Contents

Premium pricing

Above-par issuance techniques explored

Above-par issuance is becoming a staple of the European primary ABS market. Deals backed by auto loans, mortgages and credit cards have recently tested the water with this pricing concept, paving the way for other issuers navigating markets in which negative rates prevail.

"From an issuer perspective, the step was a logical one," says Serdar Ozdemir, director of structured debt capital markets at Rabobank. "With many other fixed income instruments already facing the negative rates environment, it was only a matter of time before the ABS market followed suit."

He adds: "It is operationally impossible to allow for negative coupons in securitisations, so the only option to take the new reality into account is to offer higher coupons that are further away from the zero floor."

Calculated coupons began to turn negative on many structured finance transactions last year when commonly-referenced Euribor indices fell below zero and continued to decline. Negative calculated coupons are now widespread, with S&P recently estimating that nearly 21% (€90bn) of the European ABS, CMBS and RMBS that it rates are affected.

For the increasing number of primary market issuers considering an above-par pricing solution, CPR uncertainty is one of the key considerations. Structured finance transactions - especially RMBS - are priced assuming a certain expected CPR. However, the premium paid above par in these deals is at risk, especially if CPR is much higher than expected.

"Investors are essentially concerned that they will overpay for a security that will amortise too quickly," says Ozdemir. "In the market, we have observed different ways to mitigate this risk. The STORM 2016-2 transaction, for example, included a revolving feature. This means that the bond is not subject to CPR volatility and the bond can be priced as if it is a bullet."

Other issuers have chosen to assume a higher CPR for pricing to mitigate the uncertainty around impact of CPR on price. Recent auto ABS priced above par have tended to assume a very high CPR - in some cases, as much as 20%.

"These deals can also minimise CPR risk by setting the coupons slightly lower," explains Ozdemir. "As a result, the margin is closer to the discount margin and investors will not pay much above par."

Ozdemir clarifies that the above-par price is dependent on how high the coupon is. "For example, in Storm 2016-2, the coupon was set at three-month Euribor plus 60bp [see SCI's new issue database]. The discount margin was 30bp. That differential, combined with the duration of the transaction will drive the price," he says.

Recent transactions priced above-par have arguably been met with good investor appetite. For example, Achmea's most recent RMBS, DRMP II, received strong domestic support for the class As, with 41% of the accounts coming from the Benelux. German accounts were also keen to invest, taking another 36%. Of those accounts, banks accounted for the largest part of the senior notes (45%), followed by central banks and other institutions at 31%.

Meanwhile, recent above-par issues have been subject to tightening spreads in secondary market trading. Storm 2016-2, for example, was recently seen to be trading around 21bp/22bp DM versus 30bp DM at issuance (see SCI's PriceABS database).

"The majority of investors in the recent Dutch RMBS had previous experience in this asset class," says Ozdemir. "Many are also used to buying above-par RMBS in the secondary market. For many investors, this is not a new concept - the only difference is that it is primary issuance, not secondary."

For some ABS investors, however, above-par issuance is not necessarily top of the wish-list. Andrew Dennis, portfolio manager and ABS specialist at Aberdeen Asset Management, comments that pricing above par is a feature that works for the originator but, generally speaking, doesn't always work in favour of the investor.

"As soon as you move away from par - whether that's a premium or a discount - there's a worry about whether the prepayment assumptions are right or wrong. Irrespective of asset class, CPRs are notoriously difficult to forecast," he says.

He adds: "Generally speaking, a deal priced above par adds another layer of unwanted complexity to assess."

Nevertheless, it is likely that above-par ABS issuance is here to stay - at least for the time being. Gordon Kerr, head of structured finance research Europe at DBRS, agrees that above-par issuance appears to be the prevailing trend in the European primary ABS market at present.

"It is feasible that there will be above-par issuance in other structured finance asset classes (other than ABS and RMBS)," he says. "If yields continue to drop, QE is extended and if investors show appetite for the deals, then it is possible that there will be more deals of this kind. However, up until this point, it remains only an aspect of the comparative yields to underlying sovereigns - i.e. it is driven by the direction of sovereigns, rather than the direction of lending."

Ozdemir also predicts further above-par ABS issuance. "As long as the negative rate environment continues, there is a huge incentive for issuers to issue above par," he says. "However, the swap curve is steepening lately - particularly at the back end. There may come a tipping point when it is no longer attractive to issue a deal above par. Issuers will keep an eye on the interest environment and future expectations."

He concludes: "If they feel above-par issuance does not provide that extra benefit, then they will likely switch back to par issuance."

AC

NPLs

On the agenda

Efforts to tackle European NPLs gather pace

Efforts by European policymakers to tackle the region's non-performing loan burden appear to be gathering pace. Establishing a central clearinghouse for NPLs has been mooted, while the ECB's latest Financial Stability Review calls for the creation of further government-backed bad banks.

The concept of a central clearinghouse as a solution to Europe's NPL issue has been backed by Gert-Jan Koopman, deputy director general of state aid at the European Commission. The proposal was mooted at a recent European Capital Markets Institute conference, but officials close to the Commissioner have since confirmed that it is "an idea in progress".

The issue with marketing NPLs, as understood by Commission officials, is threefold: the lack of standardisation, accessibility and process. "In certain member states, you can find data in a clear and standardised way, but such information is not available to other member states," one official states.

As to accelerating such a development, the same source says: "Ideally, we would not want to crowd out the private sector, but look at each member state for comparison and see whether they need support in publicising and standardising NPL sales."

The second and third issues concern respectively the accessibility of loan data and the process of liquidation. In particular, by increasing transparency and streamlining liquidation law, it would "make it easier for buyers and sellers to transact", according to another official. He adds: "If it takes seven years to repossess the loan, I would not do it."

The ECB's stock taking report from September - which highlights the range of practices employed to tackle NPLs in eight jurisdictions - shows that the Italian liquidation process, for example, takes on average more than six years. However, the government has begun to address this issue with Law 132/2015.

The law seeks to deal with NPLs through early intervention and restructuring, along with a reduction in the length and cost of bankruptcy. As a result of the new rules, the average length of the bankruptcy process could decrease to around four years, while judicial foreclosures could be shortened from more than four years to around three years. The ECB report, however, emphasises that "more work on this front is warranted".

Meanwhile, the ECB's latest Financial Stability Review suggests that asset management companies - such as Spain's SAREB - can offer "substantial benefits" to participating banks at times of stress, by reducing asset quality uncertainty and relieving funding pressures. It adds: "While these benefits may not be so relevant in the current euro area context, AMCs may also help precipitate secondary NPL markets."

The report, however, points out that state aid rules and the implementation of the bank recovery and resolution directive (BRRD) limit the ability of asset management firms to establish public sector-backed AMCs. In particular, concerns have been expressed that transferring assets to an AMC at values above contemporary market prices would constitute state aid.

As to how this issue could be avoided, the report states that capital support may be indirect in the form of transfers to an AMC "at values above prevailing market values, but below real or long-term economic value".

In February, the European Commission confirmed that neither the Hungarian bad bank MARK nor the Italian GACS guarantee scheme constitute state aid, according to the EU's definition of state aid. For the Hungarian bad bank, this is so since the Commission decided that "the pricing models used by the Hungarian asset management company ensure it will buy non-performing loans at market prices."

For the Italian guarantee scheme, "the state will be remunerated in line with market conditions for the risk it will assume by granting a guarantee on securitised non-performing loans." The Commission concluded: "If a Member State intervenes as a private investor would do and is remunerated for the risk assumed in a way a private investor would have accepted, then such interventions do not constitute state aid."

SP

ABS

Car trouble?

Auto loan deterioration affects ABS value

US auto ABS issuance is booming, but collateral continues to deteriorate and delinquencies have climbed by more than 10% year-on-year. With investors required to exercise ever greater vigilance, some compensation by way of spread widening may be necessary.

"Delinquencies and losses have been climbing in the auto ABS sector. While these time series have not yet deteriorated as far as they did during the financial crisis, the year-on-year increases are meaningful, especially coming at a time when the rest of the consumer balance sheet appears to be performing so well," note Morgan Stanley ABS analysts.

Although the analysts do not believe it is time for bondholders to seriously fear for their positions, they do believe that cumulative losses bear considering. Furthermore, issuance has varied by quarter, with loans originated during some quarters exhibiting far weaker performance than others and in some cases losses are in fact approaching crisis-era peaks.

These weaker quarters largely correspond to those in which subprime originators dominated issuance. Since the beginning of 2011, the share of auto origination with FICO scores below 660 has increased from 30.9% to 36.4%, as of 2Q16. During the same period, the share of borrowers with FICOs above 720 has decreased from 48.7% to 42.3%.

Origination terms have also trended longer as auto lenders aim to lower monthly payments for weaker borrowers, thereby increasing the chances of borrowers falling delinquent and potentially realising losses.

"We have observed significant collateral deterioration in the auto market. The delinquency rate has risen and the net loss rate is as high as 9.3% for subprime and 0.4%-0.6% for prime. The repossession rate is also going up," says Tracy Chen, head of structured credit at Brandywine Capital.

She continues: "This is being driven by credit expansion; as auto sales have slowed down and begun to plateau, underwriting standards have been loosened. There has also been a major shift in the lender mix, with a growth in deep subprime lenders, which has had a knock-on effect on the typical borrower profile."

Prime and subprime auto ABS issuance has been around US$100bn for the year so far. This has been boosted by a rush of issuance in October and this month, as issuers hurry to get paper out before Reg AB comes into force from 23 November. The upcoming risk retention rules, which will apply from Christmas Eve, provide another driver.

"With so much issuance, spreads have nowhere to go but wider. The spread between subprime and prime is at a 12-month high, so as an investor, we think top tier subprime paper should be really good value right now," says Chen.

Chen outlines two broad investment approaches as credit underwriting loosens. As well as targeting the top tier subprime paper, she says it can also be advantageous to go down in credit for the higher-tier issuers. She notes that loosening underwriting standards should not put investors off too strongly as even RMBS continued to perform in the wake of the mortgage crisis, so auto ABS can withstand a little credit loosening.

The Morgan Stanley analysts note that, despite deteriorating loan performance, built-in credit protections for ABS deals should be resilient. "Even during the financial crisis, we have experienced more ratings upgrades than downgrades in the auto ABS space," they say. "That said, continued deterioration in performance could lead to the possibility of future downgrades."

"As an auto ABS investor, choosing the right shelf and issuer is vital. You need an issuer with a diversified funding source; for example, someone like Ally. By contrast, we would not be so keen on deals from CPS," says Chen.

She concludes: "The age and track record of an issuer matters. We would be wary of new entrants to the market, but paper from issuers such as Santander we can get comfortable with. Certain GM bonds are also performing pretty well."

JL

CLOs

Euro CLOs mixed

European CLOs are experiencing mixed fortunes in the secondary market depending on maturity and part of the stack.

"Overall, secondary volumes are down as everyone prepares for year-end," says one trader. "However, we're still doing a fair bit in investment grade flows - particularly triple-As of all vintages - but any bids for non-IG 2.0 paper are now opportunistic ones."

Year-end is most pressing in the primary market, the trader notes. "We're still seeing the rush of new and refi deals as issuers look to get bonds out before the investment window for the year shuts, which is getting ever closer - probably a couple more weeks at the most."

Despite being generally well-absorbed the new issuance is putting pressure on 2.0 spreads lower down the capital structure. "Triple-Bs are feeling it but have moved only a little, while the widening trend we've seen for some time in double-Bs is continuing," the trader says. "That's reached the point that anyone now issuing a new double-B piece will immediately push out both primary and secondary spreads there."

Meanwhile, 1.0 paper is still well supported beyond the above mentioned triple-As. "All non-investment grade 1.0s continue to be very well bid, particularly double-Bs and equity," says the trader.

There are no European CLO BWICs scheduled for today, but there is a large list already on the calendar for tomorrow. Due at 14:30 London time the 17 line €79.821m mix of double- and single-As comprises: ARBR 2014-1X C2, AVOCA 11X C, AVOCA 12X C, AVOCA 15X B2, BABSE 2015-1X B1, BABSE 2015-1X C, CGMSE 2014-2X B, CONTE 2X B, JUBIL 2014-11X B, OHECP 2015-3X B1, OHECP 2015-3X C, PENTA 2015-2X B, PENTA 2015-2X C, PHNXP 1X A2, RPARK 1X B, SPAUL 3X C and SPAUL 4X A2.

Three of the bonds have covered with a price on PriceABS in the past three months - BABSE 2015-1X B1 at 100.325 on 24 August; PENTA 2015-2X BNV at 100H on 5 October; and RPARK 1X B at 100.09 on 17 October.

CLOs

US CLO slowdown

The slowdown towards the Thanksgiving holiday looks to have begun in the US CLO secondary market.

Yesterday saw a flurry of BWIC activity, which made for a slightly busier than of late Monday. However, the five lists that went through didn't buck recent pricing trends, though there was some surprise in that no colour at all was released from the largest list of the day a 16 line $103+m predominantly single-A auction.

Today the US CLO calendar sees just two lists with nothing further currently scheduled until 30 November. The largest of today's BWICs involves six line items totalling $22m.

Due at 10:30 New York time it comprises: ARES 2007-3RA C, ARES 2013-2A C, CECDO 2007-15X B, CIFC 2014-4A C1, OZLM 2014-8A B and WOODS 2012-9X C1. Only ARES 2013-2A C has covered with a price on PriceABS in the past three months - at LM100H on 16 September.

Secondary markets

Euro ABS/MBS firm

Tone remains firm in the European ABS/MBS secondary market albeit on low volumes.

Inevitably with the US Thanksgiving holiday flows have been very light over the past couple of sessions and look set to stay that way for the rest of the week. Nevertheless, sentiment remains positive across the bulk of sectors and consequently secondary spreads are unmoved. Even Italian paper is now holding firm ahead of the country's 4 December referendum.

There is currently one BWIC on the European ABS/MBS schedule for today. It involves 46.185m of euro and sterling original face across 11 ABS, CMBS and RMBS line items.

Due at 11:00 London time the auction comprises: BFTH 11 A2, CRSM 9 A2, DECO 2014-BONX C, DILSK 1 B, DRVUK 2 B, DRVUK 4 A, GMG 2015-1 A, PRADO 3 A, RHIPO 8 A2A, SAPPO 2016-2 B and TDA 19 A. Three of the bonds have covered on PriceABS in the past three months - DRVUK 2 B at 100.08 on 8 November; DRVUK 4 A at 100.16 also on 8 November; and GMG 2015-1 A at 100.35 on 12 October.

Structured Finance

SCI Start the Week - 21 November

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

Upcoming SCI event
SCI's latest Capital Relief Trades Seminar, 'Navigating the Cash vs Synthetic Debate, Weighing the Cost of Capital', is being tomorrow, 22 November, in London. Please email for a conference registration code or click here and follow the link to register.

The conference programme consists of a series of panel debates, focusing on the structural landscape, the cost of capital and alternatives, and issuing bank strategies among others. So far, speakers include representatives from: Apollo Management; Caplantic; Chorus Capital Management; Christofferson Robb; Clifford Chance; EIF; Lloyds; Magnetar; Mariner Investment Group; Mizuho; Nomura; Nordea; Open Source Investor Services; and Rabobank.

Pipeline
The additions to the pipeline last week were nicely balanced between ABS, RMBS and CMBS. There were five of each, with deals announced from the US, UK, Europe, Russia and China.

The ABS were: €450m Bavarian Sky France Compartment French Auto Leases 2; CNY3.65bn Driver China Five Trust; US$1.5bn Huntington Auto Trust 2016-1; US$213.6m SoFi Consumer Loan Program 2016-5; and £405m Turbo Finance 7.

The RMBS were: US$241.23m Bayview Opportunity Master Fund Iva 2016-SPL1; €1.58bn BBVA RMBS 17; JPMMT 2016-4; RUB4bn Mortgage Agent MKB; and US$623.5m Progress Residential 2016-SFR².

The CMBS were: US$415m JPMCC 2016-ASH; US$824.4m MSC 2016-UBS12; US$132m The Bancorp Commercial Mortgage 2016-CRE1 Trust; US$162.1m RCMT 2016-3; and Wells Fargo Commercial Mortgage Trust 2016-LC25.

Pricings
Last week's prints included a few more ABS, RMBS and CMBS than the week before, but fewer CLOs. The final totals were seven ABS, five RMBS, three CMBS and 10 CLOs.

The ABS were: US$1.25bn Drive Auto Receivables Trust 2016-C; US$500m Evergreen Credit Card Trust Series 2016-3; €3.784bn Locat Securitisation 2016; US$382.7m PHEAA Student Loan Trust 2016-2; CNY4.2bn Silver Arrow China 2016-2; US$584.42m SoFi Professional Loan Program 2016-E; and US$1.4bn Verizon Owner Trust 2016-2.

The RMBS were: €670m Credico Finance 16; US$460m Freddie Mac Whole Loan Securities Trust Series 2016-SC02; £2bn Permanent Master Issuer Series 2016-1; US$250m SPS Servicer Advance Receivables Trust Series 2016-T1; and US$350m SPS Servicer Advance Receivables Trust Series 2016-T2.

The CMBS were: US$975.4m CD 2016-CD2; US$1.315m FREMF 2016-K59; and US$1bn GSMS 2016-GS4.

Lastly, the CLOs were: US$407m Apidos CLO 2015-20R; €417m Ares European CLO 2016-8; US$331.2m Arrowpoint CLO 2013-1R; US$483.25m Betony CLO 2015-1R; US$372.75m Catamaran CLO 2014-2R; €338m Halcyon Loan Advisors European Funding CLO 2; US$489m Magnetite CLO 2015-12R; US$504m Symphony XVIII; US$601.6m Venture CLO 2016-25; and US$707m Voya CLO 2016-4.

Editor's picks
Fresh faces: A slew of issuance from private equity companies and other non-traditional issuers is changing the face of the European RMBS market. The trend can be seen in multiple jurisdictions, with deal structures evolving as a result...
Fine tailoring: Open-ended loan funds in Europe have grown in volume, attracting institutional investors hungry for yield, while fears over a Fed rate rise has reversed outflows from loan funds in the US. Although loan funds globally could pose a threat to CLOs in terms of issuance and investor appetite, the sector will continue to be buoyed by investors that employ a tailored risk-return approach...
Disruptive opportunities: Bijesh Amin, co-founder of Indus Valley Partners, discusses the emerging high-frequency lending model and its impact on structured credit...
'Transformational' capital offered: TCA Fund Management Group has closed the first investment made by its new fund. Touted as a hybrid opportunity fund, it features an innovative combination of private equity and credit characteristics...
US CLOs trundle on: The US CLO secondary market continues to trundle on in a positive manner, albeit without a resurgence in activity. "It's stayed quieter this week and certainly any expectation of a post-Trump victory sell-off hasn't materialised," says one trader. "People are looking for volatility before they act, but for now there's none in the CLO space..."
Container ABS decline persists: Container ABS volumes have continued to fall in Q3. This follows sluggish demand for containers, which has provided headwinds for the sector through 2016...

Deal news
• Huntington National Bank is in the market with its first prime retail auto ABS issuance of 2016. The US$1.5bn Huntington Auto Trust 2016-1 auto loan ABS is Huntington's eighth standalone retail term securitisation.
• Royal Bank of Canada has arranged a £125m mobile handset securitisation programme for Virgin Media Mobile, the first of its kind in Europe. The underlying receivables consist of loans provided by Virgin Media Mobile to its customers in order to finance the purchase of handsets from Virgin Mobile Telecoms.
• FirstRand Bank is in the market with its latest UK auto ABS, Turbo Finance 7. The deal, which is provisionally sized at £405m, includes a euro-denominated tranche - a first for the programme.
• Italian auto loan ABS A-Best 14 - which closed on 11 May (see SCI's new issuance database) - has been restructured. The amendments include the retranching of the principal amount of all classes of notes, increasing the total issuance volume and portfolio size, and changing the fixed interest rates of the class B, C and D notes.
• Fannie Mae has completed its tenth Credit Insurance Risk Transfer (CIRT) transaction of 2016. For the first time since the programme's inception, the loan pool covered by the US$11.7bn CIRT 2016-9 deal consists of 15-year and 20-year fixed rate mortgages.
• Navient has amended the transaction agreements for Navient Trust 2014-8, totalling US$469m of FFELP student loan ABS bonds. The legal final maturity of the deal's A3 tranche has been extended to 2049. The legal final maturity dates on US$7.8bn of bonds from Navient-sponsored FFELP securitisations have been extended since December 2015.
• Fitch has placed 12 classes of notes issued by Salisbury 2015-1 on rating watch positive. The move reflects a model correction, which leads to a higher rating recovery rate (RRR) in the portfolio credit model (PCM) output.

Regulatory update
• ESMA has published a report on OTC derivatives central clearing, calling for a delay to the implementation of EMIR obligations for small financial counterparties. It argues that this is necessary because EU legislation is still being finalised, among other reasons.

Structured Finance

Election may yield positive results for SF

The recent election of a Republican government "should be good for economic growth" and securitisation, with credit spreads benefitting from a tightening bias, according to Wells Fargo structured product analysts. They add that reversing already inked regulations might have a mixed result for structured finance in the US, but that a big fiscal stimulus "may push economic expansion past historic norms".

The Wells Fargo analysts suggest that that a Republican government could in general be positive for the economy in terms of greater public spending and potentially lower taxes, with credit spreads therefore benefiting from a tightening bias. For structured finance, they also believe that the election could be positive, particularly in sectors such as banks and speciality finance, gaming and lodging and energy services - although the outlook for REITs and consumer products is neutral or mixed.

While the market has repriced the unwinding of regulations imposed since the financial crisis, the analysts comment that while the time it would take could have a mixed impact, the reversal would in general likely be positive for credit spreads. Additionally, securities that "have low risk weightings under bank regulations may be sold in favour of higher-yielding assets if bank regulations are reversed", the analysts comment.

In terms of a macroeconomic outlook for the US in 2017, the bank's economists suggest that trade policy, capital spending and infrastructure spending are important areas to gauge the impact of the administration, as they are significant inputs for economic growth. They add that rising GDP growth usually fuels tighter credit spreads, with inflation being negative for bond returns and the tension between the two - combined with market movement since the election - making it challenging for bond investors.

GDP growth, the report suggests, has been sluggish since the crisis but could be boosted by a fiscal stimulus, which could also increase the deficit and fuel inflation. Growth of 1.6%-2.6% since the crisis has been low for a recovery comparatively and current forecasts for inflation are between 0.2% to 2.1%.

Commodity prices, fuel prices and the cost of labour are also big drivers in the growth/inflation equation and currently they are supportive of infrastructure and capital spending, and equally unemployment in the US has fallen steadily since the crisis. Wages, however, have changed little and an additional pressure point in the inflation/capital spending equation is that the cumulative budget deficit doubled from 2009 to 2014 - although the analysts suggest the macro-economic data point to a healthy starting point for the new political leadership.

Wells Fargo economists forecast a 2.1% GDP growth in 2017, boosted by cheap debt funding, facilitating corporate leverage and funding M&A activity. But they add that M&A activity being higher than 2007/08 peaks and transactions at 30%-40% indicates that the end of the growth phase of the credit cycle is approaching. The US economy will be entering its eighth year of consecutive growth in 2017, with a typical credit cycle lasting eight to ten years before it changes - although the analysts suggest that this cycle may differ from previous ones, due to a large amount of monetary policy intervention and banking regulation, which has limited economic growth.

The consumer ABS and agency RMBS sectors moved further along the credit cycle, however, with softening credit fundamentals and increased collateral losses in consumer ABS. In agency RMBS, the US Fed's purchases have kept spreads tight and banks and overseas investors are absorbing new issuance, supporting stability - although the Trump administration could taper Fed reinvestments, leading to spread widening.

Non-agency RMBS also progressed through the credit cycle, albeit less significantly, with strong fundamentals and tight mortgage lending standards in place. However, this could ease as the GSEs aim to unlock the market and non-QM issuance grows. Wells Fargo advises caution about investing in transactions with adverse selection, such as low loan count bonds in legacy RMBS or "non/re-performing loans that have persisted with the same servicer without progressing toward liquidation of credit curing."

Both the CMBS and CLO markets extended and moved back towards consolidation, with the extension in the CMBS credit cycle due to improved underwriting standards for new issue risk-retention compliant transactions. The CLO credit cycle extended slightly, due to the big refinancing wave limiting energy exposure. While the leverage and credit ratings mix were mostly unchanged from last year, healthcare might be a sector of concern for CLOs, the analysts suggest.

In terms of secondary market trading volumes, they find that general volumes have declined between 2014 and 2016, although issuance and market capitalisation has also declined. Concerns that regulations would reduce liquidity and cause price shocks haven't played out, as price moves have been orderly - although a loosening of regulations would promote dealer balance sheet expansion, boosting liquidity and supporting pricing, according to the analysts.

Considering the high likelihood of a Fed rate rise of 25bp in December, they assess the outcome of higher rates on bond returns, comparing Fed tightening cycles in 1994 and 2004. They suggest that the 2004 cycle is a good template for the current cycle. Between 2004-2006, the Fed moved 17 times in 24 months from 1% to 5.25%, causing the 2s/10s curve to flatten 190bp in the first 12 months, compared with 199bp in the entire two-year tightening period.

The analysts comment that the 2004 cycle is similar to the current one because both started from a very low Fed Funds rate and the 2004 cycle is closer chronologically, although the global monetary policy intervention differs. During the 2004 cycle, the three-month excess return from the CMBS and ABS indices outperformed the overall aggregate index but with excess returns of less than 10bp, with the MBS index underperforming all other sectors during the three-month tightening period.

In terms of excess returns for a 12-month holding period, however, the MBS, CMBS and ABS indices outperformed the aggregate index and corporate bond indices, while the corporate utility index outperformed all other sectors with 1.43% excess returns. Based on this historical data, the Wells Fargo analysts suggest that investors with shorter holding periods focus on shorter duration higher-quality paper and that short floating rate paper is most attractive in this environment.

Longer-term investors should benefit from adding structured products versus corporate bonds to their portfolios. The analysts conclude that such investors should focus on "incremental buying, due to the currently fluid dynamics around monetary policy and political regimes."

RB

Structured Finance

Constructive outlook for Euro ABS

This year has been a year of 'two halves' for the international ABS market, according to JPMorgan European securitisation analysts, with the supply/demand imbalance in 2H16 supplanting the volatility and uncertainty seen in the first half. Against this backdrop, they gauge both ABS investor and issuer perceptions of the sector heading into 2017, based on the results of their latest international ABS outlook survey.

The JPMorgan survey suggests that investors generally maintain a constructive outlook towards the asset class going into next year, echoing the positive sentiment currently driving market performance. Regulation and political uncertainty were frequently cited as the biggest threats to performance over the next six months.

With a reading of +2.6, the JPMorgan ABS Confidence Index is currently at its highest level since 2H14, up from a -3.3 reading in the previous survey in June. Over half (55%) of investors that participated in the survey cited current conditions in the ABS market as 'good' or 'excellent'. Investors largely anticipate that conditions will remain favourable through 1H17, with an index reading of +2.1, up from -2.2 in 1H16 and the highest reading since 1H15.

However, issuers' aggregate perception of ABS market conditions deviates somewhat, with a less encouraging confidence index reading of zero (neutral) regarding both current and future conditions.

The JPMorgan analysts suggest that investors' positive view of securitised products is aided by perceived relative value in the asset class, given strong demand for spread product. Nearly 70% of investor participants in the survey cited ABS as offering superior relative value across European financial markets. CLOs were almost as frequently cited as offering attractive relative value, garnering a near equal number of votes.

In terms of ABS issuance expectations, investors and issuers have a relatively diverse view of anticipated supply in 2017, with forecasts ranging from €50bn-€90bn. The median and average expectations of €75bn and €73bn respectively would place 2017 volume at or slightly below where 2016 supply should end the year, but still in line with volumes of €75bn-€85bn seen nearly every year post-crisis.

In the context of the current accommodative monetary policy environment, investors appear divided on whether the proportion of distributed versus retained issuance will improve next year. Though execution spreads have improved in 2H16, the majority of investors polled (circa 60%) expect issuers to remain heavily reliant on structure-to-retain transactions to access cheaper central bank funding. Similarly, issuers do not anticipate that the proportion of distributed issuance will improve.

Consequently, investor participants in the survey broadly expect the composition of distributed issuance to remain skewed towards specialist lenders, with more than 90% expecting comparable or increased activity from specialist lenders in 2017.

Meanwhile, reinvesting paydowns is anticipated to be a key component of investors' trading activity next year. With ABS cited as offering superior relative value across the European fixed income market, nearly 90% of survey respondents are looking to reinvest paydowns at least partially back into the ABS market, with CLOs the most popular alternative. While just 7% of those polled intend to reinvest paydowns exclusively back into ABS, 38% seek to reinvest in ABS and CLOs, 31% in ABS and non-securitised products and 14% across ABS, CLOs and non-securitised products.

In the primary market, investors exhibited strongest demand for higher quality sectors, including auto ABS, credit card ABS, consumer ABS and UK prime RMBS seniors, as well as SME ABS seniors and mezzanine bonds. Among secondary market opportunities, CLOs were overwhelmingly seen as offering better relative value across the capital structure. Within ABS specifically, demand appears strongest for UK RMBS seniors and Spanish RMBS seniors.

CS

Structured Finance

Euro risk retention 'agreement reached'

The European Parliament appears to have reached a consensus on its approach to securitisation. The MEPs responsible for the new securitisation bills are understood to have come to an agreement on risk retention, which had been the main sticking issue.

Risk retention recommendations ranged from the current 5% right up to 25%, with Rabobank credit analysts attributing a stalemate on this issue to the delayed consensus vote in the economic and monetary affairs committee (ECON), which should have been held on 11 November. The analysts believe that, with the exception of horizontal retention, the European Parliament will now insist on 10% risk retention.

"In our view, this approach would mainly affect arbitrage-driven transactions, as these deals will simply get less economical with higher risk retention. CLOs could potentially be most affected, although we note that arbitrage has recently also entered the RMBS market," note the Rabobank analysts.

Regular funding transactions, where skin-in-the-game is achieved by retaining the mezzanine and junior notes, should not be materially worse off. There is no current indication as to whether there will be grandfathering.

ECON is meeting again on 5 December, when the compromise agreement could be put to the vote. Such a vote would then have to be ratified in a plenary session of the European Parliament, which could happen in January. Even then, the European Commission and European Council would both have the chance to weigh in with their opinions.

"It could be that the European Parliament's stance on risk retention will be countered by these two bodies, but as the European Commission might be in a hurry to adopt these bills relatively soon, we doubt how much resistance there will be," the analysts conclude.

JL

Insurance-linked securities

Draft ILS regulations released

As part of the Chancellor's Autumn Statement, the UK government has launched a consultation setting out its proposed corporate, tax and regulatory framework for ILS. The consultation reiterates the government's aim to create an efficient and streamlined regime for multi-arrangement ISPVs (mISPVs) in the UK, setting out the draft regulations it intends to place before Parliament early in 2017.

The move has been welcomed by industry participants. "An onshore ILS centre in London would facilitate innovation, particularly in the development of risk transfer products, such as pandemic and emerging market natural catastrophe risk," comments Paul Traynor, international head of pensions and insurance segments at BNY Mellon.

He adds: "The ability to transfer emerging risks to the capital markets rests on the ability to understand, model and parameterise the peril. If a solution can be found, this will set a precedent for other emerging ILS risks."

On 1 March 2016, the government published an initial consultation setting out the overall approach for designing an effective and competitive framework for insurance special purpose vehicles (ISPVs) in the UK. Respondents agreed that a protected cell company (PCC) corporate structure was appropriate for a new ILS framework; a bespoke approach to the taxation of ISPVs would be needed; and stressed that a robust but streamlined supervision of ISPVs from the PRA and FCA would be key to the success of the regime.

The latest consultation publishes two sets of draft regulations: the Risk Transformation Regulations 2017 (Annex A), which will introduce a new corporate structure for mISPVs and propose a new regulated activity of insurance risk transformation under the Financial Services and Markets Act 2000; and the Risk Transformation (Tax) Regulations (Annex B), which set out the tax treatment of ISPVs. Separately, the PRA and FCA will be consulting on their approach to the authorisation and supervision of ISPVs in the UK.

Specifically, the government proposes to create a PCC regime for mISPVs, with a straightforward and robust approach to the segregation of assets and liabilities to permit companies to handle multiple ILS deals. The regulations amend companies and insolvency law in the UK where necessary for PCCs. The ability to use a PCC that is backed by English law is expected to be a significant benefit for ILS practitioners.

The government also proposes to introduce a bespoke taxation regime for ILS in the UK. This will include: exempting the insurance risk transformation of ISPVs from corporation tax; a complete withholding tax exemption for foreign investors; and UK investors being taxed as normal, according to their circumstances.

HM Treasury, HM Revenue and Customs, the PRA and the FCA have worked closely with the London Market Group's ILS taskforce since Budget 2015 to develop a robust and efficient framework for UK-based ILS vehicles (SCI passim). Comments on the draft regulations are invited by 18 January 2017.

CS

Structured Finance

Nordic cooperation inked

SCIO Capital has announced what it terms as "a cooperation" with Nordic-focused institutional investment advisory firm Lapposand and its owner Jessica Eistrand. Eistrand's background is in fixed income and structured products, with several international investment banks and investment advisors. More recently, she has been working with sustainability and alternative investment managers seeking to grow their Nordic institutional investor market presence.

Jörn Czech, SCIO's head of business development and investor relations, says: "We are very pleased that Jessica Eistrand has chosen to work with SCIO as well. She has a very high level of knowledge regarding our areas of expertise, as well as a deep knowledge of the Nordic investor landscape."

Structured Finance

Valuation role for structured credit pro

Alan Packman has joined Moody's Analytics in London as a product specialist in its structured analytics & valuations department. Packman previously worked at Stifel, where he was an md in asset-backed finance. Prior to that, he worked at UBS, where he was executive director and European head of global CDO trading.

Structured Finance

CLO firm nabs sales pair

Palmer Square Capital has hired Brad McClintock and Michael Daniel for its business development team. They will focus on expanding the firm's investor outreach across its fund and separately managed accounts.

McClintock takes up the role of svp in business development at Palmer Square Capital. Prior to this role, he was svp in institutional sales for Scout Investments.

Daniel will now be vp of business development at the firm. Prior to this, he was avp, operations manager for Midland Loan Services.

Risk Management

Product development head named

ICAP has appointed Stuart Connolly as head of client product development for its Post Trade Risk and Information (PTRI) division. In this newly created role, he will report to PTRI ceo Jenny Knott and be based in London.

Connolly will work with each of ICAP PTRI's businesses to leverage data and develop client data services through the identification of real life client use cases. He will also build and launch a variety of complementary data services interoperable with PTRI's businesses.

With over 20 years' experience working in financial markets, Connolly joins ICAP from Goldman Sachs, where he was most recently head of EMEA derivatives clearing services, responsible for the OTC credit and rates franchise.

RMBS

Risk firm swipes mortgage vets

MountainView has hired David Bennett and Michael Riley for its risk analytics team. Both will take the role of md and focus on expanding and improving MountainView's range of services.

Bennett was previously at Compass Analytics, where he was md working on hedging pipeline risks for mortgage originators. Prior to that, he was MSR manager at Fifth Third Bank, responsible for model maintenance, portfolio management and valuation.

Prior to MountainView, Riley was at WJ Bradley Mortgage Capital, where he held svp and vp positions on the capital markets team. He was previously vp of MSR valuation and pipeline hedging at Aurora Loan Services and was director of MSR hedging at Taylor, Bean & Whitaker.

RMBS

RMBS case settled

Ally Financial has agreed to pay US$52m in conjunction with its resolution of all outstanding investigations and potential claims by the US Department of Justice (DOJ) related to RMBS issued by the company's former mortgage subsidiary Residential Capital and its ResCap RMBS subsidiaries. It has also agreed to withdraw the broker-dealer registration of Ally Securities, which it says has not been a major part of the company for some time and will not impact Ally's ongoing operations.

The settlement brings closure to the DOJ's investigations relating to Ally and ResCap RMBS, including investigations into potential claims under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and the False Claims Act.

RMBS

RMBS legal claims dropped

Fraud claims alleged by Federal Home Loan Bank of Boston (FHLBB) against RBS Securities and other RBS companies relating to the marketing and sale of 10 RMBS certificates are being dropped after the plaintiff and defendants filed a joint stipulation seeking dismissal. However, a further two claims against RBS remain, and FHLBB also retains claims against other defendants.

"FHLBB brought this litigation against RBS and dozens of other defendants in 2011, alleging violations of Massachusetts securities laws and claiming the defendants made untrue statements and omitted material facts about the quality of the loan pools underlying the securities. Further details of the dismissal are not publicly available," notes Thomas Kidera, managing associate at Orrick, Herrington & Sutcliffe.

It is not the only RMBS litigation breakthrough this month. Ally Financial has also settled claims brought by the US Department of Justice (SCI 22 November).

ABS

Depreciation hits Hertz ABS

Moody's says that the sharp drop in Hertz Corp's Q3 earnings and reduced full-year guidance are credit negative for the company and, by extension, its rental car ABS. However, the agency notes that several structural features mitigate the impact of lower earnings on the transactions.

"Hertz Corp faces earnings challenges owing to, among other things, a substantial depreciation adjustment to its fleet of rental vehicles, as a result of continued pressure on vehicle residual values," says Moody's svp Joseph Snailer. "While such developments are credit negative for the company and, in turn, for its rental car ABS, asset value tests in the deal structures help mitigate the impact on the ABS."

In rental car ABS, the sponsor must make payments on an operating lease that eventually pays down the bonds, Snailer adds. If the sponsor defaults, the ABS are paid off from the proceeds of the sale of the fleet of securitised vehicles. The difference between the book value and the market value of the vehicles is therefore a key credit consideration in these transactions.

GAAP residual value losses don't imply that the book value of a fleet exceeds the market value in rental car ABS, Moody's says. The book value depreciation rates used for Hertz ABS are independent of the GAAP depreciation rates the company uses for earnings.

More importantly, ABS structures include monthly asset value tests that reference both third-party market value assessments of fleet valuation and actual vehicle sale prices. Failure of either test will require the company to post additional credit enhancement, increasing protection against losses in the event that the fleet needs to be liquidated to repay the ABS notes.

"In addition to the depreciation adjustment, Hertz currently also faces several other challenges," says Moody's svp Bruce Clark. "These include the pace at which it can achieve its stated target savings of US$800m-US$950m over the next few years, the narrowed cushion above the leverage covenant in its senior revolving credit facility and the need to continue rebalancing its fleet composition amid residual value pressure that's likely to continue into 2017, given the number of compact cars that remain in the fleet."

ABS

Below-prime card deal prepped

Continental Finance Company is in the market with a US ABS transaction securitising below-prime credit card debt. Continental's business model is focused on borrowers with limited credit history or a below-prime credit score.

The US$40.744m class A notes of Continental Credit Card ABS 2016-1 have been provisionally rated by Morningstar at single-A plus. The US$13.581m class Bs have been rated triple-B plus and the US$10.186m class Cs have been rated double-B plus.

The notes are backed by the outstanding balance and certain fees on a static pool of credit card accounts originated by Mid America Bank and Celtic Bank and purchased by a Continental subsidiary. The ABS is being arranged by Natixis and Griffin Financial Group.

Morningstar highlights key strengths of the deal as being excess spread of over 60% per year, the fact that Continental has a long operating history and a dedicated focus on credit cards, and the fact that all accounts in the pool will be at least 12 months old at closing. The main concerns are that the expected cumulative charge-off rate is up to 50% of the original pool balance and the sponsor may suffer from an increase in market competition or any decrease in consumer spending caused by periods of economic stress.

Structured Finance

Basel tensions flagged

Basel Committee discussions next week may expose divisions between national members and lead to further differentiation between the EU and internationally-agreed Basel standards, Fitch suggests. The latest Basel 3 amendments - sometimes referred to as Basel 4 - seek to restrict the use of internal risk models and set overall capital requirements using the revised standardised approaches.

EU politicians have expressed significant concerns in their parliamentary submissions ahead of a vote on the Union's finalisation of Basel 3 on 24 November. Meanwhile, regulators such as the FDIC's Thomas Hoenig recently warned against the dilution of the standards.

If enacted, the amendments are likely to increase capital requirements for lower risk-weight portfolios, such as mortgage loans. European banks generally hold larger mortgage portfolios, while US banks typically sell their mortgage loans to the GSEs and larger firms already hold capital at the higher of the standardised and IRB approaches.

US supervisors may be more willing to set higher capital standards due to the more supportive operating environment and lower reliance on loan-based finance than in the EU. However, EU lawmakers say they are aiming for "global standards with local calibration".

Fitch suggests that these tensions are likely to be reflected in two key areas in the 28-29 November Basel discussions. The proposal for a capital floor based on a certain percentage of the standardised approaches has the greatest potential for EU divergence, it says. EU lawmakers have protested that a floor would punish stable banks focused on low-risk lending, while banks with higher-risk assets would be less affected.

The agency believes that elimination of internal ratings models for certain credit exposures is unlikely, but that if they are eliminated, a generous transitional phase-out period would be implemented. It indicates that the introduction of constraints to reduce risk-weight variability is more likely and ensure a minimum level of conservatism.

Structured Finance

Distressed EM credit fund launched

Gramercy Funds Management closed its third distressed and opportunistic emerging markets credit strategy, Gramercy Distressed Opportunity Fund III, last month after raising almost US$1bn in commitments. The fund has a five-year investment time-horizon and will invest opportunistically in dislocated and defaulted sovereign, quasi-sovereign and corporate credits and will also target stressed credit opportunities that require flexible capital solutions.

Gramercy will actively short bonds and hedge long positions. Investments are typically subject to US and UK law, so the strategy will not target local law debt.

Structured Finance

EU proposals support securitisation

The European Commission has presented a package of reforms to strengthen the resilience of EU banks, including measures to facilitate securitisation and derivatives activity. They contribute to the Commission's ongoing work to reduce risk in the banking sector and are in line with the ECOFIN Council in June, where the Commission was invited to put forward relevant proposals no later than end-2016.

The proposals amend the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD), the Bank Recovery and Resolution Directive and the Single Resolution Mechanism Regulation. The measures aim to implement international standards into EU law while taking into account the difference in Europe and avoiding undue impact on the financing of the real economy and incorporate the call for evidence.

The proposals have several aims, with one being to increase the resilience of EU institutions and enhancing financial stability through measures, such as more risk-sensitive capital requirements and more accurate methodologies to reflect the risks banks are exposed to. Furthermore, the Commission has introduced a binding leverage ratio to prevent excessive leverage, a binding net stable funding ratio and a requirement for large, global institutions to hold minimum levels of capital and others instruments to bear losses in resolution.

A further proposal is to improve banks' lending capacity to support the EU economy, achieved through an enhanced capacity of banks to lend to SMEs to fund infrastructure projects and for non-complex, small banks to reduce their administrative burden linked to remuneration. Additionally, it stipulates that CRD/CRR rules should be less burdensome for small and less complex institutions.

The final proposal is to further facilitate the role of banks in achieving deeper and more liquid EU capital markets to support the creation of a Capital Markets Union. It aims to achieve this through avoiding disproportionate capital requirements for trading book positions, reducing the costs of issuing/holding certain instruments - including securitisation instruments and derivatives - and finally to avoid potential disincentives for institutions acting as intermediaries for clients in relation to trades cleared by CCPs.

CDO

Trups defaults decline

The number of US bank Trups CDO combined defaults and deferrals declined to 14.6% at end-October, from 14.7% at end-September, according to Fitch's latest index results for the sector. Three performing issuers representing US$40m across six CDOs redeemed their Trups last month, while one cured issuer with a notional of US$20m across two CDOs also redeemed its Trups.

In addition, two defaulted issuers with a combined notional US$43.5m across four CDOs were sold with a weighted average recovery of only 2.1%. One issuer - representing US$5m in one CDO - that has been deferring since January 2012 cured. There were no new deferrals or defaults in October.

Across 73 Fitch-rated bank and mixed bank and insurance Trups CDOs, 219 defaulted bank issuers remain in the portfolio, representing approximately US$4.9bn of collateral. As of October 2016, 78 issuers are deferring interest payments on US$622m of collateral, compared to 107 issuers deferring on US$1.3bn of notional a year earlier.

CDS

CDS 'positive for China'

The introduction of CDS on the Chinese interbank market is credit positive for asset managers, according Moody's. The agency notes that this is because CDS can provide an alternative tool to hedge bond defaults when defaults are on the rise.

Nino Siu, avp and analyst at Moody's, comments: "CDS is also key to driving bond market liquidity for non-government bonds, amid record-setting yearly bond issuance, and we believe will help the onshore bond market evolve towards global standards."

The CDS market launched in China following guidance from the National Association of Financial Market Investors (NAFMII) on 23 September that issued two major stipulations. The first is that CDS in China have to refer to a specific debt instrument and the second is that no secondary trading of CDS is allowed.

The initial batches of bonds underlying CDS are expected to come from state-owned enterprises with high domestic ratings, with market caution making it challenging to expand to lower-rated underlying bonds and longer terms in the near future. Moody's concludes that "the lack of yield differentiation between bonds with different domestic ratings would also make CDS pricing difficult."

CLOs

Cov-lite CLO prepped

Highbridge Capital Management subsidiary HPS Investment Partners is in the market with a new CLO (see SCI pipeline), which will allow up to 80% of the loans in its collateral pool to be covenant-lite. HPS Loan Management 10-2016 has been provisionally rated by S&P and sized at US$410.4m.

The US$249m class A1 notes have been provisionally rated triple-A. The class A2, B, C, D and subordinated notes have not been rated.

While cov-lite allowances have been increasing in US CLOs, this transaction - which is HPS' third deal of the year - will allow 80% of the pool to be cov-lite. At least 96% of the collateral will be senior secured loans and at least 90% of loan issuers will be based in the US, Canada or the UK.

As well as having an unusually high cov-lite allowance, the CLO will have lower total leverage and lower subordination than other recent deals, with lower weighted average cost of debt and lower weighted average spread. There is also a higher scenario default rate than similar transactions. S&P warns that exposure to cov-lite loans may reduce the CLO's recovery prospects.

The CLO is expected to close in mid-December. Its non-call period will end in October 2019 and its reinvestment period will end in October 2021.

CMBS

2017 CMBS slowdown expected

A recent recovery in US CMBS issuance will not be sufficient to balance out an anaemic first half of the year, says Kroll Bond Rating Agency. The start of 2017 is also expected to be slow, and full-year 2017 issuance is predicted to undershoot 2016.

CMBS issuance grew for six straight years before stopping abruptly this year as the global economic slowdown, energy downturn and stock market volatility all contributed to pushing spreads wider and constraining issuance. Spreads have since stabilised and issuance volume did pick up from around September.

Private label monthly deal volume averaged US$4.7bn through August, accelerating to US$8.1bn in September. A further US$10bn is expected through year-end, which would take the yearly total just below the US$70bn mark. That compares to US$95.8bn in 2015.

The 4Q16 issuance surge, combined with lingering risk retention uncertainty, should limit issuance early next year. The inauguration of President Trump, and what impact he might have, will provide another unknown for the market to grapple with.

Kroll expects CMBS private label issuance in 2017 to end the year in the US$55bn-US$65bn range, which would be slightly below 2016 levels. Trends such as strong tenant demand, steady vacancy rates and slowing rent growth are expected to continue as the property cycle continues to mature, limiting future occupancy and rent gains.

With slowing rent growth and property prices expected, the rating agency notes that loans with marginal credit metrics may be susceptible to an increased incidence of default. Downgrades could also follow if there is negative credit migration for the US$140bn of 2011-, 2012- and 2013-vintage CMBS loans as they enter the fourth, fifth and sixth years of seasoning. Kroll analysis shows these years were among the riskiest during the loan term and accounted for 40.6% of total defaults.

Multifamily loan contributions as a percentage of private label CMBS issuance declined from 14.7% in 2015 to 9.3% so far this year. Lodging has decreased from 17% to 16.1%, whereas the industrial sector has seen an increase in contribution of 50%, but still only accounts for 6% of total issuance. Retail and office dominate at 26.2% and 25.8% respectively.

Property fundamentals are expected to remain positive in 2017, which should support underlying collateral performance. Kroll therefore expects outstanding ratings to remain fairly stable, although a continued slowing in rents and property prices will lower defeasances and loan prepayments, thus resulting in fewer upgrades than there were this year.

"As we look towards 2017, we are cautious, but constructive on CMBS issuance, property fundamentals and collateral performance. Employment growth continues, property fundamentals are positive across sectors, and interest rates remain at low levels," says Kroll.

"However, although these underlying CRE attributes are favourable, crosscurrents have been forming: non-farm monthly payroll additions weakened to 181,000 jobs year-to-date through October compared to an average of 229,000 monthly job increases in 2015; construction levels are still low, but supply has increased in certain sectors and markets, with margins between completions and absorption narrowing; property rent and price growth has slowed, and with property inventory lingering in certain markets, downward price adjustments may not be too far away; interest rates are trending higher, and with risk retention approaching, total CRE borrowing costs will likely be higher in 2017."

CMBS

Loss severity spikes

US CMBS loan losses jumped well beyond the historical weighted average loss severity during 3Q16, Moody's reports. The weighted average loss severity increased to 52% for the loans liquidated during the quarter from 41.3% in the prior quarter, well above the historical weighted average of 42.9% for loans liquidated between 1 January 2000 and 30 September 2016.

"In the third quarter of 2016, loan loss severities surged well above their historical average," says Moody's associate md Keith Banhazl. "Two notable large loan liquidations contributed to this increase: HSBC Center, from the 2005 vintage, which liquidated with a loss of US$79.7m for a loss severity of 108.7%; and Chapel Hill Mall, from 2006, which liquidated with a loss of US$65.2m for a loss severity of 100% [see SCI's CMBS loan events database]."

In the past quarter, loan liquidations from the 2004 and 2005 vintages with loss severities above 50% were a major driver of the high loss severity, Banhazl adds. These vintages accounted for 32.9% of the loans that were liquidated by balance and for 34.2% by number, and had a weighted average loss severity of 70.4%.

Overall, 190 loans liquidated with an average disposed balance of US$10.2m and a loss severity of 52% in the third quarter, against 229 loans liquidated with an average disposed balance of US$10.9m and a loss severity of 41.3% in the second quarter.

The cumulative weighted average loss severity for all loans liquidated increased slightly, to 42.9% in 3Q16. The 2008 vintage continued to have the highest cumulative loss severity, at 58.6%, followed by the 2006 and 2007 vintages. As of end-September 2016, the 2006-2008 vintages constituted 34.1% of CMBS collateral and 77.4% of delinquent loans.

Among the five major property types, loans backed by retail properties had the highest weighted average loss severity in the third quarter, at 48.9%. And among the 10 metropolitan statistical areas with the highest cumulative dollar losses, New York had the largest cumulative loss, at US$2.42bn. Detroit, however, continues to have the highest loss severity, at 59.6%.

NPLs

Servicers 'could be NPL saviours'

Italian banks' outstanding balance of non-performing exposure (NPE) is nearly five times higher than the amount registered in 2007. With NPL disposal proving to be tricky, S&P believes Italian servicers can be part of the solution by leveraging their expertise and capability as third-party asset managers.

The total stock of Italian NPE decreased in 1H16 for the first time in over 10 years. Even with that decline, the banking system has a large NPE outstanding and future flows of defaults to contend with.

The gross domestic Italian banking NPE totalled €331bn at the end of June, equivalent to 19.5% of total loans in the banking system. The worst performing assets, known as sofferenze, totalled €198bn at the end of September.

Italian central authorities have passed reforms and created the Atlante funds (SCI passim) to ease the legal framework and facilitate the sale of the NPE burden, but the effect of these new laws and regulations has not yet been recognised. S&P believes that servicers could be part of the solution.

The rating agency currently ranks nine Italian servicers, with the portfolio under assessment across asset classes and different servicing activity totalling almost €94bn. If banks retain part of this stock, outsourcing its management could support banks' internal capacity of servicing defaulted loans, reckons S&P, and could support their strategic interest in building up this expertise.

"Furthermore, if banks are going to sell defaulted loans or originate publicly securitised NPL transactions, third-party servicers will represent the natural alternative to manage those loans on behalf of investors, which usually do not have any capacity to service NPL loans, or on the behalf of SPVs, which do not have this capacity by definition," says S&P.

The rating agency adds: "Servicers can leverage on their specialised organisation, long track record and expertise to provide a service better than ever. To absorb the potential flow of NPLs coming into the market, a scalable structure, reliable IT systems and experienced staff are pivotal elements that could guarantee safer growth."

Risk Management

Relief extended for non-US dealers

The US CFTC Division of Market Oversight has issued a time-limited no-action letter that extends relief provided to certain CFTC-registered swap dealers (SD) and major swap participants (MSP). The letter states that the division will not recommend enforcement action against a non-US SD or non-US MSP established in Australia, Canada, the EU, Japan or Switzerland that is not part of an affiliated group in which the ultimate parent entity is a US SD, US MSP, US bank, US financial holding company or US bank holding company, for failure to comply with the CFTC's swap data reporting requirements with respect to its swaps with non-US counterparties that are not affiliates of a US person. The relief will expire on the earlier of: 30 days following the issuance of a comparability determination by the CFTC, with respect to the SDR reporting rules for the jurisdiction in which the non-US SD/MSP is established, or 1 December 2017.

Risk Management

Clearing default implications considered

The US CFTC's market risk advisory committee has approved a set of recommendations for improving the methods that clearinghouses use to manage the default of a clearing member. At the same time, three derivatives clearinghouses intend to hold a coordinated exercise to test their procedures for managing a clearing member default.

The CFTC's recommendations cover communication with clearing members and non-clearing firms, participation in default management committees, 'fire drill' testing exercises and auctions. Issues related to porting customers from a defaulting firm to another clearing member are also covered.

The recommendations were drafted by a group of experts from clearinghouses, clearing firms and end-users. They are not binding on the CFTC, but were endorsed by nearly every member of the advisory committee, as well as all three of the CFTC's commissioners.

In a similar vein, CME Group, Eurex and LCH.Clearnet have announced that they will work together in 1H17 to test their procedures for managing a clearing member default. The exercise is still being planned and will simulate the effects of a default of a clearing firm that affects all three clearinghouses. The exercise will be monitored by regulators in the US, Germany and the UK.

RMBS

Small value operations due

The New York Fed's open market trading desk intends to conduct two small value agency MBS sales operations on 29 November and 1 December. The total current face value of sales across the two operations will not exceed US$100m.

The Fed says such small value exercises are a matter of prudent advance planning. The desk has published an operating schedule, detailing the time, operation type, securities and maximum sale amount for each operation. The results will be posted on the Fed's website at the start and following the completion of each operation.

RMBS

Positive review for RPL deals

Fitch has reviewed 175 classes from seven US RMBS transactions backed by re-performing loans. The transactions have between five and 23 months' seasoning and serious delinquencies range from 0.6% to 4.7%, which is better than initially expected for peak-vintage RPL collateral. No deal has more than 33bp of realised loss to date, as a percentage of the closing pool balance.

Specifically, Fitch has upgraded 40 tranches, affirmed 135 and revised the rating outlook from stable to positive for 98. The upgrades and positive outlooks reflect improvement in the relationship between credit enhancement and expected losses significant enough to result in positive rating pressure.

The deals have steadily delevered since issuance, with three-month CPR averaging approximately 13%. The average CE of upgraded investment grade classes and those with a positive outlook has increased to 33% from 28% at issuance.

Meanwhile, the rating affirmations reflect transaction performance within initial expectations. Fitch notes that if performance continues along this early trendline, the affirmed ratings will likely experience positive rating pressure in the future.

RMBS

Mortgage loan servicing evolving

An environment of continued regulatory scrutiny will lead US mortgage loan servicing to increasingly fall to non-banks, says Fitch. At a servicer roundtable hosted by the rating agency, 89% of servicers agreed that non-bank servicers will continue to take market share from banks next year.

The source of non-bank portfolio growth is evolving. Where growth among non-banks was previously driven by MSR sales and subservicing, future activity is expected to be driven by new loan origination activity by competitive non-banks that also service loans, believes Fitch. Servicing sales from banks that want to reduce the associated regulatory impact on capital will also drive growth.

Although increased regulation has driven servicing costs higher, the majority of roundtable attendees agree that regulation has improved servicing quality and provided benefits to consumers. Servicing transfers have become cleaner due to better data quality on in-flight loan modifications and loss mitigation efforts undertaken by prior servicers.

Attendees also agree that servicing technological improvements are required in 2017. That will increase costs, but is necessary to ensure regulatory compliance.