The Next Generation of Transactions in Portfolio Credit

1
The Next Generation of Transactions in Portfolio
Credit
IACPM General Meeting, Boston, November 15-16,
2006
2
Table of Contents

• Overview of the Credit Derivative Market
• Trading within Constraints of a Loan Portfolio
• Positioning for Divergence

3
Overview of the Credit Derivative Market
Tracey BenfordGoldman Sachs
4
Credit Derivatives Market Evolution109 Growth
in 2006

• The credit derivative market is expected to grow
  to over 35 trillion by the end of 2006

• Growth of the Credit Derivative Market
• ISDA has reported steady growth in the global
  credit derivatives market
• Drivers of future growth
• Increased liquidity
• Greater client understanding
• Improved standardization within the market
• A wider product base attracting more players

Credit Derivatives Outstanding Notional1
Late 80s
1996
1997
2003
2004
Today
Development of Cash CDOs
Introduction of Moodys ratings model
First synthetic CDOs
Creation of Dow Jones Trac-X Development of
index tranche market
Development of investor and third party managed
transactions
Investors can choose between investor selected,
third party managed or index-based transaction
1 Source ISDA, BMA and the British Bankers
Association Credit Derivatives Report 2003/2004.
5
Product Segmentation

• Within the tremendous growth of credit
  derivatives, index and portfolio products have
  continued to gain market share over single-names
  since 2003

Market Share and Estimated Product Growth1
1 Source British Bankers Association Credit
Derivatives Report 2003/2004 Standard and Poors
LCD Bond Market Association
6
Market Participants

• Banks continue to maintain substantial market
  among buyers and sellers of credit protection
• Recent accounting changes have increased bespoke
  volumes among banks and insurance companies

Buyers of Credit Protection
Sellers of Credit Protection
Other includes corporations, mutual funds,
pension funds and government agencies
7
Hedging ToolsCorporate Credit
8
Hedging ToolsConsumer Credit
9
Synthetic CreditPotential Applications

• Applications vary according to institution type
  and investment objectives

Bank Prop Desks
Asset Managers
Hedge Funds
Insurance Co.

• Relative value trading
• Efficient directional trading
• Efficient leverage

• Relative value trading
• Efficient directional trading
• Negative basis trades

• Efficient credit exposure
• Long / short strategies
• Liquidity management tool / cash substitute

• Credit diversification
• Positive basis trades
• Efficient credit exposure

DPC / Conduits
CLO Managers
Correlation Trading Desks
Bank Loan Portfolios

• More efficient hedging
• Credit diversification / rebalancing

• Managed synthetic portfolio trades
• Bespoke trades / efficient ramp-up

• Access to tight supply credits
• Reduce credit convexity

• Levered exposure to AAA assets

10
Trade Concepts Currently in the Market

• Outright Long/Short Trades
• Negative view on HY defaults in the short term -
  buy 3y CDX.HY7 0-10 protection
• Macro Trades
• IG macro short - buy protection on CDX.IG7
  outright
• Curve Trades
• View the 5/10s F Co curve as too steep - sell 10y
  F Co protection vs. buy 5y
• Pick up 40bp carry DV01 neutral
• Basis/Convexity Trades
• Buy BGG 8.875 Mar11 and buy BGG CDS protection
• Pick up 10bp carry for 4.25 years, with full HY
  covenant package, including a 101 put with a name
  that has been on LBO screens across the street
• Cash/LCDS Negative Basis Trades
• Buy LYO Aug13 and buy LYO LCDS protection
• Pick up 68bp carry for 7 years
• LCDS spreads tightening momentum has slowed down
  considerably recently
• Downturn in credit environment may force future
  refinancings at wider levels (will be reflected
  in LCDS), with increased effects in LCDS vs. loan
  due to non-callable nature of LCDS contract,
  impossibility to short loans in the cash market,
  and bank loan portfolio managers being forced to
  hedge exposure
• Credit/Equity Trades
• Buy CZN stock vs. buy CZN CDS
• High inverse historical correlations between
  equity and CDS for BB/BBB-rated names may lead to
  opportunities when decoupling occurs

For illustrative purposes only. Indicative as of
25Oct06.
11
Where is the Market Heading?

• LCDS Growth
• Broader participation in the market
• Standardization of contract (Europe)
• LCDS Index and other developments
• Synthetic Securitization
• Buy protection on x-100 tranche of synthetically
  replicated loan portfolio
• ABX.HE and CMBX Growth
• Broader participation in the market
• Tranches on the ABX.HE / CMBX
• Leveraged exposure to ABX sub-indices each
  referencing 20 subprime home equity bonds
• Standardization, pricing, and liquidity should
  take time to evolve
• Structured Product Bespoke Liquidity
• Increased pipeline will lead to increased bespoke
  liquidity
• Housing Derivatives
• Initially consist of forwards and total return
  swaps on a suite of home price indices with terms
  ranging from 3 months to 5 years, based on the
  SP/Case-Shiller Home Price Indices
• Intermediation of Levered Super Senior
• Providing liquidity to derivative product
  companies (DPCs), monolines and Canadian conduits
• Zero Cost Protection
• Allows loan portfolio managers to hedge the
  credit risk of a broad portfolio without paying
  the high initial cost associated with standard
  CDS protection

12
Trading within Constraints of a Loan Portfolio

• Pawel Mosakowski
• Deutsche Bank

13
The Context of Loan Portfolio Trading

• LEMG Business Model - Basic Guidelines and
  Constraints
• Transfer pricing mechanism
• Price to hedge methodology real transfer of
  value (asset and shortfall) if originated inside
  the market spread
• Concentration limits
• Determine minimum hedge amounts in notional terms
• No set hedge budget
• Hedging as required/needed, without budget
  constraint
• General VAR limits
• Topline VAR limits guide portfolio risk
  sensitivities for MTM instruments
• RWA relief
• Determine shortest maturity of hedges
• MTM is assumed for assets and hedges

14
Convexity Mismatch between Loans and CDS

• Loans are short various embedded options
• Prepayment option
• Extension/Term-out option
• Utilization/UGD for RCLs
• Embedded options are difficult to model and price
  as exercise patterns can be irrational
• Loans are negatively convex because of embedded
  options
• Hedges (CDS) are less convex than loans
• As a result, hedged loan portfolios are
  negatively convex even with transfer pricing
  mechanism and MTM of the loans and hedges

CDS hedge P/L profile
Profit
Loan P/L profile
Credit spreads - -
Credit spreads
Residual P/L profile
Loss
15
Challenges and Objectives

• Key Challenge Can a hedged loan portfolio be
  managed in an economically meaningful way while
  satisfying concentration hedging requirements?
• OR
• Q How do we express spread views when
  maintaining minimum amount of default protection?
• A Separate spread risk from default risk
• Q Is there anything we can do about negative
  convexity profile?
• A Trade positively convex products but need to
  be mindful of costs

16
Separation of Spread Risk from Default Risk

• Complete
• Single name forwards, index forwards
• Single name options with knock-outs
• Trade Example

17
Separation of Spread Risk from Default Risk

• Partial
• Index single name jump-to-default is reduced to
  1/N of where N denotes the number of index
  constituents
• Index tranches mezzanine and senior tranches
  have structural seniority in addition to full
  index jump-to-default diffusion
• Trade Example

18
Combating Negative Convexity

• Loan embedded options cant be directly
  repurchased from the market
• Convexity/gamma can be expensive
• Convexity can be repurchased back via
• Index tranches
• Ex Buy delta-hedged 3-7 IG tranche
• protection
• Index options
• Ex Buy deep OTM index payers and
• receivers (costs, availability)
• Trade corporate bonds with CDS
• Ex Buy low dollar price corporate bonds
• and buy shorter term protection
• (costs, curve shape)

PL of loans, CDS and tranches
PL profile of positively convexed tranche
positions
PL of loans and CDS
19
Positioning for Divergence
Zed FrancisBank of America
20
Positioning for Divergence Between Asset Quality

• Belief high yield was too tight based on models
  and historical spreads in Summer 2006
• Concern of negative carry and roll-down going
  into September 20 quarterly roll to solely be
  short
• Confidence in IG spread outlook
• Incorporated bid/offer to enter and exit trade
  with 90 day horizon

21
Positioning for Divergence Between Asset Quality

• Structured to be relatively premium neutral to
  sell IG index versus spread of targeted
  cross-over/HY names
• Executed targeted single name shorts via an OWIC
• Some home runs in short portfolio. However,
  aggregate carry and roll-down makes HY very time
  (theta) sensitive
• Took off trade within 60 days realizing profits
  (more from the long IG index)

22
Positioning for Divergence Between Bond
Derivative

• Can look to add bond/CDS package
• Negative/small positive basis (dependent upon
  funding cost)
• Positive convexity (CDS widens faster than bonds
  in negative environment)
• Possibility of bonds called (at par or premium)
  in LBO
• Creates desired forward starting protection
  with convexity and modest carrying cost

23
Positioning for Divergence Between Bond
Derivative
RRD Example

• Positioned trade to benefit from anticipated
  shareholder enhancement transaction
• Desired to minimize negative carryshort in dv01
  terms consistent with our credit view
• Structured basis package long 5/15/10 bond at
  T100 (Z50) and short 3/20/12 CDS at 57
• Market began to anticipate LBO
• Spreads widened (bonds by 124 and CDS by
  194)reflecting positive convexity
• Monetized entire position

24
Conclusion

• The market has created numerous tools to
  implement your portfolio objectives
• Utilization of these techniques (in addition to
  single CDS hedges) will improve portfolio
  performance
• Must be done within your governancework with
  your organization to receive the ability to
  incorporate structures, options and basis into
  your day to day strategies

25
Appendix
26
Important Disclaimers Please Read

• All materials, including proposed terms and
  conditions, are indicative and for discussion
  purposes only. The information contained herein
  has been prepared solely for informational
  purposes and is not an offer to buy or sell or a
  solicitation of an offer to buy or sell any swap,
  security or instrument or to participate in any
  trading strategy. If any offer is made, it shall
  be made pursuant to (in the case of swaps) a
  final swap confirmation, or (in the case of
  securities) a final offering circular (the
  Offering Circular) prepared by or on behalf of
  the issuer of any such securities (the Issuer),
  both of which would contain material information
  not contained herein and which shall supersede,
  amend and supplement this information in its
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  is eventually made may contain terms which are
  substantially different from the terms described
  herein. Goldman Sachs Co. does not provide
  accounting, tax or legal advice, however, you
  should be aware that any proposed indicative
  transaction could have accounting, tax, legal or
  other implications that should be discussed with
  your advisors and/or counsel. Any decision to
  enter into the swaps or invest in the securities
  described herein should be made after reviewing
  such final swap confirmation or final Offering
  Circular, conducting such investigations as the
  swap counterparty or investor deems necessary or
  appropriate and consulting the swap
  counterparty's or investors own legal,
  accounting, tax and other advisors in order to
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  suitability and consequences of participating in
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• Goldman, Sachs Co., its respective affiliates
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  such securities and such instruments.

27
Important Disclaimers Please Read

• Neither Goldman, Sachs Co. nor any of its
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  assumptions relating to such estimates or
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  that such projections will be realized. The
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  contain all of the information that may be
  required to evaluate such swaps or securities and
  any recipient is encouraged to read (in the case
  of the swaps) the final swap confirmation or (in
  the case of securities) the Offering Circular and
  should conduct its own independent analysis of
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  Neither Goldman, Sachs Co. nor any of its
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  Goldman, Sachs Co. or its affiliates, or any
  other organizations. In particular, the
  obligations of the Issuer are not deposit
  obligations of any financial institution.
• Projections, Pro Forma Information and Forward
  Looking Statements. These materials contain
  statements that are not purely historical in
  nature, but are forward-looking statements.
  These include, among other things, projections,
  forecasts, estimates of income, yield or return,
  future performance targets, sample or pro forma
  portfolio structures or portfolio composition,
  scenario analyses, specific investment strategies
  and proposed or pro forma levels of
  diversification or sector investment. These
  forward-looking statements are based upon certain
  assumptions. Actual events are difficult to
  predict and are beyond the control of the Issuer,
  Goldman, Sachs Co. or its affiliates. Actual
  events may differ from those assumed. All
  forward-looking statements included are based on
  information available on the date hereof and
  neither Goldman, Sachs Co. nor any of its
  affiliates assume any duty to update any
  forward-looking statement. Some important
  factors which could cause actual results to
  differ materially for those in any
  forward-looking statements include, among other
  things, the actual composition of the portfolio
  (consisting of credit default swaps), any
  defaults or Credit Events in the portfolio, the
  timing of any defaults or Credit Events, the
  timing and amount of any subsequent recoveries,
  changes in interest rates, and any weakening of
  the specific credits included in the portfolio.
  Other risk factors are also described (in the
  case of the swaps) in the final swap confirmation
  or (in the case of securities) in the Offering
  Circular. Accordingly, there can be no assurance
  that estimated returns or projections will be
  realized, that forward-looking statements will
  materialize or that actual returns or results
  will not be materially lower than those
  presented.

28
Risk Factors - Please Read

• Prospective Investors or Counterparties should
  read the final swap confirmation or Offering
  Circular, as the case may
• be, for a more complete description of risk
  factors relevant to the particular investment.
• Entering into the Default Swaps or purchasing the
  Securities involves certain risks. Prospective
  swap counterparties or Investors should carefully
  consider the following factors, as well as the
  risk factors included in the final swap
  confirmation or final Offering Circular, prior to
  entering into the Transaction. The following is
  not intended to be an exhaustive list of the
  risks involved in the Transaction
• The final Offering Circular for any funded
  transaction will include more complete
  descriptions of the risks described below as well
  as additional risks. Any decision to invest in
  the securities described herein should be made
  after reviewing the Offering Circular, conducting
  such investigations as the investor deems
  necessary and consulting the investors own
  legal, accounting and tax advisors in order to
  make an independent determination of the
  suitability and consequences of an investment in
  the securities
• Leveraged Credit Exposure to Reference Entities
• Investors and swap counterparties are exposed to
  leveraged exposure to the credit of a number of
  Reference Entities because the notional amount of
  the Reference Portfolio is significantly larger
  than the notional amount of the note or swap.
  Following the delivery of a Credit Event Notice
  by Goldman Sachs in relation to a Credit Event
  with respect to a Reference Entity and the
  satisfaction of the other Conditions to Payment,
  the outstanding notional of the investment or
  swap may be reduced. Counterparties to a swap
  will be required to make significant payments and
  Investors in the securities will suffer
  significant reductions in their outstanding
  principal amounts. The maximum loss for swap
  counterparties and/or Investors is the full
  notional amount in either case
• No Legal or Beneficial Interest in Obligations of
  Reference Entities
• Participation in the Transaction does not
  constitute a purchase or other acquisition or
  assignment of any interest in any obligation of
  any Reference Entity. The swap counterparty
  and/or Investors will not have recourse against
  any Reference Entities. Neither the swap
  counterparties nor Investors nor any other entity
  will have any rights to acquire from Goldman
  Sachs any interest in any obligation of any
  Reference Entity, notwithstanding any reduction
  in the notional of the relevant class with
  respect to such Reference Entity. Moreover, GS
  will not grant any swap counterparty or Investor
  any security interest in any such obligation

29
Risk Factors - Please Read

• Risks Associated with Management Rights
• The exercise of management rights by the
  Investor, particularly in the form of
  Subordination Trades, can potentially (a)
  increase the risk of the investment by reducing
  the Credit Enhancement and hence increase the
  probability of suffering an actual Incurred
  Loss from a subsequent Credit Event (b) cause a
  rating downgrade of the Portfolio Notes, i.e. if
  trading results in a reduction in Credit
  Enhancement such that the Rating Agencies
  determine that the tranche can no longer maintain
  its rating or (c) increase the mark-to-market
  volatility of the Portfolio Notes.
• Additional Credit Risks
• In addition to the credit risk of the Reference
  Portfolio, the parties to the Default Swaps are
  exposed to the credit risk of receipt of payments
  from the other party, and the Investors in the
  Securities are exposed to the credit risk of the
  issuer of the collateral securing the Securities
  for the full notional amount of their investment
• Limited Liquidity of the Transaction
• There is currently no market for the Default
  Swaps or Securities. The Default Swaps represent
  bilateral contracts that cannot be transferred or
  terminated without the consent of the other
  party, which consent may be withheld or delayed
  for a number of reasons. Goldman Sachs may, but
  is not obligated to, unwind or terminate a
  Default Swap under terms acceptable to it in its
  sole discretion. There can be no assurance that a
  secondary market for the Securities will develop
  or, if a secondary market does develop, that it
  will provide the holder of the Securities with
  liquidity, or that it will continue for the life
  of the Securities. Moreover, the limited scope of
  information available to the swap counterparties
  and/or Investors regarding the Reference Entities
  and the nature of any Credit Event, including
  uncertainty as to the extent of any reduction to
  be applied to the notional of each class if a
  Credit Event has occurred but the amount of the
  relevant reduction in the notional amount has not
  been determined, may further affect the liquidity
  of the Default Swaps or Securities, especially
  the subordinated classes. Consequently, any swap
  counterparty under the Default Swaps or Investor
  in the Securities must be prepared to hold such
  Default Swaps or Securities for an indefinite
  period of time or until final maturity
• Mark-to-Market Risk
• Investors and swap counterparties are exposed to
  considerable mark-to-market volatility following
  changes in any of the following spreads of the
  credits in the reference portfolio, comparable
  CDO spreads, ratings migration in the reference
  portfolio, ratings migration of the Default Swaps
  or Securities, and credit events in the reference
  portfolio (and hence reduction of subordination).
  These will be reflected in mark-to-market
  valuations which are likely to be more volatile
  than an equivalently rated unleveraged investment

30
Risk Factors - Please Read

• Additional Risk of Loss due to Definitions of
  Credit Events
• The probability of occurrence of a Credit Event
  may be higher than the probability of what may be
  perceived as a default (for example, what is
  tracked by rating agencies in their default
  studies) because of their broader
  definitions.This is particularly true with
  respect to the inclusion of Restructuring as a
  Credit Event in all standard credit default swaps
• Evolving Nature of the Credit Default Swap Market
• Markets in different jurisdictions have also
  already adopted and may continue to adopt
  different practices with respect to the Credit
  Derivative Definitions, particularly, but not
  limited to, the definition of Restructuring.
  Past events (e.g. Conseco restructuring and
  Railtrack bankruptcy) exemplify the fact that the
  Credit Derivatives Definitions may contain
  ambiguous provisions that are subject to
  interpretation and may result in consequences
  that are adverse to the investor
• Cheapest-to-Deliver Risk
• Given that Goldman Sachs, as buyer of protection,
  has discretion to choose the portfolio of
  valuation obligations used to calculate the
  severity of losses following a Credit Event, it
  is likely that the portfolio of valuation
  obligations selected will be obligations of the
  Reference Entity with the lowest market value
  that are permitted to be delivered pursuant to
  the relevant documentation. This could result in
  a lower recovery value and hence a larger loss
  amount
• Credit Ratings
• Credit ratings represent the rating agencies
  opinions regarding credit quality and are not a
  guarantee of quality. Rating agencies attempt to
  evaluate the safety of principal and/or interest
  payments and do not evaluate the risks of
  fluctuations in market value. Accordingly, the
  credit ratings may not fully reflect the true
  risks of the Transaction. Also, rating agencies
  may fail to make timely changes in credit ratings
  in response to subsequent events, so that an
  issuers current financial condition may be
  better or worse than a rating indicates
• Principal Protection
• Principal protected notes are not principal
  guaranteed and in certain circumstances,
  including as a result of a default by the issuer
  of the Note Collateral, the Notes could redeem at
  zero or an amount less than par

31
Risk Factors - Please Read

• Conflicts of interest No reliance
• Goldman Sachs does not provide investment,
  accounting, tax or legal advice in respect of the
  Transaction and shall not have a fiduciary
  relationship with any Default Swap counterparty
  or Investor. In particular, Goldman Sachs does
  not make any representations as to (a) the
  suitability of the Transaction, (b) the
  appropriate accounting treatment or possible tax
  consequences of the Transaction or (c) the future
  performance of the Transaction either in absolute
  terms or relative to competing investments.
  Prospective Default Swap counterparties and/or
  Investors should obtain their own independent
  accounting, tax and legal advice and should
  consult their own professional investment advisor
  to ascertain the suitability of the Transaction,
  including such independent investigation and
  analysis regarding the risks, security
  arrangements and cash-flows associated with the
  Transaction as they deem appropriate to evaluate
  the merits and risks of the Transaction
• Goldman Sachs may, by virtue of its status as an
  underwriter, advisor or otherwise, possess or
  have access to non-publicly available information
  relating to the Collateral, the issuer(s)
  thereof, the Reference Entities and/or the
  obligations of the Reference Entities and has not
  undertaken, and does not intend, to disclose,
  such status or non-public information in
  connection with the Transaction. Accordingly,
  this presentation may not contain all information
  that would be material to the evaluation of the
  merits and risks of entering into the Transaction
• Goldman Sachs does not make any representation,
  recommendation or warranty, express or implied,
  regarding the accuracy, adequacy, reasonableness
  or completeness of the information contained
  herein or in any further information, notice or
  other document which may at any time be supplied
  in connection with the Transaction and accepts no
  responsibility or liability therefore. Goldman
  Sachs may from time be an active participant on
  both sides of the market and have long or short
  positions in, or buy and sell, securities,
  commodities, futures, options or other
  derivatives identical or related to those
  mentioned herein. Goldman Sachs may have
  potential conflicts of interest due to present or
  future relationships between Goldman Sachs and
  any Collateral, the issuer thereof, any Reference
  Entity or any obligation of any Reference Entity