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4 Corporate-Backed Trust Securities In its most common form a corporate-backed trust security is a simple pass-through of the cash-flows of the underlying security and no credit risk is added to the structure Trust* Retail Investors Retail / Institutional Investors Secondary Market XYZ bond Corporate-backed trust certificates XYZ bond Similarities –Credit exposure to the underlying issuer –Credit decision based on public information –Underlying issuer is the only payment source Differences –Recovery upon an event of default –Voting rights Institutional Investors Interest-only certificates * This is typical of a CorTS (CITI), CBTCS (LEH) or PPLUS (ML) transaction. 1

5 Corporate-Backed Trust Securities Market Characteristics The corporate-backed trust securities market emerged in 1999 and has grown significantly since that time 260 transactions executed to date Total market volume of over $12.4 billion The most active participants are: Citigroup (CorTS®) Lehman Brothers (CBTCS) Merrill Lynch (PPLUS) Morgan Stanley (SATURN SM ) 5 other participants Mostly sold through internal brokerage network but there is a significant amount sold by participants to third party dealers 2

6 Impact of Cessation of Reporting Direct holders –No impact on the quality of credit –Possible positive technical impact on the price due to scarcity –Bonds continue to trade freely Despite their similarities, a cessation of reporting has a very different and negative impact on a repackaged transaction Repackaging investors –No impact on the quality of credit –Supply from trust termination(s) may have a negative impact on the price of the underlying securities and the resulting proceeds to investors –Repackaged securities stop trading 3

7 CPI-Based Transactions CPI-linked repackaged securities are very similar to directly-issued CPI-linked securities Investors XYZ Monthly CPI-linked payment CPI bond Directly-issued CPI bond Trust Investors Secondary Market XYZ CPI bond CPI-linked trust certificates Monthly CPI-linked payment Repackaging of directly- issued CPI bond Trust Investors Swap Counterparty Secondary Market XYZ bond Monthly CPI-linked payment Semi-annual interest on XYZ bond Monthly CPI- linked payment CPI-linked trust certificates CPI-linked repackaged security 4

8 Comparison to Interest Rate Swaps Like a floating rate repackaged security, a CPI-linked repackaged security reduces the investors fixed interest rate exposure Trust Investors Swap Counterparty Secondary Market Monthly CPI-linked payment Semi-annual fixed interest on XYZ bond Monthly CPI- linked payment CPI-linked trust certificates Trust Investors Swap Counterparty Secondary Market XYZ fixed- rate bond Quarterly LIBOR- linked payment Semi-annual fixed interest on XYZ bond Quarterly LIBOR-linked payment Floating rate trust certificates XYZ fixed- rate bond 5

9 3MO Libor vs. CPI-Index Adjustment 3-month LIBOR and CPI levels have had similar trends since 1985, highlighting the similarity between the two indices Source: Citigroup and Bureau of Labor Statistics As of 09/13/04 6

10 CPI-Based Transactions Since 1997, issuers including the US Treasury (TIPS) have issued bonds with principal and interest payments linked to the CPI –15 TIPS issues for a total of approximately $211 billion Greater liquidity in the TIPS market combined with the potential for rising inflation rates have strengthened both issuer and investor interest in CPI bonds Corporate issuers may have limited interest in issuing CPI-linked debt However, investors wish to obtain additional yield for credit risk in an inflation-protected format –Repackaged transactions can meet this desire CPI is an excellent example of a synthetic that should be included in the definition of Asset-Backed Securities 7

11 Default Swaps and Credit Linked Notes

12 Default Swaps and Credit Linked Notes Table of Contents 1. Repackaging Examples Appendices Appendix A - Credit Derivatives Market Overview Appendix B - Introduction to Single-Name Credit Default Swaps and Credit Linked Notes Appendix C - Introduction to the Dow Jones CDX.NA.IG

13 1. Repackagings Examples

14 –Investors assume credit exposure to a single bond of the underlying issuer –Underlying bond is the only payment source –Hundreds of existing public deals Example 1 - Single Bond Secondary Market Trust Single Bond Issued by XYZ Corp. Retail Investors Institutional Investors In its most common form, a corporate-backed trust security is a simple pass-through of the cash-flows of a single underlying security and no credit risk is added to the structure

15 Investors assume two separate credit risks. The risk transfer with respect to the single bond is equivalent to Example 1 -- Single Bond Default swap contract transfers no greater credit risk than the risk of a single bond that investors assumed in Example 1. Difference compared with Example 1 -- Single Bond: investors also assume credit risk of the Swap Counterparty Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed). Example 2 - Single Bond Risk Transfer Via Default Swap (No Collateral) Swap Counterparty Trust Default Swap Contract on Single Bond Issued by XYZ Corp. Retail Investors Trust Certificates

16 Example 3 - Multiple Bonds of a Single Issuer Secondary Market Trust Multiple Bonds Issued by XYZ Corp. Retail Investors Institutional Investors The risk transfer is equivalent to Example 1 -- Single Bond, except that investors assume risk with respect to multiple bonds of an issuer. Underlying cash bonds are the only payment source Existing public deals

17 The risk transfer with respect to the single bond is equivalent to Example 3 -- Multiple Bonds of a Single Issuer Default swap contract transfers no greater credit risk than the risk of the bonds that investors assumed in Example 3. Difference compared with Example 3 -- Multiple Bonds of a Single Issuer: investors also assume credit risk of the Swap Counterparty Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed). Example 4 - Multiple Bonds Risk Transfer Via Default Swap (No Collateral) Swap Counterparty Trust Default Swap Contract on Multiple Bonds Issued by XYZ Corp. Retail Investors Trust Certificates

18 Example 5 - Multiple Bonds and Loans of a Single Issuer Swap Counterparty Trust Default Swap Contract on Multiple Bonds and Loans of XYZ Corp. Retail Investors Corporate-backed trust certificates Risk Transfer Via Default Swap (No Collateral) The risk transfer with respect to the XYZ bonds is equivalent to Example 3 -- Multiple Bonds of a Single Issuer, except that loans entered into by the issuer are also included. Default swap contract transfers (i) the risk of the bonds that investors assumed in Example 3, plus (ii) the risk of loans entered into by the issuer. Difference compared with Example 3 -- Multiple Bonds of a Single Issuer: investors also assume credit risk of the Swap Counterparty Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed).

19 Investors assume two separate credit risks (assuming de minimis exposure to Swap Counterparty). Default swap contract may transfer no greater credit risk than the risk illustrated in Examples 1, 3 or 5. Difference compared with Examples 2 and 4: investors assume credit risk of the Collateral. In some cases, Swap Counterparty exposure must be considered. Swap Counterparty Trust Default Swap Contract -- see Examples 1, 3 and 5 Retail Investors Example 6 - Risk Transfer Via Default Swap (With Collateral) Issuing Entity $100 Corporate-backed trust certificates Collateral

20 Only the size of the trust assets changes. Certificates are fungible. Requiring a new issuance imposes unnecessary transaction costs on investors and results in reduced liquidity of new issue. Upsizings of Transactions Should be Permitted Upsizings

21 Appendix A - Credit Derivatives Market Overview

22 The Credit Derivatives market is one of the largest, fastest growing sectors of the financial industry The Credit Derivatives market is forecasted to reach a size of approximately 4.8 trillion by the end of 2004 (1) Credit Default Swaps account for 67% of the Credit Derivatives market (2) The default swap market presents the opportunity to: –increase returns generated from the credit markets –diversify and broaden the sources of credit investment opportunities –achieve more specialized exposure aligned with investment goals –create credit investments with attractive yields Participation by a wide range of market participants Credit Derivatives Market Overview Introduction ____________________ (1) BBA Credit Derivatives Report 2001/2002 (2) Fitch Ratings

23 Credit Derivatives Market SizeComposition of the Market as of End 2003 ____________________ Source: ISDA ____________________ Source: Fitch Ratings Market Overview

24 Appendix B - Introduction to Credit Default Swaps and Credit Linked Notes

25 Payment is contingent on triggering a Credit Event and satisfaction of the Conditions to Settlement with respect to a Reference Entity. Upon satisfaction of such requirement, Credit Protection Buyer selects Bonds or Loans of the Reference Entity to deliver to the Credit Protection Seller and Credit Protection Seller pays par for such Bonds or Loans. Premium Contingent Payment Credit Protection Buyer Credit Protection Seller Terms: Standard Credit Default Swap Reference Entity Physical Settlement. No Credit Event occurs: payout=0.

26 Example: Ford Default Swap Credit Protection Buyer Credit Protection Seller Reference Entity Ford [Premium bps] Notional = $10 MM Contingent: Payment Upon occurrence of a Credit Event with respect to Ford, Credit Protection Buyer selects Bonds or Loans issued or guaranteed by Ford with a face amount equal to 10MM USD and Credit Protection Seller pays par even though Bonds may have a market value of 40%.

27 Bankruptcy - Reference Entity (Ford) goes bankrupt. Failure To Pay - Reference Entity (Ford) fails to pay on a Borrowed Money Obligation. Credit Events

28 Deliverable Obligations: Bond or Loan Credit Protection Buyer delivers Bonds Or Loans issued by Reference Entity (Ford) or guaranteed by Reference Entity (Ford) that: - Not Subordinated to Reference Obligation - Not Contingent - Not Bearer - Maximum Maturity 30 Years - Standard Currency - Assignable/Consent Required Loan

29 A CLN is a fully collateralized credit default swap, in the form of a note issuance by a bankruptcy-remote issuer. Why Collateralize? –Eliminates the protection buyers credit exposure to the individual investor –Offers investor credit exposure in a familiar bond-like form Credit Linked Notes (CLNs) Definition Introduction to Credit Linked Notes

30 Advantages of CLNs versus bonds: –maturity, coupon, and reference entity can be customized –flexible coupon (fixed, floating, monthly, quarterly, semiannually) –still maintains bond features and convenience DTC settlement; separate CUSIP; Bloomberg listing; can be rated by the ratings agencies CLN considerations: –liquidity may be less than a benchmark bond Credit Linked Notes (CLNs) vs. Bonds Introduction to Credit Linked Notes

31 The investor is exposed to the Reference Entity and the underlying trust collateral (in the case of an SPV issuer) or Dealer (in the case of Dealer as issuer). Upon the occurrence of a Credit Event with respect to the Reference Entity, the CLNs are redeemed and the protection Buyer (Dealer) delivers to investors the par amount of defaulted debt obligations of the Reference Entity to the total principal amount of CLNs. When a Credit Event occurs, investors in a credit linked note end up in the same position as they would have been if they had bought senior debt of the Reference Entity directly. Credit Linked Note Basics Introduction to Credit Linked Notes

32 Fixed rate x bps Default Protection Protection Buyer (Dealer) Investor Trust (SPV Issuer) L + y bps $10mm Highly Rated Collateral $10mm L + x + y bps Default CLNs: Special Purpose Vehicle as Issuer For investors looking for a floating rate coupon…. Introduction to Credit Linked Notes Example CLN Structures

33 Fixed rate x bps Default Protection Protection Buyer (Dealer) Investor Trust (SPV Issuer) L + y bps $10mm Highly Rated Collateral $10mm Fixed Rate Default CLNs: Special Purpose Vehicle as Issuer Swap Counterparty L + x + y bps Fixed Rate …or a fixed rate coupon: Introduction to Credit Linked Notes Example CLN Structures

34 Appendix C -Introduction to the Dow Jones CDX.NA.IG

35 Overview Introduction to the Dow Jones CDX.NA.IG The Dow Jones CDX.NA.IG is the New US Benchmark for tradable 5yr and 10yr index products Liquidity –Proven liquidity track record from the market making group –Multiple market maker platform Transparency –A transparent rules-based approach to portfolio construction Standardization documentation Globalization –The Dow Jones CDX.NA.IG is a pillar in the Dow Jones platform

36 Introduction to the Dow Jones CDX.NA.IG Key Features Clear rules for portfolio construction Pricing via Bloomberg Standardization and multi-market maker platform to ensure transparency Active participation of Dow Jones Ltd as Administrator Track record in: –CDS flow market –Other credit indexes –Dow Jones Notes in Europe The largest platform of leading market makers Dow Jones CDX.NA.IG is the New US Benchmark Unfunded or in CLN form Tradable sector swaps Standardized documentation 5 and 10 year maturities No fees Static portfolio of 125 diverse names Liquidity & Track Record Transparency Product Breadth Globalization Structure

37 Introduction to the Dow Jones CDX.NA.IG Benchmark Tradability Standardized CDS contracts Sector trading –Financials –TMT –Energy –Industrials –Consumers

38 Introduction to the Dow Jones CDX.NA.IG Credit Event Example - Counterparty buys $100m Dow Jones CDX.NA.IG Exposure in Unfunded / CDS Form No Credit Event –The fixed rate of the Dow Jones CDX.NA.IG is [70] basis points per annum quarterly –Market maker pays to counterparty [70] bps per annum quarterly on notional amount of $100m –With no Credit Events, the counterparty will continue to receive premium on original notional amount until maturity Credit Event –The fixed rate of the Dow Jones CDX.NA.IG is [70] basis points per annum quarterly –Market maker pays to counterparty [70] bps per annum quarterly on notional amount of $100m –A Credit Event occurs on Reference Entity, for example, in year 3 –Reference Entity weighting is 0.8% –Counterparty pays to market maker (0.008 x 100,000,000)= $800,000, and market maker delivers to counterparty $800,000 principal amount of Deliverable Obligations of the Reference Entity –Notional amount on which premium is paid reduces by 0.8% to $99,200,000 –Post Credit Event, counterparty receives premium of [70] bps on $99.2m until maturity

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