Contents

CLOs

Wake-up call

Euro CLO idiosyncratic risks emerging

Vivarte's decision to suspend payments on its debt (SCI 18 February) has served as a wake-up call regarding tail risk in European CLO portfolios. While further spread tightening is anticipated across the 2.0 capital structure (notwithstanding current macro concerns), investors are likely to be more selective in 1.0 paper, given emerging idiosyncratic risks.

Daniel Leiter, an executive director in fixed income sales and trading at Morgan Stanley, warns that it is important to be aware of the risk in the tails of CLO portfolios. "The ability of CLO managers to fix certain issues is limited, so troubled names can have an impact at the bottom of the capital structure," he explains.

He adds: "Once an investor is high enough in the capital structure, avoiding troubled names becomes more about timing. But a recent performance issue around a specific loan has been a wake-up call regarding tail risk, so I expect that we'll see price action in the coming weeks on deals with exposure to other troubled names."

The number of triple- and double-B CLO BWICs circulating has increased since Vivarte suspended payments on its debt, confirms John Parker, CLO trader at Deutsche Bank. He suggests that further names getting into trouble - as well as any macro events or spread widening - could spur more BWIC sales.

Based on an analysis of the holdings of both legacy and 2.0 European CLOs, Morgan Stanley CLO strategists find that the top five loans to have endured price drops of over five points in February are: Vivarte (with €800.6m of exposure across European CLO portfolios), AVR (€424.4m), PHS (€207.5m), Autobar (€124.2m) and Stahl (€28.7m). Legacy transactions have a higher exposure to distressed loans and the exposure is concentrated among deals. More than 30 European CLOs commonly hold four loans whose prices dropped recently, according to the analysis.

The Morgan Stanley strategists point out that legacy European CLOs have lower but more dispersed OC test cushions, compared to CLO 2.0 transactions. "Thus, not surprisingly, legacy European CLOs are more vulnerable to idiosyncratic risk embedded in the collateral, and the junior debt and equity tranches of such CLO deals are more susceptible to cashflow redirection due to OC test breaches, as well as downward pressure on trading levels."

Zara Ivanova, CLO trader at Guggenheim Securities, observes that when Moody's downgraded Vivarte in December there was an up-tick in BWICs - but triple-B bonds traded at 450 DM. "It begs the question of whether the market is slow to absorb negative headlines," she suggests.

Potential investor fatigue with BWICs appears to be a way off, despite the increasing number of DNTs being recorded. Close to €6bn of European CLO bonds appeared on BWICs last year and this volume was absorbed well, according to Ivanova.

A CLO trader at another institution points out that BWIC efficiency depends on the kind of bonds on the bid-list, as well as the broader market context. "In a bull market, BWICs tend to trade well, but appetite disappears in volatile conditions. European BWIC activity has generally improved over last year, when the market appeared to be spooked by periods when there was a deluge of them. An extreme event could still trigger more senior supply."

Leiter believes that participants are generally more hesitant to provide liquidity in volatile markets, yet they may look at any re-offers. He adds that size is a factor, even in good market conditions.

Meanwhile, although a handful of legacy European CLOs were called last year, calls aren't expected to proliferate in the near term. "Triple- and double-B bonds are more interesting because of the call optionality/convexity on offer. But investors are increasingly being more selective in the junior mezz space, with tiering emerging among bonds," the trader observes.

CLO 1.0 senior tranches are paying down and experiencing a natural pull to par. In contrast, CLO 2.0 triple- and double-A tranches remain outstanding, so the cost of funding is low for many deals and it doesn't make economic sense to call them at present.

Parker doubts that many 2.0 deals will be called in the near term: NAVs currently stand at 75%-85% for equity holders, due to upfront costs of launching a deal - meaning that a near-term call would lead to very low yields to equity. However, he notes that repricing/refinancing individual tranches is a more likely option and expects to see this happen.

Looking ahead, Ivanova expects to see increased demand for 2.0 bonds and significant spread tightening, especially once the uncertainty over the Volcker Rule is resolved. "Tightening at the triple-A level will be followed by a steepening in the rest of the curve. Nevertheless, 2.0 single-Bs represent better relative value than equity because they're typically issued at a discount."

Leiter opines that European CLO 2.0 mezz is amongst the cheapest products across the entire securitised market at present. He believes single-B tranches, in particular, offer high yields - for much less risk compared to certain tranches of mezz CMBS, for example - and thinks oversubscription levels currently reflect this.

Leiter anticipates further spread tightening across the entire 2.0 capital structure, with deep mezz and triple-A positions continuing to look relatively cheap to him. But he thinks that investors are likely to be more selective in 1.0 paper in the future, as mezz bond performance is increasingly deal-dependent.

In addition, CLO manager style is important, in Leiter's view. "Equity performance varies significantly across deals and I think investors take this into account when looking at secondary opportunities and 2.0 issues. A manager's performance over the last five years is an important consideration in deciding whether to invest in their 2.0 deal."

CS

CLOs

Novel BWIC for Euro CLOs

Yesterday proved to be a busy session for the European CLO secondary market. Amidst the strong supply was what is believed to be the first CLO 2.0 single-B BWIC.

That 2.0 original single-B list included tranches from Dryden 29 Euro CLO 2013, Richmond Park CLO and St Paul's CLO III, all of which were issued towards the end of last year. SCI's PriceABS data shows that price talk and covers on those tranches were very similar.

The DRYD 2013-29A F tranche was talked in the mid/high-90s and at 97.6 and covered at 98.25, while the RPARK 1A E tranche was talked in the mid/high-90s and at 97.3 and covered at 96.7. The SPAUL 3A F tranche, meanwhile, was talked in the mid/high-90s and at 96 and covered at 96.5.

Also on the list was GROSV 2013-1A E, which was talked in the mid/high-90s and 96.5 and covered at 97.25. Beyond that single-B BWIC, PriceABS shows additional Grosvenor paper also available during the session, with the GROSV II-X SUB tranche talked at mid-60 and at 70, but failing to trade.

Further sub paper was also circulating in the form of EUROC V-X SUB and JUBIL VII-X SUB. The former tranche was covered in the low/mid-20s, while the latter was talked between the mid/high-40s and low-50s but did not trade.

Other Jubilee tranches as JUBIL VII-X D and JUBIL VIII-X D also finished the session as DNTs. The VII-X D tranche had been talked between the mid/high-80s and 90 area, while the VIII-X D tranche was talked between the low-90s and 95 handle. JUBIL 2013-10X D, meanwhile, was talked in the mid/high-90s.

There was also considerable Harbourmaster paper out for the bid, although HARBM 6X A4F, HARBM 7X C and HARBM 8X D were all DNTs. However, HARBM 7A B2 was covered at 84 and HARBM PR²X B2 was covered in the mid/high-80s.

A couple of other names of interest from the session include BOYNE 1X E, which was talked between the low/mid-90s and mid/high-90s and the CELF 2005-1X C1 tranche, which was talked between the very high-80s and the low-90s. Both tranches were recorded as DNTs, although the CELF tranche was covered in December at mid-89.

The DRYD 2006-14EX SN1, DUCHS VI-X D, EELF 2006-1 E1, EELF 2006-1 E3, MALIN 2007-1X E, RMFE III-X V and RMFE V-X IV tranches were all also recorded as DNTs. The latter tranche was covered in the mid/high-80s in November and was talked yesterday between 88 handle and around 90.

JL

CMBS

CMBS spreads sneak tighter

US CMBS BWIC volume was steady yesterday at around US$233m as spreads tightened. A considerable chunk of that supply was accounted for by the US$116.358m MLCFC 2007-7 AJ bond.

SCI's PriceABS data shows that the MLCFC 2007-7 AJ tranche was talked during the session in the mid/high-40s. A much smaller piece of the tranche was covered in August 2012 at 38 and a US$17.5m piece was talked on 29 October 2013 between the low-40s and low-50s.

Another sizeable piece of a tranche out for the bid was a US$30.646m slice of BSCMS 2006-PW12 A4, which was covered at 68. The tranche was covered at 65.5 in January and was being talked at 83 in November.

A US$22m piece of BACM 2007-2 AJ was also out for the bid and traded during the session. PriceABS shows price talk on the tranche was at 96 handle, in the mid/high-90s, in the low-500s and at around 600.

Among the other names of interest, a piece of the BSCMS 2007-T28 AJ tranche was talked at around 200 and at swaps plus 200 and was covered at 189. The earliest-vintage tranche captured by PriceABS was BAYC 2005-1A B1, which had not appeared in the archive before. It was talked at around 80.

There were also covers for GCCFC 2007-GG11 A4, LBUBS 2006-C7 A3, MLCFC 2007-5 AM, MSC 2007-HQ11 B, MSRR 2009-GG10 A4B, WBCMT 2006-C28 AM and WBCMT 2007-C30 AJ. That latter tranche was covered last week at 385 and was covered a couple of weeks before that at swaps plus 520.

Among post-crisis deals, the CGCMT 2012-GC8 D tranche was covered at 292, while DBUBS 2011-LC1A E was covered at 280 and ESA 2013-ESH7 D7 was covered at 274. The FNA 2012-M2 AB tranche, meanwhile, was covered at swaps plus 45.

JL

Structured Finance

SCI Start the Week - 3 March

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

Pipeline
There was no slowing down in activity last week as another 13 deals joined the pipeline. They consisted of four ABS, two CMBS, six RMBS and a CLO.

The newly-announced ABS were: US$201m ACER 2014-1; US$500m Chesapeake Funding 2014-1; US$104.4m HERO Funding Series 2014-1; and US$640m PHEAA Student Loan Trust 2014-1. The CMBS were US$290m China Real Estate Asset Mortgages and US$460.2m GP Portfolio Trust 2014-GPP.

The RMBS joining the pipeline comprised: Cartesian Residential Mortgages 1; RUB3.432bn Mortgage Agent MTSB; RUB3.868bn Mortgage Agent Petrocommerce-1; £350m Paragon Mortgages 19; US$435.3m VOLT 2014-NPL1; and US$427.3m VOLT 2014-NPL2. As for the CLO, that was US$478m TICP CLO I.

Pricings
Of the CLOs that joined the pipeline last week, seven went on to price. In addition, eight ABS printed, as well as one ILS, one RMBS and one CMBS.

The ABS new issues were: US$1.26bn Ally Auto Receivables Trust 2014-SN1; US$1.5bn CCCIT 2014-A2; Y25.2bn Driver Japan Three; US$650m Dryrock 2014-1; £475m E-Carat 3; US$676m SLM 2014-A; US$500m USAA Auto Owner Trust 2014-1; and US$678m Volvo Financial Equipment 2014-1.

The ILS print was US$245m Kizuna Re II and the RMBS was A$500m TORRENS Series 2014-1 Trust. The CMBS was a £110m second tap issuance of Trafford Centre Finance.

Finally, the CLO pricings comprised: €375m Carlyle Global Market Strategies Euro CLO 2014-1; US$453m Golub Capital Partners CLO 18; €425m Harvest CLO VIII; US$669.75m Limerock CLO II; US$492m Regatta III Funding; US$409m Tuolumne Grove CLO 2014-1; and US$311m Zais CLO 1.

Markets
US non-agency RMBS secondary market activity has slowed over the last few weeks and BWIC supply came in at about US$1.7bn for the last week of February. Wells Fargo RMBS analysts add: "On the new issuance front, Redwood Trust in its quarterly letter to shareholders announced it expected to complete another deal either in late 1Q14 or early 2Q14."

Generic US CMBS spreads began last week as they had ended the one before, as SCI reported on 25 February. BWIC volume for the first session of the week was around US$270m, with SCI's PriceABS data revealing a few 2013-vintage tranches out for the bid.

The US CLO market saw BWIC volumes of around US$400m, with spreads finishing the week unchanged, according to Bank of America Merrill Lynch structured products strategists. Last week was also a busy one for the European CLO market, with Wednesday's session heralding the arrival of what is believed to be the first European CLO 2.0 single-B BWIC (SCI 27 February). The bid-list included covers for tranches such as DRYD 2013-29A F and GROSV 2013-1A E.

Meanwhile, the European ABS and RMBS secondary markets tightened as primary issuance remained limited. "The continued grind tighter across most credit asset classes contributed to a further tightening of spreads across the ABS spectrum. Senior Spanish RMBS spreads at 205bp have now reached levels not seen since 1Q08. However, trading flows outside of BWICs remain on the light side," note JPMorgan securitisation analysts.

Deal news
• STACR 2013-DN1 failed its current subordinate percentage test this month and, as a result, the entire prepayment amount was directed away from the M1 tranche to the A tranche. A credit event resulted in a US$14,800 write-down of the B tranche that was enough to push the subordinate percentage to 2.99995% from 3%.
• Markit has issued a correction in connection with a loss recoupment on the CWCI 2006-C1 D tranche that wasn't reflected in January's CMBX.A.3 index settlements (SCI 23 January). A US$7,400 correction payment will now be made on US$1m original face trades.
• RBS is in the market with the inaugural transaction from Venn Partners' new Dutch RMBS platform (SCI 24 February). Dubbed Cartesian Residential Mortgages 1, the €481.3m deal is backed by prime mortgages originated by GE Artesia Bank via three SPVs - Quion 10, Ember Hypotheken 1 and Ember Hypotheken 2.
• Bemo Securitisation has closed DHC Healthcare Fund, the first revolving trade receivables securitisation in the Lebanese healthcare sector. The transaction is backed by a US$14m diversified portfolio of trade receivables provided by Dima Healthcare to its hospital, pharmacy and clinic clients.

Regulatory update
• FINRA is postponing the inclusion of CDOs, CBOs, CLOs and non-agency CMBS from its proposal to expand TRACE's coverage of securitised products (SCI 5 November 2013). The move comes after SIFMA submitted a comment letter on the proposal to the SEC (SCI 9 January).
• The US SEC has reopened for comment its proposals for ABS shelf-eligibility under Regulation AB 2. Specifically, the Commission is seeking comments on an approach for the dissemination of potentially sensitive asset-level data to address privacy issues.
• Judge Scarpulla of the New York State Court has ruled that the judgement entered by Judge Kapnick on 31 January in the US$8.5bn Countrywide RMBS settlement case will not be further delayed. AIG and other objectors had asked for the entry of the judgement to be stayed, alleging that various issues remained unclear (SCI 12 February).
• The decision by the European Parliament's Economic and Monetary Affairs Committee to postpone agreement on draft rules to regulate money market funds (MMFs) last week leaves the scope of possible investment restrictions on ABCP unclear. These restrictions may prompt significant asset reallocation for some MMFs, depending on the scope of the regulation.
• The US House Committee on Financial Services held a hearing last week on the impact of the Dodd-Frank Act on ABS. Witnesses included representatives from the LSTA, Georgetown University Law Center, Center for Capital Markets Competitiveness, CRE Finance Council and SFIG.
• The FHFA has reached a settlement with Societe Generale and related companies for US$122m. The settlement resolves claims alleging violations of federal and state securities laws in connection with private-label mortgage-backed securities purchased by Fannie Mae and Freddie Mac in 2006.
• Morgan Stanley has disclosed in a regulatory filing that it has reached an agreement in principle with the US SEC to resolve "an investigation related to certain subprime RMBS transactions sponsored and underwritten by the company in 2007". Pursuant to the agreement in principle, the bank would be charged with violating Sections 17(a)(2) and 17(a)(3) of the Securities Act, according to a Lowenstein Sandler memo.

Deals added to the SCI New Issuance database last week:
Anchorage Capital CLO 3; COA Summit CLO; CSMC Trust 2014-SURF; Dodeka I; GreatAmerica Leasing Receivables Funding Series 2014-1; Honda Auto Receivables 2014-1 Owner Trust; JFIN CLO 2014-1; JP Morgan Mortgage Trust 2014-1; JPMBB 2014-C18; Notting Hill Housing Trust; Omamori; Queen Street IX Re; Reni SPV; STORM 2014-I; TAL Advantage V series 2014-1; VCL Master Residual Value Compartment I; Venture XVI CLO

Deals added to the SCI CMBS Loan Events database last week:
BACM 2005-2; BSCMS 2003-T10; BSCMS 2006-PW12; BSCMS 2006-PW13; CGCMT 2005-C3; COMM 2005-C6; COMM 2006-C7; CSFB 2005-C2; CSFB 2005-C6; CSMC 2007-C2; CSMC 2007-C5; CWCI 2006-C1; CWCI 2007-C2; DECO 7-E2; DECO 9-E3; ECLIP 2007-2; EMC IV; EURO 28; FOX 1; GCCFC 2003-C2; GCCFC 2004-GG1; GCCFC 2007-GG11; GECMC 2004-C3; GMACC 2006-C1; GSMS 2004-GG2; JPMCC 2004-LN2; JPMCC 2005-CB12; JPMCC 2005-LDP4; JPMCC 2005-LDP5; JPMCC 2007-LD12; LBUBS 2003-C3; LBUBS 2007-C1; LBUBS 2007-C6; MLCFC 2006-2; MLCFC 2007-5; MLCFC 2007-6; TAURS 2006-3; TITN 2007-3; TITN 2007-CT1; TMAN 6; TMAN 7; WBCMT 2003-C7 & WBCMT 2003-C8; WBCMT 2004-C11; WBCMT 2004-C14; WBCMT 2005-C17; WBCMT 2005-C22; WBCMT 2006-C25; WBCMT 2007-C30; WBCMT 2007-C34

Top stories to come in SCI:
ILS outlook

CLOs

CLO equity continues excelling

US CLO equity is one of the few remaining fixed income products offering high carry. The segment posted an average cashflow return of 25% last year across 463 deals.

Based on a cashflow study and prices of US equity tranches, JPMorgan CLO analysts note that average total return last year was 8.2% for US 1.0 equity and 16.1% for 2.0 equity. As of end-2013, 2011 vintage US CLO equity had returned 47% of its face value in cash, while 2012 vintages had returned 23.7%.

Although CLO equity is a leveraged credit instrument, it has a relatively high correlation with public listed equities. The long-term average rolling one-year correlation of average US CLO equity and the S&P 500 index since 2006 is around 56%, having risen to around 85% during the crisis.

However, correlations collapsed last year as the average CLO 1.0 equity price and cashflow return declined and equities went on a bull run. While the JPMorgan analysts do not believe that CLO equity and equities are always comparable, they believe macro hedging strategies - such as equity puts - could make sense for investors.

An analysis of 595 actively managed broadly syndicated US CLOs issued between 2003 and 2012 reveals some significant equity cashflow return differences by vintage. Among 1.0s, there is considerable tiering between 2005-2007 vintage CLO equity returns this year due to amortisation.

The average 2007-vintage CLO equity return seems to have peaked in 2012, with 35% cashflow return. The 2003- and 2004-vintage equities also appear to be on their last legs: the analysts note that only 11 deals with an average 15% deal factor remain.

Annualised cashflow return for 2011-vintage equity increased to 23% in 2013, having been 21% the year before. For 2012-vintage equity, the average annualised cashflow return is 21% in 2013.

"The vintage effect is definitely at play in CLO 2.0 equity cashflow returns," the analysts observe. As of end-2013, 2011-vintage US CLO equity has cumulatively returned 47% of its face value in cash, while the 2012 vintage has returned 23.7%.

The variation in equity cashflows is a result of differences in deal leverage, launch time, initial portfolio selection, manager styles, structural features, language, warehouse and trading strategy. Some managers may have added value by trading assets in and out of the portfolio, while factors such as fee structure or X tranches will also affect cashflows.

The key risk for the future is loan spreads. JPMorgan's loan and second lien index spreads are 10bp-23bp tighter year-to-date.

However, a pick-up in leveraging transactions could put the brakes on loan spread tightening. There is also the chance for managers to pick up spread if there is volatility, as happened early in the year.

Amortisation is another source of risk and the market tends to discount post-reinvestment period equity. High yield loan prepayment rates are expected to subside to 30%-40% this year, but that still suggests reasonable amortisation.

"Depending on price and MVOC, equity that is expected to receive large principal cashflows may be attractive, such as control stakes to refinance/call," the analysts suggest.

The analysts expect a default rate of less than 2% for bonds and loans through 2015, which is below the long-term average. "Credit quality deterioration may weigh on expectations of risk-adjusted returns and impact pricing, though perversely the prevalence of cov-lite loans pushes out default risk even further," they conclude.

JL

CMBS

Titan NHP sale makes sense

The noteholder dispute over Mount Street's replacement of Capita as the special servicer for Titan Europe 2007-1 (NHP) (see SCI's CMBS loan events database) is diverting attention away from the more pressing issue that capital expenditure is not adding significant value. Selling the portfolio now rather than waiting for valuations to increase appears to make more sense.

HC-One has retained funds that would otherwise be used to service periodic loan and swap payments to instead fund the continued operation and future capex requirements of the care homes formerly run by Southern Cross. Bank of America Merrill Lynch European securitisation analysts note that HC-One is now in arrears with regards to the periodic payments owed on the forward swap by approximately £73.8m.

At the start of 2013, the market value of the HC-One properties was £356.1m, of which around £5.1m was sold during the year. At the end of 2013, the value of the properties was £379.3m - a £28.3m increase in value.

That £28.3m is significantly less than the £73.8m that was withheld from debt service and re-invested in the business. The WholeCo valuation increased by £6.7m.

Payments owed on the forward swap rank either above or below the class A notes in different situations, with swap break costs paid after class A interest and principal and unpaid periodic swap payments paid before class A interest and principal. This has pushed the LTV of the class A notes from 94.7% in January 2013 to 98.2% now.

The future projected increase in swap arrears could by itself cause losses to reach the class A notes. The BAML analysts forecast swap arrears to increase by £19.6m by the end of next year, when net proceeds from the sale of the properties could - based on the current £528.9m valuation - result in a 2.6% principal loss to the notes.

The legal final maturity of the CMBS is 1 January 2017, but the timing and scale of any future value appreciation is uncertain. As special servicer, Capita does not owe a duty directly to the swap provider and could be expected to crystallise swap mark-to-market losses rather than incur swap arrears. As capex spending appears to have reaped a negative return last year, a sale of the business sooner rather than later could make sense.

The expected net disposal proceeds from selling the portfolio would be £507.7m, which would currently be enough to repay 100% of class A note principal. All subordinated classes would suffer total principal loss.

The analysts believe that the business needs to be sold in the next six to 12 months to avoid capex pushing principal losses into the class A notes. If a sale is completed in January 2016, then the analysts estimate the swap mark-to-market would be roughly £32.2m, which would rank ahead of the class Bs.

Nevertheless, the junior notes could recover principal if valuations increase. An 8% increase from the current level would see class Bs begin to recover principal and a 17% increase would see them recover 100%. Class E notes would begin to recover principal with a 36% valuation increase and would recover 100% with a 48% valuation increase.

"We think it is unlikely that the business/property valuation can increase by 36% over the next two years, given that it increased by just 0.3% over 2013. Under even an optimistic scenario, we do not believe the class E notes (the controlling class) are likely to recover any principal," the analysts note.

They continue: "To our thinking, the class A notes are the tranche most immediately exposed to principal loss and probably deserve to be the controlling class. We view it as a structural shortcoming in the transaction that the controlling class has not migrated upwards to the class A."

Either way, there appears to be little to gain from replacing the special servicer, which is unlikely to improve recovery prospects. "The special servicer has the authority to complete a sale at the borrower level and doing so likely would not require the approval of the note trustee, in our understanding. As such, we think the sale process may continue and could potentially be concluded while the debate around replacing the special servicer continues," the analysts conclude.

JL

NPLs

GSEs to turn to NPL sales?

The GSEs have published their annual financial reports for last year, confirming that RMBS and CMBS disposals slowed down dramatically in the final quarter as sales targets were reached. With portfolios now significantly reduced, future illiquid portfolio sales may have to come from different sources and non-performing loans could be a candidate.

The GSEs had an illiquid portfolio sales target of around US$36.7bn and reported a total of US$38.6bn disposals, including around US$27.5bn in CMBS and US$10.1bn in RMBS. At the end of 2013, Fannie Mae held only US$4bn in CMBS and US$24bn in RMBS, while Freddie Mac held US$29bn in CMBS and US$61bn in RMBS.

The remaining balance of the illiquid portfolios is close to US$600bn. Barclays Capital securitisation analysts expect that the GSEs will need to sell close to US$30bn from their illiquid portfolios this year if the target is kept at around 5%.

As Fannie Mae only has a limited amount of CMBS and RMBS remaining, it may have to look beyond its securities book and pursue alternative sales strategies. The focus could shift to selling NPLs and modified loans from its illiquid portfolio.

For Freddie Mac, the picture is a little different, as it still has plenty of securities to meet its sales goals from its illiquid portfolio. "However, even here, they may have to sell the weaker parts of their securities book, as they have almost completely sold out of their IG rated RMBS book in 2013," note the Barcap analysts.

The largest component of the GSEs' illiquid portfolio is a combination of non-performing and re-performing loans. They have not yet embarked on any large-scale selling of NPLs or RPLs, but that could change if they look beyond the securities space.

The HUD already has an active programme selling such loans. The analysts believe that the success of the HUD's programme and the US$9bn issuance of NPL deals seen so far may well result in GSE sales of NPLs this year.

Another option would be to issue more pools similar to the Freddie Mac M pools that were recently issued. The analysts believe this would be "more of a cosmetic reduction in risk" than actually selling the loans as the HUD deals do, but it would still allow the GSEs to reduce the size of their illiquid portfolios.

"They would likely get better execution doing this, compared with selling the entire risk to the market. Still, [it] is unclear to us whether this transformation would fall under the definition of 'sales' as required by the FHFA scorecard," the analysts note.

JL

ABS

ARS pricing service offered

SIX Financial Information has teamed up with Pluris Valuation Advisors to help clients to value auction rate securities. Pluris has an extensive database covering thousands of recent transactions and a close relationship with SecondMarket, which is currently the only active auction rate trading venue.

The Pluris auction rate pricing available through SIX covers municipal, student loan and preferred securities. It is integrated with SIX's own proprietary evaluations and the service is rounded out by SIX's wealth of security master data for the ARS universe.

Structured Finance

SF pros set up new credit unit

Intermediate Capital Group has set up a new alternative credit team, which will be led by Sridhar Bearelly. He will be joined by Jesper Poulsen, Vincent Charles-Gervais and Simon Peatfield in London.

Peatfield currently manages ICG's existing European structured credit capabilities. Bearelly, Poulsen and Charles-Gervais join from Credos Capital, where they established an alternative credit fund platform which ICG will acquire.

Bearelly has also worked at ZAIS Group and Lehman Brothers, while Poulsen was executive director of structured credit and emerging markets structuring at Lehman before joining Nomura and later ZAIS. Charles-Gervais began his career in structured finance at AXA investment managers before joining Bearelly and Poulsen at ZAIS.

Structured Finance

Challenger bank continues growth

Aldermore Bank has expanded further by appointing Lee Rhodes to lead structured finance and block discounting activities for its asset finance team. He was most recently at Investec and has also worked for ING Lease and Kleinwort Benson.

Rhodes will be based in London. His appointment follows that of Carey Hansford (SCI 21 February) and he joins alongside Sean Jones and Kevin Tonge, who each also worked at ING Lease and join from Hitachi Capital, and also alongside Tim Biddle, who joins from Siemens Financial Services.

Structured Finance

Trade automation specialist appointed

Algomi has appointed Howard Edelstein as a strategic advisor. He specialises in driving trading efficiencies through automation.

Edelstein was previously chairman and ceo of BondDesk Group and has served as president and ceo of NYFIX. He has also worked in senior roles at Radianz and Thomson Financial ESG.

CLOs

CVC hires for middle-market

CVC Credit Partners has appointed Neale Broadhead as md and portfolio manager in London. He will focus on the origination and execution of European middle-market lending opportunities and report to Tom Newberry.

Broadhead was most recently at Lloyds, where he helped to establish the mid-market origination team. He has also worked for BNP Paribas and The Industrial Bank of Japan in London and at The Industrial Bank of Japan and NatWest Markets in New York.

CLOs

Secondary markets leader joins

Stream Capital has appointed Fabrice Toledano as director for structured credit in Geneva. He will lead the secondary markets team and focus on CLOs, CDOs and leveraged loans as well credit-linked notes and performance swaps.

Toledano was most recently responsible for global macro hedge fund investments at Unigestion. He has also worked as a structurer and trader in credit and equities for Deutsche Bank and in credit flow trading at Credit Agricole.

Insurance-linked securities

Firms target ILS opportunities

Argo Re and Horseshoe Re will work together to combine Argo's depth of underwriting experience with Horseshoe's ILS expertise. The combination will provide funds and investors with a platform to participate in reinsurance programmes that require coverage from highly-rated reinsurance carriers, which the firms believe is an underserved area of the ILS market.

RMBS

Court reinstates RMBS claims

A trial court's decision to dismiss Assured Guaranty Municipal Corp's claims for rescessory and consequential damages in an action against Credit Suisse regarding US$1.8bn in RMBS has been reversed. New York's Appellate Division, First Department has also reinstated claims for damages.

Assured sued loan originator DLJ Mortgage and underwriter Credit Suisse in 2011, alleging that they had misrepresented the quality of the RMBS loans. The trial court dismissed Assured's claims on the basis that plaintiffs' remedies were limited by the pooling and servicing agreement's 'sole remedy' clause.

The First Department has now found that the trial court was wrong to hold that the available remedy had been limited to cure of the breach or the substitution or repurchase of the securitised loan, notes a Lowenstein Sandler memo. The court has ruled that the certificate issuer should not have been counted as a party affected by the sole remedy clause.

RMBS

Subprime settlement in the works

Morgan Stanley has disclosed in a regulatory filing that it has reached an agreement in principle with the US SEC to resolve "an investigation related to certain subprime RMBS transactions sponsored and underwritten by the company in 2007". Pursuant to the agreement in principle, the bank would be charged with violating Sections 17(a)(2) and 17(a)(3) of the Securities Act, according to a Lowenstein Sandler memo. Further, it would pay disgorgement and penalties in an amount of US$275m, while neither admitting nor denying the SEC's findings.

RMBS

Further PLS settlement reached

The FHFA has reached a settlement with Societe Generale and related companies for US$122m. The settlement resolves claims alleging violations of federal and state securities laws in connection with private-label mortgage-backed securities (PLS) purchased by Fannie Mae and Freddie Mac in 2006.

Under the settlement, Societe Generale will pay roughly half of the settlement monies to Fannie Mae and half to Freddie Mac and certain claims against the bank will be released. This is the eighth PLS settlement to be achieved since the FHFA filed suits in 2011 (SCI 5 September 2011).

ABS

Stable performance expected for DFP ABS

Fitch expects dealer floorplan (DFP) ABS assets and ratings to be stable this year, due in part to a robust vehicle sales forecast. The agency's US light vehicle sales forecast for 2014 is 16 million units, which would provide ample support for US dealer revenues and profit levels.

Dealers also expect to benefit from healthy demand for both new and used vehicles as the US economy slowly recovers, increasing demand for new vehicle models and late-model pre-owned vehicles. An aging US vehicle fleet on the road, stable parts/service revenues and low interest rates also bode well for dealers' bottom lines in 2014.

Fitch expects monthly payment rates (MPR) to be stable in 2014. The agency forecasts trust agings to be stable and believes that dealer bankruptcies and trust losses should be minimal.

"Our expectations assume that manufacturers continue to manage the vehicle supply and demand equation prudently, so dealers can keep costs - including interest costs on DFP financing - down," it explains. "Interest on DFP loans is one of the biggest costs for a dealer. Excess inventory raises costs and reduces profit margins."

Managing inventory levels has become more important in recent months. Levels spiked to an 88 days' supply, up from 64 days in December, as sales were slow - partly due to recent severe winter weather. Dealers aim for a 60-days turn rate; therefore, manufacturers must look to manage excess inventories through slowing production or juicing incentives over the next few months in order to reduce stocks. To date, this has had little impact on trust MPRs.

Fitch notes that dealer consolidations may heat up in 2014 as bigger dealer groups chase growth in market share, revenues and profits. Increased dealer acquisitions may result in higher concentrations in DFP trusts, however.

ABS

Lifting of Aussie import tariffs 'credit negative'

Australia's Productivity Commission published a position paper on 31 January, describing the country's auto import restrictions and tariffs as redundant. Moody's says in its latest 'Structured Thinking: Asia Pacific' publication that the lifting of the restrictions would be credit negative for Australian auto loan and operating lease ABS because they would lower the price of cars, thereby affecting ABS pools by reducing recovery rates and raising net losses when borrowers default on their loans.

Currently tariffs and restrictions apply to imported vehicles and their removal would increase the supply of lower-priced imported second-hand cars into Australia and make new cars more affordable. As prime auto ABS typically demonstrate low default rates, their exposure to falling recovery rates is limited. By contrast, non-conforming transactions generally display higher default rates and therefore higher exposures to falling recovery rates.

Further, the value of turned-in vehicles at the end of existing lease contracts would decline if used car values fall, resulting in residual value losses. Auto operating lease ABS rely on forecasts of future car prices to set leasing rates in such a way that the cashflows during the lifetime of the contract cover the value decline of the vehicle. Unexpected declines in overall market prices will therefore result in the residual values of the vehicles being lower than the estimated residual values used in the calculation of the original lease rates, Moody's notes.

Australia's Productivity Commission has proposed measures to reduce vehicle prices for consumers, including the removal of the tax on luxury cars and the lifting of certain restrictions on second-hand car imports. In addition, Treasurer of Australia Joe Hockey has said that there is a legitimate argument to remove tariffs, if there is no longer a local motor vehicle manufacturing industry. He expects to revise the current taxation of car imports during the upcoming taxation review, which will occur over the next 18 months.

On 11 February, Toyota Motor Corporation was the last of the three auto producers in Australia to announce its exit from manufacturing in the country by 2017, following exit announcements by Ford Motor Company and General Motors Company over the past 12 months.

ABS

Korean credit card quality to deteriorate

The credit quality of receivables backing Korean credit card ABS is expected to deteriorate as a result of the recent data breach that affected millions of cardholders. The disappearance of affected cardholders from securitisation pools will weaken the overall credit quality of receivables and the principal payment rate (PPR) in credit card ABS, Moody's says.

Three credit card companies were involved in the breach, including Lotte Card Co, the originator of the Point-Plus Third International deal. However, Moody's expects the fall-out from the breach to only be minor for this transaction because the securitisation is in the amortisation stage rather than the revolving stage.

As a result of the breach, more than one million customers have asked card issuers to terminate their cards or demanded card reissuance or account suspension. Because most of these cardholders are of higher credit quality, affected ABS receivable pools will be left with cardholders of weaker credit quality.

Moody's anticipates the departure of convenience users to result in a reduced PPR in Korean credit card ABS. Convenience users contribute to an overall higher PPR for a credit card transaction because of their timely repayments every month and generally account for a significant proportion of newly generated receivables. A portfolio mix with fewer convenience users will reduce the overall PPR of the card receivables because the other receivable types generally have a lower PPR.

As a result of the data breach, investors in card transactions in revolving stages will be exposed to weaker credit-quality receivables in securitisation pools for a longer period than for transactions in controlled amortisation periods. For transactions in controlled amortisation, increased subordination will offset the increased risk from a weaker receivable pool.

South Korea's Financial Supervisory Service (FSS) reported the breach of personal data of an estimated 104 million credit card customers of Kookmin Card, Lotte Card and Nonghyup Card on 19 January. The FSS suspended some of the business operations of the three card companies for three months, starting on 17 February.

In addition, it imposed fines of KRW600m on each of the companies. The companies cannot add new customers or provide new card loans or cash advances during the suspension period.

ABS

RFC issued on TD approach

Fitch has published a criteria exposure draft for rating Portuguese and Spanish electricity tariff deficit (TD) securitisations. The agency believes that the ratings of TD securitisations cannot be more than three notches higher than the issuer default rating (IDR) of the relevant sovereign, mainly because its central expectation is that macroeconomic trends and regulatory policies have a direct impact on the electricity system and on the recoverability of TD credit rights.

"We consider that electricity system revenues are supported and influenced (both positively and negatively) by the economic strength of a country and the stability or volatility of its legal and institutional framework - factors that are indicated by the sovereign IDR as a starting point," Fitch explains.

When determining the difference between the TD securitisation rating and the sovereign IDR, the agency says it assesses quantitative and qualitative factors - such as the power and independence of the electricity regulator, the financial profile of the electricity system - and whether there is a credible agenda that aims to eliminate TDs within a realistic timeframe. The independence of the electricity regulator is important for both system sustainability and for the repayment of outstanding TDs. Fitch also analyses leverage and liquidity key performance indicators of the electricity system, which are considered in the context of convergence towards an equilibrium state, where TDs would be eliminated.

There are no rating implications for existing TD securitisation transactions from the proposals outlined in the exposure draft, as they broadly reflect analytical practices that have already been followed in these transactions. However, if the final published criteria diverge from the proposals described in the current exposure draft, the possibility of rating changes cannot be excluded.

Feedback should be submitted by 3 April, after which the updated criteria will be published.

Structured Finance

SFR operational risk highlighted

S&P says it is yet to see a single-family rental (SFR) securitisation with the level of credit enhancement and other risk-mitigating features that warrant the highest investment grade rating. The agency's primary reservations regarding the sector revolve around the industry's operational infancy, historical performance, the current business model's ability to withstand extreme economic conditions and the ultimate liquidation values of the underlying properties, given the risks associated with short liquidation periods.

S&P views SFR securitisations as having credit risk characteristics that are similar to CMBS and RMBS, as well as some less frequent non-traditional asset securitisations, such as those backed by triple-net leases. The agency believes that SFR is best seen as a hybrid asset, thus rental payments and the value of the underlying homes are all critical to the analysis of the securitisation trust's assets.

A complicating factor in SFR transactions is the degree of operational risk: the continuity of net cashflows from the underlying properties depends heavily on the ability of their owners to manage large numbers of single-family homes, which are often geographically dispersed and uniquely constructed. The properties require ongoing maintenance that can't be implemented with a one-size-fits-all approach and are likely to be leased multiple times during the course of a given securitisation's term.

The highest investment grade rating among non-traditional securitisations with associated operational risks isn't the norm for S&P, the agency notes. For example, it typically rates many CRE lease-type securitisations below the highest investment grade rating, even those sponsored by more-established players.

Furthermore, the size and depth of the property manager pool for this asset class is questionable, according to S&P. Should incumbent property management fail, there is no guarantee that an adequate replacement with sufficient experience to oversee a large portfolio of SFR properties can be found. This risk is compounded in geographic areas where SFR operators have limited local staff or affiliates.

Structured Finance

CLO relief in sight?

The US House Committee on Financial Services held a hearing yesterday on the impact of the Dodd-Frank Act on ABS. Witnesses included representatives from the LSTA, Georgetown University Law Center, Center for Capital Markets Competitiveness, CRE Finance Council and SFIG.

Testimony addressed Representative Barr's draft legislation on CLOs and Volcker - which calls for grandfathering of all CLOs issued before 31 December 2013 and the prevention of certain for-cause rights from constituting an ownership interest - and the LSTA's earlier proposal of qualified CLOs as an alternate form of risk retention. The hearing saw broad bipartisan support for the CLO market in addressing issues with Volcker and risk retention requirements, according to Bank of America Merrill Lynch analysts.

"There seemed to be overall consensus that at least a narrow form of targeted relief would be needed, especially for legacy CLOs," they note. "Judging from [yesterday] and prior hearings, we believe that grandfathering of legacy CLOs is a viable option that is being seriously considered by the regulators and legislators. However, there seems to be less consensus on how to treat the definition of ownership interests and exempting new deals from the Volcker Rule."

Meanwhile from the CMBS industry's perspective, former CREFC chairman Paul Vanderslice testified that the risk retention rule will impose a cost on borrowers of between 40bp-50bp, translating into an increased cost burden on commercial property owners of 8-10%. He summarised five core recommendations that have been presented to regulators, which cover: single borrower single credit exemption; B-piece senior-subordinate structure; modified parameters for qualified commercial real estate loans; voting quorum for special servicer replacement; and cashflow management test.

Structured Finance

PRI to boost EM issuance

Political risk insurance (PRI) for capital markets has re-emerged, with a broader scope for coverage to adapt to the changing needs of emerging markets finance, Fitch says. These newer products normally relate to a sovereign guarantee or obligation and therefore do not address private sector companies in the absence of a sovereign support mechanism.

"New PRI products that cover not only political risk, but also certain credit risks typically related to a sovereign obligation could help select EM issuers to access international capital markets," says Cinthya Ortega, director in Fitch's Latin America structured finance group. The most recent capital markets application was the Multilateral Investment Guarantee Agency's (MIGA) coverage benefiting the class A1 notes issued by Maexim Secured Funding Limited in 2013.

Traditional PRI primarily protects private companies against government-imposed transfer and convertibility (T&C) restrictions and have not covered credit risk. Therefore, if the underlying obligor does not have sufficient resources to make the local currency payment, the insurance cannot be utilised.

In recent years, leading providers - such as the Overseas Private Investment Corporation (OPIC) and MIGA - have introduced insurance products for capital markets usage that cover certain credit events, including non-payment of an arbitral award and non-honouring of financial obligations (NHFO).

Unlike traditional PRI, the determination of a claim under a new policy that covers non-payment of an arbitral award is binary in nature - meaning that a burden of proof can be fulfilled through a simple yes or no answer. New NHFO products bear a resemblance to financial guarantees, although limited exclusions exist.

CDO

Auction due for ABS CDO

Cowen and Company has been appointed as liquidation agent for Blue Edge ABS CDO, the collateral of which will be disposed of via a public auction. The collateral will be split into five separate portfolios for sale: Alt-A RMBS, mixed RMBS, ABS CDO assets, CRE CDO assets and zero-factor assets. Bids for the assets must be submitted by 6 March.

CDO

CBO on the block

An auction has been scheduled for Trainer Wortham First Republic CBO V on 21 March. The collateral shall only be sold if the proceeds are greater than or equal to the auction call redemption amount.

CDS

Air France CDS tighter on cost-cutting

CDS market sentiment towards Air France has noticeably improved since the beginning of the year, according to Fitch Solutions. This is being driven by the company's continued efforts to cut costs, reduce debt and return to profit.

"Credit default swaps on Air France have tightened 13% since January, outperforming our European Consumer Services CDS Index, which has remained largely unchanged," comments Diana Allmendinger, director at Fitch Solutions.
"The company recently reported full-year results and announced a strategic partnership with Brazilian airline GOL. This has helped drive the positive CDS market sentiment, where spreads have tightened steadily since the end of last August."

Air France CDS are now pricing at their tightest levels since February 2011, in line with its CDS-implied rating of single-B minus, which is up by one notch from a year ago. CDS referencing Air France debt are also now trading with strong liquidity, currently in the eighth regional and global percentile, implying that they are more liquid than 92% of contracts in Fitch Solutions' CDS pricing universe.

The positive CDS market sentiment towards Air France is being echoed by the equity market, where Fitch's five-year probability of default is down by 45% from a year ago to 18%.

CDS

Diamond CDS hit by earnings concerns

Credit default swaps on Diamond Offshore Drilling have widened by 47% over the past month, according to Fitch Solutions. Diamond's CDS significantly underperformed the 3.4% tightening seen for the broader North America oil and gas sector over the same period. The cost of credit protection on the firm's debt has also been climbing steadily since late-January.

After trading consistently at A/A+ levels since November 2013, CDS on Diamond have widened to price in line with triple-B plus levels. "Wider CDS spreads are likely indicative of Diamond's lower earnings, as well as market concerns surrounding the broader offshore drilling industry," comments Fitch director Diana Allmendinger.

CLOs

CLO modelling tool enhanced

Codean has released Codean CLO Analytics version 4.0, which includes the firm's structuring and rating analyser module SaRA. The service aims to provide investment banks, asset managers and others arranging new CLO transactions with the analytical tools to do so.

SaRA is a deal modelling tool with over 700 existing CLO deal models as templates to start from. This is coupled with a cashflow engine and rating analysis for the major rating agencies. It also gives users the ability to run investor analysis and automate common requests.

CLOs

CLO tail risk approach unveiled

Moody's has updated its approach to assessing tail-end risk in CLOs that hold long-dated assets. The update - which the agency proposed in a request for comment on 11 December 2013 - will not affect any current CLO ratings.

Under the new approach, Moody's will consider in its analysis capping ratings at certain time horizons before the maturity of a CLO's liabilities, if payment of the liabilities is likely to depend on the sale of long-dated assets. The agency sees high investment grade ratings as being largely inconsistent with the expectation that the timely payment of a CLO liability depends on the sale of long-dated assets within a period shorter than a year before the CLO liability's maturity.

However, it says that speculative grade ratings are more consistent with the expectation that timely payment of a CLO liability depends on the sale of long-dated assets if no more than six months remain before the CLO's liability matures. The more the liability's payments depend on sales within a short period, the lower the rating.

Moody's considers these principles only when evaluating CLO liabilities that are maturing within one year and depend on the proceeds from the sale of long-dated assets for full repayment - specifically, when the par coverage ratio from non-long-dated assets is below 100%. For liabilities that satisfy these criteria, the agency will consider capping ratings at Baa3 for liabilities that mature in six months to a year and at Ba3 if they mature within six months.

The approach will be applied starting at one year to maturity. In addition, before a deal reaches the one-year mark prior to maturity, Moody's will analyse any material accumulation of long-dated assets and conduct scenario analyses to evaluate the sensitivity of the rated notes to the potential forced liquidation of long-dated assets at maturity. When exposures to long-dated assets are material, the agency could take negative rating actions pre-emptively before the deal reaches the one-year mark.

The new approach is designed to take into account more explicitly the uncertainties involved in selling long-dated assets for cash proceeds sufficient to pay the CLOs' liabilities, a process in which a collateral manager plays a significant role and has considerable discretion. Long-dated assets constitute an increasingly larger proportion of collateral, especially in seasoned CLOs, as more deals approach maturity and collateral pays down. In addition, some CLOs are expanding their participation in amend-to-extend activities, which sometimes result in extending loan maturities past the maturity of the CLO notes.

CLOs

Euro CLO 2.0s becoming effective

Fitch's latest CLO Tracker report includes five European CLO 2.0 transactions with over €1.8bn in assets under management, indicating that the process of new issuance replacing older transactions as they exit their reinvestment period is underway. Of the Fitch-rated CLO 1.0 universe, 70% are now through their respective reinvestment periods and the average senior note factor has decreased to 68% from 75.8% since the release of the July 2013 Tracker report.

The CLO 2.0 transactions that have become effective have on average had higher weighted average recovery rates than seasoned CLO 1.0 transactions. They also have lower triple-C buckets (2.08% versus 8.7%) and are more granular (with an average of 77 obligors versus 62 for CLO 1.0 transactions).

This is likely a result of the necessity to have 'cleaner' portfolios at the pricing stage of a CLO. The granularity is more a function of CLO 1.0 transactions exiting their reinvestment periods and delevering.

Fitch has noted amend-and-extend activity on around 8.54% of each CLO portfolio on average over the past year. This is a fall from the highs experienced two years ago, when the majority of transactions were still within their reinvestment periods. It may also be a function of the return of the leveraged loan and primary CLO market in that companies can access financing again without having to ask their lenders for maturity extensions.

Meanwhile, senior and junior OC cushions have stepped up significantly over the past year. The inclusion of CLO 2.0 transactions notwithstanding, the average senior cushion now stands at 52.4% and the junior cushion at 2.8%.

As CLO 1.0 transactions roll off, Fitch expects to see these cushions continue to increase. The effectiveness of OC tests as the portfolios roll off will be governed by the granularity of portfolios and the credit quality of loans maturing towards the tail end of the transaction.

Finally, average net portfolio losses have stabilised since the last Tracker, with the average loss now at 1.63% across transactions covered in the report.

CMBS

CMBS credit creep examined

As many as 10 new conduit lending programmes could be added to the list of US CMBS originators in the coming months, potentially bringing the total to 371, Kroll Bond Rating Agency notes. While issuance is expected to grow by 15%-20% this year, it is unclear whether the increase in volume can support the new entrants. The rating agency therefore suggests that increased competition will encourage weaker underwriting standards across the sector.

Based on an analysis of the largest 20 loans in a CMBS transaction, KBRA says that one stand-out finding is the percentage of loans in the top 20 that had interest-only (IO) periods. Within the top 20 bucket, 39.5% of loans were partial IO in 2013 versus 25.9% in 2012, while 22.8% were full-term IO in 2013 versus 12.6% in 2012. This compares to 32.8% partial IO and 17.5% full-term IO for all KBRA-rated transactions.

If the largest 20 loans are split into the top 10 and 11-20 loan buckets, there is a clear distinction in the credit metrics among the two groups, as outliers within the two pools are driving the averages apart. "The marketplace generally puts a higher level of scrutiny on the top 10 versus loans 11-20, a practice that can mask credit creep. In effect, issuers are building pools where stronger-than-average large loans sit side-by-side with weaker-than-average loans - judging by credit metrics alone," KBRA observes.

For example, the average 4Q13 KBRA loan-to-value (KLTV) for the top 10 was 95.1% versus 100.8% for 11-20 in transactions rated by KBRA. Similarly, KBRA debt service coverage (KDSC) for the 1-10 pool was 1.63x versus 1.50x for 11-20. In addition, 'story' loans with more complex structures and less than squeaky-clean sponsors tend to appear in this 11-20 bucket.

Across both loan buckets, the agency observed increasing leverage levels on a year-over-year basis, as well as increasing numbers of highly leveraged loans with KLTVs in excess of 100%. In 4Q13, 11-20 loans that carried KLTVs greater than 100% increased to 60.3% from 47.8% in 3Q13.

In 2013, the percentage of loans with KLTVs greater than or equal to 110% in the 11-20 bucket increased from the previous year by almost 80% to 15.1%. There were more than 4.5 times the number of loans in this category between 2012 (10 loans) to 2013 (46 loans).

Further, the percentage of 11- 20 loans with KLTVs of less than 85% declined. The largest drop was in 4Q13, when the percentage slid into single-digits, with only 6.9% carrying low leverage (78% KLTV).

CMBS

Patient investors 'rewarded' by ESA outcome

Extended Stay America's successful IPO last November paves the way for other CMBS-backed companies to follow suit, according to Talmage ceo Edward Shugrue in the latest issue of CREFC's 'CRE Finance World'. ESA shares were priced at US$20 - nearly double its value when the firm was bought out of bankruptcy in 2010.

From 2004 through 2008, 75% of the public companies taken private were backed by both CMBS and mezzanine debt. These included Trizec, EOP, CNL Hotels and ESA.

Assembled in various stages by Blackstone, ESA - which represented 425 hotel properties - was financed with two CMBS offerings (in 2004 and 2005) totalling US$3.2bn, plus mezzanine loans of US$2.4bn. Taking the firm private in 2004, Blackstone improved ESA's income by approximately 9% before selling it to The Lightstone Group for US$8bn in June 2007. In total, with US$4.1bn of CMBS debt (at an implied LTV of 50%) and US$3.3bn of mezzanine debt, Lightstone was able to borrow 92.5% of the purchase price.

A consortium comprised of Centerbridge, Paulson and Blackstone bought ESA out of bankruptcy for US$4.2bn, financing their purchase with a US$2bn CMBS loan and US$700m of mezz debt. "Importantly, the triple-A CMBS bondholders were paid on a current basis throughout the bankruptcy and all but the two most junior CMBS classes (6% of the trust) were repaid at par plus accrued interest," Shugrue reports.

Cashflow has jumped by 28% since the acquisition and the new owners recapitalised the portfolio with a US$3.6bn CMBS and mezz debt offering. "CMBS investors that were able to withstand mark-to-market valuations and adopt a hold-to-maturity perspective have been rewarded with full recovery of principal and interest," Shugrue concludes.

CMBS

'Unsustainable' rents eyed

Moody's suggests that soaring apartment rents in Williston, North Dakota, are unsustainable in the wake of the energy boom. An analysis undertaken by the agency indicates that rents will ultimately normalise at far lower levels.

"The energy production boom in western North Dakota has led to a rapid rise in population and a significant shortage of apartments. As a result, rents in the area have soared to levels more typical of New York City or San Francisco," says Tad Philipp, a Moody's svp and director of commercial real estate research.

Energy-related employment in western North Dakota is likely to peak around 2020 and then decline because building out infrastructure requires many more workers than maintaining it. As employment starts to decline, the portion of apartment rents above that justified by construction costs will likely decline as well, which is anticipated to adversely affect newly originated loans - typically with 10-year terms maturing in 2024.

"In our analysis, we use replacement cost as a guide to assess the upper limit of sustainable rent, given that new construction tends to continue until construction costs and rents achieve equilibrium. We also use much bigger cashflow haircuts and higher capitalisation rates to arrive at the value we use in our analysis than we do for similar apartment properties in other markets," adds Philipp.

To mitigate refinancing risk in CMBS, loans backed by apartments in oil-boom regions typically have faster than normal amortisation schedules and no interest-only period. Rapid amortisation effectively channels a portion of the non-sustainable rent into paying down a loan. But risks remain, given that the barriers to construction in this sparsely populated region are few and that employment is substantially tied to one traditionally volatile industry.

CMBS

Liquidation volume doubles

US CMBS liquidation volume doubled in February, due in large part to many of CWCapital's REO asset sales flowing through remittance reports. Liquidation volume ended this month at US$2.65bn, more than double January's volume and the 12-month moving average of US$1.33bn, according to Trepp.

February loss severity came in at 45.59%, down from January's 58.51% and on par with the 12-month moving average of 46.77%. Of the loans that were liquidated, 98% by balance fell into the greater than 2% loss severity category.

The number of loans liquidated in February was 126, resulting in US$1.21bn in losses. The average disposed balance in January was US$21.06m - well above the 12-month average of US$13.42m.

Since January 2010, servicers have been liquidating at an average rate of US$1.21bn per month.

CMBS

Chinese CMBS prepped

Dynasty Property Investment is prepping its second cross-border CMBS. Dubbed China Real Estate Asset Mortgages, the US$290m transaction is backed by nine retail properties in nine cities across China.

The deal comprises US$232m class A notes (provisionally rated Aa3 by Moody's) and US$58m class Bs (A3), as well as an unrated CNH440m class C loan. The rating assigned to the class A notes is capped at China's local and foreign currency country ceilings (both at Aa3), which capture the risks associated with political, institutional, legal and economic factors, according to Moody's.

The borrower is a subsidiary of a property fund managed by Macquarie Retail Management (Asia). The loan is secured by assets in Changsha, Dalian, Harbin, Jinan, Nanjing, Nanning, Shenyang, Tianjin and Wuhan. These cities are either provincial capitals or regional commercial, cultural and political centres.

Moody's notes that the transaction benefits from: a comprehensive security package; properties with good locations and an experienced manager; and high occupancy by quality tenants. As of December 2013, the weighted average occupancy of all properties was around 98.9%, with seven of the nine properties at 100%.

Major tenants are well-known local and/or international supermarket chains, department stores, home appliance/improvement stores and cinemas - including Wal-Mart, Parkson, Grand Ocean and Wanda Cinemas. The weighted average remaining lease term across all properties was around 8.8 years, as of December 2013.

However, Moody's also points to a number of weaknesses, including: uncertainties related to China's legal/policy environment and future competition; short remaining land-use rights, at a weighted average of 28 years; tenants' rights to terminate leases and exposure to major tenants; and the lack of mortgage registration over the property located in Changsha.

The arranger is Standard Chartered Bank. The borrower will use part of the proceeds to refinance its existing borrowings.

CMBS

Fee 'blind spots' examined

Weak EMEA CMBS transaction documentation governing work-out costs and liquidation fees can lead to note shortfalls, even where no securitised loans suffer a loss, Fitch notes. The agency says that, in some cases, misalignment of loan- and issuer-level documentation can leave blind spots regarding the bearer of fees.

Charging the borrower for work-out costs ensures that equity fully bears the brunt of loan default before noteholders are affected. Only in the event of equity depletion would the CMBS issuer assume some of the costs. The lack of issuer reserve funds in a typical legacy EMEA CMBS makes this a serious concern for noteholders.

In many cases, excess spread is sufficient to absorb a variety of issuer costs. However, with a notional measure of excess spread typically earned by class X notes senior in the waterfall, whether investors in this profit-extraction class or others end up bearing costs will depend on the definition of costs netted off from the strip rate. Where this is exclusive of extraordinary or non-recurrent fees, any loans in special servicing impose interest losses for junior investors, Fitch observes.

Where the issuer has to meet extraordinary or non-recurrent costs, ensuring that the full variety is accounted for in profit-extraction mechanisms is necessary to avoid fee-related shortfall surprises. This is most simply achieved by subordinating profit-extraction as traditional excess spread. For example, in Gallerie 2013, a special servicing event would trigger the subordination of class X notes to rated bondholders.

Where a borrower does not have to meet work-out costs, a similar undermining of intended subordination can result from tranched loan structures. Senior lenders may face a loss if third-party fees are not picked up by the junior lender. One example is the Prime loan in Talisman-1 Finance, where a pro rata sharing of expenses between the senior securitised lender and the junior non-securitised lender eroded CMBS recoveries by €1.7m.

Even the method of asset sales can determine the bearer of costs. For Windermere XIV, liquidation and work-out fees arising from mortgage enforcement are payable by the borrower, whereas the same costs from a consensual sale are paid by the issuer. While this could be viewed as a financial incentive offered by the issuer to a distressed borrower for its cooperation in a sell-down, it does this by blurring the idea of subordination even further.

Looking ahead, Fitch expects that investors will look to contingency arrangements to cover spikes in costs, so that priority over collateral proceeds is preserved. "The clearest solution would be for the issuer to be entitled to charge back reasonable costs to the borrower. An alternative is for the issuer to apply penalty interest earned on defaulted loans against costs incurred, thus mitigating the risk of shortfalls - provided penalty interest is not paid out as profit even higher in the priority of payments," the agency suggests.

For costs that cannot be reasonably charged back to or recovered from borrowers, excess spread is the natural first line of defence for investors. Looking more broadly at the question of costs, Fitch says that simply holding back an amount of excess spread until the notes have repaid in full would provide the issuer with a buffer to absorb any unexpected costs, many of which are back-dated.

CMBS

Legacy repayment rate to remain low

Moody's expects the performance of loans backing European CMBS to stabilise over the next three years. CRE lending will likely remain constrained, however.

"In line with our previous expectations, the outlook for commercial real estate markets has rebounded somewhat after the recent period of financial stress and the euro-area crisis," says Oliver Moldenhauer, a vp-senior analyst in Moody's structured finance group. "While we anticipate stable performance from loans originated after the financial crisis, we expect significant losses on legacy transactions from loans that were originated pre-2008."

Lending will remain constrained over the next three years, due to increased regulatory capital requirements for banks and strict underwriting criteria. Lending will also be heavily dependent on underlying property quality, as well as the leverage of the loans to be refinanced, Moody's notes. The repayment rate will therefore remain low for highly leveraged legacy CMBS loans backed by weak quality property.

In addition, the agency expects that prevailing work-out strategies will continue to focus on avoiding fire sales of distressed properties - provided that cashflows are sufficient to service outstanding debt. However, an increase in enforcement of properties with low recovery potential and/or no sponsor support over the next three years is likely, causing further capital-value deterioration.

For outstanding European CMBS, losses on securitised loans are set to increase due to the large amount of commercial real estate loans that have already defaulted or are expected to default. Moody's estimates that European CMBS loan-level losses will total around €9bn.

Nevertheless, investment focus is anticipated to slowly move beyond prime properties, with a gradual shift to higher-quality secondary properties and markets. The rating agency expects that investor demand for weak secondary and tertiary properties will remain low.

As a result of the demand for prime properties, stable capital values are forecast for prime and higher quality secondary properties. Higher-quality secondary property values should begin to stabilise, while weak secondary and tertiary property values will continue to fall due to the lack of investor demand.

Overall Moody's expects improving real estate fundamentals, with the dynamics of tenant demand and space supply improving in line with overall economic recovery. Compared with the past five years, the agency believes that the overall magnitude of risks around its central economic scenario remains relatively low. Two main downside risks threaten to derail the CMBS central scenarios, however, reflecting uncertainties around the euro-area debt crisis and lack of financing.

CMBS

Delinquencies down on CWCAM sales

The Trepp US CMBS delinquency rate decreased by 47bp to 6.78% in February, marking the ninth straight month of improvement. The rate is 264bp lower than it was a year ago and 356bp lower than the all-time peak during the summer of 2012.

The decrease is attributed to the jump in loan resolutions, driven by the CWCapital distressed asset sales. Over US$2.6bn in previously delinquent loans were resolved with losses over the course of the month. By removing these delinquent loans from the numerator, the rate saw 50bp of improvement.

"The long-awaited resolution of the CWCapital distressed asset portfolio helped push delinquencies to multi-year lows," comments Manus Clancy, senior md at Trepp. "Beyond that, the removed uncertainty and decent results gave investors greater confidence to reach for yield in February. The outcome was a big rally of legacy mezzanine paper over the last 28 days."

Loans that cured totaled about US$1.3bn in February, which resulted in 25bp of additional downward pressure on the delinquent loan percentage. However, new delinquencies totalled almost US$1.4bn in February. These loans pushed the rate up by 26bp.

RMBS

Swap error corrected

Moody's has downgraded the ratings of five Granite Master Issuer Series 2006-3 tranches, following a correction to an input to the rating tool the agency used. The agency had either affirmed or upgraded the securities on 18 February.

The affected tranches are the class A3, A4, A7, B2 and M2 notes. Due to an error, Moody's did not identify all swaps in the transaction and the rating tool used in the 18 February rating actions therefore assumed no swap counterparty exposure for the class A3, A4, A7, B2, M2 and C2 notes. When the rating tool is updated with these swaps and the identity of the swap counterparty - Barclays Bank (rated A2/P-1) - the tool indicates higher expected losses for all the tranches, except for the C2 class, where the swap linkage shows no material expected loss increase. The downgrades reflect the impact of exposure to Barclays Bank as the swap counterparty.

The affected notes are all pre-2007 vintage, which Moody's now gives less benefit, due to older swaps containing material deviations from its current criteria. Newer swaps are generally substantially consistent with its framework and include collateral volatility buffers that the agency gives value to under its updated criteria.

RMBS

Increased investor, IO loans 'credit negative'

The increase in the proportion of investor and interest-only (IO) loans in new mortgage originations is credit negative for new Australian RMBS transactions, according to Moody's in its latest 'Structured Thinking: Asia Pacific' publication. As of 30 September 2013, the proportion of investor loans increased to 34.3% from 26.4% in March 2009, while the proportion of IO loans increased to 37.3% from 27.4%. If this trend continues, the agency expects investor and IO loans to increase in new Australian RMBS transactions from the current outstanding stock of 28.6% for investor loans and 22.5% for interest-only loans.

Moody's says the increase is credit negative for three main reasons. First, investor loans and IO loans are more sensitive to increases in interest rates than owner-occupied (OO) or principal-and-interest (P&I) loans. This is important in light of the central bank's recent indication that it will end its policy of interest-rate easing.

Second, investor and IO loans typically have higher loan-to-value ratios (LVRs) than other types of loans. Higher LVRs reduce borrowers' willingness to voluntarily sell their properties to avoid defaults because they are only able to recover a small amount of money after deducting selling costs.

The final reason is that borrowers of investor and IO loans are likely to prepay their loans more slowly than borrowers of other types of loans and will therefore build equity more slowly. As a result of these lower repayments, investor loans and IO loans will have higher LVRs throughout the life of an RMBS transaction. And because higher LVRs are key drivers of defaults, the likelihood of defaults in RMBS transactions will increase.

If reflected in new Australian RMBS transactions, this trend in collateral composition is expected to increase default rates, especially if the future economic environment becomes significantly more stressful. "We expect this trend in collateral composition to continue because the Australian mortgage loan market does not differentiate between investor and OO borrowers in terms of risk pricing, which ensures that investors will continue to achieve attractive funding rates. However, in other markets such as the UK, investor mortgage loans - which are called buy-to-let mortgages - incorporate significant risk premiums over OO loans," Moody's notes.

Investor and IO loans are more sensitive to increases in interest rates than OO loans or P&I loans because of their larger loan amounts, which therefore require these borrowers to make larger loan repayments. The average loan size of an investor loan is around A$249,500 compared with A$207,700 for an OO loan, while the average loan size for an IO loan is A$343,300 compared with A$195,600 for a P&I loan.

Investor loans have an average LVR of 60.2%, compared with 57.8% for OO loans. IO loans have an average LVR of 61.1%, while P&I loans have an average LVR of 58%.

RMBS

STACR percentage test triggered

STACR 2013-DN1 failed its current subordinate percentage test this month and, as a result, the entire prepayment amount was directed away from the M1 tranche to the A tranche. A credit event resulted in a US$14,800 write-down of the B tranche that was enough to push the subordinate percentage to 2.99995% from 3%, RMBS analysts at Barclays Capital report.

To pass the test, the balance of the subordinate tranches needs to be greater than or equal to 3% of the aggregate deal balance. With this month's prepayment being directed to the A tranche, the subordination percentage next month should work out at 3.00965% - despite two more credit events this month that caused an additional write-down of US$31,000 on the B tranche.

3.00965% corresponds to US$2.1m in additional enhancement over the 3% required to meet the trigger; in other words, it will require losses of about this magnitude to break the subordination test again. "Of course, this enhancement level will factor down as prepays get paid pro-rata to the subordinates, but at the current rate of prepayments it will still require a default in the range of US$11m-US$13m to fail this test again. With defaults likely to remain less than US$1m per month, we think it is safe to assume that the test would not fail again for at least a year - or even longer," the Barcap analysts conclude.

RMBS

Moderating servicer growth 'credit positive'

The New York Department of Financial Services' (DFS) action on Ocwen (SCI 7 February) may signal a broader regulatory push to moderate the growth of the large special servicers, according to Moody's in its latest ResiLandscape publication. The agency notes that regulatory action that moderates the growth of special servicers or otherwise strengthens their operating and financial profiles would be credit positive.

"We have regularly cited the special servicers' extraordinary growth as a key credit constraint, given the operating risks associated with the complex integration of acquired mortgage servicing rights and the potential for deterioration in servicing metrics. The DFS' suspension of Ocwen's Wells Fargo deal indicates that the regulator has similar concerns," it observes.

However, increased regulatory attention could also lead to financial penalties if the firms' operational capacity has not kept pace with their growth rates, resulting in servicing quality issues. Over the medium term the regulatory attention could accelerate a shift in servicers' business models to areas with even greater operating risk, Moody's suggests.

In particular, the agency says that a shift towards originating non-prime mortgages would be a net credit negative. "We have said that Ocwen and the special servicers could become the next generation of non-prime originators, given their wealth of non-prime servicing experience along with the cyclical, low-margin nature of prime mortgage originations. But originating non-prime loans increases legal risks and performance volatility. Although industry non-prime loan volume is currently very low and we do not expect it to grow rapidly anytime soon, we expect the market to redevelop with active participation by special servicers."

DFS Superintendent Benjamin Lawsky has questioned whether "corners [were] being cut" by servicers, as well as the purported cost savings and efficiencies of non-bank mortgage servicers. He cited off-shoring as an area that bears special scrutiny.

Any changes that result would affect Ocwen most, since approximately 65% of its employees are based offshore, primarily in India. Nationstar has been rapidly increasing its offshore activity as well, but the majority of its operations remain in the US.

RMBS

Debut Dutch RMBS marketing

RBS is in the market with the inaugural transaction from Venn Partners' new Dutch RMBS platform (SCI 24 February). Dubbed Cartesian Residential Mortgages 1, the €481.3m deal is backed by prime mortgages originated by GE Artesia Bank via three SPVs - Quion 10, Ember Hypotheken 1 and Ember Hypotheken 2.

The issuer financed the purchase of the mortgage pool by issuing unrated notes to GIFS Capital Company and subordinated notes to the seller (Ember VRM). At closing, the proceeds will be used to repay this bridge financing.

Rated by Fitch and S&P, the transaction comprises €421.33m class A notes (with preliminary ratings of AAA/AAA), €12.04m class Bs (AA-/AA) and €12.04m class Cs (A/A+), as well as unrated €12.04m class Ds, €24.08m class Es and €11.07m class S notes. The notes' interest rate will be based on three-month Euribor, while the pool contains loans linked to a standard variable rate (SVR) and Euribor, as well as fixed-rate loans. For the proportion of the pool that contains SVR and fixed-rate loans, the issuer will enter into a swap agreement with BNP Paribas to hedge the interest rate risk.

Most of the loans were previously securitised in Stitching Seven Bridges I and II. Fitch notes that the portfolio is well-seasoned (at 105 months), with a weighted-average (WA) original loan-to-market-value of 89.3% and debt-to-income ratio of 34.4%. But the portfolio contains higher than average loan balances and a significant amount (22.2%) of self-employed borrowers.

Venn will provide advisory services on a day-to-day basis, including advice on setting interest rates on the loans and advice relating to arrears management and foreclosure strategies.

RMBS

Regional factors weigh on UK RMBS

A new DBRS analysis indicates that the UK housing market in the period following the financial crisis in 2008 is better characterised as a series of regional crises. Each with their own characteristics, the impact of the crisis on different regions within the UK varies widely and has not influenced housing in a homogeneous manner.

The geographic profile of assets backing RMBS transactions may have increasing relevance to the creditworthiness of future transactions, DBRS suggests. The agency found variation in a number of metrics that impact both rating and investment decisions when assessing RMBS transactions.

While regional resilience to house price declines in the crisis differs from region to region, the subsequent recovery has also had an impact to varying degrees. For example, house prices in London returned to pre-crisis levels in 1Q13, while the bulk of UK regions still record average house prices below their 2007-2008 peaks, according to Nationwide Building Society data.

Analysis of loss severities also shows significant regional variation, being highly correlated to the prevailing house price environment in the locality of the repossession. Consequently, Northern Ireland shows the highest average loss severity (at an average of 60.8%) and London, Outer Metro and the South East show lower losses of 20.8%, 21.4% and 22.5% respectively.

Local influences, such as housing supply and demand, can also affect loss severities. In an analysis of forced sale discounts, DBRS finds that they vary from an average of 32.7% in Scotland to a low of 21.3% in East Anglia.