Credit Portfolio Strategy

26 June 2009

Credit Driver
that bondholders are assessing their options and according to press reports contacting the trustee to discuss options.

UK CRE: The next pain trade A combination of rising vacancy rates, falling rentals and extraordinarily difficult financing conditions will almost certainly drive UK CRE losses higher. This could equal losses from subprime. (page 1). Europe digests its version of SNAC the SEC Fixed coupons add significantly to efficient management of cash flow annuities and provide significant netting and compression benefits as we move towards central clearing (page 4).

Big picture remains negative, but pace of bad news declines

A combination of falling rentals and rising vacancy rates continues to weigh on credit quality. According to the May09 RICS survey, UK CRE activity continued to decline in Q1/09 after a record fall in Q4/08. According to IFD, UK commercial properties values have been declining fast with peak to current declines of around 45%, with major declines noted in all major segments - retail, offices and industrials. The good news is that the pace of deterioration moderated across the three sectors (office, retail and industrial) particularly industrial, though retail remained weak. Although the number of enquiries to occupy space continued to decline, the pace of decline moderated, from an all time low. The confidence in the outlook for rents fell to the lowest level in the surveys history (Chart 1). Chart 1: Surveyor expectations for the change in rents for the next quarter (% Balance, seasonally adjusted)

UK CRE: The next pain trade

Although the recent survey data points to a slight recovery in UK house prices, a recent report from Fitch, highlights that (i) it expects a peak-trough house price decline of 35% and that around 10% of the UK mortgages (with excellent credit history) are with negative equity. Worryingly, the figure could more than double to 23% and to a third of all loans by value, if the agencys estimates of a 30-35% peak-trough decline in house prices comes true. This would imply another 10-15% decline in house prices (given that the Nationwide index has declined by 20% so far), which is against the current consensus that appears to indicate that the bottom has been reached for the house price decline. This will predictably impact the half a dozen mortgage lenders that include NRK, Bradbi, BIRM (part of HBOS), Alliance and Leicester (part of Santander). Meanwhile, the next leg of the credit story seems to be unfurling in the commercial real estate (CRE) market, not only in the US, but also in the UK which could see a major CMBS default. Bonds backing CRE assets of a UK property investor (Simon Halabi) are likely to default on 1.15bn of debt. In this particular case, the values of the nine prime London office buildings (included the offices of JPM, the UK headquarters of Aviva, the Naval and Military Club amongst others) that were securitised have fallen from 1.8bn in November 2006 to 929mn as of 8 June, a reduction of almost 50%. This is leading to a breach of its loan to value covenant under the credit agreement that must be rectified within 10 days, else it would lead to an event of default. Equity injections (or other measures to deleverage) could help, but given the environment, one has to question whether this is possible. We understand
Vivek Tawadey vivek.tawadey@uk.bnpparibas.com +44 20 7595 8894 Mehernosh Engineer mehernosh.engineer@uk.bnpparibas.com +44 20 7595 8338

Source - RICS, May 2009

At the same time the amount of available floor space for occupation increased at the fastest pace since 1999 in all regions with the exception of London (Chart 2) and the values of inducements rose at its fastest pace since the surveys history in 1999. Collectively this implies that an upward correction in prices in the foreseeable future is unlikely.

Rajeev Shah rajeev.shah@uk.bnpparibas.com +44 20 7595 8175

Andrea Cicione andrea.cicione@uk.bnpparibas.com +44 20 7595 8296

Credit Driver

26 June 2009

Chart 2: Change in available commercial space for occupation over the past quarter (% balance)

Chart 4: Monthly Issuance of Non-US CMBS

15 12 9 6 3 0
-07 pr-07 ul-07 ct-07 an-08 pr-08 ul-08 ct-08 an-09 pr-09 J J A O O A A J J Jan

Source Commercial Mortgage Alert, BNPP Source RICS, May 2009

UK banks CRE exposures

The two UK banks that are the most exposed to Commercial Real Estate (CRE) are RBS and Lloyds Banking Group, with an exposure of 97bn each, most of which at par on their books. Needless to say that we are expecting provisions and impairments to rise significantly in this segment over the coming year or more. Table 1: Exposures to CRE at end 2008
RBS 97bn LBG 97bn HSBC $71bn Barclays 11bn

Looming refinancing risk

Around 43bn (or 19%) of all CRE loans comes due for repayment in 2009. A further 14% matures per year annually in 2010 and 2011 (Chart 3) or in excess of 100bn over the next 3 years, implying very significant refinancing risk inevitably leading to higher defaults. Although non-US CMBS issuance had picked-up slightly (in contrast to US CMBS volume which had collapsed), it appears to have slowed sharply over the past quarter. The TALF programme in the US was meant to revive this market, but recent downgrades of CMBS will almost certainly prevent a resurgence in issuance, as the TALF inclusion only include AAA rated securities. Therefore, there is little doubt that CRE losses will increase. Recent research conducted by De Montfort University in the UK confirmed: A 6x increase in the value of loans in breach of banking agreements, worth an estimated 15bn. The number of loans in default jumped 8x this year alone to 6bn. Total bank UK CRE lending increased by 8.5% in 2008 to 225bn, which represents a 4.5x increase since the start of this decade. We understand that CRE lending in 2009 has virtually stalled. The average LTV is now close to 80% and rising and with further declines in CRE prices, equity could be completely wiped out. Chart 3: UK CRE - High Refi Risk

Source BNP Paribas

RBSs total CRE exposure amounted to 97bn at year-end 2008, with the UK representing around 58%, Ireland 12%, the US 8%, Spain 3% and Germany 6%, with the rest of Western Europe making up the remainder. Of the total exposure, 73% is investment and 24% (i.e. 23bn) is development, which is riskier. Less than 2% of the CRE exposure is speculative lending. The average LTV was 84% at end 2008, but this ratio will have come up with falling prices. However, this exposure will be captured within the Asset Protection Scheme. As most of the exposure to CRE is in the lending book, it has not been written down much, and provisions as of end 2008 were minimal. The CMBS exposure has had some write-downs, but this is only a fraction of the total CRE exposure. Therefore, the bulk of the losses and provisions have yet to come. RBS did not detail provisions for CRE in its latest interim trading update, so more information on this will come in H1 reporting in July. RBS had noted however that the issue for the commercial property book is mostly busting covenants and inability to refinance, unless the bank extends financing, rather than the inability to service debt in the meantime. Therefore, the key risk remains development loans in our view. Lloyds Banking Group also had an exposure of 97bn to CRE at end 2008. Of this exposure, the UK CRE originated by Lloyds represents 23.3bn (24% of total CRE exposure), UK CRE exposure originated by HBOS 44.7bn (46%) and CRE exposure originated by HBOS Overseas 29.4bn (30%).

Source BNP Paribas

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Credit Driver

26 June 2009

UK CRE lending originated by Lloyds is mainly commercial and residential, with only 6% in housebuilders. Commercial represents about 14.5bn, i.e. 15%, of which 90% is investment and only 10% development. Lloyds says it has a well-spread nationwide portfolio that had a minimum 100% interest cover from pre-let. UK CRE originated by HBOS is also largely commercial (65%), then residential (26%) and to housebuilders (9% or 4bn). The UK CRE originated by HBOS amounts to 29.1bn, and about half is investment property. Therefore, the HBOS portfolio has a greater exposure to development loans. Finally, the HBOS Overseas property lending is split 36% Ireland, 46% Europe & North America, and 18% Australia. Of the critical Irish exposure (10.7bn), it is split 55% investment and 45% development, which is riskier, and of which 38% is stressed / impaired. So this is the most troubled portfolio. Lloyds say that it has established a 28% provision coverage against such development exposures. Lloyds said that it took significant write-offs and impairments on the HBOS books in 2008, which included virtually the full write-off of all housebuilders equity exposures. The residual exposures to housebuilders has significant security including land banks, although the bank admitted that this portfolio is suffering acutely.

In conclusion, we do expect some significant impairments on the CRE loan books at RBS and Lloyds, and this will be key to watch in the H1 earnings releases scheduled for 7 and 5 August respectively.

Perspectives: more pain along the way

We appear to be following a US-like trend in the UK, which is clearly negative for local lending banks and investors, merely compounding earlier problems caused by residential real estate. As the UK economy moved into a recession, vacancy rates in office spaces and industrial parks have soared rising to 12%+ (for the latter) the highest level ever, and 7% above the minimum recorded, at 4.2%, in March 1997. Also it is becoming increasingly evident that the problems in the CRE space are not only confined to the US, but also spreading fast across the UK and other Anglo-Saxon markets. The Eurozone CRE market remains slightly more opaque given the significant variations in the dynamics of individual markets. However, it is not immune, especially given our view of a prolonged recession there. The fact that only 10% of CRE loans are securitised in Europe (US: 30%), also underscores that more of these loans are held on bank books, leading to potential write-downs down the line. Vivek Tawadey / Olivia Frieser

Credit Portfolio Strategy

Credit Driver

26 June 2009

Europe digests its version of SNAC the SEC

The beginning of this week saw the introduction of a new standard European CDS contract as dealers agreed to modify the trading convention in Europe and provide liquidity across a series of new standard fixed coupons of 25bp, 100bp, 500bp and 1000bp for any given CDS contract length. Coming hot on the heels of the other significant changes to the CDS contract (the Big Bang protocol and the trading convention changes in North America), we expected the European CDS market to take this all in its stride and continue on its merry way. So far, so good. The first day remained quiet as dealers laid low dealing with internal systems, the calculation of accruals and around which coupon liquidity would focus for any given name. Trading returned to normal levels as the week progressed. We note that the preponderance of trades centre, as we expected, around the coupons of 100bp and 500bp, with 1000bp not yet seen and 25bp popping up every now and again. We reiterate, this is a trading convention and dealers are free to offer at other coupon strikes if their clients so wish. Furthermore, somewhat counter-intuitively, some credits which previously traded at spreads below 500bp are being traded at the 500bp fixed coupon with quoted spreads below 500bp resulting in the cash payment for a CDS trade being made by the seller of protection. Some things to keep in mind: 1) Dealers are quoting spreads with reference to a flat curve with 40% recovery for senior CDS and 20% recovery for subordinated CDS. 2) There is no fixed rate for any single name, dealers are free to quote different strikes for one name and/or change to another strike at any point depending on market conditions. So far we are generally seeing 100bp for names at quoted spreads below 350bp, moving to 500bp for names at quoted spreads above that figure. 3) The market has moved to the concept of quoted spreads from running spreads. A quoted spread is representative of the upfront payment so dealers will quote a particular fixed coupon and a quoted spread alongside it which can be converted into the actual upfront payment using the official ISDA model on CDSW on Bloomberg. Certain high yield credits (and probably others in the future) which were already trading upfront continue to be quoted in the same fashion and are not quoted using quoted spreads but rather at a fixed coupon of 500bp plus the upfront payment (see Box 1 for more details on how to go from spread to upfront and vice versa). 4) The first coupon payment is always a full one no more long and short coupon payment stubs (unless you

traded in the 30 days prior to June 22). Irrespective of the date of the trade, the coupon payment on the first IMM date post trade is a full one and this is adjusted for in the initial cash payment.

Legacy trades
Recouponing of legacy trades (pre-June 22) will involve the coupon strikes of 25bp, 100bp, 300bp, 500bp, 750bp and 1000bp but has not yet begun as Markit works through a standard algorithm for the market. We encourage recouponing for all the reasons we are moving to trading fixed coupons. Fixed coupons add significantly to efficient management of cash flow annuities and provide significant netting and compression benefits as we move towards central clearing.

Clearing all up
On the clearing side, ICE Trust in the US (currently with 8 dealer members) is live for clearing CDX Series 8-12 trades and we expect many other dealers, including yours truly, to be clearing North American CDS trades through ICE Trust in the near future. Back on our side of the pond, dealers have promised regulators that the clearing process will begin for European CDS trades by the end of July, just in time for the summer holidays. There are various competing houses: BClear/LIFFE, Eurex, LCH.Clearnet and the European affiliate of ICE Trust.

Small Bang Theory

On the horizon is the Small Bang Protocol, set for mid-July, that will amend the ISDA definitions to provide for the settlement of a Restructuring credit event by a series of auctions, matching triggered CDS transactions by their scheduled maturity to a series of 8 buckets (2.5 years, 5 years, 7.5 years, 10 years, 12.5 years, 15 years, 20 years and 30 years). Buyer and seller retain the optionality of whether to trigger their CDS contracts if the Determinations Committee declares a Restructuring credit event. The Determinations Committee, in the region where the Restructuring credit event occurs, will determine, based on the number of triggered trades and participating bidders in each bucket, whether or not to hold an auction for each maturity bucket. If there is no auction in your triggered trade bucket, you will have the option to move your trade down to the next bucket for which an auction will be held. Deliverable obligations (other than the restructured debt if it matures up to 5 years after the restructuring date whereupon it goes into the 2.5 year bucket) will be assigned into a bucket matching their maturity. One last note, adhering to the Small Bang will incorporate the Big Bang. So, if you missed the prom, heres your second chance. Belle Yang

Credit Portfolio Strategy

Credit Driver

26 June 2009

Box 1: From quoted spread to upfront

Since the adoption of the fixed coupon convention on 22 June, your typical traders run will probably look similar to this: AUTO 5YR CDS BMW DAIGR PEUGOT RENAUL VW FIAT VLVY SCANIA 100 100 500 500 100 500 U/F 100 500 173/185 175/190 385/420 455/485 203/218 12/15 170/190 400/430 +2 +5 +3 0 +20 +15 0

The first thing to note is the coupon used for the quoted spread in the first column (100bp for BMW, DAIGR, VW and SCANIA, 500bp for the others). The next column is the quoted spread, bid and offer, except for FIAT which is quoted in upfront points. The last column in this case is the change on the day. With fixed coupons, single name CDS trade similarly to how iTraxx indices trade. The quoted spread gives investors an indication of what the cost of buying (selling) insurance would be if they paid (received) the prevailing market spread, with no principal exchange. However, the actual transactions cash flows involve a fixed coupon exchange on a quarterly basis (on IMM dates) and an upfront fee exchange, which accounts for the difference between the market spread and the actual coupon. To go from quoted spread (at a given coupon level) to upfront and vice versa, one can use Bloombergs CDSW function. Chart 1 shows the example of BRITEL. For this issuer, a buyer of 10mn of protection, offered to her at 187bp for a 100bp coupon transaction, will pay a 100bp annual coupon (25bp per quarter) and an additional 398,719 upfront.

The upfront fee is the combination of a principal exchange (a 399,830 payment) minus the accrued (1,111, equivalent to 4 days of AI, subtracted to the principal because the first coupon is always a full one). The principal in this case is positive (the protection buyer pays it) because the quoted spread is greater than the coupon. Since the protection buyer is paying a coupon that is smaller than she should really be paying to buy insurance (i.e. the quoted spread), she makes up for the difference by paying the principal upfront. The principal is simply the expected present value of the difference between quoted spread and coupon, calculated quarterly over the life of the contract. Had the quoted spread been lower than the coupon, the protection buyer would have received the principal upfront, since she would have been overpaying on a quarterly basis. The CDSW screen for BRITELs CDS defaults to the correct parameters to perform the spread-to-upfront calculation, namely ISDA standard upfront model, 100bp coupon, Mode 1 (input spread to calculate upfront), Standard European Contract (STEC), and default ISDA swap curve. The opposite calculation is shown on Chart 2. In this case a buyer of 10mn of protection on FIAT, who has been offered it at 15 points upfront and 500bp running, will pay 500bp a year (125bp per quarter) plus 1,494,444 upfront, equivalent to a principal of 1.5mn (15% of 10mn) minus the accrued, in this case 5,556. The calculated spread of 939bp is only for information, as it is not needed to trade. In this case the settings CDSW chooses for us are different from the previous example, as it defaults to Mode 2 (input upfront to calculate spread); we also had to manually change the default coupon of 1000bp to 500bp, as the traders quote was for 15 points upfront and a coupon of 500bp. Note that Bloombergs CDSW function shows, alongside the spread, the implied default probability (risk neutral) for the credit, cumulative over the life of the CDS contract. Andrea Cicione

Credit Portfolio Strategy

Credit Driver

26 June 2009

Chart 1: From spread to upfront: a quoted spread of 187bp (at 100bp coupon) is equivalent to a 399,830 principal

Source Bloomberg

Note the effective date 60 days before the valuation date, now applicable to all trades (new and legacy)

Chart 2: From upfront to spread: 15 upfront points (at 500bp coupon) are equivalent to a 939bp running spread

Source Bloomberg

Note the effective date 60 days before the valuation date, now applicable to all trades (new and legacy)

Credit Portfolio Strategy

Credit Driver

26 June 2009

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Credit Portfolio Strategy