ISDA Conference on

Structured Products CDS

September 2005

Structured Products CDS

Growth of an Exciting New Market

Rajiv Krushna Kamilla, Vice President,

Structured Products Trading, Goldman Sachs

Todd Kushman, Associate Director,

Fixed Income Derivatives, Bear Stearns

September 2005
 --

Credit Default Swaps

Market Overview

W CDS enables more efficient trading of credit andlor spread risk and
identify value
- In a CDS transaction, a buyer of protection pays a protection
seller a premium in exchange for payments if certain credit
events occur
W Corporate CDS market primarily trades on two credit events:
- Bankruptcy
- Failure to Pay
The corporate CDS market has grown dramatically and
revolutionized the corporate bond market
W Index trading on corporate credit (i.e., CDX) has dramatically
increased liquidity in the sector

--

Credit Derivatives Have Been Growing Rapidly

Global Credit Derivatives Market (Excluding Asset Swaps)

Outstanding notional of corporate credit derivatives dwarfs the cash corporate

bond market
Structured Products CDS
Market Overview

Structured products CDS has emerged as an attractive vehicle for

investors to participate in, trade, or hedge single name, market, and
portfolio risks
Several dealers are investing significant resources to growing the
business
Focus on developing a broad trading business, rather than a
brokering or niche hedging business
Majority of market activity has been in real estate related structured
finance sectors - conduit CMBS and sub-prime RMBS J
- Gross trade notional already exceeds $100billion and likely to
exceed$500bnbyendof2006
- Numerous inter-dealer trades via the broker market
- Driven by emerging market consensus on proposed terms, ISDA
documentation, and anticipated index launch

Why Structured Products CDS?

Exciting New Opportunity

Provides exposure unachievable in the cash market

- Both long and short exposure to spreads and/or credit risk
- Exposure to difficult to source collateral; not limited by
availability of cash bonds or dealer inventory
- Expressing directional views in structured finance
Flexibility to create customized and diversified exposures
- Can be levered or un-levered
Creates new opportunities
- Basis trades (i.e. CDS vs. Cash bonds or CDS vs. TRR index)
- Capital structure trades (i.e. long BBs vs. short 555s)
- Cross-sector arbitrage
- Risk management and hedging
Why Structured Products CDS?
Unique Characteristics of Structured Products CDS

Why Structured Products CDS?

Exciting New Opportunity

The structured product synthetics market is expected to

exhibit rapid growth in the next few years, consistent with the
trend line in the corporate credit derivatives market
Primary trade themes:
- Single-name CDS: CDS on a single reference obligation
- Basket Trades: CDS on a basket of underlying reference
obligations - equivalent to a basket of single-name CDS
- Levered Synthetics: CDOs backed by a portfolio of
single-name structured product CDS
-

-
Single tranche bespoke synthetic CDOs
Full capital structure synthetic CDOs jW'h *C
M3.
Tqn ~5
- H y b r i d C D O s j ~ U 3
Growth in Liquidity in the Structured Product
CDS Market
12+ dealers are making 2-way markets
- RMBS & CMBS have seen the majority of trading flow
- BidlOffer currently ranges from 3-5bps range on AAA and
10-25bp area on BBB and BB
- Trade Size = $5 to 50MM
- CDS notional typically exceeds 01s notional of cash
security
CDS will likely have a significant market impact on the pricing
of risk and ultimately on cash spreads
- Tiering among RMBS servicers is being witnessed
Liquidity continues to grow
- Numerous bid and offer lists have been executed upon

,=I
Primary Market Participants & ApplicationS l

&\\
I--

Buyers Sellers
Hedge Funds & Arbitrage CDOs
Dealers - 100% Synthetic
- Flow trading desks - Hybrid (cash &
synthetic)
- Proprietary desks
Whole loan originator
- Synthetic Bucket
traders Hedge Funds & Arbitrage
Banks I Funders - LonglShort
- Negative Basis Trades - Synthetic 110
Insurance Companies - Term Funding
Portfolio Managers Insurance Companies
Portfolio Managers
Development of Index Products

Corporate index products: CDX, iTRAXX

- Estimated total market volume is $25-50billion per day with
every major broker-dealer trading
CDX and iTRAXX benefit from great liquidity, transparency and
market-maker sponsorship
Structured products market is targeted to launch similar index
products in late 2005 or early 2006
- ABX: Basket of 20 liquid subprime RMBS reference obligations
at each benchmark ratings category
- CMBX: Basket of 10-year AAA tranches of the 25 most recent
conduit/fusion transactions
- New index will be created every 6 months
- Older indexes will continue to trade after creation of each new
index (similar to CDX and iTRAXX)
Tranched index products and index options are likely to follow
11

Pay-As-You-Go I Physical (US) vs.

Cash Settlement I Physical (EU)

Debate continues among dealers as to which form is preferred

Global trading is limited as accounts search for liquidity from
local dealers
Development of a uniform confirmation (merger of both PAUG
and Cash Settlement) will require dealers price both
alternatives
The Sky is The Limit with Structured Product
CDS ..............

Structured Products CDS

ISDA Documentation

David G. Lucking, Associate,

Allen & Overy LLP

George Wilkinson, Vice President,

Morgan Stanley

September 2005
 lSDA CDS c S Confirmation with
Pay-As-You-Go or Physical Settlement
Designed to be used for RMBS and CMBS reference obligations:
Provides for "pay-as-you-go" methodology whereby the seller of protection
('Seller") will make "Floating Payments" to the buyer of protection ("Buyer") on a
current basis (i.e.. principal writedowns and principal and interest shortfalls, in each
case, with respect to the reference obligation);
= To the extent Seller makes a Floating Payment to Buyer and such amount is
"reversed," Buyer will pay such reversed amount back to Seller;
With respect to interest shortfall coverage. Seller will cover interest shortfalls in one
of three ways: (i) Seller will pay interest shortfalls up to an amount equal to the
fixed rate (i.e., fixed cap). (ii) Seller will pay interest shortfalls up to an amount
equal to LlBOR plus the fixed rate (i.e., variable cap) or (iii) Seller will pay the entire
amount of the interest shortfall (i.e., interest shortfall cap not applicable);
Credit events include (i) failure to pay principal, (ii) principal writedown. (iii) ratings
downgrade and (iv) maturity extension;
Upon a credit event, Buyer may physically settle all or a portion of the notional
amount of the trade by delivering the reference obligation (or a portion thereof) to
X Seller in return for par; if Buyer settles only a portion of the trade, the trade will
continue and the notional amount thereof will be reduced by the physically settled
portion;
The term of the trade will match the legal final of the underlying reference
obligation.

15

Obligations of Protection Buyer

/
- The payment obligations of the Buyer fall into two categories: (i) the Fixed Amount and
(ii) Additional Fixed Amounts.
The Fixed Amount is the protection premium payable by Buyer to Seller and is equal to
the product of the Fixed Rate and the Reference Obligation Notional Amount.
The Reference Obligation Notional Amount is adjusted throughout the life of the trade
as follows: (i) decreased by (a) principal payments on the reference obligation, (b)
principal writedowns on the reference obligation. (c) principal shortfalls on the
reference obligation and (d) any portion of the reference obligation that is physically

- settled and (ii) increased by (a) any writedown reimbursement.

Additional Fixed Amounts are (i) writedown reimbursements, (ii) principal shortfall
reimbursements and (iii) interest shortfall reimbursements. These amounts will be paid
by Buyer to Seller if a writedown amounf principal shortfall amount or interest shortfall
amount was previously paid by Seller to Buyer and subsequent to such payment, such
shortfall or writedown is reversed.
The amount paid by Buyer to Seller in connection with such reversal will never exceed
the amount previously paid by Seller to Buyer in connection with the applicable shortfall

- or writedown (plus accrued interest in the case of an interest shortfall).

If an interest shortfall occurs and the payment by Seller to Buver in respect of such
interest shortfall is limited due to the applicability of the "lnteiest ~ h o r k a lCap,"
l the
interest shortfall reimbursementcalculation will be affected by the applicability of the
cap. Generally, the interest shortfall reimbursement amount (i.e.. the amount paid by
. . bv. Buver
Buyer to Seller upon the reversal of an interest shortfall) will not be Davable , to
seller until the amount of the interest shortfall that was not paid by Seller due to the
applicability of the Interest Shortfall Cap is reimbursed on the reference obligation.
16
Payment Obligations of Protection Seller
~ j1 ~ r i
+gdilnk I L)P(L( el h i

1\
The payment obligations o f t e Seller are called 'Floating Payments" and fall
into three categories: (i) Writedown Amounts; (ii) Principal Shortfall Amounts

- and (iii) lnterest Shortfall Payment Amounts;

These amounts will be paid by Seller to Buyer on a "pay-as-you-go" basis;
accordingly, Seller will pay such amounts to Buyer upon the occurrence of a
shortfall or writedown, as the case may be, and (unless Buyer physically
settles the entire trade) the trade will continue;
= Writedown Amounts - if there is a principal writedown with respect t o the
reference obligation, Seller will make a Floating Amount payment to Buyer in
a n amount equal to such writedown; the notional amount of the reference
obligation will b e decreased by any writedown amount; note that a principal
writedown includes (i) a n increase in the principal deficiency ledger applicable
to the reference obligation and (ii) an "implied writedown" concept (which
applies to reference obligations that do not writedown) and such implied
' - writedown is a n amount equal to the amount by which the reference

- obligation is undercollateralized;
Princ~pnlShodfall Amounts - if a scheduled principal payment is not made
when legally due, a principal shortfall will result and Seller will make a
Floating Amount payment to Buyer equal to such principal shortfall.

Payment Obligations of Protection Seller (cont.)

- If there is an lnterest Shortfall on the reference obligation, Seller will (subject to the

. lnterest Shortfall Cap) pay Buyer the amount of the lnterest Shortfall;
An lnterest Shortfall will occur on a given payment date if the Actual lnterest Amount is
less than the Expected lnterest Amount in each case, on such payment date;
The Actual lnterest Amount is defined as the actual amount of interest paid in respect of
the reference obligation on a given payment date;
The Expected lnterest Amount is defined as the amount of interest acmed on the
reference obligation for the relevant calculation period and expressly provides that such
amount will be determined without regard to the applicability of any available funds cap
("AFC"); this has the effect of transferringthe AFC risk to the Seller;
= Notwithstanding this transfer of AFC risk to the Seller, a the parties elect the Fixed Cap
with respect to lnterest Shortfall coverage, the amount of the lnterest Shortfall payable by
Seller to Buyer for a given payment period will be capped at the protection premium
payable for such payment period;
If the parties elect the Variable Cap with respect to lnterest Shortfall coverage, the
amount of the lnterest Shortfall payable by Seller to Buyer for a given payment period will
be capped at the protection premium for the applicable period plus LIBOR;
If the parties provide that the lnterest Shortfall Cap is not applicable. Seller will pay the
entire amount of the lnterest Shortfall to Buyer.
 --

Interest Shortfall Coverage - Examples

Assumptions

W Reference Obligation Coupon is the lesser of (i) L+400 and (ii) 10% (i.e.,
10% is the AFC);
3
Reference Obligation is trading at 2d0bps at the time of the trade;
Buyer and Seller set the fixed rate (i.e., the protection premium payable
from Seller to Buver) at (i) 200bos (if the lnterest Shortfall Cao is
applicable) or (ii)b00bps (if the interest Shortfall C -
~ isP not aLplicable);
and
W The Reference Obligation fails to pay interest on a given payment date
(i.e., an lnterest Shortfall equal to L+400bps)

lnterest Shortfall Coverage -Examples (cont.)

Fixed Cap Applicable

If the Fixed Cap is applicable, the lnterest Shortfall (i.e., L+400bps) will
be capped at the fixed rate (i.e., 200bps) and Seller will pay Buyer
200bps in respect of such lnterest Shortfall; accordingly, Seller's net
payment to Buyer for the applicable period will be zero (after netting out
the 200bp protection premium due to Seller from Buyer for such period).

Variable Cap Applicable

If the Variable Cap is applicable, the lnterest Shortfall (i.e., L+400bps)
will be capped at LlBOR plus the fixed rate (i.e., 200bps) and Seller will
pay Buyer L+200bps in respect of such lnterest Shortfall; accordingly,
Seller's net payment to Buyer for the applicable period will be LlBOR
(after netting out the 200bp protection premium due to Seller from Buyer
for such period).
lnterest Shortfall Coverage - Examples (cont.)

Variable Cap Applicable and the Available Funds Cap

w Assume LlBOR goes to 10%;
W Recall that the Ref Ob pays at the lesser of (i) L+400 and (ii) lo%, but
the definition of Expected lnterest Amount excludes the effect of any
AFC (i.e., the Expected lnterest Amount in this example is 14%);
W If the Ref Ob pays interest at the AFC (i.e., lo%), the lnterest Shortfall
will be 400bps (i.e., the difference between the Actual lnterest Amount
(1000bps) and the Expected lnterest Amount (1400bps));
Since the Variable Cap is applicable. the lnterest Shortfall (400bps) will
be capped at LlBOR plus the fixed rate (1200bps) and Seller will pay
Buyer 400bps in respect of such lnterest Shortfall; accordingly, Seller's
net payment to Buyer for the applicable period will be 200bps (after
netting out the 200bp protection premium due to Seller from Buyer for
such period).

Credit Events

Credit Events include:

Failure to Pay Principal
Writedown
)k\\c, kw' '

W Distressed Ratings Downgrade

Maturity Extension

Upon a Credit Event:

W The Buyer may physically settle all or a portion of the trade.
W If the Buyer physically settles less than the entire notional amount of the
trade, the notional amount will be reduced by the physically settled
portion and the trade will continue.
Initial Payment and
Step-Up of Reference Obligation Coupon
Initial Payment
m At trade inception, one party may make an initial payment to the other (likely to be
used when the parties provide that the 'Interest Shortfall Cap" is not applicable.
H If this is the case, the Fixed Rate (i.e.. protection premium payable by the Buyer)
will be likely be set at the stated spread of the reference obligation.
If the reference obligation is trading at a discount, the Buyer will make the Initial
Payment to the Seller.
H If the reference obligation is trading at a premium, the Seller will make the initial
payment to the Buyer.
Step-up of Reference Obligation Coupon
H The parties may elect to apply provisions regarding the 'step-up" of the Reference
Obligation coupon.
If these provisions apply and the Reference Obligation coupon steps-up, the Fixed
Rate will increase by the same number of basis points by which the Reference
Obligation is increased.
m In lieu of this step-up in the Fixed Rate, the Buyer may terminate the transaction
with no amount payable by either party upon such termination.

Differences between PAYGo & CashlPhysical

PAYGo
Guarantees payment of interest and principal during life of ABS
Long-term relationship
Available funds cap risk - not consistent with European ABS structures
Can trade with fixed cap
CashlPhysical
Looks like a corporate CDS
Trigger results in payout
Follows less closely the terms of the ABS
Can be used for all ABS types, not just CMBSIRMBS (although modifications
mav be appropriate)
. . .
Current volumes FOR CashlPhysical
2005 - EUR 7-10bn
2006 - EUR 75-100bn
Portfolio managers slow to approve the document
 The Confirmation CashlPhysical -
= Looks like a corporate CDS
= Shorter than PAYGo form
= Very helpful footnotes in both forms
Buyer pays Fixed Amounts, calculated by reference to an
initial notional amount which fluctuates depending
- upon
amortization etc. (average)
= Seller pays Floating Amount on day Final Price is
deterrnined1Delivery Date

-
Credit Events CashlPhysical

Failure to Pay
Payment Requirement: USD 100,000

Loss Event
(Writedown)

m, Failure to Pay
-
BankruptcylRestructurin

Bankruptcy remote entities

m Regulatory capital reasons

Rating Downgrade
=
"CC" "default"
PAYGo - "CCC" =allows Physical Settlement
 -
Settlement CashIPhysical \

Cash Settlement, unless Seller receives NOPS prior to first Valuation Date
Valuation Date
Seller selects a Business Day 120-140 calendar days after Event
Determination Date
An amended Section 7.7 applies--

Reference Obligation Only

Payment of Floating Amount and accrued interest

60 Business Day cap
 Synthetic Delivery CashlPhysical -
Seller pays par in return for right to receive all future cash flows on ABS from Buyer

Settlement Diagram
120 r

-
-
r
Subs.quanlPhy.tcal
Buyer Deliveo sand
Seller pays Par
Dsllv.ry I
NO

t
C m h Vai~atIon Subsequlnl P h p h a l De1lv.w
(Dealer Poll1 - Buyer Deiven sand
-
180
1 Seller pay, Par
J
Final Price No Flnal Price
Days
Highsl Bid 3Oc - PIIce Deemed Oc

Buyer 6 Selleragn. wllh Final Price Seller pmpo. AIt Flnal Prls. 6oc Seller do. mt propose AI Final ~ d c a
- Seller pay$ Buyer 7Oc - Seller p a p Buyer Par
I

Buyer agrees with All Final Pdca B~yerdlsapmeswith All F l m l Pdce

- Seller pay, Buyer doc - 'Synthalic DsilvsM
. Seller p a p Buyer 40c (cmditlor$l
- Seller pay, Buyar 60cfor
rlghl lo reselva future CFs

4
Buyer pmpwms All F i n d Price tOc Seller pmpose.An
* Flnal Price 60s
vla TRS
4

S e l l r mJ.st. B u p n 20c Buyer accepls Sellen 60c

- 'Symtn~t,cD c l i ~ M - seller p e p lac
- Seiler p a p Buyer 7Oc(wdil IOPO)
- Ssilerpap Buyer 30cfwnghtL
rece,vtl tuture CF, wa TRS