Richard Gugliada Managing Director 12124382474 richard_gugliadasandp.com

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Global CDO Market Update

• Richard GugliadaManaging Director
  1-212-438-2474 richard_gugliada_at_sandp.com

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SPs Global CDO Rated Transactions by Region
(1996-2002)
o f D E A L S
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SPs Global CDO Rated Transactions by Region
(1996-2002)
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EVOLUTION OF CDOs
Leveraged Loans
ABS MBS REITs Distressed Debt Synthetic CDOs
Trust Preferred Private Equity Hedge
Funds Municipal Bonds Correlation Trades Other
HY DEBT
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Cash Flow CDOs

• Interest and principal for Corporate obligations
  are used to pay down the investors.
• Liabilities are subordinated to provide different
  levels of credit protection.
• Assets ? SPV ? Class A AAA
• Class B BBB
• Equity NR

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Cash Flow CDO Structure
Market / Sponsor
SPV
Loan/Bond Portfolio
Class A Class B Class C Equity

notes
cash
cash
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Synthetic CDO

• Investors sell credit protection to 3rd party on
  a referenced pool of obligations.
• SPV holds the money in Eligible Investments (EI)
• Investors get interest from EI and 3rd party.
• If an obligation in the pool defaults, SPV pays
  3rd party from EI, based on an agreed upon
  settlement process to value the defaulted
  obligation.

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Synthetic CDO
Eligible Investments

Assets
cash
Class A Class B Class C Equity
Sponsor/ Protection Buyer
SPV
fee
notes
contingent payment
cash
Reference portfolio
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Global Rated Volume
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Global Rated CDO Volume2001 vs. 2002
Excludes 11 US re-pack deals
Source SP Global Deal List
Rounded two decimal places
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Global CDO Volume YTD September 02 vs. YTD
September 03
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Economic and Regulatory Backdrop
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Economic Backdrop

• HY issuance remains relatively low
• Severe pool-level ratings migration
• Stigma of Record Corporate Defaults
• Too much liquidity to certain sectors (e.g.,
  telecom and healthcare)
• Depressed recoveries
• Corresponding negative correlation

• All contribute to poor performance in certain
• sub-sectors of CDO market

• But, fixed income market sell-off creating
• relative buy opportunities

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U.S. SPECULATIVE GRADE ISSUANCE
(1992 Aug. 25, 2003)
(US Billions)
Industrials
Telecommunications
Utility
Financials
140
120
100
80
60
40
20
0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Includes all public and rule 144a issuance of
straight, convertible, floating-rate,
and medium-term notes issued into U.S.
marketplace by financial and non-financial
entities.
Source Standard Poor's Global Fixed Income
Research, Thomson Financial
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Annual Default RatesInvestment Grade
Speculative Grade
Source Standard Poor's Risk Solutions
CreditPro 6.4
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Source Standard Poor's Risk Solutions
CreditPro 6.4
Quarterly Default Rates Speculative Grade
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Standard Poors LossStatsTM Recovery
Rates Based on Pre-Default Interest
1988 2003 Q2
1998 2003 Q2
1741 observations 868 observations
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Current Regulatory-Driven Issues Impact on
Investor Appetite

• FIN 46 / FAS 140
• EITF 99-20
• Traditional non-US investors under increased
  regulatory scrutiny
• Efficiency of holding downgraded assets for
  portions of CDO investorbase(e.g., conduits,
  SIVs, insurance companies, etc.)

? All combine to create buying opportunities
? But ramp-up difficult
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GLOBAL CDO PERFORMANCE
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Most Downgrades Are Caused By These Problems

• Credit migration reduction in the credit
  quality of the performing assets within the
  collateral pool
• Par erosion reduction in the par value of the
  collateral pool securing the rated notes
• Spread deterioration reduction of the weighted
  average coupon or weighted average spread
  generated by the performing assets within the
  collateral pool
• Hedging issues mismatch between the fixed rate
  of interest received off the assets in the
  collateral pool and the floating rate of interest
  paid on the liabilities

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Global CDO 1997 to 2002 Average One-Year
Transition Rates ()
includes all CDO segments
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U.S. CDO versus U.S. Corporate 2002 One-Year
Transition Rates ()
CDOs
CORPORATES
includes all CDO segments
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European CDO versus European Corporate 2002
One-Year Transition Rates ()
CDOs
CORPORATES
includes all CDO segments
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DO COLLATERAL MANAGERS ADD VALUE?
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Cash Flow CBO Rating TransitionsTen Collateral
Managers with the Most Downgraded Senior Tranches
(HY and IG CBO transactions only)
as of Aug. 31, 2003
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Leverage via Par-Building Trades
EXAMPLE 1 Before a payment date in 2000,
Manager X purchased two bonds at discounted
prices (i.e., 14 and 17), even though the
obligors were rated B and B- and on credit
watch negative. Net result was a gain of 5mm in
par because assets carried at 100. Class B O/C
ratio to pass by 80 bps. Two weeks after the
payment date one defaults. Manager X insists not
credit risk when purchased. EXAMPLE
2 Transaction has a 5 CCC bucket. Manager Y
continued to purchase CCC-rated assets, even
after bucket exceeded. Through discounted trades
(e.g., 28.5 and 30) increased par by more than
200mm since closing. Several assets defaulted
less one month after purchase. EXAMPLE
3 Immediately prior to pay date, Manager Z
purchases several heavily discounted securities
in 2 CLOs it manages because they are dollar
good (e.g., 6 rated B- watch negative).
Carrying those assets at par allows monies to pay
subordinate management fee and an equity
distribution (n.b., some equity held by Manager
Z). Direct proceeds to Manager Z from both deals
exceeded 1.5mm. Assets subsequently downgraded
to CC. Despite conference call, Manager Z does
similar (but less egregious) trade last month.
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Striking a Balance is Key
Bondholders vs. Equityholders
BONDHOLDERS Timely Interest Ultimate Principal
EQUITYHOLDERS Current Income Upside Relative to
Risk Profile

• Structural Mitigants
• Compromising to Build Rainy Day Cushion

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Static versus Managed Transactions

• Lessons Learned by looking at Corporate Static
  Pools
• Flexibility to Move In and Out of Credits Based
  on Market
• Conditions Comes at a Cost and Increases Risk /
  Leverage
• Collateral Mangers True Added Value Difficult to
  Gauge
• Mandatory Redemptions Following Breach of
  Coverage Tests Make Meaningful Comparisons to
  Most Indexes Difficult
• Certain Structures Incentives Gaming
• Adverse Selection versus Rational Decisions to
  Avoid Shutting Down Deal Given Constraints

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SPs CDO Manager Focus

• A comprehensive report of a CDO Managers
  capabilities track record developed through
  in-depth site visits transaction evaluation
• Manager capability report focuses on Manager
  team depth, coverage expertise organizational
  support investment process credit evaluation
  practices CDO structural management
• Transaction evaluation addresses managers
  results relative to their peers by evaluating
  default rates covenant breaches par erosion
  trends sales purchase prices portfolio credit
  quality diversification of their outstanding
  CDOs

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NEW INITIATIVES FROM SP

• INCREASED TRANSPARENCY
• Pre-Sale Reports Globally
• Post-Sale Reports Globally
• CDO Manager Focus Reports
• CDO Explorer Collateral Info
• Expanding CDO Indices
• CDO BENCHMARKS
• CDO Evaluator version 2.2 just out
• Roll-Out ROC Performance Tool

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Structural Mitigants address non-rating related
issues

• Notching Assets on Credit Watch
• Haircut Low-Rated Collateral
• Additional Credit Risk Disclosure / Purchase
  Discounts
• Applying Additional Defaults to Reinvested Monies
• Modeling Defaults After Breach of Traditional
• Coverage Tests, Absent Additional Coverage or
• Other Reinvestment Tests
• Treating All Monies from Defaulted Securities as
  Principal
• Limitation on Pass-Through of Trading Gains

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SP CDO Benchmarks Dissecting a Sample ROC Report
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Whats Hot and Whats Not

• Excessive leverage
• Unrealistic equity returns
• Diversity for diversitys sake
• Discretionary trading
• Difficulty in replacing collateral managers
• Abandoning transactions
• Cosmetic structural mitigants
• Inadequate staffing
• Lack of drill-down technology
• Restructuring
• Style drift

• Money market tranches
• Structural mitigants
• Marks in lieu of ratings
• ROC and other performance measures
• Single-tranche correlation trades
• Retranchings
• CDO squared technology
• Additional transparency
• Template to address FIN 46
• CDOs of alternative assets

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