Vanilla structures return - SCI magazine/SCI Mag Issue 3... · Vanilla structures return ... in the primary market. Conversely, the RMBS analysts say, ... Insurance-linked securities

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Vanilla structures returnLess complex rate products in vogue

ILS issuance expectations

Focusing on risk chemistry

RMBS and bank ratings

Structured credit ideas

CDS clearing

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In the UK it has all become about the ‘new politics’ since our last issue, or so the politicians would have us believe. Unfortunately, there is nothing new about the global economy and the mess we still find ourselves in.

While structured finance was the first into the mire, the market continues to hope that it will be the first out. However poorly the concept of bank profits riding a wave of recovery far ahead of the still-drowning general public will play, it would nonetheless be the first genuine marker along the road to recovery.

In short, what the world needs now is primary issuance and plenty of it, but that wave appears unlikely to come crashing ashore any time soon. A recent survey of 26 European ABS investors blamed the cautious nature of issuers and arrangers – let’s gloss over the irony of that for now – but did at least indicate some slightly more positive views on the 12 months ahead.

Undertaken by Bishopsfield Capital Partners, 62% of survey respondents believe new issuance will be higher over the next 12 months than in the past year, while 80% believe new issues will achieve stable or tightened credit spreads. Only a minority of survey partici-pants indicate a preference for fresh new issuance. The majority of ABS investors surveyed are equally happy to consider relative value among existing issuance, versus more thinly priced but untainted primary issuance.

The survey does not, however, go onto explain why – if investors are so ambivalent about where the paper comes from – low secondary market volumes continue to persist. It could just of course be those peskily cautious dealers again, but in any event limited activity is causing its own difficulties.

As European asset-backed analysts at RBS estimate, some 80%-85% of outstanding legacy European ABS and RMBS, totalling around €550bn, continues to be warehoused by the original holders of the risk – mostly banks or their ‘bad-bank’ subsidiaries. They point to the stark difference between the European and US markets, where programmes like the PPIP have facilitated a better redistribution of legacy product into newer investors.

The concentration of the buyer base means that the profile of primary issues is heavily influenced by the appetite of only the few, which the analysts believe explains the domi-nance of the most vanilla, high quality UK and Dutch prime RMBS and German auto ABS in the primary market. Conversely, the RMBS analysts say, the lack of primary issuer or asset class diversification is likely a significant deterrent in attracting other legacy ABS investors back into the market, given existing single name or asset limits.

Oh goody – another vicious circle to contend with. Notwithstanding such gloom and doom, we hope you enjoy our third issue.

Mark PelhamEditorial Director, SCI

London, June 2010

1www.structuredcreditinvestor.com

Page One

Contents 4The Interview Navigating changing markets

Joe Walsh,presidentofAmherstSecurities,shareshisviewsontheABSandMBSmarketsandthefuturestrategyofhisfirm

8 Wholesale Structured Products Vanilla structures return

Suddenlymundaneispopularagain.AsKathy Fitzpatrick Hoffelderdiscovers,complicatedrateproductstrategiesthathavebeenmarketedas‘toosophisticatedtofail’areout.Institutionalinvestorsinsteadarecontemplatingwaystooffsetaneversteepeningyieldcurveandfindalittlebitofyieldalongtheway

13 Structured Credit Risk chemistry

Therelationshipbetweencredittradingandriskmanagementisattractingmoreattentionintoday’splainvanilla,post-crisisworld.ManyinstitutionsareputtingagreaterfocusonCVAandreservemodels,whileothersaremovingcreditriskmanagersupthehierarchy.Rachael Horsewoodreports

18 ILS Greater expectations

Insurance-linkedsecuritiesaretypicallythoughtofasaspecialistassetclass.However,asJillian Ambroseexplains,catastrophebondsaregeneratingincreasinginterestfromnon-insuranceinvestors,whichinturncouldbemetbyincreasednewissuancevolumes

23ABS RMBS, bank ratings and risk

Richard Lorenzo,vpstructuredfinance,andPatrick Winsbury,svpfinancialinstitutions,atMoody’sInvestorsServicelookattherelationshipbetweenRMBSissuanceandAustralianbankratings

27Structured Credit Simplicity is key

Madhur Duggar,Batur Bicer,Matthew Leeming,Søren WillemannandRob HagemansofBarclaysCapitalCreditResearchtakealookatthepotentialforstructuredcreditproducts

33CDS Clearing Clearing consensus

AconsensushasbeenreachedaboutthebenefitsofCDSclearing.But,asCorinne SmithandJames LinacrediscoverinthisspecialreportundertakenforSCI’sonlineservice,concernsoverpricingandliquidityremain

39Price TalkWehighlightsomeofthekeyrecenttradingactivityinABSandCLOs

41DataABS,CDOsandnaturalcatastrophebondsissuedoverthelastthreemonths

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2 SCIJuly2010

Issue3July2010

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Q: How would you characterise Amherst Securities’ role in the securitisation space?

A: Amherst is one of the leading US broker-dealers specialising in the mortgage-backed securities space. We serve institutional investors and actively work in both the new issue and second-ary markets.

Our approach has always been to ensure we have a solid grasp on the market fundamentals by balancing our proprietary data and analytics with a deep understanding of the technical aspects of what moves the market. Our analytics and data serve as our strategic advantage over other firms and are highly valued by our customer base.

Q: How would you differentiate yourselves from other similar firms that have launched in the securitisation sector over the past few years?

A: Amherst has been around since 1993, so the first differentia-tion really is our experience and significant track record of success. We have helped our clients navigate several economic cycles, including the most recent one which resulted in many of our competitors dissolving or significantly scaling back their services.

The other real distinctions that separate our firm from others are the quality of our proprietary data and analytics, the quality of our people, and the fact that we have significant

Joe Walsh, president of Amherst Securities, shares his views on the ABS and MBS markets and the future strategy of his firm

Navigating

4 SCI July 2010

The Interview

capital behind our operations, includ-ing capital from our employees and the additional capital raised in 2008 from a group of institutional investors led by Stone Point Capital.

Q: Over the past six months you’ve made some major hires in ABS and CMBS – what are your aims for these two asset classes in particular?

A: ABS and CMBS are natural exten-sions of our leading residential plat-

form. As a firm, we are committed to looking at opportunities where access to fundamental performance data and thorough and thoughtful analytics can add value and we believe that the ABS and CMBS markets provide this opportunity.

Our aim is to succeed with the same strategy we’ve successfully deployed in the residential sector – providing better data, analysis and understanding of the market fundamentals than anyone else

in the space. The addition of these two products will also diversify our rev-enue stream and should make us even more meaningful to our customers.

Q: How does this affect your established RMBS business?

A: Our expansion into ABS and CMBS is a completely natural and complemen-tary extension of our RMBS business, which will continue to be a major focal point for our firm. There is significant

changing markets


The Interview

amount of customer overlap between the different sectors and many of the lessons we’ve learned over the years in the RMBS space can be naturally applied to these categories as well.

Q: What are the lessons you have learned in the RMBS space?

A: There were really multiple conflicts in the securitisation business model lead-ing up to the recent crisis and in large part they are still being sorted out. The level of faulty analysis and decision-making that went on in terms of select-ing which loans were securitised and which weren’t was much higher than people anticipated.

The origination and loan underwrit-ing standards that were applied in the process were severely compromised and massively underestimated by the market. To navigate through the mess that was left over you really need to have access to great data and dynamic analytics to see through the carnage and find opportunities.

Q: Where do you see the bulk of your business and/or market opportuni-ties coming from in the second half of 2010 and why?

A: Recently we have seen confidence in a steady, upward-sloping recovery erode and volatility re-introduced into the marketplace. In addition, the funda-mental performance of residential and commercial mortgages and other consumer and corporate assets contin-ues to evolve in the face of economic pressures and regulatory reform.

These factors are going to lead investors to more actively seek out the expertise and analytical edge that Amherst provides. People want a firm they can trust, particularly in this type of volatile market.

We believe the market dynamics are going to provide some interesting trading opportunities in the second half of 2010. Investors will need to react to these changing conditions and we’re going to be there to help people form those reactions and opinions.

Q: Which factors do you need to con-sider in adapting to these changes?

A: There are a lot of economic, politi-cal and regulatory issues that are impacting consumer and borrower behaviour. We believe it is critical to appreciate the potential impact on fundamental performance that these issues create.

In addition it is likely that we will see a technical response from the market to the extent the performance differs from expectations. We pride ourselves on understanding the poten-tial outcomes and factoring those into a thoughtful view of risk and opportu-nity. We’ve been extremely focused on those things, as evidenced by some of our published strategy reports show-ing our early positions on things like loan modifications, second liens in the residential MBS market.

Q: Which specific impacts could those economic, political and regulatory issues have on performance?

“Recently we have seen confidence in a steady, upward-sloping recovery erode and volatility re-introduced into the marketplace”

6 SCI July 2010

The Interview

A: Ultimately all of those factors could have a very large impact because they all can change fundamental perform-ance. For example, there was a lot of regulatory rule changing that went on when Bear Stearns essentially went bankrupt and that changed the outcome allowing their debt to get paid 100 cents on the dollar. But it’s clear these factors can have a real impact on actual per-formance. You have to understand the potential of those impacts and under-stand how exposed you are to them.

Political and regulatory pressures become extremely influential on issues like loan modifications, so while you may not be able to predict them, you had better understand what various scenarios mean to you and factor that into your strategy and make sure you are getting paid for that risk. Knowing what can happen to you, being able to see it happening and seeing it first it could create some very real and profit-able opportunities.

Q: In general, what are the types of trading opportunities you’ve mentioned?

A: Fundamental performance is going to continue to evolve and it’s likely going to end up being different than the market expects. It’s hard to predict how we will ultimately end up and why, which is the challenge for us all, and ultimately will separate the winners from the losers in this space.

For instance, how loan modifica-tions or foreclosures ultimately play out when the moratoriums are lifted will create outcomes that are likely to be different than what people expect at the moment. So companies that can see through that and see it first will have an advantage. Everyone who is trading today has some opinion on how and when these things will play out.

We think we’ll ultimately be better positioned than others, but it’s going to evolve over a very long period of time.

Q: What sort of technical response do you anticipate from the market if performance does differ from expectations?

A: I suspect there could be a series of knee jerk reactions, especially in situations where people don’t truly understand why performance differs from expecta-tions. We could elicit some uninformed responses and that could be good or bad for market participants.

Q: What is your position on loan modifications and second liens in the RMBS market?

A: Put simply, the second liens are stand-ing in the way of a lot of loan modifica-tions. We believe the most effective loan modifications involve principal reduction and it’s really difficult to do that when the second lien holder is the servicer or is unwilling to have his debt reduced or written off at that point in the modification. As a result, use of principal reductions in loan modifica-tions has yet to have a meaningful impact.

Q: Longer-term, how do you see the securitisation market landscape in 2011 and beyond?

A: If the economy is going to make a substantial recovery, then you have to believe the securitisation markets, which were such a big piece of provid-ing the capital for the vibrant and growing consumer-based economy last decade, are going to make a recovery as well. But in general, those involved in the securitisation market are going to be very focused on making sure we can use securitisation to fuel growth while eliminating the obvious conflicts which historically dominated the new issue structured finance markets and resulted many failed transactions. I suspect what you will see in 2011 is the new issue market trying to address those concerns and convince investors that they are adequately protected from the mistakes that fuelled the recent credit crisis.

Q: Beyond ABS and CMBS, does Amherst have plans to grow its busi-ness into other securitisation areas?

A: Not at this time. We think there are plenty of opportunities in the RMBS, CMBS and ABS space. We’re poised to provide more knowledge, insight and reliable data on the entire mortgage industry than any other broker-dealer. We may ultimately look to expand beyond those products, but right now we are focused on building those exist-ing businesses.

“Fundamental performance is going to continue to evolve and it’s likely going to end up being different than the market expects”

About the intervieweeJoe Walsh, president of Amherst Securities, co-manages the business and operations of the Amherst Companies. He has been in the mortgage-backed securities business for almost 25 years.

Walsh previously served as an md in the private equity business at Fortress Investment Group specialising in financial institutions. He also served for nine years as an md and head of mortgage and asset-backed origination, finance and trading at RBS Greenwich Capital.

He earned his B.A. in Biology at Princeton University.


The Interview

Vanilla structures return

Suddenly mundane is popular again. As Kathy Fitzpatrick Hoffelder discovers, complicated rate product strategies that have been marketed as ‘too sophisticated to fail’ are out. Institutional investors instead are contemplating ways to offset an ever steepening yield curve and find a little bit of yield along the way

8 SCI July 2010

Wholesale Structured Products

The landscape has changed for creating interest rate deriva-tives products that protect principal and offer attractive yields. First, the very amount

of principal to protect has vastly dimin-ished for many investors and what kind of protection is on offer is also up for grabs. Gone are the days when so-called liquid and transparent index based transactions promised ‘expected’ anything. Not much is expected anymore in this post credit crisis environment except uncertainty and volatility.

As Gary Jenkins, head of fixed income research at Evolution Securities aptly

puts it: “Most people are into preserva-tion of capital but they are concerned about exactly how you do that when your historic risk free is now full of risk.” Fur-ther he says: “Everything has basically become a credit including government bonds and that makes it very difficult. That’s why you are seeing the kind of yields you are seeing on treasuries and bunds.”

Indeed, global bond markets have been rocked by a range of events from Lehman and the start of the crisis, to sovereign debt issues with a few government bail-outs and periodic support thrown in for good measure. Bank of America Merrill Lynch’s Option Volatility Estimate (MOVE) Index, which measures option volatility on US treasuries, has seen dra-matic swings from its widest levels seen in 2008 when it topped more than 260 to the 70s currently (see chart). The 10-year bund yield has dropped to 2.67%, in from a little over 3% last summer, while the 10-year treasury yield has slid to 3.19% from 3.5% at this time last year.

Capital preservation itself has also altered in meaning and scope, according to John Brynjolfsson, md at investment management firm Armored Wolf. Capital preservation is taking on a new defini-tion where people are more sensitive to

currency concerns, he says, noting capital preservation did not help European-based investors much since the euro has depre-ciated against all major currencies.

It is not all doom and gloom out there, however. A Goldman Sachs research report in June notes the current macro and regulatory backdrop is much better than two years ago. For instance, private sector imbalances are much smaller, having moved into surplus in the major economies. “This means balance sheets are stronger and there are more savings available to fund the deficits,” the report notes.

But try convincing institutional investors of that and one gets a myriad of responses. “There’s so much risk, volatil-ity and uncertainty, it’s hard to turn the table and say you have to do this for 100% of your portfolio,” says Gary Pollack, md and head of fixed income research and trading for private wealth management at Deutsche Bank Securities.

However volatile government securi-ties and related products have been lately, investors generally agree one has to put money to work somewhere. Everyone realises the natural rate for the 10-year treasury is not 3% but something higher, notes Walter Schmidt, svp and manager of structured product strategies at FTN

Chart 1The BAML MOVE Index – three-year performance

300

250

200

150

100

0Oct 2008 Apr Jul Oct 2009 Apr Jul Oct 2010 Apr

Source: Bloomberg.com/Bank of America Merrill Lynch

MOVE is the Merrill Option Volatility Estimate. This is a yield curve weighted index of the normalised implied volatility on 1-month treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. `MOVE’ is a trademark product of Bank of America Merrill Lynch.



Financial Capital Markets. “People are concerned we might be in a bubble for bonds now. It’s just that we might be here for quite awhile so if we are here for a while and sitting in cash, you are going to underperform and underperform severely,” he says.

There is still a tremendous amount of liquidity in this system, Schmidt observes. “We’ve been in this environ-ment for almost two years now where the market is liquidity rich and capital poor. What the Fed is obviously trying to do is offset the tremendous capital burden and tremendous write-downs that still need to take place,” he explains.

Insurance companies, for one, are still looking at interest rate structures since they regularly need to match their liabilities. “A lot of insurance compa-nies have probably blown through their reserve levels. It becomes harder and harder to generate enough return on the

asset side to match your liabilities,” notes Jochen Felsenheimer, co-head of credit at Assenagon Asset Management.

Investors in general are a bit more sophisticated than prior years and demand at least a minimum return. This is the case with steepener trades put on between the 10-year and 30-year government bond curves, in which one sells CDS protection on the short end and buys protection on the long end.

Along with the trades, some investors favour having a cap and a floor, which was not the case five years ago, adds Felsenheimer. One caveat is “if interest rates stay low, you probably just earn the minimum on the interest rate structure, but normally you do not have dramatic problems on the rest of the risky part of your portfolio,” he says.

Seeking yield at the right costSince loan demand is very low, deposito-ries continue to reach for yield in the port-folio, says Schmidt. “Right now for most index based customers, and to a lesser extent, even liability based customers like depositories and insurance companies, everyone’s looking for some return in this environment,” he notes.

However, with the exception of the corporate bond market, it’s very dif-ficult to continue to add assets without the overall market overpricing itself, he notes. “This is exactly this deflationary or at least disinflationary environment that Bernanke is quite concerned about.”

Schmidt adds: “Those that are ratings-constrained are reaching a bit for yield because they have to. The fact of the mat-ter is if you look at a state pension or cor-porate pension, most of them have their returns at 6-10% but no one’s earning 6-10% in any market, including equities. The reach for yield is very, very powerful, very strong.”

Bill Gross, md at Pimco, reiterated the changed landscape for investors in his firm’s June commentary. “No longer will ‘two get you three’ in the investment world. Not 1,000%, but 4-6% annual-ised returns for a diversified portfolio of stocks and bonds is the likely outcome,” he writes.

But where to get even that yield is up for debate. The high yield corporate bond market in the US is the favoured segment of the market, says one US-based asset management firm’s research head. “When you have a great year in high yield, it leads to good years to follow and default rates come in,” he says. He also sees the sector as somewhat removed from the sovereign debt crisis in Europe. Returns often are in the 9% range, he says.

SocGen’s quantitative strategist Marc Teyssier adds that those investors that are more bullish on the economy are willing to invest in the high yield market – something that only has occurred in rapid pace since the beginning of the year. “You have all non-financial companies that have very good results so far,” he says.

“On the one side, there’s a very bearish focus on sovereign risk and on the other side, there’s more focus on what’s hap-pening on corporates,” Teyssier says. The result has led to a compression of credit spreads. “Hedging credit portfolios is the hottest topic right now among investors.”

But for Pollack, he views the invest-ment grade bond market as a better bet in

“On the one side, there’s a very bearish focus on sovereign risk and on the other side, there’s more focus on what’s happening on corporates”

Jochen Felsenheimer, Assenagon Asset Management

Walter Schmidt, FTN Financial Capital Markets

10 SCI July 2010


this post credit crisis environment. “We think this is a good opportunity to pick up some additional yield without really picking up that much increased risk as a way to capture higher returns in the fixed income markets,” he says.

Pollack is underweight in treasury holdings since he used that money to increase exposure to corporate bonds. He believes rates are likely to stay lower a little longer than originally believed.

Factoring in steepening Investors right now are also trying to take advantage of the steep yield curve so they are bidding up the price of fixed income assets, adds Schmidt. For the most part, they are focusing on the front end of the curve as opposed to the long end, he explains. The yield curve between the US two-year treasury and the 10-year treas-ury stands at about 248bp, which is in from 290bp earlier this year. Years earlier, say in 2002, for example, the yield curve was closer to the 2% level at 220bp.

While historically steep yield curves can be inflationary, they can also be a step in the right direction economically. “Steepening trades are attractive because they pay good carry. People will try to find trades which pay good carry over the short term,” says Sandrine Ungari, quan-titative strategist at SocGen, noting the trades make more sense in euros currently than in US dollars.

But further out along the curve, inves-tors start to get skittish. There are really

good trade opportunities in the long end of the euro swap curve, but people tend to stay away from it since it’s a “pain trade” due to the uncertainty in the market, says Ungari. “If everything goes wrong, it’s the kind of trade you cannot get away from,” she adds.

The 30-year maturity is also subject to huge volatility due to some flows coming from pension funds, Ungari says. The flows are not predictable and bring lots of volatility in the 10s/30s sector of the curve, she notes, adding that the segment also sees constant maturity swap hedging flows as well.

To others, the key right now is to avoid the long end at any cost. Particu-larly if interest rates rise, the US-based asset management firm’s research head is turning away from bonds with a high duration. He is also advising clients to seek out maturities 5-years and under. “Most bonds even with a 10-year duration are getting called,” he adds.

Some hedge funds and money manag-ers are, however, buying long-term US treasuries, and even have large mandates in place, but according to Brynjolfsson, the curve is still expected to be steep. “There are buyers of these long term treasuries, but I think the very steep yield curve is here to stay and possibly get steeper,” he says.

Three large sellers of long-term treas-ures are likely to keep the curve steep, he explains. The Treasury, Federal Reserve and China all have their reasons to unload or sell the securities, says Brynjolfsson. “We would expect a large amount of issuance from the Treasury in the 30-year sector not just to finance existing deficits but to finance the rollover shorter matu-rity treasuries.”

The Treasury recently extended its tar-get maturity for federal debt to 84 months or 7 years from as low as 48 months during 2009, which makes it more likely to issue out the curve. At a Treasury Bor-rowing Advisory Committee meeting in May, the Treasury said it believes its over-all debt issuance schedule is appropriate. “Consistent with the desire to increase the average maturity of outstanding debt, the Committee recommends that issuance sizes in two-year, three-year and five-year maturities be reduced meaningfully, with smaller reductions in seven-year, ten-year and thirty-year maturities.”

The Treasury also decided last May to increase the frequency of Treasury Infla-tion Protected Securities (TIPS) auctions by having a second reopening to 10-year TIPs offerings. It brings the total to six 10-year TIPS auctions per year. The new

“We would expect a large amount of issuance from the Treasury in the 30-year sector not just to finance existing deficits but to finance the rollover shorter maturity treasuries”

Marc Teyssier, SocGen Sandrine Ungari, SocGen



change begins with the July new issue 10-year TIPs offering.

The Fed’s decision last year to curtail its planned US$300bn buying programme similarly is still having an effect on the curve. “The Fed is examining very care-fully the possibility of selling their exist-ing holdings rather than let them mature,” says Brynjolfsson.

The existing plan was to hold onto their long-term treasuries and allow them to mature through the natural seasoning process rather than sell them, he notes. The process would still put selling pressure on the long-end, however, due to the Fed’s overweight position of long-term treasuries.

Globally government issuance will remain high with net issuance in the cur-rent financial year expected to be about US$1.9trn in the US, €300bn in the euro area and £150bn in the UK, according to a report by Morgan Stanley analysts last March.

A likely scenario going forward is that the Fed continues to keep short end rates low, below the inflation rate, and

continues to monetise the fiscal deficits, explains Brynjolfsson. “I would expect that would cause the bond market to remain sceptical – both of inflationary impact of those policies and the solvency impact of those policies increasing amounts of federal liabilities,” he says.

Seeking alternativesOther investors are venturing a little bit beyond their comfort zone for yields – if ever so slightly. More and more tradi-tional money accounts are now looking to create different risk return profiles by moving into new asset classes, says Felsenheimer. But more often than not it means implementing new strategies within traditional asset classes, or in a sense, creating a new definition for what alternative investment means, he explains.

Indeed, more exotic correlation trades are not as popular as they once were with investors, especially due to regulatory measures to be implemented under Basel 3 in Europe. “Market participants don’t

really know how the new regulation is going to affect them,” says Teyssier.

The tranche market is still, however, an outlet to hedge the volatility of mark to market. Lots of people buy protection on senior index tranches, he adds, noting that the combination of systemic risk and regulatory risk is why spreads in this area have widened so far, especially in Europe.

What is occurring more often, though, is a variety of hidden correlation offers, such as when banks are trying to hedge their exposure by selling part and by keeping some correlation risk, notes Felsenheimer. But problems still exist in selling the paper. “They need to find a buyer for this stuff. Except for hedge funds I don’t see any trades,” he adds.

Credit index options, however, are prov-ing they are able to withstand the credit crisis a bit more than other structured products. Options trading on iTraxx Main and on CDX have been popular lately.

“They [CDS index options] don’t suf-fer from the bad reputation of tranches. There are more clients willing to invest in that kind of instrument against a spread widening,” says Teyssier. “An out-of-the-money option does not cost a lot but is an efficient hedge against a spread blow out. Credit options are a very interest-ing product for clients that want to hedge their credit exposure.”

Whether or not rate products are the panacea for investors right now remains to be seen, but one thing is certain. Inves-tors are not going to sit around and wait for the next bubble to appear – whether in bonds or not.

“More and more traditional money accounts are now looking to create different risk return profiles by moving into new asset classes”

12 SCI July 2010


Credit risk management and trading are working together more than ever before. Some sources say this is how it should have always been. Others believe it is only perception given the market’s risk-averse mood since the crisis. “Credit risk manage-

ment is definitely experiencing a new evolution – it is viewed more as a value-added function now,” asserts David Kelly, the director of credit product development at Quantifi, a specialist software company.

He agrees credit risk management has distinguished itself more from other types of risk management since the crisis. Market risk managers, for example, are still viewed as more of a middle-office, support function. Their main responsibility is to make sure traders trade within the limits and report numbers accurately.

“It is fair to say that the credit risk manager role has moved up a notch now. When you consider that credit risk is being transferred from an originating desk to a credit risk management group, it is only natural for the risk managers and traders to work more closely. We see them working together more when it comes to valuation and pricing too. But traders are still the top dogs when it comes to pay packages since they are the ones generating revenue,” Kelly notes.

A portfolio manager in London adds: “Traders are more aware of credit risk and capital charges but not as much as they would if these things impacted their bonuses.” He says a lot of risk management heads at banks are trying to push credit risk management down to the desk level, but trading desks don’t want it. They see it as a firm-wide responsibility.

Risk chemistry

The relationship between credit trading and risk management is attracting more attention in today’s plain vanilla, post-crisis world. Many institutions are putting a greater focus on CVA and reserve models, while others are moving credit risk managers up the hierarchy. Rachael Horsewood reports


Structured Credit

This is a sell-side trend since most buy-side exposures are heavily collateral-ised, according to the portfolio manager. “It was less of a priority before the crisis when there were fewer defaults,” he adds.

Marc Loomis, a credit product man-ager at Calypso, says the relationship between trading and risk management is “cyclical like most other things in the financial world. At the end of the day risk managers are paid to mitigate risk and traders are paid to take it on – a bit like yin and yang.”

One London-based credit strategist says that although some banks try to make it look like risk management is in charge of their capital, traders really are the ones who own the risk. “Everyone is putting more resources into credit risk management, but it is a mixed bag when it comes to how they organise it. Several of the larger banks have established, cen-tralised top-down approaches, but for the

majority of institutions it is a game of hot potato right now,” he explains.

Some sources argue that trading desks were well-aware of their counterparty exposures during the crisis. “Systems used to monitor credit risk at the desk level were reasonably well-established and working before the crisis. Most of the focus on the sell-side has been on the big drive towards centralised clearing,” explains Kevin Gould, a co-founder of Markit. He says he has seen some subtle organisational changes due to pending regulation, but that the bigger story is the greater focus on data quality and liquidity risk monitoring all around the market.

The lack of liquidity in credit has made it much more difficult to trade. One head of credit trading from a French bank says this is another reason why you see risk managers coming in to help optimise the return on capital. “You can hedge interest rate risk and, on a macro basis, you can hedge your credit risk. In Europe, we have sector indexes to help us even hedge our funding risk, and because these products are so granular, we are able to fine-tune the hedges. But there is one thing none of us can hedge and that is liquidity risk.” He says the ability to execute transactions (at a reasonable price) has worsened since 2007.

A credit strategist from another European bank adds that idiosyncratic risks are more specific to credit. “This also makes credit much less resilient than other assets. When you think of Greece and what has happened there as well, you realise there are so many more lay-ers of risk within the credit market that we didn’t see a few years ago,” he says. “Many banks are now trying to combine all the talent they have in the structured credit space to create a more industrial-ised credit department.”

CVA moveSome sources say banks are also looking at Credit Valuation Adjustment (CVA) more than before because of the pressure to preserve capital and assess liquidity risks. “CVA is primarily an accounting requirement, b ut we are seeing more crossovers between credit risk manage-ment and capital optimisation,” Kelly says. He was previously a senior credit trader on the global portfolio optimisation desk at Citigroup. There he actively managed the credit risk in derivatives positions and also established a CVA business.

CVA is a valuation of the credit risk of all contracts an institution has with a given counterparty – the aggregate risks of all counterparties. It is nothing new. The first ones became known back in the 90s, when fair value accounting emerged and the chief risk manager position became norm. Back then, credit default swap (CDS) pioneers on Wall Street were also emphasising the importance of counterparty risk management and how it and trading desks should work together to optimise capital, especially after the repeal of Glass Steagall in 1999.

Jonathan Di Giambattista, md at Fitch Solutions in New York, agrees CVA has become a more topical subject. He says it is also because of the greater focus on derivatives counterparty risk. He explains that CVA managers buy credit protection as part of their mandate to level out risks, especially concentration risks created from trading desks.

“Everyone is putting more resources into credit risk management, but it is a mixed bag when it comes to how they organise it”

David Kelly, Quantifi Kevin Gould, Markit

14 SCI July 2010

Structured Credit

“You can say that the CVA function is there to capitalise on the compensation of risks since profit is relative to the risk that is taken. But it really is meant to ensure risk is accounted for. It is a centralised risk control discipline for all asset classes within an institution. We believe most of the top-tier international banks have a CVA function in place, but we have not seen any on the buy-side,” Di Giambattista says.

He continues: “We find that apart from a few of the biggest international institu-tional investors most buy-side firms really do not hedge counterparty risk exposures. This is an expensive proposition for them generally due to the transaction costs of hedging. The economies of scale are not there if it is only five names you are wor-ried about. Smaller players might put on a bilateral trade every once in a while when it makes economic sense, but they tend to rely more on internal controls, limit set-ting and the monitoring of counterparty relationships.”

However, a number of hedge funds and other large institutional investors have been hiring seasoned traders and risk managers that used to work on the credit desks at investment banks. “Former struc-tured credit traders could be valuable in many other areas of trading and managing credit risk. If you look at the composition of credit risk there is a securitisation ele-ment in transactions that are not cleared so their skills could be applied to any of those,” Kelly adds.

Ed James, a senior consultant in the risk management group at Joslin Rowe Associates in London, confirms that a lot of new credit risk management positions have been created this year. “We see demand across all types of risk manage-ment, and not just from banks but also asset management firms.”

He adds: “Many of these roles were considered part of the finance or opera-tions groups four or five years ago. But risk management has become more high-profile and is now a bigger group in its own right at most financial institutions. On the credit side, the risk manager’s opinions matter a lot more than they used to.”

“You can say that the CVA function is there to capitalise on the compensation of risks since profit is relative to the risk that is taken. But it really is meant to ensure risk is accounted for”

Salary increaseAccording to recruiters, salaries for risk management roles in general are increas-ing by around 15% from last year. Some banks are increasing salaries 25% or more in order to attract the best, most experienced candidates. Consultants say that some senior risk management salaries might look larger because their pay is normally not tied to performance or profitability, it is fixed.

Loomis agrees that while risk manag-ers’ influence might be increasing, they are never going to be paid as revenue generators. “Pay packages are unlikely to change. Giving risk managers a bonus for

Jonathan Di Giambattista, Fitch Solutions

Figure 1Elements of pricing and valuation infrastructure and operations

Cash Instrumentse.g. Corporate Bonds

Flow OTC e.g. Credit Derivatives

Structured Derivativese.g. Structured Credit

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3rd party valuations


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Front-to-Back Trading / Risk

Systems

Excel-based‘Pricers’

Structuring/ Portfolio Mgmt Apps

Excel-based‘Pricers’

Hardware/software(Bloomberg,

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FrontOffice

Market data (e.g. Bloomberg, Markit,

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Market data (e.g. Bloomberg, Markit,

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often ‘embeddedin these systemsand processes

Source: Celent


Structured Credit

catching a certain type of risk is unlikely too. A risk manager is not paid to discover where the bank should take risk. That is what a trader does. Traders look for a cheap asset and then hope that the value of it goes up. The risk manager is there to make sure the bank doesn’t over-expose itself,” he adds.

Sources say compliance is behind a lot of the new risk roles and Europe’s sover-eign debt crisis is definitely accelerating the regulatory effects on banks’ organi-sation structures and risk management practices. “The risk manager’s statue might be increasing a bit more now. Risk

managers might even be gaining more power to curtail trades. But the point is that risk management means a lot more than it did before this crisis, partly due to all of the pending regulation. Risk management is not just credit-related and it is not just about calculating your delta. It is also about transparency and suitabil-ity. It is about digging deeper and looking not only at the counterparties more but also the motivation behind each trade,” explains Loomis.

Viral Acharya, a professor of finance at New York University’s Stern School of Business, says this is why some over-

sight of the shadow banking system and off-balance sheet entities is necessary. (Shadow banking institutions are typi-cally intermediaries between investors and borrowers – e.g. hedge funds, SIVs, conduits, investment banks and other non-bank financial institutions. By definition, shadow institutions do not accept deposits like a depository bank and therefore are not subject to the same regulations.)

Acharya explains how the cycli-cal nature of credit means there can be a significant amount of aggregate and liquidity risks when trading in this asset class and that many financial institutions underestimated both. “This is where the importance of capital adequacy comes in because if there is not sufficient capital to absorb losses then people outside of the financial sector become affected. So, one key issue is whether regulators can address such socio-economic risks that have not shown up before,” he asserts.

Regulatory spiritKelly agrees that the spirit of most of the new regulations is to make sure securiti-sation and the product engineering around it has some socio-economic benefit. “It is pretty clear that the securitisations of mortgages, student loans and credit cards, for example, are beneficial to economies as long as the risk is transferred to people who want it. I think regulators are a lot more on the ball when it comes to credit

“This is where the importance of capital adequacy comes in because if there is not sufficient capital to absorb losses then people outside of the financial sector become affected” Viral Acharya, New York University Stern

School of Business

Figure 2Total lifecycle costs for derivatives analytics

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Source: Celent

16 SCI July 2010

Structured Credit

trading and risk management, but I would not say they are providing a guiding light for big international banks. These institutions know what they need to do,” he asserts.

It is clear that banks continue to invest heavily in the credit risk management area, partly due to Basel III. But some sources say that if these regulations push more transactions onto exchanges, some of the credit risk management functions could become extinct. “A lot of the coun-terparty risks will be mitigated by central clearing and standardised CDS contracts will have daily margining like futures contracts,” Kelly notes.

Even so, sources do not expect central clearing will actually replace risk man-agement roles. “Central clearing is one of the main focuses of change right now but I don’t believe it will diffuse coun-terparty risk management and I don’t believe it will cover every type of CDS. Banks have been trying to price counter-party risk for years. It is a dark science. In other words it is not just about the pure credit worthiness of your counterparty. It is also about your risk profile and the exposures you have to that counterparty,” says Loomis.

Di Giambattista adds that central clearing for OTC derivatives would not reduce the effectiveness of a CVA. Sources believe there will always be demand for bi-lateral contracts whether they are plain vanilla or the complex and esoteric type. He also says corporates will continue to use the OTC market for customised hedges. “There will always be a need to mitigate counterparty risk when you are dealing with different counterpar-ties around the world. Most CDS trades are still executed bilaterally anyway,” he says.

Greater standardisation will no doubt help make pricing more transparent and bid-offer spreads tighter. Loomis adds: “Valuation has always been a job for traders and I do not expect that to change. What will continue to change is the information that goes into models. People, mainly buy-side players, thought they did not need to understand the model because the credit rating was all that mattered. That got a lot of them into trouble during the crisis.”

Loomis says open source initiatives such as the standardised pricing model that

the International Swaps and Derivatives Association introduced last year are help-ing to improve transparency in the OTC market. “The modelling for bespoke deals is long and complicated. That is part of the reason why that market remains so illiquid.”

Sources say that although the market for bespoke credit deals (cash and syn-thetic) is very thin, interest has not totally disappeared. “The secondary credit market is extremely fragmented and the lack of price transparency is what is keep-ing investors from participating or acting regularly. The basis risk is so volatile that you cannot really use CDS the way they are meant to in the fixed income world,” the French dealer says.

“Valuation is definitely what links trading and risk management. When it comes to the credit side, pricing and risk management are instrumental in getting any deal off the ground right now,” the European credit strategist adds.

Lessons learned?This close relationship with new issuance is driving greater reflection on lessons from the past and there is no shortage of information being published to examine. For example, a new report explains that Lehman Brothers’ use of ‘inconsistent and highly subjective’ valuation methods was what brought the bank down.

Released in March, the report said that while there is always some subjectivity in assigning prices to complex securities, Lehman Brothers’ used differing valua-tion methods for trading desks that were even of the same asset class. The report,

written by Anton Valukas, an examiner who was hired by a US court to probe Lehman Brothers’ failure, also explained how the bank’s product control team was too small to be an effective independent check on business desks.

Inadequate product control has been cited in the financial markets many times since the crisis. The UK’s Financial Serv-ices Authority (FSA) has taken action against a number of institutions over the past couple of years. In its write-up against one American investment bank last year the FSA said: “Whilst junior global product control staff understood that their role was to ensure P&L was fully attributed, reconciled and explained in accordance with the firm’s systems, senior product controllers expected that juniors would undertake analysis of P&L and whether it was consistent with changes in risk and market movement. In particular there was a lack of understand-ing among junior controllers of volatility as a driver for the P&L.”

Last year, McKinsey & Company also addressed this issue in a paper titled ‘Turning Risk Management into a True Competitive Advantage: Lessons from the Recent Crisis’. It states: “In some cases, revenue producers are clearly in charge and tend not to involve the risk management function in their decisions. In best-in-class organisations, the risk management function is seen as a key enabler of profitable growth. Problems can arise when the risk function is viewed by quickly evolving businesses as a cop or a goalie trying to catch the bad shots.”

“Valuation is definitely what links trading and risk management. When it comes to the credit side, pricing and risk management are instrumental in getting any deal off the ground right now”


Structured Credit

As the 2009 global market rally falters to a limp in 2010 due to the European sovereign debt situation, catastrophe bonds are enjoying a new-found popu-larity. While it is unlikely that insurance-linked securities (ILS) will become as mainstream as

other structured finance asset classes, investors are increasingly interested in adding diversification to their portfolios and those in the ILS space are eager to encourage this, which should also encourage great volumes of new issuance.

In a post financial-crisis context, investing in ILS seems to be an increasingly appealing prospect for investors. Speaking at the 2nd Insurance Linked Securities Summit held in London at the end of April, ceo of Hanover Re, Ulrich Wallin painted a bright picture for the future of the ILS industry. In particular he explained that while the Lehman bankruptcy led to a total return swap default on four cat bonds, this consequence was an indirect one. Structural problems within the market have since been addressed, according to Wallin.

Those involved in the space are quick to point out that while other fixed income asset classes buckled under credit pressures, ILS remained largely uncorrelated, with the exception of those bonds affected by the Lehman bankruptcy. “Cat bonds have posted strong performance throughout the crisis,” points out Christophe Fritsch, head of ILS at AXA Investment Managers. “Investors have real positive elements from which they can judge the main reasons they should be investing in cat bonds: such as their low correlation and their resilience in the midst of strong financial tensions on the markets.”

As a result, adding ILS instruments to an investment portfo-lio is emerging as a promising new diversification play. “When people look back on the financial crisis this is the one area of the fixed income market that still had liquidity because it’s truly diversified,” explains md and head of ILS distribution for Swiss Re, Judy Klugman. “Our investors still had cash and we were trading bonds. The basic tenants of this sector were really vali-dated during the crisis and as a result, investors value the diver-

Greater

Insurance-linked securities are typically thought of as a specialist asset class. However, as Jillian Ambrose explains, catastrophe bonds are generating increasing interest from non-insurance investors, which in turn could be met by increased new issuance volumes

18 SCI July 2010

ILS

sification that these assets have to offer. Although further developments need to be made within the space, those within the sector are now calling for a greater inves-tor involvement in the market in order to bring ILS into the mainstream.

Historically an insurer would seek to transfer risk through a reinsurance agreement in order to remain solvent in the event of a large-scale natural catas-trophe. Although ILS does not seek to replace reinsurance, it is being touted as a complement to the traditional reinsur-ance sector. From the point of view of the sponsors, ILS offers the added benefit of a multi-year transaction with exposure to the capacity of the capital markets, while reinsurance transactions are typically a

one-year agreement. As a result, sponsors are increasingly interested in exploring the benefits of ILS.

However, despite many ILS market participants bordering on the evangelical in their calls for greater investment in the sector, the vast majority of investors have remained indifferent until now. “So far, there have not been that many institu-tional investors that have taken the cat bond leap,” confirms Fritsch.

But Henning Ludolphs, director of Hanover Re’s ILS unit, adds that he is currently seeing an increase in interest from institutional investors. “We believe that there are a lot of investors, pension funds for example, who are starting to look at allocating a small portion of their

expectations

Judy Klugman, Swiss Re

19www.storminvestor.com

ILS

funds to ILS,” he says. “A small portion of a large fund would be a huge amount of money coming into the ILS market.”

Fritsch predicts that as new investors enter the space, development within the market will increase. “As large inves-tors such as pension funds and insurance companies start investing more heavily in this sector, a new market dynamic will be created,” he says. “This obviously goes hand in hand with a larger number of sponsors as well as an increased diversifi-cation of perils.”

Mainstream option?However, ILS is still far from being accepted as a mainstream investment option and current participants believe that it’s vital to make the necessary changes to the market in order to develop ILS beyond a niche market. Part of the

problem may have to do with the overall perception of the market.

“It needs to be more widely looked at as a mainstream asset class, rather than an ‘esoteric asset class’ which scares some investors off,” says Klugman. “Really it should be part of everyone’s diversi-fication strategy. The sector needs to be demystified.”

Any enthusiasm that non-insurance specialist investors have for ILS can be dampened by confusion regarding the underlying data, market processes and the structures of the cat bonds themselves. Participants in the space simultaneously argue that the market is not as complex as it may initially appear and point to recent developments and innovations within the market as evidence of its increasing accessibility.

Concerns regarding the performance indicators used are perhaps justifiable for investors unfamiliar with the market, especially in light of the persistent con-troversy and distrust surrounding rating agencies in the broader credit markets. Those involved in ILS insist that the mod-els used in analysing the securitisations offer investors a non-subjective means of understanding the underlying risks.

Rupert Flatscher, head of Munich Re’s risk trading unit, says: “New investors need to understand that ILS are based on models which are used in the insurance industry sometimes for decades. It is not only investors relying on such models but also a far bigger industry.”

Furthermore, Klugman argues that assessing risks in ILS may be more reli-able than methods used in other credit markets. “We don’t expect an investor to be able to analyse what the probability is that a magnitude seven earthquake is

going to hit Los Angeles in the next two years. Using hundreds of years of science, independent firms assess the risk for investors,” she explains.

Klugman adds that the models used are not created specifically for the ILS markets, but are developed within the scientific community and used by third-party firms in analysing securitisations. This, she says, adds a degree of subjectiv-ity to the process. “When I look at credit and what can go wrong in terms of fraud and misunderstanding, I think there are more variables in credit than there is in analysing the risk in a catastrophe bond.”

Increasing transparencyIn order to attract a wider investment base into the market, greater calls have come for increased transparency in the market. “Transparency and liquidity is good for any market, and cat bonds are no excep-tion,” says Fritsch.

Ludolphs believes that various steps could be taken to make the market more transparent and easily understood by new investors to the space. “The market needs to be open with underlying exposure data and underlying investment data,” he says.

Further, Ludolphs suggests that under-lying data could be posted on websites in the same way as regulation now requires mainstream structured finance deals to do. “We need to share information and make underlying information transpar-ent,” he stresses.

Ludolphs also advocates the greater use of indices and parameters which

“When I look at credit and what can go wrong in terms of fraud and misunderstanding, I think there are more variables in credit than there is in analysing the risk in a catastrophe bond”

Christophe Fritsch, AXA Investment Managers

Rupert Flatscher, Munich Re

20 SCI July 2010

ILS

will naturally lead to greater transpar-ency within the market. “For example, if investors know that a bond is triggered by an earthquake with a magnitude of 8 or higher then immediately an investor can read in a newspaper whether they have lost money or not,” he explains.

Ultimately, he believes that transparency will remove much of the complexity which deters investors in the first place. “We need to make the structures easy to understand. The more complex it becomes the more expert knowledge one needs to have.”

However, Fritsch adds that investors are not satisfied by an explanation of the underlying perils alone and sug-gests a need for the structures of the cat bonds themselves to be more transpar-ent. “Transparent, easy-to-understand structures are needed,” he says. “For a market to grow, it needs transparency, and it can currently be very difficult to get information on transactions. Investment opportunities can sometimes be jeop-ardised because of that; you don’t want to invest in a transaction you don’t fully understand.”

Significant challenges Although most ILS participants agree unanimously with the idea that greater transparency in structures is required, and should be developed in a standardised format to maintain as much simplicity as possible, the implementation of these ide-als is not without significant challenges. Currently investors are faced with nego-tiating a multitude of potential cat bond trigger mechanisms which could result in the investor losing money. Parametric measurements – such as the physical measurement of wind speeds or an earth-quake – can be used, as can industry loss triggers based on the insurance company losses across the industry.

While these triggers are relatively simple processes for an investor to gauge, indemnity triggers also exist whereby the trigger is based on the losses incurred by the original sponsor. This can raise the kind of questions which act as a deter-rent to prospective investors, but which is favoured by the sponsors themselves.

“We do believe that indemnity struc-tures have a place in the market,” says Klugman. “But for this market to really grow we believe that one shouldn’t feel that they need to be an underwriting cat expert in order to analyse the bond.”

She notes though that the structures need to appeal to both investors and spon-sors in order to result in development for the market as a whole. Whereas indem-nity structures are more opaque from an investor viewpoint they offer the safest option for sponsors.

Moving forward a fine line will need to be walked in order to appease both camps. Klugman says: “If an issuer does a transaction based on anything other than their actual losses then that means that they’re taking a measure of basis risk. We need structures that meet the widest appetite for investors and sponsors.”

Furthermore, Klugman explains that steps have been taken to minimise the potential risk for investors, but that again

these innovations offer both a solution and a potential drawback for the investor. She suggests that money could be put into treasury money market accounts, but adds that in this way investors would lose the Libor-based rate.

“In today’s environment to get a Libor-return implies that you actually have to take some measure of credit risk with your assets,” Klugman says. “So that’s what we’re grappling with moving forward: how much credit risk are inves-tors prepared to take on to get a Libor-based rate, or are they fine taking very little credit risk and having a treasury money market return?” While Klugman acknowledges that this is not a major hurdle for the industry as a whole, it is an

“Transparent, easy-to-understand structures are needed. For a market to grow, it needs transparency, and it can currently be very difficult to get information on transactions”

Chart 1Catastrophe bond issuance year-by-year to 1 June 2010

Source: 2009/10 - STORM; 2000-2008 - GC Securities

0

1,000

2,000

3,000

4,000

5,000

7,000

6,000

Issu

ance

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21www.storminvestor.com

ILS

important aspect which many investors would need to negotiate when moving into the market.

Fritsch believes that this is not a line that cat bonds should try to walk. “Ide-ally, cat bonds should be a ‘pure play’ on insurance risk and should carry as little credit or counterparty risk as possible,” he says. “With regard to the concerns on the tri-party repo market, it is noteworthy that cat bonds featuring such mechanisms are rare. As a matter of fact, there are only three such deals for now.”

Certainly the introduction of credit risk into the collateral component could potentially dilute the initial appeal of ILS. “There’s a tug of war between getting a higher return on your assets by getting a Libor-based rate which would imply a certain measure of credit risk, versus taking almost no credit risk and getting a treasury money market,” confirms Klug-man. “There are investors who are on both ends of the spectrum.”

Moving forward the ILS market will need to manage these potentially conflicting interests. Klugman points to the recent issuing of a structured note by the International Bank for Reconstruc-tion and Development where investors received a Libor-rate return but were taking an IBRD risk, which the investors felt was safe given its triple-A rating. “So there are solutions and I think that as the market continues to evolve there’ll be more solutions,” says Klugman.

That evolution looks set to continue. Provided that regulators and sponsors are able to provide the transparency and standardisation needed by the market, ILS seems likely to gain a more comfort-able footing within the limelight.

Furthermore, as investors evaluate their diversification needs and allocate a greater percentage of funds to ILS, spreads are expected to tighten and drive further new issuance. Although the ILS market will always be a rela-tively small one due to limited insurance needs, one cannot ignore the fact that it is showing growth at a time when the rest of the structured finance landscape stagnates.

“With regard to the concerns on the tri-party repo market, it is noteworthy that cat bonds featuring such mechanisms are rare. As a matter of fact, there are only three such deals for now”

Alternative class?

One possible development that the ILS market might make is a move toward the securitisation

of insurance classes beyond property and casualty, such as personal insur-ance lines.

“We would like to see it,” offers Hen-ning Ludolphs, director of Hanover Re’s ILS unit. “But we are somewhat hesitant in believing that this could be easily fulfilled.” He notes that the personal line business is considerably less volatile than the natural catastrophe business.

Because of this he believes that the traditional reinsurance markets could offer a reasonably priced protection while the capital markets would require higher returns. “The difference in price between capital markets and reinsur-ance industry with respect to personal lines business makes it more difficult to bring these to the capital markets,” he explains.

Ludolphs believes that a move towards securitising personal loans would be beneficial in terms of diver-sifying an ILS portfolio, and adds that even a move towards securitising catastrophe risks from non-peak zones - such as the US west coast and Japan – would be a welcomed development. “On the one side many investors like to see investment opportunities where they can diversify their ILS investments but on the other side for these risks

there is usually strong competition from the traditional reinsurance sector,” he says. “This is a tricky situation,” he adds.

Rupert Flatscher, head of Munich Re’s risk trading unit, notes that a strong commitment from investors would be required before personal line securitisation would be possible, but would not be become a focal point for the market even then. “I would assume that the broad ILS segment will remain a natural catastrophe play or at least strongly focus on natural catastrophe,” he says.

Henning Ludolphs, Hanover Re

22 SCI July 2010

ILS

The Australian RMBS market appears to be finally emerging out of its doldrums and – barring extended debt-market turmoil – issuance should show signs of further recovery later this year. The quality of new deals is expected to be high and offshore investors,

the biggest buyers of Australian RMBS before the global finan-cial crisis, have been returning, although cautiously.

In our view, RMBS issuance can provide support to the rat-ings of Authorised Deposit-taking Institutions (ADIs) – that is banks, building societies and credit unions – by helping them

diversify their funding sources. But, in the aftermath of the cri-sis, we will be closely focused on the total proportion of funding that the ADIs derive from RMBS and other secured borrowings, as well as the degree of risk retention involved in future securiti-sations.

Prior to the crisis, annual Australian RMBS issuance meas-ured around A$50bn, but is now running at well under 20% of that level. Overseas investors – who used to take up 60-70% of total issuance – are returning, but are now buying only 20-30% of deals.

RMBS, bank ratings and risk

Richard Lorenzo, vp structured finance, and Patrick Winsbury, svp financial institutions, at Moody’s Investors Service look at the relationship between RMBS issuance and Australian bank ratings


ABS

While we expect overseas participa-tion to increase, we don’t anticipate it to return to prior levels due to the exit from the market during the crisis of structured investment vehicles (SIVs), previously the major buyers of RMBS. Nevertheless, overseas investors still see Australian RMBS as largely stable and carrying a lower level of risk than RMBS from other major markets, such as the US, UK or Spain.

The problem for Australian RMBS over the last few years – as many of these investors are quick to concede – was more one of guilt by association. Institutions, such as insurance companies and pension funds, lost their appetite for any securi-tised asset class, regardless of its specific performance history.

Generally, Australian RMBS remain favoured by offshore investors, given that no downgrade, due to performance reasons, has ever occurred. For example, since the beginning of the crisis, only one Aaa downgrade has materialised in the Australian RMBS market, and that was due to legal issues, and not the perform-ance of the underlying mortgage pool. There have also been a number of down-grades of non-Aaa tranches, but they were related to downgrades of the providers of lenders mortgage insurance.

Encouraging developmentAlthough the recent volumes of Aus-tralian RMBS issuance and overseas investor take-up are a far cry from the more buoyant situation of a few years ago,

another encouraging development – and indication of renewed confidence – is the diminishing level of participation by the governmental Australian Office of Finan-cial Management (AOFM).

During the crisis, the AOFM stepped in with A$8bn to ensure that the local RMBS market and competition within the sector survived. From Q4 2008 to Q2 2009, it invested in 70-80% of any transaction, illustrating the lack of inves-tor appetite for any structured finance product over this period. Indeed, without the AOFM, it is unlikely that any RMBS deals would have been launched.

More recently, the environment has shown some definite signs of a turna-round, although mostly before the market hiatus caused by concerns over Southern European sovereign risk. AOFM partici-pation in RMBS deals decreased to the 20% level as real money investors started to return.

A good example occurred in Q4 2009, when three transactions – A$4bn in total – were successfully issued without any AOFM support. One of these, an A$2bn deal by Westpac, was significant because global RMBS issuance was quiet at the time.

But, while overseas investors appear comfortable with Australia assets from a credit perspective, they have questions on changes to constant prepayment rates and – even more than before – macro-economic issues. We hope to address the latter subject in an upcoming special report.

Notwithstanding these questions, we anticipate a further strengthening in over-seas investor interest in Australian RMBS from 2H 2010 onwards. If increased demand tightens spreads to the region of +100bp, it would become economical for many issuers to begin issuing RMBS again, thereby increasing the volume of deals.

Recent dealMost recently, Suncorp issued an A$1bn RMBS transaction, upsized from an ini-tial A$500m on healthy investor demand and some support from the AOFM. The A$600m Class A1 tranche, with a weighted average life of 1.5 years, was sold at +100bp. Some price support was undoubtedly derived from the fact that the AOFM bought the entire A$300m tranche of Class A2 certificates at +110bp.

“Generally, Australian RMBS remain favoured by offshore investors, given that no downgrade, due to performance reasons, has ever occurred”

Chart 1Prime RMBS – market issuance

Source: Australian Office of Financial Management

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24 SCI July 2010

ABS

A return of investor appetite for Australian RMBS – at economic pricing levels – would provide some welcome relief to many smaller ADIs, which tend to focus heavily on residential mortgage lending. Pre-crisis, several of the smaller ADIs were significant users of RMBS, with a handful sourcing around half of their funding from securitisation.

By contrast, Australia’s major banks have always been much less reliant on securitisation. Before the crisis, they used it mainly as a tool for funding diversi-fication. Now RMBS accounts for only around 1% of their funding.

When the crisis hit, heavily RMBS-funded ADIs had to dramatically slow their new loan originations to levels which they were able to fund through deposit growth. Increased competition for deposits – created by the closure of the RMBS market, dislocations in unsecured debt markets and, to some degree, by the potential for new banking regulations that favour deposit funding – have pushed up deposit costs.

Furthermore, while residential mort-gage margins improved – absorbing some of the rises in funding costs – they did not keep up with improvements in margins for business lending. This situation put smaller lenders at a margin disadvantage to the larger banks, which have more substantial business loan books.

In such an environment, renewed investor interest in RMBS could conceiv-ably take some pressure off deposit com-petition, thereby helping smaller ADIs generally. It would also bring back some funding diversification options for them.

Pre-crisis, we traditionally viewed RMBS issuance as exhibiting very lim-ited downside for the unsecured debt rat-ings of Australian ADIs. The reason was that, compared to some other markets, asset sales in Australian RMBS were quite ‘clean’, with very little risk retained by the originator.

For example, mortgage assets sold into a warehouse could not be put back to the originator. And because pre-crisis RMBS structures effectively obtained their credit enhancement from lenders’ mortgage insurance, the originators were not left holding first-loss exposures.

We also valued the matched-funding of assets that Australian RMBS tradi-tionally provided, including only modest ‘clean-up call’ provisions that could be

accommodated relatively easily as part of an ADI’s ongoing funding task.

However, we did view high levels of securitisation as a constraint on the unsecured debt ratings of ADIs due to the funding concentration risk created. In addition, we viewed high levels of securitisation as weakening the average credit quality of non-securitised mort-gage books because only seasoned loans – by definition well performing – were selected for securitisation.

Key developmentsOur view of the post-crisis securitisa-tion market in Australia is likely to be coloured by four developments:

First, the degree to which market liquidity returns will influence our view on the reliability and stability of RMBS as a funding source. Given that the crisis demonstrated that investor demand for complex securities can dry up rapidly in times of uncertainty, we will focus closely on the absolute amount of funding that an ADI derives from securitisation, and its ability to either replace that funding with other sources, or to quickly adapt its business model in case investor demand for RMBS contracts.

Second, there has been a subtle shift in Australian RMBS structures over the course of the crisis. In many cases, the ratings of senior tranches of RMBS deals

“When the crisis hit, heavily RMBS-funded ADIs had to dramatically slow their new loan originations to levels which they were able to fund through deposit growth”


ABS

cover on loans with loan to value rates over 80%. Moreover, there was no market for subordinated RMBS tranches during the crisis, leaving originators to hold them.

A continuation of both trends could see originators holding some, although limited, first-loss exposures, and which

did not happen pre-crisis. This issue is even more material for banks issuing non-mortgage ABS and retaining subor-dinated tranches because – in contrast to Australian RMBS – third-party insurance is not typically used to provide credit enhancement on ABS deals.

Third, future bank regulation may require originators to hold stakes in their securitisations. The nature of such stakes – whether they are first-loss positions or ‘vertical slices’ – could affect the level of risk actually retained by an ADI that issues RMBS.

Fourth, there has been policy discus-sion in Australia as to whether ADIs should be allowed to issue covered bonds, which are currently prohibited. If such entities start to pledge some of their best-performing residential mortgage assets as collateral for covered bonds – and concur-rently sell others through RMBS funding – there would be a negative impact on the average credit quality of those assets that remain available to support unsecured creditor claims. As cumulative levels of secured funding start to rise, they would eventually create downward pressure on the ratings of unsecured obligations.

Separate to the public market, RMBS play an important role in supporting bank liquidity profiles because they are accepted under central bank repo-eligi-bility criteria. At times of market stress, the Reserve Bank of Australia will – on a case-by-case basis – accept RMBS originated by an ADI, but not yet sold to a third-party investor. This effectively allows the ADIs to reliably monetise their high-quality mortgage books in times of extreme market stress.

have been immunised from the impact of any downgrade of the mortgage insurer or insurers providing credit enhancement. This has been achieved through greater levels of subordination. Westpac’s RMBS issue in December 2009 went one step fur-ther, by carrying only mortgage insurance

“Separate to the public market, RMBS play an important role in supporting bank liquidity profiles”

Chart 2Housing loan spreads up less than business lending

2.6%

2.4%

2.2%

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0.6% Jun 2004

Sep

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Discounted mortgage vs 3 mth bank bill rate (lhs)SME overdraft vs 3 mth bank bill rate (rhs)

6.5%

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4%

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3%

Source: Reserve Bank of Australia

26 SCI July 2010

ABS

Risk reduction was the primary theme in the struc-tured credit markets in 2009. Yield enhancement was of secondary concern, particularly given the wide spreads available in vanilla markets early in the year and the easy returns generated by the

subsequent rally. In 2010, however, we expect a greater push for yield through structured products.

Attention on yield-enhancing products and relative value should grow, given the low spread, low rate environment and potentially falling IG issuance. We would expect increasing focus on simple structures referencing carefully selected credits and low-leverage, index-based products.

Given this, we begin with a shortlist of some of the products that we envisage will be used for yield enhancement. Then, we consider the status and outlook for each of the synthetic tranche, volatility, CLO and total return swap (TRS) markets in turn.

Product focusAs clarity over future regulatory changes develops over 2010, we expect banks to consider using portfolio structured credit as a means of managing risk and regulatory capital, for example, via tranche protection. On the other hand, structured credit investments for yield enhancement are likely to involve single names, small baskets, indices and strategies thereon. While issuance in simpler,

Simplicity is key

Madhur Duggar, Batur Bicer, Matthew Leeming, Søren Willemann and Rob Hagemans of Barclays Capital Credit Research take a look at the potential for structured credit products


Structured Credit

low-leverage tranche products may occur, most bespoke CSO activity in 2010 is likely to entail secondary market trading.

We see potential interest for the following products:

• Credit-linked notes (CLNs): We have seen ongoing demand for single-name CLNs and expect this to continue in 2010. With the cash/CDS basis moving towards positive territory and high bank funding levels, single-name CLNs can offer attractive returns relative to bonds sourced in the primary market. We also expect interest in simple, linear products that give exposure to a basket of names through CLNs, potentially with limited structur-ing;forexample,toallowforfixedrecovery rate credit events.

• First-to-default (FTD) baskets: Short-dated FTDs are likely to remain popular with investors who select a small basket of local, familiar credits with which they are comfortable taking 1-3y risk.

• Index and portfolio-based strate-gies: We see potential for dynamic, low leverage strategies, for example

in CPPI format, referencing indices or, as focus returns to relative value, selected long/short portfolios.

• Structured volatility products: These will be used by investors seeking short-dated yield enhance-ment with low leverage and principal protectionbasedonspecificviewsonunderlying index spread evolution.

• Bespoke CSOs: Changes to rating methodologies by the agencies will result in new bespokes attaching further up the capital structure than they used to. However, we think that at current spread levels the econom-ics are compelling and can lead to bespoke issuance if the regula-tory overhang subsides. While full capital structure trades would add minimal risk to correlation desks, we are sceptical as to whether inves-tors can be found for every tranche.

• CLOs: New-issue CLO activity is unlikely until 2H10. Funding costs are currently too high, there is considerable regulatory uncertainty and there are not enough new-issue loanstocreateadiversifiedportfo-lio. CLOs backed by a mixed bag of new-issue loans, secured bonds

and secondary loans can possibly be issued sooner.

• TRS: Stabilisation in the leveraged loan market and the availability of short-termfinancinghasbroughtTRS structures back selectively. We think that funding terms on new TRS structures are still onerous and will normaliseasfinancialspreadstighten.

Tranche marketsThree main themes dominated activity in tranche markets in 2009. These were increased idiosyncratic risk in CDX mar-kets relative to iTraxx; continued unwinds of bespoke CSOs; and lack of liquidity in on-the-run tranche products.

As we look out over 2010, we expect most of these themes to continue. Bespoke CSO issuance will be the wild card, in our opinion. The econom-ics would work, despite rating agency changes, but regulatory changes could potentiallystiflenewissuance.

Portfolio dispersion: a tale of two citiesFigure 1 and Figure 2 show the total returns (divided by delta and DV01) of the capital and term structures for iTraxx 9 and CDX 9 since the beginning of 2009.

There is a clear divergence in behav-iour between the two. In the CDX 9, there has been an elevation of idiosyncratic risk (eg, the CIT credit event). This has driven asignificantunderperformanceofequity,with 3% correlation dropping and port-folio dispersion increasing (Figure 3 and Figure 4). The rest of the capital structure has generally outperformed.

“We have seen ongoing demand for single-name CLNs and expect this to continue in 2010”

Figure 1iTraxx9 delta-hedged tranche returns in 2009

Figure 2CDX9 delta-hedged tranche returns in 2009

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Note: Returns are in bp of tranche notional and are divided by delta and index DV01. Source: Barclays Capital

Note: Returns are in bp of tranche notional and are divided by delta and index DV01. Source: Barclays Capital

28 SCI July 2010

Structured Credit

In contrast, in iTraxx 9, equity correla-tion has actually marginally increased, with junior tranches outperforming. There has been little change in the iTraxx portfolio dispersion over the year. The equitytrancheshavealsobenefitedsub-stantially from their positive convexity.

The idiosyncratic theme played out in the HY and LCDX indices as well. The performance of HY and LCDX tranches wassignificantlyaffectedbythehighdefault environment of 2009.

We observed 13 and 12 defaults in LCDX 10 and HY 10 indices respectively since the beginning of the year. High numbers of defaults coupled with low recovery rates caused severe impairments in tranches. The 0-10% and 0-5% equity tranches are completely wiped out and 10-15% and 5-8% tranches lost 30% and 70% of their principal.

Delta-adjusted changes on the two

most junior tranches were limited as these tranches were priced to be wiped out even at the beginning of the year. When defaults did take place, there was hardly any price movement on the junior tranches.

The mezzanine and senior tranches, whichunderperformedsignificantlyasindices tested all-time highs in March, bouncedbackandoutperformedsignifi-cantly since then on the back of a sig-nificantrallyinspreads.Thesetranchesexperienced the most MTM volatility throughout the year.

Finally, super senior tranches – although underperforming the belly of the capital structure – managed to generate positive returns with low volatility.

Low liquidity persists in on-the-run tranchesLiquidity in on-the-run tranches remains weak due to the absence of new bespoke issuance. iTraxx 9 and CDX 9, which

began trading in March 2008 and Septem-ber 2007 respectively, continue to be the most liquidly traded tranches.

Similar to what we have observed in the IG correlation markets, liquidity in on-the-run series has not picked up for CDX HY and LCDX tranches. Most of the trading activity is focused in series 9 and series 10.

Unwinding of existing CSOs to continue in 2010Based on anecdotal evidence, we believe that 50% of all CSOs have been unwound by now, some of which had already hap-pened in 2008. Unwinds did not result in a widening in credit spreads because correlation desks had lowered their deltas by about 50% through the initial round of spread widening. This meant that unwinds resulted in the buying of CDS protection by correlation desks on only half the original amount.

Figure 3Series 9 portfolio dispersion

Figure 55y HY.10 Delta and default-adjusted returns

Figure 4Series 9 equity correlation

Figure 65y LCDX.10 Delta and default-adjusted returns

Jan 09 Mar 09 May 09 Jul 09 Sep 09 Nov 090%

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Dispersion

CDX.IG S9 iTraxx Main S9

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Note: Numbers include carry. Source: Barclays Capital

Source: Barclays Capital

Note: Numbers include carry. Source: Barclays Capital


Structured Credit

In our view, the biggest driver of unwinds of CSOs in 2010 will be the requirement that insurance companies and banks recognise capital impairments against their bespoke positions if these positions have traded at a distressed level for a long enough period of time. Again, we do not expect this to have a mate-rial effect on spreads as these CSOs will probably be unwound opportunistically into market strength.

We are also seeing the development of a market for secondary CSOs, with investors selling CSOs to other (distressed) investors. This should also serve to keep the amount of actual unwinds low as investors who want to sell their CSOs are left with an alternative to outright unwinding.

New CSOs: the economics work but regulatory overhang remainsChanges to rating methodologies by the agencies will result in new bespokes attaching further up the capital structure than they used to. However, we think that at current spread levels the econom-ics are very compelling and can lead to some bespoke issuance if the regulatory overhang subsides.

To illustrate this point, we construct a genericefficient5ybespokeportfoliowithwelldiversifiednameswithanaveragespread of 140bp. Under S&P’s methodol-ogy,wefindthattheminimumsubordina-tion for a AAA tranche would need to be 10% and would yield a spread of 230bp (at mids) if a 5% thickness is assumed.

According to our stress scenarios, the tranche ratings would be very robust against severe idiosyncratic and systemic credit shocks. For the tranche to be down-graded to BBB, 10 or more immediate defaults are required (Figure 7). Moreover, it would need, for example, 12 names to be downgraded immediately from an average rating of A+ to CCC to achieve the same kind of downgrade (Figure 8).

The main stumbling block in our opinion is regulatory risk. There is every chance that investors in the US will havetoflowthemark-to-marketontheirbespoke exposures through P&L for GAAP purposes. This would probably generate earnings volatility and could be a major deterrent.

CLOsAs investors form their own views on the future of the CLO market in 2010, we see four questions as foremost:

1. Will we see new CLO issuance in 2010 and, if so, then in what form and when?

2. What demand are we likely to see from secondary CLOs for loans?

3. Are secondary CLO tranches still a cheaper way to invest in loans?

4. Which part of the capital structure appears the most compelling in secondary CLOs?

Primary CLO issuance depends on banks Lackofsufficientnew-issuecollateral,

high funding costs and regulatory uncer-tainty are three obstacles that will need to be overcome before we see CLOs backed primarily by new-issue loans. Issuance of CLOs backed by new loans is therefore not likely in 1H10.

By 2H10, there should be enough new loans to issue a primary CLO. However, high funding costs and regulatory uncer-tainty would still need to be overcome. Banks considering the overall busi-nessopportunityinCLOsshouldfinditprofitabletofundCLOsattighterspreadsiffinancialspreadsrally.

The current cost of funding is simply too high for rated arbitrage (ie, non-balance sheet) CLO issuance to gener-ate attractive internal rates of return (IRRs) for equity investors on CLOs backed by par loans. For CLOs to become a viable issuing vehicle again, we think AAA CLO spreads would have to rally 115bp, from L+225bp to L+110bp, and loan spreads would have to remain at cur-rent levels (Figure 9).

At L+110bp, the AAA CLO tranche is not compelling for US banks, which would have to allocate 8% capital (under Basel 1 rules) against the position but receive only L+110bp on the asset. Even if they funded the asset at Libor, the trade would generate a return of only about 14%, which is low compared with the marginal cost of capital for most banks. European banks would have to allocate far less capital (under Basel 2 rules), but they already have large exposures to AAA tranches and might be unwilling to add exposure.

It appears, therefore, that for banks to fund senior CLO tranches at tighter spreads, they would need to look at not only the return on capital generated by the AAA tranche, but also the arranging and trading fees that the structure would generate. Banks will also be wary of the regulatory overhang for securitised prod-ucts; for example, the Financial Stability

“By 2H10, there should be enough new loans to issue a primary CLO”

Figure 7Number of defaults required to downgrade a tranche to BBB

Figure 8Number of notch downgrade on 12 names to downgrade a tranche to BBB

Note: We assume that the lowest-rated credit in the bespoke portfolio default first. Source: Barclays Capital

Note: We assume that each one of the 12 names we choose in the bespoke portfolio gets downgraded uniformly. Source: Barclays Capital

Tranche Now 1 year later 2 years later

AAA 10 11 12

AA 5 6 7

A 2 2 3

Tranche Now 1 year later 2 years later

AAA 13 14 15

AA 8 9 10

A 4 6 7

30 SCI July 2010

Structured Credit

Improvement Act under discussion in the US directs the regulators to write rules to require creditors to retain 10% or more of the credit risk associated with any loans that are transferred or sold, including for the purpose of securitisation.

It is not clear whether this would include corporate loans, what exactly is meant by credit risk and who would be considered a securitiser. We believe banks will wait for more clarity before providing CLO funding.

Structure – simpler structures with low leverage will be the norm We expect the market to move to low-levered dual-class structures composed of a thick equity tranche and a senior AAA tranche.Twofactorsareatplayhere:first,under the new ratings methodology, AAA tranches will require greater subordination than they used to have. Second, thin mez-zanine tranches rated Aa through to Baa willbedifficulttoplaceinthemarket,given the recent ratings volatility observed around these tranches. Most of these posi-tions were placed with ratings-sensitive investors, such as banks, and insurance companies that will have the recent ratings volatility fresh in their minds.

Timing – we do not expect new-issue CLOs before 2H10A broad diversity of issuers also needs to come to the market before CLO activity picks up in the US. A typical CLO needs about 100 different issuer names to achieve the diversity required for it to achieve a AAA rating on the senior tranche.

We are estimating about $75bn of loan issuance in 2010 and an average loan size of about $450m, based on the forward calendar. This implies about 170 issuers coming to market in 2010, or about 42 issuers per quarter. At that run rate, it would take at least two quarters before a primary CLO composed entirely of new-issue loans could come to the market.

New-issue CLOs could come to the market faster if they include secondary loans in their collateral pool. New-issue CLOs could also come to the market more quickly if they are willing to buy secured bonds or secondary loans.

In Europe we expect €8-10bn of institu-tional term loan issuance, of which €3-4bn can be absorbed by existing CLOs. This does not leave enough term loans for a diversi-fiedCLOtobeissuedinEuropein2010.

Secondary CLO demand for loans will remain robust in 2010There is concern in the market about the ability of secondary CLOs to continue to buy loans because of deal restrictions. We believe CLO restrictions are unlikely to be binding in 2010, as almost 98% and 95% of secondary CLOs will be within their reinvestment period in the US and Europe by year-end 2010 and therefore will be able to reinvest principal proceeds.

Reinvesting prepaymentsAbout $275bn and €56bn of non-defaulted term loans are currently inside US and European CLOs that will be within their reinvestment period by year-end 20102. If we assume a 15% and 5% prepayment rate on US and European loans respectively, then this translates into about $40bn and €3bn of demand for loans in US and Europe respectively from secondary CLOs.

Trading out of CCC credits to build parCLO managers will continue to trade out of credit-deteriorated loans into higher-rated credits in order to build par. Deals within their reinvestment period and fail-ing OC tests are most likely to trade out of excess CCC credits into higher-rated loans.

Currently, about 50% and 60% of US and European deals are failing their most junior OC tests. The average excess CCC bucket sizes for these deals are 4.8% and 3.3% respectively. Assuming $325bn and €70bn of respective total CLO issuance

in US and Europe, this translates into another $6bn ($325 x 50% x 4.8% x 80%) and €1bn (€70 x 60% x 3.3% x 80%) of demand for higher-rated loans in the US and Europe respectively3.

CLOs are still cheaper than loans but not by muchCLO prices lagged the loan rally in 1H09 but have since been playing catch-up. Figure 10 shows quarterly returns on the collateral and liabilities of a typical CLO.

CLO liabilities underperformed the col-lateral in Q1 and Q2. Since then, the rally in loans has slowed and interest has shifted to CLO liabilities, which outperformed in Q3. Much of this was driven by the rally in AAA-A prices in Q3. Lately, junior CLO tranches have also caught a bid.

The late rally in CLO tranche prices has closed the gap between collateral and liability values. Figure 11 shows the difference between collateral and liability prices; ie, the ‘CLO arbitrage’. This differ-ence swelled to almost 15% in June 2009.

Since then, however, the difference has narrowed back to about 5%. We think that the gap will continue to close as the default outlook improves and investors are more comfortable holding junior tranches.

TRSStabilisation in the leveraged loan market andtheavailabilityofshort-termfinanc-ing has brought TRS structures back selectively. These new structures have lower leverage (2-3x) and a higher cost of

Figure 9Breakdown of CLO arbitrage construction at deal inception

(4)Remaining 90bp for AaaTranche

AaaRated35-100%

(5)Implied spread of L+110bp for Aaa

(1)Total asset

spread is 650bp

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equity to yield IRR at mid-teens

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L+400bp Coupon

Loans

Zero-default IRR13%

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40bp

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90bp



Structured Credit

funding (L+100-150bp), compared with older structures that allowed up to 10x leveragedonfirst-lienloansandprovidedlong-term funding at L+70bp. After deleveraging for most of 2008-2009, the market is slowly getting back on its feet, with a select group of banks providing TRS facilities to clients they have prior relationships with.

We think that the funding terms on new TRS structures are still onerous andwillnormaliseasfinancialspreadstighten. However, investors might still choose to initiate these structures today in order to buy term loans trading at a discount to par.

TRS versus CLOsTRSstructuresoffercheaperfinancing,butCLOs offer higher leverage and longer-termfinancing.Webelieveinvestorsshouldaccess discounted loans, (trading at $80-85) through CLOs and higher-priced loans ($90-95) through TRS structures.

In Figure 12 we compare a TRS and aCLOstructurebackedbyfirst-liensecondaryloanswithafive-yearhold-ing period. We consider two different portfolios.

Thefirstportfoliohasanaver-age dollar price of $90 and the second portfolio has an average dollar price of $85. Both portfolios have an average coupon of L+300bp with 10% of the port-foliohavingaLiborfloorof2.5%.

For the CLO, we require the AAA tranche to have 35% par-subordination, and for the TRS, we require the senior tranche to have 35% market-value sub-ordination. Finally, we assume that the TRS is funded at L+150bp, while the CLO

isfundedforfiveyearsatasecondarymarket rate of L+225bp.

The TRS structure provides more attractive returns to equity for the high-dollar price portfolio, while the CLO structure equity outperforms for the lower-quality portfolio. The main reason is that CLO structures require the senior tranche to have 35% par-subordination, while TRS structures require the senior tranche to have 35% market-value subordination.

This results in a lower initial invest-ment and consequently higher leverage in CLOs compared with TRS structures. In a bullish environment, this generates higher returns for CLOs that reference low dollar price loans. For high dollar price loans, the higher leverage that a CLO provides is not enough to offset the lower cost of funding of a TRS.

TRS funding is likely to decrease from currentlevelsiffinancialspreadstighten.However, even a 75bp tightening from 150bp to 75bp will not be enough, in our view,tooffsetthebenefitsofthehigherleverage that a CLO structure provides on lower dollar-priced loans.

© Copyright Barclays Bank PLC 2010. All rights reserved.

Notes

1. See Analysis of the trading book quantitative impact study, Bank for International Settlements, October 2009.

2. We estimate total US and European CLO volume at $325bn and €70bn, respectively. However, some of this volume consists of defaulted assets and assets other than secured term loans. We estimate the volume of term loans to be $275bn and €56bn, respectively.

3 We assume CCC credits are trading at $80 and €80, respectively.

Figure 10Return on collateral and liabilities of a typical CLO

Figure 11The CLO arbitrage is shrinking

% Change in loan price % Change in CLO liability price

1Q 2Q 3Q 4Q-5%

0%

5%

10%

15%

20%

25%

30%

Jan09

Feb09

Mar09

Apr09

May09

Jun09

Jul09

Aug09

Sep09

Oct09

0%

2%

4%

6%

8%

10%

12%

14%

16%

Source: Barclays Capital Source: Barclays Capital

Figure 12Comparison of CLO and TRS for two different average portfolio prices


Par Amount

Market Value

EquityInvestment

MVLeverage

CDR

0.0% 2.5% 5.0% 7.5% 10.0%

CLO 100 90 25 3.6x 14.8 11.6 8.4 5.3 2.2

TRS 100 90 32 2.9x 14.7 12.7 10.8 8.9 6.9

CLO 100 85 20 4.3x 20.9 17.5 14.2 10.9 7.7

TRS 100 85 30 2.9x 18.5 16.7 14.9 13.1 11.3

32 SCI July 2010

Structured Credit

Former Lehman team reassemblesG2 Capital Markets, a subsidiary of G2 Investment Group, has acquired the former Lehman Brothers’ private place-ment and illiquid credit trading team. They will be in familiar company, joining an existing group of former Lehman execu-tives who have come to G2 since its inception.

The esoteric credit trading team specialises in analys-ing, marketing, trading and settling illiquid credit securities. It trades an array of illiquid assets, including private place-ments, ETCs, credit tenant leases, project finance, emerging market corporate and other structured credit products. The team is led by senior partners Scott Best, James Gregorek and Larry Taylor.

“By pulling all of the less liquid asset classes together, this team literally invented a business and we are excited to have them at G2,” says Todd Morley, G2 Investment Group founder and chairman. “While at Lehman they simply domi-nated the market with a market share that was a multiple of the nearest competitor. We expect them to have an immedi-ate impact on our trading franchise and on our new issue origination and distribution.”

Best spent 14 years at Lehman, creating and running its esoteric credit trading business. Gregorek spent 21 years at Lehman, leading the esoteric sales and trading business. Finally, Taylor spent 15 years with DLJ and Credit Suisse’s high yield group.

Five hires to credit sales, trading teamsRBS Securities has expanded its US flow credit sales and trading teams within its global banking and markets division in the Americas. The five new hires to the Stamford, Con-necticut, office are Robert Williams, Michael Regan, Seth Bernstein, Richard Joyce and Tom Daly.

Williams and Regan join as credit trading mds, reporting to Sean Murdock, md, US flow credit trading for the Ameri-cas. Williams joins from Mizuho Securities, where he was executive director focusing on banks and finance companies in its credit trading group. He was previously a Bear Stearns cash bonds trader, before switching focus to cash bonds for automobile companies and CDS.

Regan comes from Christopher Street Capital, where he was responsible for credit trading. He has also spent seven years at Deutsche Bank, where he was head of credit trad-ing, and 16 years with Merrill Lynch.

Also reporting to Murdock is Seth Bernstein, who joins as credit trading svp. He was most recently a vp at Morgan Stanley, where he worked on its high yield credit trading desk as a primary market maker and risk manager. Before that he held positions in Morgan Stanley’s high yield bond sales and collateral management groups.

Joyce and Daly both join as credit sales mds, reporting to Anthony Britton, head of credit sales for the Americas. Joyce joins from BTIG, where he was credit sales md. Daly leaves his role as credit sales md for GFI Group.

J o B S W A p S Some company and people moves from SCI issue 188, 9 June 2010

Credit business expands in new directionBlueBay Asset Management has hired Mark Dowding to lead the development of a European government bond business at the firm. He joins as senior portfolio manager and will co-head the European investment grade team with Raphael Robelin, BlueBay’s head of investment grade credit. Robelin will focus on corporate bonds, while Dowding will focus on government bonds.

Dowding joins from Deutsche Asset Management, where he was European head of institutional fixed income, and has previously worked alongside Robelin at Invesco. He will arrive in early September, after which the firm will launch funds in both the European government bond and European aggre-gate space, with the latter product combining sovereign and corporate credit.

BlueBay says Dowding’s appointment marks an important strategic development, with recent macro developments introducing a significant credit element to the management of developed market government bonds. The firm believes investors will need their portfolio managers to have high quality credit skills and says it is positioning itself to provide “high performance, new generation products” in the rede-fined asset class.

Merger results in CDO manager transferBNp paribas Asset Management (BNp) has succeeded For-tis Investment Management France (Fortis) as portfolio man-ager on the Titian CDo transaction. The move follows the full merger of Fortis into BNp, including the transfer of all its assets and liabilities. BNp says that all contractual rights and duties of Fortis under the portfolio management agreement were taken over unchanged.

Changes to permacap’s operations proposedpermacap vehicle Carador is set to propose a number of changes to its operations at its 30 June AGM.

First, a change in name to ‘Carador Income Fund’ has been proposed to reflect the company’s distribution policy, whereby all net income is distributed as quarterly dividends. The investment manager believes that the discretion to make distributions out of realised and unrealised capital gains net of realised and unrealised capital losses will allow it to con-tinue to identify attractive investment opportunities in senior notes, while maintaining an appropriate level of distributions to shareholders. Accordingly, it is proposed that the Articles of Association be amended to change the distribution policy of the company accordingly.

Second, it is proposed that the ability to charge fees and expenses to capital be introduced. Currently, Carador charges its fees and expenses to income only.

Finally, the base currency of the company shall be changed to US dollars from euros in order to match the primary currency of denomination of its assets. As at 30 April, 23.83% of Cara-dor’s portfolio was invested in euro-denominated assets.

ipick of the Month

A selection of recent news published online from SCI & STORM

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9 June 2010Unclear outcomeGSE uncertainty lurks, despite performanceDespite hefty demand for MBS securities currently, much uncertainty still exists over what shape Fannie Mae (FNMA) and Freddie Mac will take after the Treasury’s backstop is up for the GSEs in 2012. Investors are expected to begin evalu-ating the potential outcomes going into the fourth quarter.

one issue is what will happen to legacy MBS after 2012. The Treasury is likely to say that FNMA and Freddie Mac leg-acy MBS will have the full faith and credit of the US, accord-ing to Glenn Schultz, md at Wells Fargo Securities.

“They will be private companies securitising MBS, with an FDIC-like insurance behind them, so you will have to pay for it. I think we know where we’re heading with this. We just don’t have a clear path of how we are going to get there,” he adds.

A new governing plan for both FNMA and Freddie Mac needs to be developed, says an MBS strategist. “It’s very difficult to visualise a scenario where, at the end of 2012, the government will pull the plug on Fannie and Freddie and say oK you are on your own devices,” he says. But everyone rec-ognises that the historical model of FNMA and Freddie Mac – in which there are half private and half public constituents – doesn’t really work, he adds.

Another potential development to watch is a possible reduction in the risk weighting on FNMA and Freddie Mac securities, which would essentially allow investors to hold less capital against their positions, note analysts in a Gold-man Sachs research note last month. Final rule changes could have implications for the value of GSE MBS relative to Ginnie Mae securities (GNMAs), they say.

The market, however, currently considers both the debt and the mortgage obligations of FNMA and Freddie Mac as if they are essentially government guaranteed like GNMAs already. “They are not legally government guaranteed, but that is how the market is treating them,” the analyst notes.

GNMA securities still trade at a premium over FNMA and Freddie Mac securities, but only slightly. GNMA 4.5% pass-throughs trade with a yield of 3.75% currently compared with Fannie Mae 4.5% pass-throughs that trade at 3.8% yield, notes the strategist.

But investors in general believe that due to the 2012 fed-eral end date, GSE 2.5-year paper should price more attrac-tively than longer paper. Some investors also prefer MBS at the moment compared to straight GSE debt, since they are comfortable having an asset behind something, adds the strategist.

Making sure the to-be-announced (TBA) market contin-ues to work well once 2012 comes is also on market partici-pants’ minds. The TBA market has held up well during the credit crisis, market participants say.

But an analyst comment put out by Annaly Capital Man-agement this week notes that since there is not enough

collateral to fill the bid from the Federal Reserve’s MBS pur-chase programme that ended on 31 March, they continue to see a problem with settlement fails in the system. The ana-lysts suggest that because of this, agency MBS are likely to remain well bid for the foreseeable future.

Reform of the GSEs is indeed necessary to fully jump-start the non-agency MBS market as well, since over the past 18 months mostly agency originations have taken place. The non-agency securitisation market received an initial boost at least from Citigroup’s jumbo MBS securitisation in April (SCI passim), when it brought a US$222.4m MBS deal backed by new mortgages. Redwood Trust was the sponsor.

The GSEs themselves have been active in improving their own securitisation programmes. Freddie Mac recently added new kinds of products available for its securitisation programme, such as multifamily senior housing and con-ventional structured finance transactions, as well as student loans (see separate News Round-up story).

Ginnie Mae, meanwhile, last month made a change that will help small lenders in particular in aggregating loans (see last issue). Under its new policy that will begin in July, lenders will be able to securitise single loans in Ginnie Mae multiple-issuer pools and not have to wait for a three-loan minimum that is currently the case.

“I don’t think anybody’s going to want to buy the sin-gle loan,” notes one MBS analyst, who says it will likely be grouped together. “With the government guarantee, you don’t care about it (single borrower exposure) so much, but you could end up with essentially a prepayment via default – even if you had the government guarantee on it,” he says.

However, he notes: “There’s good demand for Ginnie Mae securities.” They are particularly popular overseas and with Asian investors due to the US government guarantee, he says.

Ginnie Mae also will allow issuance for Ginnie II multiple issuer pools to occur more frequently. Beginning in the fall of 2010, issuance can occur on a daily basis as opposed to monthly.

“Because you can issue the pools more frequently, it puts less pressure on the issuers and their credit lines and warehouse lending,” according to a Ginnie Mae spokesperson. KFH

9 June 2010Business boostTALF helps rating agency gain market shareDBRS is making inroads into the US ABS rating market, gaining market share as its competitors see less busi-ness. Moody’s, S&p and Fitch have all seen decreases in market share this year, with the latter appearing to be most affected.

Moody’s and S&p have long dominated the credit ratings market and each rated approximately 97% of ABS issued in 2007, while DBRS was involved in only 3%. In the year-to-date, however, DBRS’ market share has grown to 25%,

N E W S A N A Ly S I S – F R o M S C I

ii pick of the Month




while Moody’s and S&p have seen declines to around 80%, according to JpMorgan estimates. Fitch has seen its market share drop by a third for 2009 and 2010 against the two pre-ceding years, down to 30% for the year-to-date.

Daniel Curry, DBRS president, explains that the turn-ing point for his firm came last year. “The biggest reason behind us gaining market share was the Fed approving us to rate TALF transactions. Initially, the TALF programme only accepted ratings from Moody’s, S&p or Fitch. In January 2009 we asked the Fed to consider opening the programme up to other rating agencies, including ourselves,” he says.

After consulting the market and reviewing DBRS’ rat-ing methodologies, the Federal Reserve Bank of New york approved the agency in December as a TALF-eligible rating agency, allowing it to be involved in the last round of issu-ance. Curry says: “We rated about half of the transactions that were done in that round, and that really introduced us to the ABS market in a way we couldn’t have done without them. We have managed to stay somewhat involved, which is very encouraging.”

Some in the market have a different explanation for DBRS’ increased activity, with the agency’s willingness to rate non-performing loans (NpLs) also cited. FTI Consulting’s Hansol Kim says: “It appears that DBRS is ‘gaining’ market share in the NpL sector, because they are the only game in town. Investors go to them because they need a rating, normally as a pre-requisite to acquisition. The investors will have already done most of the credit work themselves.”

DBRS says it has rated some NpL deals, which involved restructuring existing portfolios for institutions, but that it is not its strategy going forward. “There is not a lot of value in these portfolios, so there is limited utility in that exercise for a lot of institutions. But the scale of the problem was so signifi-cant that there was a lot of interest in that. I think though that most of the work there has actually been done,” says Curry.

The agency says it has also worked on some re-REMIC transactions, but those too are winding down as a more tra-ditional new issuance market re-emerges.

Although DBRS is now involved in a higher percentage of ABS deals than in previous years, it also concedes that vol-ume remains low. “We were aware of 58 transactions through to the end of April, whereas back in 2007 the markets were huge. It’s a pretty tough market,” Curry notes.

Tough market or not, DBRS is improving its performance. A new report by JpMorgan says that Moody’s and S&p retain their lead in the market, but “DBRS and Fitch have become increasingly interchangeable as the ‘other’ rating agency”. DBRS believes Moody’s and S&p are too well established to be displaced, but that investors are looking for more opin-ions, given the recent rating performance.

Curry says: “Fitch has done a nice job of becoming a more significant player. I think the question for us is how many rating agencies will the market support? obviously, we are hoping at least four and it may be many more than that, but it

remains to be seen. There is still a huge percentage of inves-tors out there who have Moody’s and S&p written into their investment guidelines and will always want those ratings.”

Nevertheless, DBRS plans to expand its business into European ratings and will reopen its London office over the summer. The agency says it is currently working with regula-tors to ensure it re-enters the market in a way that is consist-ent with new regulations. Curry disagrees that investors do most of the credit work themselves and says rating agencies still have an important role to play.

“There is still such a wide variety of assets out there that people are looking to securitise that there is a huge amount of information that has to be processed and it is going to be difficult for a lot of investors to do that on their own,” he explains. “I think they will need to lean on rating agencies, so I don’t think the industry is going away. Having said that, I think the industry has a lot of work to do to rebuild trust and that will take time.”

Fitch, despite appearing to be the biggest losers in DBRS’ expansion, agrees that the market still needs its rating agen-cies. A spokesperson at the rating agency says: “Fitch’s US ABS ratings have been extremely resilient throughout the cri-sis and the agency believes its rigorous analytical approach will continue to serve investors well in this sector.” JL

2 June 2010Fair value concernsFASB proposal to weigh on banks amid volatile marketsThe Financial Accounting Standards Board’s (FASB) expo-sure draft that would require banks to mark financial instru-ments to market instead of at an amortised cost could have far-reaching implications for banks. The concept of requiring positions to be marked to such volatile markets is, at present, anathema to many in the industry.

FASB says the measure that is out for comment until 30 September will put in place a more consistent framework for financial reporting than what is currently employed by US banks and companies under GAAp accounting practices (see separate News Round-up story). The board says its proposed update would improve financial reporting specifi-cally using debt instruments, which are currently measured in different ways under GAAp at amortised cost, at the lower of either cost or fair value, or at fair value.

“Given the role that mark-to-market has played in exacer-bating the current economic crisis, it is hard to understand the rationale for expanding it without regard to the business model,” comments Edward yingling, president and ceo of the American Bankers Association (ABA). The ABA says the proposal would make it difficult to make many long-term loans, for example.

“To the extent you had large loan portfolios that were at amortised cost, now in addition to maintaining the basic accounting with impairment, you also have a process to do fair value on top of it. Being required to do fair value on top of

iiipick of the Month



that is where your additional cost comes in,” says Lisa Filo-mia-Aktas, partner and accounting advisory services leader, financial services at Ernst & young.

“Essentially, the US believes that it is important to have everything at fair value; that it’s useful information. But they also understand that it’s useful to understand the amortised cost basis. on the balance sheet, they are actually asking companies to show the amortised cost amount and the adjustment to get to the fair value amount,” she adds.

The proposed changes do not seem very new to Robert Willens, president of tax consultancy Robert Willens. “This is part of their long-term strategy to subject as many assets as possible to mark to market. you could argue this began sev-eral years ago when they created the fair value option that most people didn’t take advantage of,” he says.

Though FASB’s timeline for the proposal differs from the International Accounting Standards Board’s International Financial Reporting Standards (IFRS), the two boards hope to eventually converge. FASB issued its more sweeping changes in one proposal, while the IASB made its proposals separately.

“There is concern that this isn’t converged,” says Filomia-Aktas. “They are not the same right now. Hopefully, through this comment period, they’ll start to converge them.”

A lot of loans are in amortised cost under the US model and the IFRS model today. But under the IFRS model, the loans still have the amortised cost model and most loans would stay in the amortised cost, notes Filomia-Aktas.

If a bank’s business strategy is to hold debt instruments, for example, and not sell it for short-term gains, the bank can meet either the amortised cost under IFRS or the fair value through other comprehensive income under the US model. If a bank’s strategy is to sell the instruments, it would use the fair value through the p&L model, Filomia-Aktas adds.

Despite the volatility to net worth, some of the changes proposed could hold some benefits, Willens notes. “Most of the mark-to-market changes wouldn’t have to be reported in net income. Most of it would be reported in other comprehen-sive income, so that’s a plus. But, of course, even where it’s reported in other comprehensive income, it does affect share-holder’s equity and therefore capital balances,” he says.

The proposal could also assist banks when it comes to deposits, since they will also be required to be marked to market. Including deposits under this measure would be a positive, according to Willens, since a bank would get to write down a liability, which is something of an offset to the other accounting changes.

For non-public entities with less than US$1bn in total assets, FASB is proposing to provide them with an addi-tional four years to implement the new requirements relating to loans, loan commitments and core deposit liabilities. The proposal itself does not appear to be anywhere implemented before 2013, however. Round tables on the exposure draft are planned for october 2010. KFH

26 May 2010Gaining tractionSpecialty finance firms eye ABS returnSpecialty finance firms like Consumer portfolio Services (CpS) are among a group of niche companies that are plan-ning on a return to ABS origination. Though the issuance may be a bit far out on the horizon, the companies still see securitisation as a funding vehicle worth targeting.

“Despite the most recent turmoil, it seems investor demand still is pretty strong after a year and a half of where investors really fled from the sector. It still should be a good funding option for us,” says Robert Riedl, chief investment officer at Consumer portfolio Services. “our hope would be to get back to the term market in doing term deals late this year or early next year.”

CpS used to issue 4-5 term deals a year. Its total securitisa-tion debt has fallen to US$800m from US$1.3bn a year ago.

The company has slowed its purchasing of auto loans considerably since the credit crisis. In 2007, CpS was buy-ing over US$100m of new loans a month from dealers. The company’s purchases of new loans this month are close to US$10m.

other companies in the auto financing space are also considering offerings. one structured finance lawyer is cur-rently working on an ABS transaction backed by premium finance loans.

“There will be a lot of demand for that. It’s all about mak-ing sure the loan is originated properly and doesn’t turn into a mortgage debacle,” he says.

ABS offerings in which the loans are made specifically to pay premiums on insurance companies are also proving popular, he adds.

Traditionally, companies in the specialty finance space were not large enough or were not able to achieve the triple-A ratings that the TALF programme required, so most were not able to utilise TALF to get deals done. Riedl says TALF would not have helped his company, given its size, though he credits the programme with helping the ABS market in general.

A lot of the subprime auto lenders, in particular, also had a dependence on the monolines to wrap their deals and thereby obtained lower advance rates. one of the largest specialty finance subprime lenders, AmeriCredit, returned with a wrapped offering this past March (see SCI issue 178) when it issued a US$200m offering that featured a wrap from Assured Guaranty. It plans to focus its origination efforts on senior subordinated structures, as opposed to the wrapped offerings, however.

AmeriCredit also felt the pinch from the credit crisis in terms of reduced origination, though it was able to get some TALF-eligible transactions completed. The company typi-cally had to provide a hefty amount of credit support to get its deals done, says one ABS investor.

Credit Acceptance Corp, meanwhile, came in December of last year with a US$110.5m Credit Acceptance Auto Loan


iv pick of the Month




Trust 2009-1 transaction. The deal consisted of a triple-A rated US$82.5m tranche, a double-A rated US$28m tranche and a US$3.3m tranche, which was retained by the com-pany. overcollateralisation on the deal was about 20.03%, according to DBRS.

Several of the deals that have come to market from these companies have also been private. The costs in general have been prohibitive for the smaller issuers. But market partici-pants expect more rated deals in this sector to occur.

CpS, for one, plans to get its term facility that was cre-ated at the end of Q110 rated by the agencies when it reaches US$50m, says Riedl. It has about US$15m outstanding cur-rently. This facility, which is similar to an unrated term deal with an extended prefunding period, follows another US$50m facil-ity the company initiated in Q309 that has a warehouse line.

Another structured finance lawyer, however, adds that CpS’ recent facility was expensive for the issuer and not something it could pay for on a routine basis. “This sector had a near-death experience in 2008 and 2009. It was really hard for them to get credit. It’s certainly improved – and improved a lot more for the better capitalised companies,” he notes.

“But we are not anywhere near where we were in 2006 or 2007,” he concludes. KFH

19 May 2010Options openVolatility hedges return to popularityAmid the climb to recovery away from the credit crisis, CDS index option plays are proving increasingly popular. Most CDS market participants are attempting to hedge current positions or brace themselves for even more unexpected volatile swings.

In addition to individual hedging methods, the most effective CDS index option strategies also take into account the level of volatility skew, term structure and the overall hedging budget, according to credit derivative analysts at Morgan Stanley in a recent research report. Investors have been preparing for a 30bp widening in CDX IG or a 150bp widening in CDX Hy, for example, by buying out-of-the-money puts outright.

“In an environment in which realised volatility has been declining, term structures and skew are both steep,” they note.

The analysts say the sovereign crisis drove spread volatility on both CDX and iTraxx significantly higher in a short period of time to levels that resemble what occurred just after the Lehman bankruptcy. During the past two weeks, they note that the magnitude of the recent moves in credit was as large as they saw during the peak of the credit crisis.

over the past 20-day rolling window, realised volatility for all of Markit’s family of indices has been higher than the index levels at a 90-day rolling window. Volatility in the CDX IG is at 116.94% over a 20-day rolling window versus 65.81% over a 90-day rolling window. Similarly, the iTraxx index has been at 164.31% over the same 20-day window and at 86.30% over the 90-day window.

Volatility spikes are negative for traditional CDS option traders that prefer to hedge their gamma exposure thor-oughly, says one investor. Credit hedge funds experienced considerable losses during the credit crisis due to how unex-pected the daily moves were, he adds.

If, on the other hand, market participants believe credit spreads will remain range-bound, structured credit analysts at Barclays Capital note in a recent report that straddles – or selling payers and receivers with the same strike – makes a lot of sense. An even more cautious view, they say, is to sell strangles or receivers and payers with different strikes.

Range trading has been a popular CDS index strategy ahead of some perceived market downturns or index rolls. “It’s been safer lately to revert back to that,” says the investor.

But, for some more adventurous investors, strategies can also be employed with CDS index options for yield genera-tion – though it is a relatively recent scenario, the Morgan Stanley analysts add. Similar to their use in equity markets, initiating overwriting – or the process of selling call options against long positions – works to enhance yield.

The products are also useful when seeking out cross-regional trades. The BarCap analysts note, for example, that a trade can be put on for a view that iTraxx Japan will outperform the iTraxx Main, without an overriding opinion on the performance of the two indices in a widening sce-nario. In this situation, they recommend selling receiver options on iTraxx Main and buying receiver options on iTraxx Japan.

The same relative value trade can also be used to show views on a particular asset class, such as equity versus credit. “By instead selling receivers on a credit index (losing money in a spread tightening) and using the proceeds to buy calls on an equity index, the investor can implement a trade that expresses the precise view that, in a rally, equity will outperform credit,” the BarCap analysts explain. The trade, they say, can be initiated by selling iTraxx Main receivers and buying EuroStoxx 50 calls.

Index options are also commonly used to express opinions on high yield versus investment grade indices and to put on compression trades on both sectors at the same time. KFH

19 May 2010Advantage AsiaDistressed opportunities in an evolving landscapeThe distressed structured credit space has evolved dramati-cally over the past year, which saw a general rally across asset classes. However, former Lehman Brothers bankers – Fredric Teng and Leon Hindle – believe that opportunities still exist within the space. The pair, which founded Hong Kong-based oracle Capital last year, have launched a new fund to take advantage of these opportunities.

The oracle Investment Fund began trading on 12 May 2010 and targets US$50m of structured credit products, with a second fund targeting non-US investors expected to

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follow in June. Both funds will focus on securities backed by a variety of corporate credit assets and offer a five-year invest-ment period, with a lock-up for the first year and monthly investor redemption possible thereafter.

oracle may trade or hold assets until maturity in order to achieve its target of 20% annual returns. In addition to port-folio management, the firm offers valuation, structuring and restructuring services to institutional investors.

Hindle explains that the changed distressed landscape requires a more sophisticated strategy in order to achieve further yields. “Up until now, it would have been relatively straightforward for guys to make money from buying any-thing and sitting on it – that’s going to be much harder going forward because obviously we have seen [a] rally in most segments of the asset class.”

However, he believes that this may result in an increased supply, as managers – who may have made some profit from marked-up assets and are concerned about the current eurozone volatility – reconsider their positions. “It’s prob-ably an interesting time for people to consider whether they want to keep holding these assets in situations where they’ve marked them up,” Hindle says.

operating from an Asia context offers further opportuni-ties, according to Hindle. “A lot of this paper was distributed into Asia in the first place,” he says.

Reports suggest that the Asian market may have, at one stage, accounted for as much as US$100bn worth of structured credit assets. Hindle notes that “relative to the number of hedge funds who are active in this space in the region – and the amount of staff there are in investment banks or brokers to cover that client base – I think there is a supply overhang”.

He adds that oracle enjoys a further advantage in terms of its strong connectivity within the region gained in their former careers. “We’re very well connected with the inves-tor community and the dealer community in the region,” he explains.

However, Teng adds that the need to remain competi-tive still exists, due to interest in the region on a global level. “We are all aware that there is a lot of money looking to be deployed into Asia, away from the equity space. If we look at the fixed income space, the credit market is relatively small when compared with the US and Europe, and consequently there is a huge amount of money fighting over relatively few opportunities.”

While other hedge funds in the Asia-pacific region are reportedly struggling to win over institutional investors, ora-cle has succeeded in securing institutional investor backing from the US for its first fund and has non-US backing lined up for the second. While the pair’s knowledge and connec-tivity within the Asia-pacific region is undoubtedly attractive to US investors, Hindle adds that oracle’s degree of familiar-ity with the underlying asset class makes them more attrac-tive to Asian investors.” JA

12 May 2010Power shiftSenior CLO investors seek more controlA power shift appears to be taking place within the CLo investor space. Whereas equity investors have traditionally held the most sway in transactions, triple-A investors are increasingly looking to gain more influence over portfolio composition in impending deals, as well as taking a more active part in the monitoring of transactions once launched.

Gibran Mahmud, portfolio manager at Highland Capital Management, confirms that senior triple-A investors are get-ting more involved in the structuring and the underlying col-lateral in new-issue CLos – for example, seeking to allow only senior secured loans in a portfolio or only allowing a particular amount of a certain basket of credits. “We’ve also seen another type of triple-A investor that wants to under-write all of the loans or credits that will eventually go into the portfolio – these investors are definitely much more involved than some investors in the past,” he says.

Another recent example is the CoA Tempus CLo that was launched in late March (SCI passim). Following the closing of the deal, an agent was appointed by the majority of the class A-1 noteholders to serve as a designated advisor to Fraser Sullivan CoA – the deal’s manager – to oversee certain trad-ing decisions.

According to Moody’s, the advisor will, on a limited basis, approve purchases during the ramp-up period and, after the ramp-up period, will have certain rights related to discretion-ary sales. While the concept of a CLo having a secondary advisor in place is nothing new, it has traditionally been the collateral manager that would make a sub-advisory agree-ment with another manager to help with the investment port-folio – not the triple-A investor.

Dave preston, CLo strategist at Wells Fargo, also points to the power shift taking place within the primary CLo space. “Formerly, equity investors had more say in the transaction structure, while the senior note buyer was given less consid-eration. Now, potential senior note buyers have much more influence over deal specifics,” he says. “Senior note buyers are more attuned to managerial actions that may harm senior positions – discount purchase amendments, mezzanine note buybacks, creative interpretations of triple-C bucket proce-dures – and are fighting for their rights.”

He adds that as underwriters look to attract new senior note buyers or entice returning buyers, it will be interesting to see if similar provisions – such as the ‘watchdog’ agent in the CoA Tempus transaction – gain in popularity.

For now, however, primary CLo activity remains muted.“In the short term the primary CLo market will likely com-

prise of special situation or one-off financing deals,” says Mahmud. “That said, people are optimistic that a ‘real’ pri-mary market will make a return: we might see the five biggest CLo underwriting banks doing two to three deals each this year, with a bigger pick up in 2011.” AC


vi pick of the Month



9 June 2010Temporary blipTwo widely-anticipated longevity swap deals are believed to have been cancelled in the past two weeks. However, plenty more deals are expected to come to market in the months ahead.

premier Foods recently confirmed that it would not be pursuing a longevity swap transaction for its £2bn pension scheme. Meanwhile, the Co-operative has reportedly post-poned its plans for a longevity hedge, although there is some confusion in the market over precisely which of a number of potential transactions the firm has been in discussions about has been cancelled.

The shelving of these two deals is not being seen as indic-ative of a decline in the potential for the longevity swap mar-ket, however. Expectations are quite the reverse, according to Martin Bird, principal & UK lead, longevity & risk solutions at Hewitt Associates.

“There has been an awful lot of interest and activity in the longevity sector, but great care is needed over the due dili-gence for transactions, as some will work and some won’t,” Bird says. “So it doesn’t surprise me that things will flip the other way occasionally and deals that don’t work out end up being reported as excitedly as deals that do, especially given only a handful of deals have come to market so far.”

Bird adds that his firm has been in discussions with a large number of clients over longevity swaps, but for all the right reasons the instrument is not always found to be fit for purpose in the context of the raft of different risks each client has to manage. “A swap is not always appropriate or the price doesn’t represent good value at that time,” he explains.

Nevertheless, Bird reports that his firm and others have a number of deals “bubbling away”, not all of which are public knowledge as yet. So an active rest of the year is expected.

At the same time, the pension buy-in market is coming back strongly as funding levels return to something more like those seen in better times. This too could generate longevity swap business, Bird says.

“Clients are interested in breaking down the buy-in into its individual components and do their own transactions for the parts most suitable to them rather than one big deal. Thanks to the growing market, the longevity element can easily be separated, meaning that firms can create their own DIy buy-in proposition. We expect that a large amount of synthetic longevity hedging business will be driven by this approach, particularly as we get toward the end of this year and the start of next,” he concludes. MP

8 June 2010New cat bond features test watersThe flurry of catastrophe bond offerings over the past couple of months has been well received by the tried and true ILS investor. However, the market appears to still be some way from being embraced by a wider range of new investors.

The latest shelving of the Long Bay Re transaction (see SToRM 4 June 2010) is a case in point. Catlin’s sidecar-style offering appealed to non-typical ILS investors with a maturity similar to perpetual preferred shares. “It’s targeting more equity investors,” says one ILS trader. “The volatility on the equity side is why the deal hasn’t come to market,” he adds.

The deal was to provide fully collateralised reinsurance cover for a select portion of Catlin Group’s catastrophe risk portfolio. “Currently there is no liquidity for worldwide retro indemnity cover. They thought they could get that liquidity back on the equity side. So the timing was a little bit off,” the ILS trader notes.

Cat bond offerings that are primarily index-based trans-actions generally trade tight to where indemnity based trans-actions trade, adds another ILS trader.

But though the market has moderated somewhat for new investors, the second ILS trader notes that it is still deep enough for the more typical cat bond offerings to get done. “The market is re-finding itself after being largely offline last year. The market is reprocessing how it wants to take risk and how it wants to take these transactions,” he says.

In the beginning of 2007, for example, a cat bond that priced at a 9% yield with pretty low expected loss didn’t have as many competitors as it does today, he says. “There’s a lot more opportunities now to purchase paper with a 10% yield,” he adds. He expects to see one or two more straight cat bond transactions to come before this portion of the US hurricane season closes.

In secondary trading, bonds that have a scheduled matu-rity less than six months away have been active. 2007 transac-tions Atlas Re IV, Merna Re and Longpoint Re fit this criteria, says the first trader. “The first Longpoint Re was seen trading a lot since it was effectively out-of-the-risk,” he says. KFH

7 June 2010Avalon’s class Cs defaultS&p has revised its subordinated debt rating on troubled catastrophe bond Avalon Re’s (SToRM passim) class C notes to ‘D’ from double-C.

The rating agency explains: “paid losses related to Hur-ricane Katrina and the explosion at the Buncefield oil depot totalled USD$297m and loss reserves from the July 2007 steam pipe explosion in New york City total US$17.1m. pur-suant to the reinsurance agreement, Avalon Re covers 90% of these losses in excess of a US$300m attachment point, and the class C noteholders will cover losses in excess of that amount. on the maturity date, which is today, the original principal balance of the class C notes, which is US$135m, will be reduced by the covered loss amount of U$12.69m.”

This constitutes a default under S&p’s criteria. There will be no future principal payments from Avalon Re to the class C noteholders. MP

N E W S – F R o M S T o R M

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4 June 2010Long Bay Re shelvedplans to launch Catlin’s sidecar-style vehicle Long Bay Re (SToRM passim) on London’s AIM stock market today, 4 June, have been shelved for the timebeing. The US$150m evergreen deal is understood to have been withdrawn due to the lack of firm investor commitment for the full deal size.

The transaction had been shown to a wide range of inves-tors over the past few months, but, some suggest, suffered from having unfamiliar elements to both insurance and non-insurance investors. Catlin had originally targeted non-spe-cialist investors, given the unfamiliarity of the structure to insurance buyers – thanks mainly to its contingent nature and consequent lack of a set maturity date – however, at the same time the deal offered pure insurance risk, which may have proven to be too big a challenge for some non-specialists.

Long Bay Re was formed solely to provide fully collater-alised reinsurance cover for a select portion of the catas-trophe risk portfolio of certain members of the Catlin Group pursuant to the terms of a reinsurance agreement. The company was to be managed by Horseshoe Management and had appointed Deutsche Bank, London Branch, as sole global coordinator and joint bookrunner, Macquarie Capital (Europe) as joint bookrunner and broker and Fox-pitt, Kelton as nominated adviser in connection with the placing of the shares in the company. MP

3 June 2010Guy Carp names capital markets ceoGuy Carpenter & Company has named Bill Kennedy as glo-bal ceo of analytics, capital markets, specialty practices and advisory, with effect from 1 July 2010. He will report to peter Zaffino, president and ceo of Guy Carpenter and will join the company’s executive committee. MP

2 June 2010Sparc unchangedS&p says that its credit ratings on all of AXA’s FCC SpARC Europe (Senior)’s notes remain unchanged following the annual reset of the loss ratio trigger levels. The loss ratio trig-ger level on the deal, which is a motor insurance securitisa-tion (SToRM passim), is reset for each cover period, based on the required level of protection needed for the different classes of rated notes.

S&p says: “We confirmed the loss ratio trigger levels in this transaction, although with an increased spread above the AXA-provided budget for 2010 compared with the previ-ous year for each of the tranches. This reflects our analysis of current market conditions in Europe and our view of the risk being higher year on year. We consider that the AXA-provided budget proposed for 2010 will be a relatively more challeng-ing target, given the competitive and economic environment in the four European countries covered in the transaction.”

For FCC SpARC Europe (Senior), the senior global loss

ratio trigger level for 2010 is 83.8%. For the class A, B and C notes, the loss ratio trigger levels are 98.5%, 88.4% and 83.8%, respectively.

The transaction involves the securitisation of payments related to a quota-share reinsurance agreement between Nexgen Reinsurance Ltd. (reinsurer) and AXA. The FCC SpARC Europe (Senior) and FCC SpARC Europe (Junior) transactions cover the risk on a defined motor insurance policy book in Belgium, Germany, Italy, and Spain. MP

1 June 2010Vita takedown ratedS&p has today assigned its double-B plus rating to the class E principal-at-risk variable-rate series II notes due 15 Janu-ary 2014 issued by Vita Capital IV. The US$50m takedown had been being shown to investors since last month (see SToRM 18 May).

The notes will provide Swiss Re with a degree of protection against extreme mortality events occurring to specified age and gender distributions in the US and the UK, S&p explains.

Vita Capital IV was created last November (SToRM pas-sim)for the sole purpose of issuing one or more series of notes out of a mortality catastrophe shelf programme.

The noteholders are at risk from an increase in age- and gender-weighted mortality rates that exceed a specified per-centage of a predefined mortality index value (MIV), for a given country, on an accumulated basis over four years from 1 January 2010 to 31 December 2013. The MIV self-adjusts for changes in general mortality trends over the risk period.

The MIV is defined on a rolling two-calendar-year basis, and the probability of a loss attaching and the magnitude of the loss in principal depends on the extent to which the MIV for any measurement period (that is, two consecutive years) exceeds the attachment point for the notes. Like the earlier Vita Capital IV series I transaction, the notes are trig-gered upon attachment of either the US or the U.K. and the attachment points vary by country. The attachment points are 105% in the U.S. and 112.5% in the U.K. with the exhaus-tion points being 110% in the U.S. and 120% in the U.K.

S&p explains: “At closing, Swiss Re will enter into a con-tract with the issuer using standard International Swaps and Derivatives Association (ISDA) wording. Under this contract, Swiss Re will make payments to the issuer in exchange for extreme mortality protection. The issuance proceeds are to be invested in collateral in the form of ‘AAA’ rated notes issued by the International Bank for Reconstruction and Development. The coupon on the notes will be paid from the payments made by Swiss Re under the ISDA contract and from investment earnings on the collateral held in trust.”

Swiss Re has previously securitised mortality risk through the Vita Capital II, Vita Capital III, and an earlier takedown of the Vita Capital IV transaction. The Vita III transaction is scheduled to expire at the end of 2012 and this new issuance by Vita Capital IV partly replaces those notes. MP

N E W S – F R o M S T o R M

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Market consensus finally appears to be forming around CDS central clear ing, despite the lack of regulatory clarity. However, concerns remain about margin pricing and the liquidity of the CCPs themselves.

“Central clearing is the cornerstone of the regulatory over-haul in the US, but it has been in flux since last summer when chatter about regulatory change first emerged,” an official at one US investment bank explains. “Since then, the issue of end-user carve-outs, the creation of investment bank swaps subsidiaries and the banning of proprietary trading has muddled the picture. However, most clients over the last nine months have got com-fortable with the systemic benefits of CDS central clearing.”

Indeed, as CME md and clearing house division president Kim Taylor stresses, clearing houses exist to remove systemic risk. “The idea is to protect the system from the ripple effect of the default of one of the participants and there are significant regulatory requirements, oversight mechanisms and industry best-practice standards that clearing houses hold themselves up to,” she says. These standards include verifying that a clearing house has enough financial resources to withstand the default of its largest net debtor and protecting against the worst-case scenario in a period of market turmoil.

Taylor also points out that clearing houses enhance risk management by having transparent mark-to-market prices that are updated daily, so that other entities can appropriately assess the value of products they have on their books and to ensure that losses are paid ‘as you go’, as opposed to being allowed to build up. “That really lessens the potential for an unexpected [loss]. Putting margin up also is a way to guarantee the prepayment of losses before the next time there is a mark-to-market.”

Margining and collateralisationBefore the introduction of CCPs, margining and collateralisation of bilateral transactions wasn’t standardised and, in many cases, not even sufficient to cover the associated risk. Consequently, if a party defaulted and the positions were not sufficiently collateral-ised, the non-defaulting counterparty’s claim would become part of all claims against the remaining assets of the insolvent corpora-tion under management of an administrator.

Typically this would entail a delay and the likelihood that the full claim would not be satisfied. In the worst-case scenario, such a situation could cause the other counterparty to default.

Matthias Graulich, head of clearing initiatives at Eurex, agrees that this issue is appropriately addressed by clearing busi-ness via a central counterparty. “A standardised risk management

Clearing consensus

A consensus has been reached about the benefits of CDS clearing. But, as Corinne Smith and James Linacre discover in this special report undertaken for SCI’s online service, concerns over pricing and liquidity remain


CDS Clearing

system that has daily evaluations of the positions to ensure there is sufficient col-lateral to have a confidence level of 99.9% about possible market events is therefore key. This addresses systemic risk to a large degree,” he says.

The bank official notes that CDS clear-ing is a windfall for buy-side participants. Almost all of the benefits accrue to inves-tors at the expense of the banks: they still receive interest from the securities they clear, as well as increased transparency, trade reporting and a reduction in bid/offer spreads. In addition, closing out an OTC contract typically involves a lot of friction without the benefit of a CCP, with dealers taking a portion of the bid/offer spread, as well as PV calculation and funding charges.

But Taylor suggests that central clear-ing has benefits for all sectors of the mar-ket, not just the buy-side. “Customers get the benefit of the improved customer pro-tection regime, the improved bankruptcy portability regime and the improved transparency of the mark-to-market

prices, so they don’t spend time working with their dealers on margin disputes so much – which is quite common in the bilateral world. Customers also get the benefit of the margin calculation process that we provide, which is very transparent and the structure of the algorithm is such that it is a repeatable calculation.”

She explains that the CME’s margin calculation mechanism allows both deal-ers and buy-siders to individually repli-cate the calculation, with desktop tools to ease the process. They are therefore able to run a calculation for their entire portfo-lio to get the exact estimate of margin that will be charged by the clearing house.

In addition, dealers get the benefit of operational efficiencies and structural risk protection, as well as the opportunity to do business with a wider universe of cus-tomers. “As a general rule, the customer base with which an intermediary does business will have a broader set of partici-pants than if they do business bilaterally,” Taylor observes.

TransparencyMichael Hampden-Turner, structured credit strategist at Citi, agrees that although the initial regulatory goal of central clearing for CDS was to mitigate counterparty risk, the process has become more about achieving transparency. “Since AIG, banks have started hedging their counterparty risk – the exception has been supranational bodies, sovereigns, insurance companies and CDPCs. So, the amount of counterparty risk in the system has decreased naturally as participants have become more aware of it,” he says.

He adds: “The biggest advantage of clearing is that it increases the confidence of regulators and investors about the risk that’s in the system. A good example of this is the sovereign crisis: the DTCC released data to regulators about Greece CDS posi-tions and it seems, judging from their reac-tion, they were reassured by the figures.”

Clearing OTC transactions via a clear-ing house nevertheless entails a price tag, but Graulich says that this is inevitable in order to achieve higher transparency and lower systemic risk in OTC derivatives markets. “People might complain that they’ll be able to do less business because they have to allocate more capital,” he comments. “But I don’t see that as a valid argument against central clearing; I see that as being absolutely necessary to ensure adequate functioning of the market and to reduce as much systemic risk as possible.”

For the average participant, the margin is probably not very different to what they would have to put up in a bilateral con-tract. For the very large participants, the margin creates a cost but also provides important protection, according to Taylor.

“This protection outweighs the cost, which is what regulators clearly think too,” she remarks.

Indeed, buy-siders now appear to accept that they will have to post margin in order to clear CDS trades. An end-user carve-out looks set to be implemented only for genuine commercial risk hedging purposes, but such end-users account for less than 5% of overall OTC derivatives volume.

“If you don’t require a reasonably high percentage of everyone using CDS to post margin, you end up pushing the risk back onto the broker-dealers. The regulatory language explicitly states that ‘any finan-cial institution’ will have to post margin. The margin issue has upset a few inves-tors, but if the aim is to remove the lever-age from the market, clients shouldn’t be using CDS if they’re unwilling to post margin,” the bank official observes.

StandardisationAt present, it isn’t possible to clear CDS index tranches as there isn’t enough price transparency in the sector. But Hampden-Turner suggests that this could be possible if enough dealers began providing prices on standardised tranches. If a bid/offer spread was guaranteed and two-way prices were quoted continuously, tranches could conceptually be treated like vanilla CDS.

Another complicated issue that the market still has to tackle is dealing with correlated exposures. In other words, how to offset, for example, a long on iTraxx and a long on CDX, given that they are highly correlated, rather than treating them as separate positions.

“People might complain that they’ll be able to do less business because they have to allocate more capital”

Kim Taylor, CME

34 SCI July 2010

CDS Clearing

“It’s a question of looking at collec-tive exposures and reducing the capital necessary to hold them. But this approach is perceived to be too complicated at the moment and involves models that some market participants don’t particularly trust,” Hampden-Turner comments.

He notes that the best CCP efficien-cies can be achieved by clearing only a small number of fungible deals. “A futures exchange is a good example of this,” he explains. “Over the years, CDS have become increasingly more standard-ised, yet bespoke contracts are generally still needed for hedging purposes. Odd maturities or currencies aren’t suitable for central clearing, yet – given the right incentives – holders will likely move them to a CCP because of the increased liquidity.”

Market participants are expected to be incentivised not to try and get around exchange trading – or, for that matter, cen-tral clearing – by entering into non-stand-ard CDS contracts by the expense. The ‘great or greater than’ stipulation, whereby a regulator looks at the closest example for guidance, will apply in this case.

For instance, if a participant enters into a 35-year swap, a regulator would use the average capital charge for a 30-year swap as a floor for calculating the correct charge for the trade. “The market can, consequently, expect a non-standard contract to be charged not less than the closest nearest contract. But there has yet to be any concrete guid-ance on the issue in terms of orders of magnitude,” one structured credit inves-tor observes.

Pricing and liquidityThere are an estimated 2000 CDS names, of which 1500 are actively traded and 200-300 are very liquid. But, for each of these credits, there are contracts in multiple cur-rencies and maturities, which all require accurate pricing on a daily basis in order for the right margin to be posted at a clear-ing house. Hampden-Turner says that it is easy to get prices for the top 700 names and – as most of the risk lies here – if only these contracts are cleared, it’s still a posi-tive development for the market.

However, one significant concern about clearing OTC trades via a CCP is that if it’s impossible to reliably price a contract at all points in time, it is impossible to call the appropriate vari-ation margin, according to Alexander Yavorsky, vp-senior analyst at Moody’s.

Clearing house Contracts cleared Margin requirements Guarantee fund Risk management Buy-side solutions Target market

CME Clearing Investment grade CDS index products

Standard Portfolio Analysis of risk (SPAN)

$8bn (looking for $550m more)

Mark-to-market prices updated dailyEnough resources to withstand default of largest net debtor Margin to guarantee prepayment of losses before mark-to-market

Repeatable margin calculation with desktop toolsTransparent daily marginingCustomer positions and margin held in segregated accounts

US (European platform planned)

Eurex Credit Clear €85m iTraxx CDSEuropean single name CDSCDS index products

Based on daily end-of-day price fixing for all open positions

All clearing members must pay into Eurex guarantee fundMembers holding General ClearingLicenses must provide guarantees of €5m, those with Direct Clearing Licenses must provide €1m

Unconditional portabilitySeparated credit business from listed businessCDS-specific risk model

Separate margin accountsProtection of customer positions and collateral, as well as portability to come by end of the year

Europe

ICE Trust/ICE ClearEurope

$5.7trn gross notional US CDS plus $3.3trn in Europe CDS index productsiTraxx (ICE Clear Europe)

Hybrid of traditional net and gross margin modelsGross margin held at CCPBased on ICE end-of-day prices and client positions

Exceeded US$3bn as of 31 December

Risk consolidated to derivatives clearing membersPricing algorithm based on daily auction process

Customer-related margin segregationPosition portability solutionEuropean solution expected in September

US = ICE TrustEur = ICE ClearEurope

LCH.Clearnet Over €13bn iTraxx CDSInterest rate swap clearing

Must post initial margin, based on Markit pricesSwapClear also uses the PAIRS algorithm

Members pay compulsory contributions to guarantee fundReassessed on a monthly basisContribute in proportion to 60-day riskCovers the default of largest member

Margining and clearing fundTrades novated on T+1 basis

SwapClear offers margin segregation and contract portability

Europe

Liffe Bclear All products on London derivatives marketCDS index contracts suspended (but not delisted) in August 2009

Standard Portfolio Analysis of risk (SPAN) (originally developed by CME)Minimum rates set by LCH.Clearnet

Outsources to LCH. Clearnet

Outsources to LCH.Clearnet

Europe

Source: SCI

Figure 1CCPs compared


CDS Clearing

The different CCP offerings

CME ClearingThe CME’s CDS clearing service is still in a soft-launch phase in order to provide clearing members and existing customers with an opportunity to clear trades. The platform only caters for investment grade CDS index products at present, but CME clearing house division president Kim Tay-lor says that the service will be expanded in the coming months. A broader set of index products will be added, followed by the liquid single names of the North Ameri-can index components.

The CME also plans to offer CDS clearing in the UK. “We’re in the process of establish-ing a clearing house in London and are wait-ing for regulatory recognition from the FSA,” Taylor confirms. “The additional set of CDS products cleared there would be European equivalents of the liquid indexes and single names that are cleared in North America.”

However, launching a clearing service for CDS has not been without its chal-lenges, Taylor says. “The risk profile of this product – particularly of the single name product – is quite different from many other products that are cleared, although we do clear other products that have a binary payout, so it’s not a completely differ-ent risk profile. We had to come up with a tailored, specialised risk algorithm to be able to appropriately evaluate the forward-looking price risk of each product. Another challenge was working with the industry to get the credit event processes in line with industry practices and adapting as necessary for the fact that the instruments are cleared on a going-forward basis as opposed to being bilateral.”

Taylor notes the importance to the CME’s customer base and to the dealer community that would be the intermediar-ies that basis risk would not be created between the cleared product and the equivalent product if it were not cleared. “Another aspect that was very important

to customers was the ability to clear under the Commodities Exchange Act and to provide the kind of protection that is very important to the buy-side in particular; for example, a similar experience to what they have with futures. That was a defining part of the structure that was very important to the customers,” she notes.

Eurex Credit ClearEurex offers clearing services for OTC traded European single name CDS and CDS index products based on iTraxx indi-ces via Eurex Credit Clear, targeting sell-side and buy-side firms. Eurex Clearing has developed a CDS-specific risk model that is designed to address issues, such as the asymmetric profile and the jump-to-default nature of CDS products, using a historical simulation approach.

Eurex Credit Clear is approved by the German regulator BaFin, the UK FSA and the SEC for its OTC clearing service for CDS.

Matthias Graulich, head of clearing initiatives at Eurex, explains that the CDS clearing service leverages as much as pos-sible the existing infrastructures to avoid any unnecessary inefficiencies. “On the trade repository side, for example, we have linked into the DTCC Warehouse and the CLS Bank settlement service. We have also leveraged the existing Eurex Clearing infrastructure; for example, the linkage into the European cash payment infrastructure Target 2 Cash.”

Unlike some other clearing houses, Eurex has separated the credit business from its listed business in terms of risk management and the default fund, Graulich notes. “We have a separate default fund because the risk of CDS is special – not only due to the product specifics, but even more through the high concentration across a handful of sell-side firms.”

Eurex Clearing has further analysed the needs of buy-side customers in particu-lar in the light of the Lehman default. Its

conclusion is that timely portability of positions and the respective collateral from a defaulting clearing member to a new clearing member is one of the main chal-lenges of the clearing industry – something that isn’t resolved so far in many different jurisdictions, according to Graulich.

Eurex Clearing expects to have in place by the end of this year an offering that explicitly addresses the needs of buy-side customers by managing and protecting customer positions and collateral, allowing portability in a default scenario.

Graulich indicates that the progress made in terms of standardising CDS contracts is sufficient now to be able to clear the transactions via a clearing house. “The less standardised the contracts are, the less liquid they are and the more dif-ficult it is to get a market price. This price transparency is necessary in order to fairly value the risk positions to be adequately covered in the liquidation process in case of a clearing member default.”

Eurex Credit Clear asks its clearing members, on a mandatory basis, to provide daily prices on all of their open positions. It can then create a virtual price fixing at the end of each day.

ICE Trust/ICE Clear EuropeAs at 28 May, US$5.7trn in gross notional CDS volume had been cleared through ICE Trust and US$3.3trn through ICE Clear Europe. Of the more than US$9trn cleared, US$1.2bn comes from North American buy-side transactions.

Meanwhile, Nomura was last week approved as ICE’s fourteenth clearing member and the first to be headquartered in Asia. “ICE Trust is pleased to continue to expand buy- and sell-side participation and we welcome the addition of Nomura,” says ICE Trust president Chris Edmonds.

He adds: “In addition to exceeding the US$1bn mark for buy-side clearing, we’ve cleared customer transactions nearly every week since the launch of our buy-side solution. While these are still early days for CDS clearing in general – and buy-side clearing in particular – we believe the volume we have cleared to date validates our approach.”

The launch of ICE’s European buy-side solution originally planned for June is now expected in September, however. ICE says

“The less standardised the contracts are, the less liquid they are and the more difficult it is to get a market price”

36 SCI July 2010

CDS Clearing

“This not only cancels out the benefits of having a central counterparty, but also pollutes the platform. It forces other clearing members to take on unnecessary risks,” he explains.

A related risk arises if entities, such as corporates or sovereigns, that don’t post collateral when they enter into OTC derivatives trades are required to post margin. Posting variation margin requires money to be moved back and forth every day, so a clearing house can ask for more collateral if there is a spike in market volatility. But this is a liquidity call that is unmatched with any cashflows from these entities’ daily business.

Yavorsky warns that imposing this ‘just-in-time’ liquidity requirement could lead a corporate to run out of cash and default, which could in turn imperil the clearing house. He indicates that corpo-rates have three options in terms of deal-ing with such requirements.

First, corporates could simply not engage in derivatives trades. Second, they could strike a deal with an FCM whereby the FCM posts margin on their behalf.

But Yavorsky points out that this would entail the FCM taking on the additional liquidity risk, which is unlikely to sit well with them. For example, the five biggest US dealers between them have around US$300bn in unsecured derivatives receivables outstanding, which provides an indication of how large a liquidity call could be if all their derivatives customers cleared through them.

“Nothing is free and this large cost would obviously have to be passed to the customers in the form of higher contract premiums. This is unlikely to happen without impacting customer demand,” he says.

Finally, corporates could expand their treasury departments and change their financial policy to hold pools of cash and essentially liquefy their balance sheets. This would have obvious implications on ROC, however.

There is also concern over the liquidity of the CCPs themselves. When a clearing member fails, the clearing house has to continue posting collateral to the other members that hold the opposing positions to the failed portfolio when it isn’t receiv-ing any cashflows itself.

Consequently, it becomes important to find a buyer for that portfolio as soon as possible. But the cost of finding a buyer for a portfolio can be steep.

“This demonstrates the importance of collecting the appropriate initial margin,” Yavorsky observes. “During the time until the liquidation of the portfolio, the CCP may need to get liquidity from the outside in order to be able to pledge collateral. Typically CCPs have lines with banks, but it is possible that one of the banks it has a line with is the failed clearing member.”

One solution, as proposed in the cur-rent Senate bill, is to give CCPs access to the central bank discount window in order to reduce the vulnerability of clearing houses to their largest counterparties.

Yavorsky says that the assumption of a one-day liquidation period for OTC derivatives could be problematic. The time horizon of price moves and the severity of loss used in determining the initial margin need to be calibrated to a longer liquidation period.

“The standard initial margin that CCPs require for most futures is one day’s worth, but this is usually because futures contracts are liquid and trade on exchanges. For OTC derivatives, this is not necessarily the case. A longer assumed liquidation period, particularly for concen-trated portfolios, would be more logical – at least until there is a track record of centrally clearing them through different market cycles,” Yavorsky stresses.

CompetitionOn the other hand, a clearing house doesn’t have to accept any customer that Alexander Yavorsky, Moody’s

the delay follows extensive dialogue with market participants, which has led to the development of an enhanced offering.

ICE Clear Europe expects to start clearing Western European sovereign CDS contracts in the coming months, with ICE Trust antici-pating clearing single name CDS for buy-side customers from September.

LCH.ClearnetLCH.Clearnet began clearing iTraxx CDS in March 2010, with four French banks as clearing members. Around €13bn of volume has so far been cleared on the platform and it has over €10m in open interest.

Whereas other CCPs typically employ a weekly novation cycle, LCH.Clearnet uses daily novation (a T+1 model). As LCH.Clearnet business director Francois Cadario explains, the industry is targeting intra-day novation (T+0), so daily novation is an interim solution.

In terms of infrastructure, LCH.Clearnet aimed to replicate the existing OTC model. For example, the clearing house is linked to the DTCC, its rule book is fully compliant with ISDA specifications and margin calcula-tions are based on Markit prices.

Cadario says that the CCP is currently working on phase two of its development and is planning to enhance its services by the end of the year. “We’re contemplating a solution to clear transactions coming from Markitwire and developing our risk and treasury serv-ices; for example, by introducing variation margin and linking with CLS Bank.”

He adds: “Next year onwards we’re anticipating launching single name CDS, T+0 novation and, later on, buy-side clearing. We’ve followed the actions of ISDA in terms of buy-side access and will be able to offer full customer protection for account segre-gation and collateral deposits. But we’re still working on the delivery plan for all of this.”

Cadario suggests that the buy-side is generally comfortable with the CDS clearing services which are on offer in the market, but one issue that still hasn’t been resolved is direct access, whereby investors can deliver collateral directly to the CCP. “This would allow them to be sure of the nature and amount of what they deposit. We have a contractual relationship with our clearing members, so buy-siders have to participate as a clearing member or through another clearing member. But to my knowledge, no other CCPs offer direct access either.”


CDS Clearing

doesn’t meet its eligibility criteria. But this points to the nature of competition among CCPs: do they go after every cus-tomer they can or concentrate on what the right long-term solution is for the market and for themselves, and continue to apply strict eligibility criteria for clearing mem-bers and end-users?

Certainly in the US market partici-pants appear to be divided over which clearing platform to use, with buy-siders leaning more towards the CME and dealers focusing on ICE. “The majority of OTC volume is inter-dealer and ICE is more economic for dealers,” the bank official explains. “It also has the advan-tage of having adopted the infrastructure that was already in place in the OTC market, such as trade processes and systems. CME wasn’t on the scene when dealers were first forced to begin clearing swaps.”

However, clarification of capital charges for swaps could change this apparent polarisation between clearing platforms. For example, regulatory capital charges could be decided upon the robust-ness of a clearing house, its capitalisation, governance and default management processes or even the strength of its indi-vidual clearing members.

Arbitraging the different clearing house regulators could also drive competi-tion among CCPs. Although guidelines have been formulated as to how regula-tors should treat CCPs, including the

minimum capital standards required, some authorities may choose to be more stringent in their application.

The investor agrees that structural differences between clearing houses may influence end-user choice. For example, in the US CFTC regulation underpins the concept of segregated client accounts with respect to the CME, whereas this isn’t applicable to ICE – which is regulated by the New York Fed – and Europe-based CCPs.

“There are legal opinions as to the seg-regation of accounts at ICE and in Europe that end-users can base their decisions on, but I’d advise them to scrutinise the different models very closely to ensure they’re comfortable with them,” the inves-tor remarks.

RegulationYavorsky indicates that only trades that are cleared via CCPs that meet CPSS-IOSCO standards are likely to receive a zero risk-weighted counterparty risk charge under Basel 2. “The CPSS-IOSCO guidelines will be refined over the coming months and it’s important what the final specifications will be,” he says.

He adds: “If it’s easy to comply with them, a cottage industry in CCPs will develop and this will bring the worst possible unintended consequences. It will mean that the dealers are replaced by unproven CCPs, which compete on price and laxity of risk requirements. There

needs to be some competition and failover redundancy among CCPs, but not rampant competition.”

Meanwhile, both the Dodd and Lin-coln bills – which propose mandatory exchange trading of CDS – have passed in the US Senate. But it seems likely that only trades which are eligible to be centrally cleared will have to be traded on exchange, accounting for around three-quarters of CDS volume.

“If the bills are passed by 1 July, it’ll take three to six months for the rules to be written and then there’s a 180-day adoption period. I’d say we’re at least 9-12 months from any enactment – in any case, the market needs that amount of time to prepare for it,” the investor observes.

Hampden-Turner points out that there appears to be a lack of distinction among regulators between clearing CDS and trading CDS on exchange. “It might be reasonable to trade indices and perhaps a small number of highly liquid CDS on exchange. But the thousands of less liquid names will almost certainly have to trade OTC, albeit centrally cleared.”

Nevertheless, one possible benefit of exchange-based trading of OTC deriva-tives is that – providing it has been widely adopted – it can facilitate the ability of a CCP to liquidate a failed member’s portfolio. “An exchange can act as an emergency exit when a CCP needs to quickly get out of a portfolio,” concludes Yavorsky.

Figure 2Central clearing will reduce risk…when it happens

Much of the market is customer driven (at 4Q09) Even D-to-D market remains largely bi-Lateral

IR Forex Credit Equity Commodity0

100

200

300

400

500

0%

15%

30%

45%

60%

75%

Not

iona

l am

ount

($tr

illio

ns)

D-to-D (lha) D-to-C (lha) D-to-D proportion (rha)

IR Credit Equity Commodities Forex0%

20%

40%

60%

80%

100%Centrally-cleared Bi-lateral

Centrally-cleared data represents open interest (not cleared volume). Dealer-to-Dealer data as of December 31, 2009. CDS centrally-cleared data as of February 19, 2010. IR centrally-cleared data as of February 28, 2010. Source: Moody’s, BIS, LCH.Clearnet, ICE.Trust

38 SCI July 2010

CDS Clearing

European ABSIn the broader ABS markets a decrease in trading volumes per-sisted throughout the first week of May. Although spreads did widen, traders were quick to point out that – with the exception of transactions from Greece and Portugal – the impact was limited.

A dealer pointed to decisions made by dealer-management teams as a potential reason for the drop in trading levels, saying that many dealers were under instruction not to take on any risk at all. As a result, he said that dealers had their heads in the sand. Another added that while bids had come down in reaction to the wider volatility, offers had stayed the same, which led to a stale-mate in terms of trade activity.

While the secondary market softened, the primary market showed increased concerns regarding new regulation, which threatens to hinder the market. The introduction of the SEC’s rule 17g-5 is believed to have been a large part of the reason why Santander’s second Fosse deal of the year was brought to market so soon after the first.

A portfolio manager explained that the rule requires all docu-mentation to be made public, which could be an issue for potential or prospective issuers. Traders expected Fosse to perform well based on its reputation in the market, but added that the economic climate might dampen its success.

Severe market volatility hit in the following weeks and on 7 May the market showed a dramatic spike in spreads. Dutch and UK RMBS paper widened by 30bp to as much as 160bp in some cases. In the mezzanine space, paper traded as wide as 190bp-200bp.

However, this was a temporary blip, believed to have been in response to volatility felt in the wider markets. In the week fol-lowing, Dutch and UK RMBS paper tightened back to the 130bp-140bp levels after the ECB’s support plan was announced.

Spreads then began to widen again over the following week, although to a less dramatic extent. This was believed to be as a result of non-Euro investors looking to get out of their euro-denominated positions. A trader explained that this was not nec-essarily because investors disliked the positions themselves, but rather about concerns regarding the currency.

In particular, spreads widened in the more liquid Dutch paper as it was still possible for investors to sell at a decent bid level. Away from the more liquid paper, trading seemed to stop altogether. Traders pointed out that although nervous sentiment in the market caused a halt in trad-ing, investors were not so anxious that forced-selling took place.

The wait-and-see attitude extended to the RMBS primary mar-kets. Many speculated that the Fosse deal would wait until spreads were back to the low 100s before pricing. However, by the end of the month it priced at 140bp-143bp, which was significantly wider than Arkle’s 115bp-125bp spread levels.

By the end of May, the wider ABS market began to show signs of increased strain due to the impact of sovereign contagion. Dealers dom-inated what little trading there was by trading bonds between them-selves. However, pricing remained relatively unchanged as Granite RMBS paper shifted only slightly from mid-91 to high-91 by month end.

Traders added that issues beyond those of sovereign contagion have contributed to the halt in trading activity. Talk of a double-dip recession, the Mexico Gulf oil spill and military activity in

the Korean peninsula were all offered as potential reasons for increased caution in the market.

Participants noted that the concerns weighing on the market are considered to be a ‘temporary storm’ rather than a permanent impairment. In light of this, many participants who gained yield in the run-up of prices throughout the beginning of the year were said to be patient in waiting for a return from the market and confident in the absolute credit value of assets in the sector.

In the CMBS space trading activity was also affected. While focus was on Greece, Ireland and Spain at the end of May, bids backed off and trading activity dropped.

However, due to the lack of trading activity, prices softened only slightly. High-grade senior paper was 50bp off from its previous levels, while weaker bid lists were 4bp off. Similarly, in the mez-zanine space bids were off by approximately 5bp, while better names were off only one or two points.

UK CMBS reportedly outperformed European paper. Talisman 7A, for example – which at one stage was as high as 80 – fell to a low of 72 cash price.

Traders pointed out though that only the most liquid names showed drastic price action. Otherwise traders maintained that market sentiment remained positive due to continued interest in the sector generally, but that the lack of liquidity caused by sover-eign contagion prevented buying.

US ABSThe RMBS secondary market began May with similarly buoyant sentiment, with prices holding up well, in spite of light volumes. Traders noted that some of the PrimeX sub-indices gained seven points in the first week of May.

One dealer focusing specifically on subprime bonds noted that the effect of the announcement of principal forgiveness plans on the market had been mixed. On the one hand, he acknowledged that the market’s upward trend may have been in response to the certainty that the programme brought to market participants. However, on the other hand, he noted that front-sequentials may have suffered a negative impact while last-cashflows rallied.

On the whole though, the performance of subprime improved in early May due to Citi’s liquidations of some of its subprime bond holdings, which were seasoned 2004/2005 mezzanine bonds, that reportedly traded well to a mix of dealer and retail hands. These proved to be particularly popular as subprime bonds at the time were one of the few areas in which double-digit yield was possible.

By the middle of May, the effects of European market volatility were making themselves felt in the US. In the CMBS market, trading activity dropped substantially and spreads widened by 40bp-50bp.

Benchmark triple-A 10-year bonds traded in the 50bp-75bp range and the GG10 traded as wide as 420 and as tight as 360. In addition, commercial real estate performance continued to deteriorate.

Combined with weak CRE performance, sovereign conta-gion and persistant problems in late vintage 2007/2008 transac-tions placed additional pressure on the market, but also signalled an opportunity for distressed asset investors. As a result, special servicers and servicers began to sell assets at this time.

Recent trading activity highlights in ABS and CLOs


Price Talk

As the month came towards an end, the effects of eurozone concerns increased further. Although US$3.5bn worth of auto ABS deals priced in the week to 24 May, participants noted that by the end of the week some of the deals reportedly needed more spread in order to get done. At one stage, spreads were between 5bp-15bp wider on senior bonds and as much as 20bp-40bp wider on subordinate bonds; however, a mild recovery followed.

At the same time, in the primary market a Nissan lease transaction launched and priced 5bp wider than guidance and the US$1bn Navistar deal also required more spread to get done. Although the week preceding Memorial Day weekend had originally been expected to bring a slew of auto ABS deals, sovereign contagion concerns kept them at bay.

Similarly, in the first week of June, RMBS trading remained quiet in the face of continued market volatility. The secondary markets reacted to political and economic pressure with low trad-ing volumes. Traders explained that many who had wanted to de-risk had already done so in the previous weeks and were waiting for greater improved stability before resuming trading.

Many dealers remained long though, as offers were typically 2bp-5bp wider. Buyers reportedly used a myriad of economic and political factors – including the eurozone concerns, Korean penin-sula and Israeli military issues, as well as BP oil issues – as rea-sons to decrease their bids.

Traders noted that the focus is likely to stay on the secondary side, despite the lack of activity, as financial regulatory issues seem set to hamper new issuance until greater clarification is found.

However, sentiment was described as ‘cautiously optimistic’ and participants pointed out that PPIF managers could take the opportunity to buy and help the market to grind tighter as a result. Others pointed to the potential for new issuance from JPMorgan, Bank of America or Barclays Capital, who may test the waters in the coming months.

By mid-June, JPMorgan had priced its new CMBS deal, despite the widening spreads seen in the market over the week. The US$716.3m JPMCC 2010-C1 transaction saw its US$416.12m triple-A rated 4.53-year tranche price at 140bp over swaps and was positively received by market participants.

However, in the secondary market trading volumes were down, with a particular drop-off in bid list activity. However, participants noted that while activity slowed, interest in the sector was still evident from investors who were unwilling to leave the market. The continued interest is believed to be due to improving CRE performance.

Participants noted a disconnect between the performance of underlying fundamentals and the CMBS market, due to CMBS becoming more correlated to the equity markets. However, the asset class outperformed external indicators and therefore enjoys a relatively positive – but still cautious – market sentiment from investors moving forward.

European and US CLOsIn mid-April the secondary European CLO market proved to be immune to the Goldman Sachs CDO fraud charge saga seen in the US. CLO spreads continued to tighten and, as a result, the lower half of the capital structure began to hold greater appeal. Traders noted that few other asset classes were able to offer the same returns that CLO junior bonds, mezzanine and equity could provide.

Evidence of the tightening spreads was seen in the triple-C rated Ineos loans that traded at par and a quarter. Although sec-ondary prices were generally in the 90s, traders pointed out that the market was still not where it had been pre-crisis.

At the beginning of May, the European CLO market reacted dramat-ically to sovereign contagion, with widened spreads and thin trading levels. However, ECB action taken to improve eurozone issues cleared the way for market improvements. Traders noted that the CLO sector was particularly volatile, and pointed out that the Crossover index fluctuated from the 460s to 510 and back again in the space of a week.

Despite the reduced trading levels, no forced selling was evi-dent. Participants noted that this may have helped maintain pric-ing levels; for example, double-As remained within the 500 DM region – although there were very few takers at this price.

By mid-May, offers had been seen being lifted to the low 80s. On single-As there was a 5-6 point retraction, although bids quickly returned to their usual levels in the low 70s.

Similarly, triple-Bs returned to their levels in the 60s and high 50s. Lower down in the capital structure levels were less uniform, due to varying credit quality.

Subsequent to the ECB intervention in the eurozone, the mar-kets showed a slow but steady improvement day-to-day. Sentiment improved as both strong fundamentals and supportive technicals became apparent.

As a result of the rally, European dealers returned to the market in anticipation of increased end-account activity. Real money and hedge fund participation was bolstered by the favourable arbitrage opportunities available within the CLO market; however, new issuance seemed unlikely. Traders noted that the spreads would need to come in significantly for a deal to be done.

On the other side of the Atlantic, one trader noted a 25%-30% drop in price over a few days on a US deal and speculated that euro deals may have fallen further. In addition, BWIC trading was lighter and consisted mainly of dealer bids, with selective real money participation.

This dip in performance was largely expected to be a tempo-rary pause and participants pointed to new CLO allocations from insurance pools as evidence that interest in the sector would not leave completely. Furthermore, the pushing aside of the widely anticipated Symphony deal was seen as a temporary deferral due to the widening of spreads. Market sentiment remained generally positive though, as participants noted that further new issuance was being discussed and arrangers planned to come to the market before the end of the year.

These views proved to be well-founded when Goldman Sachs brought the third CLO deal of the year so far on 28 May. The new US$450m transaction consisted of a triple-A rated US$250m piece and a US$200m equity portion, and came amid rumours of further issuance from Bank of America Merrill Lynch and Morgan Stanley.

However, eurozone contagion issues continued to impact both the Euro and US secondary markets, both of which showed very little activity in the first week of June. In the European markets double-A paper fell by 10bp-15bp from its pre-crisis highs in the 70s and traded in the 50-60 range.

Unsurprisingly, this drop was considerably larger than that experienced in the US. The few active European participants subse-quently turned to US paper. It was estimated that 60% of European bid lists did not trade at all, while 40% did not trade in the US.

Pricing is believed to have been hardest hit lower in the capital structure. At the top of the stack, paper was 2bp-5bp off, while lower down in the stack levels had fallen by 7bp-10bp. In equity and double-B tranches pricing was as much as 10bp off from a few weeks previous.

40 SCI July 2010

Price Talk

ABS issued in March 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market31/03/10 GE Capital Credit Card Master N 2010-2 A $250.00 120 6.94 NA/NA/AAA CITG/BCG Credit Cards Retail US

Storm BV 2010-1 A1 1240.00 80 2.00 Aaa/AAA/NA Rabo/SG-CIB RMBS EuroA2 1704.00 100 4.90 Aaa/AAA/NAB 120.00 4.90 Aa2/AA/NAC 116.00 4.90 Aa3/A/NAD 121.00 4.90 A2/BBB/NAE 110.00 1.70 Baa3/NA/NA

29/03/10 GE Capital Credit Card Master N 2010-1 A $500.00 100 4.96 Aaa/NA/AAA CS Credit Cards Retail US26/03/10 AmeriCredit Auto Receivables A1 $36.00 5 0.16 P-1/A-1+/NA CS/RBOS Auto Non-Prime US

Trust 2010-A A2 $71.00 90 0.99 Aa3/AAA/NAA3 $93.00 175 3.01 Aa3/AAA/NA

25/03/10 Dolphin Master Issuer 2010-1 A1 13,000.00 112 5.00 Aaa/AAA/AAA FOR/RBOS RMBS EuroA2 12,279.00 112 5.00 Aaa/AAA/AAAA3 11,000.00 115 20.00 Aaa/AAA/AAAA4 11,000.00 115 30.00 Aaa/AAA/AAAB 1172.00 200 5.00 Aa3/AA/AAC 1204.00 300 5.00 A2/A/AD 1172.00 500 5.00 Baa2/BBB/BBBE 171.00 500

22/03/10 VAB Auto Receivables 2009-1 A 1275.00 4.50% Aaa/AAA/NA Auto Prime EuroB 150.00

19/03/10 CNH Equipment Trust 2010-A A1 $268.75 -1 0.43 P-1/A-1+/F-1+ RBOS/BA BNP Equipment Heavy USA2 $172.00 25 0.99 Aaa/AAA/AAAA3 $396.00 30 2.15 Aaa/AAA/AAAA4 $205.21 40 3.73 Aaa/AAA/AAAB $32.22 185 3.97 A1/A/A

18/03/10 Ally Auto Trust 2010-1 A1 $250.00 4 0.29 P-1/A-1+/NA BOA/BNP/RBOS Auto prime USA2 $204.00 25 0.99 Aaa/AAA/NAA3 $364.00 30 2.10 Aaa/AAA/NAA4 $90.90 40 3.42 Aaa/AAA/NAB $29.10 3.92 Aa3/AA/NAC $25.60 3.97 A2/A+/NA

17/03/10 Driver GmbH 7 A 1500.00 70 1.86 NA/AAA/AAA HSBC/WLB Auto prime EuroB 119.00 165 2.16 NA/A+/A+

17/03/10 AESOP Funding II LLC 2010-2 A $100.00 185 3.20 Aaa/NA/NA BOA/CITG/CAL Auto fleet USB $15.83 400 3.20 Baa2/NA/NA

AESOP Funding II LLC 2010-3 B $62.66 425 4.95 Baa2/NA/NA BOA/CITG/CAL Auto fleet US16/03/10 Dutch MBS BV XV A1 1182.00 110 2.00 Aaa/AAA/NA CS/NIB/CAAM RMBS Euro

A2 1531.00 150 5.00 Aaa/AAA/NAB 111.00 5.00 Aa2/AA+/NAC 110.00 5.00 A1/A/NAD 110.00 5.00 Baa2/BBB/NAE 12.00 5.00 Ba1/BB+/NAF 14.00 0.60

12/03/10 Sierra Receivables Funding Co 2010-1 A $300.00 4.42% 2.60 NA/A/A CS/DB/RBS Wyndham Time share US11/03/10 IM Banco Popular MBS 2 FTA A 1596.00 30 5.09 NR/Aaa/NR Banco Popular Espanol Banco Popular Espanol MBS Euro

B 189.00 150 15.08 NR/Caa1/NR10/03/10 Foncaixa Andalucia FT Empresa 1 FTA AG 1328.00 Aaa/AAA/NA La Caixa CLO Euro

AS 182.00 Aaa/AAA/NAB 125.00 Aa3/A/NAC 165.00 A3/BBB/NA

05/03/10 Fosse Master Issuer A1 £205.00 120 4.50 Aaa/AAA/Aaa Barcap, CS, DB, Santander Alliance and Leicester RMBS UKA2 1775.00 120 4.50 Aaa/AAA/AaaA3 £525.00 120 6.90 Aaa/AAA/AaaZ £380.00

04/03/10 SLC Student Loan Trust 2010-B A1 $207.70 75 4.99 Aaa/NA/NA CITG BCG, BOAA2 $475.50 350 4.99 Aaa/NA/NA

03/03/10 CIT Equipment Collateral 2010-VT1 A1 $201.50 4 0.37 P-1/A-1+/NA R BOA/BCG/DB Equipment SM Ticket USA2 $166.00 100 1.10 Aaa/AAA/NAA3 $180.50 140 1.93 Aaa/AAA/NAB $31.12 250 2.62 Aa1/AA/NAC $46.68 325 3.03 A1/A/NAD $41.49 550 3.58 Baa3/BBB/NA

Ford Credit Floorplan Master A1 $525.00 170 4.93 Aaa/AAA/AAA BCG/BNP/CS/R Floorplan USOwner 2010-3 A2 $475.00 170 4.93 Aaa/AAA/AAAPFS Financing Corp 2010-C A $350.00 140 1.93 Aaa/AAA/NA JPM/CITG RBS Insurance US

B $20.40 275 1.93 NA/A/NAPFS Financing Corp 2010-D A $800.00 2.93 Aaa/AAA/NA JPM/CITG Insurance US

B $46.60 2.93SLM Student Loan Trust 2010-A I-A $149.00 -5 3.41 Aaa/AAA/NA BCG/BAS/JPM Student Loans (Private) US

II-A $1,401.00 325 4.31 Aaa/AAA/NA02/03/10 AESOP Funding II LLC 2010-1 A $200.00 A2/NA/NA DB/CAAM Auto Fleet US

Chrysler Financial Lease Trust 2010-A A1 $982.00 10 0.31 NA/NA/F-1+ JPM BCG,BNP Auto Leases USA2 $777.79 140 0.81 Na/NA/AAAB $148.71 300 1.05 NA/NA/AAC $111.53 400 1.13 NA/Na/A

For the latest tables please go to the SCI website


Data

ABS issued in April 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market

30/04/10 Arkle Master Issuer Series 2010-1 1A $500 1mL20 1.02 NR/NR/NR Lloyds/CITG/RBS Cheltenham & Gloucester RMBS UK

2A $1850 3mL115 2.82 Aaa/AAA/AAA

3A1 1650 3mE125 4.78 Aaa/AAA/AAA

3A2 $400 3mL125 4.78 Aaa/AAA/AAA

4A £200 3mL125 4.78 Aaa/AAA/AAA

5A £400 MS+130 6.78 Aa3/AA/AA

5B £230 3mL12 6.78 Baa2/BBB/BBB

5M £45 3mL12 6.78 A2/A/A

5C £125 3mL12 6.78 Baa2/BBB/BBB

29/04/10 Ally Master Owner Trust 2010-3 A $450 115 2.94 Aaa/AAA/AAA BCG/CITG/CS Ally Bank Floorplan US

B $43.95 175 2.94 Aa2/AA/AA

C $33.4 215 2.94 A2/A/A

D $33.4 275 2.94 Baa2/BBB/BBB

29/04/10 Toyota Auto Receivables Owner A-1 $475 0.33 P-1/A-1+/NR JPM/BCG/BOA Auto prime US

Trust 2010-A A-2 $275 13 0.95 Aaa/AAA/NR

A-3 $444 15 1.85 Aaa/AAA/NR

A-4 $56 18 2.86 Aaa/AAA/NR

28/04/10 American Express Credit Account A $850 25 2.94 Aaa/AAA/NR JPM/BCG/BOA American Express Credit cards US

Master Trust 2010-1 B $61.82 60 2.94 A2/AA+/NR

23/04/10 Admiral Finance 2010-1 A 1103 6mE115 6.7 Aaa/NR/NR BAK Banca Sai Spa RMBS Euro

B 120

23/04/10 Ally Master Owner Trust 2010-2 A $350 155 4.96 NR/AAA/AAA BCG/CS Ally Bank Floorplan US

21/04/10 Ford Credit Auto Owner Trust 2010-A A1 $285 4 0.31 NR/A-1/F-1+ JPM/MS/RBS Auto prime US

A2 $203.8 15 0.99 NR/AAA/AAA

A3 $382 15 1.99 NR/AAA/AAA

A4 $144.6 25 3.32 NR/AAA/AAA

B $32.05 65 4.12 NR/AA/AA

C $21.4 90 4.21 NR/A/A

D $21.4 175 4.21 NR/BBB/BBB

20/04/10 FCT Cars Alliance DFP France 2010-1 A 1750 1mE85 Aaa/AAA/NR CITG BNP Paribas/Banesto Floorplan Euro

B 137 1mE180

20/04/10 Dolphin Master Issuer Series 2010-2 A1 12,000 3mE107 4 AAA/Aaa/AAA Fortis Bank NV RMBS Euro

A2 12,000 3mE113 6 AAA/Aaa/AAA

19/04/10 BBVA RMBS 9, retained A 11,295 3mE30 3.29 AAA/Aaa/NR Banco Bilbao Vizcaya RMBS Euro

Argentaria SA

16/04/10 1st Financial Bank USA 2010-A A $59.18 325 2.06 NR/AAA/NR BBTC/BCG/UBS 1st Financial Bank USA Credit cards US

16/04/10 1st Financial Bank USA 2010-B A $59.18 350 2.31 NR/AAA/NR BBTC/BCG/UBS 1st Financial Bank USA Credit cards US

16/04/10 Brazos Student Loan Finance A1 $87.17 3mL90 5.92 Aaa/NR/AAA BOA Student loans US

Corp 2010-1

16/04/10 Vesteda Residential Funding II BV A7 1350 3mE163 4.25 AAA/Aaa/AAA ABN AMRO Vesteda CMBS Euro

15/04/10 BMW Vehicle Owner Trust 2010-A A1 $179.20 -3 0.26 P-1/A-1+/NR BOA/RBS/BCG BMW Financial Services Auto prime US

A2 $239 13 0.99 Aaa/AAA/NR

A3 $254 13 2.15 Aaa/AAA/NR

A4 $77.80 20 3.26 Aaa/AAA/NR

15/04/10 JG Wentworth Receivables 2010-1 A $207.99 195 9.12 Aaa/NR/NR DB Structured US

B $26.47 11.72 A2/NR/NR settlements

14/04/10 John Deere Owner Trust 2010-A A1 $224 -2 0.37 P-1/NR/F-1+ JPM/BOA/BBVA John Deere Capital Corp Agriculture US

A2 $147 15 0.99 Aaa/NR/AAA equipment

A3 $267 15 2 Aaa/NR/AAA

A4 $70.19 25 3.21 Aaa/NR/AAA

13/04/10 Mercedes-Benz Auto A1 $280 -3 0.33 P-1/A-1+/NR BCG/CITG/HSB Daimler Auto prime US

Receivables Trust 2010-1 A2 $220 13 0.99 Aaa/AAA/NR

A3 $425 15 2.15 Aaa/AAA/NR

A4 $67.82 20 3.31 Aaa/AAA/NR

12/04/10 SLM Student Loan Trust 2010-1 A $1185 1mL40 3.34 Aaa/AAA/NR JPM/CITG/DB Sallie Mae Student loans US

09/04/10 GMAC Mortgage Servicer A-1 $508 375 0.95 NR/AAA/NR BCG/CITG Real estate US

Advance 2010-1

01/04/10 Celtic Residential Irish Mortgage A-1 1260 3mE5 Aaa/AAA/NR RBOS First Active BTL Euro

Securitisation 16 A-2 1260 5 Aaa/AAA/NR

A-3 1260 5 Aaa/AAA/NR

Z 1277 100


42 SCI July 2010

Data

ABS issued in May 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market

28/05/10 Hipocat 20 A 1639 1mE30 3.03 Aaa/NR/AAA Caixa Catalunya Caixa Catalunya RMBS Europe

Permanent Master Issuer 2010-2 1A $750 3mL140 3 Aaa/AAA/AAA Bank of Scotland RMBS Europe

2A $750 3mL150 5 Aaa/AAA/AAA



Storm BV 2010-II A 950.00 3mE118 4.3 Aaa/AAA/NR Obvion Obvion RMBS Europe

B 118 3mE200 5 Aa1/AA/NR

C 115 3mE300 5 Aa2/A/NR

D 117 3mE400 5 A1/BBB/NR

E 110 3mE600 1.7 Baa3/NR/NR

27/05/10 Access Group 2010-A A $463.5 3mL275 6.59 Aaa/NR/AAA Access Group Student US

loans

Felsina Funding A 1217 6mE60 4.61 Aaa/AAA/NR Natixis/UBI Banca Banca Bologna MBS Europe

B 130.15 6mE100 NR/NR/NR

Fosse Master Issuer 2010-2 A1 $1200 3mL143 2.6 Aaa/AAA/AAA ML/Barcap/Citi/RBS/ Alliance & Leicester RMBS US/Europe

A2 £500 3mE140 2.6 Aaa/AAA/AAA Santander

A3 £210 3mL140 2.6 Aaa/AAA/AAA

Z £100.50 NR/NR/NR

21/05/10 Fondo de Titulizacion de Activos A 1872 3mE45 4.14 Aaa/AAA/NR Banco Santander Banco Santander RMBS Europe

Santander Hipotecario 6 B 163 3mE60 12.27 Aa1/AA/NR

C 153 3mE80 14.34 A1/A/NR

D 142 3mE175 14.5 Ba1/BBB/NR

E 121 3mE250 14.5 B2/BB/NR

F 1210 3mE65 10.48 C/CCC-/NR

21/05/10 Navistar Financial Corporation 2010-A A-1 $326 7 0.31 P-1/NR/NR DB/RBC/JPM/CS Navistar Financial Auto loans US

Owner Trust A-2 $262 60 0.99 Aaa/NR/NR

A-3 $217.9 85 1.89 Aaa/NR/NR

B $75.2 275 2.74 Aa2/NR/NR

19/05/10 Goal Capital Funding Trust 2010-1 A $188 3mL70 NR/AAA/NR Barcap Goal Financial Student US

loans

19/05/10 Nissan Auto Lease Trust 2010-A A-1 $201 2 0.35 P-1/A-1+/NR Nissan Motor Nissan Motor Auto lease

A-2 $243 35 0.9 Aaa/AAA/NR Acceptance Corp Acceptance Corp

A-3 $256 40 1.64 Aaa/AAA/NR

A-4 $50 45 2.11 Aaa/AAA/NR

19/05/10 Santander Drive Auto Receivables Trust A-1 $366 10 0.18 NR/A-1+/NR Santander Consumer Auto non US

2010-1 A-2 $287 60 0.9 NR/AAA/NR USA prime

A-3 $268 65 2.15 NR/AAA/NR

A-4 $79 85 3.05 NR/AAA/NR

18/05/10 Missouri Higher Education Loan Authority A-1 $822.5 3mL85 5.71 NR/AAA/AAA Student US

2010-2 loans

13/05/10 AmeriCredit Auto Receivables Trust A-1 $152.10 9 0.21 P-1/A-1+-NR DB/JPM/WF AmeriCredit Auto non US

2010-2 A-2 $177.70 50 0.99 Aaa/AAA/NR prime

A-3 $76.6 55 2.03 Aaa/AAA/NR

B $52.8 125 2.66 Aa1/AA/NR

C $65.6 275 3.33 A1/A/NR

D $60.8 425 3.87 Baa3/BBB/NR

E $14.4 675 3.88 Ba3/BB/NR

12/05/10 Golden Credit Card Trust 2010-1 A C$900 85GOC 5 Aaa/NR/NR BCCM RBC Credit cards Canada

12/05/10 Golden Credit Card Trust 2010-2 A C$325 3mCDOR60 5 Aaa/NR/NR BCCM RBC Credit cards Canada

12/05/10 Honda Auto Receivables 2010-2 A-1 $386.25 0.38 P-1/NR/F-1+ American Honda American Honda Finance Auto prime US

Owner Trust A-2 $251.25 15 0.99 Aaa/NR/AAA Finance Corporation

A-3 $507.5 20 1.99 Aaa/NR/AAA

A-4 $109.2 25 3.07 Aaa/NR/AAA

11/05/10 Volvo Financial Equipment 2010-1 A-1 $284.43 4 0.33 P-1/A-1+/NR BAS/HSBC Volvo Financial Services Auto trucks US

A-2 $133 35 0.99 Aaa/AAA/NR

A-3 $140.25 55 1.67 Aaa/AAA/NR

B $58.27 165 2.42 Aaa/AAA/NR

05/05/10 Bank of America Credit Card Trust A-1 $900 1mL30 2.92 Aaa/AAA/AAA BAS/CS/DB/JPM Bank of America Credit cards US

2010-1

05/05/10 Hyundai Auto Receivables Trust 2010-A A-1 $219 2 0.28 P-1/A-1+/NR JPM/RBS/SG Auto prime US

A-2 $238 17 0.95 Aaa/AAA/NR

A-3 $317 25 2.15 Aaa/AAA/NR

A-4 $186.85 40 3.8 Aaa/AAA/NR



Data

Natural catastrophe bonds issued in 2009 and to 31 May 2010

SPV Sponsor Tranche amount Coupon Rating PerilResidential Re 2010 United Services Class 1 $162.5m TMM+660bp BB (S&P) US hurricane, earthquake,

Automobile Association Class 2 $72.5m TMM+890bp B+ (S&P) thunderstorm, windstorm & Class 3 $52.5m TMM+1300bp B- (S&P) California wildfire Class 4 $117.5m TMM+1300bp NR

Blue Fin Series 3 Allianz Class A $90m TMM+1400bp B- (S&P) US hurricane and Class B $60m TMM+925bp BB (S&P) earthquake

Eos Wind Munich Re Class A $50m TMM+680bp Ba3 (M) US hurricane Class B $30m TMM+650bp Ba3 (M) US hurricane & Euro wind

Caelus Re II Nationwide Mutual Class A 185m TMM+650bp BB+ (S&P) US hurricane and quakeLodestone Re National Union Fire Class A $175m TMM+625bp BB+ (S&P) US hurricane and

Ins of Pittsburgh Class B $250m TMM+825bp BB (S&P) earthquakeJohnston Re Munich Re Class A $200m TMM+625bp* BB- (S&P) US hurricane (North

Class B $105m TMM+650bp BB- (S&P) Carolina)Ibis Re II Assurant Class A $90m TMM+620bp BB (S&P) US hurricane

Class B $60m TMM+925bp B+ (S&P)Merna Re II State Farm F&C $350m TMM+365bp BB+ (S&P) US earthquakeSuccessor X - Series 2010-1 Swiss Re II-CN3 $45m TMM+975bp B- (S&P) North Atlantic hurricane,

II-CL3 $35m undisclosed NR Euro windstorm, Cal and II-BY3 $40m undisclosed NR Japan quake

Foundation III Hartford Fire $180m TMM+575bp BB+ (S&P) US hurricane

SPV Sponsor Tranche amount Coupon Rating PerilLakeside Re II Zurich American $225m TMM+775bp BB- (S&P) California earthquakeRedwood XI Swiss Re $150m TMM+625bp B1 (M) California earthquakeLongpoint Re II Travelers Class A $250m TMM+540bp BB+ (S&P) US hurricane

Class B $250m TMM+540bp BB+ (S&P)Atlas VI SCOR 175m Euribor+950bp BB- (S&P) Euro wind & Japan quakeSuccessor X Swiss Re $50m $6m discount B- (S&P) North Atlantic hurricane,

$50m undisclosed European windstorm and$50m undisclosed California earthquake

Montana Re Flagstone Re Class A $100m 3mL+975bp BB- (S&P) US hurricaneClass B $75M 3mL+1325bp B- (S&P) US hurricane & quake

MultiCat Mexico 2009 Swiss Re for Class A $140m TMM+1150bp B (S&P) Mexican quakeAgroasemex and Class B $50m TMM+1025bp B (S&P) Pacific hurricaneFONDEN Class C $50m TMM+1025bp B (S&P) Pacific hurricane

Class D $50m TMM+1025bp BB- (S&P) Atlantic hurricaneParkton Re Swiss Re $200m TMM+1050bp B+ (S&P) N Carolina hurricaneEurus II Hannover Re 1150m Euribor+675bp BB (S&P) Euro & UK windIanus Capital Munich Re 150m Euribor+900bp B2 (M) Euro wind & Turkey quakeCalabash Re III Ace Insurance Class A $86M 6mL+1525bp BB- (S&P) US hurricane & quake

Class B $14m 6mL+550bp BB+ (S&P) US quakeResidential Re 2009 USAA Class 1 $70M 3mL+1300bp BB- (S&P) US hurricane, quake

Class 2 $60m 3mL+1700bp B- (S&P) and stormClass 4 $120m 3mL+1250bp BB- (S&P)

Successor II 2009 Swiss Re $60m undisclosed n/a North Atlantic hurricane andCalifornia quake

Ibis Re Assurant operating Class A $75m 3mL+1025bp BB (S&P) US hurricanecompanies Class B $75m 3mL+1425bp BB- (S&P)

Blue Fin (Series 2) Allianz Argos Class A $180m 3mL+1350bp BB- (S&P) US quake & hurricaneMystic Re II (Series 2009-1) Liberty Mutual 2009-1 $225m 3mL+1200bp BB (S&P) US quake & hurricaneEast Lane III Chubb Class A $150m 3mL+1025bp BB (S&P) Florida hurricaneAtlas V SCOR Series 1 $50m 3mL+1450bp B+ (S&P) US quake & US/Puerto

Series 2 $100m 3mL+1150bp B+ (S&P) Rico hurricaneSeries 3 $50m 3mL+1250bp B (S&P)

For the latest tables please go to the STORM website

CDOs issued in March 2010

CDOs issued in April 2010

CDOs issued in May 2010No CDOs were issued in May 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Manager/Originator Collateral Type Market31/03/10 COA Tempus CLO A1 US$327 3mL190 /AAA Citi Fraser Sullivan COA senior sec Arb US

A2 US$15 225* /AA * A2 priced at discount syndicatedB US$36.5 250* /A of 94.25%, B at 90.71% loansSub US$102.1 NR

19/03/10 Valhalla A 1750m 3mE Aaa//AAA BNPP/Danske Danske Guaranteed Bal Sheet EuroBank Danish loans

15/03/10 Lusitano Leverage A 1352 6mE30 /AAA DB/BES Banco Espirito Santo Sen secured Bal Sheet EuroFinance 1 X 121.80 50 NR de Investimento loans

Sub NR

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Manager/Originator Collateral Type Market15/04/10 Terra II CLO A 139m 3mE450 Aaa Citi Citi Asia/EM corp Arb Euro

loans01/04/10 Ayt Andalucia FT A 145 3mE40 Aaa Cajamar Cajamar SME loans Bal Sheet Euro

Empresa Cajamar FTA AG 1179 40 AaaB 127.50 75 Aa1C 127.50 100 Baa1D 121 125 B2

Ayt Andalucia FT A 130 NR/NR/AAA Cajasol Cajasol SME loans Bal Sheet EuroEmpresa Cajasol AG 1120 NR/NR/AAA

B 120 NR/NR/AAC 120 NR/NR/A


2010

*Increasing to TMM+700bp for the second and third annual risk periods

2009

44 SCI July 2010

Data

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