A Rating Agency Perspective Marc Daly Nik Khakee

2 CREDIT DERIVATIVES – A HIGHLY DYNAMIC MARKET INSTITUTION Bank Convertible Bond Buyer Fund Manager Financial Insurer Corporation Capital Structure Arbitrageur RATIONALE Regulatory, Relationship Low Volatility Equity Option Specialization, Yield enhancement Actuarial Relationship, Line Creation Monetize Inefficiency

3 CREDIT DERIVATIVES MARKET PARTICIPANTS CDO’s Credit Derivatives Market Corporations Mutual Funds Insurance Companies Pension Funds Banks Hedge Funds Reinsurers

4 MARKET PARTICIPANTS AND END USERS Banks 64% Securities Houses 18% Corporates 10% Mutual Funds & Money Managers 4% Insurance Companies 4% Risk Sellers (Default Swap Buyers/Protection Buyers) Risk Buyers (Default Swap Buyers/Protection Sellers) Banks 43% Securities Houses 20% Mutual Funds & Money Managers 8% Pension Funds 4% Reinsurers and Insurance Co. 25% Reduced Exposure Increase Exposure

5 CREDIT DERIVATIVES - RATIONALE Rationale Based on Customization, Transformation and Active Management of Credit Exposure Broad Spectrum of Motivations for Using Credit Derivatives –Isolating Credit Risk from Composite risks – Interest Rate, Currency, Equity –On-balance-sheet versus Off-balance-sheet Applications –Credit Risk Management on Single Credit and/or Portfolio Basis –Regulatory Capital management –Yield Enhancement –Market Access –Confidentiality

6 CREDIT DERIVATIVES CORE CLIENTS - BANKS Credit derivatives enable bank loan portfolio managers to hedge credit risk on a confidential basis and address traditional obligor concentrations. Credit derivatives can be used by bank loan portfolio managers to create synthetic syndicated lending opportunities. Proposed changes in BIS regulatory capital requirements will accelerate drive toward credit risk management based on underlying credit quality.

7 BANK LOAN PORTFOLIO HEDGING Ability to hedge anonymously while continuing to reap benefits of borrower relationship by remaining the lender of record. Regulatory capital relief. Economic hedging (valuing credit deterioration vs. Default) Hedging out of concentrations, freeing credit lines. Evaluation risk exposure vs. benefits of relationship across business lines. Hedging revolver exposures through synthetic term loans.

8 International Swap and Derivatives Association, Inc. (ISDA) ISDA is a global trade association representing leading participants in the privately negotiated derivatives industry

9 ISDA CREDIT EVENTS Bankruptcy Obligation Acceleration Obligation Default Failure to pay Repudiation/Moratorium Restructuring

10 S&P’s Analysis: A Credit Risk Assessment Credit event definitions which mirror the events we have captured in our default study Credit event definitions such that the holder of a credit default swap faces the same risk as the holder of the underlying credit Credit event definitions such that the holder of a credit default swap and the holder of the underlying credit are exposed to the same frequency and sometimes severity of losses Credit event definitions that allow S&P to use our internally developed models or those of our clients to rate the risk of credit default swaps

11 Single Name Credit Derivatives Single Name Credit Derivatives are bilateral financial contracts that enable an investor to buy protection against the risk of default of an asset issued by a specified reference entity.

12 STANDARD & POOR’S RESPONSE (SINGLE NAME) Standard & Poor’s will continue to accept the following credit events for single name credit default swaps: –Bankruptcy –Failure to Pay –Repudiation/Moratorium S&P will accept a modified restructuring definition which includes –Reduction or postponement of interest –Reduction or postponement of principal

13 STANDARD & POOR’S RESPONSE (SINGLE NAME) cont’d S&P will not accept a modified restructuring definition which includes –Change in ranking of priority (i.e. subordination) –Change in the currency or composition of principal and interest S&P will only accept Acceleration under limited circumstances

14 STANDARD & POOR’S RESPONSE (PORTFOLIO SWAPS) Currently S&P continues to accept the five out of the original six credit events S&P is not satisfied with ISDA’s decision to retain Restructuring, but has accepted ISDA’s rationale for retaining it and makes probability of default adjustments to attend to that reality S&P will “haircut” recovery assumptions for portfolio swaps that use cash settlement rather than physical delivery

15 S&P’S GLOBAL RESPONSE S&P is making a distinction between hard/objective credit events and soft/subjective events S&P is concerned that ISDA’s credit event definitions expose investors to a higher expected loss than holding the underlying reference security European rejection of Modified Restructuring: waiting for their Conseco.

16 Additional Risks Present in Credit Derivatives Credit Derivatives versus Financial Guaranties - Are the risks the same? New attention being focused on this can only help?