opportunities Securitisation The side-effects of reform Regulation roulette intervention Ending ABS

Issue 2 May 2010 structured finance the hopes return Life ILS equity alpha equity Structured magazine and Basel 2 Correlation Doremus GCI Mag 270x205mm 300252 Proof 01 11-02-2010

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f issue 1 of the SCI magazine was all about the new, then a great deal of issue 2 is about the old – albeit with a twist. Most of all, it’s that chestnut or bugbear that’s been around (with an appropriate time lag of course) almost as long as the derivatives and structured Ifinance markets – regulation or, even worse, political intervention. At the time of writing, those twin spectres were making headlines, thanks to the SEC’s investigation of Goldman Sachs and coincident appearance by seven members past and present of the firm before the Senate Permanent Subcommittee on Investigations. Both Editor events failed, however, to elicit any evidence of that familiar ‘Sachsdenfreude’ from the rest Mark Pelham of the market. +44 (0) 20 7438 1126 [email protected] Who can forget its peers’ very public glee at the very private alleged blow-up of Gold- Design and Production man’s dollar swaptions book back in the late 1990s? Nothing like that is in evidence this time Andy Peat [email protected] around… yet, anyway. Instead, a sharp intake of breath and an empathetic wince is all you get.

Contributors Jillian Ambrose Nor has there been any sign of an internal distancing from the individual or individuals Denise Bedell ‘at fault’. Gone, it seems, are the days when the cat in Japan was left to twist in the wind. Anna Carlisle Bertrand Delarue of BNP Paribas Charles Himmelberg, Alberto Gallo, Other slightly more recent “bad habits” are dying a little harder. Something no-one Lotfi Karoui and Annie Chu of thought they’d see for a while occurred in April, with the launch of a new CDPC – inevita- Goldman Sachs Kathy Fitzpatrick Hoffelder bly rated triple-ha-hey! The good times must be back, right? Rachael Horsewood Michael Marray Maybe not. Structured finance investors continue to privately complain about the Corinne Smith inertia at the majority of their bank counterparties. Innovation, new directions and general Managing Director thinking-out-of-the-box are what they are clamouring for – arguing that there are excellent John-Owen Waller +44 (0) 20 7061 6335 opportunities out there for the right forward-thinking solution. [email protected]

Sales Associate Some go as far as to suggest that it’s now or never, or the market will be going back- Grace O’Dwyer Smith wards again before we know it. That may sound melodramatic, but the evidence of follow- +44 (0) 20 7061 6397 the-leader issuance and paucity of new structural or cross-asset ideas on show does send [email protected] something of a chill down the spine. © SCI. All rights reserved. Reproduction in any form is prohibited without the written permission of the publisher. Furthermore, some idealists are even suggesting that, rather than ignoring them, what ISSN: 2043-7900 Although every effort has been made to ensure everyone – buy- and sell-side alike – should be doing in the least active structured finance the accuracy of the information contained in this publication, the publishers can accept no liabilities for sectors is planning for the long-term, and identifying assets and structures for future use. inaccuracies that may appear. No statement made in This would involve for some patience and agreement between market participants that there this magazine is to be construed as a recommendation to buy or sell securities. The views expressed in this WILL be a market again in this area one day: build it and they will come. publication by external contributors are not necessarily those of the publisher. Printed in England by Hastings Printing Company Limited, Drury Lane, St Leonards-on-Sea, East Sussex That, though, is probably a step too far in what remains a short-term world, so isn’t going TN38 9BJ www.hastings-print.co.uk to happen any time soon – and that really is old news. In any event, enjoy our new take on SCI is published by Cold Fountains Media Limited and distributed in the USA by SPP, 75 Aberdeen Road, the key issues in structured finance. Emigsville, PA. 17318-0437. Periodicals postage paid at Emigsville, PA. POSTMASTER: send address changes to SCI PO BOX 437, Emigsville, PA. 17318-0437. Subscription Rates: £930 +vat for an annual subscription €1200 Europe $1650 ROW Subscription enquiries Ike Aneke +44 (0) 20 7061 6334 [email protected] Mark Pelham Editorial Director, SCI

www.structuredcreditinvestor.com 1 Issue 2 May 2010 Contents 4 The Interview Challenges and opportunities Iain Baillie, head of European fixed income, and Edward Cahill, head of structured credit at Christopher Street Capital, discuss their firm and the securitisation markets it operates in 4 8 Regulation Regulation roulette Regulators are pushing numerous measures to help resuscitate the securitisation markets. But, as market players sift through the web of proposals, many say they are becoming increasingly concerned about the potential side-effects of all these reforms. Rachael Horsewood reports 8 13 ABS All in the timing Timing of exit for market support programmes is critical to both market recovery and supply and demand within the securitisation space. As Denise Bedell discovers, the ending of TALF and other market stabilisation programmes in the US could impact the market for some assets, but others are unlikely to be affected 13 1 8 ILS Where there’s life… The mortality segment of the insurance-linked securities market only saw one transaction in both 2008 and 2009. But, as Michael Marray discovers, a sizeable number of existing bonds are maturing this year and next, which – combined with increasing investor demand – should mean the pace of issuance will pick up 23 Wholesale Structured Products 18 Trends and opportunities in equity markets Bertrand Delarue, of the global structuring group at BNP Paribas, argues that 2009 was a year of dislocations, but many opportunities still exist for 2010. So, institutional investors should look for alpha in the few remaining dislocations and dare to take macro views with price-efficient derivatives 2 9 CDS 23 In the spotlight Sovereign CDS are once again the chief focus of credit derivatives market participants. As Anna Carlisle and Mark Pelham report, interest in the sector is being driven not only by sovereign concerns, but also by trading ideas 3 3 CDS Correlation concerns 29 Charles Himmelberg, Alberto Gallo, Lotfi Karoui and Annie Chu of the credit strategy team at Goldman Sachs look at how the new Basel 2 rules could change the tranche business 3 7 Price Talk We highlight some of the key recent trading activity in ABS, CLOs and ILS 33 41 Data ABS, CDOs and natural catastrophe bonds issued over the last three months

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Iain Baillie, head of European fixed income, and Edward Cahill, head of structured credit at Christopher Street Capital, discuss their firm and the securitisation markets it operates in Challenges

Q: What is Christopher Street Capital’s remit? fund, we’re not a bank. We are here to provide expertise and A: Christopher Street Capital is the buy-side facing business of liquidity to our clients, but we don’t take positions ourselves interdealer-broker GFI. GFI has built up over the course of the and that is what differentiates us from other institutions last five years or so a number of buy-side facing businesses that clients may talk to in this sector. The big picture of our across equity, fixed income and foreign exchange. business model is that we talk to leveraged investors, mainly We are responsible for the fixed income side, which is 95% banks, and we move assets out of those institutions into real credit-focused – we do some rates business as well, but that money or new capital. tends to be fairly specialised (in inflation instruments, for Our overall focus is to try to help customers in areas of example). We are responsible for the UK and Europe, but there business where liquidity has been impaired. Clearly that has is also a fixed income business that sits in New York, which we been a moving target to some extent for the last couple of years work closely with. because in the first half of that period illiquidity increased Until Edward and his team joined us in the autumn last year across the board and for the second half of it illiquidity has we were very much focused on the cash part of the credit busi- declined. ness. Since then, though, we’ve expanded to cover a number of But there are still significant areas of the credit space where areas within structured credit. there are securities that require extra work to understand how Sometimes it’s helpful to explain a company by saying they trade, where they trade, how they should be trading and what it’s not – we’re not an asset manager, we’re not a hedge what represents value. That’s the kind of stuff we focus on.

4 SCI May 2010 The Interview and opportunities

Q: What are those areas? So, we feel that we are not focused increase in liquidity. Clients now have A: We have staffed ourselves with experts on a product; we are focused on a client the ability to sell certain things; the in a number of different areas – from base. Our success or failure depends on ability to separate the wheat from the real estate and mortgages to CSOs, to how relevant we are there. chaff and reassess their portfolios and CLOs. But the reality is that you don’t decide what they want to hold and what know what problems a client faces until Q: Where do you see your business they want to sell. you talk to a specific client. opportunities coming from in 2010? We’re here to help them do that and The client may say that their prob- A: The simple answer is the same place as when they say this is what we want to lem is in aircraft finance or they may before – in the illiquid sectors where get rid of we find them the best bid we say it’s in mortgages, but we have to clients have bonds. can for that. That’s where the oppor- staff ourselves to be able to deal with In some ways the great news for tunity lies in helping people to realign any part of the credit space. This is clients is that what we’ve seen is a their portfolios. a difficult thing to do because, as we liquidity crisis rather than a credit Some clients will say they want said, it is a moving target, as whatever crisis and some steps have been taken to get out of a particular sector as it’s a client’s main problem is today, that to remedy that. Central banks have no longer one they are comfortable may not be what they are most worried injected liquidity in the market and we with, but at the same time they can’t about in two weeks’ time. have seen a rally on the back of that just remove that income – they need to

www.structuredcreditinvestor.com 5 The Interview

“The client may say that their problem is in aircraft finance or they may say it’s in mortgages, but we have to staff ourselves to be able to deal with any part of the credit space”

redeploy their capital. Again, that’s what getting out of positions that perhaps Q: Are you seeing changes in the we’re here for – to tell them what we can they don’t want to hold long-term and approach of some of your clients? get for what they’re holding and come investing in something else that they A: There are definitely some institutions up with possibilities for new investment. think is trading at a big discount to out there who are asking themselves: So, there’s not one specific type of par, but believe it to be money-good – ‘What am I meant to do in this new bond or one specific sector from which having done their credit work and are world? I have multiple stakeholders we expect to generate business; there comfortable holding it. – everybody from a central govern- is instead a client need – that they In fact, we’ve seen more activity ment and a regional government to are redefining their portfolios in the from our clients in the last few months shareholders, to my employees and my current market. The good thing is that than last year because prices have credit counterparties. I’ve got multiple there is real opportunity to do that. moved to a level where they have the people I’ve got to keep happy; how do There is a lot of risk out there for flexibility to actually do something. At I do that?’ clients, but there are also opportunities. lower levels, there were no opportuni- We expect that some institutions Consequently, some clients are more ties for trading because the losses they will retrench, while others will focus proactive at trading in this market and would have had to take were too great. on particular sectors that they feel they’re most suited to. There is also, of course, a big government influence in how that’s happening and who’s doing what. While there’s big institutional questioning of what they are meant to be doing and how they are going to do it, at the ground level when you are talking to portfolio managers that’s not the question they are asking. Once they are told what they can and can’t do, the question they are asking is what is in my portfolio and should it be there?

Q: Do you expect your firm to grow to meet these client needs? A: The challenge for any institution, and one that we are very focused on trying to overcome, is to have a firm that remains small enough to be able to be coordinated and make a difference to the client. The difficulty is that when you get too large that ability to service the client becomes more problematic. There is pressure to start becoming a new-issue business that is all about a product push and a world where you just randomly fire out instant messages. We are a lot more focused on what we do and a lot more coordinated Iain Baillie, Christopher Street Capital because we’re not too big. If we got too

6 SCI May 2010 The Interview

“These days, predicting the future is an impossible task – it’s incredible to think we are where we are, given we were where we were”

large, it would be more difficult for us any way involved with politics, but the Q: What would you like to see happen to service our clients in the way that we reality is that we have to worry more in the market? think we can now. But there is a trade- about what politicians decide than any- A: A collective plan from the market – we off in that if you don’t have a critical thing else. The only response to that is haven’t collectively analysed what mass, then you don’t have enough to be flexible – if it’s difficult predict- happened and why it happened, and liquidity to offer your clients. ing 2010, looking to 2011 and beyond, we haven’t collectively decided what We are always assessing how big we who knows? we want the market to look like going need to be and how many people we There are a lot of different ways the forward. Our view is that free market need, and if and when we feel we need financial markets could go and none of forces on their own won’t necessarily them we will add more people. But I us know what’s going to be decided. achieve the optimal solution. think for us right now it’s important It is indeed possible to imagine There will be influence from to make sure the people we have here a future without securitisation, but regulators and governments about what are coordinated and every time a client we think it’s very unlikely that that markets will look like and the sooner comes in and says I want to do this – would actually happen. Without the we have a plan, the sooner we’ll be able whether it is a buy or a sell or advice on securitisation markets in some form to stabilise the economy. a portfolio – everybody at Christopher the amount of credit available will At the same time, it is worth empha- Street Capital Fixed Income group reduce and the price of credit will go sising that there is a massive amount of knows that. up dramatically, and that has to have a structured credit out there and there It’s also important that everybody negative economic effect. has been a huge loss of expertise at knows where the pockets of expertise The critical point from our own all institutions across the board. The lie and are very comfortable in utilising perspective is that the key difference people who bought the investments are them. If one of our people is asked for between us and some of the bigger gone from where they were, the people something they cannot help with, we dealers is that we don’t position. Over who sold them are gone from where are small and flexible enough for them the course of the next two years in the they were. So the challenge of making to know who they can get that answer structured environment, there will be a the markets work properly again is a from within our firm and we will be lot of securities that are going to move massive one. more than happy to get that person in from A to B and a lot of those will We’re not saying Christopher Street front of the client. move as efficiently in an environment can solve it alone, but we are part of that doesn’t involve capital as one that solving that problem in that we have Q: How do you see the securitisation does require capital. The only type of that ability to analyse, understand and market evolving? capital that will be vital to smooth risk find the best place to hold structured A: These days, predicting the future is transfer is intellectual capital, which credit risk. It is a huge challenge, but an impossible task – it’s incredible to we have in abundance. also a huge opportunity. think we are where we are, given we were where we were. At the same time, there are so many obvious risk factors About the interviewees that could change the game completely. Iain Baillie has been involved in the European fixed income market for over 30 For example, the US administration years as a trader of both government and corporate bonds, culminating in heading could decide tomorrow to affect some European credit trading as an md of Salomon Smith Barney. He was also a founding new legislation; a central bank gov- director of European agency broker LBDP. Of late, Iain ran the European business for ernor tomorrow could decide to stop MarketAxess. injecting liquidity into the market; or, Edward Cahill runs the structured credit effort at Christopher Street Capital in in an even worse-case scenario, a mem- London. Previously, he ran the CDO group at Barclays Capital and JP Morgan in ber country could fall out of the EU. London. Prior to that, he ran European ABS and CDO trading at JP Morgan. Edward We’re sure everyone in finance began his career as a CDS trader at UBS. would love it if the industry wasn’t in

www.structuredcreditinvestor.com 7 Regulation

Regulators are pushing numerous measures to help resuscitate the securitisation markets. But, as market players sift through the web of proposals, many say they are becoming increasingly concerned about the potential side-effects of all these reforms. Rachael Horsewood reports Regulation roulette

ecuritisation has taken a beating since the credit crisis. but the real problem was not a lack of regulation for securitisation First it was blamed for exacerbating losses stemming structures. It was more about the excess of leverage and incau- from the subprime and banking crises. Then by 2009 tious extensions of credit at every level starting with origination,” policy makers were trying to revive it with new disclo- explains Kevin Hawken, a partner in the finance group at interna- sure standards and changes to regulatory capital and tional law firm Mayer Brown. Saccounting treatments. Deborah Shire, deputy head of structured finance at AXA “Regulation has been the topic of conversation for a good year Investment Managers, adds: “The structured finance market was and a half now. One of the main points in these discussions is almost killed by players who did not analyse the risks properly. how to improve transparency and increase investor confidence,” Ultimately, these players suffered from excesses building up in says Douglas Long, evp of business strategy at structured finance the market; for example, the bad underwriting policies that were software firm Principia Partners. ‘hidden’ behind complex structures.” In the UK, regulators are particularly worried about the Regulators on both sides of the Atlantic have come out with a some £440bn of bank refinancing due between now and 2012. number of proposed reforms to try to bring securitisation back to Long refers to the Bank of England’s proposal released in early life. The string of proposals really started in December 2009. The March for further disclosures of both loan-level and cashflow Basel Committee on Banking Supervision published two con- model data. Such disclosure enhancements are meant to improve sultative papers then – the deadline for responses was 16 April the transparency of ABS, including mortgage pools, and other 2010 and the Committee says it still plans to issue formal rules securities that the central bank accepts in exchange for provid- by the end of this year. The European Commission (EC) released ing liquidity in the UK’s banking system. This follows one of the its latest consultation paper for proposed changes to the Capital European Central Bank’s (ECB’s) proposals, released at the end Requirement Directive (CRD) in early March. of December 2009, for increased loan-by-loan information on The impact that all these proposed regulations have had on the underlying assets backing the ABS bonds that it accepts as col- market is clear. The securitisation markets seem to have pretty lateral for lending through the euro system. much closed down, despite some signs of economic recoveries, as Standardisation of data from the origination side seems to players wait for clarification of the rules. be the starting point for many of these regulatory proposals. “In “Together these proposals create a great deal of uncertainty, hindsight it is easy to say that regulations could have prevented which makes it difficult for market participants to make invest- some of the losses that occurred as a result of the credit crunch, ment decisions,” Hawken remarks.

8 SCI May 2010 Regulation

AXA Investment Managers had over €34bn invested in the securitisation and structured finance markets, as of the end of December 2009. “Although we strongly believe that regulatory reform is crucial to the future of this market, we do not depend on regulatory measures when it comes to selecting our investments in structured finance products,” she is quick to add. Michel Fryszman, AXA’s head of ABS investments, also explains that even though more standardised data helps the market cope better with credit and liquidity risks “because it leads to more effective evaluations and better quality of assets”, it does not mean investors have no homework to do. “Investors need to show Douglas Long, Principia Partners that they have the resources necessary for Simon Schiff, Simmons & Simmons understanding the risks associated with According to a recent data report by these assets. By this I mean skilled and consequences – is critical, he says. “Rely- the Association for Financial Markets in experienced people, as well as specialised ing on asset ratings and external credit Europe (AFME), €94.9bn of securitisa- analytics, data and IT tools,” he notes. assessments is no longer an acceptable tion was issued in the fourth quarter of “We are now in a world where it is alternative to a company’s own detailed 2009 in Europe. This was less than a only going to be acceptable to invest due diligence,” Long adds. third of the issuance in the same quarter in structured finance if you can prove Simon Schiff, a partner in the banking of 2008. you understand the underlying risks of group at Simmons & Simmons in Lon- The report says that the decrease in the assets. Major proposals have been don, agrees that a lot of the effectiveness market activity is not surprising con- influenced by the Basel 2 Securitisa- of these new rules depends on investors sidering the reduced investor base and tion Framework Enhancements and the and what they do with the added informa- overhang of retained issuance, as well as International Organisation of Securities tion. “They already get many pages of the fact that originators are using, when Commissions’ (IOSCO’s) due diligence information in the prospectus, so adding available, covered bonds and other more guidelines, which specify plenty of more pages and standardising the disclo- competitive sources of funding. In the examples of what is expected from inves- sures does not necessarily mean the risks US, three CMBS issues came to the mar- tors going forward. The G20’s Financial will be better understood.” ket in the fourth quarter of 2009, though Stability Board is pushing these reforms Many opinions are coming out of the the market there continues to be domi- through at an international level now too,” continuous string of consultation papers nated by agency issuance from Fannie Long asserts. released by regulators since the end Mae, Freddie Mac and Ginnie Mae. How organisations translate those of 2009. The Association of Mortgage requirements into practice – and modify Investors in the US, for example, recently Standardised transparency their infrastructure to avoid the capital recommended that the reliance on rating Sources agree that securitisation transac- agencies could be reduced if detailed data tions need to be more standardised and on loans were made public before deals transparent in order to restore investors’ are brought to the market. Some sources confidence and increase market liquid- have suggested that investors pay inde- ity. But, as implications of the proposals pendent third parties, such as accounting sink in, more players are saying they are firms, to double-check disclosures on the worried that overly complex or prescrip- underlying loans. tive regulations could be worse for the The ECB’s initiatives would help rat- securitisation markets. ing agencies better analyse the underlying Shire says that while regulators have to collateral, according to Frédéric Drevon, do something to try and keep “excesses” head of EMEA at Moody’s. “For example, from happening again, it is important that more detailed loan-by-loan information they do not “overshoot” their objectives. would allow us to develop our analyses “We have been involved with various of the probabilities of default in greater regulatory bodies and working groups depth,” he says. for the past two years now to see how we Drevon adds that the quality of infor- can help regulators reinstate securitisa- mation in structured finance has never tion as a sound tool for raising funds and been as reliable as it is in the corporate transferring risk,” she says. Deborah Shire, AXA Investment Managers world. “There are some areas in Europe

www.structuredcreditinvestor.com 9 Regulation

provision says that ABS investors subject “We would not want to see to the CRD (i.e. EU banks) shall only buy ABS bonds if the originator, sponsor or regulations that put a stop to original lender has explicitly disclosed that it will on an ongoing basis retain an economic interest in the transaction of no securitisation or make new less than 5%. “While we certainly are not support- issuance uneconomical” ing the retention requirement imposed on the originator, we equally believe that it is irrelevant for European ABS originators in practise. Most securitisations in Europe have been undertaken by retail banks as part of an overall funding mix and where the data we receive is just not good, securitise’ model was another example consequently most originators are already so we have to go back to the issuer and of “excesses” in the market because it satisfying the retention requirements,” the request more information. Structured offered no incentive to originate qual- report adds. finance has always been a concern when ity assets. “New retention rules partly It also says: “Regulators should have it comes to disclosure and any progress to address this issue. But regulators still noticed that their incentive scheme in arti- standardise information in this space has need to be careful not to overshoot. We cle 122a is exactly the wrong way round. usually been slow considering the com- would not want to see regulations that put In the corporate market, companies have plexity of the transactions,” he explains. a stop to securitisation or make new issu- an obligation to report their financial Drevon believes disclosure regimes for ance uneconomical,” she asserts. performance to their bond and equity the corporate debt markets could be used A much-talked about report published investors (in the EU using International as a model for increasing transparency in by Barclays Capital in late January scru- Financial Reporting Standards, IFRS) the securitisation space. “For example, the tinised the CRD rules for doing exactly and corporate investors are not threatened broad dissemination of information, which this. The European Securitisation Outlook with harsh penalties, should the corpora- gives all parties equal and simultaneous 2010, written by Reto Bachmann, an ana- tions they are invested in fail to report access, could facilitate healthier scrutiny of lyst at Barclays Capital, starts by stating: their performance – because bond inves- the data,” he says. He adds that a regulator “Determined to be seen as proactive in tors have no control over them.” would need to examine the conduct of mar- its handling of the fallout, the European Regulators in the US and Europe ket participants and data filings, or at least Commission decided to quickly introduce have addressed these issues differently, enforce compliance of the new rules. its own amendments to the CRD before as many other reports analysing the On 15 April, Moody’s and S&P the Basel Committee on Banking Super- implications of these CRD changes have released formal responses to the consul- vision amended Basel 2. This was despite pointed out. For example, the skin-in-the- tation paper on Basel 3. Moody’s said the fact that the purpose of the CRD was game proposal in the US is originator- it believes that the Basel Committee’s to transpose Basel 2 into EU law.” driven – it imposes formal obligations on proposed regulatory capital rules could One of the most controversial provi- originators – unlike the EU one, which pressure banks to raise their risk profiles. sions of the CRD lies in the new retention is investor-driven (it imposes obligations Standard & Poor’s warned that the pro- requirements, CRD article 122a. This on the classes of investors that are bound posals could lead to further reductions in by the rule). There also is a difference in bank lending and derivatives trading. how much of the securitisation deal is to be retained: originators in the US will Originate to securitise likely have to retain 10%, while in Europe Ian Sideris, a partner in Simmons & Sim- it will be 5%. mons’ capital markets group, is quick to Sideris says these differences may also point out the over-reliance on rating agen- create regulatory arbitrage opportuni- cies and triple-A ratings before the credit ties. “These regulatory differences are crisis. He also refers to investment banks’ partly due to the fact that the ‘originate to use of ‘originate to securitise’ models. securitise’ model was more of a problem “These banks discovered that they in the US. The sub-prime crisis was also could make more money from CDOs than more problematic there compared with from loan origination,” Sideris explains. Europe,” he notes. “The question now is not only whether the Many implications of the retention plethora of regulatory proposals in the US requirements were coming to light as and the EU addresses these two issues, but more institutions responded to the EC’s also what effect new rules will have on the proposed CRD reforms. “As the skin- securitisation market moving forward.” in-the-game proposals will be part of As Shire explains, the ‘originate to Ian Sideris, Simmons & Simmons Europe’s CRD rules, financial institutions

10 SCI May 2010 Regulation that are bound by the rules and that have given the short timeframe institutions SMEs, mortgages, credit cards and car securitisation exposures will as things would have for preparing. loans.” He says AFME fears that a lack of currently stand be the only players that understanding of the implications of these have to worry about the retention require- Defragmentation demand regulatory proposals could lead to new ments. However, originators and arrang- Sources argue that it will remain difficult rules that actually hamper instead of help ers will have to ensure that deals falling to structure a transaction until all of these the revival of the securitisation markets. within the ambit of these rules comply changes to capital requirements, account- On 26 February, AFME published its irrespective of the identity of the original ing treatments and rating methodolo- comments on the ECB’s proposals for prospective investors,” Schiff explains. gies are finalised. “Given the regulatory increased ABS loan-level disclosures. He adds: “Also, there are analogous fragmentation in the market right now, In a joint letter with ISDA, AFME said proposals in the draft directive to regulate we think it could be at least another year it agreed that the reporting of some the activities of EU-based fund managers before we see some sort of international loan-level data and the availability of this and hedge funds. It is also the case that, coordination take place,” Schiff says. information to the broader market on an depending on how they are structured, AFME is concerned about how and ongoing basis will help restore investors’ not all asset-backed deals will fall within when all of the proposed changes are to be confidence in the securitisation markets. the ambit of the rules.” implemented, according to Rob McIvor, However, it highlighted a number of Further, Schiff notes that all EU an md at the trade association. “AFME challenges, including how the differences member states are required to implement is concerned that some issuers currently between existing and new transactions (as the CRD directive as part of their national do not have a variety of efficient funding well as differences between asset classes laws at the beginning of 2011 – another sources, with well-diversified investor and jurisdictions) could further complicate issue widely criticised by the market, bases for core-assets, such as loans to the implementation and effectiveness of

Chart 1 Regulatory timeline for securitisation

CRD3 CESR Report on New EC EU Council CRD4 EC EP draft report CRD3 CRD4 CRD2 CRD2 and CDR3 proposal possible TRACE in consultation Agreement consultation (CRD3) Parliament proposals transportation implementation EU EU (ABS & CDO) (CRD4) (CRD3) vote deadline

Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 11

US Bank regulators FINRA proposes Comment SBC releases House FDIC safe Comment FINRA final US issue cap rules for ABS TRACE deadline for draft of regulatory passes harbor deadline rules for TRACE FAS 166-167 reporting TRACE proposal reform bill HR 4173 ANPR FDIC ANPR reporting expected

IOSCO Enhance DDL for G-20 IOSCO Basel released CEBS reply to Deadline for Basel & considers Basel 2 IOSCO Pittsburgh publishes recs results of EU Commission response to IOSCO Commission Global ABS Securitisation ABS summit for structured trading book re call for advice consultations on released proposal disclosure Framework disclosure products study on CRD2 PTT for SFP on leverage ratio

Global EU US Executive US House US Senate

• G-20 • Retention (CRD2): • Improve incentives for risk • HR 4173: mandatory 5% • Securitisers must retain credit risk at the minimum level • Improve incentives for risk management for • Increase investor due diligence management for issuers of credit risk retention for (10%) set by the SEC and the Federal banking agencies issuers of securitisations and credit analysis securitisations creditors and in some cases • Risk cannot be hedged • Considering retention requirements by 2010 • Capital charges for non- • Federal banking agencies should securitisers • GSE securitisations would be partially or totally exempt • Considering due diligence requirements by 2010 compliance implement a retention requirement • Retention amounts may be • Other exemptions could be provided on a one-off basis • National and regional initiatives to introduce • Retention: art. 122a req. • Align compensation of market adjusted by regulators • Credit risk retention can be reallocated between the quantitative reqs for originators/sponsors originators to retain at least 5% participants with performance over issuer of the secutisation and the originator of the • IOSCO “Unregulated Financial Markets and of net economic interest the life of the security underlying assets through a joint determination by the Products (FP)” Report: • Impact assessment by Dec 2009 • FDIC ANPR regarding safe harbor SEC and Federal banking agencies Issuer Incentives Issuer • Retain long-term economic exposure through for bank securitisations • New draft of language expected by early March retention

• IOSCO: “Unregulated FP” • CESR report recommends phased • SEC to increase transparency and • HR 4173 language • Requires the SEC to promulgate rules requiring issuers • Transparency through disclosure of verification approach for introduction of post- standardisation regarding loan level to perform due diligence of the underlying assets, and

& risk assurance practices; independence of trade price transparency for ABS • SEC to require robust reporting by reporting, representations disclose the methodology service providers issuing opinions, maintain CDOs issuers of asset backed securities and warranties, and other • Require disclosure of tranche, class, security, asset and current opinion reports • Disclosures: enhanced Pillar III • SEC to strengthen the regulation of requirements for asset loan data for all ABS • Regulatory support for disclosure improvement, disclosures for securitisation credit rating agencies; differentiate backed securities • Removes registration exemption for some mortgageloan investor suitability, development of tools for (CRD3) structured products sale transactions understanding complex products • Investors must increase due • Treasury proposes differentiated • IOSCO Good Practices Report: Investment diligence before investing and on ratings for SF Managers Due Diligence when Investing in SF an ongoing basis (CRD2) • SEC considering new revisions to Transparency Products ABS offering process, reporting and

Investor Confidence/ Investor • IOSCO developing global standards on ABS price disclosure transparency; disclosures and incentives including • FINRA proposal issued on TRACE retention reporting for ABS

• July 2009: BCBS issues final CRD standards to • Re-securitisation (CRD3): will • Regulatory capital changes due to raise cap requirements restrict investment in certain types FAS166/167 do not provide relief and • BIS consultation on re-securitisation capital of resecuritisations, to be defined, remove exemption for ABCP conduits treatment through much higher capital • December 2009 Basel proposal – potential impact charges to securitisation capital requirements • Re-securitisation: higher capital charges for these structures • Dynamic provisioning: first of

Regulatory CapitalRegulatory countercyclical measures (CRD4) • Leverage Ratios

• IOSCO: “Unregulated FP” • SEC revisions to money market fund • Consumer Financial • Consumer Financial Protection Agency – outlook • Assess scope of regulatory reach regulations including concentration Protection Agency unclear limits impact to money market ABS • Impact of derivatives • Impact of derivatives Other purchases and legislation on ABS issuers

Source: The Association for Financial Markets in Europe (AFME)

www.structuredcreditinvestor.com 11 Regulation

The G20 is trying to solve interna- “It is essential that further tional discrepancies under the auspices of its Financial Stability Board. The goal consultation occurs after the is for this board to serve as an umbrella organisation to unify accounting prin- cipals, as highlighted in a joint state- Basel Quantitative Impact Study ment from AFME, SIFMA and the Asia Securities Industry and Financial Markets (QIS) analysis is finished” Association (ASIFMA). But policymakers admit that some national initiatives such as, the Volcker Rule in the US (which is meant to limit if not altogether ban pro- the ECB’s proposals. The association said extensions for securitisations is a prime prietary trading at banks), are hindering that the approach to formalising reporting of example of the ‘waiting to see what G20 efforts. templates should be taken on an asset class- happens’ mode the market is in right by-asset class basis and that “each asset now, sources say. “The recent exten- What’s ahead? class must be appropriately defined and sion addresses investor concerns that Drevon says Moody’s believes that delineated from other asset classes in order on-balance sheet accounting treatment when it comes to securitisation, the US to avoid overlap between and in correct use for an issuer would affect a securitisa- and European markets will always be of the various reporting templates”. tion’s access to underlying collateral in somewhat separate in terms of the kinds On 10 March, AFME published a joint the event of default (by the issuer),” Long of deals, as well as the motivations and response to the UK FSA’s consultation explains. The FDIC said that the recent investors’ interest in them. “The only paper ‘Strengthening Capital Standards safe harbour extension “provides a transi- true global market in the credit realm is 3’. The joint response – from AFME, the tional period for adoption and implemen- credit derivatives, so that is where the British Bankers’ Association (BBA) and tation of final standards for securitisations different regulatory frameworks might ISDA – said the three trade associations initiated after 30 September 2010”. become an issue. Global issuers in the were very concerned about the timetable “Although these accounting changes consumer and commercial loan areas set out in the CRD draft. have profoundly affected the conditions for might prefer an international approach “It is essential that further consultation off-balance sheet treatment of securitisa- to disclosure standards, but I don’t occurs after the Basel Quantitative Impact tions, I don’t think they are going to kill the think regulatory fragmentation would Study (QIS) analysis is finished to ensure market. The credit crunch seems to have necessarily keep them from doing a that the right decisions are made and that encouraged faster progress on convergence securitisation.” the calibration and pace of any change is between US GAAP and IFRS, and that As Shire explains, new regulations are implemented in a manner that supports eventual convergence will be good for bound to change the type of products and market and economic recovery,” it stated. financial markets generally,” says Hawken. players making up securitisation mar- McIvor also explains that while the Hawken explains that a global kets moving forward. “In the short-term UK has typically taken a principle-based approach to reform makes perfect sense, we expect to see mainly sophisticated approach to financial regulation, the rest of as long as the rules create a level playing investors who were already investing in Europe has looked at it more quantitatively. field and make international transactions the structured finance markets, but then “We now appear to be moving towards a less costly. “That is why we have interna- some new players trying to accommodate more consistent European approach, which tional standards for bank capital require- the new risk/reward environment as well. is strongly welcomed by the market.” ments and increasing harmonisation of We expect more standardised, simplified But in the US regulatory proposals have financial relation within the EU.” structures that take into account local focused more on accounting than anything Still, he continues: “It can be very dif- constraints and specifics,” she adds. else. FAS 166 and 167 – which effectively ficult or even impossible to devise specific Long says that despite the regulatory increase banks’ regulatory capital require- regulations that make sense in different uncertainties, most of his clients remain ments – are already the rule there. countries’ financial and legal systems. optimistic about the next year. “Opportu- Players have argued for months now This is especially true for securitisation nities for securitisation continue to arise that this makes securitisation more expen- because it covers a wide range of financial because it is such an important aspect of sive to do, since any beneficial capital assets and types of transactions. Even for credit and for the stabilisation of the finan- treatment is lost. Further complicating this residential mortgages, which are more cial system as a whole. The securitisation is the fact that other institutions around standardised and more widely securitised of consumer assets is a prime example of the world are busy implementing new than other kinds of assets, between and how it helps get the banks lending again. International Accounting Standard (IAS) even within national markets there are Hopefully, national governments will regulations, including IAS39, which is different kinds of products and important implement the appropriate framework the rule for determining the fair value of differences in legal systems and market that allows for this to happen because the financial assets with fluctuating prices. customs. International regulation needs to requirements they impose on banks are The recent Federal Deposit Insur- be broad and flexible enough to allow for going to be crucial in getting the securiti- ance Corporation (FDIC) ‘safe harbour’ this variety.” sation market running again.”

12 SCI May 2010 ABS

All in the timing

Timing of exit for market support programmes is critical to both market recovery and supply and demand within the securitisation space. As Denise Bedell discovers, the ending of TALF and other market stabilisation programmes in the US could impact the market for some assets, but others are unlikely to be affected

he past two years have witnessed unprecedented As the first quarter of 2010 came to a close, few would argue market conditions, and the US government and poli- that providing the large liquidity backstops was the right thing to cymakers responded with a wealth of programmes do to ensure the financial soundness of the markets. The question aimed at helping to stabilise severely damaged now is when is it enough? At what point do the Fed and other asset-backed markets. The acronyms just pour off the agencies start to remove themselves from the private capital mar- Ttongue – from TALF to the GMPP to PPIP, and so on. kets and begin to reduce their balance sheets, and what impact However, 18 months later some of those programmes are now will that have? ending or winding down. That wind-down process will have a With parts of TALF and the GSE MBS purchase plan both significant impact on the markets and investors are watching having closed at the end of March, that question will be put closely to see what exactly that impact will be. to the test. The fact that there were no last-minute extensions

www.structuredcreditinvestor.com 13 ABS

Group – which emerged from Chapter “The asset-backed market 11 in December – student loan provider Sallie Mae and insurer Premium Finance and mortgage markets have Specialist. The $667.2m equipment lease- backed issue from CIT was its first launch since emerging from bankruptcy. The seen extensive dislocations deal was lead managed jointly by Bank of America Merrill Lynch, Barclays Capital and various government and Deutsche Bank. Sallie Mae launched a $1.55bn transac- tion through lead managers Barclays programmes were extremely Capital, Banc of America Securities and JPMorgan Chase, while Premium Finance useful in providing backstops” Specialists launched a $1.2bn insurance premium-backed bond through leads JPMorgan Chase and Citigroup. In all, the programme aided in the issuance of announced for the ABS and CMBS Geithner noted that there are still big $178bn in asset-backed transactions last market programmes that ended in March credit losses to come and the markets are year. is a signal of improved conditions in the particularly sensitive, as programmes – Warren Loui, partner at Mayer Brown, space – with liquidity returning to some such as TARP – wind down. Geithner says that the TALF helped stabilise the sectors of the market, the Fed is pulling said: “This creates a financial environ- market and reduce spreads to the point back and is less active than 12 months ment in which new shocks could have where many assets stopped requiring ago. However, it also creates a great deal an outsized effect – especially if an TALF money. In fact, according to data of uncertainty into what will happen to adequate financial stability reserve is not from Thomson Reuters, in March more those markets that have been supported maintained. As we wind down many of than two-thirds of the $21bn in auto, by such programmes. the government programmes launched credit card and student loans that hit the US Treasury Secretary Timothy initially to address the crisis, it is impera- market were issued without the benefit Geithner, in a letter in December to tive that we maintain this capacity to of TALF. “This is a sign of confidence in House Speaker Nancy Pelosi, outlined respond if financial conditions worsen the market and set the upper boundary of three areas with continued need for sup- and threaten our economy.” where spreads can go,” Loui adds. port – the housing market, bank liquidity Eventually all such programmes will Although clearly a success in return- and TALF for the ABS markets. He said: have to end and the market is adjusting to ing private liquidity to some ABS assets, “Beyond these limited new commitments, that potentiality. But there is nonetheless other parts of the market are as yet less we will not use remaining funds unless a lot of uncertainty in the short term over secure and could be significantly affected necessary to respond to an immediate and the impact it will have both on spreads by the ending of the programme. Says substantial threat to the economy stem- and on supply and demand characteristics Loui: “We would have liked to have seen ming from financial instability.” of the affected markets. Notes Andy Nybo it extended, but many asset classes now at Tabb Group: “The asset-backed market and mortgage markets have seen exten- sive dislocations and various government programmes were extremely useful in providing backstops. At some point the asset-backed market and mortgage mar- kets must stand on their own. That will come when there are realistic expecta- tions from investors in terms of what return they will receive and the credit- worthiness of assets.” He adds: “There needs to be a clearing rate that will attract investors back into the market.” The last round of TALF loans for all but CMBS went through with sales in the early March round totalling almost US$7bn. TALF will end for legacy CMBS in June. The biggest issuers in the March Andy Nybo, Tabb Group subscription were commercial lender CIT Warren Loui, Mayer Brown

14 SCI May 2010 ABS

“Other asset classes, such as private label MBS, or more specific structures, such as mortgage servicer advances or credit card issuance by retailers were relying more heavily on TALF”

Melina Hadiwono, SVB Asset Management Outside TALF, the ending of the GSE big spread widening as the GMPP ended. MBS purchase programme provokes less The changes give Fannie and Freddie as have spreads that are relatively close concern, coming as it does in the wake much as $300bn in additional portfolio to normal levels. However, there is a of extensions to government support space for MBS purchases throughout 2010. worry that some asset classes have not increases to Fannie Mae and Freddie Mac. completely recovered. For example, the The Treasury in December announced an Fed balance sheet reduction CMBS market still does not have access extension and changes to the Preferred One issue that has raised a great deal of to the liquidity that [it] had two or three Stock Purchase Agreements programme concern among investors is the timing of years ago. We would like to have seen it conditions to provide higher caps and Fed plans to reduce its balance sheet by extend a couple of more months to ensure increased available capital to the two selling off assets. Although clearly the we had returned to pre-credit levels.” agencies. goal is to eventually reduce the $2.26trn On the CMBS side, there has been This sent a clear signal to the mar- Fed balance sheet, when that would begin little new issuance – which gets back to ket that the agencies will continue to be and how it will be managed is of critical underlying fundamentals. There is still supported as long as necessary to ensure import to investors concerned about the a significant risk of delinquencies in the stability in the mortgage space. It was a impact of a potential flood of new assets underlying market and a large volume of welcome relief to investors, who feared a hitting the market. commercial real estate loans are set to mature over the next couple of years that will need to be refinanced. Melina Hadiwono, head of credit research at SVB Asset Management, adds: “Other asset classes, such as private label MBS, or more specific structures, such as mortgage servicer advances or credit card issuance by retailers were relying more heavily on TALF.” She says that it is these types of asset classes that will be most affected by the ending of the programme. Hadiwono continues: “With the expira- tion of TALF, issuance of these securi- ties won’t go away but the pricing will have to provide higher yields. It will be more challenging to issue, spreads will be wider and we will see smaller deals. It will be more expensive, depending on the nuances of the particular deal itself.” For such assets, private market liquidity will decrease as demand falls and investors expect more bang for their buck.

www.structuredcreditinvestor.com 15 ABS

Fed candidates will affect market view is any kind of perceived shift in monetary policy through different asset classes, rojecting expected monetary for big changes at the Fed. They will there is a quick reaction in the markets. policy changes is critical to be key to decisioning around when to The danger is that there is no transpar- Pdecision-making on securitisa- reduce or unwind market support built ency or formal plan or clear understand- tion market investment. Any hint from up over the past two years. ing of what will happen and when.” the Fed that rates are going to rise cre- The fear is that Fed chairman Ben This makes the market and investors ates a rapid price adjustment. With four Bernanke could face a more divided uncertain, and that is reflected in quick new members of the FOMC committee committee, making timing of exits that market corrections. If the Fed and other either already in place or coming soon, much more difficult to manage. From a liquidity providers could outline a clear, this could have a big impact on policy market perspective, this would translate measured plan or exit strategy to all of the going forward and investors are watch- into less clarity and greater ambiguity. steps they have taken to provide liquid- ing closely to see who is selected for With polarised views already on the ity, that would make the market more the committee. timing of balance sheet reduction, this comfortable and allow it to adjust in more Dan Tarullo was appointed to the could create even more uncertainty. measured step. FOMC by the Obama administration However, should the administration’s early last year – the first appointment first selection, Tarullo, be any indica- Delicate recovery by this administration. Now FOMC tor, then maintaining loose monetary Although programmes such as TALF vice-chair Don Kohn has announced his policy until full economic recovery is have clearly helped, US recovery is still in retirement and two other board slots achieved would seem to be the order a very delicate place, according to Loui. have also opened up, leaving the way of the day. “It would be nice to still have the security blanket that TALF provides. I know that the Fed and others believe it is not neces- In the FOMC committee meeting min- Although any such programmes would sary anymore and certainly within the utes from February committee members be slow to build and occur over a number prime auto and some other ABS sectors were split over when to start selling off of years, they could still have some effect we are seeing a number of transactions assets, with some members believing it on the supply-demand balance in the that don’t require borrowings under should start soon, while others felt that an securitisation markets, should they begin TALF, but I would have liked to see it asset sell-off programme should not begin in the near-term. However, realistically continue – particularly for more esoteric in the near-term. But Fed Chairman Ben any additional supply is likely to be stag- asset classes.” Bernanke affirmed the Fed’s position in gered significantly in order to minimise Meanwhile, other stabilising pro- March, outlining plans to reduce its bal- impact. grammes are still building up steam, ance sheet. Says Mike Kagawa, portfolio strategist according to Kagawa. “We have other The institution will use reverse repur- at asset manager Payden & Rygel: “I can programmes that are starting to help, but chasing agreements to sell securities to a understand from a supply and demand still have ways to go, such as the PPIP third party, with an agreement to repur- perspective that it could be a problem, programme.” chase them at a later date. In addition, it but in reality I don’t think policymakers He says that such programmes will plans to sell what are effectively certifi- would allow that to happen. It would be continue to be essential as long as cates of deposit to banks and financial too devastating.” underlying fundamentals continue to institutions – they pay a steady exchange Nonetheless, the lack of clarity on tim- decline. “The underlying collateral is still rate and the Fed accesses a piece of the ing is where the issue arises, as it creates residential mortgages and they are still FI’s reserves. uncertainty. Adds Nybo: “Whenever there declining in value, so until the underly- ing fundamentals are fixed we need that support. We still have some wood to chop there yet.” Timing of exit is critical to both “I can understand from a supply market and overall economic recovery, Kagawa adds. “The timing is really a function of how well the secondary mar- and demand perspective that kets are working and how much liquidity is being provided to those markets. In the it could be a problem, but in case of TALF, the markets are no longer as gridlocked as they were towards [the] reality I don’t think policymakers end of 2008. Secondary trading can and is being done.” Another important factor in maintain- would allow that to happen. It ing ABS market stability is timing of fiscal and monetary policy changes. Poli- would be too devastating” cymakers continue to be quite cautious,

16 SCI May 2010 ABS

“The risk is that because of the delicate point we are at in the economy, if we dip down towards double-dip recession, liquidity will dry up and people will not be able to raise capital for securitisation”

notes Kagawa. “If you listen to everything box office receipts, and also, for example, Securitisation is clearly an essential coming out of Bernanke and Paulson, they looking to trade survivor bonds. People tool for companies to raise capital. When are very cautiously optimistic. But it does are already looking at complex finan- developing new financial structures or not sound as if they are ready to change cial structures, so clearly there must be technologies, the basic fundamental the target Fed funds rate in the immediate more scrutiny to ensure that the same concepts become more complex and future, and the market itself is saying the excesses are not repeated. But I am a little sometimes existing models do not hold up same thing. The yield curve is so steep concerned about the number of changes as a result. Says the lawyer: “We do need that the market is saying that [the] bank coming along relatively quickly and the to have some oversight on what people are market is not healthy right now. We still time commitment it demands on all in the doing, but the pace of change of oversight have some work to do.” industry to read and understand how they does make for apprehension.” With high unemployment and worries make sense in [the] context of our day-to- Nybo adds that stabilisation of supply that this could lead to more delinquen- day activities.” and demand characteristics in the mar- cies or defaults in the mortgage space, Says Loui: “There are a number of kets will be a slow, drawn-out process. the government must maintain interest questions that people have raised over the He concludes: “The capital will come rates at artificially low levels to continue implementation of many new regula- back and be deployed in more liquid plain improvement of securitisation market tions. Have we thought through all of the vanilla assets over time. But you can’t recovery, notes Loui. “The risk is that implications and concerns in responding put a timeline on that. There are so many because of the delicate point we are at to regulatory requirements? Things are different moving parts that it is really in the economy, if we dip down towards happening quickly and it is hard for all of hard to project when these will come double-dip recession, liquidity will dry up us to be on top of everything going on.” together.” and people will not be able to raise capital for securitisation.” Although the discount rate was increased slightly in February – from 0.5% to 0.75% – Bernanke and other Fed officials were quick to assure that this was intended only to unwind emergency measures in place during the crisis and was not an indication that monetary policy was set to tighten in the short term. Fed officials said that rate rises would be months away, which Bernanke reaffirmed in March.

Pace of change Another big concern that is stifling market growth and investor demand is the pace of regulatory change and the fact that volume and magnitude of regulatory change is still on the upswing. There will be more scrutiny paid to securitisation markets and everyone accepts that. As one lawyer notes: “Excesses are still being seen today. People are talking about the futures markets and Hollywood

www.structuredcreditinvestor.com 17 ILS

The mortality segment of the insurance-linked securities market only saw one transaction in both 2008 and 2009. But, as Michael Marray discovers, a sizeable number of existing bonds are maturing this year and next, which – combined with increasing investor demand – should mean the pace of issuance will pick up Where there’s life…

ecuritisation in the life insurance segment has always But, following the demise of Lehman, ILS arrangers were lagged behind that for earthquake or hurricane risk, but quick to come up with new collateral solutions that investors new perils such as the H1N1 swine flu virus are forcing have found acceptable (see box for more). And, as pricing right reinsurers to reassess their potential exposure. Further, across the global fixed income markets tightened in from very demand for assets with low correlation to the equity and wide levels from spring 2009 onwards, a steady flow of natural Scredit markets is on the increase following the financial crisis, catastrophe bonds began to appear. in spite of the disappearance of the monoline insurers who had With pricing on the way down, it was major ILS player Swiss broadened the investor base by wrapping deals. Re that opted to reopen the mortality bond sector, with its $75m As with all asset classes right across the global financial fourth offering from the Vita Capital programme in late Novem- markets, pricing for insurance-linked securities (ILS) ballooned ber 2009. Vita Capital IV means that Swiss Re may receive up to after the collapse of Lehman Brothers in September 2008, as $75m in payments in the event of severe population mortality in some new investors exited the market and others stopped to the US and UK prior to the bond’s maturity in late 2014. reassess the exposure in their fixed income portfolios. ILS were S&P rated the Vita Capital IV notes double-B plus, which specifically impacted by the Lehman collapse, in that investors were privately placed globally under Rule 144A. The five-year who were looking for uncorrelated risk found that they were floating rate bonds were priced at 650bp over where collateral exposed to more credit risk than they thought, since the bank provider International Bank for Reconstruction and Development was an active player in the market as a counterparty on the total (IBRD) was borrowing at the time the deal was launched. return swaps (TRS) used to reduce market and credit risk for the As a sub-Libor borrower achieving spreads 33bp inside Libor, this collateral pool in ILS deals. translated into a spread of 617bp over six-month Libor. Swiss Re

18 SCI May 2010 ILS

Cap­ital Markets acted as sole manager and across the fixed income markets and bookrunner on the transaction. made the pricing on an investment grade mortality transaction uneconomical Strong diversification versus where reinsurers were taking in In its analysis of the transaction S&P noted the business on the incoming side. As that the underlying mortality risk exposure the credit crisis eased, the layer where it in terms of geographic location, age and made economic sense to hedge was on the gender shows strong diversification and below investment grade side, so Swiss Re that there is a low probability of default due as a sponsor decided, for the first time, to to the frequency and severity needed for an securitise below investment grade pure event to reach the index attachment point. mortality risks.” Indeed, as Judith Klugman, md at Swiss “We got a positive reception from Re Capital Markets in New York, explains: a global group of investors, including “Historically, what has been transferred on money managers and hedge funds,” con­ the mortality side is very remote mortality tinues Klugman. “Natural catastrophe bonds risk and thus almost all mortality bonds are usually below investment grade and have been investment grade.” there is a certain investor universe that is However, she adds: “During the financial attracted to that risk-return profile, and crisis, spreads widened out significantly since mortality bonds have historically Judith Klugman, Swiss Re Capital Markets

www.storminvestor.com 19 ILS

the RiskMarkets Group at RMS. “Relying “Previous mortality bonds were on an actuarial model that is inherently backward-looking would not have given actuarial and used a baseline investors the right picture of the potential risk associated with this type of bond.” The RMS model includes the probabil- mortality figure that was then ity of pandemics – including H1N1 and the probability of a new virus mutation stressed, but we tried to put the – and their likely impact based on a coun- try’s preparedness, number of vaccines on hand, likely public health system response H1N1 virus in a scientific context” and so on. “Previous mortality bonds were actuarial and used a baseline mortal- ity figure that was then stressed, but we tried to put the H1N1 virus in a scientific context,” says Stroughair. “The modelling been above investment grade they have $1.5bn bond programme that it had was favourabley received by the issuer built up a different investor base.” established to protect itself against large and by investors, and we believe that this “Because we went down the credit losses deriving from an exceptional rise type of approach will be used in future spectrum we did see some crossover buy- in mortality rates after major pandemics excess mortality bonds.” ers from the natural catastrophe investor or similar events across the US, Canada, While investors appear to be happy with base, some of whom valued the diversifi- England and Wales, and Germany. the modelling and structuring of mortality cation of mortality bonds versus their nat Munich Re said that it had structured deals, there are still hurdles to be over- cat or broader fixed income portfolios,” the programme so that Nathan may issue come. One factor could be the absence of she explains. future series of notes at short notice in the monoline insurers, which were playing Prior to Vita IV, the previous mortal- response to increased capacity demand a role in the mortality market in 2006 and ity deal had been in February 2008 for from Munich Re’s reinsurance clients. 2007, just as they were wrapping many Munich Re, which sold $100m worth of other forms of risk being transferred into principal at risk variable rate notes at a New model the capital markets via securitisation. tight pre-financial crisis spread of 135bp The mortality market experienced a shift For example, MBIA UK Insurance, over three-month Libor. The notes were between the launch of the Munich Re deal Financial Security Assurance and CIFG privately placed with investors across the in early 2008 and the Swiss Re deal in Europe all wrapped various tranches in Americas, Europe and Asia Pacific. late 2009, with the appearance of a new excess of $100m on the Vita Capital III The deal came under the brand of a new and unpredictable virus in the form of deal for Swiss Re back in early 2007, ILS issuance platform – Nathan. At the swine flu. This meant that the risk model- when $705m worth of bonds were sold time of its launch, Munich Re announced ling for Vita IV had to be approached in denominated in both dollars and euros. that it was the first deal in a potential a different way, especially given all the And CIFG Europe wrapped a €100m uncertainty surrounding H1N1. tranche on another Swiss Re deal, OSIRIS Typically, mortality models are back- Capital, which expired in January 2010. ward-looking, but the newest models are But after being hit by significant losses large simulations of what might happen in various risks that they did not seem to based on the latest scientific data. They fully understand – most notably in the CDO take excess mortality rates by looking market – the monolines have now disap- at pandemics over the past one hundred peared from the market. The early Vita years and then adjust them for develop- series were very large deals and so the lack ments, such as changes to public health of monoline support could be a factor in policies (which could include closing overall market capacity. However, wrapped schools, measures taken at airports and so deals remained a relatively small part of on) and the stockpiling of vaccines. overall volume and bankers suggest that Risk Management Solutions (RMS) mortality bond issuance will be able to move undertook the modelling of the poten- forward in 2010 and 2011 in sizeable volumes. tial for higher-than-expected mortality rates in the US and the UK. This was the Investor demand first time that a probabilistic catastrophe Natural catastrophe bonds and mortality model had been used versus simply rely- bonds can often access different investor ing upon historical data. bases, but there is quite a lot of crossover “This deal was coming into the market between the two groups of buyers. There at a time when there was a clear new risk is growing interest from big institutional John Stroughair, RMS out there,” says John Stroughair, head of investors in getting exposure to ILS and,

20 SCI May 2010 ILS

Collateral concerns

s noted in the main text, since Under a repo agreement, BNP Pari- the demise of Lehman Brothers, bas will buy back the assets as and when Acollateral solutions have become a needed for payments of interest and critical issue for both mortality and nat cat principal to note investors, or payments bonds. There are now a number of differ- to Hannover Re in the event of a catas- ent structures on offer in the market. trophe trigger event. An additional safety Prior to the Lehman collapse, inves- feature is the involvement of Euroclear to tors were comfortable with collateral monitor the assets, rather than investors backed by a total return swap (TRS) just leaving this task to BNP Paribas. from a highly rated counterparty. In an The Eurus II deal was arranged by era where the bankruptcy of an entity BNP Paribas and Aon Benfield Securi- such as Lehman seemed highly unlikely, ties, with Cadwalader, Wickersham & few investors paid much attention to the Taft acting as transaction counsel. This underlying collateral quality. repo structure has subsequently been Lehman was TRS counterparty on used on other nat cat bond deals. four live catastrophe bonds when it col- An alternative solution also brought lapsed and, even though the collateral to market under several deals is to utilise used in those deals was mainly of high a fund that only invests in US Treasuries quality, much of it was invested in long- as the collateral. However, returns are term bonds, which were hit particularly very low on such instruments, thereby hard as credit spreads ballooned in late- David Harrison, S&P increasing the cost of the transaction to 2008. There were no top-up mechanisms the sponsor. for posting additional collateral in any of “We have seen deals with tailored bonds “There are a number of different these deals, so the marked-to-market from Kreditanstalt für Wiederaufbau and collateral structures and for the Eurus II collateral was insufficient to cover all on the Vita Capital IV transaction the transaction a tri-partite repo structure future payments and the cat bonds collateral is in the form of notes issued was used with BNP Paribas, which limits were downgraded and, eventually, two by triple-A rated International Bank for counterparty exposure and has the defaulted – Ajax Re and Willow Re. Reconstruction and Development.” advan­tage of being able to generate Since ILS investors are often looking Another solution which will likely be greater returns for the transaction than for uncorrelated risk, this reminder of their repeated going forward in the mortal- more static collateral structures,” says exposure to credit risk was highly unwel- ity sector is the tri-party repo struc- Angus Duncan, partner at Cadwalader, come and caused the cat bond market to ture used in the July 2009 European Wickersham & Taft in London. “There stall for several months. A range of new windstorm deal for Hannover Re – Eurus is always some element of credit and structures were subsequently brought to II. This involves the Eurus SPV using counterparty risk in any of the collateral market to address investor concerns and the cash raised by the sale of the €75m structures, but here an independent were all well received. worth of notes to buy a portfolio of third party monitors the collateral on Now, the belief is that several will highly rated corporate and sovereign a daily basis, so any exposure to BNP be used going forward, rather than the bonds from BNP Paribas. Paribas is very limited.” market having to settle for one best solution as it had in the past. Equally, these structures will be interchangeable between mortality bonds and natural “The collapse of Lehman catastrophe bonds. “The collapse of Lehman Brothers Brothers highlighted issues highlighted issues with the type of collat- eral used within total return swaps and a number of solutions have been found with the type of collateral used to mitigate the reliance upon the TRS provider,” says David Harrison, credit within total return swaps and a analyst at S&P in London. “Investors do not want financial risk number of solutions have been – they just want the insurance risk – and they want to see very high quality col- lateral, such as tailored bonds, provided found to mitigate the reliance by a multilateral or supranational,” adds Stephen Hadfield, credit analyst at S&P. upon the TRS provider”

www.storminvestor.com 21 ILS

anticipate that at some point some of this risk will need to be passed on to capital “There is an expectation that the markets investors. Entire pension funds are also a target for specialised pension transfer of longevity risk will grow fund managers in M&A deals and, simi- larly, here there may be some scope for significantly, as there is a need deals, especially on the longevity side. “There is an expectation that the trans- fer of longevity risk will grow signifi- for governments, pension funds cantly, as there is a need for governments, pension funds and corporates to manage and corporates to manage their their exposure to longevity,” says Angus Duncan, partner at Cadwalader, Wick- exposure to longevity” ersham & Taft in London. “We see the transfer of longevity risk as potentially a significant market in the future and there are already moves to standardise derivative documentation, which will help given the level of expertise needed, this Future changes develop the OTC market for this product is often outsourced to specialised funds. For the future, one interesting area for the and to better enable the risk to be trans- Many institutional investors, such as life sector is the transfer of longevity risk ferred to capital markets investors.” pension funds, asset managers and hedge from corporate pension plans. Pension Regulatory changes also point to funds, are seeking exposure that is uncor- liabilities are increasing as people live greater transferring of life risk into the related to the broader financial markets. longer and corporations are being forced capital markets in the coming years. Some are also buying directly them- to tackle this issue. Under the new Solvency II framework, selves. For many of these big institutional Early in 2010 German auto manufac- the impact of risk transfer on the balance investors, taking a $10m piece of a bond turer BMW transferred some of the lon- sheet will no longer simply be based on is a small investment compared to what gevity risk in its pension liabilities, with the form of the instrument used but on its they are buying each month and, as the €3bn of its pension liabilities transferred. economic effect, as part of the so-called desire for assets that are not correlated to Abbey Life is stepping up to insure the ‘substance over form’ principle. equity and credit markets grows, more are longevity risk and has, in turn, passed Since cat bonds and mortality bonds likely to enter the market. some of this risk on to reinsurers, includ- are fully collateralised, generally with Thus the investor base seems to be ing Hannover Re, Partner Re and Pacific triple-A rated assets, lower capital in place for the mortality bond market Life Re. requirements will be in place versus using to bounce back and reinsurers have an The volume of longevity risk in global the retrocession mar­ket (where one rein- incentive to come to market with regular pension schemes is vast and analysts surer lays off risk with another reinsurer) offerings in order to build up an investor and where there is higher counterparty base and keep close relationships with risk, especially since a major event could them. There are a number of likely candi- hit all reinsurers at the same time. dates to offer new supply. But ILS issuance is always a trade- Swiss Re has issued over $2bn in mor- off between capital markets pricing and tality bonds over the past decade, including retrocession pricing, and a relative lack of the four Vita Capital bonds to date and Osi- insured catastrophes mean that reinsurers ris Capital, which expired in January 2010. are currently faring reasonably well. The And, as previously noted, the Munich Re last big nat cat event in the US market Nathan programme has so far only issued was Hurricane Katrina and swine flu $100m out of a potential $1.5bn. seems to not have been as deadly or infec- Back in 2006 AXA, the largest tious as had been thought, even though reinsurer in France, sold €345m worth it could yet mutate into something more of mortality bonds and is thought to be dangerous. likely to issue again. So might French Thus reinsurers are profitable and well reinsurer SCOR – though in September capitalised at present and are doing secu- of 2009 it continued on a different tack ritisation deals as much for diversification and added a new layer of protection to its and hedging reasons as for any great cost four-year mortality swap with JPMorgan, advantage. Hence, life risk transfer deals with a mixture of pandemic, terrorism are only expected to come at a trickle and natural disaster risk. The use of such – but that could change very quickly if private swap arrangements is an alterna- Angus Duncan, Cadwalader, there is a major event in any of the core tive to capital markets issuance. Wickersham & Taft reinsurance markets.

22 SCI May 2010 Wholesale Structured Products

Bertrand Delarue, of the global structuring group at BNP Paribas, argues that 2009 was a year of dislocations, but many opportunities still exist for 2010. So, institutional investors should look for alpha in the few remaining dislocations and dare to take macro views with price-efficient derivatives Trends and opportunities in equity markets

he turmoil in financial markets following the collapse Charts 1 and 2 of Lehman Brothers created significant distortions CDX and VIX return to pre-Lehman levels and relative value opportunities in all markets. Some of the distortions turned out to be golden opportuni- 300 CDX IG CDSI S9 5Y CORP ties for institutional investors, if they recognised 250 Tthem and acted quickly. The most obvious examples that resulted in substantial profits in the equity world were to be found in divi- 200 dends, long-term implied repos and convertible bonds. 150 In early 2010, the equity markets have largely normalised Equilibrium Line Lehman and we have witnessed a significant improvement in terms of 100 Brothers’ credit spreads and overall liquidity. We have mostly returned to collapse the conditions that prevailed prior to the Lehman crisis, and risk 50 Jun 08 Sep 08 Dec 08 Mar 09 Jul 09 Oct 09 appetite seems to have returned. Risk indicators such as CDS spreads and implied volatility, which are reflected in the CDX 90 VIX Index and VIX (the so called ‘fear index’, which measures the volatility 80 used to price options on the S&P 500), have returned to pre- 70 Lehman levels. 60 Although equity markets seem to be back to normal, there are a 50 few areas where dislocated parameters still exist. Investors who are 40 30 looking to generate alpha in the equity space in 2010 should choose 20 Equilibrium Line to either exploit the last remaining dislocations or make use of effi- 10 Lehman Brothers’ collapse cient derivatives to express ‘old fashioned’ directional views. 0 We will first illustrate the remaining dislocations with two Jun 08 Sep 08 Dec 08 Mar 09 Jul 09 Oct 09 Jan 10 examples: the implied repo on the Nikkei 225 index and the Source: BNP Paribas

www.structuredcreditinvestor.com 23 Wholesale Structured Products

Chart 3 buy a shorter-term total return swap against it (this spread trade is necessary to hedge Historical 5-year repo out the delta exposure to the underlying 0.6% stock index). A TRS is a contract between a buyer 0.4% and a seller, who periodically exchange 0.2% cash flows. The buyer receives what is called the equity amount and pays what is 0% called the floating amount: 2006 2007 2008 2009 2010 -0.2% Equity amount -0.4% Buyer Seller -0.6% Floating amount -0.8% EuroSTOXX 50 Nikkei 225 The equity amount reflects a long total -1% return index position profit/loss (includ- -1.2% ing price and dividend returns). The

Source: BNP Paribas Data from January 1st, 2006 to March 17th, 2010. Historical past performance should not be floating amount reflects the index position taken as an indication of future performance. cost-of-carry, quoted as a floating interest rate (typically Libor plus a fixed spread (set at swap inception)). The spread in the Chart 4 floating amount is the price of the total return swap and is commonly referred to Repo curve on NKY as the implied repo, since it is the main component of this spread. On forward contracts or TRS with short maturities, the level of implied repo Dislocation during Room for is very strongly linked to the physical the crisis improvement repo rate – i.e. it is linked to the demand for stock lending and borrowing. As such, it does not generally display dislocated Way to characteristics because the physical repo

Repo level normalisation market on stock indices is well arbitraged. On long maturities, however, the implied repo market is driven primarily by structured product dealers looking to risk- manage the costs and benefits of carrying stocks. Investors profit by taking exposure Years to a risk that structured product dealers

Current Mid 2009 Long term pre-crisis average often prefer to take off their books. This is where dislocations can be found. Source: BNP Paribas In early 2009, five-year-plus Euro­ STOXX 50 and Nikkei 225 implied repo rates collapsed to historically low, negative correlation between the components of stock into account. Like yields and bond levels. The sharp decline in long-term stock indices. We will then make the prices, repos and forward prices have implied repo was mostly a consequence case for potentially profitable directional an inverse relationship: the higher the of the sharp stock price declines some trades, with two more examples – divi- implied repo rate on a stock index, the months earlier, which led to a sharp spike dends and multi-asset options. lower the forward price for this stock in demand for long-term equity forwards index. from structured product issuers hedging Nikkei implied repo The most common way to get expo- their stock market exposure. Negative Implied repo is the remaining component sure to implied repo is to get exposure to levels on repos are extremely rare and are of an equity index forward’s price after the market price of forward contracts on roughly comparable to negative interest spot, interest rate and dividend risks have equity indices, and the most common way to rates: the stock owner is willing to lend been ‘stripped out’. Ultimately, the level achieve this is to trade total return swaps his inventory for a negative return. of implied repo reflects the supply and (TRS). For instance, to buy implied repo on Such a situation cannot last very long demand for forwards, taking the interest a given stock index, an investor would need and, as the stock indices rallied in the sec- rate cost and dividend benefit of holding to sell a long-term total return swap and ond half of 2009, demand for these long-

24 SCI May 2010 Wholesale Structured Products term forwards ebbed, especially on the Chart 5 EuroSTOXX 50 that has also experienced High valuations; lower valuations? reduced structured products issuance. On the Nikkei, however, there has been some 50 70% normalisation, but structured products P/E S&P 500 rolling 10y average (lhs) Rolling average or 1y US index realised correl (1bd lag) (rhs) issuance has remained strong. As a consequence, even though the 40 60% potential profits have decreased, oppor- tunities for dislocations in the long-term Nikkei implied repo market still exist. It 30 50% is important to insist on the role of struc- tured products in creating this disloca- tion: the other stock index for Japan – the 20 40% Topix index – is not used for structured products and its implied repo rates have not moved during the crisis. The opportu- 10 30% nity exists only on the Nikkei index. With the pricing conditions that prevailed at the end of February, it was 0 20% still possible for institutional investors to ’20 ’30 ’40 ’50 ’60 ’70 ’80 ’90 ’00 generate a positive return to the order of Source: BNPP Equity Derivative Strategies, Robert Schiller rolling p/e defined as ratio of current price to average 10 25% per annum because of a 0.50% price year trailing S&P 500 annual earnings. Note we use a Dow Jones Composite Correlation number. discrepancy between short-term and long- term implied repos. To earn this return, the investor would have to execute the TRS spread trade described earlier. As Chart 6 any market relying on structural imbal- S&P 500 and EuroSTOXX 50 dispersion correlation ances, the long-term repo market is best 70% suited for investors who can stomach S&P 500 6m ICD mark-to-market fluctuations. S&P 500 6m RCD EuroSTOXX 50 6m ICD EuroSTOXX 50 6m RCD Correlation 60% (Source: BNP Paribas equity derivatives strategy) Correlation is a measure of how, on average, two assets move in relation to 50% each other. If assets move on average in the same direction, correlation is positive and it can reach a maximum of one. But if assets move on average in different 40% directions, correlation is negative with a minimum of minus one. In the following we look at the correla- tion between individual stock returns for 30% the components of a given stock index. Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10

Equity valuations and correlation show Source: BNP Paribas Equity Derivatives Strategy. ICD = Implied Dispersion Correlation 1bd lag. RCD = Realised a broadly negative relationship. A pos- Dispersion Correlation 1bd lag sible driver is that when valuations look cheap, investment decisions are macro based, so investors are mostly shifting index and selling options on that stock correlation remained high as risk aversion broad equity allocations. High valuations, index in appropriate quantities calculated remained high. however, make investment decisions more by the bank involved, so that the client As risk tolerance returns, realised stock likely at the sector/stock level, reinforcing can effectively be selling correlation. This correlation can be expected to decline low correlations. strategy profits if realised correlation or remain low through much of 2010. There are several ways to trade among stocks is low, but loses if realised This process has already begun for the correlation; e.g. correlation swaps and correlation is high. S&P 500 but for EuroSTOXX 50 realised dispersion trades. For instance, disper- Demand for correlation was huge correlation is still high, hence there is sion trades involve buying options (i.e. throughout the crisis. In 2009, there were some dislocation as it is expected to fall, volatility) on the components of a stock still leftovers from the crisis and in line with S&P 500 realised correlation.

www.structuredcreditinvestor.com 25 Wholesale Structured Products

Chart 7 to buy correlation for retail products and over the years this has created large Harewood Euro Long-Dividends vs DJ EuroSTOXX 50 inventories of short correlation positions 190 at leading houses. DJ EuroSTOXX 50 As a result, there is a general appe- 180 Harewood Euro Long-Dividends tite among these houses to buy back 170 correlation from other sources, such as 160 institutional investors or hedge funds. +46.9% As a leading structured product house, 150 BNP Paribas is well placed to believe that 140 selling correlation will keep performing in 2010. 130

120 Macro-economic opportunities 110 The crisis has created dislocations in many markets, but as these have begun to 100 normalise, they have been replaced with 90 opportunities of another type: we can call Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 them ‘macro-economic’ opportunities. These opportunities are directly linked Harewood Euro Long-Dividends DJ EuroSTOXX 50 to the economic uncertainty that still lies Performance since launch +75.5% +28.6% ahead, with many questions unanswered, Annualised volatility 17.8% 22.8% and a lot of potential for volatility down the road. Source: Bloomberg, BNP Paribas Will inflation reappear? Will the Chinese bubble burst? Will the yields on government debt skyrocket? Chart 8 As investors’ views most likely differ on these issues, it is possible for them to Dividends outperformed all other asset classes express their views in new ways, using 150 150 very innovative and efficient derivatives. CRB Commodity Index Alpha will now be generated by a clever 140 EuroSTOXX 50 140 combination of the right view and the Exane Convertible Bond Index 130 SX5E Dividend Future 2011 130 right method to express it. German Treasury Bonds Index The return to favourable market condi- 120 120 tions has resulted in a growing appetite for innovative investment solutions to 110 110 help clients express their macro-economic 100 100 views. The two we will present are the following: dividends and multi-asset 90 90 options. 80 80

70 70 Dividends Before we talk about market opportuni- 60 60 ties, a short primer on the market for Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09 Nov 09 Jan 10 stock dividends is necessary. Many mar- Source: BNP Paribas, Bloomberg, Exane ket participants believe that the only way to receive a stream of dividends is to buy and hold the underlying stock. But in fact it has long been possible for sophisticated It is believed that selling dispersion implied volatilities to rise more than investors to buy the stream of dividend correlation on the top 50 names on the single stock implied volatilities), so dis- payments of a single stock (or for all the EuroSTOXX 50 and S&P 500 offer value persion correlation levels may regularly stocks in an index), without any exposure for investors and they should look for reach the sell zone. to the stock or the index itself. attractive entry points in the first half of In addition to currently elevated levels, This is done through dividend swaps, 2010, particularly after any equity sell- selling correlation generally benefits which like any swap involve the exchange offs. A steep correlation skew is expected from structural imbalances in the market, of cashflows between the buyer and the through 2010 (as markets fall, elevated created by structured products investors. seller. The buyer pays to the seller the index skew will likely cause index These investors are generally looking expected value of the dividends to be

26 SCI May 2010 Wholesale Structured Products detached and receives the actual divi- Chart 9 dends when they are paid. SX5E: EPS and dividend growth (%, fiscal year) There is absolutely no exposure to the price of the underlying stock. Dividend 400 60% swaps are quoted on many stock indices EPS and on individual large caps. 350 DPS For clients with no possibility or Payout ratio 55% willingness to trade swaps, there are also 300 futures on dividends for a few Euro- 250 pean indices, listed on Eurex. The most 50% actively traded are, by far, the Dow Jones EuroSTOXX 50 dividend futures. 200 Dividends have been the success story 45% of 2009. In the aftermath of the Lehman 150 bankruptcy, dividends were heavily sold off, reaching a nadir in March 2009. Since 100 40% this point, the rally has been as impres- sive as the correction had been brutal and 50 dividends have been the best-performing 0 35% asset class in 2009. 2004 2005 2006 2007 2008 2009 2010 2011 2012 Thanks to BNP Paribas’ market leadership in dividends – we have been Source: BNP Paribas, Exane, Facset consistently ranked number one in market share for futures – we were able to launch Chart 10 the first-ever UCITS III Fund (Harewood Euro Long Dividends, see Chart 7) in EuroSTOXX 50 long-term maturities – 4% LT growth

April 2009, allowing a broader base of 220 investors to access this fast-growing and Mid 2009 implied levels (at the time) undervalued asset class. 200 Current implied levels After the 2009 rally, dividends are not Base case 180 Realised levels as dislocated as they were in March 2009. 168 159 162 Nevertheless, there is still a discrepancy 160 155 147 149 144 between market levels (i.e. futures prices) 138 140 132 133 127 130 and fundamental analysts’ target levels. 124 122 123 125 119 121 116 117 This discrepancy plays out on two lev- 120 111 els: dividends are still cheap versus target 112 100 95 levels; and the implied growth rate for long- 85 81 82 81 82 83 84 76 78 78 79 80 term dividends is too low (i.e. the term 72 80 68 71 structure of dividend futures is too flat). 61 54 60 49 We propose two strategies to benefit from 46 this situation: outright directional dividend 40 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 exposure and ‘steepener’ structures.

Directional outright Bottom / up Top down approach The comparison between the implied Source: BNP Paribas Equity Derivatives Strategy levels of dividends in 2009 with the base-case scenario (as shown in Chart 10) clearly illustrates the huge disloca- tion that existed last year. As we can see, Despite the reduced upside (versus March dividend levels. It takes advantage of the a substantial discrepancy – between the 2009), many investors who played the divi- very low implied growth rate for divi- base-case scenario of fundamental ana- dend story in 2009 are choosing to stay in dends and will profit from any steepening lysts and current implied levels of divi- the game, with some rolling their positions of the implied dividends term structure. dends – remains, with potential upside of into longer maturities and others diversify- This is not a directional trade on divi- 8% to 10% in the short term (up to 2012) ing into different indices such as Nikkei. dends (it has no exposure to the absolute and up to 30% for longer maturities. To Another possibility for investors to dividend level) and can be seen as more of benefit from these discrepancies, inves- benefit from price discrepancies in the an ‘alpha’ trade than a directional expo- tors can simply buy dividend futures of dividend market is a steepener structure. sure to dividends. the maturity that best meets their return This product gives exposure to the differ- As an example, the current estimate for expectations. ence between long-term and short-term 2012 dividends is 133.4 and the estimate

www.structuredcreditinvestor.com 27 Wholesale Structured Products

Chart 11 ing clients and high net-worth investors looking for new structured investments, EuroSTOXX 50 dividend term structure (div. pts) through to institutions pursuing more effi- 180 cient management of their portfolio risks. BNP base case In the current environment, sophis- Current 160 ticated investors prefer investments that November 2009 are risk-controlled, so they favour options July 2009 140 March 2009 because the loss is limited to the upfront premium. But options are expensive and 120 hybrids can be a good way to control the cost. Investors with precise ‘macro’

100 views can use hybrids to buy tailor-made products for affordable prices. The example described below illus- 80 trates how hybrid products fit with clients’ complex views based on macro-economic 60 scenarios while using cross-asset correla- tion to reduce the option price. 40 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 A client has a bullish view on the EuroSTOXX 50 Index in one year’s time Source: BNP Paribas (see Chart 12) but is not willing to pay the premium of the vanilla at-the-money (ATM) call option. At the same time, he also has a bearish view on the euro-dollar exchange Chart 12 rate. A hybrid conditional call is the appro- EuroSTOXX 50 Index prediction priate solution to fit this overall macro- economic view and reduce the option price. Underlyings: SX5E Index, condition on EURUSD currency Maturity: 1 year Conclusion We have outlined a few investment ideas in Vanilla Payoff: SX5E ATM call option = Max( SX5E(1y)/SX5E(0) – 1 , 0 ) equity markets, using simple and transpar- Hybrid Payoff: SX5E ATM call conditional to the EURUSD being below ATM ent derivative transactions. Some of these at maturity (dollar strengthens) investment ideas rely on price dislocations, while others make use of efficient products If EURUSD(1y) < EURUSD(0): Hybrid Payoff = Max(SX5E(1y)/SX5E(0) – 1 , 0 ) to minimise the cost of a directional view. Otherwise Hybrid Payoff = 0 We wish to conclude with two observations. In the first place, there is no such thing Price as a ‘miracle’ product with guaranteed Hybrid Payoff 4.15% returns above government debt yields. If a Vanilla SX5E 7.50% transaction has an expected profit, it also has an expected risk and it is important that any investment decision be made with the full picture in mind. for 2017 dividends is 162.3 – for an esti- estate, hedge funds, commodity prices Second, despite all the criticism mated spread of 28.9 points, representing and inflation, along with equities. Bonds heaped on derivatives following the crisis, an implied growth of 4% per annum. In and equities are usually the primary it must not be forgotten that these instru- the market, the spread could be bought underlyings for hybrids. Returns are then ments are a powerful solution to manage recently for seven points – an indicative hedged, boosted or triggered through the risk, whether to hedge an investment level that would need to be updated for use of other asset classes. portfolio or to gain access to new markets any transaction. Of course, this trade Over the past few years, the behaviour in a risk-controlled way. We expect the depends on the actual realisation of divi- of equity markets has changed signifi- use of derivatives to monitor and control dends every year until 2017 and, as such, cantly: more volatile markets, unprec- risk will grow in the near future, espe- cannot be seen as a pure carry trade. edented bearish share price movements, cially after the market volatility investors shorter and stronger market cycles, and have just experienced. Multi-asset options unstable correlation between equities As their name implies, multi-asset or and other assets. As a result, demand for All prices quoted in this article and its ‘hybrid’ structures are derivatives based hybrids has been growing – from retail charts are March 2010 figures and are on multiple and distinct asset classes, clients eager to venture out of a pure therefore subject to change. such as interest rates, exchange rates, real equities/bonds portfolio or private bank-

28 SCI May 2010 CDS

Sovereign CDS are once again the chief focus of credit derivatives market participants. As Anna Carlisle and Mark Pelham report, interest in the sector is being driven not only by sovereign concerns, but also by trading ideas In the spotlight

overeign CDS have been around since the credit deriva- Greece’s financial crisis has created the current focus on tives market began and were at one point its most vis- sovereign CDS and dragged politicians into the debate. By ible sector before becoming ‘just another asset class’ in mid-March German chancellor Angela Merkel, French president the great credit boom. Now, they are once again at the Nicolas Sarkozy, Financial Stability Board head Mario Draghi forefront of the market’s attention. and EC president José Manuel Barroso had all called for a ban on SWith concerns rising about budget deficits and government speculative ‘naked’ sales of sovereign CDS. debt, sovereign CDS have become an increasingly important tool Against this backdrop, European commissioners held an for managing risk and expressing views, whether via bilateral ‘educational’ call with ISDA and CDS dealers to clarify some trades or based on the relatively new Markit iTraxx SovX indices aspects of the CDS market, including the concepts of gross and (see ‘Tradable indices’ box). At the same time, the sector is now net notional amounts. The EC is expected to announce further producing anomalies, such as sovereign CDS trading above cor- actions or enquiries into the market in the future, however. porate CDS (see ‘Company versus country’ box). Whether the politicians achieve their goal remains to be seen.

www.structuredcreditinvestor.com 29 CDS

Chart 1 of DTCC’s reports since the beginning of 2010 shows the net outstanding CDS posi- Greece 5 YearBond yield vs Euro CDS bps % tion on the Hellenic Republic has changed 450 5 little over the course of this year. The Greece CDS 5 Yr USD (LHS) net position for Greece was $8.7bn in the 400 5Y Greek yield over Bund (RHS) week of 1 January 2010 and has ranged 4 350 between $8.5bn and $9.2bn since then. Furthermore, the DTCC data indicates 300 the net position for Greece was $7.4bn a 3 year ago. None of the data suggests there 250 has been a surge of open interest in either

200 2009 or 2010.” 2 As for the impact of sovereign CDS 150 on the underlying Greek government bond market, ISDA argues: “The activity 100 1 and outstanding volumes in the Greek 50 CDS market need to be contrasted with the outstanding volumes in the Greek 0 0 government bond market, which exceeds 1 Aug 07 6 Feb 08 13 Aug 08 18 Feb 09 26 Aug 09 3 Mar 10 $400bn. None of the data can possibly Source: Fitch Solutions, Datastream lead to a conclusion that a market of $9bn can dictate prices in the $400bn govern- ment market. Chart 2 instrument transparency, outstanding Indeed, ISDA continues, if prices in sovereign CDS volumes and the possible the CDS market widened significantly Outstanding sovereign CDS impact of sovereign CDS on the underly- relative to the Greek government market, ing Greek government bond market as arbitrageurs and holders of Greek govern- Sovereign Reference Entity Net Notional key issues to be considered before any ment bonds would simply sell the bonds Republic of Italy $26bn judgement is made. and write protection in the form of the Kingdom of Spain $16bn “Critics of the CDS market assert that the sovereign CDS. The fact that government

Federal Republic of Germany $13bn market is complex and opaque. At the same bond and CDS spreads have remained time, the critics argue that, despite its com- essentially in line while outstanding posi- Federative Republic of Brazil $12bn plexity and opaqueness, the CDS market is tions have remained constant underlies Portuguese Republic $9bn liquid enough to influence markets of enor­ the association’s assertion that the CDS Republic of Austria $9bn mous size. ISDA believes this line of reas­ market has had little or no impact on the French Republic $9bn oning is flawed and inconsistent,” ISDA says. government market. ISDA believes that the most com- The trade association adds: “It is Hellenic Republic $9bn monly traded CDS, including sovereign important to understand that Greek CDS Source: ISDA, DTCC CDS, are simple and relatively liquid. At are useful for controlling risk for inves-

Data is of 27 February 2010. Net notional represents the the same time, the market for sovereign tors and lenders. Greek CDS provide maximum possible net funds transfer (excluding any CDS is much smaller than the underlying effective hedges not only for holders of recoveries) between net sellers of protection and net buyers of protection that could be required upon the market for government bonds. Greek government bonds, but also for occurrence of a reference entity credit event. international banks that extend credit to The industry uses net notional rather than gross notional Greek corporations and banks, for inves- as most contracts remain outstanding even as risk is Far from opaque offset. For example, if a client writes or buys protection It is also ISDA’s view that the CDS mar- tors in Greek stocks and for entities that through a CDS, the client will typically use a dealer and ket is far from opaque. The association have significant real estate or corporate the dealer making the price to the client will very often trade a CDS with another dealer to offset its position. argues that market participants and the holdings in Greece. For many of these This dealer, in turn, may lay off its position with another dealer. Thus the gross position increase but the actual general public have ready access to data participants, the sovereign CDS market risk is the amount of the original transaction. to evaluate market activity. is the most effective means of hedging The amount of outstanding CDS and credit risk in Greece.” weekly transaction activity for the 1,000 But credit strategists suggested that some largest names (including sovereign CDS) Misinterpreted activity form of regulation of sovereign CDS could are publicly available through the website Further, anecdotal evidence indicates that emerge at some point, as governments try of DTCC Trade Information Warehouse. banks with significant credit exposure to prevent the shorting of their debt. In addition, policymakers have access to to entities in Greece have been active Nevertheless, the International Swaps transaction level data to evaluate market purchasers of Greek sovereign CDS and Derivatives Association (ISDA) has activity. protection. Much of this activity could spoken out against any such plans. The On the subject of outstanding sovereign be misinterpreted as ‘naked’ CDS. ISDA trade association points to: market and CDS volumes, ISDA says: “Examination believes that this activity cannot have any

30 SCI May 2010 CDS significant impact on Greek government Company versus country prices because of its insignificant size in relation to the underlying government s the Greece crisis has evolved, it investor perception of the UK CDS as bond market. has become clear that sovereign riskier than BP’s is not attributable to Fitch Solutions finds agreement with ACDS have at times driven the economic fundamentals. But this also ISDA’s argument in a report the firm CDS market more broadly. As a result, highlights valid reasons why the CDS issued on 30 March 2010 – ‘Greece Sover- market participants have seen pricing market believes corporates might have eign CDS – A History of Myth and Real- anomalies emerge – most notably a lower risk premiums than for sover- ity’. “This evidence suggests economic disparity between corporate CDS and eigns; in other words, the risk premium fundamentals, rather than CDS market sovereign CDS levels. for BP – a global oil company – is more speculation, have been driving Greek In a report published in early Febru- closely linked to the price of oil than to government bond yields wider,” com- ary 2010, Fitch Solutions says that the health of the UK economy. ments Damiano Brigo, co-author of the despite the counterintuitive price levels, However, when undertaking a similar report and md at Fitch Solutions, London. there are valid reasons for corporate calculation for the bonds, the opposite The report observes that between CDS to be pricing at narrower spreads result occurred (75bp for the UK versus June to August 2009, Greece’s sovereign than sovereign CDS and, conversely, 123bp for BP) – showing that bond mar- CDS liquidity significantly diverged from for sovereign bond yields to be lower ket investor perception of the risk for the the broader developed market sovereign than corporate bond yields. The firm bonds on these entities is quite different liquidity trend and was accompanied by the uses the UK and Greece as two case from the risk premium perceived for beginning of a sustained market switch into study examples and shows that British the corresponding CDS. Evidence of US dollar- rather than euro-denominated Petroleum (BP) and Hellenic Telecom the divergence between the CDS and Greek sovereign CDS contracts. Further- both trade at significantly narrower CDS bond risk premium can be explained more, during this period, while Greek sov- spreads to the respective sovereign by the current low level of government ereign CDS liquidity was rising – reflecting CDS of UK and Greece. However, when bond yields partially due to the effects increased CDS market uncertainty on the assessing bond yields, it highlights of quantitative easing (QE), in conjunc- prospects for Greece’s economy – activity that there are valid reasons why the UK tion with the need for investors to hold in the cash bond market was driving Greek sovereign bond yield is lower than BP’s triple-A rated paper to be compliant government bond yields down and consen- bond yield – contradicting the CDS mar- with their investment mandates. sus CDS spreads narrower. ket – whereas the relationship between Moreover, the bulk of government “The surge in Greek sovereign CDS corporate and sovereign bond yields bond investors are not major players in liquidity last summer was likely caused by in Greece is in fact consistent with the the CDS market, which remains a more active CDS market investors who believed CDS market. specialised asset class. In essence, that lower Greek government bond yields In terms of the CDS market for the one way of looking at the CDS market were unsustainable and, furthermore, that UK, by calculating the risk premium is that it is characterised by a group of the euro would be impacted by any poten- for the UK sovereign and BP, Fitch investors who believe that the current tial widening of yields,” says Thomas Solutions found it is much higher for low level of UK government bond yields Aubrey, md at Fitch Solutions, London. the UK than for BP (135bp versus 74bp is not sustainable and will rise to attract Fitch Solutions’ analysis of consen- respectively). This confirms that CDS new investors once QE finishes. sus spreads on both euro and US dollar CDS contracts for Greek government bonds highlights a number of implica- tions for the USD/Euro FX rate. Since the end of January 2010, the USD/Euro FX “The surge in Greek sovereign rate devaluation following any poten- tial default of Greece has increased to CDS liquidity was likely caused approximately 10% versus a high of 5% in 2009 and a 2007-2008 average of well by active CDS market investors below 4%, reflecting heightened CDS market concerns about Greece’s impact on the euro in relation to the dollar. who believed that lower Greek

Broadly consistent government bond yields were Outside of the June to August 2009 period, the report notes that Greek sover- unsustainable and that the eign CDS liquidity has been broadly con- sistent with the overall increasing liquid- ity trend for developed market sovereigns euro would be impacted by any since the beginning of 2009 – even during January and February of this year – when potential widening of yields”

www.structuredcreditinvestor.com 31 CDS

Tradable indices

here are currently three tradable house the Friday prior to 30 days before will include the following constituents: purely sovereign CDS indices – the six-monthly roll date. Australia, China, Indonesia, Japan, Tthe long-standing Markit CDX.EM The constituent countries for the Korea, Malaysia, New Zealand, Philip- and the more recently launched Markit current iteration of the index, Series 2, pines, Thailand and Vietnam. More than iTraxx SovX Western European Index are: Austria, Belgium, Denmark, Finland, ten market makers, including interna- and Markit iTraxx SovX CEEMEA Index. France, Germany, Greece, Ireland, Italy, tional and local financial institutions, A fourth, the Markit iTraxx SovX Asia Netherlands, Norway, Portugal, Spain, are expected to provide liquidity for the Pacific index, is scheduled at the time Sweden and the UK. index. of writing to begin trading in early May The Western Europe Index was joined 2010. on 20 January 2010 by the Markit iTraxx Further possibilities CDX.EM currently references debt SovX CEEMEA Index, which is composed There are also two indices in the Markit from 15 sovereigns. These are: Argen- of the top 15 most liquid sovereign enti- iTraxx SovX family that are not yet tina, Brazil, Colombia, Hungary, Indo- ties from CEEMEA countries that trade on offered in the form of tradable indices, nesia, Malaysia, Mexico, Panama, Peru, emerging markets documentation. The but do currently have their theoretical South Africa, Philippines, Russian Fed- numbers of constituents is set at 15 from prices quoted. One is the Markit iTraxx eration, Turkey, Ukraine and Venezuela. the full universe of 26 CEEMEA countries, SovX Global Liquid Investment Grade The Markit SovX Western Europe but may be changed from time to time at Index, which is composed of a variable Series 2 index started trading on 28 an index roll upon reasonable notice. number of constituents based on the September 2009. It is composed of 15 The current iteration of the index, most liquid high grade global sovereign equally weighted sovereign constituents Series 3, references debt from the fol- entities. The other is the Markit iTraxx from an 18-name universe, comprising lowing countries: Abu Dhabi, Bulgaria, SovX G7 Index, which is an equally Eurozone countries that are traded on Croatia, Czech Republic, Hungary, Kaza- weighted index composed of constitu- Western European documentation plus khstan, Lithuania, Poland, Qatar, Roma- ents selected from the universe of the Denmark, Norway, Sweden and the UK. nia, Russian Federation, Saudi Arabia, G7 states. The current iteration of the The constituents are the 15 countries South Africa, Turkey and Ukraine. index, Series 2, references debt from with the largest net amount outstanding Meanwhile, the initial series of the France, Germany, Italy, Japan, the UK in the DTCC Trade Information Ware- Markit iTraxx SovX Asia Pacific index and the US.

Greek bond government bond yields and Credit Derivatives Research (CDR) chief February. The GRI represents seven of the CDS spreads widened dramatically. strategist Tim Backshall suggests that this largest sovereign debt issuers, including While focus has so far been on Greek is more of a systemic crisis in developed France, Germany, Italy, Japan, Spain, the sovereign risk and therefore its sovereign nations than most would like to believe. UK and the US. CDS, sovereign credit risk more broadly CDR’s Government Risk Index (GRI) “The dramatic rise in the market’s per- continued to surge throughout the remain- jumped by almost 40% in the month to 9 ception of credit risk among these ‘most’ der of March and into April. Indeed, April to 80bp – its highest level since 25 developed nations stands in dark contrast to the performance of the less developed nations of the world,” Backshall explains. Chart 3 “Emerging markets and CEEMEA The CDR Government Risk Index nations outperformed very notably in the last month as worries over the double- 110 whammy of higher rates and greater aus-

100 terity start to weigh on investor’s minds in deficit nations, whereas oil/commodity 90 price strength helped the less-developed (but often surplus) nations.” 80 At the same time, the week to 9 April 70 saw the average risk among the PIIGS (Por- tugal, Italy, Ireland, Greece, and Spain) 60 move to the widest-ever level relative to the average risk of the BRICs (Brazil, Russia, 50 India and China) and Greece now trading 40 wider than Dubai. Oil and gold’s strength in the face of a stronger dollar further rein- 30 force this tendency to perceive more devel- Apr 09 May 09 Jun 09 Jul 09 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 oped nations as facing considerably more Source: Credit Derivatives Research LLC prescient risks, Backshall concludes.

32 SCI May 2010 A selection of recent news published online from SCI & STORM

Job swaps Company and people moves from SCI issue 180, 14 April 2010

Permacap snaps up discounted assets Morgan Stanley’s European ABS strategy team was pre- viously led by Sarah Barton, who left the bank in 2008 for a Permacap European Equity Tranche Income (EETI) reports similar role at GLG Partners. that it has reinvested part of its cashflow by purchasing three A spokesperson for Morgan Stanley declined to comment rated ABS bonds for a total consideration of €700,000. The on Sankaran’s hire. average discount to the face value of the bonds is two-thirds and the expected undiscounted cashflow of these invest- ments is well in excess of three times the invested amount. ABS duo recruited These bonds are performing and paying contractual cou- pons, and are expected to mature within four to six years. Goldman Sachs is understood to have made two ABS hires The investments include Portuguese securitisations of in London. Rohit Sen, previously an ABS trader at Bank of prime residential mortgages and Spanish ABS, backed by a America Merrill Lynch, will take on a similar role at the bank. diversified pool of loans to SMEs and benefiting from com- Morten Pedersen joins Goldman’s European ABS team as a mercial and residential mortgages with low average LTVs. desk quant, having previously worked at UBS. EETI says it intends to continue to selectively reinvest part A spokesperson for Goldman Sachs declined to comment of its free cashflow in RMBS and ABS opportunities, as they on the hires. arise, capitalising on the ongoing dislocation of the European securitisation market. Credit derivatives salesman appointed

Illiquid assets platform enhances ABS trading Bank of America Merrill Lynch is understood to have hired Michael Poppel as head of structured bank sales for the SecondMarket says it has formally launched the first centralised EMEA region. It is thought that Poppel will be based in Lon- market for ABS, which will be run by the platform’s structured don, reporting to head of EMEA fixed income structured products team. The move comes off the back of significant inter- solutions sales Chris Gugelmann from May of this year. est expressed by the SecondMarket buyer and seller bases. Poppel is an executive director and credit derivatives Esoteric ABS – such as leased-back receivables, fran- sales/marketer at Goldman Sachs. chise loans, medical and heavy equipment leases, and man- ufactured housing – will trade on the platform, as well as the more common consumer assets. Hedge fund makes ABS hire “We have closely followed this market as pockets have remained largely illiquid and we believe our experience with Otaso Osayimwese has joined Ravenscourt Capital Partners, an array of structured products will allow us to seamlessly where he is understood to be working on the ABS desk. He integrate the broader set of ABS into our existing platform,” previously held roles at JC Rathbone and Lehman Brothers. says SecondMarket ceo Barry Silbert. “The introduction of David Sol, an ABS investor at Ravenscourt Capital, left this market was a natural progression in our effort to create a the firm last month. He has reportedly taken on a new role at global secondary platform for illiquid financial assets.” Standard Life in Edinburgh. SecondMarket has already completed a number of ABS transactions while examining the feasibility of fully launching a new market. “Over the past several months, we have seen DB tapped for credit sales co-head significant buy- and sell-side interest from our market partici- pants in a variety of securities across multiple sectors,” adds Bank of America Merrill Lynch has hired Gerry Walker to Elton Wells, head of structured products at SecondMarket. co-head Americas credit sales with Steve Hollender. As co- “The increased demand and completion of numerous ABS heads, Hollender and Walker will jointly manage investment deals prompted us to officially launch this new market.” grade, structured credit, leveraged and distressed sales in the Americas, reporting to Bryan Weadock, co-head of glo- bal fixed income, currencies and commodities sales. Bank rebuilds Euro ABS strategy Walker moves over from Deutsche Bank, where he worked for more than ten years in fixed income sales. He UBS’ European ABS strategist Srikanth Sankaran is understood was most recently head of US loans, high yield and dis- to be moving to Morgan Stanley to head up its ABS research tressed sales, and prior to that he was head of global loan team in Europe. In his new role, he will report to Vishwanath sales and trading. Previously he worked at JPMorgan in Tirupattur, global head of securitised product strategy. high yield sales.

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News analysis – from SCI

14 April 2010 five-year maturities. Previous Aria deals had three-, five- and CSO return? seven-year tranches. New deal eyed as more in the offing “When you compare that to the cash markets in securiti- A new CSO marketed by JPMorgan and managed by AXA sation, it’s hard to get short-term risk like that; that’s where Investment Managers, which has yet to get out of the starting the interest is from, on a risk taking perspective. If you take gate, is already receiving mixed reviews. When and if the deal three-year risk on this portfolio, it looks like it could be attrac- actually comes to fruition, it is, however, expected to receive tive for certain investors,” notes an asset manager. accolades for its brave attempt at bringing a new investment However, some think the price guidance on the deal could grade synthetic CDO while the credit crisis embers are still be too tight. The triple-A tranche is marketed at about 100bp smoking. over Euribor, while the double-A tranche is aiming at 200bp No size has yet been attached to the deal, called Aria IV, over Euribor, according to a trader. The A2 tranche is at as JPMorgan and AXA are still in the process of gauging 200/210bp for the five-year and the double A2 tranche is at demand. Participants familiar with the offering say JPMorgan 100bp for the five-year. has been shopping the deal mostly to European investors, Most of the tranches are structured at 7.5% for the first similar to the draw for its earlier series of Aria CSOs that attachment, going up to 14% or so. started in 2004. Aria’s mezzanine tranches could be a draw more than the The Aria deals, like Aria II via arranger and dealer JPMorgan, senior pieces. It’s becoming easier to sell to investors look- incorporated several multi-currency tranches, including euro, ing at triple-B, double-B and equity in this marketplace, adds yen and US dollars. More than 50% of the Aria portfolio con- a second trader, since those are the participants with the sists of euro-denominated tranches, says one structured cash as opposed to the higher rated credits. finance trader. As least one trader familiar with the deal says he could As one US-based trader explains, the transaction is a good see the offering actually price during the summer, similar to way for people to take a view on credit risk and get some the first Aria deal. The initial Aria, he says, had a hard time excess spread. “But the way the CSO market comes back, if it marketing when JPMorgan began shopping it in 2004. But, does, will look very different than it did before,” he says. after gauging interest over several stable months of market Indeed, any new CSO has some sizable shoes to fill. The activity, the deal priced during the summer. investor base – those still keeping at least one eye on this Regardless of how long this transaction takes to actually market, which all but collapsed during the credit crisis – is price, other dealers are believed to be waiting in the wings decidedly different than when the original Aria offerings were to launch similar deals. UBS, for one, was cited as already initiated. For one thing, investors are demanding higher attach- marketing a similar managed CSO offering with Prudential ment points per tranches, such as about 10%. They also want as manager. cleaner names in the portfolios and more diversification. Of the two deals, investors say AXA’s strong reputation JPMorgan and AXA are at least aiming to meet these new should prevail in getting the Aria deal done first. requirements in marketing the 100- to 200-name deal, but If both the JPMorgan and UBS CSOs go off successfully, the process has been slow. Investors are said to be inter- market participants say more banks will follow suit. “I sus- ested, but not enough orders have materialised just yet. As pect there will be more bank deals. A lot of CDS structurers one former CDO investor notes, JPMorgan could tranche are sitting around in banks looking for something to do,” says this deal for specific global investors with different trades for one CLO trader. different appetites. However, the offerings come as downgrades continue to European investors would be the natural audience for plague outstanding synthetic CDOs. Earlier this week, Fitch the Aria transaction, since many who have left the CDO/ downgraded 99 tranches of these securities globally that affect 87 CSO space years ago are slowly returning looking for yield. public ratings (see also separate News Round-up story). KFH Clients, particularly French, Asian and Middle Eastern inves- tors, have been inquiring from dealers lately how they can get back into structured credit – more so than US, British or 7 April 2010 Irish investors. Questions of principal Dealers have been filling that interest so far with partially Could US forbearance initiatives be replicated in funded synthetic deals that resemble synthetic corporates European MBS? and have underlying CDS. In some of the deals, the mezza- The non-agency mortgage principal forbearance initia- nine tranche is issued and then retained. tives currently underway in the US are being seen as useful JPMorgan’s transaction should appeal to some partici­ templates for stressed European residential mortgage mar- pants already active in the correlation space. The deal’s kets, such as Ireland and Spain. However, some believe that short-dated maturities are one of the selling features, since principal forgiveness will ultimately play a greater role in resolv- it includes senior and mezzanine tranches with three- and ing problems in the region’s commercial mortgage markets.

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News analysis – from SCI

“Both Ireland and Spain have witnessed mortgage debt The recent implementation of NAMA has brought some rescheduling initiatives of sorts in the past couple of years, clarity around stress in the Irish mortgage sector, with banks led mostly by lender delinquency management practices,” being forced to take write-downs and then be recapitalised. says Ganesh Rajendra, head of EMEA asset and mortgage- But it appears that Spanish banks, in contrast, are trying to backe d strate gy at RBS. “But e mploying a more compre he n- stretch their loss reporting out over a number of years. sive approach to loan modification seems to us like a logical Indeed, the Spanish government would rather merge next step in order to help ameliorate some of the stress in weaker banks together than force them into bankruptcy. the mortgage market, given the extent of mortgage debt “The process is being supported by a state-backed fund, but outstanding and the sharp decline in house prices in both it is still taking longer than expected. A bankruptcy doesn’t countries.” serve bank customers well, yet the uncertainty is discourag- He adds: “The idea of a bold and comprehensive loan ing investors from entering the market and slowing the coun- modification programme in Europe is only of course conjec- try’s recovery,” the investor notes. ture at present, but we wouldn’t rule it out over the next two He suggests that principal forgiveness is more likely to or three years, should the housing market recovery prove be implemented in the commercial real estate sector – at lacklustre – especially if the impact of the US programmes is the CMBS SPV or development company subsidiary level deemed economically beneficial.” – than in residential mortgages in Europe. “Investors would Overall arrears trends in many European RMBS markets rather reduce the debt and keep the borrower paying than be continue to stabilise or improve, but it is too early for this to left holding a property. Banks are doing their best to avoid have permeated through to loss rates or – in countries with becoming landlords on a wide scale.” long repossession times – late-stage delinquencies. As a case Furthermore, most investors are pleasantly surprised in point, S&P last week downgraded the class A3, B and C about how little litigation has occurred in the European CMBS notes of both the Celtic Residential Irish Mortgage 12 and 13 market. “It seems that investors prefer to see consensual deals due to more pessimistic WALS and WAFF assumptions, workouts and voluntary restructurings – for example, through driven by house price declines and deterioration in arrears. maturity extensions – for distressed CMBS. The majority of Asset-backed analysts at RBS note in a report that Ireland European deals are held by banks, which are reluctant to be has so far seen relatively few repossessions. “We remain con- associated with the publicity of a court case and certainly cerned that foreclosures, which have been delayed to some wouldn’t claim to have not understood the structure properly degree by lender forbearance and the relatively slow repos- from the outset,” the investor concludes. CS session process, could ultimately climb significantly and crys- tallise outsized losses in light of the collapse in house prices. A comprehensive loan modification initiative in Ireland could 31 March 2010 serve to either stave off or indeed accelerate – through debt Decisive action forgiveness – some of the pent-up loss risks,” they say. Market weighs consequences of Ambac restructuring Crucial details would obviously have to be worked out in ISDA has declared a bankruptcy credit event on Ambac terms of the sharing of any forbearance-based losses among Assurance Corporation (AAC) following a move by the mono- borrowers, lenders and investors – for instance, around how line to segregate its liabilities for structured finance transac- a securitisation structure should be compensated for the tions into a separate account. In doing so, Ambac joins a dilution in cashflow caused by principal forgiveness – before growing number of its once-rivals in splitting the profitable any proposal could be implemented. Such issues are still part of the business from the non-profitable. being thrashed out in the US, for example. It was at the direction of Ambac’s regulator – the Office of However, one ABS investor points out that any measure the Commissioner of Insurance of the State of Wisconsin (OCI) that isn’t voluntary will be extremely difficult to implement – that a segregated account for policies related to CDS, RMBS from a legal perspective, due to concerns about overriding and other structured finance transactions was established, with contract law. “Anything a lender does on a one-to-one basis the OCI believing immediate action was necessary to address with their customer is fine,” he explains. “Even the Bank of AAC’s financial position. Claims on these exposures will not be America forbearance programme in the US is voluntary – paid until a rehabilitation plan (see box) is approved. anything that isn’t will end up straight in the Supreme Court. Tim Brunne, senior credit strategist at UniCredit, sug- The US appears to be willing to go further than other juris- gests a bankruptcy credit event has been called rather than dictions with respect to loan modifications, but lenders still a restructuring or failure to pay credit event due to the nature aren’t being forced to forgive principal.” in which the assets were seized by the regulator – similar The investor adds that if forced principal forbearance was to the case of Fannie Mae and Freddie Mac last year. “It’s a realistic prospect, mezz RMBS tranches would typically be also a case of the CDS documentation having a very wide trading at zero in the secondary market, given that 10%-20% definition of what constitutes a bankruptcy,” he says. “The write-downs on positions could be expected. documentation has to contend with a lack of an international

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News analysis – from SCI bankruptcy law and certain jurisdictions will class asset sei- Although the company has the liquidity to make short-term zure as a bankruptcy event.” interest payments, it does not have the liquidity to pay down all The default is expected to trigger payouts on about its debt. “It is quite possible, therefore, that the company will US$33bn of CDS referencing the operating company. choose to preserve cash rather than make interest payments, Structured credit analysts at Barclays Capital note that Syn- even in the short term,” says BarCap. “Interest payments cora and FGIC had business models that were similar to AAC. In on the 7.5% 2023 bonds are due on 11 May 2010, with a 30-day both these cases, final CDS recovery was materially higher than grace period. Failure to make this payment would trigger holdco the internal market midpoint (IMM) and the levels at which the CDS contracts maturing on or after 20 June 2010.” cheapest-to-deliver bonds were trading prior to the auction. US Ambac-wrapped structured finance securities are “CDS markets are already anticipating this for Ambac, with expected to trade lower following the events; however, most opco CDS trading at 60-65 points, implying recoveries of European exposures are written through Ambac Assurance 30%-35% – 5%-10% higher than lower priced HELOC bonds UK (AUK), which is a separate legal entity. AUK last week are indicatively trading in the market,” the analysts note. cancelled its reinsurance agreement with AAC. AAC CDS is one of the most widely referenced credits “It seems that the implication of ‘all of AAC’s liability as in bespoke structured credit portfolios. Fitch estimates that reinsurer under certain reinsurance agreements’ being the credit event on Ambac will result in 32 corporate CSOs included in the segregated account was that this agreement tranches defaulting. was affected,” says Michael Cox, structured finance strategist “Ambac Assurance is a widely referenced name, present at Chalkhill Partners. “AUK will therefore retain the premiums in 58% of the 169 global Fitch-rated synthetic CDO trans- that would otherwise have been paid in respect of this rein- actions,” says Jeffery Cromartie, senior director and head surance, but will not be able to call on the resources of AAC of EMEA structured credit surveillance at the rating agency. to support European exposures.” “Therefore, Fitch expects to see negative rating pressure as AUK says it will remain able to meet all of its obligations well as principal impairments on exposed tranches rated as they fall due. “It therefore does not appear that a default triple-C and below.” or any form of regulatory action is likely in respect of this Any impairment is likely to result in a significant loss to entity and its controlling creditor status in transactions will a tranche. For example, relative to their respective refer- be retained,” adds Cox. ence portfolios many tranches are less than 1% thick (from He concludes: “While there is clearly significant uncer- attachment point to detachment point). tainty, the potential outcome of these actions for AAC is posi- As the initial credit enhancement is largely exhausted, tive in that it may emerge stronger and without the threat of any further portfolio losses are likely to completely impair an rehabilitation hanging over it. However, for those who relied on affected tranche. If a tranche is written down or experiences a the wrap most of all (those expecting some sort of payment, payment default, Fitch will downgrade the tranche to single-D. for example), we see it as likely to be a negative in itself.” AC The BarCap analysts suggest that bespoke exposure to AAC CDS is about as large as that for CIT (SCI passim). “Using the CIT auction as our guide, open interest to buy 24 March 2010 could be of the order of US$1bn, most of which would come Residual value from correlation desks,” they explain. “This would then have Non-performing CLO equity in demand to be netted against any open interest to sell bonds. It is diffi- CLO equity is in demand: fund managers are recording sub- cult to estimate the magnitude of the latter interest, although stantial increases in equity valuations, while traders report that in the past this has often been driven by bond-basis package residuals of certain deals are pricing as high as 70c or 80c on holders who have sold bonds into the auction.” the dollar. Investor attention is now being turned to non-per- BarCap notes that although all of these auctions have had forming equity in the anticipation that improving deal metrics large open interest to buy bonds, the final open interest has will result in the resumption of cashflows for those assets. been difficult to pin down because of a lack of clarity about Non-performing CLO equity prices in the US have jumped the net open interest to sell. In some cases, such as Syncora from 1c on the dollar to low-teens in a matter of months. and FGIC, there was a net open interest to buy bonds, which Meanwhile, performing deals are trading between 30c and pushed final recoveries above the IMM. In other cases, such 60c on the dollar, having been quoted at between 5c and as CIT, there was a net open interest to sell bonds, which 15c/20c twelve months ago. Some performing equity has caused final recovery to settle lower than the IMM. even been quoted as high as 70c or 80c, although this is Market participants are also anticipating a credit event on manager- and deal-specific. AAC’s parent company. According to Ambac’s statement, “The last cycle has shown the resilience of CLOs,” says the monoline “may consider a negotiated restructuring of its Gene Phillips, director at PF2 Securities Evaluations. “Equity debt through a prepackaged bankruptcy proceeding or may tranches trading above 40 is a good indication of this, partic- seek bankruptcy protection”. ularly taking into account that many of these tranches were

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News analysis – from SCI initially bought at a substantial discount to par and so have residual CLO investments this month. The February mark- had a positive IRR at their current values.” to-market valuation for the fund’s CLO equity investments Prop desks, credit opportunity funds with baskets for moved up 19.3% – this follows a 30.1% mark-to-market rise structured credit and hedge fund managers are all driving recorded a month earlier (SCI passim). demand for CLO equity tranches. Some of the smaller bou- “Trading levels are one thing. On the valuation side, it tique banks are also said to be entering this space. depends on who is valuing what,” says the investor. Hedge funds and distressed credit funds appear particu- He adds: “Some managers are being overly optimistic. In larly keen to buy non-performing CLO equity. One portfolio previous valuations some managers were pricing in one to two manager, for example, says he recently received an 8c bid years of cashflows, but now they are pricing some positions on a non-performing equity tranche that he had marked at with up to three or four years of cashflow. They are also being 0.6c on his books. very aggressive in terms of reinvestment assumptions.” “Many investors are looking into non-performing equity The investor also suggests that, in some cases, prices tranches with the view that metrics governing equity pay- being quoted for CLO equity are unjustified. “I agree that the ments will improve,” confirms Paul Roos, portfolio manager worst is over, but at the same time it’s not like everything was at Highland Capital. “A lot of those people holding the non- a bad dream – there’s still a lot of uncertainty in the market,” performing equity are, however, of the view that in a couple he says. “I also think there is very little differentiation in what of years the equity will start cash-flowing again and therefore some investors buy – some of the badly performing equity is don’t want to sell it at current levels. From a non-performing overpriced. Then again, if new primary issuance is only going equity perspective, there’s not enough supply.” to offer an 8% yield on the equity, it makes sense to look Jonathan Cohen, ceo of T2 Advisors, also confirms that at the secondary market where you can still pick up a deal CLO equity trading is now much more active with increased offering a 20% yield.” investor interest. “CLO equity as a secondary trading product Mahmud agrees: “There is nothing in this sector that is a fairly recent development,” he says. “It was originally matches the yield potential of CLO equity. Investors have designed as a hold-to-maturity product, but this has changed also woken up to the fundamental value that CLOs offer, pro- in the past year or so.” vided you have the ability to do the analysis.” AC He stresses that prices for CLO equity are highly deal- specific. “It depends on the cashflow characteristics of a deal, as well as where the deal is in terms of its reinvestment 17 March 2010 period,” he says. A new approach Cohen puts the trading range for CLO equity between 30c- Banks pin hopes on multi-borrower CMBS revival 60c on the dollar, with non-performing deals at the lower end Despite the few single-borrower CMBS offerings that graced of the range and performing, better quality names at the top the US market last November and December (SCI passim), the of the range. “When comparing today’s CLO equity prices new issue market is not yet considered open. But that could with where they were a year ago, the stats are somewhat all change if some multi-borrower or conduit deals begin to illusory. When these deals were indicated at very low prices, surface – which some say could occur as early as Q2. there were very few trades going through, so to say prices JPMorgan is widely expected to be preparing a conduit- have moved up ten-fold, for example, isn’t really justified.” type CMBS offering since its Commercial Mortgage Securi- European CLO equity has also been trading up in recent ties Corp updated a shelf registration earlier this month. The months, but generally not to the same extent as its US coun- bank has told investors that there are no further details avail- terparts. “The US market offers a lot more opportunity in able. It is not known whether the proposed deal would be terms of the depth of the loan market and the size of the TALF-eligible. CLO market more generally,” says Gibran Mahmud, portfolio The bank is one of two dealers that has been accumulating manager at Highland Capital. loans for the purpose of bringing a new deal, adds a CMBS A Europe-based CLO investor agrees that US CLOs have analyst. “That will be an important sign. Just getting the first the advantage over European deals, but comments that he restructurings done was huge, but the next thing would be to recently bought equity in European deals. “The main reason get a new issue conduit deal,” the analyst says. is because it was cheap: it was trading in the low-20s/30s In December, JPMorgan surfaced with a US$500m CMBS and it still had quite a bit of potential,” he says. “Having said offering backed by Inland Western Retail Real Estate Trust retail that, you have to be very selective. One of the main problems properties. Similarly, Bank of America also priced a US$460m with European deals is that most deals offer semi-annual CMBS deal backed by Fortress Investment Group property at payment. It’s a much bigger hit if one payment is missed that time. Both were not eligible for the TALF programme. compared to a quarterly deal.” However, Developers Diversified Realty (DDR) brought Volta Finance, Axa IM’s European permanent capital vehi- a US$400m TALF-eligible CMBS offering via Goldman last cle, recorded a second substantial rise in the valuation of its November.

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RBS, Goldman, Bank of America, Deutsche Bank and about currently is devoid of natural buyers for mezzanine paper. As three other non-bank issuers have also been cited as prep- the advisor puts it: “You need a sponsor to take that back ping conduit CMBS offerings, say investors. Bridger Commer- and keep it. That’s an issue that is sticky.” KFH cial Funding, for one, said last December it was resuming its CMBS loan origination platform (see SCI issue 165). The pending new issue transactions are to be split between 10 March 2010 100 smaller loans and those that have 10 or so larger loans, Primary flurry according to investors. The first deal is likely to be the larger New European ABS deals brought to market loan variety, notes an investment advisor. The primary European ABS market has seen a flurry of activ- The new deals, when and if they surface, would be quite ity over the past week. The pricing of Santander’s UK RMBS different than those initiated in 2006 and 2007, when offer- Fosse 2010-1 on 5 March was swiftly followed by announce- ings typically featured 100-200 individual loans in a pool. ments by VW Bank of a new auto ABS and by NIBC of a Conduit issuance in years past accounted for the majority of Dutch MBS XV transaction. CMBS issuance. Fosse 2010-1, the first UK RMBS to be issued since 2007 Yields are also expected to be more in sync with pre-credit without a put option, was upsized from £1bn to £1.4bn after crisis years than in recent years when issuers and investors good investor demand. The transaction was built through have grown too unrealistic on pricing, says the advisor. He traditional book-building and investor roadshows in the UK anticipates the deals to feature less than a 6% yield on the and Europe. In total, over 40 accounts across 12 countries senior pieces. participated in the transaction. The low LTVs on deals currently will also help keep prices Three triple-A tranches were issued: a £205m five-year tight, he adds. Instead of a pool whose cost was close to FRN, which priced at 120bp over three-month Libor; a €775m 100% LTV in the past, the new conduit deals should see five-year FRN, which priced at 120bp over; and a £525m LTVs in the 60% range. seven-year fixed-rate tranche that priced at 120bp over mid- A number of REITs, such as Simon Property, Vornado and swaps. The final price is some 20bp tighter than Europe’s others, also had talks with rating agencies and bankers over most recent RMBS issue, Silk Road (SCI passim). the feasibility of bringing CMBS offerings, say industry bank- “This deal represents a significant positive step for Euro- ers. But their ability to raise capital in the unsecured debt pean RMBS because, unlike competitor deals recently markets – and for some, in the equity markets – seemed to announced, the Fosse securitisation does not include an put a damper on those plans. investor put back to the sponsoring bank – making this a But, according to one investor, REITs collectively used true securitisation transaction,” says Antonio Lorenzo, cfo of bank lines and prefunded using unsecured debt. “So they Santander UK. are in a sense warehousing it today,” says the investor, who In this case, the lack of put option was mitigated by a cou- still expects to see more REIT deals on tap. pon step-up, which doubles the margin in case of non call. The Indeed, the inability to warehouse loans during the time it underlying mortgages were originated by Alliance & Leicester takes to get the deals done has been challenging for origina- and are representative of the overall mortgage portfolio. tors. CMBS market participants also suffered greatly from Volkswagen Bank’s new transaction – Driver Seven – is some of the hedges they had on their warehousing. also expected to see good investor take-up. The transaction “Hedging is really playing in more than one way,” says comprises a €457.5m triple-A rated tranche and a €17.5m Malay Bansal, md at NewOak Capital. “Cost needs to come single-A plus tranche, and is backed by auto loan receiva- down and leverage needs to go up for this market to get bles originated by Volkswagen Bank within Germany. The moving. Some way of hedging has to be there,” he notes. roadshow starts today (10 March) and ends on 16 March, Participants used to hedge using total return swaps, par- according to WestLB, which is arranging the deal. ticularly Lehman or BoA’s indices, but they are not applicable The transaction is static and will amortise from closing. anymore due to downgrades. Spreads on new deals created The provisional portfolio consists of 38,305 loans, with an from recent loans do not match the spreads on older legacy outstanding discounted principal balance of €500m and an bonds. Markit’s TRX.NA index, however, addresses some of average balance of €13,053 per loan. these concerns. NIBC, meanwhile, will test demand for Dutch RMBS with But, even without the perfect CMBS hedge, some issuers its new issue, Dutch MBS XV. This is a €750m prime RMBS may be motivated to get new deals done. According to the backed by Dutch residential mortgage loans originated or investment advisor, some will end up quoting the loans at a acquired by the subsidiaries of NIBC Bank. Ratings have wide enough spread whereby if the market moves against been assigned to six classes of notes ranging from triple-A them by 50bp or 100bp the deal is still worth doing. to double-B. According to one London-based ABS investor, Regardless of price, however, the junior or mezzanine a two-year and a five-year triple-A tranche is being publicly pieces of the offerings will still be a hard sell. The market offered. AC

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13 April 2010 GC bullish on cat bonds and ILWs GC Securities has published its latest quarterly review of ILW rates on the other hand. The combination of overcapac- the catastrophe bond and ILW markets, which also includes ity in the market, a benign 2009 US hurricane season and bullish predictions for the coming months. In the first quar- model change prompted year on year pricing down by 20% ter of 2010, two catastrophe bond transactions were com- for US hurricane only protection and in excess of 30% for US pleted, and US$300m of risk capital was issued, the report earthquake specific coverage. notes. Markets were mindful of current conditions and offered It continues: “As the insurance linked securities (ILS) asset reductions to secure renewal orders. Moreover, a number of class continues to increase in prominence (and additional opportunistic cedents bound protection with terms proving asset allocations are made to the space) issuance condi- always more appealing. tions continue to improve. For sponsors, this makes more However, GC adds: “Particularly in the second half of the compelling the argument for locking significant amounts of first quarter of 2010, ILW rates stabilised. Cedents’ appe- multi-year fixed price capacity. This is particularly relevant tites for absorbing catastrophe losses have shrunk following in the context of the catastrophe activity of the first quarter the recent earthquake in Chile so they have begun explor- which included a significant earthquake in Chile and Euro- ing additional cover for peak territories. As the US hurricane pean winter storm Xynthia.” season approaches, ILW market activity is likely to increase Consequently, GC believes the issuance outlook for the further.” second quarter of 2010 is positive, with between five and ten In the first quarter of 2010, all 2009 participating markets new transactions expected (covering a wide variety of perils). with the exception of IPC Re returned to the ILW space. It anticipates more activity later in the year, with total issu- However, with prices softening for much of the first quar- ance for the year ranging from US$3bn to US$5bn. ter it remained the rated carriers (rather than unrated hedge Further, it says: “In our updates throughout 2009, we funds, which typically must collateralize their obligations) frequently mentioned the need for catastrophe bond that provided the majority of ILW limits. MP spreads, in the aftermath of the credit crisis, to come back into rough approximation with the traditional market to spur further issuance. A great deal of progress has been made on 12 April 2010 this front, as spreads have come in better than 40% relative New Miu released to the first half of 2009. Risk Management Solutions’ (RMS) has released the latest Looking forward, GC suggests that while the rate of version of its insurance-linked securities (ILS) portfolio man- spread tightening may moderate, net cash inflows to sector, agement platform - Miu. RMS says new features include: and more than US$4bn of scheduled maturities (the majority allowing investors to quickly analyse the impact of multiple of which are expected to return cash into the hands of dedi- historical events on their portfolios for the first time; enhanced cated ILS funds) should continue to exert downward pres- reporting capabilities; the ability to more rigorously stress sure on spread levels. Sponsors have certainly taken note of test portfolios; and the provision of greater analytical insight this price tightening, particularly in the context of what will into underlying risks. likely prove to be the most costly first quarter (measured by Using the new functionality, RMS conducted a series of insured losses) on record. analyses that revealed that a modern-day repeat of the 1926 Importantly, the report says: “While the losses of the Great Miami Hurricane and the 1811 New Madrid Earthquake earthquake in Chile, European storm Xynthia and other in one year would cause almost 40% - or some US$4.7bn of catastrophe loss activity have created earnings strain for the total $12.4bn volume of bonds in the market - to trigger. reinsurers globally, neither event has put catastrophe bond Of this, US hurricane would account for the large majority, layers in meaningful jeopardy. Potentially, this could con- at around US$4.1bn, while for US earthquake it would be tribute to an environment where traditional rates stabilise or approximately US$2.3bn (with some bonds covering multi- decline more slowly, further enhancing relative pricing and ple peril regions). capacity available in the catastrophe bond market. Addition- “Although the likelihood of two major catastrophes like ally, the attractiveness of fully collateralised, multi-year fixed the Great Miami Hurricane and New Madrid Earthquake price capacity tends to increase in an environment where occurring in one year is minimal, investors want to assess significant catastrophe activity is at the forefront of protec- their worst-case scenarios and determine how a combina- tion buyers’ minds.” tion of events would impact the probability of a multi-year or In the industry loss warranty (ILW) space, GC reports that multi-peril bond attaching,” says John Stroughair, vp of buyers were drawn on the one hand, toward ILW alternatives, RiskMarkets, RMS’ dedicated ILS team. with upper normal limit retrocession capacity readily obtain- able and cat bond issuance vibrant, but attracted to falling

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12 April 2010 is mounting over a possible future cat bond as a longer-term BMS strengthens ILW capabilities structure continues to do the rounds. Reinsurance and risk solutions intermediary BMS has The three new deals are 2010 versions of previous transac- announced the appointment of Stefano Nicolini, as svp con- tions referencing US perils. Liberty Mutual’s Mystic Re 2010 centrating on industry loss warranty (ILW) business. He will follows on from last year’s US$225m quake and hurricane be based in New York. bond and is being brought by Aon Benfield; Guy Carpenter “As our reinsurance business is developing, it is a good is leading Parkton Re II for Swiss Re, which issued the first time for BMS to be strengthening its capabilities in ILWs and Parkton US$200m hurricane bond in 2009; and the annual we are delighted that Stefano has joined us to work with our Residential Re deal from USAA is also in the pipeline, but teams in London, Bermuda and the US. His track record in without a confirmed arranger as yet. In recent years the role this market stretches back over a decade and his experience has been taken by Goldman Sachs, but there are some who and expertise will enhance our product offering in this area” believe there may be a change of lead this year - possibly a comments Jonathan Morris, md of BMS Re. return to BNP Paribas. Nicolini previously worked for Guy Carpenter as North Further down the line there are whispers of a completely American ILW practice group leader developing new oppor- new transaction. There is some market speculation that AIG tunities in the ILW market. MP insurance/Chartis is mulling a new offering. Meanwhile, Catlin’s contingent capital deal Evergreen (STORM passim) is still being shown to investors. The trans- 12 April 2010 action is targeting US$100m to US$200m and thought to be PERILS releases Xynthia loss estimate looking for a pre-hurricane season close. PERILS, the company established to aggregate and provide No in-depth details, such as expected loss, have yet been industry-wide European catastrophe insurance data, has furnished to the broad array of investors being spoken with. today, 12 April, disclosed its initial loss estimate for Wind- Catlin had originally targeted non-specialist investors, given storm Xynthia, which occurred at the end of February 2010. the unfamiliarity of the structure to insurance buyers - thanks PERILS’ initial estimate of the property insurance market mainly to its contingent nature and consequent lack of a set loss for Xynthia is €1.28bn. maturity date. However, some ILS investors are believed to This loss estimate encompasses all nine countries cur- be interested and would be suitable buyers because Ever- rently covered by PERILS, with the main losses stemming green is offering pure insurance risk, which may prove too from France, Germany and Belgium. It is based on the ulti- big a challenge for some non-specialists. MP mate gross losses as reported by primary insurance com- panies, ie the total of paid, outstanding and incurred-but- not-reported claims, and excludes losses indemnified by the 8 April 2010 French CatNat government scheme. Cat bond perils analysed Eduard Held, head of products at PERILS, comments: Guy Carpenter Securities (GC) has analysed catastrophe “Xynthia is the second event for which we have calculated a bond issuance from 1997 through to 1 April 2010 on a peril loss estimate based on our standard methodology. It helps by peril basis. It finds that on a standalone basis, the two us to establish a track record which will increase market most frequently securitised perils are US hurricane, amount- participants’ support for PERILS and further improve our ing to US$7.08bn of cover and US earthquake at US$4.71bn. products.” Other perils securitised on a standalone basis include Euro- In January 2010, PERILS issued its final loss estimate for pean windstorm, Japanese earthquake and, to a lesser Windstorm Klaus at €1.57bn. This deviated less than 5% extent, Japanese typhoon. Multi-peril transactions, in which from the initial loss estimate produced six weeks after the the same dollar of risk principal is exposed to at least two or event proving the robustness of PERILS’ market loss esti- more perils accounts for 42% of total risk principal issued, mates, the firm says. GC says. In line with the PERILS reporting schedule, an updated “Insurance linked securities (ILS) investors typically prefer estimate of the Xynthia market loss will be published on 28 single-peril/single-zone transactions as they provide greater May 2010. MP ability to construct granular portfolios according to each investor’s risk preferences. ILS sponsors however, particu- larly large national and global writers with aggregate con- 9 April 2010 cerns across multiple perils and geographic zones, often More deals line up prefer to economize risk transfer spend by applying a single Catastrophe bond investors have been given headline details limit across different non-correlated perils, for example US of three new deals and expect to receive full information on hurricane and earthquake,” GC explains. MP them in the next week or so. At the same time, speculation

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Correlation concerns Charles Himmelberg, Alberto Gallo, Lotfi Karoui and Annie Chu of the credit strategy team at Goldman Sachs look at how the new Basel 2 rules could change the tranche business

egulators around the world are working to A potential return of CLOs would help match the demand for strengthen the resilience of the financial system. loan financing from companies with the increasing search for yield Among the areas under scrutiny is securitisation, from investors, a function very valuable in the current environment which has been both blamed for exacerbating the where bank capital is scarce. And in addition to this, CLO tranches crisis, but also “plays an important role in the still offer very good returns (Exhibit 1). Rintermediation of credit in the economy” – according to Brian By contrast, we are less optimistic on synthetic securitisation Sack, head of the markets group at the New York Fed in a recent activity. The proposed changes to Basel 2 are likely to increase capi- speech. Despite the normalisation in financial stress, securitisa- tal charges for CDS products, capping future growth in the market. tion remains frozen. Collateralised synthetic obligations (CSOs) became very popular We are mildly optimistic on a recovery in cash securitisations. in 2006 and 2007, after investor demand exhausted other plain- In particular, the extraordinary performance of loans and CLO vanilla sources of yield. Unlike cash products, where loans or bonds tranches in the secondary market, as well as the return of funding are tranched and sold to clients after issuance, synthetic products through total return swaps (TRS) could be early signs of a thaw. involve dealers selling protection on the CDS secondary market.

www.structuredcreditinvestor.com 33 CDS

Exhibit 1 This means CSO tranche payoff pro- files are highly customisable by senior- Assuming equal losses, cash securitisations handily beat synthetics ity, maturity and underlying portfolio. Table compares spreads available on AAA credit instruments (super-senior), alongside the But this flexibility comes at the cost of capital charges applied under Basel 2 increased hedging costs for dealers, who Capital Charge Max IRR have to risk-manage bespoke deals until Instrument Risk Weight (RW) Spread (bp) (8% of RW) (zero losses) maturity. As spreads widened and liquid- iTraxx AAA tranche 7% 0.6% 20 38% ity dried up during the crisis, CSO posi- CDX IG AAA tranche 7% 0.6% 25 47% tions became expensive or very difficult to hedge in the secondary market. 7% 0.6% 160 287% LCDX AAA tranche At the same time, deteriorating credit CLO AAA tranche 7% 0.6% 200 358% quality in underlying portfolios pushed US AAA MBS tranche ('05) 7% 0.6% 250 446% investors to unwind a large amount of these products. Following these events, Source: Goldman Sachs Credit Research rating agencies and regulators have turned more conservative on CSO products. Exhibit 2 The increased capital charges implied Increase in overall capital requirements from changes to Basel 2 by new rating agency models already Table reports summary statistics on the amount by which capital requirements will increase due weigh on synthetic securitisations and to new overall capital requirements for a sample of 43 banks across 10 countries new Basel 2 proposals would add to these charges. Over the past few months rating Share market risk Impact of agencies have introduced stricter criteria Equity for CSO tranches, resulting in multi- Stressed VaR IRC Re-sec Total specific risk notch downgrades (especially for the Mean 7.3% 4.6% 0.2% 6.2% 5.4% 11.5% ex-triple-As). Now, bank regulators plan

Median 3.9% 2.7% 0.1% 3.6% 0.1% 3.2% to increase the capital charges on these products, as well as the treatment of risk StDev 9.9% 5.4% 0.3% 9.5% 14.5% 18.3% in dealer’s correlation books, which risk- Min 0.3% 0.3% 0.0% -2.9% -5.2% -0.4% manage CSOs after issuance. Max 57.1% 29.1% 0.9% 40.8% 67.5% 85.0% We think the new Basel 2 standards are unlikely to cause a sudden, large-scale Source: BIS, Goldman Sachs Credit Strategy unwind of synthetic products. However, the steep costs of risk management, together Exhibit 3 with current tight valuations, will penalise Increase in market risk capital requirements from changes to Basel 2 senior and super-senior tranches and make it hard for synthetic issuance to recover. Table reports summary statistics on the amount by which capital requirements will increase due to new market risk requirements for a sample of 43 banks across 10 countries The lack of new issuance and poten- tial unwinds will increase the floor for Share market risk Impact of spreads above levels seen during past Equity Stressed VaR IRC Re-sec Total economic expansions. Our view of spread specific risk tightening in IG (50bp) and HY (150bp) Mean 7.3% 110.8% 4.9% 102.7% 92.7% 223.7% this year is consistent with this. Median 3.9% 63.2% 1.9% 60.4% 1.8% 102.0% The proposed changes to Basel 2, effective 31 December 2010, will increase StDev 9.9% 125.1% 6.7% 130.8% 205.5% 287.7% bank capital requirements on average by Min 0.3% 7.2% 0.1% -38.3% -65.0% -19.5% 11.5% overall and by 223.7% in the trading Max 57.1% 694.5% 19.9% 534.5% 904.2% 1112.8% book (see ‘Analysis of the trading book quantitative impact study’, BIS, October Source: BIS, Goldman Sachs Credit Strategy 2009). According to a BIS analysis based on 43 banks in 10 countries, the impact of new capital requirements will vary strongly “All securitised products, across banks (Exhibits 2 and 3). The dispersion is particularly high for including synthetic ones, may increases in the trading book, due to the new treatment of derivatives instruments. Given the large amounts of credit deriva- now have to use the ratings- tives outstanding, these increases have become a major concern for investors, based standard model” who are worried about a spill-over to the

34 SCI May 2010 CDS

“The new treatment of CSO tranches and credit derivatives hedges would make it hard for dealers to risk-manage their synthetic CDO exposure going forward. For banks, this would mean a much higher cost for running the CSO issuance business” broader credit market and about unwind only by hedging with nearly identical In some cases, we think the new charges risk. Below is a summary of the changes. instruments (same underlying portfolio, would make it uneconomical to hold maturity and seniority). The aggregate structured products on a bank’s book; for Banking book impact of each measure is shown in example, for re-securitisations (LSS or All securitised products, including Exhibit 3. CDO-squareds). synthetic ones, may now have to use the The new treatment of CSO tranches and The final impact of these capital ratings-based standard model. This means credit derivatives hedges would make it charges may be different if policymak- CSO tranches will be treated like assets hard for dealers to risk-manage their syn- ers and regulators change their proposed in the banking book and their risk weights thetic CDO exposure going forward. For actions. But the current proposal would will depend on ratings and seniority, banks, this would mean a much higher cost imply three direct consequences: senior rather than the economic risk of the posi- for running the CSO issuance business. tranches would probably widen going tion as determined by VaR models. The For investors it would mean higher forward; unwinds of bespoke portfolios risk weights for resecuritisations, such as bid-ask spreads and margins, resulting in which cannot be hedged efficiently would leveraged super-seniors (LSS) or CDO- lower IRRs compared to other products. probably spur widening in single names; squared products, will also increase by up to 200% (see Exhibit 4). For correlation products, the Basel Exhibit 4 Committee proposed that banks can also use an alternative risk-based approach, Specific risk weights on securitisations based on external credit ratings the Comprehensive Risk Measure (CRM). Table reports risk weights by rating bucket (capital charge is 8% of this risk weight). “Senior” This would apply to the correlation book refers to only the most senior tranche by rating (i.e., if there are multiple AAA tranches, it applies of banks involved in the CSO tranche busi- to the most senior). “Granular” refers to tranches for which the effective number of underlying exposures is 6 or more ness, at the discretion of local regulators. However, this result will be subject to External rating Securitisations Re-securitisations a minimum floor, fixed as a percentage of Granular Non-granular the charge that would be applied using the Senior Non-senior Senior Senior Non-senior ratings-based approach. While the floor AAA/A-1/P-1 7% 12% 20% 20% 30% has yet to be set, we think it is unlikely that the CRM will offer a large advantage AA 8% 15% 25% 25% 40% over the standard model. A+ 10% 18% 35% 35% 50%

A/A-2/P-2 12% 20% 40% 65% Trading book The proposed rules also introduce an A- 20% 35% 60% 100% additional ‘stressed VaR’ requirement, BBB+ 35% 50% 0% 100% 150% which refers to historical periods of high BBB/A-3/P-3 60% 75% 0% 150% 225% volatility and is thus stricter than current BBB- 100% 0% 0% 200% 350% requirements. They also increase the charges for ‘specific risk’; i.e., charges for BB+ 250% 0% 0% 300% 500% (non-securitised) trading book assets that BB 425% 0% 0% 500% 650% depend on each asset’s downgrade and BB- 650% 0% 0% 750% 850% default risk. Finally, trading desks will be able to Below BB-/A-3/P-3 Deduction offset capital charges on credit derivatives Source: Goldman Sachs Credit Research

www.structuredcreditinvestor.com 35 CDS

Exhibit 5 We think the risk of a sudden sell-off is limited, for the following reasons: Senior tranches hit most by new charges Showing the ratio of spreads over capital charges. The lower the ratio, the less attractive the 1. Banks have already unwound a large tranches compared to the charges. HY-rated tranches are generally not held by banks fraction of their liquid synthetic 4.5x tranche exposure. This is reflected by the high levels of risk premia we have 4.0x seen on synthetic tranches compared to other assets during the economic 3.5x recovery. 3.0x 2. Some dealers may prefer to hold these tranches on their books even at higher 2.5x capital charges, rather than sell and realise losses (since these losses could 2.0x be higher than the cost of the charges, 1.5x for low-liquidity bespoke products). This would seem more likely for 1.0x tranches with high subordination, which will likely recover par at 0.5x maturity. 0.0x 3. Given the fragile state of the markets, AAA AA A BBB BB B policymakers have an incentive to Source: Goldman Sachs Credit Strategy reduce headline risk and volatility. Hence, we expect policy changes would be phased in gradually. and European banks with high credit make it uneconomical for banks to hold That said, we still think synthetic derivatives exposure would be hit with these positions on their books (Exhibit 5). senior tranches will face lower demand. higher capital charges. We discuss them We estimate around US$330bn of In addition to this, the absence of syn- below. senior and super-senior tranche risk is thetic securitisation issuance, combined still in the market, based on Creditflux with potential unwinds, will increase the Heavyweight impact data. This number reflects the total floor on spread levels in CDS. Without We believe the new capital charges would notional issued over the 2006-2009 period institutional demand backed by leverage, weigh heaviest on senior (triple-A) CDS (US$550bn), assuming 40% has been spreads are unlikely to reach the lows of tranches. One of our major concerns for already unwound. 2006-2007 again. the re-start of synthetic issuance has been According to our rough estimates based the tight spreads and low ratings on senior on DTCC data, at least half of the remain- © 2010 The Goldman Sachs Group, and super-senior tranches. ing US$330bn probably sit on dealer books. Inc. All rights reserved. Ratings-based investors – the typical Thus, we estimate that at least US$165bn of This article is an extract from an buyer of this risk – have been reluctant risk-adjusted senior tranche notional would issue of ‘The Credit Line’ report – ‘The to come back in the market because of be affected. We exclude junior tranches new Basel II proposals: Implications for CDS markets’ – that first appeared on high volatility and low current valuations. from the analysis as their investor base is 26 February 2010. Now, proposed capital charges would much less sensitive to ratings.

36 SCI May 2010 Price Talk

Recent trading activity highlights in ABS, CLOs and ILS

Asset-backed securities trading patterns, with aggressive dealer bidding on BWICs, which saw an upward hike in prices. This trend was attributed to the Europe short supply of paper and the relative value of BWICs. March in the Euro ABS sector began quietly. The low volumes In the RMBS sector, the secondary market remained steady but resulted in wide price movements, as seen in Granite paper that quiet, as triple-A paper traded around the 90 level. New issuance traded in a range from 89-90 to 19-20 in the week to 2 March. showed positive signs as NIBC announced its new Dutch MBS deal. Alliance & Leicester’s Fosse deal – the first UK RMBS to be By the end of the month, both the NIBC deal and a new issued without a put option since 2007 – drew attention as mar- Volkswagen Driver transaction had proven to be well-received ket talk had it pricing at 110bp-120bp, significantly tighter than and many market participants were claiming a spring awakening Europe’s previous RMBS Silk Road that priced at 140bp and for the markets. widened on the break. Fosse was seen as good quality paper and The Driver deal ultimately printed tighter and proved more benefitting from its association with Alliance & Leicester’s par- popular than the Dutch RMBS, as auto deals were more of a rarity ent Santander, who made it clear that it would also be keeping its within the market at the time. In addition, traders pointed out that other UK subsidiary Abbey’s Holmes RMBS programme up and NIBC’s inability to call previous transactions during the financial running alongside Fosse. crisis may have contributed to its comparative lack of appeal rela- While market participants suggested that the two programmes tive to the Driver deal. were likely to become virtually indistinguishable over time, they did agree that at 110b-120bp the Fosse pricing seemed too tight and predicted that the deal would widen on the break as Silk Road did. The reception of the Fosse deal later in the month was highly favourable and the deal was consequently enhanced by 40% fol- “Granite triple-As bid lowing dealer feedback. Meanwhile, activity was sparked in credit card ABS by at 91.5 for euro and MBNA’s support of its master trust, which also improved market sentiment. Amid thin volumes, some credit card paper tightened sterling tranches, and by 100bp-120bp. This even reversed the existing pricing differ- ential between European and US cards, causing some European tranches of credit card paper to be bid better than US equivalents. the triple-Bs were in the Over the next two weeks to the middle of March, the MBS market remained quiet. The CMBS sector returned to pre-Greece range of a 41 bid”

www.structuredcreditinvestor.com 37 Price Talk

By 23 March, BWIC trading was seen to increase, particularly higher as bonds become rarer. Market chatter regarding new issu- within CMBS and non-conforming RMBS paper. However, trad- ance persisted through to mid-month. ing was based primarily on participants seeking favourable market Also, speculation regarding an expected new Spanish auto ABS position and was reportedly not due to any pressure to sell. Addi- deal from Volkswagen was mixed. While some traders raised con- tionally, the market moved away from the aggressive dealer bids cerns regarding the jurisdiction of the loans backing the deal, oth- and saw the introduction of increased client involvement, which ers pointed out that Spanish RMBS has performed well in the past was perceived by many to be a sign of growth. despite its jurisdiction, which boded well for auto transactions. By the end of March, the market saw a flurry of activity as Despite this, the Driver Espana One paper was expected to trade investors sought to not only prepare for month-end reviews but at 15bp-25bp wider than the comparable German paper. also for the end of the quarter. At this time, prime triple-As had tightened significantly, while in the mezzanine space room for fur- US ther tightening still existed. The forthcoming conclusion of the TALF programme saw spreads Granite triple-As bid at 91.5 for euro and sterling tranches, and come in over the first week of March. Most participants agreed that the triple-Bs were in the range of a 41 bid. BWIC activity remained the expiration of the programme was well-timed; however, traders strong towards the end of the month, with a return of dealers to maintained that what the CMBS market needs most is new issuance. the market. One trader suggested that the Federal Reserve should modify The European CMBS market also fared well towards month- the existing TALF programme in order to facilitate new issuance. end – the senior level remained stable and the mezzanine tranches Although new transactions were available at the time, the majority enjoyed increased popularity. However, the quality of the paper were found to be refinancing of old deals. remained the key factor in terms of trading levels, due to the lack Traders described early-March market activity as being bar- of new issuance in the market that drove participants to look lower belled – with both senior notes and equity trading well, while the down in the capital structure in order to grasp for yield. Notes mezzanine levels remaining softer. On-the-run generic CMBS that were thought likely to benefit from refinancing were particu- paper was reportedly trading at 300bp-500bp in early March, as larly popular and the driving force behind such market activity is investors responded to negative news regarding underlying real believed to have come from dealer bids. estate collateral valuations. By mid-April, news of what was seen at the time as the One trader estimated that it will take at least two years before improved situation in Greece helped market sentiment to become underlying collateral shows an improvement. However, he pointed overwhelmingly positive. The ABS sector was perceived as being out that market conditions are as expected and noted that given the relatively cheap compared to other sectors and thus enjoyed a circumstances the market is performing well. steady rally. Furthermore, Granite traded at its then-highest post- In the non-mortgage ABS space traders noted that prices and crisis level at around 93. activity remained relatively neutral throughout the expiration of Non-conforming RMBS and CMBS garnered particular atten- TALF as increased selling was met with demand. Prices dropped tion, having not experienced the same price compression as the only slightly, with single-As pricing in the 40s and triple-Bs in the rest of the market, therefore making it an attractive option for mid-30s. Although the retreat of dealers from the market might those who were looking for a higher yield. The demand came not have resulted in a more dramatic drop in prices, market partici- only from dealers, but also from real money accounts. pants observed that end accounts came into the market and helped Participants saw this as not only a positive sign of market to stabilise pricing levels. improvement, but also a development that might drive prices Traders noted that sufficient demand exists to support the emergence of new non-mortgage issuance. They pointed out that this is especially true, as newer deals would be of a higher quality due to the increased attention paid to the underlying fundamen- tals and performance data and would therefore garner even greater demand from investors. In the second half of March the CMBS market saw a dramatic tightening in spreads. The US CMBS benchmark deal GSMS 2007 tightened 125bp from its February levels and traded at 400bp, while richer paper traded at swaps plus 200bp. Tightening in the GG10 notes was believed to be due to inves- tors playing the momentum and banking on spreads compressing further. As a result, positive sentiment began to build within the top half of the capital structure. However, many investors voiced increasing concerns over the lower half of the capital stack, where losses are expected and write-downs likely over the next couple of years. The Riverton Apartments foreclosure was held as an example of these concerns. A trader pointed out that assumptions regarding the fundamentals hadn’t held true once the deal had been finalised and, as a result, it traded in foreclosure for US$120m, whereas the loan amount when it was written was originally US$225m.

38 SCI May 2010 Price Talk

Meanwhile, in the RMBS space, Bank of America’s announce- ment of a principal forbearance programme towards the end of March emerged as an influential factor in current and future trad- ing activity. Although investors believed that the implementation of this programme was inevitable, and perhaps even delayed, it was welcomed by the market as a positive step necessary for long-term growth in the sector. However, in the short-term trad- ers noted that second-lien HELOC collateral would most likely be negatively affected by the programme. In terms of new issuance, traders predicted that that a new securitisation would soon be brought to market. They noted that a back-and-forth discussion between rating agencies was already taking place. One trader noted that any potential new issuance would be very clean, and possibly include jumbo collateral and loans with a 55% LTV.

Structured credit European CLOs While most structured finance markets recovered from the Greek sovereign scare within the first weeks of March, the European In particular, US-originated transactions performed well in CLO market lagged behind. This lag was explained by one trader Europe. An investor observed that both Blackstone and Alcentra as being due to the time taken by accounts in reviewing deals prior deals were well-bid. Furthermore, Oakhill triple-Bs were in the to investing, noting that the CLO sector has a tendency to lag other very high-50s and came close to touching 60s. markets generally. Good reports regarding underlying collateral and a continued Another trader added that despite the slow-down in the pri- trend of improving OC ratios bolstered the market. The investor mary market, secondary market pricing levels remained resilient. pointed out that deals that had had their cashflow cut-off and had By mid-month, senior notes had backed off from the mid-200s to breached their OC tests came back in terms of performance. high-200s DM. Although the CLO sector showed positive growth gener- He explained that double-As had backed off from the mid- to ally, this was not the case for SME CLOs, where trading levels high-70s to high-60s or low-70s, while single-As had moved from remained low. This was explained as being due to pricing being high-60s to low-60s and triple-Bs from mid- to low-50s to mid- to very deal-specific in the segment. high-60s. However, double-Bs did not change much and remained High quality, granular transactions traded in the area of 150bp, in the 50s. while other transactions traded up to +1000bp. Due to this dispar- In terms of the underlying loan market, a CLO manager observed ity in pricing, new issuance was not considered a viable option that investors welcomed a deal from KKR’s Pets at Home. Accord- for banks. Traders pointed out that the spread differential between ing to the trader, although the loan pricing had flexed slightly, the senior bank paper or covered bonds and the gap between RMBS market was comfortable with it. He explained that he expected it and balance sheet CLO was still too large. to perform well in part because of the strong appetite in the market and the shortage of investment opportunities at the time. US CLOs A dealer pointed to the trading levels of another widely-refer- By mid-April, the US CLO market had showed a marked improve- enced loan – the triple-C rated Ineos loan – as another example of ment as both appetite and prices increased. A trader explained that increasing investor appetite. In February 2009 the Ineos loan had reached a low of 35, while the second lien traded at 10. By Febru- ary 2010, the senior loan had climbed to the low-90s and by mid- March it traded in the mid-90s. Although the dealer claimed at the “The CLO market time that it was an unsustainable level for a triple-C rated loan, it continued to tighten throughout March. The CLO market generally performed well throughout the generally performed month in terms of both pricing levels and underlying collateral. This was due, in part, to the increased presence of real money well throughout the accounts into the space and their heightened interest in the mez- zanine space. month in terms of Although trading levels did not quite reach the same level as January’s highs, the market did see single-As trading at high-50s and double-As at the mid-70s to high-70s. In addition, improved both pricing levels and performance in the underlying collateral contributed to improved market conditions. underlying collateral”

www.structuredcreditinvestor.com 39 Price Talk as CLOs reached new highs, investors began to return to the mar- ket with renewed positive sentiment. “Although traders In the month ending 14 April, triple-As traded in the 90s and double-As in the 80s. It was observed that particular interest was expected spreads to shown in the lower half of the stack as double-Bs enjoyed strong appetite and equity tranches experienced increased participation. The demand was described as being primarily based on the quality continue to tighten, of the paper, so as a result triple-A or double-A CLO paper was bid competitively. market participants Another factor that contributed to the improved tone of the mar- ket was the appearance of conservative money. A trader explained that it seemed that end accounts had come back into the market agreed that genuine with new allocations and an increased appetite. This resulted in a buy-and-hold pattern at the top of the capital structure, which may new issuance entering have helped to drive prices higher due to the decreasing supply available to other market participants. into the market remains However, despite the improved sentiment and performance, the market was still unable to support genuine new issuance. The Tempus CLO, as well as the Orix, Apollo and GSO Blackstone transactions a distant prospect” offered a glimmer of hope, but proved to be mainly refinanced deals. However, the traders observed that due to the demand for tri- ple-A paper Tempus was upsized slightly. Furthermore, traders multi-cat bonds dominated secondary trading over the first four explained that the GSO Blackstone deal had a similar focus on months of the year, amounting to over US$400m in Q110. leveraging the triple-A component. Traders reported about 50 trades on average occurring during Although traders expected spreads to continue to tighten, mar- both January and February and an increase to over 60 in March. ket participants agreed that genuine new issuance entering into The majority of trades were in 2008 and 2009 cat bonds, while the market remains a distant prospect. A trader noted that both none of 2010’s new deals traded in the secondary market. senior and subordinate tranches would need to tighten by quite a Market participants were specifically looking to exit one type few points relative to the underlying collateral for new issuance to of cat bond structure for another, such as selling an indemnity- be a viable option for issuers, and added that he did not expect to structure cat bond for a non-indemnity deal. Caelus Re, for one, see any for the foreseeable future. which is an indemnity deal, traded a few times in the first half of April, according to one trader. About US$10m in trades in this bond were offered in the first Insurance-linked securities couple of weeks of April. Transactions were in the high $99 dollar price; with spreads seen just above 625bp. Caelus Re was launched Catastrophe bonds in June of 2008, with a spread of 625bp over three-month Libor. An active new issue queue of catastrophe bonds expected over Q2 S p r e a d s o n a v e r a g e t i g h t e n e d b y a b o u t 9 0 b p f r o m y e a r - e n d D e c e m - and Q3 prompted insurance-linked securities (ILS) investors to ber 2009 through to the end of Q1, but cat bonds carrying the high- dump their older positions and free up cash during Q1 and early est coupons were the prime targets of trades. Coupons higher than April 2010. US hurricane, earthquake and non-peak diversified 8 0 0 b p o r s o, e ve n t h o u g h t h e y m ay h ave n a r r owe d f r o m a s h ig h a s t h e 1400bp level, garnered the most interest because most traded sol- idly above par. There were exceptions to this rule, however, with many Japanese earthquake bonds not dealing as much in the sec- ondary market. A lot of volume in the first half of April occurred in short- dated bonds maturing in the beginning of the wind season. Cat bond investors were looking to pick up extra yield over a couple of months and actively traded Residential Re’s 2007 cat bonds, for example, which were seen trading at the 300bp-400bp level. Those bonds maturing over the next four months, in particular, also traded strongly because investors were looking to raise cash for expected new issues. Assurant’s Ibis Re wind offering, for one, traded ahead of the issuer closing a new US$100m Ibis Re II deal. The 2009-1 class B notes had a high coupon of 1425bp at issu- ance, but since tightened to the high 800bp area, trading well over par at $111. Nevertheless, investors said they would still be keen to buy seasoned cat bonds from an issuer due to launch a new deal instead of the new issue, if they believed they may not get their full allocations for the new bond.

40 SCI May 2010 Data

ABS issued in January 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market 29/01/10 Permanent 2010-1 1A $1,000.0 +115bp 2.95 Aaa/AAA/AAA BAML, JPM, Bank of Scotland RMBS UK 2A1 £200.00 +130bp 5.19 Aaa/AAA/AAA Lloyds TSB 2A2 €750.00 +125bp 5.19 Aaa/AAA/AAA 3A £600.00 +125bp 6.95 Aaa/AAA/AAA 4A £400.00 +130bp 6.95 Aaa/AAA/AAA Ford Credit Auto Lease Trust A1 $624.68 2 0.29 P-1/A-1+/NR BAS/CAL/CITG Auto Leases US A2 $770.02 60 0.88 Aaa/AAA/NR A3 $120.00 85 1.41 Aaa/AAA/NR Ford Credit Floorplan Master O 2010-2 A $220.50 180 5.03 Aaa/AAA/NR/AAA CS Floorplan US B $6.21 240 5.03 Aa2/AA/NR/AA C $23.29 300 5.03 A2/A/NR/A 28/01/10 Goldfish Master Issuer BV 2010-1 A1 €29.00 5.21% 1.83 NA/NA/AAA Fortis Fortis RMBS Euro A2 €70.40 +13bp 2.30 NA/NA/AAA A3 €50.00 +16bp 6.83 NA/NA/AAA A4 €3,575.00 +60bp 1.58 NA/NA/AAA B €157.10 +100bp 1.58 NA/NA/AA- C €371.00 +200bp 1.58 NA/NA/A+ Progress 2010 - 1 Trust A A$ 500.0 NA/AAA/NA RMBS Australia AB A$ 30.5 NA/AAA/NA B A$ 13.0 NA/AA-/NA 27/01/10 Gosforth Funding No.1 plc A1 £500.00 +7bp 0.73 Aaa/AAA/NA BARC Northern Rock RMBS UK A2 £500.00 +9bp 2.25 Aaa/AAA/NA A3 £500.00 +11bp 4.32 Aaa/AAA/NA A4 £500.00 +13bp 7.84 Aaa/AAA/NA Z £173.90 +90bp 10.40 NR/NR/NA Nissan Master Owner Trust Rec 2010-A A $900.00 115 2.93 Aaa/AAA/NR RBS/BAS/BCG Floorplan US Discover Card Master Trust 2010-A1 A1 $750.00 65 3.11 Aaa/AAA/AAA BAS/CS BCG,D Credit cards US 25/01/10 Bavarian Sky SA Compartment 2 A €742.00 1.88 NA/AAA/AAA SG-CIB, WestLB BMW Auto Loans Euro B €58.00 3.17 NA/A/A 22/01/10 Bank of America Auto Trust 2010-1 A1 $527.90 0 0.29 P-1/A-1+/F-1+ BCG,CITG BAS Auto Prime US A2 $308.00 25 0.99 Aaa/AAA/AAA A3 $ 507.00 25 1.99 Aaa/AAA/AAA A4 $153.77 35 3.19 Aaa/AAA/AAA Volkswagen Auto Loan Enhance 2010-1 A1 $345.00 -2 0.34 P-1/A-1+/NR BOA,B RBS/DB Auto Prime US A2 $ 297.00 17 0.99 Aaa/AAA/NR A3 $488.00 22 1.95 Aaa/AAA/NR A4 $248.80 32 3.22 Aaa/AAA/NR 21/01/10 VCL Master SA Compartment 2010-1 €103.50 +100bp 1.90 NA/AAA/AAA VW Leasing HSBC Auto Loans Euro 2010-2 €69.00 +100bp 1.90 NA/AAA/AAA 2010-3 €69.00 +100bp 1.90 NA/AAA/AAA 2010-4 €103.50 +100bp 1.90 NA/AAA/AAA World Omni Auto Receivables Trust 2010-A A1 $249.00 -3 0.29 P-1/A-1+/NR BCG/DB BAS,J Auto Prime US A2 $197.00 22 0.95 Aaa/AAA/NR A3 $241.00 25 1.90 Aaa/AAA/NR A4 $198.11 35 3.21 Aaa/AAA/NR 19/01/10 Silver Arrow SA Compartment 3 A €1,599.60 2.35% 1.20 NA/NA/AAA Mercedes-Benz Mercedes-Benz Auto Loans Euro B €100.40 5.00% 2.75 NA/NA/BBB Bank Bank 15/01/10 Stichting Orange Lion III RMBS A1 €4,500.00 +150bp 4.00 NA/NA/AAA ING ING RMBS Euro A2 €4,500.00 +160bp 5.10 NA/NA/AAA A3 €6,500.00 +170bp 5.11 NA/NA/AAA A4 €6,374.20 +180bp 5.12 NA/NA/AAA B €3,920.90 +300bp 5.13 NA/NA/NR 14/01/10 E-MAC DE 2009-1 A1 €178.00 300 3.25 NR/AAA/NR DB RMBS Euro A2 €28.00 7.50 NR/BBB/NR B €158.00 11/01/10 MS Resecuritization Trust 2010-F A $255.40 145 1.41 Aaa/AAA/NR MS Floorplan US 07/01/10 Ford Credit Floorplan Master Own 2010-1 A $1,250.00 165 2.93 Aaa/AAA/NR RBS/BOA/CITG/ Floorplan US B $91.91 225 2.93 Aa2/AA/NR C $137.87 250 2.93 A2/A/NR

For the latest tables please go to the SCI website

www.structuredcreditinvestor.com 41 Data

ABS issued in February 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market 25/02/10 MMCA Auto Owner Trust 2010-A A1 $48.00 0 0.35 P-1/A-1+/NR WF BCG Auto Prime US A2 $29.00 30 0.95 Aaa/AAA/NR A3 $78.00 35 1.95 Aaa/AAA/NR A4 $41.30 52 3.37 Aaa/AAA/NR B $10.96 125 3.86 A2/AA-/NR C $4.70 275 3.86 Baa2/A/NR 22/02/10 Nepri Finance Srl A €310.20 +40bp 4.76 NA/AAA/NA Banca Mediocredito Banca Mediocredito CMBS Euro B €178.10 NA NA/NR/NA 21/02/10 Series 2010-1 Harvey Trust A1 A$470.0 NA/AAA/NA Credit Union Australia RMBS Australia A2 A$20.0 NA/AAA/NA B A$10.0 NA/AA-/NA 18/02/10 Honda Auto Receivables Owner 2010-1 A1 $399.99 -2 0.35 P-1/A-1+/NR RBS/DB BNP, JPM Auto Prime US A2 $298.60 12 0.95 Aaa/AAA/NR A3 $ 507.11 15 1.90 Aaa/AAA/NR A4 $154.81 20 3.00 Aaa/AAA/NR 17/02/10 Nelnet Student Loan Trust 2010-1 A $523.27 80 4.82 Aaa/AAA/AAA CS, JPM, MS GS StLns - Cons US USAA Auto Owner Trust 2010-1 A1 $252.00 P-1/A-1+/NR JPM/WFB BOA Auto Prime US A2 $179.00 12 0.99 Aaa/AAA/NR A3 $399.00 15 2.05 Aaa/AAA/NR A4 $152.50 23 3.36 Aaa/AAA/NR 15/02/10 Silk Road Finance No. 1 Plc A1 £2,500.00 +140bp 3.90 Aaa/NA/AAA HSBC, JPM RMBS UK B1 £407.00 NR/NA/NR B2 £ NA NR/NA/NR C £ NA NR/NA/NR D £ NA NR/NA/NR 09/02/10 CarMax Auto Owner Trust 2010-1 A1 $109.00 0 0.32 NR/A-1+/F-1+ JPM WFB/BOA Auto prime US A2 $110.00 27 1.05 NR/AAA/AAA A3 $142.00 33 2.20 NR/AAA/AAA A4 $69.05 45 3.48 NR/AAA/AAA B $31.73 160 3.91 NR/A/A C $8.23 275 3.91 NR/BBB-/BBB+ 08/02/10 Tidewater Auto Receivables Trust 2010-A A $93.75 1.20 NR/AAA/NR BBT Auto non-prime US B $12.50 2.74 NR/BBB/NR 04/02/10 Ally Master Owner Trust 2010-1 A $900.00 175 2.93 Aaa/AAA/NR BO BCG/DB/MS Floorplan US 04/02/10 AmeriCredit Auto Receivables Trust 2010-1 A1 $132.60 5 0.23 P-1/A-1+/NR CS, UB BCG/DB Auto non-prime US A2 $147.54 55 0.85 Aaa/AAA/NR A3 $123.30 65 1.85 Aaa/AAA/NR B $75.86 2.73 Aa1/AA/NR C $79.31 3.55 A2/A/NR D $41.39 3.84 Baa3/BBB/NR 04/02/10 ARI Fleet Lease Trust 2010-A A $500.00 145 1.13 Aaa/AAA/NR PNC BOA/JPM Auto fleet US 04/02/10 Cabela's Master Credit Card Trust 2010-I A $255.00 145 4.93 NR/AAA/AAA BCG WFB/JPM Credit card retail US 04/02/10 Marlin Leasing Receivables LLC 2010-1 A1 $29.00 10 0.44 NR/A-1+/NR JPM JPM Equip SM-ticket US A2 $33.69 145 1.83 NR/AAA/NR 04/02/10 Navistar Financial Dealer Note MT 2010-1 A $214.80 165 1.95 Aaa/AAA/NR BAS/SCOT Com Floorplan US B $16.40 250 1.95 Aa2/AA/NR C $18.80 350 1.95 A2/A/NR 04/02/10 Ocwen Advance Receivables 2010-1 A $200.00 280 1.51 NR/AAA/AAA WF/BCF/RBS Other US 03/02/10 Goals 2009 A €122.40 +125bp 3.79 NA/AAA/AAA WestLB Grenkeleasing Lease Euro B €22.40 +275bp 4.75 NA/A/A C €15.20 +350 bp 4.75 NA/NR/NR 02/02/10 Plato No.1 A €700.00 +90bp 7.00 NA/NA/AAA HSH Nordbank HSH Nordbank CMBS Euro B €30.00 +125bp 7.00 NA/NA/A+ C €461.10 NA/NA/NR 01/02/10 Series 2010-1 REDS Trust A A$ 462.5 +130bp 3.00 Aaa/AAA/NA Bank of Queensland RMBS Australia AB A$ 30.0 +175bp 5.20 NR/AAA/NA B A$ 7.5 5.20 NR/AA-/NA

For the latest tables please go to the SCI website

42 SCI May 2010 Data

ABS issued in March 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Originator Type Market 31/03/10 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 €240.00 80 2.00 Aaa/AAA/NA Rabo/SG-CIB RMBS Euro A2 €704.00 100 4.90 Aaa/AAA/NA B €20.00 4.90 Aa2/AA/NA C €16.00 4.90 Aa3/A/NA D €21.00 4.90 A2/BBB/NA E €10.00 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 US 26/03/10 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/NA A3 $93.00 175 3.01 Aa3/AAA/NA 25/03/10 Dolphin Master Issuer 2010-1 A1 €3,000.00 112 5.00 Aaa/AAA/AAA FOR/RBOS RMBS Euro A2 €2,279.00 112 5.00 Aaa/AAA/AAA A3 €1,000.00 115 20.00 Aaa/AAA/AAA A4 €1,000.00 115 30.00 Aaa/AAA/AAA B €172.00 200 5.00 Aa3/AA/AA C €204.00 300 5.00 A2/A/A D €172.00 500 5.00 Baa2/BBB/BBB E €71.00 500 22/03/10 VAB Auto Receivables 2009-1 A €275.00 4.50% Aaa/AAA/NA Auto Prime Euro B €50.00 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 US A2 $172.00 25 0.99 Aaa/AAA/AAA A3 $396.00 30 2.15 Aaa/AAA/AAA A4 $205.21 40 3.73 Aaa/AAA/AAA B $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 US A2 $204.00 25 0.99 Aaa/AAA/NA A3 $364.00 30 2.10 Aaa/AAA/NA A4 $90.90 40 3.42 Aaa/AAA/NA B $29.10 3.92 Aa3/AA/NA C $25.60 3.97 A2/A+/NA 17/03/10 Driver GmbH 7 A €500.00 70 1.86 NA/AAA/AAA HSBC/WLB Auto prime Euro B €19.00 165 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 US B $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 US 16/03/10 Dutch MBS BV XV A1 €182.00 110 2.00 Aaa/AAA/NA CS/NIB/CAAM RMBS Euro A2 €531.00 150 5.00 Aaa/AAA/NA B €11.00 5.00 Aa2/AA+/NA C €10.00 5.00 A1/A/NA D €10.00 5.00 Baa2/BBB/NA E €2.00 5.00 Ba1/BB+/NA F €4.00 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 US 11/03/10 IM Banco Popular MBS 2 FTA A €596.00 30 5.09 NR/Aaa/NR Banco Popular Espanol Banco Popular Espanol MBS Euro B €89.00 150 15.08 NR/Caa1/NR 10/03/10 Foncaixa Andalucia FT Empresa 1 FTA AG €328.00 Aaa/AAA/NA La Caixa CLO Euro AS €82.00 Aaa/AAA/NA B €25.00 Aa3/A/NA C €65.00 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 UK A2 €775.00 120 4.50 Aaa/AAA/Aaa A3 £525.00 120 6.90 Aaa/AAA/Aaa Z £380.00 04/03/10 SLC Student Loan Trust 2010-B A1 $207.70 75 4.99 Aaa/NA/NA CITG BCG, BOA A2 $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 US A2 $166.00 100 1.10 Aaa/AAA/NA A3 $180.50 140 1.93 Aaa/AAA/NA B $31.12 250 2.62 Aa1/AA/NA C $46.68 325 3.03 A1/A/NA D $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 US Owner 2010-3 A2 $475.00 170 4.93 Aaa/AAA/AAA PFS 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/NA PFS Financing Corp 2010-D A $800.00 2.93 Aaa/AAA/NA JPM/CITG Insurance US B $46.60 2.93 SLM 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/NA 02/03/10 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 US A2 $777.79 140 0.81 Na/NA/AAA B $148.71 300 1.05 NA/NA/AA C $111.53 400 1.13 NA/Na/A For the latest tables please go to the SCI website

www.structuredcreditinvestor.com 43 Data

CDOs issued in January 2010 No CDOs were issued in January 2010

CDOs issued in February 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Manager/Originator Collateral Type Market 25/02/10 Lusitano Leverage A €352 6mE30 3 /AAA BES BES Lev loans Arbitrage Euro Finance 1 X €21.85 50 and bonds Sub €206.80 23/02/10 Foncaixa Andalucia AS €82 3mE30 Aaa/AAA La Caixa La Caixa SME loans Bal Sheet Euro FT Empresas 1 AG €328 50 Aaa/AAA B €25 125 Aa3/A C €65 175 A3/BBB 17/02/10 Liffey Funding CLO 1 A €1.42bn 3mE10 Aaa/AAA RBS Ulster Bank Ireland SME/Corp Bal Sheet Euro VFN N/A 10 loans Z €978 05/02/10 Stichting Lion 1 A €7.07bn 3mE180 3.3 Aaa ING ING SME loans Bal Sheet Euro B €2.99bn 250 3.3

CDOs issued in March 2010

Date Issue Class Size (m) Spread WAL M/S&P/F Arranger Manager/Originator Collateral Type Market 31/03/10 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 syndicated B US$36.5 250* /A of 94.25%, B at 90.71% loans Sub US $102.1 NR 19/03/10 Valhalla A €750m 3mE Aaa//AAA BNPP/Danske Danske Guaranteed Bal Sheet Euro Bank Danish loans 15/03/10 Lusitano Leverage A €352 6mE30 /AAA DB/BES Banco Espirito Santo Sen secured Bal Sheet Euro Finance 1 X €21.80 50 NR de Investimento loans Sub NR

For the latest tables please go to the SCI website

Natural catastrophe bonds issued in 2009 and to 1 April 2010 2010 SPV Sponsor Tranche amount Coupon Rating Peril Merna Re II State Farm F&C $350m TMM+365bp BB+ (S&P) US earthquake Successor 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

2009 SPV Sponsor Tranche amount Coupon Rating Peril Lakeside Re II Zurich American $225m TMM+775bp BB- (S&P) California earthquake Redwood XI Swiss Re $150m TMM+625bp B1 (M) California earthquake Longpoint Re II Travelers Class A $250m TMM+540bp BB+ (S&P) US hurricane Class B $250m TMM+540bp BB+ (S&P) Atlas VI SCOR €75m Euribor+950bp BB- (S&P) Euro wind & Japan quake Successor 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 hurricane Class 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 quake Agroasemex and Class B $50m TMM+1025bp B (S&P) Pacific hurricane FONDEN Class C $50m TMM+1025bp B (S&P) Pacific hurricane Class D $50m TMM+1025bp BB- (S&P) Atlantic hurricane Parkton Re Swiss Re $200m TMM+1050bp B+ (S&P) N Carolina hurricane Eurus II Hannover Re €150m Euribor+675bp BB (S&P) Euro & UK wind Ianus Capital Munich Re €50m Euribor+900bp B2 (M) Euro wind & Turkey quake Calabash Re III Ace Insurance Class A $86M 6mL+1525bp BB- (S&P) US hurricane & quake Class B $14m 6mL+550bp BB+ (S&P) US quake Residential Re 2009 USAA Class 1 $70M 3mL+1300bp BB- (S&P) US hurricane, quake Class 2 $60m 3mL+1700bp B- (S&P) and storm Class 4 $120m 3mL+1250bp BB- (S&P) Successor II 2009 Swiss Re $60m undisclosed n/a North Atlantic hurricane and California quake Ibis Re Assurant operating Class A $75m 3mL+1025bp BB (S&P) US hurricane companies Class B $75m 3mL+1425bp BB- (S&P) Blue Fin (Series 2) Allianz Argos Class A $180m 3mL+1350bp BB- (S&P) US quake & hurricane Mystic Re II (Series 2009-1) Liberty Mutual 2009-1 $225m 3mL+1200bp BB (S&P) US quake & hurricane East Lane III Chubb Class A $150m 3mL+1025bp BB (S&P) Florida hurricane Atlas V SCOR Series 1 $50m 3mL+1450bp B+ (S&P) US quake & US/Puerto Series 2 $100m 3mL+1150bp B+ (S&P) Rico hurricane Series 3 $50m 3mL+1250bp B (S&P) For the latest tables please go to the STORM website

44 SCI May 2010 structuredcreditinvestor

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