CorporateBacked Trust Securities

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Corporate-Backed Trust Securities
SecondaryMarket

• Similarities
• Credit exposure to the underlying issuer
• Credit decision based on public information
• Underlying issuer is the only payment source

XYZ bond
XYZ bond
Trust
Retail / Institutional Investors
Corporate-backed trust certificates

• Differences
• Recovery upon an event of default
• Voting rights

Interest-only certificates
Retail Investors
Institutional Investors
This is typical of a CorTS (CITI), CBTCS (LEH)
or PPLUS (ML) transaction.
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
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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 (SATURNSM)
• 5 other participants
• Mostly sold through internal brokerage network
  but there is a significant amount sold by
  participants to third party dealers

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Impact of Cessation of Reporting

• 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

• 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
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CPI-Based Transactions
Repackaging of directly-issued CPI bond
CPI-linked repackaged security
Directly-issued CPI bond
Secondary Market
SecondaryMarket
XYZ CPI bond
Monthly CPI-linked payment
XYZ bond
Semi-annual interest on XYZ bond
Trust
Swap Counterparty
Trust
XYZ
Monthly CPI-linked payment
MonthlyCPI-linked payment
CPI-linked trust certificates
Monthly CPI-linked payment
CPI bond
CPI-linked trust certificates
Monthly CPI-linked payment
Investors
Investors
Investors
CPI-linked repackaged securities are very similar
to directly-issued CPI-linked securities
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Comparison to Interest Rate Swaps
Secondary Market
Secondary Market
XYZ fixed- rate bond
XYZ fixed- rate bond
Semi-annual fixed interest on XYZ bond
Semi-annual fixed interest on XYZ bond
Swap Counterparty
Trust
Swap Counterparty
Trust
Quarterly LIBOR-linked payment
Monthly CPI-linked payment
Quarterly LIBOR-linked payment
Floating rate trust certificates
Monthly CPI-linked payment
CPI-linked trust certificates
Investors
Investors
Like a floating rate repackaged security, a
CPI-linked repackaged security reduces the
investors fixed interest rate exposure
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3MO Libor vs. CPI-Index Adjustment
As of 09/13/04
Source Citigroup and Bureau of Labor Statistics
3-month LIBOR and CPI levels have had similar
trends since 1985, highlighting the similarity
between the two indices
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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
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Default Swaps and Credit Linked Notes
CONFIDENTIAL
DRAFT
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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
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1. Repackagings Examples
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Example 1 - Single Bond

• Investors assume credit exposure to a single bond
  of the underlying issuer
• Underlying bond is the only payment source
• Hundreds of existing public deals

Secondary Market
Single Bond Issued by XYZ Corp.
Trust
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
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Example 2 - Single BondRisk Transfer Via Default
Swap (No Collateral)

• 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).

Swap Counterparty
Default Swap Contract on Single Bond Issued by
XYZ Corp.
Trust
Trust Certificates
Retail Investors
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Example 3 - Multiple Bonds of a Single Issuer

• 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

Secondary Market
Multiple Bonds Issued by XYZ Corp.
Trust
Retail Investors
Institutional Investors
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Example 4 - Multiple BondsRisk Transfer Via
Default Swap (No Collateral)

• 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).

Swap Counterparty
Default Swap Contract on Multiple Bonds Issued
by XYZ Corp.
Trust
Trust Certificates
Retail Investors
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Example 5 - Multiple Bonds and Loans of a Single
Issuer
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).

Swap Counterparty
Default Swap Contract on Multiple Bonds and Loans
of XYZ Corp.
Trust
Corporate-backed trust certificates
Retail Investors
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Example 6 - Risk Transfer Via Default Swap (With
Collateral)

• 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
Default Swap Contract -- see Examples 1, 3 and 5
Trust
100
Issuing Entity
Collateral
Corporate-backed trust certificates
100
Retail Investors
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Upsizings
Upsizings of Transactions Should be Permitted

• 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.

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Appendix A - Credit Derivatives Market Overview
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Credit Derivatives Market Overview
Introduction

• 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

____________________ (1) BBA Credit Derivatives
Report 2001/2002 (2) Fitch Ratings
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Market Overview
____________________ Source Fitch Ratings
____________________ Source ISDA
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Appendix B - Introduction to Credit Default
Swaps and Credit Linked
Notes
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Terms Standard Credit Default Swap

• 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
Credit Protection Buyer
Credit Protection Seller
Contingent Payment

• Physical Settlement.
• No Credit Event occurs payout0.

Reference Entity
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Example Ford Default Swap
Premium bps
Credit Protection Buyer
Credit Protection Seller
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.
Reference Entity Ford
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Credit Events

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

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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

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Introduction to Credit Linked Notes
Credit Linked Notes (CLNs) Definition

• 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

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Introduction to Credit Linked Notes
Credit Linked Notes (CLNs) vs. Bonds

• 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

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Introduction to Credit Linked Notes
Credit Linked Note Basics

• 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.

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Introduction to Credit Linked Notes Example CLN
Structures
CLNs Special Purpose Vehicle as Issuer

• For investors looking for a floating rate coupon.

Fixed rate x bps
L y bps
Highly Rated Collateral
Protection Buyer(Dealer)
Trust(SPV Issuer)
Default Protection
10mm
Default
10mm
L x y bps
Investor
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Introduction to Credit Linked Notes Example CLN
Structures
CLNs Special Purpose Vehicle as Issuer

• or a fixed rate coupon

Swap Counterparty
L x y bps
Fixed Rate
Fixed rate x bps
L y bps
Highly Rated Collateral
Protection Buyer(Dealer)
Trust(SPV Issuer)
Default Protection
10mm
Default
10mm
Fixed Rate
Investor
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Appendix C - Introduction to the Dow Jones
CDX.NA.IG
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Introduction to the Dow Jones CDX.NA.IG
Overview

• 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

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Key Features
Introduction to the Dow Jones CDX.NA.IG
Transparency
Product Breadth
Liquidity Track Record

• 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

• Unfunded or in CLN form
• Tradable sector swaps

Globalization
Structure

• Dow Jones CDX.NA.IG is the New US Benchmark

• Standardized documentation
• 5 and 10 year maturities
• No fees
• Static portfolio of 125 diverse names

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Benchmark Tradability
Introduction to the Dow Jones CDX.NA.IG

• Standardized CDS contracts
• Sector trading
• Financials
• TMT
• Energy
• Industrials
• Consumers

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Credit Event Example - Counterparty buys 100m
Dow Jones CDX.NA.IG Exposure in Unfunded / CDS
Form
Introduction to the Dow Jones CDX.NA.IG

• 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

• 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

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