Contents

Credible values

AIFMs evaluate Brexit implications

Alternative investment fund managers (AIFMs) are facing a number of uncertainties following the UK's vote to leave the EU. Their immediate attention will be focused on how to reflect the Brexit result in tomorrow's mid-year valuation reports. Longer term, UK-domiciled managers will be evaluating the prospects of relocating operations to a country within the EU.

Last Friday's referendum result has left portfolio managers with more questions than answers. Valuing illiquid assets in a way that adequately reflects the impact of the vote is one of the most pressing issues in the near term, particularly for those managers that have illiquid investments in or referencing UK real estate and UK financial services.

The timing of the Brexit news makes the valuation issue all the more challenging, since 30 June is the day that funds are due to report their mid-year valuations. Given the market volatility since the 'leave' result was announced and the expected instability over the coming days and weeks, life will be extremely difficult for those tasked with valuing illiquid bonds and other Level 3 assets in their portfolios.

"The question that managers invested in illiquid assets will be asking is how to make their valuations express the impact of the Brexit vote in a way that is credible," says Ryan McNelley, md at Duff & Phelps. "Valuing illiquid assets requires judgment. Managers will have to assess their valuations on a case-by-case basis."

He adds: "It is important for fund managers to think of the message they are sending to their investors: they need to be forthright and transparent. If they don't know what the full impact of the Brexit is going to be on their portfolio, the best they can do is to be honest with their clients. What you shouldn't do is leave your valuations unchanged."

McNelley notes that the intermediate and long-term outlook of private equity and private debt investments - particularly those with exposure between the UK and the EU - will need to be carefully monitored and the impact of their rapidly changing outlook should be reflected in ongoing NAV reporting. Investments with significant FX exposure will also need to be looked at carefully, he says. Additionally, refinancing risks will be a key consideration, if there is a protracted disruption to the capital markets.

With regard to the upcoming mid-year valuation reporting date, McNelley suggests that - if acceptable to limited partners - it may be prudent to delay the results for a few days. "In particular, investors would probably prefer managers to take their time and estimate a credible value - and if possible, validate that conclusion through an external review - rather than rushing things. There will be a lot of news to digest over the next few days," he adds.

At a London-based Infoline buyside valuation conference held yesterday (28 June), fund managers agreed that valuation uncertainty would be amplified as a result of the Brexit vote. One delegate suggested that investors would demand a greater degree of transparency around valuations and valuation models in the wake of the vote. The likelihood of increased movement of assets through the fair value hierarchy following the Brexit vote was also mooted.

Away from pressing valuation deadlines, AIFMs will also have to contend with the viability of their business remaining in the UK in the longer term. Although nothing is clear at this stage, it can be assumed that European directives will not be applicable to UK funds once the UK has formally exited the EU.

In particular, UK-based fund managers will likely no longer be subject to the valuation requirements under AIFMD and UCITS. For some UK-focused funds, this may not be concerning. But for those funds that need the AIFMD passport allowing the marketing of the fund to European investors, this could be a problem.

"If funds want to maintain their passport within the EU, they are probably going to have to be domiciled in a EU country," says Ian Blance, md at Voltaire Advisors. "I can see Luxembourg and Ireland benefitting enormously from the Brexit decision. Both are large areas of administration for many funds, so in some cases it won't be a massive leap."

He adds: "We cannot know what the replacement regulatory regime will look like in the UK. The FCA may choose to adopt a policy that means that UK funds remain aligned with European-based funds. However, for now, the regulatory procedures around valuation for those funds that remain domiciled in the UK after Brexit is going to be uncertain."

It is likely that some fund managers will be looking to Ireland and Luxembourg and scrutinising fund structures available to them. The Irish Collective Asset Management Vehicle (ICAV), for example, could be of interest, according to Blance.

Operationally, many managers had contingency plans in place before the Brexit vote. They will now have to act upon the realities of implementing those plans.

Some funds more than others will be expecting redemptions as a result of the Brexit vote, such as open-ended funds with illiquid investments. "Sidepocketing is the nuclear option, but it's an option that a lot of investment managers may have to look at," McNelley concludes.

AC

Structured Finance

Recruitment rocked

Brexit compounding ABS hiring issues

The recruitment outlook for structured finance took a potentially big blow when the UK decided to leave the EU last week in its referendum vote. With hiring activity already at a moribund pace this year, concerns about immigration limits and capital outflows are weighing further on human resources both in Europe and the US.

The surprise Brexit result sent shockwaves across the global financial markets and saw a number of banks lose a substantial amount of money. A number of these banks in mainland Europe and the UK had already been scaling back their staffing requirements (SCI passim), but the vote to leave ushered in a new dynamic and could precipitate even more cutbacks.

"Like with any uncertainty, the markets haven't responded well to Brexit and the result will probably put a massive strain on recruitment opportunities," says a London-based headhunter. "It could certainly dislocate any hiring strategies and structure that firms had put in place previously. On the upside, we haven't seen any sort of fundamental collapse so far and, until they know more, rumours of banks shipping jobs out of the UK have been unsubstantiated."

He adds: "Perhaps the recent scaling-down by some banks might have been a timely blessing."

Nonetheless, the EBA has already reportedly noted that it will have to relocate from its current office in London's Canary Wharf, which would see its 159 officials move to the continent. Paris and Frankfurt are the two cities being mooted for consideration right now as its new location.

AFME ceo Simon Lewis released a statement last Friday that described the vote as a leap into "uncharted territory". The association expects the result to "significantly affect" UK-based financial services firms in their ability to serve clients and customers.

Certainly, banks and asset managers in the structured finance space are expected to be wary of hiring EU nationals until there are more concrete details about the immigration policy the Brexit negotiation team will attempt to achieve in its departure talks with the EU. "You'd hope there will be some common sense and any planned hiring of EU nationals is not suddenly being backdated two years down the line," explains the London headhunter.

He continues: "The one human resources head I've talked to so far has said they just don't know what is going to happen. The picture will hopefully become a bit clearer over the next couple of weeks and months."

Both the referendum result and the lead up to the vote also had a significant effect across the Atlantic. Similar to their European peers, US banks have seemingly had their hands tied in recent months ahead of 23 June.

"A narrow vote was the worst-case scenario too because it implies division within the country and, consequently, more potential for risk," says Chadrin Dean, managing partner at Integrated Management Solutions. "What the markets in New York and London were looking for was a comprehensive victory that showed confidence and assurance."

This has led US firms to follow their European counterparts down a similar path of recruitment stagnation, with the occasional trimming down in ABS a more common theme than the prospect of beefing up within structuring teams. Such circumstances have resulted in an even slower last six months for hiring than that of 2H15, explains Dean.

"This is also down to the other key issue, which is the awful Q1 results that the big US banks posted earlier this year," he explains. "With the country's general election later this year, people are just waiting now to see what will be drummed up in Q3 as the main crisis. This cycle of perpetual uncertainty has been a detriment to any sort of hiring opportunities."

The pre-referendum focus in the UK only weighed further on European structured finance recruitment activity that had already suffered another slow year so far. It follows a consistent theme that has been playing out in the post-crisis era.

"The ABS space has been very quiet this year and it's got to the point where I no longer have regular rounds of meetings with people in structured finance," says the London headhunter. "There have been enough deals coming through the pipeline, but a lot of banks are happy to work within their current means. In that respect, the market truly is at its size right now."

Some large banks have even chosen to trim their ABS structuring and trading capabilities in Europe. For instance, BNP Paribas announced in May that it was cutting its 35-person London securitisation team by half, but followed up this month by hiring Mehdi Kasani to head European ABS trading (SCI passim).

In addition, speculation in late 2015 that Credit Suisse would be cutting its London securitisation team (SCI 23 December 2015) was confirmed earlier this year (SCI 24 March). The bank said it planned to pull the plug on its European ABS presence, while also revealing that its US CLO positions had been substantially cut from US$800m to US$300m.

"Our origination capabilities will be retained through the US trading team," says a Credit Suisse spokesperson. "We will also continue to act as syndicates within transactions; for example, in the instance of the Granite and Hercules deals."

Another feature of the slimming process within banks' ABS teams has been the change in composition. A number of senior industry figures appear to be being replaced by fresher faces.

"Banks no longer need 20 people in a team to be making these deals, so they are being cleared out from the top," says Lisa Wilson, managing partner at Invictus Executive Search. "Since banks are looking for more junior positions to be filled, the senior figures are the ones being cut loose."

This trend, however, has not necessarily led to these people being recycled within the structured finance space. A number of heads are choosing instead to test other waters in the financial sector, while ABS teams are also looking to branch out into other areas too.

"A number of ex-structured guys have emerged in the non-bank lending space," says the London headhunter. "Whole loans have also been mentioned a fair amount and generated interest from investors, so it would make sense if the reports are true regarding ABS trading teams diversifying."

Other forms of finance still within securitisation are also filling the gaps. One example has been the trade receivables segment, which has seen firms such as Finacity and Demica leverage their position as alternative options to the investment banks. The latter in particular has hired a number of people this year to build out a brand new securitisation team (SCI passim).

"They are an attractive option in the market because they are able to undercut the banks and provide a useful advisory alternative," adds Wilson. "They are effectively providing a leaner and meaner option."

Outside of this, rating agencies are continuing to build out their analytical teams, particularly as less established agencies like Scope Ratings and Kroll Bond Rating Agency continue to seek a greater presence in the market. Buy- and sell-side hiring across assets classes, however, is still showing little potential for growth.

"The CLO space is still a bit more dynamic than ABS, but even that has gone incredibly quiet," explains the headhunter. "Admittedly, law firms are continuing to hire those with expertise in deal structuring and regulation. Otherwise the wider credit markets, like the distressed market, are a more attractive option for recruitment because there's a little more opportunity."

Another reason for the lacklustre development of new structured finance jobs has been the continued burden of regulatory change. Of most recent significance was the perceived setback in the EU's Capital Markets Union (CMU) plan after the original 5% risk retention proposal was challenged by Dutch MEP Paul Tang (SCI 9 June). The ECON Committee rapporteur instead proposed a 20% requirement, sparking bewilderment in the market.

The issue has been further compounded by Financial Services Commissioner Jonathan Hill's resignation in light of the UK's referendum result. Hill was one of the main architects and supporters of reinvigorating the European securitisation market through the CMU bill.

"A lot of the talk at IMN's annual Global ABS conference is just now centred on endless regulation, but at least the CMU looked like it had some momentum," the headhunter observes. "Now this just sets it back again and makes one wonder why more investors would bother to flood to the market."

Away from Europe, the US recruitment outlook continues to be a mixed bag. Dean notes that prior to the Brexit vote, recruitment on a broader basis had dropped this year, but he suggests that regional banks present the only real sign of any minor expansion in the structured finance space.

"There is one bank where something could still come to fruition with a team of potentially 10 people for sales and trading," he says. "It could happen in Q3, but even this is just a blip in the grand scheme of things."

He concludes: "Other than that, there was a play with asset managers on structuring whole loans, but that has withered too and the arbitrage has now gone there. So, everything seems to have lost a little momentum."

JA

Structured Finance

Damage control

Brexit hits European ABS recovery, capital markets reform

The UK's vote to leave the EU has caused untold damage to the recovery of the European securitisation market. Not only will issuance volumes suffer, but reform of the European capital markets via the CMU has also been set back significantly - both of which could limit the role that securitisation can play in economic regeneration and the reshaping of the financial system.

Mark Hale, cio of Prytania Investment Advisors, says that there are three key aspects to consider in connection with the impact of Brexit on the securitisation market - the UK-specific effects, the effect on Europe and policy developments relating to the future of the sector. The most immediate impact on the UK securitisation market is that the flood of issuance that had been expected post a Remain vote and prior to the summer holidays has been put on hold, due to the combination of uncertainty and market volatility.

Gordon Kerr, head of structured finance research in London at DBRS, confirms that a few deals have been delayed in the aftermath of the referendum result. "A surge of retained issuance could also occur as banks batten down the hatches. In the long term, we expect issuance to remain relatively muted," he says.

While the European securitisation market has been dominated by UK RMBS issuance this year, this dynamic has now been stymied, according to Hale. "Originators that do not rely on securitisation issuance for funding and can afford to wait for spreads to recover - not that UK prime RMBS has seen very significant widening - will be fine. It will be more difficult for challenger banks and specialty lenders, whose business models are more substantially built on securitisation, as accessing the market will likely become more expensive for some time and the whole loan market may also be affected."

Brexit may also deter cross-border investment in UK issuance, although anecdotal evidence from recent days suggests that US investor demand is increasing in some cases, due to the cheapening of UK assets and the sense that a wider market dislocation will yield more opportunities. More caution can be expected from Japanese investors, who are typically more sensitive to political changes, but there appears to be no reason why - should signs of stabilisation emerge - the dynamics that were driving them offshore couldn't resume.

At this stage, it is assumed that spread levels will eventually stabilise. "The overall driver is low returns in other asset classes and limited supply, which suggests that primary activity can pick up in time, providing deals are sensibly priced," Hale notes. Nevertheless, given the expectation of a more limited UK presence in the market, JPMorgan European securitisation analysts have revised their international ABS issuance forecast for 2016 to €60bn from €85bn.

Secondary markets
Notably, secondary market activity appears to be weathering the Brexit fall-out better than expected, to the extent that bids declined somewhat and offers often did not move much. Hale continues: "There hasn't been much visibility, but we've seen a number of BWICs circulate and prices have held up well. There hasn't been any panic or forced selling - just more of a spill-over effect from the turmoil in FX or equity markets. The securitisation market typically reacts quite slowly and there has been a sense of measured calm since 2009, in the case of UK assets, which is reinforced by the limited supply and stronger fundamentals in the last seven years."

Indicative spreads on sterling-denominated UK credit card ABS and prime RMBS are 22bp-23bp wider on the week (at one-month Libor plus 80bp and three-month Libor plus 110bp respectively) in the wake of Brexit, while 'riskier' non-conforming and buy-to-let bonds have widened by 32bp-33bp (to plus 185bp and 175bp respectively), according to JPMorgan figures. In comparison, Dutch RMBS and European auto ABS were each 5bp wider, and Spanish and Italian RMBS 18bp-19bp wider.

The JPMorgan analysts expect a more extensive re-pricing of UK and, to a lesser extent, peripheral risk to materialise over the next few weeks. In addition, credit curve and quality curve steepening could occur as higher quality senior risk outperforms.

Credit quality
Only a modest challenge to credit quality is anticipated in the short-term, but in the medium-term a more serious impact could materialise if there is a sustained rise in unemployment. "While the UK currently has a strong level of total employment and has been enjoying real wage gains, demand for labour is likely to slow and household incomes can be squeezed by higher inflation. A prolonged recession and weakened labour market would raise corporate defaults, constrain the level of consumer spending and cause a more material drop in house prices," Hale suggests.

Prytania projections continue to show the strong prime and buy-to-let RMBS that the firm favours can sustain a repeat of the last two serious downturns in the economy and house prices with ease. However, it remains cautious on more junior, non-conforming paper.

The analysts remain neutral on UK prime RMBS, UK credit card ABS and UK BTL across the capital structure, as well as UK NCF seniors, as they believe that better entry points to add risk will emerge. "However, newer vintage UK NCF subordinate bonds will be most adversely impacted by the outcome of the referendum, both from an initial technical and longer-term fundamental performance perspective. Accordingly, we recommend an underweight position in UK NCF subs and continue to prefer the BTL sector, which in our view remains better insulated from performance deterioration relative to NCF," they concur.

Should a prolonged period of economic weakness cause house prices to fall, mortgage market churn rates could decline and CPRs slow across the UK RMBS market, although performance is expected to remain tiered by programme type. UK prime RMBS in master trust format, with scheduled amortisation or bullet repayment structures, should remain most immune to slowing prepayment speeds.

In contrast, the European (ex-UK) securitisation market should see a continued slow recovery based on fundamentals and the support provided by the ECB. Kerr suggests that European collateral could also potentially be supported if jobs migrate from the UK to the continent. Similarly, while Brexit is expected to have a negative impact on UK commercial real estate - especially the London office segment - it again presents opportunities for Europe as businesses relocate.

On the political front, however, Hale suggests that secessionist and separatist movements in other countries had not been properly 'priced in' for both periphery and core countries in the run up to the Brexit vote. But, as with the UK, there is scope for policymakers to implement further monetary easing and other support measures if conditions demand them.

Regulation
Meanwhile, from a long-term perspective, the recent moves towards more securitisation-friendly European capital markets has been badly hurt by the UK exit and by the associated resignation of Financial Services Commissioner Jonathan Hill. "The unintended consequence of Brexit is a set-back in reforming the European capital markets. This is most concerning, given that securitisation can play a significant role in economic regeneration and the reshaping of the financial system," says Hale.

He adds: "There could eventually be a cathartic change of heart across Europe. But, for the moment, the referendum result has provided more power to those that are anti-reform and anti-securitisation. Having said that, there are a number of countries - such as Ireland, Holland and Sweden - that do not share the hostility to Anglo-Saxon capitalism in countries like France, and which may have to pick up the mantle of pushing the EU forward."

Kerr suggests that Brexit creates the potential to introduce new regulations that are supportive of UK issuance. "EU risk retention requirements will be in place until the UK actually leaves," he says. "If the UK adopts an alternative risk retention regime, issuers may still want to meet EU investor requirements. But there will always be demand from UK and US investors that wouldn't necessarily have such stringent requirements."

Specifically with regard to CLOs, it is unclear whether UK-based CLO managers can still be authorised under MiFID as sponsors after the country leaves the EU. This has raised questions about how to achieve EU risk-retention compliance for European CLO managers and whether the 'sponsor' route will remain viable.

One solution being discussed is for European CLO managers to relocate from the UK and to an EU member country. It is also possible that European managers will increasingly consider using the originator route to achieve compliance, according to Morgan Stanley CLO strategists.

The common presumption is that the UK will pull out of the EU completely and find itself in the worst of all scenarios, akin to Switzerland and Norway's situation (but without the gold and the oil). However, Hale counsels that it is unclear whether the UK will fully leave the eurozone and negotiations could ultimately lead to the country enjoying an 'EU-lite' status.

"The UK's flexibility to 'go it alone' and improve its competitive position in financial markets is limited: the regulatory environment is constrained by the need to accede to certain demands of the single market, such as passporting, and international regulatory initiatives like Basel 3 and Solvency 2," he explains. "However, if an accommodation isn't reached, regulatory arbitrage could emerge to some degree. The UK was the banking centre for Europe before the eurozone era and it could conceivably compete more aggressively, if necessary, potentially sucking business away from other over-regulated and over-taxed jurisdictions."

Policy implications
As yet, there is no clear political thought on what is feasible in the UK, but the policy outcome largely depends on the new government that will be formed by October. There could be displacement of activity to the UK if a reform-minded government takes over that, for example, cuts the corporate tax rate significantly further and lightens the regulatory burden on financial entities here. This may offset the damage that will inevitably result from EU efforts to 'repatriate' business from London to Frankfurt and Paris.

"At the margin, prudential and supervisory policy adjustments could be made available to soften a severe downturn. The UK government will have a hole in its finances post-Brexit, which - coupled with policy reconfigurations and regime change - could allow more creativity to emerge and some of the more damaging rules and regulations to be toned down," Hale indicates.

By contrast, a new government with a more 'Establishment' leadership may perpetuate what are seen as the often misguided policies of the last three administrations and be too timorous to deviate meaningfully from policies driven by Brussels.

Hale warns that the extent to which the UK's financial sector in general and trading in securitisation in particular is 'hollowed out' could also lead to a permanent lack of liquidity in Europe. "We've already lost significant financial and human capital since 2008 and further negative forces on liquidity would be extremely unwelcome."

He points out that a number of factors could positively impact liquidity, including supportive policy action in terms of the Bank of England cutting interest rates or resuming QE. "Additionally, longer-term dynamics could lead to more efficient intermediation of investor and borrower capital, some of which could find its way into the securitisation market. Online marketplaces and fintech platforms could continue being a growth story as bank activity remains limited. While this may not be the way all regulators would ideally like the market to evolve, they could have a passive tolerance of such disintermediation if it helps to address the constraints on bank balance sheets and concerns over their levels of leverage."

CS

Secondary markets

Euro secondary sidelined

Most participants are waiting on the sidelines in the European securitisation secondary market amid broad market volatility.

Two sessions on from the Brexit vote and liquidity remains thin across the board, but there is yet to be any sign of the tailspin seen in wider markets. Dealers in every sector widened their bids on Friday but other than some opportunistic buyers, particularly in UK bonds, there is little widespread desire to add currently as the Brexit story begins to play out. Equally, the majority of sellers look to be unwilling to relinquish bonds at current levels for now and are similarly holding back from re-entering the market.

In the end there were four BWICs yesterday involving CLOs and MBS across sectors and currencies. Aside from a handful of DNTs, where colour was released most bonds traded in the region of recalibrated expectations.

There is currently one BWIC on the European schedule for today. It is a 17+m original face five line UK buy-to-let RMBS auction due at 15:00 London time.

The list comprises: AIREM 2005-1X 2B2, AIREM 2006-1A 1A, AIREM 2006-1X 2A1, AIREM 2007-1X 2A1 and PARGN 11X A2B. Two of the bonds have covered on PriceABS in the past three months, last doing so as follows: AIREM 2006-1A 1A at 97.261 on 16 May and PARGN 11X A2B at 90.1 on 15 April.

Secondary markets

US CLOs silenced

The US CLO secondary market has been largely silent in the immediate aftermath of the UK's vote to the leave the EU.

"The issue was that a lot of people came into their desks on Friday morning with little information", says one trader. "The UK's decision to leave is an unprecedented move, so the market was left in unchartered territory and not completely sure how to react. Traders therefore took a wait and see attitude."

The top of the stack has been the main focus in reaction to last week's momentous events, the trader adds. "Accounts have been feeling out opportunities in triple-A territory. So, there's been a general flight towards quality up the stack, but at the same time people are mostly waiting to see how the volatility plays out"

The circumstances have prompted caution, but there is still cash on the sidelines waiting to come back in. "Some bid lists are coming today after it being quiet yesterday, but we are in a bit of a stand-off because people don't want to sell cheaply," the trader explains. "Nonetheless, I think there could be some good buying opportunities coming up soon as the market picks up again. I'd also expect to see some prints follow through lower down the stack."

There are three BWICs on the US CLO calendar so far today, including a chunky, three line triple-A auction at 14:00 New York time. The list comprises: $40m BLUEM 2014-4A A1, $30m BSP 2015-VIA A1A and $30m OCT23 2015-1A A2. None of the bonds has covered on PriceABS in the past three months.

Secondary markets

Euro ABS/MBS normalising

European ABS and MBS have been quick to shrug off Brexit worries, with activity building up again this week and more BWICs scheduled for today.

"The market seems to be over the shock of last week. There was a drop on Friday morning but things started trading again on Tuesday and yesterday was pretty much back to normal," says one trader.

He adds: "Today we are seeing more buying enquiries than sellers. It is going to be an active day, particularly as it is the end of 1H16."

The trader notes that prime paper has traded well this week. The market's quick return to normality has been aided by the absence of any forced selling.

There are currently two BWICs on the European ABS/MBS schedule for today. Both of which involve UK non-conforming RMBS.

At 14:30 London time there is a four line 15.61m euro and sterling mix. It comprises: CELES 2015-1 E, NGATE 2006-3X CB, RMAC 2005-NS1X M1 and THRON 2014-1 D. Only RMAC 2005-NS1X M1 has covered on PriceABS in the past three months - at 84.63 on 15 April.

At 15:00 there are a further four line items totalling £14m - MORGT 2014-1 A1, PMF 2015-1 A, WARW 1 B and WARW 2 B. Three of the bonds have covered on PriceABS in the past three months, last doing so as follows: MORGT 2014-1 A1 at 96.18 on 29 June; PMF 2015-1 A at 97.5 on 29 June; and WARW 1 B at 94.33 on 20 May.

In the primary market, Mercedes is expected to price its Silver Arrow 7 deal this week. The trader notes: "It is around €1bn of triple-A paper and we expect it to price a little wider than it would have done a couple of weeks ago, but still at decent levels."

Secondary markets

US CLOs rebounding

The US CLO secondary market has begun rebounding in the past few sessions after the caution seen immediately following the UK referendum result.

"The vote brought with it a lot of unknowns obviously, but we have seen some good volume over the last couple of days," says one trader. "Double-Bs had a couple of good names in for the bid yesterday that sold well, while some of weaker names like Limerock and Mountainhawk traded in the mid-to-high-50s."

However, most of the action has come at the bottom and top of the stack. "Equity has been strong - prices haven't dropped much," the trader notes. "It is a sign of the sector's robustness, which is particularly evident in the stronger names."

Meanwhile, the top of the stack saw some stronger named, second tier triple-A bonds trade a little wider Tuesday. "Some ALM paper traded at around 155 DM, but then Anchorage and Apollo were a bit weaker at 174 and 175 respectively," says the trader. "These would have been around 5bp to 7bp tighter before the referendum vote."

Looking ahead, the trader expects the referendum result's impact to be limited in the US CLO market. "Broadly, the market is quite temperate and there's a limited UK exposure. So this issue shouldn't become too profound unless a major recession is triggered."

The trader adds that a healthy supply and demand cushion in the market has enabled it to adapt to the current global situation. "There was a lot of money raised over the end of last year and the beginning of this - it was put on the side for moments like this and the proof has come in the healthy number of bids seen over the last two days."

There is currently only one BWIC remaining on the US CLO calendar today, due at 13:00 New York time the $3.795m three line triple-A list comprises: BABSN 2013-IA A, DRSLF 2013-28A A1L and TPCLO 2013-1A A1. None of the bonds has covered on PriceABS in the past three months.

Reclassification challenges outlined

A number of financial institutions have reclassified their structured finance books in accordance with IFRS 9, in order to carry out parallel runs in 2017. Although the formal implementation of IFRS 9 is not due until 2018, firms hope that the early implementation of infrastructure and audit trails may eliminate capital management and volatility of provisioning risks, which are more likely given the unique structures and idiosyncratic risk profiles found in structured finance securities.

"Failure to build and maintain a scalable and efficient IFRS 9 structured finance platform could expose SF investors to significant costs and potential errors in their IFRS 9 compliance programme," warns Moody's Analytics in a new report. "This can affect provisioning estimates and capital management, and ultimately impact shareholder returns."

IFRS 9, which replaces the current accounting standard IAS 39, will see a move away from incurred loss measurement to a forward-looking expected credit loss (ECL) measurement, based on changes to obligor creditworthiness (SCI passim). There are also changes to the way in which an asset is classified for financial statements. Under IFRS 9, assets will be classified according to their contractual cashflow characteristics and the business models under which they are held.

Challenges exist for structured finance investors relating to both the ECL calculation process and the classification of assets under IFRS 9. With these challenges in mind, Moody's Analytics has released two new reports that explore the specific challenges faced by SF investors.

The first report, entitled 'IFRS 9 Analytical and Reporting Solutions for Structured Finance', sets out a number of challenges that IFRS 9 poses for structured finance investors with regard to calculating the ECL. Specific challenges include the loss attribution characteristics of SF securities, which often reflect 'cliff effects' more dramatically than traditional fixed income instruments, such as corporates, financials and sovereigns.

Moody's Analytics notes that, in general, loss and return distributions of SF securities are unique and often not easily characterised by distributions used for more traditional fixed income instruments. "These 'cliff effects' could result from many different causes (for example, credit losses, barbelling of portfolio, thin mezzanine/subordinate tranches, triggers that trip liquidation/control rights etc that might need to be carefully considered in analysing SF securities," the report authors note.

Another challenge, says the firm, is the need to assess the possibility of default for purposes of determining a 'significant' change in credit risk. IFRS 9 paragraph B5.5.13 indicates 'changes in the risk of a default occurring over the next 12 months might be a reasonable approximation of the changes in lifetime risk of a default occurring'.

Moody's Analytics points out that for SF securities, the upcoming 12-month default rate is often not a good proxy of lifetime credit risk, given, for instance, the nature and longevity of residential mortgages. "That said, the 12-month rate might serve as a sufficient proxy for shorter-dated consumer debt, for example," the report says.

The report also highlights that the risk of default for certain types of SF securities is often back-ended and concentrated around optional call event timing or around maturity, notwithstanding often a very low impending 12-month probability of default. "Furthermore, many SF securities do not even recognise losses until their maturities," the authors say. "As such, the lifetime default rate is often generally a more appropriate proxy of credit risk than the 12-month estimated default rate for SF securities."

Additionally, there are numerous complexities involved in assessing how a financial asset should be classified under IFRS 9, particularly so for structured finance assets. The new accounting categories under IFRS 9 are amortised cost (AC), fair value through other comprehensive income (FVOCI) and fair value through profit and loss (FVTPL).

In order for an asset to be measured at AC or FVOCI, the asset's contractual cashflows must meet SPPI criteria (in other words, whether contractual cashflows are solely for payment of principal and interest). The nature of the business model in which the financial asset is held is also taken into account.

According to a study undertaken by Reinhard Klemmer, financial services at KPMG, fixed-rate instruments with a stated principal and maturity will typically meet the SPPI criteria. However, there will be assessment challenges for contracts that allow cashflows to change during the life of that instrument.

"Some loans and other financial instruments issued by a bank may contain complex features and clauses that make it difficult to determine whether contractual cashflows are SPPI," he notes. "Just asserting that a financial asset feels like a basic lending arrangement does not mean that it meets the contractual cashflow test in IFRS 9."

In Moody's Analytics' second report - 'Structured Finance Investments - Key Considerations and Challenges for Classification and Measurement' - the firm explains the new classification process in detail, particularly given the unique challenges SF securities are faced with in the SPPI test. The SPPI testing criteria for SF securities is especially complex in that it is applied at the deal, tranche and underlying asset level across numerous asset classes that are each individually governed by unique transaction documentation.

"Often, there is no getting around the need to review the deal documents, surveillance reports and other documents to test for SPPI," says the firm. "Given the lack of liquidity in the SF secondary markets relative to the more conventional fixed income markets, large demographics of the structured finance real money investor base are buy-and-hold focused, along with defensively managed books. This approach makes the SPPI test pivotal to continued classification."

The report includes a 'decision tree', offering investors a clear way to work out how to classify various structured finance assets under IFRS 9 (see Table 1).

Moody's Analytics explains that many institutions that currently classify their portfolios as 'available for sale' (AFS) under IAS 39 include banks, insurance companies and other active SF investor demographics. These investors, it notes, would typically classify part - if not all - of their SF portfolio under FVOCI to ensure a 'like for like' classification under IFRS 9.

Any FV movements less change in provisioning would be reported in other comprehensive income (OCI), while changes in provisions due to any FV movements would be reported in the P&L statement. FVOCI requires marking SF securities at FV, while the changes in FV flow through the OCI statement.

"As this calculation is not included in earnings, it does not impact volatility in earning per share (EPS)," the authors observe. "This change means that the effect of the overall FV movement is presented in separate sections of the income statement. After an asset classified via FVOCI is liquidated, then any gain or loss on sale switches from OCI crystallising into P&L."

The report also explains that a SF book is typically accounted for at AC when the business objective of the unit holding the securities is to collect contractually due principal and interest (P&I), which again could conceivably include the types of institutions mentioned above.

"AC only accounts for the change in provisions through P&L, so the book value (equal to the amortised cost) is unaffected by market pricing, leading to smoother asset values with less volatility," Moody's Analytics notes.

The firm concludes that SF investors that currently benefit from AFS or HTM classifications and are invested in predominantly senior and triple-A rated securities would be introducing more risks and volatility into financial statements, if these positions are later classified under FVPL. "Examples of these include market or credit risk in times of economic severity, or volatility in terms of adjustments for fair value into earnings for SFS currently marked near to par, for instance under AC."

AC

Source: Moody's Analytics

Structured Finance

SCI Start the Week - 27 June

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

Pipeline
Pipeline additions were limited last week. The only ABS was €1bn Silver Arrow 7, while the RMBS were RUB5.65bn JSC Mortgage Agent BFCO and US$209m Nationstar HECM Loan Trust 2016-2 and the single CMBS was US$737m SGCMS 2016-C5.

Pricings
Many more deals came out of the pipeline. There were 12 ABS prints as well as an RMBS, two CMBS and three CLOs.

The ABS were: US$1bn Cabela's Credit Card Master Note Trust Series 2016-I; €1.3bn Caixabank Consumo 2; US$175m Elara HGV Timeshare Issuer 2016-A; US$1.35bn Ford Credit Auto Owner Trust 2016-REV2; US$123m Golden Bear Funding Notes Series 2016-1; US$324.7m Harbour Aircraft Investments Series 2016; US$520m Navient Student Loan Trust 2016-4; US$111.15m North Mill Equipment Funding 2016-A; US$150m Oportun Funding III 2016-B; CNY4bn Rongteng 2016-2 Retail Auto Mortgage Loan Securitization; US$135m Sierra Auto Receivables Securitization Trust 2016-1; and US$379.8m SoFi Consumer Loan Program 2016-1.

US$400m NRZ Advance Receivables Trust Series 2016-T1 was the RMBS, while the CMBS were US$1.185bn FREMF 2016-K722 and US$300m Shops at Crystals 2016-CSTL. The CLOs were US$410m Anchorage Capital CLO 8, US$510m Ares XXXIX CLO and US$411m GoldenTree Loan Opportunities XII.

Markets
The UK's vote to leave the EU is likely to put the brakes on British issuances. For European ABS and RMBS secondary market prospects, JPMorgan analysts add: "Following the referendum, the entire ABS market repriced meaningfully wider. Within the UK, credit card ABS and prime RMBS widened by 22bp-23bp, while BTL and NCF spreads widened 32bp-33bp. Elsewhere, Spanish and Italian RMBS seniors moved 18bp-19bp wider, while the Dutch RMBS and European Auto ABS 'stalwarts' widened 'only' 5bp.

There was also a reaction in US CMBS, where the CMBX 6, 7, 8 and 9 indices opened substantially wider the day after the referendum. Morgan Stanley analysts note: "Triple-B minus indices [widened] out an average of 58bp from [Thursday's] close." They add: "The other indices opened wider by an average of 9bp for triple-A, 20bp for AS, 41bp for double-A, 49bp for single-A, and 72bp for boule-B."

Many markets were cautious in advance of the referendum, with the US CLO market quiet last Tuesday, as SCI reported (SCI 21 June). Tiering was still being seen but mezzanine paper was attracting healthy attention.

Editor's picks
Sufficient scrutiny?: The resignation of Lending Club ceo Renaud Laplanche and the subsequent disclosure of 'control deficiencies' at the platform shocked the marketplace lending sector. Investors have pulled back and getting them onside again is dependent on demonstrating that the market can be open and transparent...
Stepping up: Industry efforts to address the FFELP student loan ABS maturity issue have stepped up a gear with the launch of Nelnet's investor forum via the DealVector platform (SCI 17 June). The market received a further boost when Moody's released its updated FFELP student loan ABS methodology (SCI 15 June)...
Brexit effects: The immediate financial market reaction to the UK's decision to leave the EU has been pronounced, with spreads on senior financials and subordinated CDS indices higher by around 30bp and 70bp respectively. In the European securitisation secondary market, dealer bids were wider across the board at the open, but little trading was seen in the first few hours...

Deal news
• The US solar and PACE ABS market has been busy this week, led by Spruce Finance bringing the largest deal so far to encompass unsecured residential energy efficiency loans and retail instalment contracts. The US$83.78m dual-tranche Spruce ABS Trust 2016-E1 received investment grade ratings from Kroll Bond Rating Agency.
• VTB Capital has completed the first-ever single-tranche Russian RMBS, sponsored by Metallinvestbank. The RUB3.28bn deal offers a 10.25% coupon and will allow the bank to further develop its mortgage business.
• Moody's has downgraded the rating of the Navigator Mortgage Finance No. 1 €10m class C notes from Ba1 to Ba2. The move reflects the correction of an assumption in the cashflow modelling for the Portuguese RMBS deal, as well as a reassessment of the mitigating factors in relation to counterparty risk.
• The holders of a majority of the controlling class of Gramercy Real Estate CDO 2007-1 have selected C-III Investment Management as successor collateral manager. Should any noteholders wish to object to the appointment, they are requested to notify the trustee in writing by 21 July.
• S&P has lowered the ratings on 11 classes of notes from six US CDOs to triple-C from single-B, following the downgrade of MBIA Insurance Corp (SCI 17 June). The affected transactions are Coronado CDO, Fulton Street CDO, Mulberry Street CDO, Mulberry Street CDO II, Oceanview CBO I and Zohar II 2005-1.
• Yesterday's [Wednesday 22 June] CDS auction for Norske Skogindustrier ASA comprised four buckets, with 10 dealers submitting initial markets, physical settlement requests and limit orders to settle trades across the market referencing the entity. An auction in respect of Bucket 1 was not held, following the repayment of the €150m 11.75% senior unsecured notes due 2016 (SCI 17 June), and the final price was deemed to be 100.

Regulatory update
• The introduction of three significant regulatory changes over the past two months could have transformative implications for India's structured finance market, according to Moody's. A new tax regime is expected to lift post-tax investment returns from securitisation trusts, changes with regard to foreign portfolio investors (FPIs) should encourage foreign investment and changes to deal structures, while a new bankruptcy code will reinforce creditors' rights.

Deals added to the SCI New Issuance database last week:
Alba 8 SPV; Bavarian Sky China 2016-1 Trust; Benefit Street Partners CLO IX; Chase Issuance Trust 2016-3; Chesapeake Funding II Series 2016-2; COLT 2016-1; Foursight Capital Auto Receivables Trust 2016-1; FREMF 2016-KJ05; Golden Bear series 2016-1; Laurelin 2016-1; Spruce ABS Trust 2016-E1; Towers CQ; Venture XXIII CLO

Deals added to the SCI CMBS Loan Events database last week:
COMM 2012-CR1; CSMC 2006-C1; CWCI 2007-2; ECLIP 2007-2; JPMBB 2014-C22; JPMCC 2006-CB15; JPMCC 2006-LDP9; JPMCC 2007-LD11; JPMCC 2014-FL5; LBUBS 2004-C1; LBUBS 2006-C6; LBUBS 2007-C7; MBSAM 2015-C22; MLCFC 2007-5; MSC 2006-HQ9; MSC 2012-C4; UBSBM 2012-WRM; WBCMT 2007-C30; WBCMT 2007-C32; WBCMT 2007-C33

CLOs

UK CLO exposure examined

Morgan Stanley figures show that UK exposures account for 13.7% of European CLO 2.0 collateral. Variation among portfolios and managers is apparent, with the 25th-percentile deal exposure to the UK at 10.3% and the 75th-percentile deal exposure at 16.4%.

A Brexit-related recession would increase the risk of performance deterioration across the sector, although any negative impacts should be mitigated by factors such as the limited sterling exposure in European CLO portfolios, current high overcollateralisation across 2.0 deals and otherwise generally supportive trends for European credit. However, Bank of America Merrill Lynch European securitisation analysts note: "The risks to performance and pricing have clearly increased, in our view, and we expect to see increased price volatility - particularly for lower mezzanine and equity tranches. We believe credit and price tiering is also likely to increase across deals and managers."

European CLO 2.0 exposure to UK companies has remained stable over the last 12 months, with few signs of managers reducing exposure in the months ahead of the referendum. As of May 2016, 2.7% of European 2.0 collateral was sterling-denominated compared to 2.4% in May 2015, according to BAML.

The implications of the UK exiting the EU for different industries are unclear at this stage. But uncertainty over future trade negotiations impacts export-focused companies, for example, while domestic growth, employment and disposable income trends affect companies focused on domestic consumers.

The UK companies in European CLO 2.0 portfolios appear to be relatively concentrated in consumer industries, with around 48% in the consumer discretionary or consumer staples categories, BAML figures show. Materials (20%), technology (10%) and financials (8%) also account for significant proportions of UK exposures.

For aggregate European CLO 2.0 portfolios, exposure to the consumer discretionary and consumer staples categories account for 22% in total. Other significant exposures include materials (20%), communications (17%) and healthcare (13%).

The BAML analysts point out that some notable shifts in exposure are evident during the last 12 months. For example, exposure to the industrials sector has fallen from 12% to 9%. On the other hand, exposure to materials, technology and financials has generally increased in the period.

"We believe these shifts partly reflect the availability of collateral and trends in loan issuance. We believe this likely reflects a combination of trends in loan issuance, as well as managers implementing trading strategies based on their outlooks for different companies and industries," the analysts observe.

As of 24 June, the top three UK names in the European CLO 2.0 universe were Convatec, WP Midco3 and Magic Newco 5 - with 4.73%, 4.09% and 4.03% exposure respectively - according to Morgan Stanley. Among the top-held industries across UK exposures in European CLO portfolios, the retail industry raises a specific concern, according to Morgan Stanley CLO strategists.

Looking ahead, they suggest that while the option for European CLO managers to continue including UK assets will exist, investors are more likely to impose a tighter limit and therefore lower the net exposure to UK assets in CLO portfolios.

CS

RMBS

Settlement reinvestment options weighed

Current holders of non-agency RMBS from 512 Countrywide deals have finally received almost US$8bn in cash payments, five years after the original settlement (SCI passim). As investors look to put the cash back to work, Morgan Stanley analysts believe other securitised products would make a natural destination for reinvestment.

The Countrywide settlement covers breaches of certain representations and warranties as well as violations of prudent servicing violations. It covers 530 legacy Countrywide private label RMBS trusts, with US$7.7bn of the US$8.5bn settlement going to the 512 trusts receiving cash.

It is very likely that some proceeds will be reinvested into legacy non-agency RMBS, but the continued shrinking of that market could encourage investment in alternatives as well. Credit risk transfer deals would allow many investors to stay close to home, but that is a growing market which lacks the size and also potentially the liquidity of other options.

The analysts note that those who can invest in agency mortgage derivatives can find interesting opportunities within bonds in the GNMA sector. CMBS has several opportunities, while mezzanine tranches of CLOs could offer decent yields with good principal protection.

In favour of reinvesting in residential credit are strong technical tailwinds supporting secondary market pricing and robust fundamentals, with home price appreciation recently accelerating and delinquency rates continuing to fall. However, the analysts note that liquidity has dropped away and that amortisation has led to a growing share of low loan count pools.

Investors could stay in mortgage credit by investing in the credit risk transfer space, which diversifies away from the legacy residential credit market but still allows investors to make the most of the strong fundamentals supporting mortgage credit risk. The analysts identify CAS M2s and STACR M3s as attractive options.

Even controlling for LTV and FICO scores, credit risk transfer pool mortgages continue to outperform historical experience, so the last-pay M2 and M3 tranches are not expected to take losses. However, short-term volatility remains a market risk and steep capital requirements and unfavourable NAIC ratings have limited bank and insurance company involvement.

As for agency mortgage derivatives, unhedged bonds can offer up to 7% yield to forwards, although hedging is typically required. Bonds in the GNMA sector which may be exposed to more cuts in the mortgage insurance premium (MIP) along with bonds benchmarked off jumbo or high LTV collateral offer wider spread, while investors looking to take less risk might feel more comfortable in more stable derivatives off of loan balance paper.

There are many alternatives in the CMBS space, and the analysts highlight three that each offer yields of around 4%. First is 2.0 SASB mezz, second is 2.0 conduit double-A and single-A paper, and third is legacy AM paper.

2.0 SASB mezz trades at around swaps plus 250bp for seven-year duration. However, secondary market opportunities are limited as most investors are buy-and-hold.

2.0 conduit double-A and single-A bonds offer 3.5%-4.5% yields and have significant credit enhancement. Meanwhile, 2006 and 2007 vintage AM bonds which were originally rated triple-A but have since been downgraded can offer yields of up to 500bp over swaps for durations inside of two years.

In the CLO space, mezzanine tranches offer several opportunities. "We find sizable investment opportunities of 5+% yield in CLO mezzanine tranches rated triple-B or below, in both long-dated CLO 2.0 paper from more recent vintages and shorter-dated ones from deleveraging CLO transactions. We estimate the total size of such investment opportunities to be US$36bn in the US, and expect another approximately US$2bn to come from new issue deals in the second half of 2016," say the analysts.

Most CLO triple-B and double-B tranches with good credit enhancement are unlikely to lose principal even if defaults increase meaningfully, while investors can also choose bonds with a range of WALs. However, there is some downgrade risk and liquidity for CLO mezzanine tranches is lower than for comparably rated corporate credit bonds.

JL

RMBS

New York foreclosure boost

New York Governor Andrew Cuomo last week signed a series of laws that could have a sweeping impact on the foreclosure process in the state of New York, according to Morgan Stanley RMBS strategists. In particular, the legislation establishes a pre-foreclosure duty to maintain on mortgagees and creates an expedited foreclosure process for vacant and abandoned houses.

Under the new law, a bank/servicer has a duty to maintain and secure a residential property where it has a reasonable basis to believe it is vacant and abandoned. If they fail to do so, the mortgage owner faces civil penalties up to US$500 per violation, per property, per day.

"Previously, the mortgagee only had the responsibility to maintain a vacant property once a judgment of foreclosure and sale was obtained. In New York, substantial foreclosure timelines invite the possibility that a significant number of properties could currently be subject to these fines," the Morgan Stanley strategists observe.

A 2015 New York Department of Financial Services report on New York's foreclosure process found a number of delays in the length of time from the filing of the foreclosure action to the entry of judgment of foreclosure and sale, ranging anywhere from 650 to 900-plus days, depending on whether the property is in 'Upstate' or 'Downstate' New York. Roughly 31% of homes in Upstate New York start the foreclosure process vacant or become vacant at some point during the process, while this is the case for 8% of homes in Downstate New York.

The strategists believe that if the new legislation incentivises servicers to work through their delinquency queue in the state of New York more quickly, the impact could be acutely felt in the legacy non-agency RMBS sector. While option ARM deals appear to be comparatively sheltered from increased CDRs in the state of New York, mortgages from the state make up over 10% of the outstanding balance of the subprime universe and close to that amount of the Alt-A universe. New York mortgages are also overrepresented within the delinquency queue, as roughly one in five seriously delinquent Alt-A and subprime mortgages are in New York state.

CDRs in New York state have been increasing towards CDR speeds across the rest of the US for over a year and this new law could push them even higher, according to the strategists. "Any shift in mix towards New York among liquidated mortgages would likely lead to higher loss severities, especially if the homes being liquidated are vacant properties that servicers have neglected to maintain, thereby damaging potential recovery value. While the rest of the country is seeing loss severities improve - if not at least remain level, as home prices improve - loss severities in New York have been moving in the wrong direction," they conclude.

CS

RMBS

Countrywide cash benefits 'broad'

Holders of 512 legacy Countrywide deals receiving allocated shares of US$7.7bn in settlement proceeds are not the only beneficiaries of that settlement, say Morgan Stanley analysts. The massive paydown has also put many more bondholders into better positions in terms of credit enhancement and outstanding principal balance.

By the terms of the Countrywide settlement agreement, once investors have received their allocable share, the trustee must then "allocate the amount of the allocable share for that covered trust in the reverse order of previously allocated realised losses", to increase the current balance of bonds to which realised losses had previously been allocated. This means bonds which had previously received losses have been written back up and other bonds further down the stack have seen credit enhancement increase significantly.

As an example, in CWL 2005-AB1, the A3 bond was the sole recipient of the allocable share from the settlement, but was not the sole beneficiary. Due to the paydown of the A3 bond, the M1 and M2 bonds have picked up around 23 additional points of credit enhancement.

"The M3 bond went from being written down to a factor of 36.5% to being written all the way back up to its original balance and having 12.8% of credit enhancement. The M4 bond, previously written down to US$0 in March 2013, now has a factor of 75.4% and is due interest on that certificate balance upon the deal's next distribution date in July," note the Morgan Stanley analysts.

Further, more cashflow from healthier borrowers remaining in the pools could now be distributed to bondholders further down the capital structure than would previously have been anticipated. The CWL 2005-AB1 A3 class received as much principal in June as it had done in the previous 21 months combined.

"Concurrently, the underlying mortgages for this deal have not changed - June prepayments and defaults notwithstanding. It follows that the mortgages from which the A3 bondholders were planning on receiving cashflows are now more likely to flow to the M1, as the month where its principal window opens has now moved forward substantially. The M3 and M2 bondholders, while still years away from receiving unscheduled principal payments, are now the beneficiaries of far more credit enhancement," add the analysts.

Looking beyond the settlement cashflow to the fundamental performance of the Countrywide mortgages, most products and vintages prepay more slowly than the rest of the residential credit universe, while default rates and loss severities are also elevated. The analysts do not expect Countrywide VCPRs to close the gap with the rest of the deals in the legacy residential credit space.

JL

Structured Finance

Energy expert picked up

Crédit Agricole has appointed Gerard Vincitore as md in its structured finance advisory group for the Americas. He joins as part of the bank's larger corporate and investment banking arm, where he will head up advisory activities in the North American power and utilities sector and be involved in specific energy-related transactions in the Americas.

Prior to joining the bank, Vincitore was a financial executive with the New York Power Authority, where he was svp of corporate finance. His responsibilities involved identifying, evaluating, structuring and supporting the implementation of the public authority's initiatives. These included new generation and transmission projects, customer financial offerings and energy policy projects.

Structured Finance

Barclays boosts credit team

Barclays has recruited Michael Khouri as md and a member of its credit trading team in London. He will join the bank in late September and report to Dan Friedman, head of European high yield and distressed credit trading.

Khouri previously held various senior roles at Morgan Stanley, most recently as head of European distressed trading and global risk. He has also worked at Lehman Brothers and Jefferies, the latter at which he traded European high yield and distressed credit.

Structured Finance

Rating agency increases reach

Scope Corporation is set to acquire FERI EuroRating Services, effective from the start of August. The firm intends to establish itself as the European alternative to the US rating agencies.

Scope Group intends to spread its business across three areas under Scope Corporation. Scope Ratings will be responsible for all credit rating activities; Scope Analysis will be in charge of analysing investment funds, asset managers and investment markets; and Scope Investor Services will offer individual system solutions to institutional investors for the monitoring and risk management of their portfolios.

The acquisition of FERI EuroRating will give Scope access to areas that it has not previously covered, helping to consolidate the fragmented European rating market. Scope is gaining additional core competencies in sovereign credit ratings, real estate research and fund analysis.

Structured Finance

LatAm expansion inked

DBRS has opened a new office in Mexico City as part of its ongoing global expansion program. The agency has named Salvador Cruz svp, country manager and head of business development for Mexico, and Luis Alvarez vp, global compliance officer and regulatory counsel for Mexico.

Cruz began working at DBRS in early January 2016 and reports to Sean O'Connor, md, head of the global business development group. He previously worked at Scotiabank and its predecessor Casa de Bolsa Inverlat. His most recent position was head of global transaction banking for Latin America at Scotiabank, working in the company's Mexico City and Toronto offices.

Alvarez joined DBRS in March 2016 and reports to Brian Weiss, svp, chief compliance officer. He previously worked at HSBC and Santander Mexico. Most recently, he was head of compliance for the Mexico office and coordinator for the regulatory affairs operations for Argentina, Brazil, Chile and Uruguay.

The new operation, DBRS Ratings Mexico, has received authorisation from the Comisión Nacional Bancaria y de Valores to issue credit ratings within Mexico. The agency already issues a sovereign debt rating for Mexico (BBB (high) with a stable trend) under its global sovereign ratings group.

CLOs

CLO trading head hired

Nirjhar Jain is set to join Guggenheim Securities' structured products group as an md, based in New York. He will serve as head of CLO trading, reporting to structured products co-heads Scott Levy and Eric Voelker.

Jain moves from TIG Securitized Asset Fund, where he was the senior portfolio manager focusing on CLOs. Previously, he served as managing partner at Plus Funding Group. Prior to that, he served as head of structured products credit trading at Morgan Stanley and held various positions in the structured products trading group at Deutsche Bank, having begun his career at Lehman Brothers in 2002.

Risk Management

Exchange offer launched

Markit has commenced an offer to exchange any and all of the outstanding US$750m aggregate principal amount of 5.000% Senior Notes due 2022 issued by IHS for up to an aggregate principal amount of US$750m of new 5.000% Senior Notes due 2022 to be issued by Markit and cash. For each US$1,000 principal amount of existing IHS notes tendered, eligible holders could receive US$1,000 principal amount of new IHS Markit notes and US$5 of cash. The purpose of the exchange offer is to promote a more efficient capital structure following the merger of the two firms (SCI passim).

Markit is also soliciting consents from eligible holders to adopt certain proposed amendments to the indenture under which the existing IHS notes were issued that would eliminate certain of the covenants, restrictive provisions and EODs. Eligible holders may not deliver a consent without tendering existing IHS notes in the exchange offer. If an eligible holder tenders existing IHS notes in the exchange offer, it will be deemed to be delivering its consent.

Holders who validly tender their existing IHS notes before 11 July will be eligible to receive the total exchange consideration, which includes an early tender premium of US$50 principal amount of new IHS Markit notes. Eligible holders who validly tender their existing IHS notes after that date but before 25 July (unless extended) will receive only the exchange consideration of US$950 principal amount of new IHS Markit notes and US$5 in cash.

ABS

Cross-border first for Korean ABS

Hyundai Commercial has completed the first cross-border cash securitisation of auto loans to obligors in Korea. The US$250m Top Commercial Auto I ABS has two equally-sized tranches of floating rate notes, each rated Aaa by Moody's.

The underlying pool only includes loans to purchase new commercial vehicles and the transaction benefits from several sources of credit enhancement, as well as strong interest alignment, as the originator retains the entire subordinated piece of the structure. There are also cross-currency swaps to mitigate for the mismatch between the won-denominated loans and US dollar-denominated notes.

ABS

Solar value proposition discussed

KBRA says that the phenomenal recent growth of distributed solar photovoltaic (PV) generation in the US is largely due to the increasing affordability of solar - with PV systems now priced at approximately US$3.5/watt, a reduction of more than 50% in the past five years - and solar developers offering creative financing mechanisms, such as power purchase agreements (PPAs) and leases. The agency believes that the economic interest of solar contracts is one of the most important drivers of future performance, based upon the assumption that customers will continue to purchase electricity from a solar PV system, so long as it is cheaper than the local utility.

The installed capacity of grid-connected residential PV generation systems has increased by over 136% in the last two years, to 4,931MW as of March, according to the latest US Energy Information Administration statistics. The industry has benefited from favourable regulatory rules that have contributed to the growth of renewable energy, such as the federal government's solar investment tax credit (ITC), renewable portfolio standards (RPS) and retail rate net metering.

However, KBRA believes that the economics of solar generation is likely to change as RPS thresholds in certain states have been met, government-supported programmes are scheduled to expire and potential changes to net metering could affect reimbursement rates for excess power. The agency adds that widespread incorporation of regulations similar to those developed by Nevada (SCI 11 January) will be negative for the distributed solar sector, as the value proposition declines with adverse changes to net metering rules and increased fixed charges.

"It's likely that solar developers will cease business in states that incorporate these measures, as the attractiveness of distributed solar is limited. KBRA would expect developers to continue to service existing systems in these states. In the event a solar company was unable to continue to maintain the systems, KBRA would expect a third party to take over the operation, management and servicing of the solar platform (which is an underlying assumption in all solar transactions that KBRA has rated)," the agency observes.

If changes to net metering rules are grandfathered for existing customers, the economic proposition of outstanding solar contracts will only be affected by utility rate adjustments in the ordinary course. However, the retroactive application of new net metering rules and incorporation of larger fixed charges for solar customers will fundamentally change the economics of existing solar contracts and will likely result in a higher-than-expected percentage of solar customers either renegotiating their solar contracts or selectively defaulting. Both of these outcomes would negatively impact the performance of outstanding solar ABS.

Most utilities are not taking such a radical stance as Nevada. For example, Austin Energy developed methodologies that net meter at a new 'value of solar' rate that considers not only the energy value of the electricity provided, but also the value of the avoided costs and other savings provided by the solar PV system. As methodologies for measuring the true value of distributed solar energy continue to be developed, Austin Energy's approach may prove to be a credible compromise in the debate over how to best capture the cost and value of distributed solar, according to KBRA.

The agency suggests that the installed cost of solar power will need to continue to decline in order for distributed generation to be economic without subsidies or regulatory support. Variables that could further reduce the value proposition of distributed solar, if excess electricity generation is purchased at wholesale rates, include: properties consistently producing excess electricity that is fed back into the grid; a large mismatch between solar generation and customer consumption; customers spending long periods of time away from a property, resulting in the purchase of PV electricity at the solar contract price, which is then sold to a utility at potentially lower wholesale rates; contracts with high annual escalators that could outpace changes in retail utility prices; and changes in seasonality, resulting in large fluctuations in electricity production, with more power being produced and sold at wholesale rates during the summer months.

KBRA argues that solar customers may reduce the impact of regulatory changes by modifying their load profile to use a larger portion of the electricity generated by solar or investing in batteries to store solar electricity for use at night, thereby reducing the amount of electricity purchased from the grid.

ABS

Cross-border ABS prepped

Engenium Capital is in the market with a cross-border Mexican equipment ABS. Dubbed Engenium Capital Equipment Dollar Trust, the US$340.5m single-tranche deal is backed by a revolving pool of equipment leases and loans originated in Mexico with the notes denominated in US dollars.

S&P has assigned a preliminary triple-B plus rating to the notes due in 2026. The collateral pool consists of 923 contracts with 249 obligors, with concentration limits of 6% for the largest obligor, 4.25% for any single obligor and 22.5% for the five largest obligors. With respect to industry concentration, the indenture has a limit of 25.5% for the single-largest industry.

As of the 31 May 2016, the collateral pool had a net present value (discounted at 6.5%) of approximately US$414.06m in equipment loans and leases, with approximately US$8.18m comprising 50% booked residual values for transportation equipment only. The issuer is a trust organised under Mexican law, established to acquire the assets from the originators, enter into the documentation related to the issuance, issue the notes, manage the trust estate and pay all amounts due under the notes. The assets will be originated and serviced by Engencap, Engencap Fin, SOFOM ENR and Engencap Holding (formerly GE Capital Mexico's equipment loan financing business).

The transaction structure includes a master collection trust held in Invex into which obligors will deposit their payments in US dollars, which will in turn transfer on a daily basis the collections to the issuing trust accounts held by Bank of New York Mellon, so that it can use the proceeds to make the payments on the notes.

Structured Finance

ESMA reviews harmonisation issues

ESMA has released a peer review which pinpoints areas for greater EU harmonisation among national securities regulators. The review notes that regulators are sufficiently resourced and have approved prospectuses within legal deadlines, but suggests further convergences would be beneficial.

The review, covered between January 2013 and December 2014, found that prospectuses have been seen as often complex and difficult to understand for investors. The main concerns included their length, the format of the summary section, and the amount and manner in which information is incorporated by reference. Another key finding is that national regulators are applying different interpretations of certain disclosure requirements - an area where ESMA views harmonisation as a potential remedy.

Further, approval times vary substantially among regulators, but the driving factors behind this largely fall outside of the regulators' responsibilities. These factors include the quality of the first draft that the regulators receive, the issuers' response times to queries and the complexity of the issuers' circumstances.

There has also been concern surrounding the seasonal nature of prospectus approvals. These have led to concerns being raised that regulators could struggle to handle high volumes of documents while maintaining rigorous scrutiny during peak periods.

ESMA says that it will apply its findings towards its supervisory convergence work and treat it as a priority over the next four years. The regulator highlights the intelligibility of prospectuses, the disclosure of risk factors and the interpretation of certain requirements as particular areas of focus.

The EU's Prospectus Directive is currently being revised under the European Commission's Capital Markets Union project. ESMA believes this directive may well address some of the legislative clarifications that its review has identified.

Structured Finance

Debut cell phone deal nears

Fitch has assigned preliminary ratings to the first securitisation to be backed by cell phone contracts in the US. At the top of the capital structure, the US$1bn of class A notes in Verizon Owner Trust 2016-1 have been assigned an expected triple-A rating.

The deal also comprises US$84.52m double-A rated class B notes and US$84.51m single-A class Cs. S&P is also expected to assign preliminary ratings to the deal.

The transaction's pool consists entirely of device payment plan agreements with 24-month original terms, all originated by Verizon. The pool comprises an average FICO score of 708 and a weighted average remaining term of 22 months.

The strong preliminary ratings that Fitch has assigned are due to a number of factors, including strong servicing capabilities. Cellco Partnership will service the pool of receivables and brings a long track record of servicing such contracts.

Bank of America Merrill Lynch, Barclays and Mitsubishi UFJ are lead managers on the deal.

Structured Finance

SF upgrades keep momentum

The global structured finance upgrade rate reached a record high in 2015, according to S&P. Although the downgrade rate was still higher at 11.2% last year, the upgrade rate increased to an all-time high of 9.8% in 2015 and a jump from 8.4% in 2014.

Downgrades were up from 10% in 2014, but still presented a slow-down in growth for all but one of the previous seven years. The default rate was also only 4.2% in 2015, flattening off after three years of decline.

Simultaneously, Fitch also notes in its own findings that upgrades outpaced downgrades in 2015 for the second consecutive year. The agency last recorded two straight years of positive rating activity back in 2005 to 2006. The share of ratings affected by downgrades declined to 3.8% in 2015 from 6.7% in 2014, while upgraded ratings declined to 8.4% from 11.5% a year earlier.

Credit performance continued to diverge between asset classes and regions, according to both agencies. S&P says that most downgrades continued to occur in US RMBS, but European CMBS and RMBS saw higher downgrade rates.

In contrast, both the US and European structured credit sectors - including transactions, such as synthetic CDOs and CLOs - exhibited strong credit performance. These saw double-digit upgrade rates, mainly due to structural amortisation in more seasoned cash transactions.

Meanwhile, the two largest sectors outside the US and Europe - Japanese and Australian RMBS - performed well in 2015. Neither witnessed any defaults and downgrade rates hovered around only 3%.

Fitch identified varied stability rates across all major regions, but all remained at a high level. This was led by the APAC region (at 96%), followed by North America (88%) and EMEA (84%).

On a global perspective, Fitch says that ABS continued to display a positive rating drift in 2015. The ABS downgrade rate of 1.1% was below the 3.7% rate in 2014 and the lowest since 0.9% in 2007.

In addition, global CMBS recorded largely positive rating activity in 2015. The 3.4% share of ratings downgraded trailed those upgraded (7.2%), similar to 2014.

Structured Finance

Madden uncertainty to continue

The US Supreme Court has denied certiorari in the Madden vs Midland Funding case, electing not to review a Second Circuit decision that found state usury laws applied to debt that had been purchased from a national bank (SCI passim). The decision is expected to prolong the legal uncertainty related to the marketplace lending and securitisation industries.

Other circuits are not anticipated to adopt the reasoning of the Second Circuit - in part due to the arguments made by the Solicitor General - but the appellate decision stands as good law in New York. "The case will return to the district court for further consideration of other issues and there is reason to believe that the outcome there may be favourable for the financial services industry, due to a choice of law issue, which remains to be decided. For the foreseeable future, parties can be expected to structure their arrangements in an attempt to distinguish the Madden decision from their transaction - though it is not clear how best to do that," observes Vincent Basulto, partner at Richards Kibbe & Orbe.

The decision nevertheless opens the door for further lawsuits to be brought against marketplace lenders. Indeed, the Supreme Court yesterday allowed a class-action lawsuit against debt collector Encore Capital Group to move forward, following the denial of cert.

Joseph Cioffi, chair of the insolvency & financial institutions practice group and partner at Davis & Gilbert in New York, says: "Not only are marketplace lenders at risk, but so will be the sponsors and other participants in the securitisation of marketplace loans to the extent loans are held unenforceable or interest rates are reduced. Experience shows that when cashflows to investors are reduced, litigation follows."

Structured Finance

UK sovereign-linked deals downgraded

Fitch has downgraded 18 tranches, and placed another two on rating watch negative, from six transactions which are credit-linked or have significant direct credit exposure to the UK sovereign. The rating actions follow the downgrade of the country's long-term issuer default rating to double-A earlier this week.

Annington Finance No.1 and Sceptre Funding No.1 rely entirely on rental payments from the central UK government for note repayment, and both were downgraded from double-A plus to double-A. The Honours and Chepstow Blue indirectly rely on payments or guarantee from the state, and the class A1 and A2 notes of each were downgraded from double-A plus to double-A.

Leek Finance 18 and 19 both had UK government gilts added to their collateral portfolio as part of a June 2011 restructuring, so the class B and C notes in Leek 18 and classes B, C and D notes in Leek 19 have all been downgraded from double-A plus to double-A. Class M notes in Leek 19, currently rated double-A plus, have been placed on rating watch negative.

CMBS

CMBS liquidations move up

US CMBS liquidation volume was below the 12-month average in June, according to Trepp. Disposition activity reached US$809.3m for the month, which is below the US$902.9m average but up from US$501.5m in April and US$854.5m in May.

The average loan size liquidated also dropped to US$10.1m across 80 loans, below the US$13.4m average figure over the past 12 months. In addition, seven loans worth a total of US$66.4m were resolved with losses of 100% or more. This included a relatively small B-note with a remaining balance below US$1m.

The largest loan disposed of in June was the US$40.3m Riverview Square, with a 77.68% loss severity. The occupancy of the East Harford, Connecticut office building that backed the note dropped to 37% after the property's main tenant, the State of Connecticut, vacated at the end of its lease term in October 2015.

Two other loans liquidated with heavy losses - the US$35.8m Steeplegate Mall and the US$27.6m Severance Town Center (see SCI's CMBS loan events database) - were resolved with 82.29% and 72.51% in losses respectively. Both loans were originated in 2004 and were collateralised by retail properties that are currently REO.

June loss severity spiked to 53.9%, which is a 20bp increase from the previous two months. Loss severity for April and May was lower due to several large loans paying off with less than 2% in losses. Looking only at June losses greater than 2%, total volume was US$727.7m, with a 59.84% loss severity.

CMBS

Freddie K-series defeasance soars

Close to 30% of Freddie Mac K-series eligible first mortgages have either defeased or taken on supplemental debt, says Kroll Bond Rating Agency. Out of 75 rated five-, seven- and 10-year K-series fixed rate transactions with a current outstanding principal balance of US$97.9bn, 8.6% have defeased and 19.9% have taken on supplemental debt.

To be eligible for defeasance, first mortgages must have seasoned two years from date of securitisation. Eligibility for supplemental debt typically occurs one year from the first mortgage's loan origination date.

"Defeasance and supplemental debt accelerated through 2015 as rent and property values climbed. This trend continued for defeasance through the first quarter 2016, which was up 50% year over year," says Kroll.

During that same period, supplemental debt actually fell 16%. Those property owners selecting defeasance may believe that property prices are at or near the peak and gains should be locked in through a sale or refinance. Those seeking supplemental debt may believe there is further space for property appreciation, but have turned more cautious and hesitant to re-leverage existing equity, reasons the rating agency.

CMBS

Special servicer transfers accelerating

Fitch has observed US CMBS loans transferring to special servicing at an accelerated pace through the first six months of this year. The agency expects this trend to continue for the remainder of 2016.

At year-end 2015, Fitch identified approximately US$65bn of conduit loans scheduled to mature in 2016. Of that amount, US$10bn was already defeased and US$11bn was already defaulted. Across the remaining US$44bn, over 90% were from loans securitised within the 2006 vintage (accounting for US$33bn) and 2007 vintage (US$7bn).

Following an analysis of its rated universe of 2006 and 2007 vintage conduit loans that transferred to special servicing this year, the agency notes that these transfers (through mid-June) represent approximately US$4.5bn across 203 loans. This is approximately 11% of all non-defeased and non-defaulted loans from the 2006 and 2007 vintages scheduled to mature in 2016. The total for just the 2006 and 2007 vintages this year is already approaching the US$5bn figure from last year that includes all transfers to special servicing in 2015.

The pace of loan transfers peaked in March and April, with nearly US$1bn and US$1.6bn of 2006 and 2007 vintage loans respectively transferring to special servicing. Office loans accounted for the largest portion of transfers at over US$2bn, followed by retail (US$736m) and multifamily (US$671m).

Of the US$4.5bn of 2006 and 2007 loans transferring to special servicing through mid-June this year, approximately 14% (accounting for US$621m across 38 loans) have already been liquidated, as they likely only needed additional time to sign tenants and/or secure financing. The average loss severity has been relatively low, according to Fitch, with the majority of these liquidated loans - with an average loan size of US$16m - experiencing losses from special servicing fees.

Of the remaining US$3.8bn - made up of 165 loans, ranging in size from US$645,000 to US$474.6m - still with the special servicer, approximately half of the loans by balance have debt service coverage ratios (on a net operating income basis) of less than 1.25x. One-fifth of these loans currently do not cover debt service, based upon the most recent servicer-reported information and will need additional equity in order to refinance or will likely incur losses. As many of these loans have been underperforming for some time, these losses are factored into Fitch's ratings.

CMBS

JQH exposure eyed

Last Sunday's John Q Hammons Hotels & Resorts bankruptcy protection filing is being closely monitored by Kroll Bond Rating Agency. The rating agency has identified five loans across 10 CMBS with an aggregate balance of US$690m that are impacted by the filing.

Kroll rates four of the 10 securitisations. No ratings are being put on watch at this time.

The four transactions are exposed to two loans. One is a pari passu split loan that was securitised in three of the four deals, as well as a fifth not rated by Kroll. The Kroll-rated transactions are GSMS 2015-GC34, GSMS 2015-GS1, CGCMT 2015-GC35 and WFCM 2015-C26, with exposures to John Q Hammons ranging from 3% to 8.5%.

Insurance-linked securities

Acorn Re notes affirmed

Fitch has affirmed Acorn Re Series 2015-1's US$300m class A notes at double-B. The rating agency believes the notes and indirect counterparties are performing as required and adds that there have been no reported early redemption notices or events of default, nor have there been any reported covered events within the risk period.

The notes, which provide reinsurance protection to Hannover Rueck, are exposed to earthquake risk in several US and Mexican states as well as the Canadian province of British Columbia. They are due to mature in July 2018.

RMBS

RFC issued on front-end CRTs

The US FHFA is seeking input in response to two new reports it has released on Fannie Mae and Freddie Mac's credit risk transfer (CRT) programmes. One of the reports sheds further light on single-family CRTs, in an attempt to assist the GSEs in their analysis of front-end transactions.

The document seeks feedback from stakeholders on specific proposals to adopt additional front-end structures, such as a deeper mortgage insurance structure, as well as on other CRT policy issues. The other report documents the status of the GSEs' transactions and their volume through year-end 2015.

"The CRT progress report demonstrates transparency and documents that there has been a great deal of progress in the CRT market in a short period of time, even though the market is still relatively young," says FHFA director Melvin Watt.

The FHFA says that interested parties must provide feedback on the report and its proposals by 29 August.

RMBS

Freddie starts RPL sales

Freddie Mac is offering its first structured sale of seasoned loans by offloading a US$199m pilot deal from its mortgage-related investment portfolio. The collateral consists of option adjustable-rate mortgages or similarly originated loans that have since been modified under a HAMP or proprietary modification.

The two-step process will first involve the sale upon the result of a competitive bidding process, subject to a securitisation term sheet. After due diligence is undertaken on the loans, the purchaser will then be obliged to securitise the loans, with Freddie guaranteeing and buying the senior tranches. However, the first loss subordinate tranche will be initially retained by the loan purchaser.

The majority of the loans, which are currently serviced by JPMorgan, have payment histories that are less than six months current or are moderately delinquent.

Freddie stresses that a key requirement of the transaction be that the buyer of the subordinate tranche is an investor with 'substantial experience' in managing 'high-risk' mortgage loans. This experience should also extend to securitisations.

The servicing of the loans will be in accordance with the requirements applied in Freddie's NPL sales. Credit Suisse, JPMorgan and First Financial Network are assisting the GSE in the transaction.

RMBS

Chinese RMBS announced

Postal Savings Bank of China (PSB) is prepping a RMB3.82bn RMBS called Jiamei 2016-1. The transaction is backed by 9,441 first-ranking Chinese full-documentation mortgage loans with a weighted average loan-to-value ratio of 57.8%.

Fitch has assigned expected ratings to the deal, which comprises: RMB500m single-A plus rated class A1 notes; RMB900m single-A plus class A2s; RMB1.91bn single-A plus class A3s; RMB156m triple-B class Bs; and RMB353m unrated subordinated. The tranches are a mix of fixed and floating rate notes, and will be issued by CITIC Trust in its capacity as trustee.

The ratings of the class A1, A2 and A3 notes address the timely payment of interest and ultimate payment of principal, while the rating of the class B notes addresses the ultimate payment of interest and ultimate payment of principal, according to Fitch. The agency has capped the rating of this transaction at single-A plus, reflecting the limited history for housing loans and RMBS in China and the limited data set available for analysis.

Fitch says it derived a single default probability assumption for PSB loans from historical data provided by PSB, as well as publicly available data from other Chinese banks and RMBS transactions. The agency adds that it is comfortable that eligibility criteria for the transaction ensure that the securitisation will perform at least as well as the total PSB portfolio. Loss severities were derived from historic national property price data and made specific to the location of each security property.

The weighted average seasoning of the pool is 2.43 years and the average current loan size is RMB404,266. There are no interest-only loans and all loans are fully amortising and are limited to a maximum 70% initial LVR.

Haitong Securities Company and China Post Securities are co-leads on the deal.

RMBS

Freddie hits ACIS milestone

Freddie Mac has recorded its largest purchase to date under its Agency Credit Insurance Structure programme, obtaining three policies that provide up to a combined maximum limit of US$788m for losses on single-family loans. The policies transfer much of the remaining credit risk associated with the GSE's three STACR issuances this year, STACR 2016-DNA2, STACR 2016-HQA2 and STACR 2016-DNA3.

These transactions transfer a significant portion of mortgage credit risk on approximately US$75bn of unpaid principal on single-family mortgages. Freddie Mac has now placed over US$5bn in insurance coverage through 20 ACIS transactions since it launched its programme in 2013.

Aon Risk Solutions and Aon Benfield assisted the GSE in the transaction. "After a period of educating insurers and reinsurers on US mortgage credit risk, we have found they have become comfortable and very receptive to this new line of business," says AON Benfield ceo Eric Andersen.

RMBS

MBIA-wrapped RMBS hit

S&P has lowered its ratings on 112 classes from 58 US RMBS transactions. The affected securities are insured by MBIA Insurance Corp, apart from six, which are re-REMIC notes that have their underlying bonds insured by MBIA.

The rating actions follow the downgrade of S&P's financial strength rating on MBIA to triple-C from single-B (SCI 17 June). Based on the agency's criteria, the ratings on any bond-insured classes reflect the higher of the rating on the respective bond insurer and the rating on the classes, assuming no bond insurance.

S&P says it will continue to monitor its ratings on all MBIA-insured US RMBS classes and take further rating actions as appropriate.

RMBS

Countrywide ratings affirmed

Fitch has reassured Countrywide bondholders that there will likely be no significant US RMBS rating actions as a result of the US$8.5bn in distributed payments from the Bank of America settlement made five years ago. Following the agreement back in 2011 and a series of litigation issues since then (SCI passim), this month finally saw bondholders from most of the 530 trusts receive their payments.

Fitch has outstanding ratings on only 203 of the 530 transactions included in the settlement. Of the roughly 3,000 classes included in the settlement that Fitch actively rates, 74% have incurred principal write-downs to date, and are currently rated single-D.

The settlement pay-outs improved the principal recoveries for many defaulted classes. However, Fitch does not expect to upgrade these classes above the single-D level because the lost interest to date from the write-downs is not expected to be recovered.

Fitch also identified 48 RMBS classes in July 2015 as potential upgrade candidates following the pay-outs, subsequently putting them on rating watch positive. The agency plans to assess these classes in 3Q16.

RMBS

GSE risk model update praised

Fannie Mae last week announced an update to its credit risk assessment model, Desktop Underwriter, as it seeks to better assess the credit risk of non-traditional mortgage borrowers. In its latest Credit Outlook, Moody's says that the GSE's existing technology will improve the credit assessment of loans with non-traditional credit by providing an objective and thorough standard for analysing the risk of the underlying borrowers.

The update will incorporate specific guidelines targeting such borrowers, which is critical to RMBS portfolios. This is because it provides insight into the borrower's willingness to repay by considering their track history of achieving timely debt payments.

Non-traditional borrowers do not have the type of credit that would be reported to the credit bureaus or have sufficient history to generate a FICO score. Fannie Mae's current system requires a FICO score to determine loan eligibility, so lenders to borrowers with non-traditional credit currently must manually underwrite each loan. However, Moody's explains that the update will automate, standardise and improve the decision-making process for lenders to such borrowers.

The GSE's current lending requirements for a non-traditional borrower require three to four lines of verifiable non-traditional credit for standard loans depending on the programme. One line of credit must document a minimum of 12 months of a borrower's housing history. By being able to underwrite these loans in Desktop Underwriter, only two sources of non-traditional credit will need to be verified, one of which must continue to be the borrower's housing history.

The non-traditional loan underwriting process will also gain the benefit of incorporating other factors in the GSE's model. These include coverage on LTV ratio, debt-to-income ratio and reserves to ensure that the borrower's probability of default is within acceptable tolerance levels. Moody's says that the minimum requirements for verification of borrower credit histories are set clearly and with detail, and also have acceptable alternatives, such as written credit references and proof of housing rental payments.

RMBS

Reps framework welcomed

Fitch has commented on the proposed representations and warranties (R&Ws) included in the Structured Finance Industry Group's (SFIG) RMBS 3.0 initiative, noting that they would be an improvement to current practices, if accepted by the US RMBS market. The proposal includes up to four categories for each rep, with each category containing slight variations to reflect feedback from market participants or to address different loan characteristics.

After completing a comparison of the language in each proposed variation to the reps listed in its current criteria, Fitch views all proposed categories for every rep as consistent with its criteria or credit positive. A notable proposed improvement is fewer 'knowledge' qualifiers, which the agency believes will result in a stronger R&W framework. It recognises that the presence of a knowledge 'clawback' is a potential mitigant for a knowledge qualifier.

Fitch does not plan to revise its existing criteria until the SFIG rep proposal becomes more widely adopted in US RMBS transactions. However, it stresses that if they are included in a transaction, the currently proposed reps would be deemed as acceptable to it.

SFIG recently released its RMBS 3.0 TRID Compliance Review Scope documentation to facilitate a uniform testing standard as a result of a consistent Truth-In-Lending Act liability interpretation, as it applies to the TRID rule across third-party review (TPR) firms. The underlying premise of the SFIG documentation is to establish a best practices approach to pre-securitisation testing logic that will drive the due diligence conducted by TPRs.

SFIG notes that the recommendations do not necessarily reflect how courts and regulators may view liability for TILA violations. The association continues to work with the Consumer Financial Protection Bureau (CFPB) towards providing formal guidance for the benefit of the consumer, primary and secondary mortgage markets.

Meanwhile, Fitch has introduced a new loan-level due diligence grading methodology as part of its newly updated US RMBS master criteria. Key changes include a realignment of items driving 'C' and 'D' grades, and the inclusion of compliance grading for TRID errors and exceptions.

The agency requests that TPR firms use 'A' through 'D' grades when reporting diligence findings on credit, property and compliance reviews for RMBS transactions. 'A' grades indicate that there are no exceptions noted and exceptions have been satisfied; 'B' grades indicate that non-material exceptions noted have not changed with this criteria update; the 'C' grade is to be assigned when material exceptions are noted; and the 'D' grade is to be used exclusively in cases where material loan documentation is missing from the loan files and they are not sufficiently complete to enable the basic diligence review to be performed.

When reviewing loans specifically for TRID compliance, Fitch expects the TPR firm to determine whether the loans were originated and closed in adherence with TRID rules and regulations. The TPR firms should provide detail of their TRID compliance findings and assessments consistent with SFIG's RMBS 3.0 TRID Compliance Review Scope. The agency also requests that TPR firms determine whether any findings are deemed more likely to carry statutory damages and assignee liability, or assignee liability only.

Loans with unresolved TRID exceptions that carry the risk of statutory damages and assignee liability will be expected to receive 'C' compliance grades from the TPRs and Fitch will assume an additional loss severity impact of US$15,500. Loans with missing documentation that prevent an assessment of TRID compliance will receive a 'D' grade and will receive the same loss adjustment as a 'C' grade, but - depending on the significance of the missing documentation - may be subject to additional rating adjustments.

Loans with TRID exceptions that carry a low risk of statutory damages are expected to receive 'B' grades and Fitch will not make an adjustment to its loss severity assumptions. However, the agency says it will make additional adjustments to its loss expectations if the TRID compliance results from the TPR review indicate generally heightened operational risk across an entire pool of loans.

A further change to Fitch's US RMBS master criteria is its inclusion of RMBS deal agent (DA) reviews. Clayton Holdings, one of the largest DAs, is launching the initiative.

The agency expects the participation of DAs in new RMBS to improve R&W enforcement, as well as heighten servicer accountability and effectiveness in mitigating losses on distressed loans. DA reviews result in a qualitative assessment of 'acceptable' or 'unacceptable'.

Initially, the assessments will be viewed as credit positive in Fitch's analysis of a transaction's R&W framework and may result in a modest benefit to expected losses.

RMBS

Brexit MSR impact weighed

The UK's vote to leave the EU last week could hurt valuations for some US residential mortgage servicers, says Fitch. The agency expects US mortgage rates to drop in the fall-out from the Brexit decision, which comes after mortgage servicer right (MSR) valuations already declined in 1Q16.

MSR-holding entities with portfolios more exposed to interest rate movements are expected to feel the effect the most in their earnings and ability to finance MSRs. This could lead to the acceleration of refinance-driven servicer portfolio run-off.

Independent non-bank servicers could be most exposed, as they do not have associated origination platforms and service mostly performing loans. Fitch believes these entities would be exposed to MSR volatility, stemming from a lower rate environment where prepayments may be higher. Out of all of the monitored assumptions, the agency says that prepayment rates are typically the most difficult to predict and introduce the greatest amount of volatility into MSR present value calculations.

Fitch adds that some entities do apply certain hedging techniques to attempt to reduce the financial impact of lower mortgage rates on their MSR portfolios. However, infrastructural burdens often deter non-bank servicers from being active in such hedging.

Servicers that also originate mortgages do have a type of 'natural hedge' from the additional revenue brought in by the production of new loans. This may help offset MSR valuation declines, with the ability of the originator or servicer to 'recapture' borrowers that are refinancing being seen as crucially important by Fitch. In addition, some non-bank servicers also specialise in servicing underperforming loans that are often less responsive to rate movements.

MSR holders calculate their values through either the amortisation or fair value method. The former is considered to produce less volatility to earnings, but the latter is impacted by rate movements because the value is worked out at each reporting period. Therefore, the changes are reflected in the earnings in that period.