans and prepay out as they qualify for lower-cost mortgages. But origination is expected to be very limited for the next few years.

Another area of mortgage credit expansion could be HELOCs or closed-end second liens going to lower combined-LTV borrowers. Borrowers that took out mortgages over the last couple of years have low rates and significant home price appreciation, providing an opportunity to cash out some equity, perhaps using a lower CLTV closed-end second lien or a HELOC.

JL

Structured Finance

CRA launches in London

A new credit rating agency has been formed in London. ARC Ratings will have a global reach and profile and promises a unique and innovative approach to empower investors to make better decisions through its ratings of structured products, sovereign debt and financial institutions.

ARC is independent of issuers and investors and its corporate governance code and rating methodology are designed to avoid conflicts of interest in the rating process. The agency has partners from four continents and will use this diversity of presence and perspective to institute an open-minded and holistic rating process.

The rating agency will use systemic risk rating (SRR) and financial stability rating (FSR). The former will allow for a holistic view of emerging risks integrated into all credit ratings and the latter will apply along the entire rating scale to serve as a rating ceiling in jurisdictions, where appropriate.

ARC will also introduce a reconfigured rating scale that does not distinguish between investment grade and non-investment grade but instead distinguishes between different levels of risk. ARC's methodology will be dynamically adapted to keep pace with market needs.

ARC is a product of the transformation of Companhia Portuguesa de Rating. Its structure consists of a multi-country shareholding owned by five shareholders from five jurisdictions on four continents: CARE Ratings in India, GCR in South Africa, MARC in Malaysia, SaeR in Portugal and SR Rating Group in Brazil.

Structured Finance

Law firm promotes three

Cadwalader, Wickersham & Taft has named three new partners. The trio specialise in different areas of structured finance and are each based in the US.

Joseph Beach specialises in CLOs, CDOs and other asset-backed classes. He has particular experience in ABCP facility origination and restructurings.

Shlomo Boehm works on securitisations, investment fund structuring, structured finance transactions, derivatives and financial product development, cross-border lending, medium-term note programmes and ILS. He also has experience in mergers and acquisitions, workouts, IPOs and tax controversies.

Robert Kim has extensive experience in CMBS. He has also worked on CLOs and CDOs, structured mortgage and mezzanine loan participations and several other forms of financing involving real estate and other assets.

Structured Finance

Banks rethink fixed income

Banks are continuing to restructure their global fixed income businesses, scaling back or exiting certain products and geographic markets. The aggregate market share of the world's top three dealers fell from 29.3% in 2012 to 28.4% last year in a contraction which is being seen as an indicator of a more general shift.

Dealers are focused on finding the right balance for size, resources commitment and profitability. As individual banks seek to capitalise on the opportunities created by others pulling away, a survey by Greenwich Associates has found Deutsche Bank has secured the top spot among global dealers in fixed income trading market share, while Barclays has emerged as the leader in overall quality of service.

Retrenchment in Europe by some of the largest global banks has created opportunities for national players in their home market. Certain bigger banks such as BNP Paribas and HSBC are also expanding their customer bases.

In the US there is a similar trend. Strategy shifts by traditional market leaders have opened the door for firms like Wells Fargo, Nomura, Jefferies and RBC Capital Markets to gain customers.

Meanwhile, in Asia the decision by some global banks to pass on the local currency bond business has created opportunities for both Western banks and national players. ICICI Securities, ICBC and Axis Bank have all been active.

Greenwich Associates' survey shows Deutsche Bank led the market last year with a 10% market share in global institutional fixed income trading. Barclays and JPMorgan shared second spot with 9.2% each and Citi had 8.9%.

The impact of recent industry changes on investors has not been favourable, with reduced liquidity in major products in markets around the world making it harder to complete trades. This is especially true for smaller institutions and is complicated by the replacement of veteran sales people with less experienced staff, according to the survey.

CDS

IDC adds OTC data

Interactive Data has signed an agreement to provide BGC Partners' OTC data via its consolidated feed and through its 7ticks network. BGC's pricing and data contains executable prices sourced directly from its global electronic platform and voice-hybrid broking operations. The move expands Interactive Data clients' access to data to support their front, middle and back office operations and will help to support trading and reporting requirements.

CDS

Derivatives lawyer makes switch

Sebastian Reger has joined Sackers as an associate director. The derivatives lawyer was previously at Freshfields Bruckhaus Deringer, where he focused on structured finance transactions and advised on a range of structured products and derivatives. Reger will be part of the finance and investment group.

CDS

Trade reporting system expanded

Xtrakter has teamed up with the CME European Trade Repository to launch TRAX Repository Link (TRL). TRL is a single point of entry for reporting firms, providing EMIR-compliant technology to route, translate and validate derivative transactions to CME Group's European Trade Repository.

The CME European Trade Repository will store reported transactions and pair across other approved trade repositories if needed. TRL is an extension of TRAX and covers all derivative asset classes, including credit.

CDS

Derivatives pro steps up

Richards Kibbe & Orbe has appointed Jennifer Grady and Craig Newman as managing partners, succeeding Kenneth Werner. Grady specialises in derivatives and distressed debt.

Grady joined the firm in 2004 and has previously worked for Simpson Thacher & Bartlett and has experience in the evolving regulatory treatment of loan-based derivative transactions. Newman has been at the firm since 2007 and previously spent more than a decade at Arnold & Porter.

CLOs

Key person switch proposed

The issuer and portfolio manager for Harvest CLO V intend to amend the provisions of the portfolio management agreement to replace Paul Carman as a key person with Peter Goody. The trustee has already concurred that the proposed amendments are not materially prejudicial to the interests of any noteholders.

Goody has 17 years of experience in the leveraged loan market and has been actively involved in the daily management of Harvest CLO V since June 2008. He transferred to the portfolio manager 3i when it acquired Mizuho Investment Management and has also worked at RBS.

CLOs

CLO portfolio to spin off?

GLI Finance has disclosed in its latest trading update that preparatory work for the potential transfer of its CLO portfolio into a separately listed fund is underway. GMB Partners is advising GLIF on realising value from its CLO investments (SCI 22 April 2013) and the company intends to assess market support for an offering in the first half of the year.

GLIF expects 2014 to be another year of positive change, as it continues to diversify revenues by asset and geography, while maintaining a strategic focus on SME finance. The company negotiated a number of transactions in 4Q13 that are expected to provide opportunities to develop its SME finance business in the UK, Europe and the US.

As at 31 December 2013, GLIF's unaudited net asset value per share was 50p, compared to 51.8p as at 30 September 2013. The drop in NAV is attributed to a reduction in the value of the company's US dollar-denominated CLO positions.

Insurance-linked securities

Reinsurance investment strategies minted

New Ocean Capital Management has launched two reinsurance investment strategies. In addition to capital furnished by its founders - XL Group and Stone Point Capital - the firm has received capital commitments from funds managed by Dowling Capital Partners I and a global asset manager. Dowling Capital has also acquired an equity participation in the company. New Ocean deployed capital in reinsurance programmes incepting during the 1 January renewal cycle.

Insurance-linked securities

Capital markets head named

Montpelier Re has appointed Daniel Brookman as svp and head of capital markets. He will also serve as coo for Blue Capital Management.

Brookman will take responsibility for managing capital markets relationships with an initial focus on developing Monteplier's underwriting partnership businesses. He will report to chief corporate development and strategy officer William Pollett.

Brookman was previously global head of insurance-linked structuring within Barclays Capital's global markets division in New York and London. He has also worked at Merrill Lynch in London and was head of alternative distribution for Benfield Advisory in New York.

RMBS

Mortgage vet takes production role

John Marr has joined Greystone's production team as md. He will focus on originating debt financing solutions across Fannie Mae, Freddie Mac, CMBS and Greystone's proprietary lending platforms.

Marr joins from Alliant/ACRE Capital and has also worked at PaineWebber and Citibank. He is based in Connecticut and will report to head of agency production, Joe Mosley.

ABS

Equity upside benefit in Punch proposal

Punch's restructuring proposal (SCI 15 January) includes a number of modifications from December, including increased PIK coupons on junior notes. Barclays Capital analysts believe the proposal for Punch A represents a transfer of upside in the recovery of the Punch group from the junior bondholders to Punch equity as a result of the principal write-off in the class B, C and D bonds.

Punch B's juniors would probably be more likely to agree to such a transfer in upside considering the cross holding between equity and junior bonds. The Punch A class B bondholders face a write-off in their par value of bonds of 37.5% without being offered equity as compensation. This is mitigated by an upfront cash payment of 23% of par, 11% in the new M3 notes and 29% of the new class B4 bonds.

An optimistic scenario in which the new M3s and B4s trade at around par would result in value to the class B bondholders of 62.5 from the proposal, compared with current indicative prices in the low-50s. However, net income is growing, so there may be greater upside for the fixed rate class Bs in their current position.

Failure to agree the restructuring could lead to a prepayment at par for the class A bondholders of £123m in Punch A and £65m in Punch B. Whether that happens depends on whether bondholders could waive an event of default to prevent the payment at par from occurring.

ABS

New SLM conduit minted

Sallie Mae has closed a new US$8bn ABCP facility that matures in January 2016. The facility replaces a US$5.5bn conduit that is set to expire in January 2015, with the remainder available for federally guaranteed loan acquisition or refinancing. Deutsche Bank ABS analysts suggest that Sallie Mae could use the facility to call outstanding FFELP student loan ABS that are call-eligible, if the economics make sense.

Student loan ABS issuance last year reached US$21bn, according to Deutsche Bank figures, US$18bn of which was backed by FFELP loans and US$3.5bn by private loans. Analysts at the bank expect private student loan ABS issuance to be flat to slightly higher in 2014, although they anticipate a 50% decline in overall student loan supply due to the closing of the Straight-A Funding conduit, which was the primary source of FFELP issuance in 2013.

Sallie Mae contributed 46% of the 2013 supply, with state entities contributing 27% and Nelnet 15%. The remaining 12% came from a number of smaller issuers.

As of year-end 2013, student loan ABS outstandings stood at US$228bn - US$187bn of which is backed by FFELP loans and US$36bn by private loans.

ABS

Card performance to level off

US credit card charge-offs and delinquencies improved in 4Q13, locking in year-end results on a positive note, according to Fitch's latest quarterly index for the sector. Monthly payment rates also held steady at record highs.

"Borrower behaviour has clearly improved as consumers remain disciplined in paying down their credit card debt," observes Fitch md Michael Dean.

Charge-offs finished the year at 3.04%, compared to 3.44% in 3Q13. Losses broke below the 3% threshold in November and held relatively steady during December. Payments more than 60 days past due registered 1.27% for the quarter.

Fitch expects credit card ABS performance to level off in the latter half of this year.

Structured Finance

Euro issuance to rise in 2014

S&P expects investor-placed European securitisation issuance to rise in 2014. However, several ongoing regulatory initiatives continue to threaten the future viability of securitisation investment for banks and insurers and pose the greatest risk to issuance volumes.

Issuance in 2013 was slightly lower than 2012, although this was largely due to a disproportionate decline in UK volumes, which is expected to be a short-term effect. For example, revisions to the terms of the UK's FLS are expected to lead UK RMBS issuance to rise in 2014.

By contrast, a Dutch government initiative for state-guaranteed mortgage-backed bond issuance could depress Dutch RMBS volumes. On balance, annual European RMBS volumes are expected to be comparable to those from 2013.

German auto ABS issuance more than doubled in 2013 and will stay strong, while UK auto and credit card volumes should rise, pushing up overall ABS issuance. The growth in European CMBS issuance may slow given weaker characteristics among underlying loans in legacy transactions that are due for refinancing.

The leveraged loan CLO sector's recovery could be challenged by European risk retention rules, but the market is expected to take such developments in its stride. The European Investment Fund and European Investment Bank are considering initiatives to bolster SME lending, which could include official support for the SME CLO sector and thus boost issuance.

Structured Finance

SFR structuring innovation unveiled

FeatherStone Investment Group says it has designed a new class of security that will allow qualified institutional buyers to participate in the equity-like returns of single-family rental securitisations without a long-term capital commitment to the sector. Dubbed a residual tracking tranche (RTT), it is anticipated to have a three- to five-year maturity based on the longest issued debt tranche within a securitisation.

FeatherStone expects to include an RTT within its forthcoming debut SFR transaction. Under the tranche, investors receive income from excess cashflows after operating expenses and debt servicing payments, yet are not exposed to refinancing or collateral liquidation once the short-term debt has matured.

Investors can therefore participate in the equity knowing that their exit from the trade happens at maturity of the outstanding debt. It is hoped that the feature will bring more liquidity to the SFR sector, as the primary market matures and a secondary market develops.

Structured Finance

Improved fundamentals highlighted

The Fitch Fundamentals Index (FFI) remained in neutral territory but rose to +2 in 4Q13 from zero in 3Q13, indicating a small improvement in underlying credit fundamentals. Quarter-over-quarter, positive FFI credit fundamental components outweigh negative by six to three, with one at neutral.

"On the positive side, we saw an up-tick in the rating outlook component, due in part to positive outlook revisions on US regional banks. This brings Fitch's rating outlook negative-to-positive ratio almost into parity, four years after negative outlooks outnumbered the positive 10 to one," comments Jeremy Carter, Fitch md.

He adds: "On the negative side, US mortgage delinquencies increased slightly due to rising interest rates and a deceleration in home prices, which pushed the mortgage performance component to neutral and ended its 15-quarter positive run."

The FFI mortgage performance component score fell to zero, or neutral, in 4Q13 from +5 in 3Q13 due to a slight decline in prime mortgage performance. US residential mortgage delinquencies started to stabilise from 3Q10, peaking at 12.48% in 1Q12 and steadily falling to 10.45% in 3Q13 before rising to 10.54% last quarter. The mild uptick this quarter marks the first increase since 1Q12.

Long-term, the mortgage performance score remains at +10 year-over-year. This trend is driven by a growing US economy and substantial regional housing market price increases, which indicates that borrowers previously underwater are able to refinance and sell.

Structured Finance

Infrastructure risk transfer unit debuts

Mariner Investment Group has launched Mariner Infrastructure Investment Management (MIIM), a bank deleveraging and regulatory capital management investment business. MIIM, in turn, serves as portfolio manager for two investment vehicles - the International Infrastructure Finance Company Fund (a US$350m comingled fund) and Mariner Breakwater (a US$100m fund-of-one).

MIIM aims to take leveraged exposure to loans, bonds and other debt instruments associated with global infrastructure, energy and transportation assets. Target investments are designed to enable banks to manage their balance sheet in light of new financial regulations, providing them with risk-transfer tools that optimise and enhance their regulatory capital and funding requirements. The idea is to capitalise on two investment themes: tightened Basel 3 standards and an urgent need for additional infrastructure finance around the globe.

The MIIM team's primary investment strategy is to provide credit protection against certain losses in specific infrastructure loan portfolios. Assets will be selected based on strict credit underwriting criteria, coordinated by an experienced in-house team led by Andrew Hohns.

"Our new infrastructure investment mandates provide global project finance banks with innovative, customised and attractive solutions for the management of risk weighted assets in their infrastructure, power and transport loan books - thereby addressing a critical and unmet need within the financial sector," comments Bracebridge Young, Mariner's ceo.

Over a half-dozen institutional investors participated in the initial capitalisation of the vehicles, the majority of which are first-time investors with Mariner. MIIM completed its first investment with UniCredit, which transferred to the two vehicles junior/mezzanine risk on a €910m portfolio of Italian project finance loans.

Structured Finance

Country risk weighs on covered bonds

Country risk remains the main influence on the performance of European covered bonds, according to S&P. Furthermore, because weakening balance-sheet quality and earnings means that credit conditions for Western European banks are still largely negative, the agency believes that the role of and support for covered bonds in the funding mix of individual banks will remain an important rating factor.

"Careful consideration and monitoring of individual risk elements are important building blocks for covered bond ratings," comments S&P credit analyst Karlo Fuchs. "Although we see pronounced differences in the individual risk characteristics of covered bonds from country to country, we also see a narrowing and convergence in the spreads at which they are traded. Despite some positive developments - such as active rebalancing of asset-liability mismatching and improvements in the outlooks on covered bonds - we believe that covered bond ratings reflect the still-fragile state of bank and sovereign ratings."

The downgrade of France last November, combined with S&P's country risk criteria for covered bonds, affected public sector covered bonds backed predominantly by French collateral. As a result, more than a third (36%) of covered bonds rated by S&P carry ratings below triple-A.

"The increasing acceptance of covered bond ratings below triple-A has, in our view, resulted in a structural shift in how issuers manage the overcollateralisation that supports a covered bond rating. As a consequence, we contend that monitoring developments in issuer-provided overcollateralisation is becoming more important than ever," the agency concludes.

CDS

Sears CDS underperforming

CDS on Sears Roebuck Acceptance Corporation have widened by 39% over the past month, according to Fitch Solutions. Sears CDS spreads significantly underperformed the 9% tightening seen for the broader North America Retail CDS Index over the same time period.

The cost of Sears credit protection has climbed to levels not seen in nearly two years. "Worsening sentiment for Sears is likely attributed to disappointing holiday sales and a lowered forecast for the fourth quarter," comments Fitch director Diana Allmendinger.

Meanwhile, CDS liquidity for Sears is now trading in the second global percentile. "After pricing consistently tight relative to JC Penney during the latter half of last year, CDS on Sears are now trading 90bp wider than credit protection for JCP,' adds Allmendinger.

CDS

JCP CDS gap out

Widening in JC Penney's five-year credit default swap (CDS) spreads underscores continued investor concern about the entity, according to Fitch Solutions. The retailer is set to close 33 stores in the US and cut 2,000 jobs as it struggles to resuscitate revenue growth.

JCP CDS have gapped out by 111bp over the course of the past month, with a 29bp jump recorded on Thursday. The sharp rise in cost to protect JCP's five-year senior bonds reflected investor disappointment on the holiday sales update, which did not provide much details on December performance besides saying that performance is in line with expectations and would be better than 3Q results.

JCP CDS hit record wide levels last October after the company scaled back its partnership with Martha Stewart Living Omnimedia and denied rumours of bankruptcy (SCI 25 October 2013).

CDS

Sovereign CDS move tighter

Global sovereign credit default swap (CDS) spreads tightened by 9.5% in 4Q13 as stocks continued to rally, according to S&P Capital IQ's latest quarterly global sovereign debt credit risk report. The report - which focuses on the implied risk profile of sovereign debt issuers in S&P Capital IQ's global database over the previous three months - highlights that CDS spreads for most regions were tighter overall during the quarter, with Scandinavia the only region remaining flat.

Globally Japan CDS spreads tightened the most - by 37.3% over the quarter - and closed 2013 at 40bp, a level not seen by this sovereign since the middle of 2009. Italy and Spain saw the largest tightening in Western Europe, with five-year spreads ending the year at 167bp and 153bp respectively.

Venezuela CDS spreads widened by 214bp (23%) over the quarter - the most of all sovereigns globally - with five-year spreads ending 2013 at 1148bp. Rising concerns about the level of Venezuela's foreign currency reserves made access to the US dollar increasingly difficult.

Meanwhile, although Austria was the largest percentage widener over the quarter - at 24% - it only changed by 7bp and ended the quarter at 37bp.

Elsewhere, Turkey spreads widened by 11.52% over the quarter and on 27 December reached an intra-day high of 259bp, as protest against the government resulted in violent clashes with the police. Brazil spreads ended the year at 192bp, as civil unrest continues to unsettle the host nation of the 2014 FIFA World Cup.

CLOs

More CLO 1.0 redemptions due

Optional redemptions for CLO 1.0 deals - particularly 2005-2007 vintages - will continue this year, but there will be fewer for CLO 2.0 deals as investors instead turn to individual tranche refinancing features. Around 80% of 2005-vintage deals remain outstanding, as do more than 90% of deals from 2006 and 2007, notes Moody's.

Last year the most heavily redeemed vintage was 2004 and more redemptions of later CLO 1.0 vintages are expected this year. CLO equity returns declined last year, providing extra incentive to call.

Deals with high OC levels and cost of funding will be the best redemption candidates, while equity holders in CLOs with outsized equity returns are less likely to call their deals, particularly if senior notes have not fully amortised. Moody's notes that deals tend to be called slightly more than two years after the end of their reinvestment periods, with all 2005 deals and half the 2006 deals reaching that stage in 2014.

Transactions issued in 2008 are also prime redemption targets because of their higher cost of funding. However, many of these have already been refinanced or redeemed in recent years.

Liability costs on CLO 2.0 deals are much higher than for 1.0 deals and so some early-vintage 2.0s were called in a tightening market when their non-call periods expired. However, even if spreads tighten again, Moody's expects redemptions to be curbed by individual tranche refinancing features introduced in more recent CLO 2.0 deals, which became common over the last couple of years.

There have been 126 CLOs called since 2011 and the 2004-vintage has been most affected, with 80% of all CLOs issued that year having been redeemed. Around 20%-30% of deals from other pre-2005 vintages remain outstanding, while the vast majority of the 2005-2007 CLO universe remains outstanding.

CLOs

Volcker-compliant CLOs emerging

Banks that own non-compliant transactions have a number of options if regulators do not provide clarity on the Volcker Rule as it pertains to CLOs (SCI 16 January), according to Wells Fargo CDO strategists. In the meantime, the uncertainty has pushed triple-A spreads slightly wider and slowed the pace of new issuance.

Banks are mainly expected to attempt, on a deal-by-deal basis, to work with managers to remove bonds from CLO asset portfolios. However, CLO equity holders may push back on this, as bonds can provide value to equity tranches - especially during times of volatility and as assets to purchase prior to the end of the reinvestment period. Equity holders may even look to take punitive action against managers that empty their bond buckets.

The Wells Fargo strategists suggest that banks may also seek to include existing manager removal clauses as events of default, albeit with less punitive remedies. "If the 2015 deadline for compliance approaches with no clarity, banks may be forced to waive manager removal rights as a last resort. This would remove a significant investor protection, as a certain class of senior tranche holders would no longer be able to remove a manager for cause," they add.

Although new CLOs - for example, last week's ACIS CLO 2014-3 and Oaktree CLO 2014-1 - are being structured with mechanisms to ensure Volcker compliance, many investors appear to be waiting for further clarity on the rule. "Investors fear buying in the primary, only to have an adverse ruling push secondary spreads meaningfully wider," the strategists observe.

CLOs

Call for CLO carve-out

The Financial Services Roundtable (FSR), the Loan Syndications and Trading Association (LSTA), SFIG and SIFMA have submitted a letter to the regulatory agencies regarding the definition of 'ownership interest' under the Volcker Rule as it pertains to CLOs. Specifically, the associations request that regulators provide confirmation in a FAQ or other guidance that CLO debt securities that have a contingent right to remove a manager for cause or to vote for a replacement do not constitute an ownership interest.

The associations suggest three alternative clauses that would alleviate concerns about control rights of the bondholders constituting ownership interest, including a condition that the CLO must be comprised predominantly of loans. Further, they are calling for legislation that would grandfather existing CLO loans issued before 10 December 2013, thereby allowing banks to continue to hold those debt securities.

Elliot Ganz, evp and general counsel of the LSTA, yesterday testified before the US House Financial Services Committee that the definition of ownership interest in the final Volcker Rule will have significant unintended consequences on the CLO market, result in material and arbitrary losses to American banks, and negatively impact credit availability for American businesses. He explained that the rule effectively converts CLO debt securities into the equivalent of equity securities, thereby making them ineligible to be held by banks.

US banks currently hold approximately US$70bn in these securities. Without clarification on the first "indicia of ownership", they would be forced to divest or restructure these notes over the next 18 months, possibly at a significant loss.

"We are disappointed that the agencies have addressed the issue of CDOs of Trups while not yet addressing the important concerns relating to CLO notes," said Ganz. "We are hopeful that the agencies will quickly take up our request that they confirm in guidance that the ability of holder of highly rated triple-A and double-A rated debt securities to remove or replace a manager 'for cause' does not constitute an ownership interest. Without that guidance, the CLO market could be disrupted because banks could be forced to divest these securities within the next 18 months."

CLOs

'Qualified CLO' mooted

The Loan Syndications and Trading Association, SFIG and SIFMA have submitted a further letter to the US regulatory agencies regarding risk retention as it pertains to CLOs. The associations propose an approach that would create a definition of a 'qualified CLO'.

Specifically, under the approach, open market CLOs that meet a series of criteria would qualify to satisfy the credit risk retention requirement through the manager's purchase of 5% of the CLO's equity (rather than equity in the amount of 5% of the total balance of the CLO) and through credit risk retained by the manager through the deeply subordinated compensation structure. A CLO satisfying the conditions of a qualified CLO would be subject to less restrictive risk retention requirements than previous proposals of the agencies would require.

Deutsche Bank CLO strategists note that many of the proposed conditions are similar to those included in most CLO indentures. They cite collateral constraints, exposure limits, overcollateralisation, interest coverage tests and fee structures as examples. Furthermore, the equity of a qualified CLO must equal at least 8% of the value of the CLO's assets and there would be restrictions on cashflow to the portion of the equity held for risk retention purposes.

"If this new proposal would be adopted, then that would be some recognition of the different nature of the managed CLO and the built-in incentive structure, as compared to originate-to-distribute securitisations. And this would significantly lighten the burden of risk retention and likely prevent most of its adverse affects, such as manager consolidation," the Deutsche Bank strategists conclude.

CMBS

Low prepays for Euro CMBS

Only 22% of the 31 CMBS loans - totalling €2.3bn - scheduled to mature in 4Q13 repaid at maturity or prepaid, lower than the four-quarter rolling average of 37%, Moody's reports. At the same time, Q4 had the highest proportion of defaulted or repaid-with-loss loans of any quarter in the last two years.

Moody's says that the low prepayment rate was due to the high leverage of the loans and the secondary quality of the underlying assets. "The high Q4 default rate was in line with our expectations, as predicted by the high Moody's loan-to-value ratios of the loans and the fact that secondary retail and mixed portfolio assets - which have underperformed other property types - backed a large number of the loans," explains Radostina Atanasova, a Moody's analyst.

Most loans maturing in Q4 were secured by assets located in the UK and Germany, at 45% and 29% respectively. Additionally, small loans with balances of up to €50m accounted for more than half of the total.

"For 1Q14, a total of 25 loans with a securitised balance of €2.5bn have original scheduled maturity dates and we expect only a third of them to repay upon maturity. We base our expectations on the high proportion of loans with high LTV ratios and low Moody's debt yield, as well as the secondary quality and locations of the underlying assets," adds Atanasova.

A total of 77 EMEA CMBS loans representing approximately €7.3bn have to refinance in 2014.

CMBS

Borrower default behaviour examined

New Freddie Mac research shows that a commercial real estate borrower's loan default decision for an underperforming property is based on several factors, including property and loan characteristics, as well a economic and market conditions. The report, entitled 'Default Ruthlessness: Examining Borrower Default Behavior', analysed and compared borrower default behaviour for CMBS loans and Freddie Mac multifamily loans. The analysis aims to help debt investors better manage their investment expectations.

The research shows that CMBS borrowers are more likely to exhibit ruthless default behaviour than Freddie Mac borrowers and to default when facing a volatile market environment or a more stressed market. For CMBS loans, borrowers with terms of less than seven years appear more likely to default. Borrowers with longer loan terms of seven or more years were more likely to keep the loan current, despite weak property conditions, because the property owner has more time to improve the property's operations and performance.

The report found that Freddie Mac borrowers are less ruthless in their default decisions. The results suggest that Freddie Mac's conservative approach to purchasing loans backed by strong properties with strong borrowers who have the ability to withstand adverse market situations results in a greater ability and commitment to support an underperforming property until the market or property performance improves.

"We found that if a borrower has access to capital and overall liquidity, they are less likely to default and will support the property until the market improves," comments David Brickman, svp of Freddie Mac Multifamily.

CMBS

Margaux asset sold

Hatfield Philips International has agreed the sale of the Margaux portfolio, securitised in the Titan Europe 2006-2 CMBS, for a purchase price of €268m (see SCI's CMBS loan events database). IN-WEST Partners managed the purchase and also co-invested alongside the purchasing institutional investors.

The portfolio comprises of circa 8,500 residential units mainly located in Berlin, Dusseldorf, Neuss, Leipzig, Halle und Gotha. Completion of the sale of the asset is expected to occur at end-2014.

Paul Hastings represented Hatfield Philips International, the special servicer for the transaction, on the property sale.

CMBS

CWCapital sale results emerging

Results from the US$2.57bn CWCapital CMBS auction (SCI passim) are beginning to trickle out. Over 700 potential buyers signed confidentiality agreements in mid-October after the liquidation was announced, with 153 of them eventually lodging bids.

Starwood Capital, Lone Star and an Oaktree Capital Management/Sabal Financial Group venture are said to be among the successful bidders. Additionally, Blackstone is believed to have bought Four Seasons Resort and Club in Dallas (which secures a US$175m loan securitised in WBCMT 2006-C28), while CIM Group reportedly purchased Two California Plaza (securing a US$468m loan securitised in GSMS 2007-GG10).

Not all of the auction's 67 assets have closed, but CMBS strategists at Morgan Stanley note that the loss severity on the pool's unpaid principal balance currently stands at 33%. "Some of the higher quality assets were sold for 70 to 80 prices, while lower quality assets for 30 to 50 prices. Winners of the deal's lower quality assets may look to issue liquidating trust CMBS deals," they observe.

CMBS

Shortfall discrepancies examined

Fitch is rolling out a series of comments highlighting lessons learned in EMEA CMBS, which aims to identify structural shortcomings in legacy CMBS transactions. The first of the reports examines discrepancies between loan maturity dates and loan interest payment dates, which can lead to note interest shortfalls.

In recent years several transactions have suffered note interest shortfalls attributable not to poor loan performance (for which external liquidity support is typically available), but rather to issuer documentation deficiencies. One striking example was Tahiti Finance, a UK single-borrower CMBS, the underlying loan of which was repaid in full at maturity on 24 May 2013.

Despite a successful outcome at the borrower level, the notes suffered a final payment interest shortfall because of timing mismatches at the loan level. Although loan maturity was extended as part of a restructuring approved around the time of the original maturity date (24 May 2010), the opportunity to fix an obscure timing problem in the loan was not taken. As with the original date, the extended maturity fell in between loan IPDs set as the fifteenth day of January, April, July and October (with the note IPDs one month thereafter). Accordingly, no interest would be earned from the borrower between 24 May and the earliest note IPD on which principal could be repaid to investors - 15 August.

Although this problem was subsequently identified, investors had already accrued unaffordable interest before the trustee convened a noteholder meeting to resolve to bring forward the notes' final payment date. The magnitude of the final shortfall was considered by Fitch to be minimal in comparison to the size of the deal (which otherwise repaid in full) and did not warrant negative rating action. The agency suggests that the effect of such a mismatch was not appreciated either when the loan was securitised or subsequently restructured.

Such a structural defect would likely be more problematic in a single-borrower transaction than in a multi-borrower deal, where the effect of a timing mismatch may be contained. Fitch has reviewed outstanding single-borrower transactions in its rated portfolio, as well as those that have repaid in the last three years for similar timing mismatches at the loan level. Furthermore, prepayment language was reviewed in case mid-period repayment could cause a similar outcome.

In one other case - Mesdag (Delta) - something similar was observed, although Fitch found that the corresponding note accrual period was automatically adjusted, thus avoiding negative carry. In another case - Bluebonnet Finance - the loan contained a similar timing mismatch, although provisions were in place to ensure the borrower would make whole a full period of interest at maturity.

The agency also found that such make whole language is a common feature in EMEA CMBS loans, where it serves to prevent note shortfalls arising due to mid-period prepayment.

CMBS

JCP closures to hit CMBS

JCPenney is set to close 33 underperforming stores beginning this year. Nine US CMBS loans have exposure to these properties.

CMBS analysts at Barclays Capital note that the largest of these loans is the US$115m Centre at Salisbury, securitised in JPMCC 2006-LDP7, which is reporting a DSCR NCF of 1.31x. The next largest is the US$36.79m Laurel Mall loan, securitised in BSCMS 2007-PW15, which is reporting a DSCR NCF of 1.03x.

Indeed, several of the malls have DSCRs that are only slightly above the 1x mark and may be unable to cover debt service once the JCP lease expires, the Barcap analysts suggest. For instance, the US$28.95m Hickory Point Mall (BSCMS 2006-PW11) and the US$17.32m Bristol Mall (BACM 2006-5) are reporting DSCR NCFs of 1x and 1.04x respectively.

Many of the stores lined up for closure have leases expiring over the coming year or two. The leases for the properties behind the US$9.59m Wayne Town Plaza (MSC 2007-IQ15) and the US$7.93m Natchez Mall (CGCMT 2006-C4) loans, for example, respectively expire in March and May this year.

In one of the affected properties - the Military Circle Mall (which secures a US$58.81m loan in GMACC 2004-C2) - JCP is not part of the securitised collateral. However, it is the biggest anchor, occupying more than 200,000 square-feet of floor space.

The analysts point to additional factors that will impact the loans once the stores are closed, including decreased foot traffic depressing rents, potential co-tenancy clauses being invoked and the effect on other stressed retailers. Several of the largest malls impacted by the closures also list Sears as a tenant.

CMBS

EIOPA urged to reconsider CMBS

CREFC Europe and INREV have submitted comments to EIOPA on its technical report on standard formula design and calibration for certain long-term investments (SCI 20 December 2013). The two organisations call for certain CMBS to qualify for 'Type A' capital treatment - by reference to objective, qualitative criteria - and not to condemn all CMBS to 'Type B' treatment.

Doing so would promote valuable diversification at two important levels, according to the comments: in the investment portfolios of insurers, where CMBS have different investment characteristics from other forms of exposure to CRE and CRE debt; and in the constitution of the CRE finance market, which has historically been excessively reliant on banks and the limited range of products they are willing to keep on their balance sheets, to the detriment of financial stability. Following this recommendation would also reward industry efforts to address the problems that affected CMBS before the crisis, so that a better product can emerge in the future, the two organisations note. Further, they would be happy to work with officials on the development of appropriate criteria.

CREFC Europe and INREV support EIOPA's initiative to conduct a thorough and considered review of the treatment of securitisation bonds under Solvency 2, but are concerned about the impact that the revised approach will have on insurers' ability to invest in ways that make sense economically and commercially, on the CRE industry and its ability to serve the wider economy, and ultimately on financial stability. "We are particularly concerned that the capital treatment for CMBS is now set to be even worse than previously proposed," they note. "We accept that a trade-off has to be made between simplicity and fairness (and recognise the appeal of simplicity), but we do not consider it appropriate for all CMBS to be classified as higher risk, higher cost 'Type B' securitisation."

The comment highlights that CRE debt has characteristics that make it a highly appropriate component of diverse insurer portfolios, because it generates long-term inflation-protected cashflows benefiting from security. Automatic 'Type B' treatment is likely to deter investment in CMBS by insurers, significantly reducing the options available to those that want CRE debt to have a place in their portfolios.

CMBS

CMBS can absorb JCP impact

The Fitch-rated CMBS that are exposed to JC Penney's announced store closures (SCI 16 January) are capable of absorbing the potential loss, the agency says. It believes significant cashflow changes are unlikely as the stores that are closing have been underperforming for some time and are not drawing substantial traffic to their shopping centres. Some malls could even benefit if JCP is replaced with a stronger tenant.

Seven Fitch-rated deals are exposed to the planned closures. Over the longer run, the agency believes that continuing struggles for major retailers (including Sears and BestBuy) may impede the general stabilisation seen in the retail CMBS market.

"Both JC Penney and Sears have significant real estate portfolios in a wide range of markets. If large scale closures take place, we would expect dominant class-A malls to re-tenant space, while weak malls could be put under pressure," it observes.

CMBS

Japanese CMBS criteria updated

S&P has updated its methodology and assumptions for rating Japanese CMBS. The agency has also published a commentary clarifying how its global property evaluation methodology would be applied to such transactions.

The new criteria are designed to refine the approach S&P uses when assigning ratings to Japanese CMBS and to provide a more transparent framework for analysing such transactions. The agency says its analysis of Japanese CMBS is essentially a recovery-based approach that assumes loan defaults, reflecting the concentrated nature of the transactions.

The criteria use rating-specific base loan-to-value (LTV) thresholds that reflect declines in property market values in corresponding stress scenarios. The methodology then adjusts these base LTV thresholds to account for specific loan, transaction or additional characteristics.

CMBS

CMBS delinquencies dip below 6%

US CMBS delinquencies declined by 12bp in December to 5.98% from 6.1% a month earlier, according to Fitch's latest index results for the sector. Late-pays now stand at three percentage points below their July 2011 peak of 9%, with multifamily and hotels seeing the largest improvements last year.

Resolutions of US$1.1bn last month outpaced additions to the index of US$717m. Aiding in the decline of the delinquency rate was new issue activity, with a post-recession high of 11 Fitch-rated deals totalling US$9.3bn coming to the market. December also saw US$7.8bn in portfolio run-off, driven largely by the US$3.4bn pay-off of the EOP Portfolio, securitised in GSMS 2007-EOP (see SCI's CMBS loan events database).

Another positive development last month was that no loans over US$100m transferred into the index. The largest addition was the US$73.6m Islandia Shopping Center, which fell 60-days delinquent. Meanwhile, the largest resolution was the US$73.4m Astor Crowne Plaza, a real estate owned asset that was sold for an amount in excess of the outstanding debt.

Multifamily was the stand-out performer in 2013, with delinquencies falling by 3.6 percentage points on the year. The strong performance was led by the resolution of the US$375m loan on The Belnord property (securitised in JPMCC 2006-LDP9), which was modified and brought current in March. Additionally, the multifamily denominator increased over the year thanks to roughly US$13bn in new Fitch-rated Freddie Mac issuance, which far exceeded portfolio run-off.

Hotels also experienced strong gains in 2013, with delinquencies falling by 2.4 percentage points. Roughly US$1.7bn in resolutions outpaced US$808m of new delinquencies last year. In addition, new hotel issuance was strong, edging out run-off and keeping the denominator stable year-over-year.

Office and retail delinquencies fell by about 1.5 percentage points each last year, with retail continuing to lead the major property types with the lowest late-pay rate. Office delinquencies were driven lower by the resolution of the originally US$678m Skyline Portfolio loan, which was modified in October. Meanwhile, retail saw US$4.4bn in 2013 resolutions outpace US$2.7bn in new delinquencies.

Run-off of office and retail loans exceeded new issuance, causing decreases in the denominators for each.

Finally, industrial delinquencies were largely unchanged year-over-year, falling by only 16bp. The improvement was attributable to the resolution via a note sale of the US$190m StratReal Industrial Portfolio I loan (BACM 2007-1). Fitch notes that industrial represents the smallest of the major property types and thus remains highly susceptible to swings based on individual loan delinquencies or resolutions. For example, the US$159m StratReal Industrial Portfolio II (JPMCC 2007-LDP10) is currently REO and will send the industrial late-pay rate down by another roughly 80bp once it is sold.

Current and previous delinquency rates are: 8.45% for industrial (from 8.5% in November and 8.61% at year-end 2012); 6.89% for office (from 6.77% and 8.41% respectively); 6.5% for hotel (from 6.96% and 8.87%); 6.48 for multifamily (from 7.01% and 10.12%); and 5.63% for retail (from 5.78% and 7.14%).

CMBS

Rare equity reimbursement seen

Seven loans backing the CWCI 2006-C1 deal - totalling US$219m in outstanding balance - have been liquidated, including a couple of properties that appear to be part of the large CWCapital Auction.com sale in December. Unusually, the sales resulted in an equity class loss reimbursement pay-out.

The liquidated assets include the US$52m Addison Corporate Center (see SCI's CMBS loan events database), the US$43m DHL Perimeter Center Building, the US$34m Carefree Pebble, the US$28mn Valley View Portfolio, the US$26mn Pheasant Run Resort, the US$23m Carefree Spring Valley and the US$14m Auburn Distribution Center. The properties had been appraised at US$148m, but net proceeds from the liquidation were somewhat lower at US$130m. The sales led to US$112m in realised losses for the deal, implying a 51% severity, according to Barclays Capital figures.

The losses wrote off the B-D tranches, while the AJ tranche took US$22.9m in losses, or 11% of outstanding balance. Appraisal reductions of US$52.4m remain outstanding on the deal, indicating that the AJ tranche will likely face additional losses to come.

Barcap CMBS analysts note that even as the AJ was taking a loss, the bottom-most D tranche was actually reimbursed previously realised losses of about US$6.4m. The sales generated about US$10.8m in ASER and other interest reimbursements that were used to repay all outstanding interest shortfalls on previously outstanding tranches. After this, about US$6.4m of interest reimbursements remained and were then applied to repay previously realised losses on the equity D tranche.

Insurance-linked securities

Dynamic ILS fund offered

Falcon Private Bank has launched the Twelve-Falcon Insurance Opportunities Fund, a dynamic catastrophe bond fund in UCITS format. The offering - which will be managed by Twelve Capital - is designed to provide a low-correlation investment opportunity, as well as a flexible scheme for allocation.

Insurance-linked securities

ILS exposures, sponsors expanding

S&P rated US$5.16bn of catastrophe bonds last year, a slight increase on 2012's total of US$4.8bn. The number of cat bonds the agency rated in 2013 (approximately 68% of all cat bonds issued last year) was the second highest ever, surpassed only by the total US$6.1bn it rated in 2007.

Last year, cat bonds were issued by five new sponsors: American Coastal Insurance Co, Axis Specialty, the Metropolitan Transportation Authority of New York, QBE Insurance Group and Renaissance Reinsurance. S&P rated its first bond with a parametric trigger linked solely to storm surge, MetroCat Re, in 2013. It also rated Bosphorus 1 Re, which has a parametric trigger linked to earthquakes in Turkey - marking the first time since 2007 that it rated a bond covering this peril.

Covered exposures expanded as well. In the Tradewynde Re issuance, certain exposures - such as damage to airplanes, marine and inland marine cargo, and onshore oil rigs, as well as the clean-up costs from pollution caused by covered perils - were not included in the risk modelling. Due to the composition of the covered business, S&P says it did not anticipate the expected contribution to losses as being significant and so adjusted the modelled results to account for this.

Meanwhile, cat bond pricing continues to fall. Typically, interest spreads are at 3x-4x of expected loss. However, the final deal S&P rated last year - VenTerra Re - priced at 2.76x of expected loss.

"Our general view is that, while pricing may not drop much further, it will not likely increase either," the agency says.

One change seen in 2013 was a variable reset. Usually, the probability of attachment and the expected loss reset to maintain their initial percentages established at closing. This past year, some deals permitted these percentages to fluctuate within certain parameters.

Based on the reset percentages, the interest spread paid to bondholders would also fluctuate. From a rating perspective, if the probability of attachment can increase from its initial level except for the final reset, S&P says it would look to the highest permitted reset probability of attachment as the basis for assigning the rating.

The share of rated issuance for indemnity triggers increased during the year. Based on notional amounts, 48.4% of issuance has an indemnity trigger and 33.1% an industry loss trigger; 11.6% have a parametric trigger and 6.9% have either a modelled loss or combination of modelled loss and industry loss triggers.

"While issuing indemnified bonds is generally the preferred option for sponsors since it reduces basis risk, until recent years investors seemed to prefer parametric and, to a larger extent, industry loss triggers. The shift to indemnified triggers seems to indicate that investors are becoming more knowledgeable of risks and the influx of capital into this market is giving issuers greater influence in structuring bonds," S&P observes.

A record year for cat bond issuance is expected in 2014.

Insurance-linked securities

Tohoku-related distribution disclosed

CATCo Investment Management has announced that a distribution of 2.887c will be payable to ordinary shareholders of the CATCo Reinsurance Opportunities fund on 24 January. The payment relates to the Master Fund's exposure to the Tohoku earthquake in Japan, following an agreement with a reinsurance counterparty.

CATCo had two reinsurance counterparties with potential exposure to the event and took a full provision for one counterparty, representing 30% of the Japanese exposure, in January 2012. The other counterparty had ILW protections that were expected to shield CATCo from any losses, but subsequently increased its loss reserves as the costs of the tsunami continued to escalate. However, the loss reserve was subsequently reduced, enabling CATCo to renegotiate a partial recovery of value (which Numis estimates to be around 50%).

The fund's NAV at 31 December was US$1.1059, representing an increase of 21.9% in 2013. In Q4, CATCo purchased some additional portfolio protections at a cost of around 2%, leading to slightly lower NAV growth for the year than had previously been projected.

A dividend of 5.737c will be paid on 31 January, in addition to the 20c per share distribution (US$74m) that can be treated either as a capital or income payment by shareholders.

Risk Management

MiFID 2 rules agreed

An agreement in principle has been reached by the European Parliament and the European Council on MiFID 2 rules. The rules are designed to close the loopholes in the existing legislation and include proposals to regulate high-frequency trading.

The new rules will apply to investment firms, market operators and services providing post-trade transparency information in the EU. They are set out in two pieces of legislation: one deals with transparency and access to trading venues; and the other governs authorisation and organisation of trading venues and investor protection.

Under the new rules, all systems enabling market players to buy and sell financial instruments would have to operate as regulated markets (RMs), like stock exchanges, multilateral trading facilities (MTFs) or organised trading facilities (OTFs) designed to ensure that all trading venues are captured by MiFID. Trading on OTFs would be restricted to non-equity instruments, such as interests in bonds, structured finance products, emission allowances or derivatives.

The duty of firms providing investment services to act in clients' best interests would also include designing investment products for specified groups of clients according to their needs, withdrawing 'toxic' products from trading and ensuring that any marketing information is clearly identifiable as such and not misleading. Clients should also be informed whether the advice offered is independent or not and about the risks associated with proposed investment products and strategies.

Finally, conditions for competition in the trading and clearing of financial instruments will be improved. For this purpose, MiFID establishes a harmonised EU regime for non-discriminatory access to trading venues and central counterparties (CCPs).

Smaller trading venues and newly established CCPs will benefit from optional transition periods. The non-discriminatory access regime will also apply to benchmarks for trading and clearing purposes. Transitional rules will ensure the smooth application of these provisions.

Third countries whose rules are equivalent to the new EU rules would be able to benefit from the 'EU passport' when providing services to professionals.

RMBS

Solid execution seen for IABF sale

The Dutch State Treasury Agency completed its second IABF sale yesterday (16 January). The auction comprised 360 individual securities totalling approximately US$4.27bn current face (SCI 13 January), which will leave the portfolio with just US$2.2bn remaining exposure.

BWIC execution appeared solid and approximately 29 of the bonds out for the bid had observable re-offer levels in the immediate wake of the sale. "Compared with the average price talk across the six dealers, all 29 bonds are being re-offered at the upper end of guidance, with a few line items actually coming in above the max price talk," Interactive Data reports. "On the surface, this would seem bullish and implies a fair amount of optimism on the part of the broker-dealer community regarding their ability to redistribute these bonds. However, [today's] FINRA trade data should be highly scrutinised for an indication of how much actual take-away customer buying was witnessed."

The sale pushed BWIC volume to around USS$4.37bn for the session, according to Interactive Data. The bulk of the supply consisted of a mix of fixed rate and adjustable rate bonds. While fixed rate supply was concentrated mostly in senior Alt-A bonds, the adjustable rate supply comprised of a mix of senior prime and Alt-A hybrids.

RMBS

Affordability surveyed

Fitch expects house prices to increase modestly in the US and remain broadly flat in Canada in 2014. Meanwhile, Australian housing remains expensive by many global measures and slight nominal price increases are possible in Japan and South Korea.

Fitch believes that most of the US will see continued home price growth, reflecting market momentum, the effects of inflation, the improving economy and a return of buyers attracted by signs of stabilisation. However, gains are expected to slow compared to prior years, due to rising mortgage rates and more inventory becoming available. Mortgage volumes are expected to decline as rising rates further curtail refinancing.

The agency remains concerned about regional overvaluation. According to its Sustainable Home Price model (SHP), national prices are now about 15% overvalued in real terms.

This risk is most pronounced in markets that have seen very high home price growth in recent years that has outpaced improvements in local housing and economic fundamentals. Prices appear increasingly overvalued in California when compared with fundamental demand drivers. For example, San Francisco price-to-rent and price-to-income ratios have increased by nearly 25% since the beginning of 2012 and are approaching all-time highs.

While Canadian prices may fall this year, Fitch believes any decline would be slight due to the country's strong macroeconomic trends and cautious lending policies driven by government measures, which are expected to slow lending in 2014.

However, affordability in the country is already very stretched, with the agency's SHP model suggesting that national prices are approximately 20% overvalued in real terms. It expects the central bank to maintain rates at current levels for most of 2014 but increase them towards the end of the year, potentially putting additional stress on the market.

Despite Australian house prices being high according to price/income ratios, house price/GDP per capita and house price/rent measures, the market will be supported by continued - albeit slowing - economic growth, strong affordability following rate cuts by the Reserve Bank of Australia in 2011-2013 and possible undersupply. Fitch therefore forecasts a moderate national increase of 4%.

The combination of high house price-to-income ratios and prices that are above the long-term average ratio relative to rents suggests that the potential for further increases in real terms is limited over the next decade, however. The agency expects affordability in Australia to deteriorate in the near term, with house prices continuing to rise more than income levels.

Prices in Sydney, Melbourne and Perth are likely to rise again in 2014, although more slowly than in 2013. Arrears are expected to increase slightly as unemployment rises in the country.

Net lending volumes should continue to grow steadily due to increasing activity in the housing market. But first-time buyer activity has fallen to historical lows, reflecting the inaccessibility of housing to lower-income households.

Overall Japanese house prices remain high, but a mild improvement in affordability is expected this year. Fitch anticipates prices to be broadly flat, as government measures such as mortgage tax deductibility offset a fall in demand after the planned consumption tax rise in April. However, wages should increase slightly, with affordability supported by low mortgage rates.

The Korean government is also supporting the housing sector, via measures such as house purchase tax cuts, lower government mortgage rates through the Korea Housing Finance Corporation or limiting supply. Combined with an improving economy, this should result in stable prices in 2014, according to Fitch.

RMBS

Jumbo CPR assumptions 'aggressive'

The 15% CPR pricing speed assumption used for most US RMBS prime jumbo deals issued in 2012 and 2013 is aggressive and may underestimate extension risk in new issue prime jumbo securitisations, say Wells Fargo analysts. They suggest that a pricing speed range of 5%-10% CPR would be a better approximation.

A bear steepening of the yield curve is expected. Alongside speeds that are slower than current assumptions, that could increase risk for new issue prime jumbo investors.

Voluntary prepayment speeds will be driven by the natural housing turnover rate and typical borrower prepayment behaviour in a rising interest rate scenario. The analysts expect the housing turnover rate to come in at around 4%.

As for borrower prepayments, the transition from a premium to a discount environment suggests speeds slower than the 15% CPR benchmark that has been used. Comparing agency 15-year, 30-year and 30-year conforming jumbos, the analysts find that there is very little difference in borrower behaviour in a discount environment.

"By extension, while there are fundamental differences between non-agency prime jumbo collateral and agency 30- and 15-year collateral, we believe that we can use the prepayment experience in a discount environment as a proxy of where non-agency prime jumbo collateral could prepay, assuming borrower behaviours converge," say the analysts. "Therefore, we believe that a pricing speed range of 5%-10% CPR is a better approximation than 15% CPR for 2012/2013 vintage non-agency prime jumbo collateral as we head into a discount environment."

RMBS

CFPB rules take centre stage

From a US residential mortgage servicing perspective, last year will be remembered as a year of regulation and consolidation. However, going into 2014 the Consumer Financial Protection Bureau (CFPB) will take centre stage as the ability-to-repay (ATR), qualified mortgage (QM) and servicing rules go into effect, according to DBRS.

The agency believes that the issuance of the ATR and QM rules removes much of the ambiguity that has caused many originators to sit on the sidelines for the last few years by setting underwriting standards that ensure lenders only make loans to borrowers who have the ability to repay them. For the first half of 2014 - as market participants continue to grasp the various components of the rules - the majority of originations will likely consist of QM Safe Harbor Loans.

However, DBRS also expects that some of the large bank lenders will be more willing to originate QM Rebuttable Presumption and non-QM loans because these lenders have a high degree of comfort with their origination and servicing processes, technological capabilities and compliance with residual income calculations. Over time, QM Rebuttable Presumption and non-QM loan originations will likely increase as court precedents are set and greater certainty around liabilities and damages is established.

Nevertheless, many creditors may be reluctant to make loans that are not QM safe harbour loans, even though they are responsibly underwritten. This may greatly constrain the availability of credit.

Additionally, DBRS is concerned that allowing consumers to argue that a violation of a qualified mortgage occurred months after origination because the consumer's income and debt obligations left insufficient 'residual' income or assets to meet living expenses may be used as a stalling tactic to prevent a servicer from proceeding with a foreclosure that is justified. This delay, coupled with the already long foreclosure timelines, could ultimately result in higher losses for investors.

Since the rules are so complicated and require a high degree of technological capabilities to ensure compliance, not all industry participants are confident that they have appropriately adopted the changes into their operations or fully understand how to quantify the liability for non-compliance. As a result, DBRS anticipates that 2014 will be a year of fines and lawsuits for servicers as they work to perfect the art of following the new servicing rules.

As a result, even though home prices have continued to rebound and delinquency and foreclosure rates are at their lowest level in four years, DBRS expects the first half of 2014 to result in historically low volumes of mortgage loan originations and therefore organic servicing growth.

The OCC last month released its Mortgage Metrics Report for 3Q13, which showed that the overall performance of mortgages improved from a year earlier. The percentage of mortgages that were current and performing at the end of the quarter was 91.4%, compared with 88.6% a year earlier. The percentage of mortgages that were 30 to 59 days past due was 2.6%, a decrease of 15.5% from a year earlier. The percentage of mortgages in the foreclosure process at the end of the quarter was 2.4% of the portfolio, a decrease of 39.3% from the previous year.

Seriously delinquent loans accounted for 3.6% of the portfolio at the end of the quarter, a decrease of 16.8% from a year earlier and the lowest level in five years. The number of seriously delinquent loans has decreased from both the previous quarter and one year ago across all risk categories.

Delinquency trends are expected to continue to decline as successful modification plans and short sales replace foreclosure filings, DBRS notes. But borrowers will likely still find it difficult to refinance or buy a home because of existing negative equity and the tightened underwriting standards issued by the CFPB, making the rental market an attractive alternative for consumers who do not have a FICO score in the 700s or meet the maximum 43% back-end ratio.

Modifications that reduce rates, capitalise monies owed and extend terms will continue to be the preferred loss mitigation strategy for many servicers, particularly as re-default rates remain under 20%. However, with the shadow inventory of homes that are still tied up in the foreclosure process and those that are about to enter foreclosure driven by serious delinquencies at close to 2 million loans, using short sales will continue to be one of the key loss prevention techniques used in 2014.

At the same time, strict credit underwriting and regulatory standards that limit lending are expected to keep the REO-to-rental market alive because most borrowers will be unable to obtain a mortgage. However, since a large number of investor purchases of REO properties to date have been predominately focused on areas with healthy population growth, low unemployment rates, good schools and affordable homes with positive HPI projections, it remains to be seen if the operators will be able to maintain profitability as they expand into less desirable markets.

RMBS

Servicer stability examined

Three US mortgage servicers - Ocwen, Nationstar and Walter Investment Management - have significantly grown their servicing portfolios over the past two years. Moody's focuses on the servicing stability of these three entities in its latest Servicer Dashboard publication.

The agency notes that the three servicers have undergone rapid transformations, which continue to pose significant operational risks that constrain their credit ratings. "These companies are transitioning from performing non-prime servicing to providing full-service mortgage banking," it explains. "They now originate prime agency-eligible mortgages and service a full spectrum of mortgage loans, from the seriously credit-impaired to super-prime. As the housing market continues to improve, the companies will benefit from increasing profitability, a credit positive. Nevertheless, the companies' high growth rates will challenge their ability to service loans, a credit negative."

All three companies have at least doubled in size, with Ocwen now ranked fourth, Nationstar fifth and Walter ninth among the largest US residential mortgage servicers. Opportunistic bulk transfers from servicers that are unable to manage their high volumes of seriously delinquent loans and from companies exiting the servicing business continue to largely drive the growth in the companies' portfolios.

Over the last year, all of the companies significantly increased their capacity to originate prime agency mortgages, primarily through acquisitions. This new source of revenue growth is expected to at least partially offset run-off risk.

"Origination is the new frontier for the mortgage servicers. It is uncertain how well the companies will be able to compete with banks in prime mortgage banking over the long term," Moody's says. Given the companies' histories as non-prime originators, their wealth of non-prime servicing experience and the cyclical, low-margin nature of prime mortgage originations, they could look to become the next generation of non-prime loan originators.

The companies' growth rates will likely slow significantly as they transition their newly expanded full-service mortgage banking offerings from acquisition-based growth to organic growth. Sacrificing profitability or increasing operating risks to continue their rapid growth would be credit negative, the agency suggests.

Since the delinquency rates of special servicers' servicing portfolios are higher than those of prime servicers, special servicers have the most to gain from the declining delinquency and default rates that accompany a rising housing market, according to Moody's. First, their expenses will be lower with a better performing portfolio: the cost of servicing delinquent loans is approximately 10 times greater than the cost of servicing current loans. Second, their fee revenues will increase - since higher interest rates lower prepayment rates - in turn increasing the duration of their servicing portfolios and the valuations of their mortgage servicing rights (MSR).

With regard to the wider residential servicing sector, jumbo and Alt-A collection metrics improved for all servicers in Q3 with the exception of GMAC. GMAC's current-to-worse roll rate rose slightly for jumbo and Alt-A product types.

Re-modification rates for Bank of America, Wells Fargo Bank and GMAC increased across all product types. Bank of America and Wells Fargo strived to meet their modification performance goals related to the settlement with attorneys general, while GMAC's re-modification volumes rose after Ocwen acquired the operations.

Bank of America's re-default rate increased for all product types as its level of re-modifications rose. Chase's re-default rate outperformed its peers for all product types, suggesting that its more recent modifications performed better than previous ones.

Finally, timelines for completed foreclosures continued to lengthen in 3Q13 as servicers worked their way through their aged pipelines. Moody's expects timelines to begin improving in 2014, as the foreclosure pipelines clear and judicial state court backlogs diminish.

RMBS

Euro residential performance diverging

The outlook for all major European residential mortgage markets has improved or stayed the same compared with a year ago, but performance among countries is diverging, Fitch notes. The agency expects house price affordability in some cities to be stretched further over 2014, given near-term expected house price increases.

The divergence in European markets reflects country-specific property cycles and factors such as government and central bank intervention. Ireland, Portugal and the UK are the markets with the most improved outlooks. However, Fitch says it has concerns about regional overheating in the UK.

In the UK, the economic and housing market recovery will support short-term mortgage performance and market-wide arrears will to continue to fall. But low rates and government initiatives, such as Help-to-Buy, are a risk over the medium term.

Lenders are again extending high loan-to-value mortgages and the market is showing signs of regional house price inflation. UK house prices are expected to rise by 5% this year, but Fitch believes they are already about 15% higher than is justified by income growth. A possible rate rise later this year or at some point next year remains a key risk for borrowers.

Meanwhile, Ireland faces a crucial year due to increased clarity on measures to resolve distressed mortgages. The agency expects Irish arrears to peak this year after more than five years of steep increases, as existing arrears cases start being resolved and the inflow of new cases subsides due to a stabilising economy and housing market.

Equally, the Bank of Portugal non-performing loan ratio on housing loans is anticipated to stabilise at around 2.5% in the next two years, alongside a gradual recovery of employment - although performance is vulnerable to interest rate increases and high long-term unemployment.

In Greece, arrears are expected to peak in 2015. Levels of new arrears have begun to shrink as the economy starts to recover. The foreclosure moratorium - extended for another year in December - may continue to have an impact on arrears, but it delays the prospect of additional supply putting pressure on house prices.

In Spain, prices will continue to fall this year - thanks to a property overhang, banks selling at deep discounts and sales by SAREB - before hitting a trough in 2015 as improved affordability boosts demand. Fitch expects a further increase in the proportion of housing loans that are non-performing, following a sharp rise in 2013 of higher long-term unemployment and loss of benefits, as well as the Bank of Spain's requirement that some refinanced mortgages are reclassified as non-performing.

Dutch house prices should bottom out by end-2014 as consumer confidence grows, mortgage rates stay low, affordability is high and greater clarity emerges around future tax treatment of mortgage interest. However, 90-day plus RMBS arrears will likely increase, albeit from a relatively low starting point of 0.9%, to up to 1.5% by the end of this year. This reflects rising unemployment and the rolling-off of benefits, lower earnings and servicers increasingly using forbearance.

Fitch expects new gross mortgage lending in most European countries to grow, due to the economic recovery and supporting policies. The eurozone periphery will recover from a low base, with cautious growth forecast in the Netherlands and Germany and stronger growth in the UK. Volumes in France should fall due to lower housing market and refinancing activity.

At the same time, the agency expects 2014 house prices to increase in Germany and the UK, due to low interest rates, sound GDP growth and improved credit availability. House prices are likely to increase modestly in 2014 in the US and Australia but remain flat in Canada.

Further house price declines are anticipated in the Netherlands and Italy, and to a larger extent in Greece and Spain. Eurozone economic stabilisation should lead to steady prices in 2015 in the Netherlands and Italy, while Greece and Spain are likely to see prices bottom out in that year.