ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION ® Client-Driven Solutions, Insights, and Access Global Securitized Products Weekly Structured Products Strategy Agency MBS We maintain a modest overweight on the MBS basis. The supply/demand picture for specified pools remains robust in 2013 due to a sharp projected decline in supply overwhelming a moderate decline in demand. Last weekend's loosening of LCR standards by the Basel committee is near-term neutral and longer-term negative for Agency MBS. Non-Agency MBS Non-agency markets have remained firm with balanced flows to start the year. Herein, we provide an estimate of which private label MSRs Nationstar acquired from BofA on Monday. On another note, we believe the amended Basel III LCR requirements were at first glance very positive for US RMBS, but we also see a few hurdles for private label RMBS to clear in order to be allowed as high quality liquid assets. CMBS The CMBS market has enjoyed a strong rally since the start of the new year, not only continuing the December spread tightening move but also with the trend accelerating. We are not surprised by the direction of the move over the first few trading days of 2013, but the speed and the magnitude exceeded our expectations. While the rally has been impressive, it has not been evenly distributed over the various sectors, and bonds with more cuspy risk profiles have been the best performers. Consumer ABS In Auto ABS, spreads remained flat, whereas short-term performance in both the prime and subprime sectors was stable to marginally better. Defaults inched down 6 bps in prime and 16 bps in subprime. Severities were constant and net losses were flat in prime but fell a marginal 5 bps in subprime. CDO / CLO The new-issue CLO market showed no signs of slowing in December. Sixteen CLOs, or a total of $7.9bn, were issued, bringing the 2012 final tally to $54.2bn. In this section, we also discuss the initial Equity Par Coverage (EPC) ratio as a very useful metric for analyzing CLO equity investments. European Update Trading volumes have been light this week with muted BWIC activity so far. Despite the light activity, we have seen long duration paper in senior space tightening this week in core and periphery RMBS. Longer paper continues to attract a lot of attention as spread curves remain steep and structured product money looks to extend duration in portfolios. Portuguese, Spanish and UK non-conforming RMBS were the biggest winners on the week. The new issuance pipeline looks dry thus far, however, we expect activity to improve as the New Year kicks into gear. Modeling and Analytics A new agency model CS6.7 is currently in parallel with production CS6.6. The main updates are modeling the volatile current coupon/swap basis due to QE3 and “sticky” primary rates. Future additional G-fee increases are added to conventional 30year and 15year products, as well as to the five states mandated by FHFA. Given the recent persistently high HARP2.0 activities and newly announced HARP program changes, CS6.7 extends peak HARP2.0 effectiveness by another six months, from November 2012 to May 2013. Finally, MHA pools’ delinquency buyout projections are reduced by 25%-30%, due to the effects of payment reduction and credit selection bias. Research Analysts GLOBAL HEAD Roger Lehman +1 212 325 2123 [email protected]AGENCY MBS Mahesh Swaminathan +1 212 325 8789 [email protected]Qumber Hassan +1 212 538 4988 [email protected]Vikram Rao +1 212 325 0709 [email protected]NON-AGENCY MBS/CONSUMER ABS Chandrajit Bhattacharya +1 212 325 1546 [email protected]Marc Firestein +1 212 325 4379 [email protected]Gaurav Singhania, CFA +1 212 325 0620 [email protected]CMBS Roger Lehman +1 212 325 2123 [email protected]Sylvain Jousseaume +1 212 325 1356 [email protected]Serif Ustun, CFA +1 212 538 4582 [email protected]Tee Chew +1 212 325 8703 [email protected]CDO/CLO David Yan +1 212 325 5792 [email protected]EUROPEAN UPDATE Carlos Diaz +44 20 7888 2414 [email protected]MODELING AND ANALYTICS David Zhang +1 212 325 2783 [email protected]Table of Contents Core Views 2 Agency MBS 3 Non-Agency MBS 9 CMBS 18 Consumer ABS 27 CDO / CLO 34 European Update 40 Modeling and Analytics 41 10 January 2013 Fixed Income Research http://www.credit-suisse.com/researchandanalytics
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ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER
IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION®
Client-Driven Solutions, Insights, and Access
Global Securitized Products Weekly Structured Products Strategy
Agency MBS We maintain a modest overweight on the MBS basis. The supply/demand picture for
specified pools remains robust in 2013 due to a sharp projected decline in supply
overwhelming a moderate decline in demand. Last weekend's loosening of LCR standards
by the Basel committee is near-term neutral and longer-term negative for Agency MBS.
Non-Agency MBS Non-agency markets have remained firm with balanced flows to start the year. Herein, we
provide an estimate of which private label MSRs Nationstar acquired from BofA on Monday.
On another note, we believe the amended Basel III LCR requirements were at first glance
very positive for US RMBS, but we also see a few hurdles for private label RMBS to clear in
order to be allowed as high quality liquid assets.
CMBS The CMBS market has enjoyed a strong rally since the start of the new year, not only
continuing the December spread tightening move but also with the trend accelerating. We
are not surprised by the direction of the move over the first few trading days of 2013, but the
speed and the magnitude exceeded our expectations. While the rally has been impressive,
it has not been evenly distributed over the various sectors, and bonds with more cuspy risk
profiles have been the best performers.
Consumer ABS In Auto ABS, spreads remained flat, whereas short-term performance in both the prime and
subprime sectors was stable to marginally better. Defaults inched down 6 bps in prime and
16 bps in subprime. Severities were constant and net losses were flat in prime but fell a
marginal 5 bps in subprime.
CDO / CLO The new-issue CLO market showed no signs of slowing in December. Sixteen CLOs, or a
total of $7.9bn, were issued, bringing the 2012 final tally to $54.2bn. In this section, we also
discuss the initial Equity Par Coverage (EPC) ratio as a very useful metric for analyzing
CLO equity investments.
European Update Trading volumes have been light this week with muted BWIC activity so far. Despite the
light activity, we have seen long duration paper in senior space tightening this week in core
and periphery RMBS. Longer paper continues to attract a lot of attention as spread curves
remain steep and structured product money looks to extend duration in portfolios.
Portuguese, Spanish and UK non-conforming RMBS were the biggest winners on the week.
The new issuance pipeline looks dry thus far, however, we expect activity to improve as the
New Year kicks into gear.
Modeling and Analytics A new agency model CS6.7 is currently in parallel with production CS6.6. The main updates
are modeling the volatile current coupon/swap basis due to QE3 and “sticky” primary rates.
Future additional G-fee increases are added to conventional 30year and 15year products,
as well as to the five states mandated by FHFA. Given the recent persistently high
HARP2.0 activities and newly announced HARP program changes, CS6.7 extends peak
HARP2.0 effectiveness by another six months, from November 2012 to May 2013. Finally,
MHA pools’ delinquency buyout projections are reduced by 25%-30%, due to the effects of
After six long years of continued price declines, home prices finally found a bottom in 2012. Although prices started inching up during the first quarter, we think the foundation for a sustainable recovery was laid during the middle of 2012 as supply-demand fundamentals began to turn unequivocally in a positive direction, driven by increasing demand and plummeting supply. As we look ahead, we think much of the supply constraints will remain in place, providing support for a sustainable recovery in home prices. We expect a roughly 4.0%-4.5% increase in home prices in 2013, following an estimated 5.0%-5.25% increase in 2012.
Prepayment
Prepayment S-curve for new production (post HARP/MIP)should gradually steepen in 2013. The scheduled January launch of a bright line performance test for lenders to avoid putbacks, continued increase in lender capacity, outlook for continued increases in home prices, and possible introduction of traditional GSE streamlined refi programs are potential drivers.
Speeds on HARP-eligible cohorts may remain elevated for longer supported by active cross servicer refis, a more lender-friendly putback policy, and continuing transfers of high-risk loans to special servicers and active curing.
Non-Agency MBS
The housing market should continue to improve. We estimate home prices increased 5.0%-5.25% in 2012, followed by a 4.0%-4.5% increase this year.
Lower volatility and continued performance improvement can bring in more leverage. Yields could compress further.
Net negative issuance of $150B this year and lighter dealer balance sheets should provide technical support. Jumbo new issuance is projected to be $10-$15B.
Add with leverage or hold on to high coupon cleaner Prime and Alt- As. We still prefer fixed coupon Prime and Alt-A with slightly higher delinquency but higher optionality.
Continue to remain overweight on Inverse IOs – on muted prepays and low rates.
Overweight Alt-As and POAs due to optionality and incrementally higher carry.
Neutral on Subprime LCFs and Penns – the sector has richened significantly and has low carry.
Underweight (slightly longer duration) front pay Subprime with servicing issues.
Long Prime and Alt-A Re-Remic Mezz
Consumer ABS
Spreads ground tighter in 2012, but we maintain a bullish outlook in 2013.
Fundamental performance in major sectors continues to improve.
We project net positive issuance for 2013. We believe the hunt for yield will compress the credit curve in 2013.
Neutral on prime auto seniors. Remain overweight subprime autos and prime subs. Value in highly rated SDART & AMCAR subs, prefer SDART seniors.
Prefer auto lease and dealer floorplan (FORDF & AMOT) over prime auto due to spread pick-up.
Overweight longer duration FFELP paper and short duration PSL seniors.
Franchise deals have tightened but still have room for further tightening.
We remain neutral on 2yr COMNI paper – but risk/reward favors continued holding.
CMBS
The CMBS market has enjoyed a strong rally since the start of the new year, not only continuing the December spread tightening move but also with the trend accelerating. We are not surprised by the direction of the move over the first few trading days of 2013, but the speed and the magnitude exceeded our expectations. While the rally has been impressive, it has not been evenly distributed over the various sectors, and bonds with more cuspy risk profiles have been the best performers.
We find relative value in:
Wider AMs and select, mid-tier AJs;
Agency CMBS versus tighter super-senior bonds;
We remain cautious on new issue BBB bonds; and
More differentiation is needed on premium super-seniors.
CLO/CDO
Moderate growth and a low rate environment make corporate credit more attractive relative to other risky assets; corporate default rates should stay low – market consensus expects them to be about 2%-3% for 2013.
QE3 and the Fed’s pledge to keep interest rates low until mid-2015 will likely encourage further yield chasing; however, we remain concerned about the longer-term picture and near-term earnings slowdown and macro headwinds, such as the upcoming “debt ceiling” debate.
On the new-issue front, the pipeline looks strong for 2013. New issue AAA spreads stay around 135bp-140bp.
CLOs, in general, appear cheap to most other securitized products.
Within the non-PIK-able space, we recommend overweighting senior AAA tranches.
Within the PIK-able space, we now favor the primary equity tranches over secondary paper and also recommend an overweight in the BB tranches.
We favor new-issue mezz tranches over seasoned mezz tranches.
Source: Credit Suisse * Bolded parts are updated for the week
10 January 2013
Global Securitized Products Weekly 3
Agency MBS Strategy
We maintain a modest overweight on the MBS basis. Although valuations versus
rates benchmarks are compellingly cheap following this week’s rebound, a favorable FN
3 dollar roll, cheap valuations versus corporates, and potential for supportive Fed
comments remain positives.
The supply/demand picture for specified pools remains robust in 2013 due to a
sharp projected decline in supply overwhelming a moderate decline in demand.
Last year’s roughly 200% surge in gross supply of specified pools was largely driven by
HARP activity, which will generate a much lower volume in 2013 despite comparable
speeds because of a sharply lower starting balance. Demand technicals are somewhat
weaker, mainly due to a projected decline in REIT demand.
We believe that prepayments on high coupons (5s and above) may only rise
modestly as a result of servicing transfers from BofA (7 January 2013 Mortgage
Market Comment). We expect speeds in these coupons to rise by low- to mid-single digit
CPR compared to current BofA speeds. This is in contrast to the 15-20 CPR higher
speeds on BofA loans transferred by Fannie to specialty sub-servicers. The knee-jerk
reaction in the market potentially misses this distinction, in our view.
Last weekend's loosening of LCR standards by the Basel committee is near-term
neutral and longer-term negative for Agency MBS. Although liquidity standards have
not been the primary driver of Agency MBS demand in the current environment, delayed
implementation, reduced liquidity needs, an expansion of eligible assets, and the
absence of an upgrade to level 1 status all lower eventual potential demand for MBS.
Trade recommendations
Hold long MBS basis (buy $50MM FN 3, sell $18.2MM 10-yr swap, sell $22.6MM 5-yr
swap) based on cheap valuations, favorable supply/demand and carry outlook. This
trade is up 11.5 ticks since inception.
Hold buy DW 3/FN 3.5 swap (buy $100MM DW 3s vs. $71MM FN 3.5) based on cheap
valuations adjusted for changes in prepayment trends (10 October 2012 Global
Securitized Products Weekly). This trade is down half a tick since inception.
Hold sell G1/G2 4 ($100MM each), based on attractive risk/reward (19 September 2012
Global Securitized Products Weekly). This trade is down 24+ ticks since inception.
Hold buy DW 3.5/2.5 swap based on cheap valuations adjusted for changes in
prepayment trends (4 October 2012 Global Securitized Products Weekly). This trade is
up a tick since inception.
Hold buy IOS 3.5 versus FN 3.5 based on cheap valuations adjusted for changes in
prepayment trends (29 November 2012 Global Securitized Products Weekly). This trade
is up 10 ticks since inception.
Hold buy FN 5.5/5 swap based on cheap valuations and significant pricing in of policy
risk premium (17 December 2012 MBS Trade Note). This trade is up a tick since
inception.
Closed the remaining leg of sell G2/FN 3 swap ($50MM) at a profit of 14+ ticks
(9 January 2012 MBS Trade Note).
Closed buy NG/DW 3 swap ($100MM) at a profit of 5 ticks (8 January 2012 MBS
We continue to recommend this trade despite the recent sharp underperformance
(Exhibit 1). Negative carry (of roughly 3 ticks) of this swap has been the key reason for
underperformance as the G1 4 roll continues to trade special. However, both our
"Through-the-box" reports as well as our estimates of WTD speeds (Exhibit 4) show that
the G1 4 deliverable has been increasingly faster than G2 4s in recent months. Adverse
selection risk in G1 TBA is high due to availability of high-VA% and high-loss mitigation%
pools in the float. We expect the G1/G2 4 roll difference to compress and this trade to
outperform as the market returns to fundamentals.
Exhibit 4: Credit Suisse "Through-the-box" reports as well as our estimates of WTD speeds show that the G1 4 deliverable is increasingly faster than the G2 4 deliverable.
CS TTB
As of G1 4 G2 4
Dec-12 36 29
Nov-12 35 29
Oct-12 21 21
Sep-12 28 24
2011 origination
As of
G1 4s, 25%+ VA-
share, 150k+ AOLS
($7B ex-CMO balance)
G2 4
Dec-12 35 30
Nov-12 32 28
Oct-12 30 27
Sep-12 25 22
Source: Credit Suisse, CPR/CDR
Specified Sector - Supply/demand outlook remains robust despite a potential drop in REIT demand
Specified issuance exploded in 2012 with a more than 200% and nearly 500% increase in
gross and net issuance over the past two-year average, respectively (Exhibit 5). This was
driven by a massive pickup in HARP activity during the year. We note a significant
issuance increase in the loan balance sector as well over this period. However, a closer
look reveals that even this increase was driven by HARP activity. Based on Freddie Mac’s
loan-level data, we find that all of the increase in net issuance for sub-150K loan balance
paper in 2012 came from 80+ OLTV loans (Exhibit 6). Originators have been pooling
eligible HARP-ed loans into loan balance pools, whenever possible, instead of MHA pools
due to higher pay-ups on the former.
We estimate that specified issuance should decline by roughly $100B in 2013. This is
driven by an expected decline in HARP volumes as a result of the ongoing shrinking of the
HARP-eligible universe. For instance, we estimate that the outstanding universe of FN/FH
105+ LTV loans was roughly $250B at the beginning of 2012. At a roughly 39 CPR 12-
month voluntary speed (45 CPR overall speed), this contributed an estimated $96B
issuance of CQ/CR/U6/U9 pools in 2012. However, as a result, the outstanding balance of
this universe at the beginning of 2013 is reduced to $140B. This implies that even under a
relatively flat prepayment rate assumption, the issuance of 105+ LTV pools should drop by
roughly 50% in 2013. This analysis assumes a flat HPA. A rising HPA would only reduce
this supply further.
10 January 2013
Global Securitized Products Weekly 7
This projected decline in the supply of specified pools overwhelms any potential decline in
REIT demand. REITs have absorbed a significant portion of the 2012 specified supply by
buying as much as $50B on a net basis. This demand is expected to decline in 2013
assuming a weaker outlook for equity raises compared to last year. However, even under
an extreme scenario of zero sponsorship from REITs, the overall supply/demand gap
widens in favor of the specified sector.
We do not expect any meaningful change in specified pool demand of other investor
constituencies. The overall positive supply/demand picture bodes well for specified pay-
ups, in our view.
A sharp selloff in rates driven by improved economic outlook is a key risk to this view. In
this scenario, investor appetite for call protection stories could decline, but net supply in
the specified sector should remain robust due to continued HARP refinancings (which are
relatively less rate sensitive).
Exhibit 5: Gross/net issuance of specified pools should drop by roughly $100B in 2013
All fixed-rate FN/FH products combined
Gross Issuance ($B) 2010 2011 2012 2013 est
Investor 14 15 18 25
Loan Balance 102 110 162 130
MHA 11 18 47 25
CQ/CR/U6/U9 7 14 96 49
Total 135 157 324 229
Net Issuance ($B) 2010 2011 2012 2013 est
Investor 9 9 7 14
Loan Balance -9 18 40 18
MHA 11 17 43 18
CQ/CR/U6/U9 7 14 93 46
Total 19 58 184 95
Source: Credit Suisse, CPRCDR
Exhibit 6: 2012 spike in loan balance supply is driven by HARP
Loan size <150K; FH loan-level data
Product OLTV Year
Gross Net
All fixed- <80 2011 46 10
rate 2012 60 9
80-105 2011 8 0
2012 15 5
30-year <80 2011 20 -3
2012 28 -4
80-105 2011 5 -1
2012 11 2
Issuance ($B)
Source: Credit Suisse, CPRCDR
10 January 2013
Global Securitized Products Weekly 8
Revised LCR standards near-term neutral and longer-term negative for Agency MBS
Last weekend's loosening of LCR standards by the Basel committee is near-term neutral
and longer-term negative for Agency MBS. Although liquidity standards have not been the
primary driver of Agency MBS demand in the current environment, a delayed
implementation, reduced liquidity needs, an expansion of eligible assets, and the absence
of an upgrade to level 1 status all lower the eventual potential demand for MBS.
The key changes are:
1. Only 60% compliance is required by the start date of 1/1/2015, increasing by 10%
annually to full compliance by 2019.
2. High quality liquid assets (HQLA) will be expanded to include A+ to BBB- rated
corporates with 50% haircut, equities with a 50% haircut, and certain AA or higher
rated residential MBS with a 25% haircut. The aggregate of these new additions is
subject to a 15% cap as a share of HQLA. Note, the standards for Agency MBS have
not changed (GNMA still level 1, FN/FH MBS still level 2 HQLA subject to a 40% cap
as share of total HQLA).
3. Outflow standard has been reduced: 3% of certain retail insured deposits down from a
5% level previously; 20% of fully insured non-operational corporate deposits down from
40%; other non-operational deposit outflow rate down to 40% from 75%.
10 January 2013
Global Securitized Products Weekly 9
Non-Agency MBS Market Views
Non-agency markets have remained firm with balanced flows. BWIC volumes were light
for the first few days of the year; yesterday was the first time since the start of the year
that BWIC volumes crossed the $1B mark. Investor participation has remained high and
prices have been firm. Although trading volumes have been low, Subprime cash bonds
have registered gains between 1-2 points since year-end. Prices on other sectors
remain unchanged.
From a technical standpoint the market remains well supported with balanced flows
between buyers and sellers. Dealers, having reduced their holdings by $700M during the
first few days in January, remain well positioned.
Meanwhile, one potential source of supply – the PPIPs – continue to pare down their
holdings. According to Treasury reports, the PPIPs holdings have dwindled from $14.9B at
the end of September to about $8.9B as of the end of November. If the same pace of
sales continued in December, then their total holdings could potentially have declined to
only about $6B by year-end. Additionally, there could be opportunistic sales out of Europe,
but we think the market remains well poised to absorb such sporadic supply.
While we look out for any pull-back in investor demand and large increases in dealer
positioning, we continue to favor high coupon Prime and Alt-A bonds for higher carry and
lower price volatility and Option Arms over Subprime due to better optionality and carry.
Post FOMC minutes last week, the market remains concerned that Fed’s QE program
could end much earlier than anticipated. As our economists have noted, any downward
adjustments or tapering off of the Fed’s QE program will have to be preceded by extremely
strong and consistent job growth scenarios. We acknowledge that an earlier-than-
anticipated Fed exit could be a potential negative technical for risky assets – resulting in
diminished demand for such assets. However, for non-agencies in particular, a better-
than-expected employment and economic outcome could act as a countervailing factor to
the pullback in incremental demand. In such a strong macro-economic scenario, we would
expect fundamental performance to register strong gains and offset much of the negative
technical fallout.
Exhibit 7: Dealer balance sheets have remained flat since the beginning of December
Exhibit 8: PPIPs continue to pare down their holdings
Exhibit 9: Nationstar cures more of its Subprime book every month than BofA …
Exhibit 10: … while generating more cash flow from them as well
Subprime, 90+ and FC loans curing to current per month Based on cash flow generated during Jul-11 to May-12 as % of 60+ balance, total cash flows net of balance capitalization
* This is the midpoint between the RBC charge for this NAIC designation and the next one. For example, 7.3% for NAIC 3 is the average of 4.6% and 10.0% Source: Credit Suisse, NAIC
The RBC charge incurred at each designation is averaged with the RBC charge at the
designation below to calculate what the NAIC calls a Breakpoint Expected Loss. So,
continuing our example, the Breakpoint Expected Loss for NAIC is 7.3% (the average
RBC Charge on NAIC 3 and NAIC 4 or the average of 4.6% and 10.0%).
The Breakpoint Carrying Price can then be calculated from the Intrinsic Price and the
In this section, we will discuss a very important metric for investing in CLO equities – the
so-called initial Equity Par Coverage (EPC) ratio.2 We define “initial” here as of the
effective date – because the collateral should be fully ramped up by the effective date.
The EPC is defined as: (Collateral Par – Liability Notional)/Equity Notional. After
rearranging the terms, we can calculate the EPC in the following formula: EPC = D/E * (Jr.
OC - 1), where D/E is the debt-to-equity ratio of the CLO equity tranche and Jr. OC is the
most junior – i.e., right above equity – OC (overcollateralization) ratio. For example, if a
CLO has a total initial size (i.e., deal balance) of $500mn, and the equity tranche is $50mn,
the D/E ratio will be 9 (i.e., 450/50).
Keep in mind that the numerator of the OC ratio is usually the collateral par adjusted for
haircuts such as default, excess CCC exposure, deep discount, etc.; however, at the initial
date (i.e., as of the effective date in our analysis), the OC numerator usually equals the par
value of the collateral.
There are at least two important factors an equity investor needs to consider: leverage and
funding cost. Interestingly, both factors are reflected in our formula for EPC. First,
needless to say, the D/E ratio is one popular measure of leverage – the higher the D/E or
leverage, the higher the par coverage; Second, the OC ratio, or more precisely, the initial
OC ratio, is at least partially and indirectly related to the funding cost, and the key lies in
the numerator of the OC ratio.
The second factor needs further detailed explanations. Keep in mind that the
issuer/structurer of a CLO always has to strike a balance between the nominal
coupon/spread and the selling price of the debt tranches. Obviously, the higher the
spread or coupon, the higher the (on-going) funding cost, But, the trade-off is that, the
higher the spread or coupon, the higher the price at which the debt tranches could be sold,
all else being equal – which means the issuer could raise more proceeds to purchase the
underlying collateral. Given the same purchase prices, more collateral par could be built
with more proceeds – thus, the higher numerator of the OC ratio.
So, if a CLO has a higher initial EPC due to a higher OC ratio, the next question an
investor should ask is: how is this higher OC ratio achieved – is it achieved by sacrificing a
higher funding cost (i.e., higher liability spread) for more proceeds from issuance or is it
achieved by buying/ramping the collateral at a relatively lower cost? Assuming the
collateral credit quality stays the same, we would prefer the higher OC is achieved by
acquiring assets at cheaper prices – which could be a function of how fast the assets
could be acquired and the timing of ramping up the collateral.
In addition, other factors could also impact the OC ratio, such as the structuring fees and
other initial transaction costs. All else being equal, the higher the transaction cost, the less
proceeds are available for acquiring the collaterals, thus resulting in a lower OC ratio.
We randomly selected 15 2012-vintage CLOs and calculated their initial EPC, as shown in
Exhibit 53.
2 There are other important measures investors need to check, such as the market value or NAV coverage ratios. However, we
limit our discussion to the par coverage ratio here.
10 January 2013
Global Securitized Products Weekly 36
Exhibit 53: Calculation of Equity Par Coverage (EPC)
Deal Name Closing Date As of Date D/E Ratio Jr. OC EPC (= D/E * (Jr. OC – 1))
Sample_1 Mar 19 2012 Oct 24 2012 8.63* 110.11% 87.24%
Sample_2 Apr 5 2012 Oct 31 2012 8.13 109.92% 80.62%
Sample_3 Mar 20 2012 Nov 5 2012 9.22 107.53%** 69.45%
Sample_4 May 1 2012 Nov 2 2012 7.33 110.65% 78.07%
Sample_5 Apr 19 2012 Nov 7 2012 7.71 111.09% 85.54%
Sample_6 Mar 27 2012 Oct 15 2012 7.78* 109.45% 73.56%
Sample_7 Apr 11 2012 Nov 2 2012 8.23 109.09% 74.84%
Sample_8 Mar 21 2012 Nov 5 2012 9.22 108.57% 79.01%
Sample_9 Mar 8 2012 Nov 6 2012 8.52 111.37% 96.92%
Sample_10 Mar 22 2012 Nov 2 2012 8.13* 110.51% 85.47%
Sample_11 Feb 23 2012 Nov 5 2012 8.07 110.08% 81.33%
Sample_12 May 8 2012 Nov 13 2012 8.66 108.37% 72.49%
Sample_13 Jan 20 2012 Nov 5 2012 8.84 108.16% 72.08%
Sample_14 Feb 15 2012 Nov 5 2012 9.38 108.13% 76.26%
Sample_15 Jan 19 2012 Nov 6 2012 7.03* 110.62% 74.63%
Source: Credit Suisse, INTEX * Equity includes unrated debt tranches ** OC ratio is at Single-B level
First of all, as we can see, there is generally an inverse relationship between the D/E ratio
and the Jr. OC ratio, which can be shown by plotting the numbers in Exhibit 54. This
should be expected because, the higher the leverage or D/E ratio – i.e., the more the debt
– the higher the denominator for the OC ratio, and thus the lower the OC ratio, all else
being equal. Interestingly, the net effect of these two offsetting ratios will be reflected in
one number: the EPC.
Exhibit 54: Inverse relationship between D/E ratio and initial OC ratio
R² = 0.5286
107.0%
107.5%
108.0%
108.5%
109.0%
109.5%
110.0%
110.5%
111.0%
111.5%
112.0%
6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0
Jr.
OC
Rati
o
D/E Ratio
Source: Credit Suisse, INTEX
As we look at the EPC column, we see a wide range – from below 70% to almost 97%.
A special comment on the deal with the lowest EPC – Sample #3 – is needed: what
makes this deal different from all the other sample deals is that it has a Single-B tranche
and there is an OC test set at this level. Consequently, its equity has a higher leverage
and a lower junior OC ratio, and the net result is that it has the lowest EPC among all
sample deals.
10 January 2013
Global Securitized Products Weekly 37
One way to better understand the EPC ratio is as follows: if we run the cash flows,
assuming zero prepayment, zero default, and no reinvestment (even during the
reinvestment period), we should get a principal writedown amount on the equity
tranche, as a percentage of its notional, close to (1-EPC). However, what we found is
that, for some deals, that is not the case. For example, take Sample #3 as an example
again, if we run the cash flows, the principal writedown on the equity actually turns out to
be close to 40%, about 10% higher than what its EPC ratio suggests (which is supposed
to be around 30%). Isn’t it strange?
As it turns out, the answer to this “puzzle” is that, under this particular scenario – i.e.,
no prepay, no default, and no reinvestment – there will be money taken out of the
principal proceeds to pay the incentive fee to the manager once the equity reaches the
hurdle IRR rate. In this particular deal, if we hypothetically add these incentive fees
back to the principal proceeds and assume they will be paid to the equity holder
instead, the writedown on the equity tranche actually turns out to be very close to 30%
– as the EPC suggests.
EPC versus potential equity return
Ignoring everything else, CLO equity investors likely prefer a higher EPC, simply because
they will get more notional back at the end, all else being equal. However, there are other
factors that could also impact the ultimate return to equity investors.
In this section, we ignore prepayment, default risk/loss, and reinvestment; we simply look
at a “static” scenario, whereby there is no prepayment, no default, and no reinvestment. In
Exhibit 55, we show the equity yields/returns – assuming a par purchase price – under this
“static” scenario, versus the EPC ratios. As we can see, in some cases, an equity tranche
with a high EPC could actually have a low “static” yield. The best example is Sample #9 –
it has the highest EPC of 96.9%, but with the lowest yield. Why?
That’s because, although a higher EPC means the equity investor would get more notional
(or initial investment) back, there are other factors that could also determine the ultimate
return of the equity. More specifically, one of the most important factors is the “arbitrage,”
or the excess spread between the collateral spread/yield (i.e., WAS/WAC) and the funding
cost. Exhibit 55 shows these numbers of each sample CLO.
As we mentioned earlier, a higher OC ratio means a higher EPC with the same leverage.
However, if it is achieved – even if partially – at the expense of a higher funding cost, it
could hurt the equity return. In the case of Sample #9, its funding cost is around 193 bps,
higher than the average of these samples: 189 bps. Even more important, its collateral has
a very low WAS (weighted average spread) of only 285 bps, compared with the average of
the samples: 414 bps. As a result, its excess spread is only 92 bps. Thus, despite its
highest OC ratio of 111.4%, given its relatively higher funding cost and a higher price paid
for the collateral – relative to the spread it can earn from the assets, it will only achieve a
low equity return of 11.8% under this “static” scenario.
10 January 2013
Global Securitized Products Weekly 38
Exhibit 55: Equity Par Coverage (EPC) vs. funding cost and excess spread
Deal Name EPC “Static” Par Yield*** Current Funding Cost (bps) Collateral WAS (bps)**** Excess Spread (bps)
Sample_1* 87.24% 25.4% 158 455 297
Sample_2 80.62% 19.1% 188 440 252
Sample_3** 69.45% 13.2% 214 434 220
Sample_4 78.07% 17.2% 172 449 277
Sample_5 85.54% 14.1% 173 282 109
Sample_6* 73.56% 22.2% 207 461 254
Sample_7 74.84% 16.7% 166 419 253
Sample_8 79.01% 13.5% 197 432 235
Sample_9 96.92% 11.8% 193 285 92
Sample_10* 85.47% 18.8% 204 413 209
Sample_11 81.33% 23.6% 184 425 241
Sample_12 72.49% 18.4% 176 433 257
Sample_13 72.08% 19.0% 195 447 252
Sample_14 76.26% 14.8% 194 400 206
Sample_15* 74.63% 19.6% 210 439 229
Average 79.73% 17.8% 189 414 225
Source: Credit Suisse, INTEX * Equity includes unrated debt tranches ** OC ratio is at Single-B level *** Assuming zero prepayment, zero default and no reinvestment (even during the reinvestment period) at all **** Ignoring fixed assets, as they are typically 5% or lower of the collateral
A similar observation could be made on Sample #5 – it has a relatively high EPC of 85.5%,
but its excess spread level is low: 109 bps, due to its low collateral WAS. As a result, its
equity yield is only 14%. Exhibit 56 shows the positive relationship between the excess
spread and the “static” par yield, and we can clearly see Sample #5 and Sample #9 falling
to the far lower left, compared with the rest of the samples.
Exhibit 56: Relationship between excess spread and equity yield/return
R² = 0.4334
50
100
150
200
250
300
350
10.0% 15.0% 20.0% 25.0% 30.0%
Co
llate
ral W
AS
-O
n-g
oin
g F
un
din
g C
ost
(bp
s)
"Static" Par Yield Source: Credit Suisse, INTEX
10 January 2013
Global Securitized Products Weekly 39
Certainly, one could argue that, maybe the assets in Sample #9 and Sample #5 have a
higher credit quality (and thus the lower spread) – which means, if adjusted for potential
default risk, their risk-adjusted returns could be higher than other sample deals.3
If we put default risk aside, these examples show the limitation of the EPC ratio. As useful
as it is – as we show in this section, it needs to be combined with other measures – such
as NAV coverage, funding cost, and collateral yield – to evaluate an equity investment
comprehensively.
And, of course, default, prepayment, and reinvestment are all very important factors.
Further analysis should be conducted with regard to these factors as well. Nevertheless, at
least as a “starter,” EPC could be a valuable measure for CLO equity investing, in our view.
3 The WARF (weighted average rating factor) of these two deals - around 2480 to 2560 - don't really provide an evidence on this
argument, as they are in line with other deals.
10 January 2013
Global Securitized Products Weekly 40
European Update Market Commentary
Trading volumes have been light this week with muted BWIC activity so far. Despite the
light activity, we have seen long duration paper in senior space tightening this week in
core and periphery RMBS. Longer paper continues to attract a lot of attention as spread
curves remain steep and structured product money looks to extend duration in portfolios.
Portuguese, Spanish and UK non-conforming RMBS were the biggest winners on the
week.
In The Pipeline
The new issuance pipeline looks dry thus far, however, we expect activity to improve as
Modeling and Analytics Mortgage rates processes under QE3 and “sticky” primary rates Expect additional g-fee increases for 2013-2014; HARP2.0 effectiveness extended by six months; lower delinquency buyout speeds for MHA/CQ/CR pools due to payment reduction and credit selection
We have released an updated agency model CS6.7 into the CS+/Locus calculator. Clients can parallel the model runs through the model dropdown menu in Locus agency calculators. The main changes from CS6.6 are as follows:
Mortgage rates processes under QE3 and “sticky” primary rates
Primary/secondary spread: the sensitivity of the primary mortgage rate to shocks in the secondary rate, the “p/s beta,” is a function of direction of secondary rate movement, mortgage origination capacity, and relative attractiveness of the current mortgage rate. When the secondary rate rises, this beta ranges from 1 at high capacity to 0.75 at low capacity. When the secondary rate rallies, this beta extends from 0.45 to 0.25 depending on the attractiveness of the new mortgage rates.
Agency current coupon/swap basis: CS6.7 keeps the current QE3-induced tight cc/swap basis for 12 months, then mean-reverts to long-term mean as in CS6.6.
Given the challenges of modeling the mortgage origination landscape longer term and the specialness of the current situation, we have decided to deploy these two model changes in a short-term model component, while keeping the long-term model parsimonious and transparent.
G-fee updates
We expect conventional g-fee increases of 25bps for 30yr products and 10bps for 15yr products in 2013-2014. Hence, long-term primary/secondary spread is increased from 75bps (in CS6.6) to 100bps for 30yr products and 85bps for 15yr products.
State level g-fee: CS6.7 factors in additional upfront g-fee increases for the five states (NY, NJ, IL, FL, CT) mandated by FHFA, effective January 2013.
HARP2.0 timeline: current CS6.6 forecasted that overall HARP2.0 effectiveness peaks between May and November 2012, and starts to burn out afterwards. In October 2012, after the announcement of FHFA’s new reps/warrants policy on HARP loans, we increased our cross-servicer HARP effectiveness, starting in 2013. Given the recent persistently high HARP2.0 activities and newly announced HARP program changes, CS6.7 extends peak HARP2.0 effectiveness by another six months, from November 2012 to May 2013.
Added effects of payment reduction and credit selection bias to the delinquency roll rates for MHA pools: MHA pools’ delinquency buyout projections are reduced by 25%-30%.
The impact on prepayment projection and valuation from CS6.6 to CS6.7 varies
Cusp coupons are most affected by the new agency cc/swap basis assumption: CS6.7 keeps the current QE3-induced tight cc/swap basis for 12 months, then mean reverts it to long-term mean as in CS6.6. One-year speeds will be 3-6 CPR higher for cusp coupons, while long-term CPR changes less due to higher g-fee. CUSP TBA OAS tighten 2-3 bps, IOS OAS tighten ~150bps.
High coupons’ one-year speeds will increase 5-6 CPR due to the six-month extension of HARP2.0 peak effectiveness in CS6.7. IOS OAS tightens ~150bps.
CQ/CR pools’ long-term speeds reduced ~ 1CPR due to lower delinquency roll rates, caused by payment reduction and credit selection.
Clients can parallel the model runs between CS6.7 and CS6.6 through the model dropdown menu in Locus agency calculators. The model default setting will be switched to CS6.7. We welcome feedback from clients on the new model.
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