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A round up of this week's structured credit news
US Treasury Secretary Tim Geithner revealed his proposed regulatory reform programme on Monday, 30 March. The programme comprises four broad components, further details of which will be presented in the coming weeks: addressing systemic risk; protecting consumers and investors; eliminating gaps in the regulatory structure; and fostering international coordination.
Geithner's testimony before congress focused on systemic risk because financial stability is critical to economic recovery and growth, and because systemic risk is expected to be a primary focus for discussions at the G20 Leaders' Meeting on 2 April. He plans to tackle systemic risk by introducing: a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems; higher standards on capital and risk management for systemically important firms; registration of all hedge fund advisers with assets under management above a moderate threshold; a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market; and new requirements for money market funds to reduce the risk of rapid withdrawals.
Among other aspects, the plan encompasses regulating CDS and OTC derivatives and subjecting all dealers in OTC derivative markets to a strong regulatory and supervisory regime as systemically important firms. Additionally, all standardised OTC derivative contracts will be "forced" to be cleared through central counterparties, while non-standardised derivatives will also be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices and close-out practices.
Central counterparties and trade repositories will also be required to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to appropriate federal regulators.
Derivatives losses revealed
US commercial banks reported a US$9.2bn trading loss for Q408, according to the Office of the Comptroller of the Currency in its 'Quarterly Report on Bank Trading and Derivatives Activities'. For 2008, banks reported an annual trading loss of US$836m, compared to trading revenues of US$5.5bn in 2007.
"While banks reported reasonably strong client demand and wide intermediation spreads in the fourth quarter, large write-downs on legacy credit positions continued to take a toll on trading results," explains deputy comptroller for credit and market risk Kathryn Dick. "Trading results continue to reflect large changes in the fair values of derivatives receivables and payables, based upon market participants' views of the credit quality of both banks and their counterparties."
She adds that trading results suffered from an unfavourable combination of higher overall corporate credit spreads and lower bank credit spreads, each of which result in trading losses.
The report shows that the notional amount of derivatives held by insured US commercial banks increased by US$25trn (14%) in the fourth quarter to US$200trn. The increase resulted from the migration of investment bank derivatives activity into the commercial banking system. Credit derivatives fell 2% to US$16trn.
The OCC also reported that net current credit exposure, the primary metric the OCC uses to measure credit risk in derivatives activities, increased by US$364bn, or 84%, during the quarter to US$800bn. Dick also notes that, similar to the notional derivatives increase, migration of derivatives activity from investment banks into the commercial banking system accelerated the growth in credit exposure.
Among other things, the report also noted that:
• Derivatives contracts are concentrated in a small number of institutions. The largest five banks hold 96% of the total notional amount of derivatives, while the largest 25 banks hold nearly 100%.
• CDS are the dominant product in the credit derivatives market, representing 98% of total credit derivatives.
• The number of commercial banks holding derivatives increased by 33 in the quarter to 1,010.
Commerzbank details bad-bank plans
Commerzbank has revealed its plans to de-risk its balance sheet by transferring a number of problematic structured finance assets into a 'divisional restructuring unit' (DRU). In a presentation given on Friday, the bank stated that - via the planned de-risking by the DRU, in particular in the area of structured finance - it expects a significant decrease in credit spread during the course of 2009.
Commerzbank estimates that the management of its ABS portfolio, together with its leveraged acquisition finance portfolio poses the greatest challenge in 2009. It has published details of the assets it currently holds, which show that government-wrapped ABS amounting to €5.8bn constitute the biggest sub-asset class on its books.
Of the €5.8bn, some €4.1bn constitutes US student loan ABS. Negative P&L effects are not expected on the student loan ABS assets; however, the bank sees further P&L risks with regard to its CDO (€2.3bn US ABS CDO), RMBS (€0.9bn US RMBS and €2.6bn non-US RMBS) and CMBS (€1.3bn CMBS/CRE CDO) positions.
The bank also says the economic value of its ABS positions hedged by monolines are in doubt. The current replacement value of the relevant CDS hedges amounts to €2.6bn, it estimates.
K2, the former Dresdner Kleinwort SIV taken on by Commerzbank last year, resulted in a P&L hit in 2008 of €681m, due to market value deterioration of the assets. However, the bank says it sees potential for write-ups in the case of a market recovery, given the good quality of the ABS portfolio.
Station Casinos settled ...
Markit and Creditex, in partnership with credit derivative dealers, have announced the results of a credit event auction conducted to facilitate settlement of CDS trades referencing Station Casinos Inc. The final price of Station Casinos bonds for the purpose of settling CDS transactions was determined to be 32% of par value.
According to analysts at Credit Derivatives Research, this is the second auction in a row where the final price was above the IMM, but it also received the lowest total bid on record at US$42m. Additionally, the bid-to-cover of 57% was huge compared to previous auctions. The highest bids were from RBS and Credit Suisse.
... while four more credit events are announced
ISDA is to launch CDS auction protocols to facilitate the settlement of CDS trades referencing Idearc Inc, Abitibi-Consolidated Inc, Charter Communications Holdings and Capmark Financial Group Inc. In addition, Markit LCDX index dealers have voted to run a credit event auction to facilitate settlement of LCDS trades referencing Charter Communications Inc.
Idearc Inc, the Dallas-based phone-directory publisher, has filed voluntary petitions to reorganise under Chapter 11 of the US Bankruptcy Code. AbitibiBowater, which was formed in 2007 through the merger of US-based Bowater and Canada's Abitibi-Consolidated, failed to make a payment on its loan debt on 13 March, while Charter filed a Chapter 11 petition in the US Bankruptcy Court for the Southern District of New York at the end of last week. On 24 March Capmark announced that it failed to make a payment due on its bridge loan agreement that matured on 23 March.
The auctions for Capmark and Idearc bonds have tentatively been scheduled for 22 and 23 April respectively. In addition, LCDX dealers are expected to vote on whether to hold an auction for LCDS transactions referencing Idearc.
New counterparty risk criteria options proposed
Fitch is proposing new counterparty risk criteria options, reflecting concerns that structural mechanisms based around counterparty triggers alone may not be sufficient to isolate securitisation transactions from the credit risk of the counterparties on which they rely. The agency is seeking market feedback on these new proposals.
The new criteria options address the potential interaction between rating triggers and so-called 'cliff' risk, which has been highlighted by recent bank failures. This relationship can itself undermine the effectiveness of rating triggers as a mitigating factor, as the extent of actions which have to be taken on trigger breaches can further impact the counterparty's credit profile in the near term. Other aspects discussed include jump-to-default risk and the relative ability to replace counterparties when necessary.
"Fitch's proposed criteria options suggest that there are a number of alternatives to the current approach, including posting collateral from day one, raising triggers to higher levels or supplementing rating triggers with Fitch's support floor ratings. All provide enhanced mitigants to problems, such as cliff risk, but equally each option has its own drawbacks as well as advantages," says Stuart Jennings, md at Fitch.
Fitch is planning to update its structured finance counterparty criteria to reflect the significant evolution in the market environment in recent months. Following extensive internal discussion and analysis, the agency has published an exposure draft in which it outlines a number of possible options through which counterparty risk could be addressed in the rating of structured finance transactions. Given generally increased counterparty risk for structured finance transactions, Fitch believes that existing structural protections based around rating triggers need to be either supplemented or replaced.
"Likelihood of counterparty replacement has also been a focus of the review. Esoteric and off-market counterparty positions have always been a feature of structured finance transactions," says Andreas Wilgen, senior director at Fitch Ratings. "Sourcing replacement counterparties for the most 'plain vanilla' counterparty exposure in the current market environment is difficult. The exposure draft also examines ways in which the replaceability of a counterparty position might be better assessed."
Fitch recognises that - depending upon market reaction - changing counterparty criteria with respect to its structured finance ratings could have an impact on its ratings. It could also impact the way market participants choose to address counterparty risk when structuring new transactions.
The intention of the report is to open a dialogue with the market on this issue and the options outlined, with the aim of gathering extra information and hearing different points of view. In particular, the agency invites comments on the various questions that are framed throughout the report. The information gathered will be factored into developing the final criteria amendments to be developed after the consultation period.
EC consults on resecuritisation risk-weightings
The European Commission has opened a public consultation on further risk-weighting penalties for resecuritised products, such as CDO-squareds. ABS analysts at SG note that potential higher risk weightings would reflect the complexity and illiquidity of such bonds, which have the potential to destabilise the banking system.
Market participants have until 29 April to make counter proposals. The new proposal is based on three elements:
• strengthening trading book capital requirements. The trading book securitisation position could be given the same risk-weighting (RW) treatment as the banking book position. However, this might be overruled by the Basel Committee's proposal to apply 100% RW to all net positions in the trading book;
• raising capital charges for certain kinds of securitisation exposure. Resecuritised products such as ABS CDOs or CDO-squareds would have a special RW grid, with a potentially dilutive capital charge;
• upgrading risk management and disclosure standards for securitisation positions. The Commission is open to any necessary changes, but considers that the European legal framework is sufficient at this stage and coherent with the recommendations of the Basel Committee. If necessary, the Commission is ready to implement further disclosure standards following accordance with requests from regulatory bodies.
CSO manager actions scrutinised
Fitch says in a new special comment that the ability of IG CSO managers to trade has been dramatically reduced, due to structural constraints, a lack of market liquidity and unprecedented spread widening. These liquidity and operating pressures have partly resulted from a reduction in the number of credit derivatives dealers and the capital allocation to correlation desks, the agency explains.
In this context, IG CSO managers have refrained from executing trades that would reduce the amount of available subordination or would result in a breach of one or more other portfolio parameters. This has led to a number of transactions becoming virtually unmanageable, leaving them exposed to potential credit events.
Fitch says that the commentary is intended to highlight several key factors hindering the ability of IG CSO managers to trade and what solutions market participants are considering in an attempt to improve the situation. For example, certain managers have shifted their primary investment objectives to preservation of capital from avoidance of tranche downgrades.
This entails the maximisation of the protection levels in order to absorb any potential losses resulting from a credit event or removal of a distressed name. As such, certain managers have stopped managing to a model for tactical spread/rating or tranche pricing optimisation, preferring to base their investment decisions on their own fundamental credit views.
Furthermore, most corporate synthetic CDO managers rated or reviewed by Fitch have attempted to increase the protection levels across the CDOs in order to absorb any potential loss from rising idiosyncratic risk. To do so, they increased their portfolio allocations to defensive sectors ahead of the downturn in 2007 and intensified their efforts until mid-2008, when trading conditions deteriorated further.
However, in most cases, managers were unable to implement their targeted allocations, due to the cost of substitution, initial portfolio industry and obligor concentrations and limited subordination.
Beyond a change in the overall management of the transaction, CSO managers have also pursued other paths in an attempt to relieve liquidity and operating pressures currently facing such transactions. These actions include increasing dialogue with arrangers and CDS traders regarding subordination calculations and price quotes to achieve fair pricing.
ABX ...
Default rates for the Markit ABX index in March rose to reach 18.87%, 22.15%, 18.96% and 17.35% for the 06-1 through 07-2 series respectively. CDR numbers have generally levelled off, likely reflecting the effects of foreclosure moratoriums and loan modification programmes, as well as seasonal and day count factors, according to structured credit strategists at JPMorgan.
60+ delinquencies are above 40% across all of the indices, while 90+ delinquencies and foreclosure buckets continue to increase. Cumulative losses increased by 83bp for the 07-2 index to reach 8.09% and rose by approximately 60bp-70bp for the other indices.
Out of the 480 ABX constituents, 66 deals have now been depleted, while a number of new tranches have begun taking write-downs concentrated in the 06-2 index. MSAC 06-WMC2 M-5 (06-2 constituent) and LBMLT 06-6 M-5 (07-1 constituent) continue to be the only single-As that have been written down completely, and the tranches currently taking write-downs are the ones second junior to the double-As.
"To-date, the 06-2 and 07-1 indices have been hit the hardest by write-downs and we expect that trend to continue; the 06-1 index is a better performer and therefore will not experience as serious write-downs as the more recent vintages, and the 07-2 is still not seasoned enough to be in line with the previous indices. It is only a matter of timing when the write-downs will come in at an increased speed for the 07-2 index," the JPMorgan strategists conclude.
... and CMBX remits in
US CMBS performance continues to deteriorate: the latest remits show that the overall 30+ days delinquency rate across the fixed rate universe rose by 28bp, to 1.98%. The pace of increase is slightly higher than the average 23bp jump over the past four months, note ABS analysts at Barclays Capital.
The delinquency rate of the 2000-2004 vintage loans over the past few months had been stable, but this month saw a 25bp increase in line with the more recent vintages. Across CMBX, Series 4 led the increase in non-performing loans with a 42bp jump, while CMBX.1 remained a relative outperformer.
Multifamily showed the biggest uptick among the recent vintage loans by property type in terms of 30+ day delinquencies, followed by retail. Multifamily delinquency rates are above 3% for all vintage stratifications, according to the BarCap analysts. They also note that a large volume of multifamily loans transferred to special servicing-current status in recent months.
"The volume of loans in special servicing-current status suggests that the pace of new delinquencies will increase," they explain. "For example, across 2007+ vintages, it is 1.21%, up 43bp from last month. Most of the loans entering special servicing-current status are aggressively underwritten pro forma loans, and we expect further deterioration."
Meanwhile, credit strategists at BNP Paribas note that, while the Geithner plan has had little impact on ABX.HE triple-A tranches, CMBX triple-As have rallied strongly. They suggest that this indicates that banks are more likely to sell their toxic commercial real estate portfolios than their housing portfolios, as the consumer recession gains strength going forward and unemployment has a significant impact on retail and office space.
Freddie Mac brings Reverse REMIC
Freddie Mac is to offer Reverse REMIC Giant PC securities, a new mortgage-related security intended to provide liquidity to the US residential mortgage market and new options for investors. The programme permits a pro-rata portion of all outstanding Freddie Mac REMIC security classes from a previously issued REMIC group - which, in aggregate, constitute a pass-through from the mortgage collateral backing the original REMIC group - to be recombined into a pass-through re-REMIC class. This pass-through re-REMIC class in turn becomes the collateral backing a new Freddie Mac Giant PC security that is eligible collateral for all Freddie Mac resecuritisation programmes.
Additionally, if the collateral backing the original REMIC met SIFMA TBA (to be announced) market good-delivery guidelines at origination, the new Giant security will also meet those same good-delivery guidelines.
"Freddie Mac Reverse REMIC Giant PC securities are designed to provide a new, additional dimension of liquidity to the residential mortgage-backed securities market," says Mark Hanson, vp for mortgage funding at Freddie Mac. "Historically, remaining tranches in REMIC securities lacked the liquidity sought by investors. Freddie Mac Reverse REMIC securities provide a new alternative investment vehicle by converting them into Freddie Mac Giant PC securities."
Barclays rejects APS participation
Barclays has announced that it will not participate in HM Treasury's Asset Protection Scheme (APS). In a statement, the bank said the board of Barclays determined that it would not be in the interests of its investors, depositors and clients to participate in the scheme.
Last week Barclays confirmed that its capital position and resources were expected to meet the capital requirements of the UK FSA after application of a detailed stress test to determine resilience to stressed credit risk, market risk and economic conditions.
Barclays says it continues to manage its balance sheet and capital position actively. Since the beginning of 2009, the bank has continued to sell credit market exposures following the disposals effected in 2008, and has done so at or around their carrying values.
Trading the XO range
Structured credit analysts at Barclays Capital expect Series 11 of the Markit Crossover index to trade in a 750bp-1050bp range for the next three months. The target reflects the intrinsically higher quality of the index, with any potential widening to the top of the range based on earnings disappointments for individual credits. Consequently, the analysts recommend trading the range by buying crossover protection under 750bp and selling protection beyond 1050bp.
Series 11 is currently exhibiting a -47bp skew. For the short term at least, the analysts expect more skew trading to occur, albeit the average skew on S11 is likely to be narrower than that of S10.
Meanwhile, with the market pricing in short-term default risk, BarCap expects the 5s/10s curve to stay inverted - if not flatten - at the current inversion of -171bp. Given the volatility on the index, the analysts prefer using the curve on single name default views rather than the index.
"We would execute on curve trades in the single name level, as some of these names are overpricing in front-end default risk," the analysts note. "The trades work on names that we do not expect to default over the course of the next year... Selling six months to one-year protection on a buy-and-hold basis is an attractive opportunity to add alpha to a portfolio."
Call for CDS transparency
CDS interdealer broker IDX Capital has submitted a petition to the SEC in response to the Commission's File Number S7-02-09, 'Temporary Exemptions for Eligible Credit Default Swaps to Facilitate Operation of Central Counterparties to Clear and Settle Credit Default Swaps'. The firm's ceo Jamie Cawley comments in an open letter that "we have been an outspoken proponent of regulatory oversight and execution transparency since our founding in 2006. We strongly support the SEC's recent efforts to promote central counterparty clearing of credit default swaps."
The letter calls on other market participants to embrace a dialogue with regulators and "embrace the electronification of the asset class, so that we can prevent future events that threaten systemic risk". Cawley expounds on the need for transparency in credit derivatives, as well as the benefits of openness and fair dealing.
'Unique' CLO structure launched
Moody's has assigned a Aa3 rating to the US$560.79m Class A notes issued by KKR Financial CLO 2009-1, a managed cashflow deal backed by a portfolio of primarily US senior secured leveraged loans. The transaction structure is unique in a number of ways, according to the rating agency.
KKR CLO 2009-1's portfolio at closing will be entirely transferred from an existing market value CDO - Wayzata Funding - that closed in November 2007, with the original noteholders reimbursed at through delivery of the new notes. Clawback risk is consequently a potential issue on the transferred portfolio if Wayzata went bankrupt, although this is primarily mitigated by the fact that Wayzata is a bankruptcy-remote orphan SPV.
The final legal transfer of all obligations included in the initial portfolio may not be achievable at closing date and Wayzata will hold title to some of these obligations until final transfer. KKR CLO 2009-1 will remain exposed to some risk from Wayzata's legal title to these assets until the transfer is perfected.
51% of the shares issued by KKR CLO 2009-1 will be owned by an affiliate of KKR, while the remainder will be owned by an independent share trustee. The deal lacks the degree of independent ownership from that of KKR that Moody's would normally expect to achieve the level of bankruptcy-remoteness necessary for an issuer in a rated structured finance transaction. The absence of independent ownership is mitigated by the requirement in the constitutional documents of KKR CLO 2009-1 for a special majority vote of shareholders (equivalent to 66.6%) for corporate actions that would either wind-up, or otherwise dissolve the company or amend its constitutional documents.
Finally, there is no overcollateralisation test in the waterfall of payments, which usually is a way to protect noteholders against potential adverse selection risk due to haircuts on deep discount obligations being applied on the OC. Moody's explains that this transaction shows a negative carry of interest from the start, thus the analysis and therefore assigned ratings have a limited reliance on the potential diversion of interest flows to pay down the notes.
ABX influence on mortgage risk pricing analysed
The BIS has published a working paper entitled 'The pricing of sub-prime mortgage risk in good times and bad: evidence from the ABX.HE indices'. The paper investigates the market pricing of sub-prime mortgage risk on the basis of data for the Markit ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis.
After an introduction into ABX index mechanics and a discussion of historical pricing patterns, the authors use regression analysis to establish the relationship between observed index returns and macroeconomic news, as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007.
In particular, while fundamental factors - such as indicators of housing market activity - have continued to exert an important influence on the subordinated ABX indices, those backed by double-A and triple-A exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors, such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks' balance sheets - such as the TARP initiative.
Fair value proposals examined
Fitch has released a special report in response to the Financial Accounting Standard Board's (FASB) recent impairment and fair value proposals, which suggests that transparency and added disclosures by issuers would benefit investors. Because much of both proposals hinge on either the intent and/or estimations provided by management, the proposed qualitative disclosures by themselves may not be sufficient for financial market professionals' understanding of the impairment and fair value conclusions reached by an issuer, the agency says.
"Absent increased disclosures, investors and analysts may assume the issuer has taken the least conservative approach to valuation and impairment," notes Dina Maher, senior director at Fitch.
The FASB proposes to change the method for determining whether an investment is other-than-temporarily impaired and for identifying inactive markets and distressed transactions when measuring fair value (SCI passim). Fitch believes that, should these proposals be adopted, disclosures by issuers should be expanded to allow for thorough and meaningful analysis, regardless of the minimum requirements.
Alternative FDIC assessment proposed
An analysis of FDIC data as of end-2008 conducted by consultancy firm BancVue shows that commercial banks US$10bn or larger hold just over US$24 worth of credit derivatives for each dollar of equity. By comparison, the rest of the industry has essentially one-tenth of a penny of CDS for each dollar of equity.
Against this backdrop, the FDIC is seeking comments on whether the agency should use total assets or some other base for its proposed emergency premium special assessment. BancVue chairman Don Shafer suggests that part of the assessment should be based on the amount of credit derivatives a bank holds compared to their equity. "If you are going to unfairly burden smaller banks that played by the rules, the least the FDIC can do is base the levy on the banks that helped trigger the crisis," he concludes.
LLP RFC launched
The Federal Deposit Insurance Corporation (FDIC) has announced the opening of the public comment period for the US Treasury's new legacy loans programme (LLP). The FDIC is requesting comment from interested parties on the critical aspects of the proposed LLP by 10 April.
The programme is intended to boost private demand for distressed assets that are currently held by banks and facilitate market-priced sales of troubled assets (see last week's issue). It is necessary because uncertainty about the value of these assets makes it difficult for banks to raise capital and secure stable funding to support lending to households and businesses, the FDIC says.
The LLP will combine an FDIC guarantee of debt financing with equity capital from the private sector and the Treasury. The partnerships will purchase assets from banks and place them into public-private investment funds (PPIF).
Institutions of all sizes will be eligible to participate in the LLP to sell assets and it is expected that a range of investors will participate, according to the FDIC. "The programme will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors. Investors will be pre-qualified by the FDIC to participate in auctions," it notes.
For providing a guarantee, the FDIC will be paid a fee, a portion of which will be allocated to the Deposit Insurance Fund. The FDIC will be protected against losses by the equity in the pool, the newly established value of the pool's assets and the fees collected.
The FDIC will play an ongoing reporting, oversight and accounting role. In addition, it will structure the debt that the selling bank will take back when the legacy loans are sold. Participant banks may then resell the debt into the market.
TruPS CDO criteria revised ...
Credit deterioration among banks and thrifts that have issued trust preferred securities (TruPS) through CDOs has been rapid and significant over recent months. This performance has prompted Fitch to revise its criteria for reviewing the ratings of approximately US$38bn of CDOs backed by these assets.
Through to 22 March 2009, Fitch-rated bank TruPS CDOs have experienced defaults and deferrals of US$780m, which is in stark contrast to bank defaults and deferrals of US$103.5m observed in 2007. Increased bank failures and continued deferral activity are expected to curtail cashflows to bank TruPS CDOs, which may reduce their ability to meet payment obligations to noteholders.
The review criteria address Fitch's analytical treatment of assets that are defaulted, deferring or where the agency sees default or deferral as a real possibility in the future. Other changes to the review criteria include the analysis of concentrated portfolios of insurance assets and the qualitative credit given to other structural features, such as excess spread and cashflow redirection mechanisms.
The revised review criteria will affect CDOs backed by TruPS issued primarily by banks and thrifts (collectively banks) and, to a lesser extent, insurance companies, as well as real estate investment trusts and other structured finance assets.
Fitch's revised bank TruPS CDO review criteria begins with an updated analysis of the credit quality of the underlying assets from Fitch's financial institutions group. The credit enhancement measurement is adjusted for issuers that are currently defaulted, deferring on their TruPS obligations or scored in the lowest two sub-categories of Fitch's US bank scoring model scale of 1 to 5.
Specifically, the credit enhancement measurement assumes 100% loss on defaulted issuers, which is consistent with the deeply subordinated nature of trust preferred securities and Fitch's previously stated recovery estimates on these instruments. Credit enhancement is further adjusted for issuers that are currently deferring on their TruPS obligations. The analysis assumes that approximately 50% of deferring issuers may be unable to cure their deferral within the contractual five-year period and may migrate to default, should the current environment persist.
Finally, Fitch has observed that issuers with a Fitch bank score of 4.5 and 5 have generally exhibited high probability of deferral and default. As such, the revised review criteria assume that 25% of these issuers will ultimately default on their obligations.
The agency expects to conclude the rating review of its bank and insurance TruPS CDO portfolio using this review criteria within the next month. At that time, it will also resolve the rating watch status that is currently outstanding on 75 bank TruPS CDOs.
... and rating actions taken
Moody's has downgraded 429 tranches across 89 trust preferred (TRUP) CDOs, due to their exposure to trust preferred securities issued by small to medium-sized US community bank and insurance companies. Due to the continued credit crisis and weak economic conditions, the number of interest payment deferrals and defaults has sharply increased in the past year and is expected to continue to rise, the agency says.
As a result, the number of assumed problematic banks has increased from roughly 200 in November 2008 to about 300 as of today. This corresponds to a significant increase in FDIC problematic banks from 171 last September to 252 at year-end. Moody's believes that, while the various actions proposed by the Federal Reserve, Treasury and FDIC are positive developments for the financial sector, they may not be sufficient to prevent further deferral of interest payment on their trust preferred securities for the weaker banks and insurance companies in TRUP CDOs.
The rating actions are the result of using a combination of the following analyses: (1) coverage level and problem bank analysis; (2) event of default analysis; (3) cashflow analysis; (4) pass-through of the underlying portfolio credit analysis; and (5) break-even analysis.
In order to promote market transparency, Moody's encourages the underwriters and collateral managers for all TRUP CDOs to publish the list of collateral securities in each of their respective CDOs. TRUP CDOs with exposure to REITS will be reviewed in the coming weeks.
NY Fed reports MBS purchases
The New York Fed purchased US$33.15bn net (US$47.25bn gross) in agency MBS between 19 and 25 March under the Agency Mortgage-Backed Securities Purchase Programme. Purchases in agency MBS were made by investment managers acting as agents for the System Open Market Account (SOMA).
SecondMarket Ecosystem launched
SecondMarket has launched the SecondMarket Ecosystem, a network of product and service providers for buyers and sellers of illiquid assets (see SCI issue 123). With over 25 companies already participating and more than 250 other firms expressing interest in joining, SecondMarket's Ecosystem offers buyers and sellers free access to critical resources for trading illiquid assets, including valuation, research, data, analytics, legal and transaction advisory services.
The addition of the Ecosystem to SecondMarket's centralised marketplace creates a single location for buyers and sellers to not only trade illiquid assets, but also to access a global community of experts. This combination of trading and information ensures a more transparent, more liquid market for these assets, the firm claims.
Economic capital issues discussed
The Basel Committee has released a report, entitled 'Range of practices and issues in economic capital frameworks', which aims to address the challenges that banks face with respect to economic capital.
"[Economic capital] has increasingly become an accepted input into decision-making at various levels within banking organizations. Despite the advances that have been made by banks in developing their economic capital frameworks, the further use and recognition of risk measures derived from these frameworks remain subject to significant methodological, implementation and business challenges," the report notes.
As economic capital has - to varying degrees - become a component of many banks' internal capital adequacy assessment processes (ICAAP), the paper is addressed to banks that have implemented or are considering implementing economic capital into their internal processes. The paper is also aimed at supervisors, which are required under Pillar 2 (supervisory review process) of the Basel 2 framework, to review and evaluate banks' internal capital adequacy assessments.
Economic capital models and the overall frameworks for their internal use can provide supervisors with information that is complementary to other assessments of bank risk and capital adequacy. While there is benefit from engaging with banks on the design and use of the models, supervisors should guard against placing undue reliance on the overall level of capital implied by the models in assessing capital adequacy, the Committee notes.
The report outlines recommendations that identify issues which should be considered by supervisors in order to make effective use of internal measures of risk that are not designed for regulatory purposes. The areas covered include: the use of economic capital models in assessing capital adequacy; senior management; transparency and integration into decision-making; risk identification; risk measures; risk aggregation; validation; dependency modelling in credit risk; counterparty credit risk; and interest rate risk in the banking book.
SIV notes impacted
Moody's has downgraded its senior debt and capital note ratings of Carrera, a SIV sponsored and backed by HSH Nordbank. The rating action does not affect the short-term Prime-1 ratings of the Euro and US CP programmes.
The rating action on Carrera's Euro and US MTN programmes follows the downgrade on 20 February of HSH's long-term rating to A1 from Aa3. The direct linkage between the senior debt ratings of Carrera and those of HSH is based on the bank's commitment to support the SIV's senior debt through a note purchase and liquidity facility, as well as a committed repo facility. Under these agreements, the repo facility covers two-thirds of senior debt while the note purchase and liquidity facility makes up the balance of senior debt.
The rating action on Carrera's capital notes is the result of the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of CDOs, as well as further deterioration in the credit quality of the SIV's asset portfolio since the last rating action.
FGIC downgraded, ratings withdrawn
Moody's has downgraded to Caa3 from Caa1 the insurance financial strength (IFS) ratings of the main operating subsidiaries of FGIC Corporation, including Financial Guaranty Insurance Company and FGIC UK Limited. At the same time, Moody's affirmed the Ca ratings on FGIC's contingent capital securities, Grand Central Capital Trusts I-VI, and the senior debt ratings of the holding company, FGIC Corporation.
The rating action reflects Moody's expectation of higher mortgage-related losses arising from FGIC's insured portfolio, insufficient claims paying resources to cover Moody's estimate of expected loss and the constrained liquidity and financial flexibility of the holding company. The outlook for the ratings is negative.
Moody's has also announced that it will withdraw the ratings of FGIC and FGIC Corporation for business reasons.
According to Moody's, the rating action is the result of FGIC's substantial exposure to sub-prime mortgages and ABS CDOs. The rating agency currently estimates that the expected loss for FGIC's insured portfolio now exceeds claims paying resources. The negative outlook reflects the possibility of even greater than expected losses in extreme stress scenarios, with losses possibly reaching sectors beyond mortgage-related exposures as corporate and other consumer credits face a more challenging economic environment.
More CSOs and ...
Moody's has downgraded a further 118 CSO notes. The agency explains that the rating actions are the result of: (i) the application of revised and updated key modelling parameter assumptions that Moody's uses to rate and monitor ratings of corporate synthetic CDOs; and (ii) the deterioration in the credit quality of the transactions' reference portfolio.
... SF CDOs downgraded
Moody's has downgraded its ratings on 118 notes issued by 30 CDO transactions that consist of significant exposure to Alt-A, Option-ARM and sub-prime RMBS securities, CLOs or CMBS. Moody's explains that the rating actions reflect certain updates and projections and recent rating actions on underlying assets on these asset classes.
Further deterioration expected for EMEA CMBS
The performance of a number of CMBS and multi-family transactions in EMEA deteriorated in Q408, says Moody's in its 'EMEA CMBS Q408 Surveillance Report'. Looking ahead, the agency expects a further deterioration in EMEA CMBS loan performance.
Throughout Q408, Moody's observed an increase in the cumulative number of loans within EMEA CMBS transactions that are on the respective servicer's watchlist, are in default and/or require special servicing. "Given that a total of approximately 660 loans in large multi-borrower transactions are currently monitored by Moody's, the rising absolute number of loans which have either defaulted, been transferred into special servicing or put on the respective servicers' watchlists is still at a low level, but it is expected to rise significantly over the next couple of quarters and years," says Stephan Ebe, a Moody's associate analyst and co-author of the report.
Moody's also notes a near doubling in the number of loans that suffered a payment default and a rise in the number of instances of loans breaching their ICR/DSCR covenants due to decreasing property cashflows. "This deterioration in property cashflows attests to the weakening of the occupational markets, with more tenants having difficulty making rental payments, the demand for space diminishing in certain occupational markets and non-recoverable costs for borrowers being higher than anticipated," adds Deniz Yegenaga, a Moody's associate analyst and co-author of the report.
The worsening state of the commercial real estate lending, investment and property markets in the various EMEA countries had a negative impact on the ratings to varying degrees. This affected both the junior and mezzanine notes in EMEA CMBS transactions, as well as some senior notes during Q408.
Overall, the ratings of a total of 35 classes of notes in 20 transactions were downgraded by Moody's during Q408. Moreover, 14 classes of notes in six transactions were placed on review for possible downgrade. An additional 39 classes of notes remained on review for possible downgrade during the quarter, having been placed on review in the previous quarter following the insolvency of Lehman Brothers.
Moody's expects the number of negative rating actions for EMEA CMBS to increase significantly in the coming months and quarters. In early 2009, amid the ongoing adverse development of EMEA commercial real estate markets and subdued commercial real estate lending and investment activity, the rating agency adjusted its EMEA CMBS central scenarios that are used to analyse EMEA commercial real estate loans and CMBS transactions. Moody's intends to finalise its property-by-property and loan-by-loan analysis of all outstanding EMEA CMBS deals against the background of these central scenarios during the course of H109. The rating agency anticipates that 20% to 30% of all senior EMEA CMBS notes that it rates are likely to be downgraded by one to four notches, and 50% to 60% of all Moody's-rated mezzanine (including junior Aaa notes) and junior notes will potentially be downgraded by three to seven notches.
SNAC CDS compliance for Quantifi
Quantifi has released Version 9.1.4 to support the new standard North American corporate (SNAC) CDS set to begin trading on 8 April. The upgrade will provide specific enhancements to pricing, risk management and operations to support the new contracts.
The enhancements include:
• The new ISDA CDS standard model to convert spreads to upfront fees and to calculate exact settlement payments
• Support for calibration of survival curves based on the new SNAC quoting convention
• The ability to calculate hedges and sensitivities based on the SNAC contract
• Trade capture support for the SNAC contract, along with ISDA-compliant validation to ensure accurate trade representation
• Support for the new Markit fixed coupon report, which contains quotes for the SNAC contracts.
Rohan Douglas, Quantifi ceo, comments: "There are profound changes occurring in the CDS market as part of the ISDA CDS 'big bang'. As these changes will have a significant impact on existing modelling and trading infrastructure, support for these new contracts before they begin trading on 8 April is crucial for all market participants. With this release, we are making sure our clients are fully prepared so that the transition is as seamless as possible."
Australian mortgage performance worsens
Fitch says in its latest report that Australian mortgage delinquencies have worsened through Q408 and are expected to continue through Q109 due, in part, to the seasonal effect of Christmas credit spending.
"Throughout 2009, there will be a steep contrast between those borrowers who continue to struggle and those who begin to really feel the relief provided by the five cuts in the official cash rate to 3.25% - only a portion of which has been passed on to borrowers. The key factor will be each borrower's ability to retain full employment during this continued global downturn," says Leanne Vallelonga, associate director in Fitch's structured finance RMBS team.
Australian mortgage performance - as measured by mortgage delinquencies - deteriorated in Q408, evidenced by the increase in the Fitch Dinkum Index for 30+ day delinquencies to 1.75% in Q408 from 1.50% in Q208, which is the measure for full-documentation loans. Most of the jump in delinquencies occurred in the 90+ day arrears.
Non-conforming low-documentation 30+ day delinquencies currently stand at a new record high of 19.73%, almost five times higher than conforming low-documentation 30+ day delinquencies of 3.95%. Fitch believes the non-conforming sector continues to suffer from an inability to refinance with the practical closure of the low-documentation origination market. The agency expects its low-documentation index to deteriorate at a consistently faster speed than the full-documentation index.
Negative outlook for global CRE
Fitch says in a new report that senior CMBS notes remained resilient to the extremely challenging economic environment and declining commercial property values during 2008. The agency notes that 99.4% of the agency's triple-A CMBS ratings were unchanged during the year. Further, more than 92% of all triple-B rated CMBS bonds either retained their rating or were upgraded.
However, for the first time, global CMBS experienced net negative ratings performance in 2008, with an upgrade-to-downgrade ratio of 0.7 to one. Fitch expects that loan defaults will increase, while prepayments will continue to slow considerably during 2009, leading it to assign a negative outlook to the global commercial real estate market and CMBS ratings for the current year. Downgrades are expected to significantly outweigh upgrades in 2009 across all rating categories.
"As most CMBS loans do not amortise greatly over their term, the largest current risk in global CMBS remains defaults on balloon maturity payments," says Rodney Pelletier, head of EMEA structured finance performance analytics at Fitch. "However, this refinance risk is partly mitigated by the fact that only a small volume of CMBS loans will mature in 2009 and 2010. More maturities will occur from 2011-2013, but most will occur after 2015."
"Given the global economic environment, performance is expected to decline further in 2009, reducing ratings stability - especially at single-A level and below," adds Charlotte Eady, associate director, EMEA structured finance performance analytics at the agency. "Fitch expects that triple-A and double-A rated bonds will also be affected negatively, but to a lesser extent."
In the US, Fitch expects retail and hotel properties to experience greater stress as performance of these assets is heavily dependent on consumer spending, as well as business and leisure travel - all of which have fallen off sharply. In European and Asian commercial property markets, challenges in the retail and financial sectors in particular are expected to pressure CMBS performance metrics.
Troubled company index deteriorates sharply
The Kamakura index of troubled public companies deteriorated sharply in March after holding steady in January and February, increasing by 1.1% to 24.3% of the public company universe. This is 0.3% above the current recession's previous peak of 24% reported for December 2008.
Kamakura defines a troubled company as a company whose short-term default probability is in excess of 1%. The all-time high in the index was 28%, recorded in September 2001. Credit conditions are now worse than credit conditions in 96.4% of the period since the index's initiation in January 1990.
The index has expanded its coverage to 23,900 companies, an increase of more than 1,000 firms since the previous month - predominately made up of Canadian public firms. Kamakura reports that the expanded corporate coverage has had no significant impact on the level of the index.
"On 2 March, Kamakura reported that Chemtura Corporation was among the rated companies with the largest one-month jumps in short-term default risk," comments Warren Sherman, Kamakura president and coo. "Chemtura filed for Chapter 11 bankruptcy on 18 March. This month, among rated public companies, the companies showing the sharpest rise in short-term default risk were Blockbuster Incorporated, Fairpoint Communications, Cumulus Media, Gannett Co and Eddie Bauer Inc."
Analytics functions analysed
Firms should adopt a joint approach to pricing functions in the front office, according to a new report entitled 'OTC Derivatives and Structured Product Pricing Practices: Trends and Technology Strategies for the Coming Market Reformation', published by financial research and consulting firm Celent.
The key finding of the report is that trends and developments towards greater transparency in pricing and valuation functions had been increasing even before the onset of the credit crisis. In a post-crisis period of financial reform and with a substantial pool of complex securitised assets and structured products, the market is now seeing unprecedented levels of scrutiny and requirements for firms to show procedural consistency in their complex deal pricing and portfolio valuation activities. Regulators, investor groups, quasi-governmental organisations and government agencies are pushing for greater transparency, independence and accountability, with the emphasis on having well-defined processes and ensuring that these processes are repeatable.
Celent consequently advises firms to: 1) move towards a federated 'publish & subscribe' organisational model for pricing functions; 2) improve consistency of pricing analytics front-to-back across the value chain; 3) define a coherent strategy for a model development infrastructure; 4) align front office, risk control and support interactions based on derivative product lifecycle dynamics; 5) establish pricing information transparency 'upstream' in order to inform control activities 'downstream'; and 6) rethink building blocks that play into a pricing/valuation architecture.