Income Research & Management 0 CDOs and CDS: The Insatiable Appetite for Innovation Derivatives Market Update Presented By: Jack Sommers, CFA Managing

Income Research & Management 1

CDOs and CDS:

The Insatiable Appetite for Innovation

Derivatives Market Update

Presented By:

Jack Sommers, CFAManaging Principal

Income Research & Management

The views contained in this presentation are those of IR&M and are based on information obtained by IR&M from sources that are believed to be reliable. This presentation is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.


Structured Credit

Source: Morgan Stanley


CDO Market Started in the Late 1990s

The Collateralized Debt Obligations market started as an efficient mechanism for managing credit risk on bank balance sheets and for obtaining regulatory capital relief

CDOs have evolved into complex instruments to achieve leveraged returns for investors with a wide range of credit risk appetites

Today’s CDOs encompass a vast array of underlying assets:

High grade

High yield

Emerging market bonds

Middle market and leveraged loans

Trust preferred securities


How is a CDO Structured?

BB (3%)

Equity (10%)

BBB (4%)

A (2.5%)

AA (3%)

AAA (7.5%)

Super Senior

Tranche (70%)

Losses are borne by

the tranches

in reverse seniority

order

¹Source: Morgan Stanley. Ratings and capital structure shown above are for illustration purposes and do not represent an actual transaction.

A bankruptcy remote Special Purpose Entity purchases a pool of securities and funds the purchase by issuing debt collateralized by the purchased securities

Within the structure of CDOs, losses flow up, while principal & interest flow down

If the portfolio below experiences losses equal to 15%, the equity and the BB tranches would be wiped out and the BBB tranche would lose half of its notional

CDO¹

Pool of assets

Principal

& Interest

30%

22.5%

19.5%

17%

13%

10%

0%


CDO Market Growth Peaked in 2006

¹Source: Morgan Stanley as of 12/31/2008

2053

100 93 96 10484 99

146

274

505

461

201

-

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0

100

200

300

400

500

600

700

800

900

1,000

Issuance ($B) - LHS # of Transactions - RHS

Growth in CDO Issuance¹$B


CDS Market Began in the Late 1990s

Credit Default Swaps were invented in 1997 by a team working for JPMorgan Chase

Credit Default Swaps became exempt from regulation with the Commodity Futures Modernization Act of 2000

The market became rampant with gambling as sellers and buyers of CDS were no longer owners of the underlying asset (bond or loan)

CDSs were increasingly used by investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties

The market size for Credit Default Swaps began to grow rapidly from 2003, by late 2007 it was approximately ten times as large as it had been four years previously1

¹Source: Morgan Stanley as of 12/31/2008


What is a Credit Default Swap

Privately negotiated, over the counter (OTC) bilateral contracts that provide protection against risk of default on debt obligations issued by a referenced entity

Buyer of protection pays premiums periodically (typically quarterly) during the life of the contract

Seller agrees to cover the CDS buyer against losses from default over the life of the contract

If triggered the contract is settled and terminated

Protection Seller

Protection Buyer

Periodic Premium

Protection Seller

Protection Buyer

Par – Recovery Value

Following a credit event, one of the following takes place:

Cash Settlement

Protection Seller

Protection Buyer

Par

Physical SettlementObligati

on

Typical Structure


CDS Product Usage is Varied

¹Sources: Banc of America Securities LLC Estimates²Other includes total return swaps, asset swaps, and equity linked products

Protection Seller

CDS Product Usage, 2003

CDS Product Usage, Forecast 2008

Single name CDS, synthetic CDOs, and Index CDS remain the largest segments of the market

Options3%

Other9%

Baskets4%

Tranched Index2%

Credit linked notes6%

Index (excl. Tranches)

9%

Synthetic CDOs16%

Single-name CDS51%

²

Options3%

Other8%

Baskets1%

Tranched Index10%

Credit linked notes3%

Index (excl. Tranches)

29%

Synthetic CDOs16%

Single-name CDS30%

²


There are Many Buyers & Sellers of CDS

¹Sources: Banc of America Securities LLC Estimates²Other includes total return swaps, asset swaps, and equity linked products

Protection Seller

Sellers of Protection, 2006

Buyers of Protection, 2006

The dominant players within the market have been banks and dealers, hedge funds, and insurers

B&D (Trading Portfolios)

33%

Other1%

Corps.2%

Mutual Funds3%

Pension Funds5%

Hedge Funds31%

Insurers18%

Loan Portfolios7%

²

B&D (Trading Portfolios)

39%

Other1%

Corps.2%

Mutual Funds2%

Pension Funds2%

Hedge Funds28%

Insurers6%Loan Portfolios

20%

²


CDS Market Growth Peaked in 2007

¹Source: ISDA, through June 2008

0.6 0.9 1.6 2.2 2.7 3.75.4

8.412.4

17.1

26.0

34.4

45.5

62.2

54.6

-

10

20

30

40

50

60

70

Notional Amount Outstanding

Growth of the CDS Market¹$B

2001

2003

2004

2005

2006

2007

2008

2002


What Were the Risks?

Unprecedented connection between Wall Street and Main Street

Mortgages - - - - - MBS - - - - - CDOs

Leverage

Modeling mistakes-leading to faulty underwriting and mis-rated securities

Synthetic Deals ( CDS)

CDS on RMBS: reduced previous barriers to collateral; increased default correlations

CDS on CDOs had similar effect

The views contained in this report are those of IR&M. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.


What’s the Relevance in Today’s FI Markets?

Rating Agencies having to play catch up and reconfigure their models

Large scale ratings actions creating forced sellers

We believe the good is getting thrown out with the bad

Investment grade corporates, super senior CMBS, SBAs…

Banks are teetering

Insurance companies

Individual investors/Municipalities at risk



CMBS

CDO

FNMA

SIVFGICFSA

AIG ML

ARSMBIA

Casualty Soup

ARM

LEHMMF

CLO

CDS

C


Recent Government Market Intervention

¹Term Auction Facility (TAF). ²Term Security Lending Facility (TSLF). ³Troubled Asset Relief Program (TARP) Temporary Liquidity Guarantee Program (TLGP) Term Asset-Backed Lending Facility (TALF) 6Capital Assistance Program (CAP) Emergency Economic Stabilization Act (EESA) Each change in the Federal Funds Target Rate includes an equal change in the discount rate. Sources: IR&M, Federal Reserve (www.federalreserve.gov), Barclays Capital and JP Morgan as of 2/28/09The views contained in this report are those of IR&M and are based on information obtained by IR&M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.

OAS (bp) Government Actions and Spreads

Traditional monetary policy did not get the job done

Fed pulled almost everything out of the toolbox with unprecedented intervention

Despite the efforts, stress continued across the capital markets and financial system

We believe this policy will eventually work if the combined actions outweigh the continued force of de-leveraging

0

100

200

300

400

500

600

3/07 4/07 5/07 6/07 7/07 8/07 9/07 10/07 11/07 12/07 1/08 2/08 3/08 4/08 5/08 6/08 7/08 8/08 9/08 10/08 11/08 12/08 1/09 2/09

Barclays Credit OAS

PDCF announced/25bp disc. rate/ JPM, BSC

in GSE conforming loan limit

TSLF announced²

TAF expanded

50 bp FF

75 bp FF

25 bp FF

TAF announced¹

25 bp FF

50 bp FF

50 bp disc. rate

GSEcapital

requirement lowered

FF: Federal Funds Target Rate

75 bp FF

25 bp FF

Fannie/Freddieunder

conservatorship

Original AIGloan provided

TARP³ Announced

(Broad $700B bailout)

Citigroup rescue

announced

TALF announced

TLGP announcedRevised

AIG package

GMAC gets TARP funds

75 - 100 bp FF

Auto bailout

CAP6

announced

EESA7

announced


How Has This Affected IR&M’s Approach?

At IR&M we tended to stay away from many areas of the market place that have suffered recently

We believe an emphasis on high-quality corporate and securitized issues, which still generate a solid yield advantage, remains prudent

We believe this crisis has created many compelling opportunities in both the corporate and mortgage space



Yield Levels Across Sectors

¹Yields may change.²High quality is defined as issues rated Baa2 or better by Moody’s, S&P, or Fitch.Sources: Bloomberg and IR&M estimates as of 2/28/09The securities mentioned are for illustrative purposes only. This is not a recommendation to purchase or sell any of the above mentioned securities. The views contained in this report are those of IR&M and are based on information obtained by IR&M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.

High quality spread product including corporates, mortgages and CMBS trade at significant yield advantages relative to Treasuries²

We believe the cushion against losses is substantial given the current level of spreads

Very little upside in Treasuries yielding 0.2% to 3.7%

Yields by Maturity¹Yield (%)

Bud

GE Coca-ColaProcter & Gamble

AAA Super Senior CMBS

SBA's

Lockheed Martin

AT&T Corp

VerizonMcDonald's

Agency Hybrid ARM

Top Tier Credit Card

AAA Seasoned CMBS

0

4

8

12

16

0 5 10 15 20 25 30

U. S. Treasury Lockheed Martin Bud AT&T CorpGE Coca-Cola Verizon McDonald'sProcter & Gamble Agency Hybrid ARM Top Tier Credit Card AAA Seasoned CMBSAAA Super Senior CMBS SBA's

Years


0.0

0.5

1.0

1.5

2.0

2.5

3.0

1970 1975 1980 1985 1990 1995 2000

The yield of Corporates provides a cushion against defaults

Corporate bond spreads have widened to the point where they out-yield Treasuries by over 5% (as of 2/28/09 corporate OAS is 505bp¹)

We believe investment grade corporates look compelling at these spreads when considered in the context of historical default rates²

The highest 5-year cumulative default rate from 1970 to 2004 was 2.4% for bonds that were rated investment grade in 19863

The current yield advantage over Treasuries provides enough yield to more than offset greater than 8% defaults each year going forward at a 40% recovery rate4

Although recoveries are likely to be lower and defaults will likely increase over the remainder of this down cycle we feel comfortable that compensation is ample for this risk

The investment grade corporate bond market is currently pricing in a 35% 5-year cumulative default rate (505bp OAS)4

¹Source: Barclays Capital as of 2/28/09²Source: IR&M analysis using Moody’s Annual Defaulted Bond and Loan Recovery Rates from 1982 to 20083Source: Moody’s; default rates for companies that were investment grade as of Jan. 1st of each year4Source: JPMorgan/Bloomberg Par Credit Default Swap Spread Approximation from Default Probabilities Model and Barclays Corporate Index as of 2/28/09. Approximate math: Spread= Probability of Default x Loss Upon Default. 1 Year Example: 505bp Spread (5.05%)=8.3% Probability of Default x 60% Loss on Default. 505bp over 5 years implies 35% 5-year Cumulative Probability of DefaultThe views contained in this report are those of IR&M and are based on information obtained by IR&M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.

Cu

mu

lati

ve d

efa

ult

s (%

)

Beginning year of 5-year period

Moody’s 5-year Cumulative Investment Grade Default Rates3

0.0

10.0

20.0

30.0

40.0

50.0

50 100 150 200 250 300 350 400 450 500 550 600Im

plie

d level of

defa

ult

s (%

)

Credit spread

Implied Probability of Cumulative Defaults over 5 Years4

Probability of Default (40% Recovery) Probability of Default (20% Recovery)

Largest Historical 5-Year Cumulative Default Rate (2.4% in 1986)

Current level


Liquidity & Headlines Have Pushed CMBS Spreads to Historic Wides

Breakeven spread widening¹:

2 year bonds trading at s+1250 can widen ~850 bps over 12 months and break even to Treasuries

10 year bonds trading at s+1200 can widen ~250 bps over 12 months and break even to Treasuries

Attractive Yield to Maturity²

2 year bonds trading at s+1250 currently have YTM greater than 14%

10 year bonds trading at s+1200 currently have YTM close to 15%

0

300

600

900

1200

1500

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0

2

4

6

8

1030% Super Senior Spread (LHS)

60+ Delinquencies (RHS)

Barclays Capital Agg Senior AAA Spreads vs. Delinquencies

(As of 2/26/09)S

pre

ad

vs.

LIB

OR

(b

p)

60

+ D

elin

quenci

es

%

¹Assumes horizon durations of 1.5 and 5.0 years respectively for 2 year and 10 year bonds. Source: IR&M as of 2/26/09.²Source: IR&M as of 2/26/09.


Borrower Equity

Loan made on 60% to 80% of Property

Value

Property Loan Level CMBS Deal Level CMBS Tranche Level

Loans diversified by borrower, property type, location, and

size

IR&M focuses on Super Senior

tranches with 30% subordination

Subordination can provide protection from

losses

CMBS Offer Multiple Layers of Risk Reduction

The views contained in this report are those of IR&M. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.Actual results may vary.


Super Senior Credit Enhancement Can Provide Significant Protection

Bonds priced at a discount may allow for significantly more losses before invested principal is impaired

30% Credit Enhancement

Hold LCF Super Seniors at $60

Additional Protection from Price Discount is $40 x 70% =

28%

30% Total Enhancement at Par

58% Total Enhancement at $60

Priced at Par Priced at a Discount

Typical CMBS Structure:

30% Credit Enhancement

Super Seniors, Priced at $100



Technicals may push spreads wider over the near term, but over the long term we believe risk premiums should narrow

Current crisis has been much more severe than previous periods but pricing more than reflects this

We expect a similar pattern for this cycle; however, given the severity, we believe positive excess returns will be much larger

0

200

400

600

800

1000

1200

6/ 01 5/ 02 4/ 03 3/ 04 2/ 05 1/ 06 12/ 06 11/ 07 10/ 08 9/ 09

0

200

400

600

800

1,000

1,200

Enron

9/ 11Accounting Scandals

GM Downgrade

Subprime/

Financial Crisis

Where do we go from here?

¹Source: Barclays Capital, Credit Sights as of 2/28/09The views contained in this report are those of IR&M and are based on information obtained by IR&M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR&M product.

OAS (bp)

Economic armageddon Investment grade defaults rise

precipitously Unemployment spikes drastically Government intervention is not

successful

Government initiatives begin to take hold

Economy continues to be weak, but we believe light can be seen at the end of the tunnel

Spreads compress although still remain above historical averages

Negative headlines persist Economy continues to struggle U.S. Government intervention stems

the flow, stabilizing markets Fixed income sector spreads

moderate as dire scenario is not realized

De-leveraging abates

OAS (bp)

Dramatically wider spreads:

Stable spreads:

Tighter spreads:

Barclays Investment Grade Corporate OAS ¹

Documents

Income Research & Management 0 CDOs and CDS: The Insatiable Appetite for Innovation Derivatives Market Update Presented By: Jack Sommers, CFA Managing