JP Morgan CDO Handbook

Global Structured Finance Research
CDO Research
J.P. Morgan Securities Inc.
New York
February 19, 2004
Structured Finance CDO Handbook
Overview Contents
Overview 2
Structured Finance (SF) CDOs are leveraged investment vehicles that invest Whats In an SF CDO? 3
primarily in the senior and mezzanine tranches of structured products (ABS, SF CDO Assets: 101 12
RMBS, CMBS, and CDOs). They utilize the same technology as traditional Does SF Collateral Work for CDOs? 24
SF CDO Structure 32
credit CDOs with the only difference being their underlying collateral. Should SF CDOs be Managed or Static? 44
SF CDOs issue securities to fund the purchase of collateral or assume risk SF CDO Rating Methodologies 48
synthetically via credit derivatives. Appendix A: Rating Transition Matrices 51
Appendix B: Rating Agency Classification
of Structured Products 53
Highlights Appendix C: SF CDOs from
SF CDOs are designed to exploit arbitrage opportunities by taking advantage Seasoned Issuers 54
of liquidity/complexity premiums and the credit curve, to be a source of

funding, or to manage balance sheet exposures. They have been growing
as a portion of total CDO issuance.
Overall, the SF CDO underlying collateral makeup largely mirrors the
structured products market. Some adjustments are made to enhance arbitrage.
Structured product collateral offers a spread pick-up, lower event risk, and
comparable default/recovery rates versus like-rated corporates, as well as
diversification opportunities.
Rating agency structured product default and recovery assumptions are
conservative compared with actual collateral performance.
SF CDOs have several variables, including quality of collateral (AAA/AA or
BBB) and form of exposure (cash or synthetic). Each type has unique
structural features.
Manager/issuer selection is critical in both actively managed and static deals.
Chart 1 Christopher FlanaganAC
Structural Overview of a Typical SF CDO (1-212) 270-6515
christopher.t.flanagan@jpmorgan.com
Asset Manager Hedge Trustee & Rishad Ahluwalia (London)

or Issuer Counterparties Custodian (44-207) 777-1045
rishad.ahluwalia@jpmorgan.com
Asset Pool CDO Liabilities
AAA
Ryan Asato
(1-212) 270-0317
ABS AA ryan.asato@jpmorgan.com
RMBS
CDO SPV A Benjamin J. Graves
CMBS
BBB (1-212) 270-1972
CDOs
benjamin.j.graves@jpmorgan.com
Equity
Edward Reardon (London)
(44-207) 777-1260
Source: J.P. Morgan Securities.
edward.j.reardon@jpmorgan.com
The certifying analyst(s) is indicated by a superscript AC. See last page of the
report for analyst certification and important legal and regulatory disclosures.
www.morganmarkets.com
February 19, 2004 Global Structured Finance Research
CDO Research
Analyst Structured Finance CDO Handbook
Christopher FlanaganAC
Overview
SF CDOs have been growing as a portion of total CDO issuance in both the US
(currently about 45% of total) and Europe (currently about 20% of total).
SF CDOs are Growing Chart 2
as a Percentage of Funded CDO Issuance: 1996-2003*
US $ Billion (bar graph) % SF CDO (black line) Europe $ Billion (bar graph) % SF CDO (black line)
Total CDO Issuance
90 45% 35 25%
80 40%
30
70 35% 20%
25
60 30%
15%
50 25% 20
40 20% 15
10%
30 15%
10
20 10% 5%
5
10 5%
0 0% 0 0%
1996 1997 1998 1999 2000 2001 2002 2003 1996 1997 1998 1999 2000 2001 2002 2003
*Funded issuance includes all cash issuance and the funded (i.e. non super senior) portion of synthetics.
Source: JPMS, IFR Markets, MCM, Bloomberg, CreditFlux.
SF CDOs offer a spread pick-up to most like-rated securities. This pick-up can be
attributed to liquidity, complexity, and a new asset class premium.
SF CDOs Offer a Spread Table 1

Pick-Up to Most Like Spread to Swaps/Libor (bp)*
Rated Securities 5-8 Yr 10 Yr 10 Yr UK 5 Yr
7-12 Yr IG Syn 6-10 Yr RMBS 10 Yr 3-5 Yr Floating Sterling 10 yr
SF CDO CDO HY CLO Jumbo CMBS HEL Cards RMBS Industrial
AAA 60** 70 46 30 25 18 15 -8
AA 125 125 90 100 38 50 34 6
A 175 175 140 120 45 105 61 28
BBB 375 375 265 175 88 170 105 107 60
*As of 1 February 2004.
**Indicative weighted average AAA spread for traditional SF CDO.
Source: JPMS.
Growing Cadre of This spread pick-up, as well as the opportunity to diversify exposures, is attracting a
Market Participants growing investor base, which varies by position in the SF CDO capital structure.
Senior investors include banks, conduits, SIVs, and finance companies. Equity
investors are typically banks, pension funds, endowments, private banks, insurance
companies, fund managers, and hedge funds.
SF CDO asset managers are keen to become involved in this market as a way to
increase assets under management, build their franchise, and receive fee income. On
the other hand, balance sheet transactions can enable entities to reduce economic and
regulatory capital, manage credit risk, and achieve long term funding.
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CDO Research
Whats In an SF CDO?
SF CDOs source collateral from several distinct sectors of the broader structured
products market, including CMBS, RMBS, CDOs, ABS, and REITs. Collateral
composition varies by deal, with individual deals sourcing from 0% to 100% of their
collateral from each of the above sectors. Several factors, including asset manager
experience, issuance volume, region, and arbitrage opportunity influence collateral
composition. Despite differences between deals, US/European SF CDOs can be
broadly characterized into two sub-sectors1.
SF CDOs can be classified Real Estate SF CDO: Greater than 60% of collateral is backed by residential or
as Real Estate or Diversified commercial real estate (RMBS, CMBS, or REITs). In 2003, Real Estate CDOs
accounted for approximately 45% of funded SF CDO volume.
Diversified SF CDO: Also referred to as multisector or ABS CDOs. Deals

in this category consist of a diversified mix of structured finance assets and, as
such, dont exhibit asset concentration (in Real Estate) described above. In 2003,
Diversified CDOs accounted for approximately 55% of funded SF CDO volume.
In addition to the two broad categories Chart 3

above, SF CDOs may be distinguished 2003 SF CDO Collateral Distribution (total)
by several other characteristics, includ-
CDO
ing: Cash/Synthetic, Arbitrage/Balance 15%
Sheet, or US/Europe. Chart 4 to Chart 9 RMBS
39%
on the following page show the aggre-
gate collateral composition (Consumer CMBS
ABS, Commercial ABS, RMBS, CMBS, 19%
CDO, REIT) for deals completed in

2003. Chart 10 to Chart 14 detail the REIT
collateral breakdown within each of the 3% Consumer
Other ABS Corp ABS ABS
aforementioned sectors. We stress, how- 2% 6% 16%
ever, that different types of SF CDOs
hold these underlying asset classes in Source: JPMS, IFR Markets, MCM, S&P, Fitch, Moodys.
materially different proportions.
SF CDO Sectors - Some Definitions

CDO: CLO, CBO, SF CDO, IG Synthetic CDO, Small-to-Medium Entity CDO, Other CDO
CMBS: Conduit, Large Loan, Credit Tenant Lease
Consumer ABS: Student Loan, Auto, Card, Consumer Loan
Corporate ABS: Equipment, Health Care, Small Business Loan, Structured Settlement, Aircraft,
Aerospace, Trade Receivables, Franchise
REIT: Unsecured corporate debt of company that invests in Regional Malls, Shopping Centers, Office
Buildings, Warehouses
RMBS: Prime* (Jumbo, Alt A), Home Equity (Subprime or B/C, 2nd Lien), NIMS, Manufactured
Housing, Prime European Mortgages (UK, Netherlands, Spain, Italy, Portugal)
* Note: Prime RMBS also traditionally includes the conforming Agency (Fannie Mae, Freddie Mac) paper, which is out of the scope
of this paper because it is guaranteed and not typically included in SF CDOs.
1. CDOs-of-CDOs (majority of collateral is tranches of other CDOs) can also be considered SF CDOs, but they
are beyond the scope of this paper.
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CDO Research
2003 US/Europe SF CDO Collateral Distribution: By Deal Type

($billion notional)*
Chart 4 Chart 5
Cash: 16 Euro, 35 US deals ($29.1) Synthetic: 22 Euro, 4 US deals ($39.8)
Consumer
Corp ABS ABS
4% 4% Consumer
Corporate ABS
0% 28% RMBS
34%
RMBS
CMBS
48%
33%
Corp ABS
8%
CMBS
REIT 7% CDO
CDO
5% 23%
6%
Chart 6 Chart 7
Arbitrage: 19 Euro, 33 US deals ($32.5) Balance Sheet: 19 Euro, 6 US deals ($36.4)
Consumer
Corp ABS ABS
4% 5%
Corporate Consumer
0% ABS
27% RMBS
37%
RMBS
CMBS 44%
31%
Corp ABS
8%
CMBS
REIT 9%
CDO REIT CDO
5% 0% 19%
11%
Chart 8 Chart 9
US: 39 deals ($25.2) Europe: 38 deals ($43.6)
Consumer
Corp ABS ABS
4% 5% Consumer
Corporate ABS
0% 23%
RMBS
RMBS 39%
43%
CMBS Corp ABS
34% 7%
Corporate
0%
CMBS
11% REIT
REIT CDO CDO
5% 1%
9% 19%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
* As a percent of total notional value.
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CDO Research
2003 US/Europe SF CDO Collateral Distribution: By Sub Sector

($billion notional)*
Chart 10 Chart 11
RMBS ($27.4) CMBS ($13.5)
MH
2%
Large Loan
22%
Prime
43% CTL
2%
HEL
55%
Conduit
76%
Chart 12 Chart 13
Corp ABS ($4.0) Consumer ABS ($10.9)
Aerospace Student Loan

Structured Aircraft
1% 2%
Settlement 1%
7% Consumer Loan
20% Auto
Equipment 34%
28%
Health Care
Small Business 2%
Loan
Card
61%
44%
Chart 14
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20%
15%
10%
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* As a percent of total notional value.
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CDO Research
SF CDO Collateral The SF CDO collateral concentrations shown above are largely representative of the
Mirrors the Overall Market underlying collateral markets as a whole. That is, SF CDOs tend to source collateral
from the largest sectors, such as home equities (HELs) and CMBS. The one possible
exception (at least with US collateral) is the large prime RMBS market, from which
SF CDOs source smaller amounts of collateral. This is due to both the relatively
larger rate component of this sector (CDO technology is better equipped to take credit
risk than rate risk), as well as the smaller supply of subordinates (due to relatively low
credit enhancement associated with the prime quality collateral). European SF CDOs
tend to source larger portions of Consumer ABS, Prime RMBS, and CDOs2, as these
sectors represent a significant portion of the European structured products market.
The tables below provide a breakdown of recent collateral issuance for the US
and European markets, as well as JPMorgans 2004 forecast as of year-end 2003 3.
Table 2 and Table 3 provide volumes for the overall markets. Table 4 and Table 5
provide volumes for subordinate tranches and indicate the percentage of the total
structure that is non-AAA.
Table 2
US Structured Product Supply and Forecast ($Billion)
2001 2002 2003 2004 Forecast
% of % of % of % of
$bn Total $bn Total $bn Total $bn Total
RMBS: Prime 152.6 27.1% 228.9 32.7% 350.0 38.2% 325.0 36.6%
RMBS: HEL 94.2 16.7% 159.0 22.7% 219.9 24.0% 200.0 22.5%
Consumer ABS: Autos 70.2 12.5% 88.2 12.6% 77.2 8.4% 75.0 8.5%
Consumer ABS: Credit Cards 59.3 10.5% 65.8 9.4% 64.8 7.1% 75.0 8.5%
CMBS 67.2 11.9% 52.1 7.4% 77.9 8.5% 70.0 7.9%
CDO 62.8 11.1% 58.5 8.4% 66.4 7.3% 69.1 7.8%
Consumer ABS: Student Loans 9.5 1.7% 19.5 2.8% 30.7 3.4% 40.0 4.5%
Other 23.7 4.2% 6.6 0.9% 12.0 1.3% 12.0 1.4%
REIT 9.8 1.7% 10.6 1.5% 9.2 1.0% 10.0 1.1%
Corp ABS: Equipment 7.0 1.2% 5.9 0.8% 6.8 0.7% 8.0 0.9%
RMBS: MH 6.8 1.2% 4.6 0.7% 0.8 0.1% 3.0 0.3%
Table 3
Europe Structured Product Supply and Forecast ($Billion)
2001 2002 2003 2004 Forecast
% of % of % of % of
$bn Total $bn Total $bn Total $bn Total
RMBS: Euro (non-UK) 27.7 21.0% 34.6 24.2% 83.8 37.5% 80.0 35.0%
CDO 29.0 22.0% 22.2 15.6% 28.8 12.9% 28.0 12.3%
RMBS: Aussie 9.5 7.2% 11.0 7.7% 21.5 9.6% 25.0 10.9%
RMBS: UK 8.8 6.7% 11.6 8.1% 19.6 8.7% 20.0 8.8%
CMBS 14.3 10.8% 13.7 9.6% 15.5 6.9% 17.0 7.4%
Corp ABS: Whole Business 7.8 6.0% 10.7 7.5% 14.2 6.3% 12.0 5.3%
Consumer ABS: Student Loans 0.0 0.0% 0.5 0.4% 4.5 2.0% 11.0 4.8%
Other 12.0 9.1% 10.4 7.3% 12.3 5.5% 9.0 3.9%
Consumer ABS: Autos 4.4 3.3% 8.9 6.2% 4.7 2.1% 8.0 3.5%
Other: Sov/Ag 11.8 9.0% 9.9 6.9% 9.8 4.4% 8.0 3.5%
Consumer ABS: Credit Cards 3.3 2.5% 5.8 4.1% 5.9 2.6% 7.5 3.3%
Corp ABS: Equipment 3.0 2.2% 3.3 2.3% 3.2 1.4% 3.0 1.3%
2. A significant portion of CDOs re-securitized in European SF CDOs are Small to Medium Entity (SME) CDOs,
which are collateralized by receivables on a large number (typically thousands) of small business loans. The
granular collateral pool makes arguably makes these CDOs more akin to ABS than to a traditional CDO.
3. Other includes Dealer Floorplan, Stranded Asset, RV, Boat, Consumer, EETC, Aircraft, Small Business Loan,
Non-Performing, and Aircraft.
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CDO Research
Table 4
US Subordinate (non-AAA) Structured Product Supply
2001 2002 2003
$bn % Sub $bn % Sub $bn % Sub
RMBS: HEL 9.5 10.1% 18.4 11.6% 32.4 14.7%
CMBS 13.0 19.3% 9.6 18.4% 10.5 13.5%
CDO 12.5 19.9% 12.4 21.3% 10.1 15.3%
Consumer ABS: Credit Cards 10.0 16.8% 10.5 16.0% 9.6 14.8%
REIT 9.8 100.0% 10.6 100.0% 9.2 100.0%
RMBS: Prime 5.0 3.3% 6.4 2.8% 8.8 2.5%
Consumer ABS: Autos 2.4 3.4% 3.2 3.7% 2.5 3.2%
Consumer ABS: Student Loans 0.3 2.8% 0.6 3.2% 1.3 4.3%
Other 6.9 28.9% 2.0 30.8% 1.2 9.9%
Corp ABS: Equipment 1.3 17.9% 0.6 9.7% 0.6 9.1%
RMBS: US MH 1.4 21.2% 1.1 23.5% 0.2 26.7%
Table 5
Europe Subordinate (non-AAA) Structured Product Supply
2001 2002 2003
$bn % Sub $bn % Sub $bn % Sub
Corp ABS: Whole Business 5.0 63.6% 6.3 59.0% 6.1 43.1%
CDO 5.8 20.0% 4.4 20.0% 5.8 20.0%
CMBS 7.3 51.4% 3.8 28.0% 5.6 36.3%
RMBS: Euro (non-UK) 2.5 9.2% 2.4 7.0% 5.6 6.7%
Other 4.9 40.4% 1.8 17.5% 2.7 22.2%
RMBS: UK 1.4 15.8% 0.9 7.9% 2.7 13.8%
RMBS: Aussie 0.7 7.8% 0.9 7.8% 1.9 8.9%
Other: Sov/Ag 5.6 47.6% 1.6 16.6% 1.4 13.9%
Consumer ABS: Credit Cards 0.1 3.5% 0.6 9.6% 1.2 19.8%
Consumer ABS: Autos 0.2 4.1% 0.4 5.0% 0.2 5.1%
Corp ABS: Equipment 0.2 8.0% 0.3 10.1% 0.1 4.3%
What's Not in Seasoned SF CDOs under-performed in 2003 due largely to exposures in esoteric
SF CDOs and Why ABS sectors such as manufactured housing, tobacco, aircraft, mutual fund fees, and
franchise loans. With the possible exception of manufactured housing, exposure in
esoteric ABS was generally limited to a small portion of the portfolio, but it was
enough to impair performance in many deals.
These small (and sometimes new) sectors were included in older vintage SF CDOs
(2000-2002) because they offered some of the highest yields and added diversity to
the portfolio. However, the drawback is that they were often unseasoned, with
potentially flawed business models that take time to uncover. For example, franchise
loan amounts were typically based on the business value, rather than the real estate
value, leaving loans under-collateralized in the event of business failure. Another
example is mutual fund fees, which were based on the assumption of a growing share
of assets invested in equity funds, and did not anticipate the negative fund flows
during the market downturn.
7
CDO Research
The manufactured housing sector accounts for the bulk of structured products
tranches that have defaulted. The sector was severely hit with loose underwriting,
irrational competition, overproduction, and high exposure to the weakest sectors of
the economy in the past few years. The result was a perfect storm where external
forces totally changed the rules of the industry causing performance to significantly
diverge from original expectations. This was combined with deals that were
structured with lower initial required loss coverage ratios from the rating agencies
and lower excess spread requirements.
Todays next-generation SF CDOs contain less exposure to these esoteric sectors,

and have instead substituted established sectors such as HELs and CMBS. Although
trading is allowed in SF CDOs, all collateral concentrations are subject to
limits/prohibitions set at the inception of the deal.
Another exposure that caused problems in early SF CDOs was exposure to CDOs,
many of which have performed poorly (especially US HY CBOs) over the last
several years. As a result, most traditional US mezzanine SF CDOs have scaled back
CDO collateral concentrations (e.g. from a 20% bucket to a 5-10% bucket). Others
continue to allocate to this sector, reasoning that newer CDOs benefit from the debt-
friendly structures that characterize todays CDO market. European SF CDOs still
often have moderate-sized CDO buckets, but these are typically concentrated in SME
CDOs, which have developed a positive performance track-record. High grade SF
CDOs may have 10-15% concentrations in non-PIKable AAA and AA tranches. We
think that while a general reduction in CDO exposure is an understandable response
to current investor sentiment, CDOs still make sense for the SF CDO structure, and
there is no compelling reason to avoid CDO exposures once investor sentiment turns.
Far Less Deterioration in Table 16 shows migration of the Chart 15

Later-Vintage SF CDOs Weighted Average Ratings Factor vs. Ratings Trigger
Weighted Average Rating Factor (% compliance, negative number indicates non-compliance)
(WARF) versus the trigger WARF as 50
set in the indenture for all SF CDOs
rated by Moodys between 1999 0
and 2002. The chart illustrates the
problems in 1999 and 2000-vintage -50
SF CDOs, which have rapidly

-100
deteriorating ratings on the
underlying collateral. In contrast, -150
2001 and 2002-vintage SF CDOs
have had far less rating deterioration. -200
Whereas many esoteric ABS sectors -250May-02 Aug-02 Nov-02 Feb-03 May-03 Aug-03 Nov-03
are collateralized by business value 1999 2000 2001 2002
or depreciating assets, most sectors
in recent SF CDO transactions are Source: Moodys.
securitized by real estate, which

should provide a backstop on losses (the property value) in the event of default.
Those assets not secured by real-estate (cards, autos, equipment) are some of the
8
CDO Research
most seasoned in the ABS market (although investors should still be diligent in
evaluating the servicer risk in these sectors) and have well-established performance
track records.
SF CDOs Capitalize on SF CDO allocations to various structured product sectors change according to deal
Arbitrage Opportunities vintage, and deals are designed to capitalize on a market anomaly or arbitrage
opportunity at issuance. To illustrate this point, we look at the HELs minus CMBS
spread differential for the 2002-2003 period (Chart 16). Chart 17 illustrates the
change in SF CDO collateral breakdown during this same period.
Chart 17
Chart 16 Global SF CDO Collateral Distribution by Funded
BBB Spread Differential: HEL minus CMBS Volume: 2002 & 2003
bp
250 45%
40%
200 35%
30%
150 25%
20%
100
15%
10%
50
5%
0%
0 RMBS CMBS ABS CDO REIT
Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 2002 2003
During 2002, the exceptionally stable CMBS sector was pricing nearly in line with
HELs, and SF CDOs concentrated 40% of their collateral in CMBS versus 18% in
HELs. However, as spreads on HELs gapped out in 2003 (partially due to large
issuance volumes), new SF CDOs altered their collateral makeup to exploit the
opportunity, reducing CMBS exposure to 31% and increasing HEL exposure to
46%. As relative spreads and issuance continue to change in the structured products
markets, we expect that new SF CDOs will adjust to achieve maximum advantage for
investors. Of course, investors should perform appropriate due diligence to ensure
that asset managers are staying within their area of expertise.
Shifting Asset Allocation: Table 6 illustrates the substitution of HELs for CMBS as well as the decline in
A Real Life Example esoteric assets in four deals issued by Declaration Management and Research4
between 2000 and 2003. We selected this manager because they have been a repeat
issuer in the market, with a transparent history dating back several years. Note the
dramatic rise in HELs and decline in CMBS. Also note the significant decline in
manufactured housing, aircraft, and other smaller structured product sectors.
4. Formerly known as Independence Fixed Income LLC.
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CDO Research
Table 6
Investment Portfolios by Structured Product Sector
Independence I Independence II Independence III Independence IV
(2000) (2001) (2002) (2003)
Current Avg Rating/Trigger Avg Rating Baa3/Baa2 Baa3/Baa2 Baa2/Baa2 Baa2/Baa2

% of Total Portfolio
RMBS: HEL 18.92 22.44 25.09 55.48
RMBS: Prime 10.63 11.56 13.14 13.73
CMBS 20.14 31.35 32.29 9.88
RMBS: MH 13.31 14.09 11.61 5.28
CBO (Baa) 4.92 3.95 4.01 4.97
REIT 1.71 1.65 4.75
Corporates 2.50
Corp ABS: Structured Settlements 0.63 1.32 1.25
Corp ABS: Aircraft Lease 12.29 7.50 2.48 1.16
Corp ABS: Small Business Loan 3.62 0.61 1.55 0.99
Other 4.15 3.47 2.95 0.01
Consumer ABS: Auto 2.41 2.00
Consumer ABS: Credit Card 4.66 2.19 1.10
Corp ABS: Entertainment 0.05
Corp ABS: Equipment Leasing 0.81 0.37
Corp ABS: Franchise Loans 3.85 0.50 0.44
RMBS: Property Tax Liens 0.24
Source: Fitch.
Collateral Quality: Since each of the aforementioned asset classes may issue notes of various ratings and
Weighted Average Rating with various levels of subordination, the quality of collateral is at least as important
as the type of collateral. While traditional SF CDOs typically used collateral with
weighted average ratings in the BBB vicinity (relatively higher spreads created
attractive arbitrage), the advent of new securitization technology has allowed the
development of high grade SF CDOs, which typically source AAA/AA collateral.
Chart 18 and Chart 19 show weighted average ratings for cash and synthetic SF CDOs
issued in 2003. Note that synthetics, with lower overall funding costs due to the
presence of a large super senior tranche, are overwhelmingly high grade SF CDOs.
Although cash deals remain largely backed by BBB collateral, the number of cash
high grade deals has grown to 22%. This growth has been helped by the development
of short term money market eligible tranches at the top of the capital structure.
The advent of high grade SF CDOs bodes well for SF CDO supply, since there is
a much larger supply of AAA/AA collateral, which typically makes up 80-85% of the
capital structure in many structured product transactions. Supply of the (relatively
smaller notional) subordinate tranches may be limited, especially in higher interest
rate environments5. Potential lack of mezzanine structured products supply creates
reinvestment risk in traditional managed mezzanine SF CDOs. Investors should
insure that asset managers have sufficient access to collateral during both the ramp-
up and reinvestment periods.
5. Although higher interest rates would also impact senior tranche supply, the reduction would have less impact on
SF CDOs because supply is much larger in the first place.
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CDO Research
Chart 18 Chart 19
Cash SF CDO Collateral Quality Breakdown: 16 Synthetic SF CDO Collateral Quality
Euro, 35 US deals ($29.1) Breakdown: 22 Euro, 4 US deals ($39.8)
B BBB
BB 5% A
AA 5%
7% 5%
21%
AA
29%
A
14%
AAA
61%
BBB
53%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys,
Standard and Poors, Fitch. Standard and Poors, Fitch.
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CDO Research
SF CDO Assets: 101

Most structured products share certain similarities (ownership in a pool of
receivables, subordination, sequential pay structure, overcollateralization), but there
are also key differences across asset classes (specific assets, weighted average life,
structural variations). The following pages provide an introduction to the elementary
characteristics of structured products typically found in SF CDOs, including
collateral, market participants, structure, and principal risks. This section may be
skipped by investors that already possess a strong understanding of the structured
products markets or used as a reference guide for those with a strong understanding
of some sectors but not others.
We cover four of the largest SF CDO collateral components (HEL, CMBS, US Prime
RMBS, and UK RMBS) in some detail, and provide a brief overview of other
structured products. To begin, Table 7 provides an overview of four key sectors.
Table 7
Structure Comparison
HEL CMBS UK RMBS US Prime RMBS
Major Currencies USD USD USD, GBP, EUR, USD

CHF
Typical New Issue Size $750mm $1bn $6-$7bn $750mm - $1bn
Weighted Avg. life 3 - 5 years 5 - 10 years 1.0 - 5.5 years 7 years
Spread Indices Libor, Swaps Swaps Libor, Euribor Treasuries
Coupon Type Fixed and Floating Primarily Fixed Fixed and Floating Fixed and Floating
Rating Stability Relatively more Very stable and Very stable and Very stable and
volatile due to sector marked by upgrades marked by upgrades marked by upgrades
consolidation and in seasoned in seasoned in seasoned
transformation transactions transactions transactions
Typical Structure AAA - 15.0% sub. AAA - 16% sub. AAA - 8% sub. AAA - 2.5% sub.
AA - 10.0% sub. AA - 13% sub. AA - 5% sub. AA - 1.25% sub.
A - 6.0% sub. A - 10% sub. BBB 1.5% sub. A - .85% sub.
BBB 2.5% sub. BBB - 6% sub. (plus Reserve Fund) BBB - .50% sub.
(overcollateralization) BB - 3% sub.
Liquidity Medium liquidity; Very High High; one of the Very High
largest issuers have most liquid sectors
the best liquidity in Europe
Key Issuers Ameriquest, Chase, CSFB, Goldman, Abbey National, Chase, Countrywide,
Countrywide, Lehman, Morgan HBOS, Northern Washington Mutual,
GMAC/RFC, Stanley Rock Wells Fargo
Option One
Source: JPMS.
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CDO Research
The largest SF CDO collateral sector is RMBS. Chart 20 illustrates the difference
between the most common forms of prime and subprime RMBS to appear in SF
CDOs. There are also regional differences. Below, we explore several RMBS
sectors in detail.
Chart 20
Types of RMBS
B&C 2nd Prime Prime

Subprime ARM Lien Alt-A Jumbo
Credit Prime Documentation Pristine
Borrower Impaired Property Type Credit
1st 2nd 1st 1st

Lien
80% 90% 75% 75%

LTV
7.5% 9%-10% 6.5% 6.0%

WAC
630 715 715 725

FICO
Ameriquest Chase Countrywide Chase

Originators
Chase Countrywide GMAC/RFC Countrywide
Countrywide GMAC/RFC IndyMac GMAC/RFC
GMAC/RFC First Franklin Well Fargo
Option One
Home Equity Prime
Source: JPMS.
RMBS: Home Equity Loans (HEL)

HELs are secured by residential real estate property, primarily first mortgages to
borrowers unable to obtain prime funding due to the borrowers credit (sometimes
referred to as B/C loans). Second-lien loans are also included under the HEL
moniker, although these are a much smaller proportion of the market. HELs are the
largest sector in the public ABS market. Volumes have increased dramatically due to
the current low interest rate environment and home price appreciation. Chart 21
below provides a brief overview of the HEL market.
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CDO Research
Chart 21
Overview of the HEL Market
Certificates
Residential homeowners Lenders include banks and Certificates are sold in the
borrow funds which are finance companies. To public and/or private
collateralized by real securitize, lenders sell a markets and are secured
property. Loan types pool of receivables into a by trust receivables.
include: trust. They generally retain These certificates can
Subprime B/C: servicing of the loans. have a variety of
structures:
Fixed rate mortgage Lenders may alternatively
(FRMs) sell the receivables to be Fixed vs. floating coupon
Adjustable-rate packaged by Wall Street
Wrapped vs. senior/sub
mortgages (ARMs) conduits. In this case,
servicing responsibility is Multi-tranche vs. single
2nd Lien Mortgage:
generally not retained by tranche
Closed-end fixed rate the lender.
Bond structure will depend
Revolving home on the underlying
equity lines of credit collateral, trust structure,
(HELOCs) and credit enhancement.
Home improvement
loans (HILs)
High LTV loans
(125s)
Source: JPMS.
Chart 20 provides an overview of different types of HELs. Note that Alt A and Prime
Jumbos (addressed later on under the Prime RMBS heading) are included here for
purposes of comparison.
Most HELs are HELs may be floating rate (Adjustable Rate Mortgage or ARM) or fixed rate (Fixed
Floating Rate Rate Mortgage or FRM). ARMs currently account for approximately 75% of HEL
volume. Most ARMs are indexed off 6-month LIBOR. Typically, ARMs are fixed
for a period of time before resetting and are referred to as Hybrid ARMs. Types of
Hybrid ARMs include 1/29, 2/28, 3/27, 4/26, or 5/25 loans, where the first number
references the period the loan rate is fixed and the second references the period the
loan rate is floating. Over the years, the majority of ARMs originated have shifted
towards the Hybrid ARM product, with 2/28s the most popular. After the initial
fixed period, ARM rates are determined by adding the loans margin to the
benchmark. On each reset date thereafter, typically every 6 months, the new rate is
calculated and principal payments are adjusted so that the loan fully amortizes over
its remaining life.
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CDO Research
Credit Enhancement Excess spread is the first line of defense against losses. It is composed of excess
funds from interest paid on the HELs after expenses. Depending on deal structure, it
may be (a) used to cover payment shortfalls in the current period, (b) used to
maintain target overcollateralization levels, or (c) flow out of the structure to the
residual class holder.
Overcollateralization. Overcollateralization is equal to the par value of collateral
minus the par value of issued securities. Overcollateralization may exist at inception
or be built over time using excess spread. The overcollateralization cushion may
be used to absorb principal losses as they occur. If overcollateralization levels are
not in compliance with test levels, excess spread is used to accelerate principal
payments to bondholders, thereby rebuilding overcollateralization levels.
Subordination. More senior securities have principal/interest payments subordinated
to their own, which provides a natural layer of protection because they are not
impacted by loss that is absorbed by the layer or layers below them.
Prepayments/ HELs typically amortize over their term-to-maturity. Some loans require balloon
Prepayment Penalties payments (more common for 2nd lien) and others may have an interest only period.
Loans may prepay in advance of the scheduled maturity due to voluntary prepayments
(refinancing or sale of home) or involuntary prepayments (repossession or loss of
home). When a prepayment occurs, principal is paid through to the security holders,
thus retiring that portion of principal that is attributable to the loan that has prepaid.
HELs exhibit much less interest rate sensitivity as compared to Conforming and
Jumbo MBS. Contributing to the greater prepayment stability are: higher baseline
speeds due to credit curing and the equity take-out component of the market, as well
as prepayment penalties. Both FRMs and Hybrid ARMs have significant prepayment
penalties. Penalties typically last 3-5 years for FRMs and the initial fixed period for
Hybrid ARMs. An example of a typical prepayment penalty is 6 months interest on
any prepayments in excess of 20% of the outstanding loan balance.
Net Interest Margin NIMs are typically securitizations of front-end residual cashflows (after bond
Securitizations coupons, fees, and losses) from a single unseasoned HEL deal. They are also entitled
to overcollateralization releases after the step-down date as well as prepayment
penalty income. NIMs typically achieve ratings of BBB by discounting the expected
cash flow stream and applying various default, interest rate, and prepayment stresses.
The notes have a weighted average life of 0.8 to 1.5 years and offer a spread
premium of 250-300bp to like-rated ABS. The high spread premium is the primary
reason that NIMs appear in CDOs. NIM performance has been excellent over the
past few years due to declines in floating rate funding costs associated with an
accommodative Fed policy.
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RMBS: Prime6
Chart 22 below provides an overview of the Prime RMBS market.
Chart 22
Overview of the Prime RMBS Market
Certificates
Residential Wall Street dealers Mortgage cashflows are

homeowners borrow purchase pools of loans carved up to address:
funds, collateralized by and structure securities
real property. Including: based on demand Prepayment Risks & Cash Flow
Uncertainty
Call and/or Extension Risk
Conforming: Meet US Negative Convexity
Government Sponsored Specific client needs
Enterprise (e.g. Fannie Different Targets: Average Life,
Mae, Freddie Mac) Yield, Duration, Credit Quality
criteria. CDOs dont
typically have exposure
to GSE loans.
Non-Conforming:
Jumbo: Exceed the
single-family loan limit
for GSEs ($333,700 in
2004).
Alt A: Issued to prime
borrowers that have
documentation or other
non-standard loan
characteristics.
Source: JPMS.
Structure The earliest, simplest of MBS classes, sequentials split pass-through cash flows into
classes with different average lives. Sequentials are sensitive to prepayments, with
all classes extending or shortening simultaneously.
Floating-rate MBS may have a variety of average life profiles, some stable and some
volatile. Coupons typically reset monthly based on a fixed spread over a specific
index rate (often LIBOR). The maximum coupon (cap), spread over index, and
average life profile are main determinants of yield. Floaters, due to their shorter
duration, generally have less price volatility than fixed-rate MBS (unless rates rise
and the coupon reaches its cap).
Prepayments Borrowers have the right to prepay at any time without penalty in effect calling
their loans away from investors prepayments may be partial or complete. Timing
and rate of prepayments vary and produce non-level, less-predictable cash flows.
Given current interest rate expectations and following rapid prepayments over the last
few years, prepayments are generally expected to slow in the coming years.
RMBS: UK
UK RMBS is one of the fastest growing sectors of the ABS market. UK RMBS is
the largest sector in the European securitization market and a widely held asset class
6. A special thanks to Rajan Dabholkar and Eliza Hay for their help with the US Prime RMBS portion of
this publication.
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CDO Research
among European investors. It also provides an opportunity for investors to diversify

away from US consumer credit into high quality secured asset-backed product.
Chart 23 above provides an overview of the UK RMBS market.
Chart 23
Overview of the UK RMBS Market
Certificates
The underlying collateral is prime UK UK mortgage lenders The master trust structure
mortgages for owner-occupied can be divided into used in global UK RMBS
homes. Mortgage brokers are a vital three basic categories: creates a clean bullet
source of new mortgage origination banks, building repayment profile similar to
(up to 60% of new loans for some societies (operate that of credit cards.
lenders), branches and telephone under the principle of
distribution are also important. mutual ownership), and An issuer can issue
specialized mortgage multiple series of Notes
UK Mortgage Product lenders (a focus on from the master trust and
Standard variable rate mortgages non-conforming principal payments from
(capital repayment over 25 year life). borrowers). The UK each series (as in credit
Flexible mortgages have market is dominated by cards) may be shared
experienced dramatic growth in the the largest lenders, among series to create a
past few years. Allow borrowers to which are primarily bullet or meet a repayment
prepay their principal and feature banks. schedule for an individual
payment holidays series.
Fixed rate or hybrid mortgages.
Initial fixed rate reverts to floating
after specified time period (2-5 yrs).
Source: JPMS.
Despite the growth in new product types, UK mortgages typically have a number of
common characteristics, including a term of 25 to 40 years, a floating interest rate, full
amortization over the life of the loan, and a first charge (i.e., lien) on the property. The
mortgages interest rate (the standard variable rate, or SVR) is set at the discretion of
the lender and is loosely tied to the central bank rate.
UK residential mortgages have historically been marked by stable mortgage

prepayments. In recent years, the introduction of a number of flexible mortgage
products and increased competition among mortgage lenders have led to increased
remortgage activity among existing lenders. In turn, this remortgaging activity has
pushed prepayment speeds marginally higher.
Master Trust For investors familiar with the mechanics of a credit card ABS master trust structure,
Structure the UK RMBS master trust uses a similar technology to create a soft bullet repay-
ment profile. Because the total amount of mortgage collateral in the trust exceeds the
size of any RMBS tranche due, prepayment leverage ensures the trust can create a
bullet payment in a short accumulation period. An issuer can issue additional series
from the master trust by either adding new mortgage collateral to the trust or
transferring part of the sellers share to the investor share (since the sellers share is
very large when the master trust is first established). In anticipation of notes
becoming due, principal payments are accumulated for the purpose of creating a
bullet repayment for that series.
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CDO Research
The sellers share represents the total interest in the trust collateral retained by the
seller and is set to a minimum amount. The sellers share does not represent a form
of credit enhancement, as it ranks pari passu with the investor share. Excess seller
interest is the interest in the collateral retained by the seller that exceeds the required
minimum seller interest. Excess seller interest absorbs temporary fluctuations in the
collateral balance of the trust (i.e., higher than normal redraws).
Collections on the mortgage pool are split between interest charges and principal
repayments. Interest income is allocated on a pro rata basis among each series of the
master trust. The allocation of principal collections depends on the cash flow stage
of each series. Principal repayments may be used to 1) amortize pass-through notes
or to accumulate principal for a bullet repayment, 2) pay the seller and reduce the
size of the trust (provided the seller maintains a minimum sellers interest, or 3)
purchase new mortgage receivables from the seller during the revolving period.
US$ Securities UK RMBS typically issue a portion of their liabilities (typically shorter term) as US$
denominated, SEC registered securities. This is due in part to lower short term rates
in the US, with more aggressive pricing in the US on securities inside three years.
US$ tranches also help to diversify the UK RMBS investor base.
Credit Enhancement UK RMBS use a senior/subordinate structure with credit enhancement provided by
subordination and excess spread. In general, reserve funds provide liquidity and credit
enhancement to the structure. The reserve fund provides liquidity in that it can be used
to cover any interest shortfall on the notes and acts as credit enhancement in that it
absorbs any losses in a calculation period to the extent that excess spread is insufficient.
For master trusts with structured bullets, the reserve fund can also provide liquidity to
pay AAA bullet principal (again, to the extent necessary). Additional structural features
(eg, cash reserves and liquidity facilities) interact with the priority of payments to help
ensure the timely payment of interest and principal to the notes.
RMBS: UK Non-Conforming
UK non-conforming mortgages are analogous to US HELs. Like HELs, non-
conforming RMBS are secured by residential real estate property, primarily first lien
mortgages to borrowers unable to obtain funding from conventional mortgage lenders.
Borrowers in the non-conforming market include self-employed (without sufficient proof
of income and financial history), foreign nationals working in the UK (no credit record),
and those with County Court Judgements (CCJs). In the UK, County Court Judgments
are recorded when an individual has not repaid some form of debt, ranging from credit
card bills to an unpaid mortgage. As of year-end 2003, the largest originators are
GMAC RFC (RMAC), Kensington Group plc, and Britannia Building Society.
RMBS: Continental Europe

Together, German, Dutch, Spanish and Italian RMBS represent a large source of
European structured products issuance. While mortgage characteristics (e.g., loan-to-
value, prepayments, fixed/floating, mortgage features, etc.) vary by country, the
collateral is considered prime in that mortgage borrowers have not experienced
past credit problems. The mortgages are typically first-lien (except Germany),
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CDO Research
owner-occupied properties. Mortgage credit performance has been strong, and the
sector has experienced a number of upgrades due to better-than-expected
performance and prepayments (i.e., deleveraging of the structure). Highly rated
European banks seeking diversified funding and regulatory capital relief have been
the primary source of these deals. While structures also vary by country, continental
RMBS transactions typically pay down senior tranches sequentially and may only
amortize subordinate tranches provided that certain performance criteria are met.
CMBS7
The CMBS market emerged in the last decade as a response to the real estate cycle in
the United States, as traditional lenders (commercial banks, insurance companies)
avoided real estate exposure during the real estate downturn of the late 80s and early
90s. CMBS allows lenders to spread underwriting risk, diversify geographically, and
increase liquidity. It has also increased funding options for developers and large owners
of commercial property. Chart 24 below provides an overview of the CMBS market.
Chart 24
Overview of the CMBS Market
Certificates
CMBS are backed by mortgages on Wall Street firms & other conduit Conduit/Fusion (67.9%): Conduit
commercial and multifamily operators securitize portfolios of deals are well-diversified, about
properties that are income- newly originated loans to empty the $1billion in total size. Fusion deals
producing and operated for warehouse and take profits are conduit deals that include some
economic profit. CMBS are backed large loans (>$50MM), which are
by a wide range of property types Banks, thrifts and insurance typically high quality, shadow-rated
(total portion of issuance in companies securitize seasoned loans investment grade loans but pose
parentheses): to clear the balance sheet, adjust some concentration risk.
exposures, or exit the sector
rental apartments (22.4%)
Multi-borrower floater (19.3%):
shopping centers and other retail Wall Street firms and real estate Backed by floating rate loans from
facilities (36.2%) "opportunity" funds acquire and several borrowers. They are
securitize portfolios of seasoned generally shorter term deals with
office buildings (25.2%)
loans to finance the acquisition some adverse selection risk.
hotels (1.8%) and/or cash out of the investment
Single asset/single borrower (9.8%):
warehouse/industrial (7.9%)
Owners of large commercial Either backed by a single property
nursing homes, mobile home parks properties and pools of smaller or a single borrowers portfolio.
and self-storage (6.5%) commercial properties secure
attractive financing as an alternative
to a portfolio lender
Source: JPMS.
Structure/Credit Credit enhancement is achieved mainly through subordinated bond classes (AA to
Enhancement unrated classes). Default risk is a function of the initial LTV (Loan-to-Value) and
DSCR (debt-service-coverage-ratio).
Prepayments/ Extension Newly originated fixed rate loan pools carry significantly less prepayment risk, as
there are large prepayment penalties to the individual borrowers, typically in the form
of strong loan-level call protection and a lock-out period followed by defeasance.
7. A special thanks to Pat Corcoran and Yuriko Iwai for their help with the CMBS portion of this publication.
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CDO Research
Extension risk is created when not enough income and equity are available to pay the
balloon payment. CMBS with low LTVs have less extension risk.
Regional Differences European CMBS can be differentiated from US CMBS by several factors. First,
US issuance is typically more standardized and uses the conduit structure. In
Europe, different countries have different underlying lease terms and the Conduit
market is smaller because banks have (historically) been able to fund real estate on
balance sheet very cheaply. This is changing over time. Broadly, the European cash
CMBS market can be broken up into the following categories:
Single borrower, single property (mostly UK based deals, with trophy assets).
Single borrower, single tenant with no disposal strategy on the properties
(typically linked to rating of underlying corporate).
Single borrower, single tenant with a disposal strategy on the properties (i.e. sell
the properties to pay the principal on the bonds).
Multi-borrower
CMBS: Interest Only Strips

IOs are coupons stripped from an underlying pool of commercial mortgages. They
allow an issuer to sell near par priced securities, even if the coupon on the underlying
mortgages is greater than the bond coupons. A single IO strip (traditional form) is
defined as the adjusted WAC of the loans minus the WAC of the principal bonds. An
alternative form is two IO strips (PAC and Support). The PAC IO is stripped from
the traditional IO. Its notional amount and size is determined assuming certain
default and prepayment scenarios. PAC IOs generally have a WAL of 7.0 years. The
Support IO is the leftover and bears most of the brunt in the event of early
prepayment. CMBS IOs are typically limited to at most 5% of the SF CDO collateral
pool. They are not included in diversity score or WARF calculation and are typically
haircut for purposes of par value tests.
CMBS: Non-Performing Loan (Europe)

Following the introduction of the Italian Securitization Law in 1999, non-performing
loans (NPLs) represented a large percentage of the Italian securitization market. A
key driver behind NPL securitization was the favorable tax treatment that allowed
Italian banks to amortize any losses (over a five year period) arising from sale or
securitization of NPLs. However, this special tax provision was terminated in mid-
2001, which has caused Italian NPL securitization to decline. NPL securitizations are
typically backed by commercial real estate properties. NPL securitizations frequently
depend on a property disposal strategy for the repayment of bond principal and
interest. Because the loans are non-performing, the loan servicer plays an important
role in transaction performance (i.e., ensuring that the loans move quickly through
any court proceedings). Going forward, German banks may begin securitizing non
performing loan portfolios as well.
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CDO Research
Real Estate Investment Trusts (REITs)

REITs are companies that own and (in most cases) operate income-producing real
estate, with assets in the $300 billion area. Common REIT property types include
diversified pools of regional malls, shopping centers, office buildings, warehouses,
and residential facilities. REITs are typically financed using about half debt and half
equity (equity pays out at least 90% of its taxable income as dividends). This is a
significant improvement versus the early 1990s, when individual properties were
typically financed by mortgages with LTVs in the 90% area, leaving companies less
flexibility and more exposed to interest rate risk. There have been no REIT bond
defaults in the last 10 years. Positive performance can be attributed to conservative
debt ratios, the ability to access the secured market in times of distress, and the
property cycle upswing.
SF CDOs invest in unsecured fixed rate REIT debt, the majority of which is rated
BBB. In addition to an interest rate swap, the CDO structure typically also includes a
timing swap to match semi-annual REIT payments to quarterly CDO payments. With
BBB REITs typically pricing within +/- 20bp of CMBS BBBs (T+120 ten year
average), the inclusion of REITs in a SF CDO is not yield enhancement. Rather, it
helps to improve diversity, since rating agencies give some diversification credit
versus CMBS.
Consumer ABS: Auto and Credit Card

Auto ABS securitize secured consumer installment loans or leases used to finance
new and used car purchases. Receivables carry a fixed interest rate and usually have
a 36, 48, or 60 month term. Receivables are originated by captive manufacturer
finance subsidiaries (GMAC, Ford, DaimlerChrysler, Honda, Toyota), banks (Chase,
M&I, Regions, USAA), and specialty finance companies (AmeriCredit, Onyx, WFS).
Auto ABS typically use the Owner Trust structure, which provides flexibility in
structuring cashflows, permitting multiple senior tranches, as well as floating rate
tranches. Credit enhancement to senior notes are typically provided by subordinated
certificates supplemented with a reserve account. Loans may prepay in advance of
the scheduled maturity due to voluntary prepayment (refinancing or sale of vehicle)
or involuntary prepayment (repossession or loss of vehicle).
Credit Card ABS are backed by receivables from unsecured consumer loans. Types
of cards include revolving lines of credit (Visa and Master Card) as well as retail
cards from issuers such as Macys and Neiman Marcus. Non-revolving charge cards
from AMEX are also common. Large issuers include Chase, Capital One, Citibank,
and MBNA. Nearly every Credit Card ABS issuer uses the master trust structure,
similar to the UK RMBS structure discussed above. Structures include a revolving
period of 1-10 years (where monthly principal collections are used to purchase new
receivables), followed by an accumulation period. Notes may be fixed or floating,
typically with a 5yr expected life. Excess spread, early amortization triggers, and
subordination are key forms of credit enhancement.
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CDO Research
Auto and Credit Card ABS are two of the largest, most mature, most liquid sectors in
the ABS market. Both typically are priced at or near the tightest spreads in the ABS
market. Because low spreads reduce CDO arbitrage opportunities, CDOs tend to limit
exposure to most Auto and Credit Card ABS (although some is typical as a means of
increasing diversity).
Consumer ABS: Consumer Loan (Europe)

Credit card penetration among Europeans remains low compared to the US and
amortizing term loans represent a large part of unsecured lending in many countries.
Unsecured consumer loans may be used for an auto purchase, home improvement,
or other reasons, although the loans purpose does not always need to be stated.
Consumer loan ABS transactions frequently have a revolving period, during which
prepayments are used to purchase new loan collateral. Cumulative loss rates for
consumer loan ABS have remained very low (less than 2%), while excess spread has
remained healthy (e.g., over 5%). Italian consumer loan performance varies
according to the region where the loans are originated, with southern regions
frequently experiencing higher default rates.
Corporate ABS: Equipment

Equipment ABS is backed by loan or lease receivables including agricultural,
computer, industrial, medical, small ticket office, and trucking. Lessors include
both independent leasing companies and captive subsidiaries of large manufacturing
firms. Credit analysis includes a review of the projected remaining cashflows and
underwriting standards. Leasing company receivables are typically diversified across
geography, industry, and obligors, and additional analysis and credit enhancement are
required in cases where concentrations are high.
Lease payments typically cover over 90% of equipment costs and 75% of the useful
life for financing leases (essentially a monthly payment plan). Operating lease
payments cover less than 90% of equipment value. Residual value (estimated value
at the end of the lease term) can be realized via a buyout option or sale, and may
be given some credit in rating agency analysis. Credit enhancement includes
subordination, reserve funds, and de-leveraging performance triggers. SF CDOs
typically purchase the single-A tranche. Bonds are typically fixed-rate, with a spread
pick-up of 6-8bp to like-rated autos, and have a weighted average life of two to three
years and experience low prepayment volatility. Equipment ABS supply is typically
correlated with performance of the overall economy, with businesses willing to
add/replace equipment in robust economies. In Europe, large Italian lease companies
have originated the majority of equipment lease ABS. To date, equipment, vehicles
and real estate leases have backed these transactions.
Corporate ABS: Whole Business Securitization (Europe)

Whole business securitizations are bonds that are backed by the cash flows from a
company. WBS companies typically have very stable cash flows and usually benefit
from regulation or other protections that make it unlikely that these cash flows will
change. For example, water utilities, funeral homes, and pubs are all types of
operating companies that have been securitized. Whole business securitizations
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CDO Research
achieve higher ratings than unsecured debt through covenants (e.g. bondholders right
to replace management) and committed liquidity. WBS may also include property
or high profile assets that have real value for WBS bondholders. To date, whole
business securitizations have been a UK phenomenon, due to the favorable legal
status afforded to WBS bondholders.
CDOs
Other CDOs may be included in the SF CDO structure. Unlike CDOs-of-CDOs, where
nearly 100% of the collateral pool is other CDOs, SF CDOs typically source a limited
amount of other CDOs as collateral. This number was often 20% in earlier deals, but
has been closer to 5-10% in more recent deals. The purpose for including CDOs in the
collateral pool may be either yield enhancement or diversification. In addition to
overall CDO concentration limits, SF CDOs also have limits on PIKable collateral.
CDOs of small- and medium-sized enterprise (SME) loans are common in Europe.
SME CLOs are not arbitrage-driven, and the primary motivation for banks to do these
deals is balance sheet relief. SME loan pools usually offer a very large number of
underlying obligors and thus a high degree of granularity in the portfolio. Germany,
the Netherlands, Spain and the UK have all contributed to SME CLO volume.
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CDO Research
Does SF Collateral Work for CDOs?

There is a good case, we think, for applying CDO technology to structured product
collateral. Structured products offer a spread pick-up to like rated corporates, as well
as comparable default and recovery rates. Low event risk, a relatively stable arbitrage
opportunity, and low correlation with traditional CDO collateral are also positive.
Spread Pick-Up
The rise in SF CDO issuance was primarily the result of a sharp widening in
structured products spreads in the fall of 1998. At that point, there was a severe
dislocation in many non-government markets that injected huge liquidity premiums
into spreads and presented attractive arbitrage opportunities. The resulting
exploitation of these opportunities resulted in the take-off of SF CDOs. Fortunately
(for arbitrage purposes), structured products spreads have remained relatively wide,
explaining their continued growth as an asset of choice in CDOs.
We make the case later in this section that structured product performance has been
in line with like rated corporates. As such, we believe the spread pick-up arises from
relatively less liquidity and higher barriers to entry (complexity) in the structured
products markets. SF CDOs, in essence, monetize this premium, which arises from
several factors:
Small size of the subordinate structured product market8
Small size of individual subordinate tranches
Small size of the subordinate structured product buyer base
Complex structures that require more sophisticated analysis
To illustrate, Chart 25 shows a significant spread pick-up for BBB and single-A
HELs to like rated finance corporates. By contrast, the most liquid structured
products sector, Credit Cards, prices much closer to the corporate market (Chart 26).
For this reason, SF CDOs typically have larger allocations to HELs and other less
liquid sectors than to Cards.
Chart 25 Chart 26
HEL vs. Finance Spread Differentials Credit Card vs. Banks Spread Differentials
350 80
300
60
250
200 40
150 20
100
0
50
0 -20
-50
-40
-100
-150 -60
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Credit Card minus Banks (A 5-year)

HEL Minus Finance (A) HEL Minus Finance (BBB)
Credit Card minus Banks (BBB 5-year)
Source: JPMS. Source: JPMS.
8. Small size of both the subordinate market and individual subordinate tranches also (arguably) leads to scarcity,
which has the impact of tightening spreads. This effect is in most cases outweighed by the liquidity premium.
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CDO Research
Stability/Event Risk
The CDO universe can be roughly divided into moderately leveraged sectors (HY
CLOs at 12x, HY CBOs at 8x) and more highly leveraged sectors (investment grade
corporate CDO at 25x, SF CDO at 20x). In general, highly leveraged sectors are able
to apply greater leverage because they are backed by relatively more stable high grade
assets. The problem with applying greater leverage to stable assets, however, is
that these sectors become more exposed to single names and tail risk, where
unusual (based on historical experience) scenarios can quickly eat through the small
amount of equity subordination in the structure. Note that leverage can vary greatly
across SF CDOs (8-25x), with less levered structures less exposed to event risk.
The experience of IG CDOs in 2002 and 2003 when incidents of fraud, defaults,
and fallen angel 9 corporates were high is illustrative. These unusual events
(fraud in particular) were painful for IG CDOs. For example, in an IG CDO backed
by 100 equally weighted corporates, a 4% equity tranche would be wiped out by four
defaults (assuming zero recoveries). Although IG CDO portfolios may not have
exposure to every case of fraud (e.g. Enron, WorldCom, Parmalat), exposure to even
a few of these cases leaves little room for error.
Although SF CDOs employ similar leverage to IG CDOs, they are less exposed to
event risk. This can be largely attributed to the higher levels of granularity in the
underlying structured products, which are often referenced to a large number of
individual consumers. In addition, the underlying structured products are themselves
credit enhanced to withstand multiples of base case scenarios. Some idiosyncratic
risk is clearly present in the form of issuer concentrations (model risk) and servicer
risk. These risks, however, can be mitigated by concentration limits, limiting
exposure to established sectors with proven models, and investing in sectors with
adequate back-up servicing capability.
Stable Arbitrage Opportunity

The subordinate ABS and CMBS markets are particularly dependent on the
CDO bid. We use the US HEL and CMBS market as an example, although a
parallel argument could be made for Europe, where the CDO market has a similar
importance. Weve calculated that newly issued cash SF CDOs purchased
approximately $10.2 billion in HEL subs and $7.9 billion in CMBS subs in 2003. In
terms of 2003 issuance, this equates to approximately 32% of HEL subs and 80% of
CMBS subs. The percentage of HEL subs was probably even higher in late 2003.
Although CDOs purchase a significant portion of their collateral from the secondary
market, these figures help put the CDO bid in context of the collateral market size.
However, as we hope this paper makes clear, we believe the SF CDO market is
here to stay, meaning the CDO bid is not expected to go away.
SF CDOs Exert As such, the SF CDO bid can exert significant technical pressure on collateral spread
Technical Pressure On levels. When collateral is cheap, CDOs will enter the market, supplying additional
Collateral Markets demand and effectively putting a cap on spreads. This effect is enhanced due to the
lumpy (not smoothed over the year) nature of SF CDO supply, as large numbers of deals
tend to begin ramping up collateral simultaneously when the arbitrage looks attractive.
9. Defined as a investment grade security (BBB and above) falling to high yield (below BBB) or default.
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When collateral is rich, CDO demand decreases. Since the structured products
markets are dependent on the CDO bid for subordinate paper, SF CDOs effectively put a
floor on subordinate spreads at the point where the CDO arbitrage disappears.
To a certain extent, this phenomenon Chart 27

can also be observed in the institutional Normalized CDO Funding Gap 10
leveraged loan market, where CDOs are 10
significant buyers. In contrast, the CDO 9
8
bid is less influential in investment grade 7
CDS, due to the size of that market 6
5
(approximately $5 trillion). 4
3
Chart 27 shows arbitrage levels in terms 2
1
of the CDO funding gap (by definition, 0
spread on assets minus cost of debt) for -1
-2
both SF and IG CDOs. Because SF -3
CDOs put caps and floors on
Sep-01
Dec-01
Sep-02
Dec-02
Sep-03
Dec-03
Mar-01
Jun-01
Mar-02
Jun-02
Mar-03
Jun-03
collateral spreads, the arbitrage has been IG CDO SF CDO
much less volatile in this sector over the Source: JPMS.
last several years.
Correlation
Exposure to structured finance offers strong diversification benefits for CDO investors.
This is because SF CDOs have exposure to several different asset classes (CMBS, Prime
RMBS, HEL) that each have low correlation to traditional CDO asset classes (High
Yield Bonds, Leveraged Loans, Investment Grade Corporates). Higher diversification
reduces risks since it implies lower correlation in the variability of returns. Please note
that correlation in this sense means spread correlation, and not default correlation.
Table 8
US Monthly Spread Correlation (2000-2003): AAA/AA Structured Products & Traditional CDO Collateral
10 Yr AAA 10 Yr AA 5 Yr AAA JPM USD 5 Yr BB/BB- 10 Yr BBB
CMBS MBS HEL HY Index Lev Loan Industrial
10 Yr AAA CMBS 1.0 0.5 0.2 0.4 0.4 0.4
10 Yr AA Prime RMBS 1.0 0.3 0.4 0.4 0.1
5 Yr AAA HEL 1.0 0.1 0.3 -0.1
JPM USD HY Index 1.0 0.1 0.7
5 Yr BB/BB- Lev Loan 1.0 0.2
10 Yr BBB Industrial 1.0
Source: JPMS, S&P LCD.
Table 9
US Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral
10 Yr AAA 10 Yr AA 5 Yr BBB JPM USD 5 Yr BB/BB- 10 Yr BBB
CMBS MBS HEL HY Index Lev Loan Industrial
10 Yr BBB CMBS 1.0 0.4 0.4 0.3 0.5 0.3
10 Yr BBB Prime RMBS 1.0 0.1 0.4 0.2 0.1
5 Yr BBB HEL 1.0 -0.1 0.1 -0.1
JPM USD HY Index 1.0 0.1 0.7
5 Yr BB/BB- Lev Loan 1.0 0.2
10 Yr BBB Industrial 1.0
10. Note: The actual funding gap values are normalized at 10. It is the yield on CDO collateral minus the cost
of CDO liabilities, fees, and expected loss.
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Table 10
Euro Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral
Dutch 5-7 Yr UK 5 Yr BBB Euro Leveraged JPM EUR
BBB RMBS Dollar RMBS Loan HY Index
Dutch 5-7 Yr BBB RMBS 1.0 0.3 0.0 0.1
UK 5 Yr BBB Dollar RMBS 1.0 0.2 0.0
Euro Leveraged Loan 1.0 0.0
JPM EUR HY Index 1.0
Table 11
Euro Monthly Spread Correlation (2000-2003): AAA Structured Products & Traditional CDO
Collateral
Dutch 5 Yr UK 5 Yr AAA
AAA RMBS Sterling RMBS Pfandbriefe AA Financials
Dutch 5 Yr AAA RMBS 1.0 0.5 0.1 0.2
UK 5 Yr AAA Sterling RMBS 1.0 0.3 0.1
Pfandbriefe 1.0 0.4
AA Financials 1.0
Source: JPMS.
Default and Recovery Performance

Any analysis of default and recovery in the structured product markets is challenged
by a lack of historical data. Nevertheless, now that the structured products markets
have matured and been tested through several economic cycles, we do have some
(limited) history and experience to start examining defaults in the market and to
assess the ultimate recovery on these bonds. Ultimately, default and recovery data
allows investors to evaluate current SF CDO portfolio assumptions, and should help
guide investment decisions, as defaults and recoveries play a key role in the
structuring processes.
Unlike corporates, where a default is caused by a discrete event like a bankruptcy or

a missed coupon payment, structured products typically suffer principal losses over
time as loans default and as those move through the cashflow waterfall. Thus, it may
take months or even years before losses eat through the credit enhancement and
bonds take their first dollar loss of principal. Even after the bond starts taking
principal losses, it still may take months, or even to the end of the deal, before the
ultimate loss of principal can be determined. In addition, missed interest and
principal may sometimes be deferred to the next period or a later period. Missed
payments may also sometimes be capitalized and repaid over the remaining life of
the transaction.
For our analysis of structured products defaults and recoveries, we use a recent
Moodys study of material impairment rates11, a concept that Moodys has
introduced to address the vagaries of default discussed in the paragraph above. One
of the downsides of this study is that it addresses US structured products only, and
nothing of its kind yet exists for the European market (largely due to the relative
youth of the market). Nevertheless, we think the conclusions reached using the
Moodys US data are broadly applicable to European structured products given that
11. Payment Defaults and Material Impairments of US Structured Finance Securities: 1993-2002, Moodys
Investors Service, December 2003.
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ratings are designed to have consistent meaning across regions. If anything, some
conclusions are likely to be conservative given the exceptional rating stability of
European structured products as shown in Appendix A.
Material Impairment Rates Materially impaired securities are defined as follows:

Securities that have not paid promised principal and interest in entirety by the final
maturity date (unambiguously in default).
Securities that have sustained a payment default that has not been cured.
Securities that are rated Ca or C and hence are expected to suffer a significant level
of payment losses in the future.
Table 11 below shows the cumulative material impairment rates for both corporate
and structured product securities (by sector). Table 12 shows the annualized material
impairment rates by year, as well as the five year average.
Table 11 Table 12
Cumulative Material Impairment Rates of Annual Material Impairment Rates of
US SF & Corporate Securities by Original US SF & Corporate Securities by Original
Rating, 1993 - 2002 Rating, 1993 2002 12
5 Yr. Annual
Year 1 Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5 Average
Corporate
Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Aa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
A 0.00% 0.00% 0.00% 0.21% 0.21% 0.00% 0.00% 0.00% 0.21% 0.00% 0.04%
Baa 0.58% 1.20% 1.86% 2.78% 3.87% 0.58% 0.62% 0.67% 0.94% 1.12% 0.79%
Ba 4.10% 8.67% 13.38% 16.97% 20.82% 4.10% 4.77% 5.16% 4.14% 4.64% 4.56%
ABS (including HEL)
Aaa 0.00% 0.00% 0.05% 0.05% 0.05% 0.00% 0.00% 0.05% 0.00% 0.00% 0.01%
Aa 1.29% 1.94% 2.27% 2.71% 2.83% 1.29% 0.66% 0.34% 0.45% 0.12% 0.57%
A 0.05% 0.49% 0.87% 1.10% 1.10% 0.05% 0.44% 0.38% 0.23% 0.00% 0.22%
Baa 0.25% 1.36% 2.30% 3.76% 4.38% 0.25% 1.11% 0.95% 1.49% 0.64% 0.89%
Ba 1.41% 8.57% 14.38% 18.26% 19.70% 1.41% 7.26% 6.35% 4.53% 1.76% 4.26%
CMBS
Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Aa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
A 0.00% 0.00% 0.00% 0.23% 0.23% 0.00% 0.00% 0.00% 0.23% 0.00% 0.05%
Baa 0.13% 0.41% 0.55% 0.83% 0.83% 0.13% 0.28% 0.14% 0.28% 0.00% 0.17%
Ba 0.29% 0.29% 1.47% 1.77% 1.77% 0.29% 0.00% 1.18% 0.30% 0.00% 0.36%
RMBS (prime mortgages)
Aaa 0.00% 0.00% 0.00% 0.36% 0.58% 0.00% 0.00% 0.00% 0.36% 0.22% 0.12%
Aa 0.00% 0.00% 0.44% 0.89% 1.01% 0.00% 0.00% 0.44% 0.45% 0.12% 0.20%
A 0.00% 0.16% 0.47% 0.47% 0.63% 0.00% 0.16% 0.31% 0.00% 0.16% 0.13%
Baa 0.40% 1.33% 3.86% 5.06% 6.00% 0.40% 0.93% 2.56% 1.25% 0.99% 1.23%
Ba 0.00% 1.10% 3.32% 4.42% 4.98% 0.00% 1.10% 2.24% 1.14% 0.59% 1.01%
Source: JPMS, Moodys.
Overall, the default history has been favorable, with structured products performing
Material Impairment in-line with or better than the corporate market in most cases. Structural protections,
Data is Conservative including subordination and excess spread, have helped to insulate ABS investors
from taking principal losses. However, we expect that some of these figures are
conservative, for the following reasons.
12. Annual MI Rate for yr. n = 1- (yr. n survival rate / yr. n-1 survival rate).
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A concentration of distressed sectors gives the ABS rate an upward bias. Table
13 shows that a large number of ABS Material Impairments come from sectors such
as healthcare, franchise, and manufactured housing. Problems in these story
sectors have been addressed in previous sections of this report, and, importantly, they
are typically not included in todays SF CDO collateral pools. At the risk of stating
the obvious, material impairment rates would be significantly lower if these sectors
were excluded from the calculation.
Table 13
Number and Percentage of US ABS Material Impairments, 1993 - 2002
ABS # Rated ABS # Rated # Of
Collateral Securities # Of Material % Collateral Securities Material %
Type in Sample Impairments Impaired Type in Sample Impairments Impaired
Healthcare
Receivables 30 12 40.0% Equipment 70 0 0.0%
Franchise
Loans 136 31 22.8% Floor-plans 105 0 0.0%
Manufactured Sml Business
Housing 661 80 12.1% Loans 108 0 0.0%
Autos 623 9 1.4% Student Loans 343 0 0.0%
HEL 2,320 31 1.3% Other 68 0 0.0%
Receivables
Leases 368 3 0.8% Other ABS 418 4 1.0%
Credit Cards 1,272 4 0.3%
Source: Moodys.
Structures and assumptions have been tested. As we have seen in our analysis,
bonds have taken losses primarily when unforeseen market forces have severely
impacted an industry (MH), rating agency assumptions about losses were inadequate
(MH and HELs), and/or structures were ill equipped to handle losses (HELs). In
addition, prime RMBS material impairment rates are inflated by losses in Quality
Mortgage transactions, which are backed by assets that were arguably closer to
subprime than prime at origination. While we cannot protect against unforeseen
events, the market today is in better shape as the rating agencies have additional
history to more accurately project losses and structures have been tested through
several economic cycles.
The market is now dominated by investment grade, well capitalized players.

Many downgrades can be attributed to problem issuers that have since exited the
business. HELs are a good example of a sector that has consolidated into stronger
hands. Industry consolidation has weeded out the weakest players. Aggressive
underwriting was a main cause of the downfall for many issuers (e.g. extending down
to low quality borrowers, overstated appraisals, insufficient credit enhancement).
Consolidation has left stronger, higher quality and well-capitalized players with more
focused and disciplined business strategies (e.g., tighter underwriting, stepped up
collections efforts). As a result, the industry is much healthier today with more
resilient issuers to better handle the expected rise in losses in the context of weakening
consumer credit. To whit, Chart 28 shows the top 10 home equity issuers in 1997 and
2003. Only three issuers were rated single-A or higher in 1997 vs. six in 2003.
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Chart 28
Top 10 HEL Issuers in 1997 and 2003
1997
1997 Top
Top 10
10 Issuers
Issuers 2003
2003 Top
Top 10
10 Issuers
Issuers
Issuer Rating $mm % Market Issuer Rating $mm % Market

ContiMortgage Ba1 5,685 9.0% GMAC A3 30,714 15.6%
Money Store A1 5,505 8.5% Ameriquest NR 23,302 11.9%
IMC NR 4,857 7.5% New Century NR* 17,369 8.8%
Advanta Ba2 3,150 4.9% Countrywide A3 15,721 8.0%
FirstPlus BB- 2,983 4.6% Lehman Aa3 14,482 7.4%
Conseco Finance Baa1 2,734 4.2% Option One BBB+ 11,008 5.6%
UCFC Ba1 2,725 4.2% CSFB Aa3 6,692 3.4%
GMAC Aa1 2,685 4.2% Washington Mutual A2 6,674 3.4%
Bank of America A1 2,674 4.1% JPMorgan Chase Aa3 6,482 3.3%
Amresco B1 2,291 3.5% NovaStar NR* 5,694 2.9%
*No debt outstanding
Source: JPMS, MCM.
All of the aforementioned factors point to the conclusion that the default rates
implied by Moodys material impairment study are probably conservative, and we
dont think its a far stretch to use slightly more aggressive (i.e. lower default rates)
base-case assumptions for SF CDOs. However, we point out that the Moodys data
covers only a short credit cycle (albeit one that includes a severe downturn), and
that it takes a few cycles to fully assess default risk. As such, a bit of conservatism
is certainly healthy for CDO structures.
Recovery Rates Moodys defines structured product loss severity as the present value of periodic
losses (including both interest and principal shortfalls) as of the origination date.
Defaulted securities accumulate their losses gradually, so complete information on
recoveries is only available for a small sample of securities that have been paid down
or permanently written-down (84 tranches). Recovery rates for these securities are
shown in the Zero Outstanding Balance (i.e. actual final recovery rates) column in
Table 14. Nevertheless, we can get a good idea of expected recoveries on a larger
Table 14 Table 15
Recovery Rates by Sector, 1993-2002 Projected Recovery Rate on HEL13
Yr. After Origination
Zero # of Tranches
Out-standing Recovery Original Original
> 6yr* > 8yr* Balance (%) Rtg. A Rtg. BBB
ABS (including HEL) 0%-10% 3
Mean Recovery 81.6% 66.1% 59.4% 10%-20% 2
Standard Dev 27.4% 33.7% 33.0% 20%-30% 3
# Observations 55 24 20 30%-40% 0
CMBS 40%-50% 1 1
Mean Recovery 100.0% 100.0% 100.0% 50%-60% 1 0
Standard Dev 0.08% 0.00% 0.00% 60%-70% 1 4
# Observations 6 4 4 70%-80% 2 0
RMBS (Prime) 80%-90% 1 2
Mean Recovery 73.0% 67.5% 54.5% 90%-100% 1 3
Standard Dev 29.2% 31.1% 32.5% 100% 7
# Observations 136 102 60 Average 70% 56%
Source: Moodys, JPMS. Source: JPMS, Intex Solutions.
* In addition to those with zero outstanding balance. includes impaired
securities >n years past origination.
13. ABS Monitor, JPMS, 16 September 2003.

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sample by looking at current loss-implied recovery rates on impaired securities that

are far away from their origination date (>6yr and >8yr column). Note that eventual
recoveries will inevitably be lower than these implied numbers since losses will
continue to accumulate over time.
There is significant recovery rate volatility within each sector, as evidenced by

standard deviations of 27% - 33% for ABS and RMBS. Table 15 looks explicitly at
expected recoveries on HEL subordinates, and suggests similar conclusions about
recovery volatility. Moodys offers several explanations for recovery variation across
deals. Among these is that securities with higher recoveries typically defaulted late,
after much of the principal balance had been paid down. Securities with lower
recoveries typically defaulted earlier or had quicker loss accumulation. For this
reason, Moodys notes that the recoveries on securities with zero outstanding balance
are probably more severe than can be expected on a going forward basis, since this
population represents the deals that were written down over a short period of time,
and represents the more risky set of defaulters.
Subordinate tranches are likely to have lower recoveries (less subordination and
smaller overall size) than senior tranches. Table 15 supports this axiom for HELs.
Because the Moodys data set is largely representative of subordinate tranches (few
seniors have defaulted), recovery rates may reasonably be adjusted upward for
senior tranches.
Putting It All Together: Now that weve looked at both default and recovery rates for structured products, the
Annualized Loss Rates question becomes what is a reasonable loss assumption for a SF CDO model. The
answer, of course, depends on both the rating and the collateral. In Table 16 below,
we work through an example for a hypothetical SF CDO with a Baa weighted
average rating and collateral allocated as follows: 50% ABS, 30% CMBS, 20%
RMBS. Note that we are using the annual material impairment rates from Table 12
and recovery rates from the zero balance column in Table 14.
Table 16
Annualized Loss Rate for a Hypothetical SF CDO
Portfolio Annual Material Recovery Loss Aggregate
Weight Impairment Rate Rate Rate Annual Loss Rate
ABS (including HEL) 50% 0.89% 59.4% 0.36%
CMBS 30% 0.17% 100.0% 0.00% 0.29%
RMBS 20% 1.23% 54.5% 0.56%
Source: JPMS, Moodys.
We stress that the loss rate derived here stems directly from Moodys studies.
Undoubtedly, investors and SF CDO originators should make modifications to these
assumptions. For example, at the risk of stating the obvious, the assumption of 100%
recoveries for CMBS will likely prove unrealistic over a larger sample. In addition, we
have already made a case that the annual material impairment rate may be overstated,
particularly for ABS. These are but two examples, and other modifications are possible.
Ultimately, our purpose for this study is to give investors and issuers the best
information available regarding performance to date. This current reality check
will prove particularly useful in evaluating the rating agency assumptions (see Rating
Agencies section) used to structure SF CDOs.
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SF CDO Structure
To begin our analysis of SF CDO structures, Table 17 provides a comparison to
traditional term ABS transactions, as well as CLOs (the most popular CDO sector).
As seen, SF CDOs have longer average lives than traditional ABS, ranging from 6 to
14 years. While expected losses on the underlying collateral are expected to be fairly
minimal, due to the leveraged nature of the transactions, triple-A credit enhancement
levels are substantially higher than traditional structured products.
Table 17
Structural Comparison: Traditional SF CDOs v Other CDOs & Structured Products
SF CDOs HY CLOs IG Syn CDO Credit Cards HEL
Collateral Mezzanine ABS BB/BB- Leveraged BBB / single-A Revolving Term Loans
(0 - 15 years) Loans (5 years) credit default unsecured credit (15 - 30 years)
swaps (5 years) Secured by real
estate
Average Size $400 mm $400 mm $1-4 bn $775 mm $750 mm
Cash flow Amortizing Amortizing Bullet Bullet Amortizing
structure
Average Life 6 - 12 years 6 - 12 years 5 - 8 years 3 - 10 years 0 - 10 years
Coupon Primarily Floating Primarily Floating Primarily Floating Primarily Floating Fixed and Floating
Credit Senior/Sub or Senior/Sub or Senior/Sub or Senior/Sub, Senior/Sub or
Enhancement Insured, Excess Insured, Excess Insured, Excess Spread Accounts, Insured, Excess
Spread, O/C Spread, O/C Spread, O/C Excess Spread Spread, O/C
Net Excess 60 - 80bp 150 - 160bp 75 - 85bp 6% - 7% 3.5% - 4.5%*
Spread
Expected Loss 0.12% - 0.30% 0.45% - 1.00% 0.15% - 0.20% 5% - 8% 0.75% - 1.00%
Typical AAA 20% 20% - 27% 12% 10% - 20% 10% - 20%
Enhancement
Source: JPMS.
* ARM HEL assuming flat LIBOR.
SF CDOs have higher subordination requirements compared to traditional structured

products partly because the rating agencies use a conservative approach in evaluating
them (see Rating Methodologies section). Furthermore, the tranches which make up
the SF CDO portfolio themselves have structural and credit protection in the form of
paid-in subordination, excess spread, overcollateralization, and cash flow diversion
triggers, all of which are lacking in the collateral (e.g. consumer loans) used for
traditional structured products.
SF CDOs can be broken down into three different types: traditional cash, high
grade cash, and synthetic, all of which have material differences, which are driven
by the underlying collateral. Table 18 below compares the basic characteristics of
each type in order to help investors better assess risk and value in each. Following
Table 18, we provide an analysis of unique structural issues in structured products,
and how these issues are addressed in SF CDOs.
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Table 18
SF CDO Comparative Analysis
Cash (Mezzanine) Cash (High Grade) Synthetic
Collateral & Single-A/BBB tranches AAA/AA tranches AAA/AA tranches

Issuance 44 deals (39 US, 5 Euro) 8 deals (7 US, 1 Euro) 25 deals (5 US, 20 Euro)
2003 ($bn) $19.8bn $8.4bn $45bn (notional)
Slow/steady growth in Little issuance before 2003 Rapid growth, especially

issuance since early 2002. since mid 2002.
Transaction Size $250 - $600mn $800mn - $1.3bn $600mn - $4bn
Cash Flow Structure Amortizing Amortizing Bullet
Most common Arbitrage. Arbitrage or Balance Sheet Balance Sheet

Purpose
Typically managed with Typically managed Typically static
10-20% annual substitution
limit.
Credit AAA: 15-21% AAA: 4-9% Super Sr: 3-15%

Enhancement (%) AA: 9-12% AA: 1-4% AAA: 3-5%*
A: 8-10% A: 0.5-2% AA: 1-4%
BBB: 4-6% A: 0.5-2%
*Effectively 'second senior';

less credit enhancement vs.
cash.
WAL AAA: 4-6yr (1st AAA) AAA: 1yr or less (MM) Super Sr:
6-8yr (2nd AAA) 6-8yr (2nd AAA) AAA: 5-7yr
AA: 7-10yr A: 7-10yr AA: 5-7yr
A: 9-10yr A: 5-7yr
BBB: 9-10yr
3-5yr (w/ turbo-pay)
Indicative A/B* 103-105% MM and A-1: 103-105% NA

O/C Triggers (min) C: 101-102% A-2: 103-104%
B: 100-102%
*Some transactions carry a
Class A O/C test (when the
class B is PIKable), which is
typically in the 106-110%
area.
Indicative A/B: 113-116% Most do not require I/C NA

I/C Triggers (min) C: 104-109% tests.
Liquidity Less liquid than other more New sector: little trading Synthetics issue very little in
established CDO sectors to-date. Relatively easier funded liabilities, hence the
(CLO/CBO), but improving. analysis of underlying HG secondary market for
structured products is posi- synthetic paper may be
tive for liquidity. Relatively limited. Generally less liquid
smaller amount of term than cash deals.
paper is negative for
liquidity.
Source: JPMS.
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Synthetic SF CDOs: Credit exposure in synthetic SF CDOs is governed by the credit event language in
Credit Events each transaction. In some ways, SF CDO credit events (i.e. events that result in the
settlement of a credit derivative trade) mirror corporate credit event definitions as
defined by the International Swaps and Derivatives Association (ISDA). However,
there are important differences. We provide an overview below. For more information,
see Moodys Approach to Rating Synthetic Resecuritizations, October 29, 2003.
Chart 29
Structural Overview of a Typical Synthetic SF CDO
Tranched risk Cheaper Liabilities

Portfolio
credit
Portfolio credit default
default swaps swaps Typically
Super Unfunded
Senior Swap
BBB Synthetic
A CDO
AA Issuer
AAA Senior Funded
Notes or
Mezzanine Unfunded
Equity Swaps
Source: JPMS.
In most cases, SF CDOs use portfolio CDS (one contract for the entire reference
portfolio) to create exposure. This structure is necessary because the single name
market has struggled to develop since, although there are plenty of potential sellers
(i.e. investors), there are few natural buyers of protection. In contrast, corporate
synthetic CDOs typically use single-name CDS (one contract per reference entity) to
create exposure.
Unlike credit events in the corporate market, there is not yet an accepted
standard (or set of standards) for structured products. Although the rating
agencies have made some progress in defining appropriate structured product credit
events and impose penalties (e.g. default or recovery rate stress) for non-compliance,
the market is not yet uniform. The lack of an accepted market standard has two
primary implications. First, investors must perform appropriate due diligence to
ensure that they understand the credit event definitions in a particular transaction.
Second, secondary market liquidity may be impaired to the extent that a transaction
utilizes exotic definitions.
Both the lack of consistency, as well as the relative youth of the structured product
credit default swap (CDS) market, mean that there is a relatively smaller sample of
actual triggered credit events, and less certainty as to how events will function in
practice. However, due to the high credit quality (AAA/AA) of the reference entities
and subsequent low probability of default, many investors place less emphasis on
credit event definitions.
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Another difference is that, unlike corporate credit events, which reference any
obligation of the reference entity, structured product events reference a specific
tranche within the structure. In other words, if there is a credit event in a
mezzanine tranche and the SF CDO references a senior tranche, the credit event will
not be triggered. This eliminates the cheapest-to-deliver option embedded in
corporate CDS, which has been a factor in depressing recovery rates in that market.
Below, we review credit event definitions for SF CDOs, which have been vital to the
growth of this sector. Although definitions will vary from deal-to-deal, typical
provisions are detailed below.
Failure to pay: This credit event applies to both interest and principal. Typical
provisions exclude deferrable securities and temporary failures due to clerical or
other errors.
Loss: This credit event is triggered by write-downs to the reference obligation, but
is restricted to write-downs that are irreversible (i.e. excludes securities that include
various provisions for investors to be made whole at a later date). This credit event
may be settled in part (only marginal amount written down) or in full.
Rating Triggers: This credit event applies to securities that have been downgraded
to Ca or below and do not experience either (a) loss or (b) failure to pay within a
six month waiting period or their downgrade to a certain rating level (typically
Caa2 or Ca). This provision addresses the back-ended losses that are exhibited in a
significant number of distressed structured product tranches.
Note that several typical/familiar credit events from the corporate market dont neatly
fit into the structured product definitions. For example, bankruptcy typically does not
apply to structured products, which are designed to be bankruptcy remote. In
addition, restructuring is also difficult to apply to structured products, since holders
of the reference entity may have various non-credit related motivations for
restructuring (including reputation, and incentives outside the structure) that can lead
to moral hazard in decision to restructure.
In some cases, bankruptcy and/or restructuring are included in SF CDO credit event
definitions, primarily because regulatory bodies require institutions to have them for
capital relief. In these cases, modifications are typically made to the event definition
to mitigate the problems addressed above.
As a final point, we note that credit events in a SF CDO can be settled in either
physical (protection seller pays par and receives reference entity) or cash (protection
seller pays par and receives current market value) form. The distinction is important
since the reference entities may be illiquid. Market value risk (from the need to sell
an illiquid security) is typically avoided as long as settlement is not forced before the
earlier of legal maturity, acceleration or final workout. In other cases, rating agencies
will typically haircut recovery rates to address market value risk.
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HG SF CDO: Investors that are uncomfortable with synthetic SF CDOs, but desire exposure to high
Short Term grade structured products, may want to consider a high grade (HG) cash SF CDO.
Tranches Like their synthetic counterparts, HG cash SF CDOs reduce their weighted average
funding costs by employing a low-cost super senior tranche. However, they do so
in entirely cash form by using short-duration money market or medium term note
tranches. These tranches are senior to the term AAAs and pay sequentially. In
limited cases (post reinvestment period, performing deal) they may pay pro rata for a
period of time.
Although not new to the CDO market, this type of funding has been appearing in
several recent deals. Generally, money market tranches mature every three months to
one year, leading to cheaper spreads than with term notes. Medium term notes
typically mature every 2-3 years. This structure cheapens overall funding, but also
introduces the risk that the short term paper, if re-issued at a discount, will eat into
excess spread.
This remarketing risk created by the short term tranches is typically assumed by a
third-party liquidity provider, who must purchase the short-term notes if they cannot
be successfully re-marketed below some maximum spread (ensures timely repayment
of 100% of maturing notes). As such, the rating of the short term notes are tied to the
ratings of the liquidity provider.
Presumably, the high quality of the portfolio (AAA/AA) is a comfort to the liquidity
provider, who holds downgrade risk (although it may be sold to a third party in some
cases). We expect this is why most recent deals with money market features are
backed by stable high quality collateral such as AAA/AA rated real estate ABS. Of
course, it is possible to apply short term tranches to traditional subordinate collateral,
although this would likely require incremental cost to the liquidity provider. The
presence of a liquidity provider benefits the equity holder. Those holders would see
excess spread deterioration without provisions for the liquidity provider to step in and
prevent issuance at substantially wider spreads.
Money market tranches are favored by bank (e.g. Citibank) liquidity providers that
have ready access to liquidity at short notice. Medium term notes are favored by
non-bank liquidity providers that dont have commercial paper programs and have
relatively less access to immediate liquidity.
In a typical structure, at the time of writing, money market tranches are sold in
the L minus 2 to plus 10bp area. The liquidity put costs an additional 20bp and a
remarketing fees cost an additional 4-6bp, leading to an all-in cost in the L+22-36
area, well below spreads on a typical SF CDO senior tranche (L+60). If remarketing
is unsuccessful, the tranche can be put to the liquidity provider in the L+40-70bp area
(i.e. liquidity provider is a backstop buyer at an agreed upon price). We note that
money market tranche price is also a function of size of issuance, with tighter pricing
often achieved on larger tranches because, for example, many institutions are limited
as to the percentage of a tranche that they are allowed to purchase.
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In contrast, spreads on medium term note issuance are slightly wider (L+12), but the
liquidity put is slightly less expensive (15bp) because the notes mature less often. As
such, the total cost for medium terms notes is a few bps higher than for money
market tranches.
Traditional SF CDO: Senior and subordinate AAA tranches are becoming more common in traditional SF
Senior/subordinate AAA CDOs (unlike HG SF CDOs, both AAA tranches are term paper). In most cases,
structure subordinate AAAs receive interest and principal after senior AAAs, and tend to price
wider. These tranches have found demand from investors seeking to construct a
barbell portfolio, who might use a subordinate AAA to overlay an existing position in
lower quality CDO, ABS, or corporate paper. Such a fund benefits from a wider
spread, but does not go down in rating.
Senior AAAs typically have shorter maturities (4-6 years) and have seen demand
from insurance and reinsurance companies, as well as other highly risk-sensitive
AAA investors. One issue worth noting for senior AAA investors is prepayment risk,
which is primarily a reinvestment concern from an investor perspective. In several
recent deals, prepayment risk has been addressed by using a pro rata pay structure for
all senior notes, subject to deal performance triggers being within compliance. This
structure reduces reinvestment risk for senior AAA noteholders, and at the same time
prevents the rising funding costs that would otherwise follow the amortization of the
most senior (i.e. cheapest) tranche. As an added benefit, the resulting pro rata
amortization of the single-A noteholders decreases credit risk for that tranche by
reducing the notional balance.
Technical Note:
Second-seniors are sometimes split-rated between AAA and AA based on differences
in rating agency criteria. The critical difference between the rating agencies stems from
the evaluation of loss. S&P rates a tranche by its likelihood of incurring the first dollar
of loss. Put in the context of CDOs, the entire tranche above a certain attachment point
can receive a AAA rating. Although based on a similar concept, Moodys rates a tranche
using the expected loss concept. At the heart of this rating methodology is the idea of
loss as a proportion of the total investment. The result of the differing methodologies is
illustrated in the hypothetical diagram below. Although the expected notional loss
amount is the same for both the 20% and 10% second-senior tranches, it is larger as a
proportion of the whole for the 10% tranche. For this reason, the 10% tranche may
receive a AAA rating from S&P but a Aa1 rating from Moodys.
Split-Rated All Triple-A
90% Aaa / AAA 80% Aaa / AAA
10% Aa1 / AAA 20% Aaa / AAA
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In addition to customizing risk profiles for specific investors, in certain cases (such as
with top-tier managers, or high quality portfolios), the average spread of a senior-
subordinate AAA structure may be slightly less than indicative AAA spreads,
reducing the deals liability costs. This may be accomplished if the senior AAA is
particularly large compared to the subordinate AAA, and prices especially tight.
Therefore, although terms are deal specific, issuing senior-subordinate AAAs may
allow certain deals some additional flexibility to purchase higher quality assets
without impairing the arbitrage available to equity.
In most cases, the aggregate amount of the AAAs is roughly equal to the size of a
single AAA in a comparable deal. Since subordinate AAAs are generally not first-
priority tranches, their expected loss assumptions are generally higher than first-
priority AAAs, but of course still above the minimum required for a AAA rating.
Extension Risk and the Many structured products securities (which may, for example, have a 30 year legal
CDO Structure final and five year average life) may extend beyond their expected maturity in the
event that payment speeds or performance does not meet expectations. Any
extension in the underlying structured products may result in an extension for SF
CDO tranches, impacting the most subordinate tranche first, because CDOs pay
principal sequentially. However, there are several factors that mitigate extension risk
in both the structured product securities and the CDO structure:
Clean Up Call: Many structured products have a provision for a clean up call (at
par value) at the option of the servicer or residual holder once the amount of
collateral remaining falls below 10-20% of the original par amount. The call-
holder may exercise the clean up call to collapse the deal and avoid ongoing deal
expenses. In addition, the call-holder has an incentive to exercise the call to
preserve its reputation and insure that future issuance will price to call.
Prepayments: As discussed below under the interest rate cap heading, prepayment
speeds in some structured products, particularly Hybrid ARMS (HELs), are quite
fast due to refinancing activity, which mitigates extension risk. We do note,
however, that the loans that do not prepay (left in the pool) may include those that
who couldnt refinance due to credit issues. These remaining loans typically have
greater credit risk, which makes the clean-up call somewhat important.
CDO Structural Features: As discussed below, CDO auction calls exist to
facilitate the liquidation of collateral once the CDO is past its expected maturity
date. The mezzanine turbo feature uses excess spread to accelerate amortization of
the most subordinate tranche, reducing extension risk.
Rating Agency Stress: SF CDOs typically assume that prepayments occur at the
speed modeled in the transactions. The agencies then stress prepayment speeds.
Moodys applies a standard stress of up by 2x and down by half, and notes that
more severe stress levels may be used for interest rate sensitive securities such as
prime RMBS.
Other structured products may have a bullet maturity (Cards, UK RMBS) or balloon
payments with low prepayment assumptions (CMBS), which make extension less
likely for these securities. Finally, all else equal, extension risk is more significant
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for traditional mezzanine CDOs than for high grade CDOs, because mezzanine
structured products tranches are more prone to extension.
Auction Call Most SF CDOs have a 35-40 year legal final, which is appropriate given the long
maturity dates for some structured products. Despite their long legal-final, most SF
CDOs have a maximum collateral weighted average life of 7-9 years from issuance,
which makes the expected life on the CDO notes considerably shorter.
The potential mismatch between the maturity of underlying SF CDO collateral (as
much as 30 years) and the expected life of the CDO notes (7-10 years) is addressed
explicitly in many SF CDOs. This is necessary because some institutions cannot
buy notes with a long-dated legal final. To reduce the legal final, SF CDOs may
include provisions for an auction call at the expected maturity (often 8 years).
The auction call will be repeated semi-annually until it is successful (proceeds are
sufficient to pay out all notes and accrued fees). To encourage timely execution,
both senior and junior notes may include provisions for coupon step-ups each period
that debt remains outstanding. Alternatively, equity coupon may be diverted either
immediately or after a grace period following the expected maturity. The rating
agencies do not give credit for the auction call in their ratings.
Mezzanine Turbo-Pay Many deals include provisions that provide for early amortization of, or equity
upside for, mezzanine note holders. These provisions are not uniform and may take
different forms for high grade versus traditional cash SF CDOs.
Traditional cash SF CDOs often place a cap on payments to equity holders (e.g.
10-20% per annum), which vary according to market clearing levels for the equity
tranche. Excess returns above this amount are redirected to pay down or turbo-
pay the most-subordinate rated note (generally BBBs, which are often a large
percentage of the structure at 4-6%), which shortens their duration and effectively
lowers the weighted average funding cost for the CDO going forward. The cap may
continue until the stated tranche is paid down, or for a given number of years after
issuance (paying down the next-most subordinate after the most-subordinate tranche
is fully amortized). The equity cap is beneficial for mezzanine investors, and
tranches with this feature typically exhibit a small spread give-up to like-rated
longer duration securities.
The turbo feature is generally acceptable to senior investors as well, because by

retiring the most expensive notes, excess spread is increased, improving the funding
gap (which is available to senior note-holders should collateral deterioration trigger
a diversion of capital to pay-down senior notes). In addition, the presence of a turbo
feature also is positive for senior noteholders because asset managers (especially
those with significant equity holdings in the deal) will be less likely to overheat
the deal by investing in risky collateral in search of high equity returns.
Rating agencies may or may not give credit for a mezzanine turbo feature in their
rating analysis. In cases where they do, it (somewhat paradoxically) makes the
ratings more conservative. For example, Moodys requires a mezzanine CDO
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tranche to withstand certain loss based on its probability weighted average life,
which is heavily weighted to the base case (turbo functioning, shorter tranches allow
less expected cumulative loss). However, the stress that the tranche is subjected to
is based off an average life that, in higher default scenarios, is much longer, because
it does not benefit from the equity turbo (no excess spread available).
The mezzanine tranches in High Grade SF CDOs are structured somewhat

differently. Importantly, for many, the lowest rated tranche achieves a single-A
rating and is a relatively smaller portion of the capital structure. These tranches
often receive payments diverted from equity investors, but are more likely to
conceptualize this payment as an option for equity upside than early amortization.
These tranches typically receive some percentage of equity cashflows (rather than a
cap feature) that can vary by deal.
Diversity and SF CDO collateral tests are similar to other CDO sectors. Both O/C and I/C tests
Concentration Limits are present. O/C haircuts may apply to collateral rated below Baa3 (instead of below
Caa1) in excess of some threshold. Most deals also have the standard tests for
weighted average rating factor and name/industry/servicer concentrations.
One significant structural modification for next generation SF CDOs is the

reduction of single-issue concentrations to 1-2% from up to 5% in early deals. Also
important, maximum servicer concentrations are down from 20% in some early
deals to approximately 7% in newer transactions. This structural development has
also occurred in investment grade synthetic CDOs, which suffered greatly from
single-name exposures in the 2002 credit market downturn.
Although we are strongly encouraged by the trend toward decreased single-name

concentrations in investment grade synthetics (where the market has increasing
depth), we are cautious of this trend for some SF CDOs. Our rationale is that the
market is dominated by relatively few servicers and, at any given time, there may be
a small number of issues available in the structured product market. As such, SF
CDOs may be forced to either slow ramp up speeds (to address single-issue
concentrations) or move into non-benchmark issuers and off-the-run names (to
address servicer concentrations). In many cases, off-the-run names offer wider
spread levels. To the extent that these levels are liquidity driven and not credit
driven, an opportunity exists for CDOs due to their buy-and-hold focus. However,
we stress that servicer concentrations should not be set so low as to force
issuers/managers into poor credits or outside their area of expertise.
A similar logic applies to the application of a minimum diversity levels across

structured product industries (e.g. equipment, cards, CMBS, HEL)14. Older
vintage SF CDOs attempted to diversify across industries (sometimes venturing
outside of a managers area of expertise) to improve their diversity scores, which
averaged about 25. Newer deals have accepted lower diversity scores, which are
now in the 17-20 area.
14. See Rating Agencies section for a detailed description of the diversity score.
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HG SF CDOs: High grade SF CDOs, like other CDOs, are subject to up-front fees (rating,
Building Overcollateralization underwriting, etc.) that reduce funds available to buy collateral at the inception of
the deal. They also have a smaller equity component than many CDOs. As such,
overcollateralization (which measures the amount of collateral as a percentage of
rated debt) is reduced in HG SF CDOs because a greater proportion of the structure
is rated. SF CDOs address potential undercollateralization with a provision to
borrow under a swap agreement. The swap is then repaid at the top of the cashflow
waterfall over time, reducing excess spread.
Available Funds Cap Risk Available funds caps are generally found in HEL ARM transactions, and limit the
and the SF CDO Structure rate of interest that the deal is obligated to pay investors based on the interest
accrued on the asset pool. The cap limits the investor coupon to the weighted
average loan rate for the pool minus servicing fees and other costs.
Caps on the underlying loans can be both periodic and lifetime. Periodic caps
limit the amount the rate can reset upward at each reset date. Many of the loans
have a higher periodic cap for the first adjustment period to allow the loans to more
quickly adjust to market rates after being fixed for the initial teaser period. Life
caps dictate how high the rates can reset over the life of the loan. Lifetime caps are
generally quite high and therefore unlikely to be a limiting factor. On most deals a
shortfall reimbursement feature covers any interest payment shortfalls by drawing
on future excess spread.
For the most part, fast prepayments have helped to mitigate most of the cap risk.
Due in part to the teased nature of the product, ARM speeds have consistently come
in above 50% CPR at the time of the first reset date. Because of the fast
prepayments, by the time the caps start to matter later in the life of the transaction,
the majority of the pool has already been paid off. In some respects, placing any
significant value in the cap cost is a bet that ARMs will not continue to prepay
quickly, which historically has not been the case in both the subprime as well the
conforming ARM markets.
Moreover, from our perspective, at the present time, there appears to be an irrational
willingness to accept forward Libor rates as an interest rate forecast and at the same
time assume that home price growth slows and employment growth remains
weaken. While using forward Libor to value the available funds cap may be
theoretically correct, it is nonsensical to assume that weak housing and labor
conditions will prevail in a forward rate environment. Indeed, if that rate
environment were to prevail, it would mean that the Fed is responding to
exceptionally strong economic conditions, including home price and employment
growth. Under such conditions, intense credit curing and equity takeouts would
keep HEL prepayments at highly elevated rates and HEL loss rates at levels well
below current rates. The market is missing this in the assumptions being made in its
present valuations of HEL available funds caps. We draw two CDO related
conclusions from the overvaluing of available funds caps:
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Positive for CDO Equity: The overvaluation is most beneficial for equity, which
receives an excess spread that has been driven higher by rising BBB HEL spreads,
and represents the best arbitrage opportunity currently available.
Low probability that CDO debt tranches will be impacted: There are several
ways to mitigate exposure:
1) Hedge exposure by buying interest rate caps
2) The HELs with the most stringent caps have large fixed rate loans in the
collateral pool. CDOs can reduce the cap issue by restricting HEL purchases to
those with primarily floating rate pools.
3) Use a BBB turbo-pay feature to divert equity payments above a to the CDO
BBBs, which would otherwise be the first rated tranche to miss coupon payments
in the event that HEL coupon payments were insufficient to cover CDO
liabilities. This strategy results in the early amortization of the BBBs and
reduces the CDOs funding costs.
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To conclude our section on structure, Table 19 below summarizes many of the

differences between first and second generation SF CDOs that we have addressed
throughout this paper.
Table 19
SF CDO Comparative Analysis
First Generation Second Generation
Vintage Years 1999-2001 2002-2004

Funding Structure Cash form Various forms including traditional cash funding,
cash with money market tranches, and
synthetic.
Leverage Typically 20x Significant variation according to collateral
quality
Collateral Sectors Relatively higher exposure to esoteric Most sectors are seasoned (less model risk).
structured product sectors such as MH, US deals have high percentage of real estate
franchise, and mutual fund fees. collateral.
Diversity Often diversify across industries Newer deals have accepted lower diversity
(sometimes venturing outside of a scores, which are now in the 17-20 area.
managers area of expertise) to improve
their diversity scores, which averaged
about 25.
Management Manager ability impaired by poor Collateral may be more liquid and better
liquidity in underlying collateral. suited to a managed structure.
Asset Managers have developed measurable

track records and programmatic issuers have
been identified.
Event Risk Significant servicer risk. Less servicer risk in on-the-run sectors, which
have more servicer depth.
Structural Features BBB-turbo, Auction Call
Source: JPMS.
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Should SF CDOs be Managed or Static?

SF CDOs may be managed or static. In 2003, approximately 75% of cash and 60%
of synthetic transactions were managed. As a general rule, managed transactions are
undertaken for the purposes of exploiting an arbitrage opportunity and generating
fee income for the manager. In contrast, static transactions may be a funding
vehicle or balance sheet management tool for the issuer.
Managed Transactions In managed deals, asset managers are typically allowed a 10-20% annual trading
bucket as long as certain collateral quality tests are met (O/C, I/C, WARF, various
concentration tests). Most deals have a reinvestment period of 3-5 years, after
which discretional trading eliminated. Managers often have some flexibility
(irregardless of reinvestment period or collateral quality tests) to sell defaulted and
credit risk securities at any time. This flexibility is sometimes extended to credit
improved securities.
Senior management fees (paid at the top of the cashflow waterfall) are typically 10-
20bp. Subordinate management fees (paid at the after rated notes) are typically 20-
30bp. Both senior and subordinate fees have been falling for the last several years.
In addition to holding a portion of the equity tranche, managers may also retain an
incentive management fee equal to a percentage of excess cash flow after the equity
tranche has received a benchmark return.
Static Transactions Although static transactions are not actively managed and have no reinvestment
period, issuers may have the ability to substitute credit improved and/or distressed
securities. In addition, issuers are responsible for the selection and/or origination of
the original collateral pool. Static transactions feature reduced management fees.
Unmanaged transactions have no reinvestment period, so senior noteholders may
have shorter weighted average lives (and corresponding reinvestment risk) due to
prepayments and natural amortization of the collateral balance. We feel compelled
to note that there exists a potential for issuer moral hazard here, whereby the issuer
includes less-desirable assets than they are willing to hold on their own balance
sheet. As always, investor caution and appropriate due diligence is key. Ultimately,
balance sheet deals are probably more appropriate for investors with some
experience in the underlying assets that are able to carefully examine the pool
without relying on an asset manager.
Special Considerations Below, we explore several asset manager considerations specific to structured
product collateral.
Liquidity and Transparency. Structured products are typically less

liquid/transparent relative to the corporate market. As such, managers have an
increased opportunity to add alpha. In addition, there is significant price tiering
among structured product issuers. Managers can also add alpha by selecting
cheaper non-benchmark names. On the other hand, managers are somewhat
restricted from active management due to the detrimental effect of crossing the
(higher) bid/offer. Although the bid/offer spread is lower for senior structured
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products tranches, the impact of crossing the bid/offer on excess spread is magnified
because of the lower excess spread and higher leverage in these deals.
Contagion Risk. Structured products are exposed to contagion risk, and securities
with performance problems may exhibit negative momentum. Sectors with
negative momentum benefit from active asset management, which can help
minimize losses.
Table 20 below shows 1-5 year cumulative material impairments for BBB structured
products and corporates based on their original rating (at issuance) and cohort rating
(at the start of the year, may be lower or higher than original rating). The table
shows that material impairment rates for structured products are higher by cohort
rating across all time horizons. The difference suggests that securities that have
been downgraded to BBB from a higher rating (as shown by the cohort rating) fare
worse than securities that were initially rated BBB. This momentum effect is not
apparent in corporates.
Table 20
Cumulative Material Impairments for All BBB Securities by Cohort and Original Rating
Year 1 Year 2 Year 3 Year 4 Year 5
Structured Finance
Cohort Rating 0.99% 2.53% 5.01% 6.49% 8.36%
Original Rating 0.26% 1.09% 2.27% 3.33% 3.87%
Corporate
Cohort Rating 0.44% 0.95% 1.52% 2.21% 3.06%
Original Rating 0.58% 1.20% 1.86% 2.78% 3.87%
Source: Moodys.
Delayed rating actions on structured product collateral. Rated noteholders

depend on credit enhancement derived from the O/C tests, which divert excess
cashflows in the event of collateral deterioration. Collateral, however, is held at par
value or a haircut par value (e.g. sub-investment grade bucket) for the purpose of the
O/C tests. This means that distressed collateral that is still investment grade will
still be given full credit for the purposes of the O/C tests. This methodology is
particularly problematic for structured products, where rating actions often severely
lag the market developments. Asset managers can enhance rated-note stability via
proactive management of the collateral pool before a downgrade occurs (realized
losses are reflected in O/C tests).
Programmatic Issuers. In both managed and unmanaged transactions, the

selection of the issuer/manager is critical. Investors (especially those with limited
structured products credit expertise) should favor high-quality programmatic
issuers with a long-term commitment to the market. These issuers have an interest
in preserving their reputation, as well as a visible track record, which minimizes any
moral hazard in portfolio selection. In addition, programmatic issuers are familiar to
the market, which increases liquidity of their notes. In some cases, because the SF
CDO market is still relatively young, good managers of underlying structured
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products are just now bringing their first SF CDOs. In these cases, it is especially
important for investors to carefully evaluate the managers infrastructure and long-
term commitment to the market. Infrastructure is particularly important due to the
complexity of the collateral.
Quantitative Table 21 below provides information on 37 managers of 58 SF CDOs issued

Manager Analysis between 1999 and 2002 for which Moodys provides performance data. Although
Moodys data does not cover the entire issuer universe (e.g. it is only US), it does
provide some of the more detailed performance measures available, these measures
are briefly described below. It is important to note that these metrics measure
performance on what we have referred to as first generation SF CDOs. Many
lessons have been learned from the experiences. See Appendix C for a listing of
seasoned SF CDO managers (managers with two or more deals in the last two
years); this list includes some European managers.
Moodys Deal Score (MDS)

MDS measures changes in expected loss for tranches that were originally rated
investment grade. When current deal ratings deteriorate (expected loss increases),
the MDS increases.15 Although ratings may lag performance, they can be a good
indicator of manager ability over the long run.
Annual Loss or Gain of O/C

O/C is a measure of current collateral value relative to current liabilities. The O/C
calculation measures most collateral at par value. Exceptions include defaulted
securities (measured at lesser of market value or recovery rate). The table shows
the annualized percent change in O/C. Negative numbers indicate that O/C is
increasing.
Weighted Average Rating Factor (WARF) Cushion

WARF is an indicator of collateral pool risk. Higher rating factors indicate lower
average collateral ratings. Cushion is the amount by which current levels exceed
test levels imbedded in the deal. A negative cushion indicates that a deal is in
violation of its test levels. Management flexibility is generally restricted following a
breach of test level.
15. See Moodys Publication CDO Rating Methodology: Moodys Deal Score, February 2003, for more information.
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Table 21
Moodys SF CDO Asset Manager Analysis16
Current Average Annual Current Moodys
# of Moody's Deal Loss/Gain WARF
Collateral Manager Deals Score (MDS) of OC Compl./Violation
Alliance Capital Management L.P. 1 0.00 -0.02% 5.62%

Asset Allocation & Management Company 1 2.29 -0.48% -191.65%
Beacon Hill Asset Management, L.L.C. 2 0.91 0.20% -102.43%
Capital Guardian Trust Co. 1 0.00 0.37% -20.32%
Clinton Group, Inc. 2 0.00 -0.37% -7.40%
Coast Asset Management, L.P. 1 0.00 0.37% -17.21%
David L. Babson & Company Inc. 1 0.00 -0.04% -8.49%
Deerfield Capital Management LLC 3 0.11 0.74% -86.61%
Duke Funding Management , L.L.C. 1 0.00 -1.37% -78.16%
Ellington Capital Management 2 0.00 -0.57% -10.59%
Fischer Frances Trees & Watts, Inc 1 0.00 -0.01% -37.75%
Fortress Investment Corp. 1 0.00 0.23% 22.78%
General Re-New England Asset Management, Inc. 1 0.00 -0.40% -29.34%
HarbourView Asset Management Corporation 1 0.00 0.79% -109.87%
Hyperion Capital Management Inc. 1 0.32 0.52% -79.85%
Independence Fixed Income Associates, 3 0.11 -0.86% -54.83%
ING Baring (US) Capital Corporation 2 0.00 -0.11% 13.30%
Lord, Abbett & Co. LLC 1 0.00 -0.62% 2.49%
Metropolitan Life Insurance Company 1 0.00 0.89% -18.66%
Metropolitan West Asset Management, LLC. 1 0.55 0.54% -55.97%
MKP Capital Management, L.L.C. 2 0.00 -1.37% -135.24%
MONY Life Insurance Company 2 0.00 -0.64% 28.31%
New York Life Investment Management LLC 1 0.00 0.40% -16.25%
Newcastle Investment Corp. 1 0.00 -0.39% 23.25%
Pacific Investment Management Company 2 0.00 -0.11% -3.18%
Phoenix Investment Counsel, Inc. 1 2.26 0.40% -146.77%
PPM America Inc. 1 2.28 0.04% -309.14%
Putnam Advisory Company, Inc. 2 0.00 -0.32% 9.82%
RWT Holdings, Inc 1 0.00 1.12% 7.74%
State Street Research 1 0.00 -1.14% 16.90%
Structured Finance Advisors, Inc. 2 1.48 0.68% -67.76%
TCW Asset Management Company 4 0.00 -0.38% -30.30%
Teachers Ins. and Annuity Assoc. of America 1 0.00 -0.05% -83.59%
Wells Fargo Bank, N.A. 1 0.00 0.48% -0.02%
West LB 4 0.06 0.17% -5.01%
Western Asset Management Company 3 0.65 0.30% -135.52%
ZAIS Group Inc. 1 0.00 1.60% 12.35%
Source: Moodys Investors Service.
16. Moodys Deal Score Report, Moodys Investor Service, January 2004.
47
CDO Research
SF CDO Rating Methodologies

Although assumptions vary by rating agency and by deal, to some extent SF CDOs
benefit from conservative structures versus CDOs that source like-rated corporate
collateral. Like all other CDOs, defaults, recovery rates, and correlation are key
determinants in the credit enhancement processbelow we provide a brief overview.
Defaults and Recoveries Due to the relative youth of the ABS market and the lack of a sufficient default
history, Moodys bases its expected loss assumptions on similarly-rated corporates.
Moodys does acknowledges that to date, ABS performance has been superior, and
that their recovery rate assumptions may be somewhat conservative 17 (as follows,
if you back out default rates holding expected loss constant, implied defaults are
somewhat lower than corporates). Table 22 below illustrates Moodys current
recovery assumptions. Excessively thin tranches are penalized, as are CDOs with
low Diversity Scores (reasonable, we think).
Turning to S&P, less stringent default assumptions are used, but this is at least partially
offset by more onerous ABS default correlation assumptions. Additionally, S&P uses
a 7 year weighted average maturity for the purposes of determining subordination
levels for SF CDO liabilities. This is particularly conservative for junior SF CDO
Table 22
Moodys Recovery Values for Structured Finance collateral
Structured Finance Sector % of deal Tranche Rating
Aaa Aa A Baa Ba B
Diversified Securities1 > 70% 85% 80% 70% 60% 50% 40%
10 - 70% 75 70 60 50 40 30
< = 10% 70 65 55 45 35 25
Residential Securities2 >70% 85 80 65 55 45 30
10 - 70% 75 70 55 45 35 25
5 - 10% 65 55 45 40 30 20
2 - 5% 55 45 40 35 25 15
< = 2% 45 35 30 25 15 10
Undiversified Securities3 > 70% 85 80 65 55 45 30
10 - 70% 75 70 55 45 35 25
5 - 10% 65 55 45 35 25 15
2 - 5% 55 45 35 30 20 10
< = 2% 45 35 25 20 10 5
Low Diversity CDOs4 > 70% 80 75 60 50 45 30
10 - 70% 70 60 55 45 35 25
5 - 10% 60 50 45 35 25 15
2 - 5% 50 40 35 30 20 10
< = 2% 30 25 20 15 7 4
High Diversity CDOs5 > 70% 85 80 65 55 45 30
10 - 70% 75 70 60 50 40 25
5 - 10% 65 55 50 40 30 20
2 - 5% 55 45 40 35 25 10
< = 2% 45 35 30 25 10 5
Source: Moodys Investors Service.
1. Autos, Car Rental Receivables, Credit Cards, Student Loans.
2. Home Equity Loans, Manufactured Housing, Residential A/B/C.
3. CMBS Conduit, CTL, and Large Loan. Others not included in Diversified Securities.
4. CDOs with a Moodys Diversity Score < = 20.
5. CDOs with a Moodys Diversity Score >= 20.
17. Moodys Approach to Rating Multisector CDOs, Moodys Investors Service.
48
CDO Research
tranches, which tend to have longer average lives than 7 years (say 10 years). These
tranches are effectively penalized as they must withstand a higher scenario default rate
than if their actual expected life were used to calculate subordination.
Finally, Fitch also uses historical default rates of corporates as the basis for ABS
again given the performance of ABS (excluding CDOs) they reduce rates by as
much as 20%. The agency also takes into account tranche size and seniority level to
determine recovery ratei.e. more senior (and/or larger) tranches would receive a
higher rate.
Correlation Turning to default correlation, the rating agencies acknowledge that the lack of a
default history poses a problem in accurately estimating joint-default probabilities of
ABS sectors and issuers. S&Ps CDO Evaluator18 assumes a correlation of 30% for
the same ABS sector within the same country, 20% for the same sector within the
same region (i.e. UK RMBS vs Italian RMBS), and no correlation only in cases with
the same sector but within different regions (i.e. US RMBS vs Australian RMBS).
In contrast, S&P assumes no correlation between corporate sectors for other CDOs.
For Moodys, its more difficult to make an explicit comparison, but we describe
their Alternative Diversity Score methodology (adapted from the original
framework for corporates). The calculation groups a portfolio into a matrix of ABS
sectors and adjusts for par amount, default probability, and correlation. In the final
analysis an actual, correlated portfolio is reduced to an idealized, uncorrelated one.
Moodys assumes lower joint-default probability for investment grade ABS than for
sub-investment grade ABS and also makes specific adjustmentsi.e. consumer
sectors (such as Cards and Autos) might be highly correlated with each another, but
as a group, largely uncorrelated with real estate sectors (such as CMBS and RMBS).
Somewhat similar to S&P, Fitch uses a rule based approach that captures both
regional and sector diversitybut all things equal, correlation between ABS is
assumed to be higher than correlation between corporates. Correlation is assumed
to be around 45% between ABS assets within the same sector and the same region.
This assumption is reduced for assets from different sub sectors and/or different
regions, and for CDO tranches the agency applies a look through methodology that
derives the correlation between CDO tranches, from the correlation between the
underlying corporates. See Appendix B for an overview of rating agency
classifications for structured securities.
Prepayment Stress Finally, ABS collateral prepaying or extending at speeds different from whats been
originally modeled can be problematic, as it can impact the stability of the expected
cash flows from the portfolio, affecting the credit quality of the CDO tranches. For
example, a significantly higher prepayment rate than what was expected would lead
to more asset cash flows than expected. If this is occurring in a declining interest
rate environment, and/or during a slowdown in ABS issuance, the deals manager
might have difficulty reinvesting this excess cash. As a result, Moodys halves and
18. Global Cash Flow and Synthetic CDO Criteria, Standard and Poors.
49
CDO Research
then doubles prepayment speeds of ABS collateral. The other agencies perform
something similarfor example S&P stresses the base case prepayment speed by
0.5 times and 1.5 times the base case to come up with slow (and fast) prepayment
scenarios. Wearing our ABS hat, we think all of this is potentially more stressful
than what has happened to ABS during different periods in the markets history
but again highlight the benefit of this conservatism to CDO investors.
50
CDO Research
Appendix A: Rating Transition Matrices

Table 23
Five-Year Transition Matrix for US Structured Products
U.S. CMBS Five-Year Rating Transition Rate, 2003 and 1985-2003
AAA AA A BBB BB B CCC/C D

AAA 96.4 3 0.2 0.4
AA 15.2 77.9 3.4 0.9 0.1 1 0.9 0.6
A 8.8 14.1 70.1 3.8 2.3 0.4 0.6
BBB 3.9 11 9.2 66.7 6.6 0.7 1.3 0.6
BB 3.6 1.6 2.8 9 64.1 6.2 5.2 7.4
B 0.3 1.4 1.6 4.9 10.7 58.2 8.8 14
U.S. ABS19 Five-Year Rating Transition Rate, 1982-2003

AAA 99.5 0.3 0.1 0.1
AA 8.7 83.5 6.5 0.5 0.2 0.5
A 3.3 2.4 91.1 0.7 0.1 1.2 0.1 1.1
BBB 6.2 3.1 1.1 73.7 1.5 1.9 4.5 8
BB 2.7 4.7 0.7 1.3 70.5 6.7 5.4 8.1
B 84 16
U.S. RMBS20 Five-Year Rating Transition Rate, 1978-2003

AAA 99.1 0.6 0.1 0.1
AA 27.2 66 4.7 0.8 0.1 0.7 0.5
A 21 14.2 59.3 2.5 0.4 0.5 0.6 1.5
BBB 15.9 13.4 12.6 46.4 2.1 2.9 2.3 4.4
BB 2.7 10.8 11.4 17.8 42.3 2.9 3.8 8.2
B 0.8 0.9 3.6 11.6 15.4 49.2 6.2 12.2
Source: Standard and Poors.
19. US ABS includes: Mutual Fund Fees, Auto, Consumer ABS, Credit Card, Equipment, Franchise Loan, MH,
Small Business Loans, Student Loans, Tobacco, Trade Receivables.
20. US RMBS includes: Prime (Jumbo/Alt A) and Subprime/Home Equity.
51
CDO Research
Christopher Flanagan AC
Table 24
Lifetime Transition Matrix for European Structured Products
CMBS
From Starting AAA AA A BBB BB B CCC CC-D Up- Stable Down-

Rtg. (#) graded graded
AAA 94 100.0 0.0 100.0 0.0
AA 68 5.9 94.1 5.9 94.1 0.0
A 86 4.7 1.2 94.2 5.8 94.2 0.0
BBB 79 1.3 2.5 2.5 93.7 6.3 93.7 0.0
BB 41 2.4 2.4 90 2.4 2.4 4.9 90.2 4.9
Ending 368 104 67 83 75 37 1 0 1 16 350 2
Rtg. (#)
Subprime RMBS

AAA 59 100.0 0.0 100.0 0.0
AA 19 26.3 73.7 26.3 73.7 0.0
A 42 23.8 21.4 54.8 45.2 54.8 0.0
BBB 31 3.2 25.8 71.0 29.0 71.0 0.0
BB 7 14.3 71.4 14.3 85.7 14.3 0.0
Ending 158 74 24 32 27 1 39 119 0
Rtg. (#)
Prime RMBS

AAA 310 89.0 5.5 5.5 0.0 89.0 11.0
AA 140 3.6 87.9 8.6 3.6 87.9 8.6
A 164 3.7 7.9 87.2 1.2 11.6 87.2 1.2
BBB 162 1.9 1.2 96.9 3.1 96.9 0.0
BB 16 100.0 0.0 100.0 0.0
Ending 765 287 156 174 159 17 2 30 717 48
Rtg. (#)
Corporate Securitizations

AAA 23 95.7 4.3 0.0 95.7 4.3
AA 3 100.0 0.0 100.0 0.0
A 27 88.9 7.4 3.7 0.0 88.9 11.1
BBB 26 92.3 3.8 3.8 0.0 92.3 7.7
BB 6 100.0 0.0 100.0 0.0
Ending 85 22 4 24 26 8 1 0 79 6
Rtg. (#)
Other ABS
AAA 223 98.2 1.8 0.0 98.2 1.8
AA 67 100.0 0.0 100.0 0.0
A 125 2.4 2.4 95.2 4.8 95.2 0.0
BBB 66 3.0 3.0 1.5 93.9 1.5 4.5 93.9 1.5
BB 5 100.0 0.0 100.0 0.0
Ending 488 224 74 120 62 6 2 9 474 5
Rtg. (#)
Source: Standard and Poors.
52
CDO Research
Appendix B: Rating Agency Classification of Structured

Products
Moodys Fitch Standard and Poors
Asset Backed Securities CMBS Project Finance

Consumer finance-related instruments
Auto (loan or lease) RMBS Prime CDO
Credit Card
Student Loan RMBS Sub-Prime ABS Consumer
Home Equity Loans/Line of Credit
Aircraft/Equipment Leasing Consumer ABS ABS Commercial
Entertainment Royalties
Small Business Loans Commercial ABS* CMBS Diversified (conduit and CTL)
Tax Liens Travel and Transport
Mutual Fund Fees Small Business CMBS (large loan, single borrower,
Others single property)
Structured Settlements
Floor Plan CDO of Corp. REITS and REOCs
Utility Stranded Cost
Health Care CDO of ABS RMBS A
Rental Car
RMBS B&C, HELs, HELOCs,
Tax Lien
Consumer Mortgage-Backed
Securities Manufactured Housing
Conduit
Large Loan US Agency (explicitly guaranteed)
Credit Tenant Lease
Monoline/Financial Enhanced Rating
(FER) Guaranteed
Residential Mortgage Backed
Securities Non-FER Company Guaranteed
Residential A
Residential B&C US FFELP Student Loans
(over 70% FFELP)
REIT Debt
Hotel
Multifamily
Office
Retail
Industrial
Healthcare
Self Storage
Diversified
Collateralized Debt Obligations

Domestic Corporate
Emerging Market
Source: Moodys, Fitch, S&P.
* In Europe, no split between Commercial ABS sub-groups.
53
CDO Research
Appendix C: SF CDOs from Seasoned Issuers*

Asset Manager/Issuer Issue and Series Year Cash/ Synthetic Region
American Capital Access ACA ABS 2002-1 2002 Cash US

American Capital Access Grenadier Funding I 2003 Cash US
Blackrock Financial Mgmt Anthracite CDO I 2002 Cash US
Blackrock Financial Mgmt Anthracite CDO II 2002 Cash US
Blackrock Financial Mgmt LEAFS CMBS Trust I 2002 Cash US
BNP Paribas CDO Master Investments II 2001 Synthetic Euro
BNP Paribas Iliad Investments Plc 1 2002 Synthetic Euro
C-BASS C-BASS CDO I 2001 Cash US
C-BASS C-BASS CDO II 2001 Cash US
C-BASS C-BASS CDO III 2002 Cash US
C-BASS C-BASS CDO IV 2002 Cash US
C-BASS C-BASS CDO V 2002 Cash US
C-BASS C-BASS CDO VI 2003 Cash US
C-BASS C-BASS CDO VII 2003 Cash US
Clinton Group Tribeca Mortgage Fund I 1 1999 Cash US
Clinton Group Bleecker Structured Asset Funding I 2000 Cash US
Clinton Group Varick Structured Asset Fund, Ltd I 2000 Cash US
Clinton Group Fulton Street CDO I 2002 Cash US
Clinton Group Mulberry Street I 2002 Cash US
Clinton Group Mulberry Street II 2003 Cash US
Credit Agricole Indosuez ABSolute Synthetic CDO Ltd. I 2003 Synthetic Euro
Credit Agricole Indosuez Triplas Synthetic CDO SA 1 2003 Synthetic Euro
Credit Agricole Indosuez Triplas Synthetic CDO SA 2 2003 Synthetic Euro
Declaration Mgmt & Res Seneca Funding I 1999 Cash US
Declaration Mgmt & Res Independence CDO I 2000 Cash US
Declaration Mgmt & Res Independence CDO II 2001 Cash US
Declaration Mgmt & Res Independence CDO III 2002 Cash US
Declaration Mgmt & Res Independence CDO IV 2003 Cash US
Deerfield Capital Mgmt Mid-Ocean CBO 1 2000 Cash US
Source: JPMS, MCM, Thompson/IFR Markets, Moodys, S&P, Fitch.
*Includes all SF CDOs from issuers with two or more deals issued within the last two years. Due to lack of transparency in the CDO
market, list may be incomplete for some managers.
54
CDO Research
Table (Continued)
Deerfield Capital Mgmt Mid-Ocean CBO II 2001 Cash US

Deerfield Capital Mgmt Oceanview CBO Ltd. I 2002 Cash US
Deerfield Capital Mgmt NorthLake CDO I 2003 Cash US
Deutsche Bank Strips CDO 2002-1 2002 Cash US
Dresdner Bank Alexandria Capital 2003-1 2003 Synthetic Euro
E*TRADE AM E*Trade CDO 1 2002 Cash US
E*TRADE AM E*Trade CDO 2 2003 Cash US
Ellington Capital Mgmt Duke Funding, Ltd. I 2000 Cash US
Ellington Capital Mgmt Duke Funding, Ltd. II 2001 Cash US
Ellington Capital Mgmt Duke Funding, Ltd. III 2002 Cash US
Ellington Capital Mgmt Duke Funding, Ltd. IV 2002 Cash US
Ellington Capital Mgmt Duke Funding, Ltd. V 2003 Cash US
Fisher Francis Trees & Watts Spinnaker I 1998 Cash US
Fisher Francis Trees & Watts Commodore CDO I 2002 Cash US
Fisher Francis Trees & Watts Commodore CDO II 2003 Cash US
Fortress Investment Group Fortress CBO Investments, Ltd I 1999 Cash US
Fortress Investment Group Newcastle CDO II 2003 Cash US
Fortress Investment Group Newcastle CDO III 2003 Cash US
GMAC G-Force 2001-1 2001 Cash US
GMAC G-STAR 2002-1 2002 Cash US
GMAC Blue Bell Funding I 2003 Cash US
Gulf Intl Bank (UK) Ltd. FAB CBO BV 2002-1 2002 Cash Euro
Gulf Intl Bank (UK) Ltd. FAB CBO BV 2003-1 2003 Cash Euro
ING Mane Funding I 2002 Synthetic Euro
ING AJAX 1 2001 Cash US
ING AJAX 2 2002 Cash US
Lennar Partners LNR 2002-1 2002 Cash US
Lennar Partners LNR 2003-1 2003 Cash US
MFS IM Crest Clarendon CRE CDO 2002-1 2002 Cash US
MFS IM Crest Dartmouth Street 2003-I 2003 Cash US
Pacific Investment Mgmt Co. Pacific Coast CDO 2001 2001 Cash US
Pacific Investment Mgmt Co. Euro Multi-Credit CDO I 2002 Cash Euro
Pacific Investment Mgmt Co. Pacific Shores I 2002 Cash US
Pacific Investment Mgmt Co. Pacific Bay I 2003 Cash US
Putnam Investment Mgmt Putnam Structured Prod CDO 2001-1 2001 Cash US
Putnam Investment Mgmt Putnam Structured Prod CDO 2002-1 2002 Cash US
Putnam Investment Mgmt Putnam Structured Prod CDO (TAP) 2003 Cash US
Putnam Investment Mgmt Putnam Structured Prods CDO 2003-1 2003 Cash US
Redwood Trust Acacia CDO II 2003 Cash US
Redwood Trust Acacia CDO III 2003 Cash US
Royal Bank of Canada Caribou 2002 2003 Synthetic Euro
Royal Bank of Canada Caribou 2002-D (Herald Ltd.) 2003 Synthetic Euro
Royal Bank of Canada Caribou 2003-2 (Herald Ltd.) 2003 Synthetic US
State Street Research Fort Point CDO Ltd 1 2002 Cash US
55
CDO Research
Table (Continued)
State Street Research Descartes CDO Ltd 1 2003 Cash US

State Street Research Fort Point CDO Ltd II 2003 Cash US
Structured Credit Partners Crest 2000-1 2000 Cash US
Structured Credit Partners INGRESS CBO, Ltd 1 2000 Cash US
Structured Credit Partners Crest G-Star 2001-1 2001 Cash US
Structured Credit Partners Crest G-Star 2001-2 2001 Cash US
Structured Credit Partners Crest 2002-IG 2002 Cash US
Structured Credit Partners Crest 2003-I 2003 Cash US
TCW Advisors Inc. Eastman Hill Funding 1 2001 Cash US
TCW Advisors Inc. South Coast Funding I 2001 Cash US
TCW Advisors Inc. South Coast Funding II 2002 Cash US
TCW Advisors Inc. Davis Square Funding, Ltd I 2003 Cash US
TCW Advisors Inc. South Coast Funding III 2003 Cash US
TCW Advisors Inc. South Coast Funding IV 2003 Cash US
TCW Funds Mgmt Westways Funding Ltd 1997-1 1997 Cash US
TCW Funds Mgmt Westways Funding Ltd 3A 1998 Cash US
TCW Funds Mgmt Westways Funding Ltd 4A 1998 Cash US
TCW Funds Mgmt Westways Funding Ltd II 1998 Cash US
TCW Funds Mgmt Charles River CDO 1 2002 Cash US
TIAA TIAA Structured Finance CDO Ltd I 2000 Cash US
TIAA TIAA Real Estate CDO 2002-I 2002 Cash US
TIAA TIAA Real Estate CDO 2003-I 2003 Cash US
TIAA TIAA Structured Finance CDO Ltd II 2003 Cash US
Trainer-Wortham Trainer Wortham 1st Republic CBO 2000 Cash US
Trainer-Wortham Trainer Wortham ABS CBO II 2002 Cash US
Trainer-Wortham Trainer Wortham ABS CBO III 2003 Cash US
Trainer-Wortham Trainer Wortham ABS CBO IV 2003 Cash US
UBS Asset Mgmt Diversified REIT Trust 1999-1 1999 Cash US
UBS Asset Mgmt Diversified REIT Trust 2000-1 2000 Cash US
UBS Asset Mgmt Brooklands Euro RLN 2001-1 2001 Synthetic Euro
UBS Principal Finance Brooklands Euro RLN 2002-2 2002 Synthetic Euro
UBS Principal Finance North St Ref Linked Notes Ltd 2003-5 2003 Synthetic US
UBS Warburg North St Ref Linked Notes Ltd 2000-1 2000 Synthetic US
Vanderbilt Capital Bristol CDO I 2002 Cash US
Vanderbilt Capital Grand Central CDO 2003 2003 Cash US
Vanderbilt Capital Lakeside CDO I 2003 Cash US
Wachovia Bank Calibre 2003-1 2003 Synthetic US
Wachovia Bank Calibre II 2003 Synthetic US
West LB Blue Heron Funding I 2001 Cash US
West LB Blue Heron Funding II 2002 Cash US
West LB Blue Heron Funding III 2002 Cash US
West LB Blue Heron Funding IV 2002 Cash US
West LB Blue Heron Funding V 2003 Cash US
West LB Blue Heron Funding VI 2003 Cash US
56
CDO Research
Table (Continued)
West LB Blue Heron Funding VII 2003 Cash US

West LB House of Europe Funding I 2003 Cash Euro
Western Asset Management Arroyo CDO I 2001 Cash US
Western Asset Management Pasadena (formerly Arroyo II) I 2002 Cash US
Western Asset Management Coronado CDO I 2003 Cash US
ZAIS Group LLC Euro Zing I 2002 Cash Euro
ZAIS Group LLC Euro Zing II 2003 Cash Euro
ZAIS Group LLC High Tide CDO I 2003 Synthetic Euro
57
CDO Research
58
2004 Research Directory
G LOBAL S TRUCTURED F INANCE R ESEARCH
Christopher Flanagan (1-212) 270-6515

Managing Director
Executive Assistant
Carolina Sumaila (1-212) 270-5864
carolina.sumaila@jpmorgan.com
ABS/CDO RESEARCH
Rishad Ahluwalia (London) (44-207) 777-1045 Edward Reardon (London) (44-207) 777-1260
rishad.ahluwalia@jpmorgan.com edward.j.reardon@jpmorgan.com
Ryan Asato (1-212) 270-0317 Parul Sahai (1-212) 270-0137
ryan.asato@jpmorgan.com parul.sahai@jpmorgan.com
Benjamin Graves (1-212) 270-1972 Amy Sze, CFA (1-212) 270-0030
benjamin.j.graves@jpmorgan.com amy.sze@jpmorgan.com
Ting Ko (London) (44-207) 777-0363 Tracy Van Voorhis (1-212) 270-0157
ting.ko@jpmorgan.com tracy.vanvoorhis@jpmorgan.com
CMBS RESEARCH
Patrick Corcoran (1-212) 834-9388

patrick.j.corcoran@jpmorgan.com
Yuriko Iwai (1-212) 834-9380
yuriko.iwai@jpmorgan.com
59
CDO Research
New York Structured Finance CDO Handbook www.morganmarkets.com
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Global Structured Finance Research

Structured Finance CDO Handbook

of liquidity/complexity premiums and the credit curve, to be a source of

Asset Manager Hedge Trustee & Rishad Ahluwalia (London)

SF CDOs Offer a Spread Table 1

Diversified SF CDO: Also referred to as multisector or ABS CDOs. Deals

In addition to the two broad categories Chart 3

CDO, REIT) for deals completed in

materially different proportions.

SF CDO Sectors - Some Definitions

2003 US/Europe SF CDO Collateral Distribution: By Deal Type

* As a percent of total notional value.

2003 US/Europe SF CDO Collateral Distribution: By Sub Sector

Aerospace Student Loan

* As a percent of total notional value.

Todays next-generation SF CDOs contain less exposure to these esoteric sectors,

Far Less Deterioration in Table 16 shows migration of the Chart 15

SF CDOs, which have rapidly

securitized by real estate, which

4. Formerly known as Independence Fixed Income LLC.

Current Avg Rating/Trigger Avg Rating Baa3/Baa2 Baa3/Baa2 Baa2/Baa2 Baa2/Baa2

SF CDO Assets: 101

Major Currencies USD USD USD, GBP, EUR, USD

B&C 2nd Prime Prime

1st 2nd 1st 1st

80% 90% 75% 75%

7.5% 9%-10% 6.5% 6.0%

630 715 715 725

Ameriquest Chase Countrywide Chase

Home Equity Prime

RMBS: Home Equity Loans (HEL)

Residential Wall Street dealers Mortgage cashflows are

among European investors. It also provides an opportunity for investors to diversify

UK residential mortgages have historically been marked by stable mortgage

RMBS: Continental Europe

CMBS: Interest Only Strips

CMBS: Non-Performing Loan (Europe)

Real Estate Investment Trusts (REITs)

Consumer ABS: Auto and Credit Card

Consumer ABS: Consumer Loan (Europe)

Corporate ABS: Equipment

Corporate ABS: Whole Business Securitization (Europe)

Does SF Collateral Work for CDOs?

Credit Card minus Banks (A 5-year)

Stable Arbitrage Opportunity

To a certain extent, this phenomenon Chart 27

Default and Recovery Performance

Unlike corporates, where a default is caused by a discrete event like a bankruptcy or

Material Impairment Rates Materially impaired securities are defined as follows:

The market is now dominated by investment grade, well capitalized players.

Issuer Rating $mm % Market Issuer Rating $mm % Market

Source: JPMS, MCM.

13. ABS Monitor, JPMS, 16 September 2003.

sample by looking at current loss-implied recovery rates on impaired securities that

There is significant recovery rate volatility within each sector, as evidenced by

SF CDOs have higher subordination requirements compared to traditional structured

Collateral & Single-A/BBB tranches AAA/AA tranches AAA/AA tranches

Slow/steady growth in Little issuance before 2003 Rapid growth, especially

Transaction Size $250 - $600mn $800mn - $1.3bn $600mn - $4bn

Cash Flow Structure Amortizing Amortizing Bullet

Most common Arbitrage. Arbitrage or Balance Sheet Balance Sheet

Credit AAA: 15-21% AAA: 4-9% Super Sr: 3-15%

*Effectively 'second senior';

Indicative A/B* 103-105% MM and A-1: 103-105% NA

Diversified SF CDO: Also referred to as multisector or ABS CDOs. Deals

Todays next-generation SF CDOs contain less exposure to these esoteric sectors,

Does SF Collateral Work for CDOs?

sample by looking at current loss-implied recovery rates on impaired securities that

One significant structural modification for next generation SF CDOs is the

Moodys Deal Score (MDS)

17. Moodys Approach to Rating Multisector CDOs, Moodys Investors Service.

Moodys Fitch Standard and Poors