Discussion on CDO Equity as an Investment Strategy

1
Discussion on CDO Equity as an Investment Strategy
April 2006
Overview of Collateralized Debt Obligations
2
Table of Contents

• Overview of CDOs
• Overview of Senior Secured Bank Loans
• Overview of the Structured Finance Market
• Conclusion

Table of Contents
3
Overview of CDOs

4
Overview of CDOs

• What are CDOs?
• Collateralized Debt Obligations (CDOs) are
  securities issued to finance a diversified pool
  of credits.
• A special purpose vehicle issues notes and
  preferred shares to raise capital to fund the
  purchase of one or more types of debt
  obligations, such as Bank Loans, Asset Backed
  Securities, Trust Preferred, etc.
• The portfolio of securitized assets in a CDO is
  typically financed by a credit-tiered capital
  structure, consisting of both investment grade
  and non-investment grade tranches of debt,
  supported by an equity tranche.
• The majority of the financing for a CDO is
  usually provided by a large AAA rated tranche of
  debt, thereby making the weighted average cost of
  capital significantly cheaper than the return on
  the portfolio of assets.
• Below the rated debt tranche in the structure of
  a CDO is a tranche of Equity. This tranche is the
  beneficiary of the spread differential between
  the returns on the portfolio of assets and the
  weighted average cost of financing.
• The Equity receives all residual cash flow after
  payment of fees and interest to the note
  investors.
• An investment into the Equity tranche therefore
  benefits from the low cost, long term financing
  with no recourse.

Overview of CDOs
5
Growth of the Global CDO Market (
Billions)Global issuance since 1997 has totaled
1.22 trillion
Overview of CDOs
Overview of CDOs
Source Bear Stearns CDO Research
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Overview of CDOs
CDO Issuance by Sector - U.S. (MM)

• Bank Loans and ABS/MBS/CMBS have become steady
  sources of collateral.
• Strong demand emerging for synthetic transactions
  and Trust Preferred CDOs.

Overview of CDOs
Source Bear Stearns CDO Research funded
issuance.
7
Overview of CDOs
Issuance Trends for U.S. CDOs in 2006

• ABS CDOs could see a shift in issuance towards
  synthetic structures
• Expected slowdown in mortgage originations should
  impact cash ABS CDO volumes
• Increasing market comfort with synthetic
  structures / ease of execution should compound
  effect
• CLO issuance should remain strong
• Leveraged loan volumes expected to remain strong
• Credit fundamentals should remain robust as
  default rates remain near lows
• Trust Preferred CDOs
• Older vintage Trust Preferreds come out of
  non-call periods in the second half of 2006
• New Innovations
• Long-short ABS CDOs on the back of a vibrant ABS
  CDS market

Overview of CDOs
8
Overview of CDOs
Rating Performance of CDOs

• Average One-Year Downgrade Risk (1996-2004)

Overview of CDOs
Source Moodys Investors Service
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Overview of CDOs
Spread Comparison

• Spread pick-up over underlying collateral

Overview of CDOs
Source Moodys Investors Service
10
Overview of CDOs
New Issue CDO Spreads

• New issue spreads are at or near their historic
  tights across the capital structure

Overview of CDOs
Source Moodys Investors Service
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Overview of Senior Secured Bank Loans

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Overview of Senior Secured Bank Loans

• Leveraged Loan Market Volume
• Leveraged Loans refer to below investment grade,
  senior, secured loans to corporate obligors.

Source Loan Pricing Corp.
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Overview of Senior Secured Bank Loans
Average Spread of Leveraged Loans (1998 2005) -
by four-quarter rolling average
Source Standard Poor's Leveraged Commentary
Data (LCD) Numbers on Chart represent the
quarterly rolling average of the spreads.
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Overview of Senior Secured Bank Loans
Purchasers of Leveraged Loans by Institutional
Investor Type (1994 2005)
CLO/CDO/Synthetic CLO
Prime Funds
Hedge, Distressed High-Yield
Insurance companies
Finance Cos
To provide a more realistic view of institutional
buying habits in todays market, SP adds to the
CLO tally the institutional commitments held by
the arranger at close. For tax purposes, CLOs
tend to participate as primary assignees and
therefore are often left off the at close
allocation list. In addition, beginning in 2002,
SP has made a better effort to track hedge funds
and other investors in this analysis. As a
result, SP can only provide data for finance
companies and hedge distressed high-yield funds
starting in 2002.
Source Standard Poor's Leveraged Commentary
Data (LCD)
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Overview of Senior Secured Bank Loans

• Leveraged Loan Default Rates
• U.S. Leveraged loan default rate peaked in
  December 2000 at 7.3 and was 1.98 at the end of
  December 2005.
• U.S. High Yield Bond default rate peaked in
  January 2002 at 11.6 and was 2.20 at the end of
  December 2005.

Loan Source Standard Poor's Leveraged
Commentary Data (LCD) Bond Source Moodys
Investor Service 12-month lagging default rate by
number of issuers Leveraged Loan Information not
available before December 1998
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Overview of Senior Secured Bank Loans
Historical Recovery Rates for Leveraged Loans
Average 82
Source Standard Poors LossStats Database.
Recoveries are discounted at each instruments
pre-default interest rate. Includes all bank
debt.
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Overview of Senior Secured Bank Loans

• Comparison of Leveraged Loans to Other Asset
  Classes 1997 - 2005

• Leverage Loan Risk Return Comparison 1997 -
  2004

Note the returns shown above are averages of
the annualized monthly returns from January 1997
to August 2004. 1. Source Lehman Brothers
Corporate Bond Index from Jan 1997 to Sep 2003,
and Bear Stearns Corporate Bond Index thereafter.
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Overview of the Asset Backed Securities Market

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Overview of the Asset Backed Securities Market

• What are Asset Backed Securities?
• Asset Backed Securities, or ABS are securities
  backed by a pool of financial assets.
• Asset Backed securitization is a financing
  technique in which financial assets are pooled
  and converted into instruments that may be
  offered and sold freely in the capital markets.
• Payment on the Asset Backed Securities depends
  primarily on the cash flows generated by the
  assets in the underlying pool, not based on the
  credit of the originator of the loans.
• The portfolio of securitized assets are typically
  financed by a credit-tiered capital structure,
  consisting of both investment grade and
  non-investment grade tranches of debt, supported
  by an equity tranche..
• While residential mortgages were the first to be
  securitized, non-mortgage related securitizations
  have grown to include many other types of
  financial assets, such as credit card
  receivables, auto loans and student loans.

Overview of CDOs
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Overview of the Asset Backed Securities Market
ABS Outstanding by Asset Type
Source BMA, Trepp
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Overview of the Asset Backed Securities Market
ABS/CMBS Outstanding Volumes
ABS Outstanding
CMBS Outstanding
Warehouse
Industrial
Health Care
Unknown
0.11
4.82
1.05
0.25
Other
Home Equity
Self Storage
15
Lodging
26
1.43
7.19
Mixed Use
Student Loans
2.37
Retail
7
Mobile Home
29.80
1.83
Manufactured
Housing
2
Lease
3
Other
CBO/CDO
Multi-Family
2.98
15
21.50
Credit Card
Office
Auto
20
26.66
12
Source BMA
Source Trepp
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Overview of the Asset Backed Securities Market
Asset Backed CDOs come in Various Forms

• CMBS
• Primarily composed of various types of Commercial
  Mortgage Backed Securities
• Multi Sector
• High Grade ABS
• Primarily composed of AA AAA rate Real
  Estate ABS Securities
• Mezzanine ABS
• Primarily composed of A- BBB- Real Estate
  ABS Securities
• Multi Sector
• CDO2
• Primarily composed of a diversified pool of CDO
  debt tranches

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Overview of the Asset Backed Securities Market
Collateral Found in Typical Multi Sector CDOs

• CMBS
• Retail, Multi-Family, Lodging, Office,
  Industrial, etc.
• Prime
• Prime FICO1 above 700 e.g. Alt A Good credits
  but non-conforming for Agencies (Fannie
  Mac/Freddie Mac), Prime Home Equity Loans
• Mid-Prime FICO1 between 640 700
• Sub-Prime FICO1 below 640 e.g. Manufactured
  Housing Homes built offsite, value lt 35,000,
  Sub-Prime Home Equity Loans
• CDOs Many ABS CDO structures have buckets for
  CDO debt tranches, e.g. CLOs, CBOs, etc.

• A FICO is a credit scoring method to determine
  the likelihood that individual credit users will
  pay their bills. The score attempts to condense
  the borrowers credit history into a single
  number. The range is about 350-900.

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Overview of the Asset Backed Securities Market
Sample Portfolio for a CDO of Mezzanine ABS
Securities
Ba1
A3
A2
CMBS
Mid Prime Fixed
3.0
CMBS Fixed
3.4
1.3
1.0
1.2
Ba2
3.7
CLO
4.0
Mid Prime
Baa1
7.0
32.8
8.9
ABS CDO
8.0
Baa2
Prime
55.6
15.0
Baa3
24.2
Sub Prime
31.0

• 1. Moodys MAC Score replaces the Diversity Score
  in conjunction with their new rating model, the
  Moodys CDO ROM.

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Overview of the Asset Backed Securities Market
ABS/CMBS Outstanding by Rating Bucket
ABS Outstanding 1
CMBS Outstanding
Ba
B
Ba
Baa
A
Baa
B
0.2
2.3
1.1
2.3
4.4
5.0
Aa
0.01
A
3.3
5.3
Aa
4.2
Aaa
Aaa
89.8
82.0
1. Original Notional
Source Bear Stearns
Source Trepp
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Overview of the Asset Backed Securities Market
Historical Loss Rate Analysis Loss-Given-Default
(LGD) Rates for Defaulted RMBS and HEL
Securities, 1988-2004H1 1

• Source Moodys Investors Service, Inc. -
  Default Loss Rates of Structured Finance
  Securities 2004 First Half Update.
• Loss-Given-Default (LGD) rate lifetime
  cumulative losses (interest shortfalls and
  principal losses included) as a share of
  defaulters' original balance or balance at
  impairment date, and discounted by their coupon
  rates. Impairment uncured payment default, and
  securities downgraded to Ca or C even though not
  yet in payment default.

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Conclusion

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Conclusion
Conclusions Value in CDO Equity

• Credit environment expected to be benign in 2006
• Possibility of turn of credit cycle sometime in
  late 2007/2008
• Natural complement to alternative investment
  portfolio
• Low correlation of leveraged loans to similar
  asset classes
• Highly appropriate for a low volatility
  environment
• Outperforms traditional volatility driven
  vehicles like hedge-funds private equity
• Front-ended returns alleviate concerns about
  increasing default rates
• Yield profile robust even under high default
  rates
• Re-investment option adds value to investors

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Conclusion
Illustrative Preferred Share Returns for CLO - to
8.2 year Call
Upper Range Graphed
30
Conclusion
Illustrative Preferred Share Returns for ABS CDO
- to 7 year Call
Upper Range Graphed