Introduction SM to PCDS

Preferred Risk in Derivative Form

August 4, 2005 Ashish Shah 212-526-9360 asshah@lehman.com Sonny Kathpalia 212-526-0414 skathpal@lehman.com Preferred CDSSM (PCDSSM) trading volumes have grown substantially since being rolled out by Lehman Brothers in February 2005. Active markets now exist in more than 50 reference entities, with the most liquid names seeing single-day activity of more than $100 million of notional. With additional dealers beginning to make markets in PCDSSM, the liquidity, depth and breadth of the product will likely grow, broadening the investor base for preferred-level risk. As the first derivative contract to reference the preferred level of a corporate capital structure, PCDSSM represents an important investment tool for both preferred and bond investors. This report: reviews the major differences between PCDSSM and senior CDS, defines a valuation framework for PCDSSM relative to senior CDS, identifies why PCDSSM can be useful for preferred and bond investors, and discusses the potential effect of PCDSSM on the cash preferred market.

It concludes that: PCDSSM is an efficient way for credit investors to gain bullet exposure to the preferred level of capital structure, and PCDSSM will broaden the preferred investor base.

WHAT IS PCDSSM? Preferred CDSSM is just another type of credit default swap. No new ISDA documents are required to trade PCDSSM, as it shares the majority of traits with traditional CDS. There are just two major differences:
PCDSSM includes the deferral of a trust preferred coupon or preferred stock dividend as a fourth credit event. With a few exceptions, a company can defer or suspend payments on preferred level securities while continuing to pay interest on more senior debt. Accordingly, the deferral feature is included as a fourth credit event in addition to bankruptcy, failure to pay, or restructuring.
Preferred CDS and PCDS are service marks of Lehman Brothers Inc.

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PCDSSM references preferred-level securities as an additional deliverable: While the majority of default swaps reference companies senior unsecured debt, the reference asset for PCDSSM is either preferred or trust preferred stock. If a credit event (including deferral) occurs, the buyer of protection can deliver either a preferred/trust preferred security or any obligation more senior in the capital structure. Optionally, convertible securities are deliverable upon cessation of dividend, while mandatory converts are not.

Minor changes have been made to the traditional CDS contract to ensure that preferred securities are deliverable. Since most preferred securities are either perpetual or have extended maturities, the 30-year maximum maturity limitation does not apply to preferred securities. However, following a restructuring trigger, preferred securities would be subject to the restructuring maturity limitation date, as PCDSSM trades with modified restructuring.
Figure 1. PCDSSM Is Similar to Traditional CDS
PCDSSM Terms Reference Entity Reference Obligation Physical Settlement Scheduled Termination Date Quarterly Pay Credit Events Bankruptcy Failure to Pay Restructuring Deferral Deliverable Obligation Senior Debt Subordinated Debt Preferred Securities Reference Obligation Preferred or Trust Preferred Senior Unsecured * Traditional CDS

* Most investment-grade and emerging markets CDS contracts trade with restructuring as a credit event

VALUING THE PREMIUM OF PCDSSM TO CDS In order to develop a valuation framework for PCDSSM, it is helpful to start with the basic valuation framework for CDS and adjust for the added deliverable and trigger event. The valuation of senior CDS is laid out in the Quantitative Credit Research publication Valuation of Credit Default Swaps. For simplicitys sake, we will refer to the credit events of bankruptcy, failure to pay, and restructuring jointly as default.

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PCDS

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spread

Probability of Default

Loss on Default

Probability + of Deferral Only x

Loss Following Deferral Only

Senior CDS spread

Probability of Default

Loss on Default

= Senior Premium = Probability of Default x RecoveryPreferred Recovery + 100% - Min x (Recovery of All Deliverable Obligations)

Probability of Deferral Only

A typical CDS spread compensates investors for the expected loss on the credit, which is simply the cumulative probability of default times the loss on default. For the same issuer, the probability of default will be the same for both senior CDS and PCDSSM. However, the loss for PCDSSM will be greater than or equal to that of senior CDS because of its subordination. In addition, it is possible for deferral to occur without default. In that case, only the preferred CDS contract would trigger. This feature, combined with its deeper subordination, will cause PCDSSM to trade at a premium to senior CDS.

Figure 2. EOP: PCDSSM versus Senior CDS

Spread PCDS
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Recovery 10% 45% 35% Loss Differential on Default

118 bp 39 bp 79 bp

Senior CDS Premium

As of August 2, 2005.

Implied Default Probability = 39 bp / (100% - 45%) = 0.71% Subordination Premium = 0.71% * (45% - 10%) = 25 bp Deferral Premium = 79 bp 25 bp = 54 bp

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Figure 3. Current Premiums by Sector (bp)

Sector Agency Yankee Banks REITs Banks Brokers Energy Utility Insurance
As of August 2, 2005.

PCDS 57 39 121 55 59 315 67 53

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Senior CDS 14 10 38 22 27 146 33 29

Difference 43 29 83 33 32 169 35 23

Multiple 4.2x 4.0x 3.2x 2.5x 2.2x 2.2x 2.1x 1.8x

FUNDAMENTAL FACTORS THAT DRIVE PCDSSM PREMIA Due to the limited amount of data for preferred deferrals, it is difficult to estimate the value of the factors that influence probability of deferral without default and losses in such cases. In addition, the cash markets provide limited spread guidance because of differences in tax treatment and structures across cash preferreds. However, we have attempted to identify the major factors that may influence the premium to senior CDS based on past and recent deferral events. This analysis can be divided into a view about credit events and preferred losses related to credit events.
What Will Drive the Chances of Simultaneous Default and Deferral as Opposed to Deferral Only?

Large regulated financial entities are more likely to experience a deferral without default because of regulatory intervention aimed at protecting depositors, policyholders, consumers, or other operating company counterparties from incremental financial harm. These entities are likely to have significant access to liquidity through government facilities such as the Fed window, reducing the probability of a liquidity-driven default while increasing the likelihood of a deferral trigger forced by the regulators. One recent example of such a deferral was by Riggs Bank. Riggs had agreed to be acquired by PNC, but was facing charges from the Justice Department. During November 2004, the regional Federal Reserve Bank required the bank to defer its dividend on all (trust) preferreds. In this case, because an acquisition was likely, the deferral only caused the preferred to trade to $100. Looking at more senior deliverables, based on the limited pricing available, it does not seem that any other deliverable Riggs bond was trading below par, so a seller of protection most likely would not have sustained a loss on deferral. For non-financials, the likely path of credit deterioration is very important. For most non-financials, expectations of a gradual credit deterioration will increase the chances of deferral without default over the case of a jump to default due to fraud or a major loss that results in strategic bankruptcy. New mandatory deferral structures may increase the likelihood of deferral without default. These structures have become popular because of the high equity content allocated by the rating agencies (often up to 75%.) For issuers that have preferred with mandatory deferral triggers outstanding, the PCDSSM premium should be higher than for issuers that do

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not. This premium should be limited, however, since the severe rating consequences of deferring a dividend will encourage companies to use the cure features to avoid deferral.
What Drives Preferred Recoveries (in Default and Deferral versus Deferral Only)?

If default and deferral are simultaneous, then preferred recoveries will be very sensitive to senior bond recoveries. Unless senior bonds are covered and suffer limited loss, preferred recoveries are likely to be close to zero. If senior bonds are covered, preferred recoveries may be higher than zero, particularly in the case of strategic or liquidity driven bankruptcies. In a recent study of defaults from 1982 to 2003, Moodys found that the median recovery rate for senior unsecured bonds was 31 percent, compared with only 9 percent for preferred stock.1 This is not surprising, given the relatively low standing of preferred stock in bankruptcy proceedings relative to senior debt. If deferral occurs without default, preferred recoveries will be driven by the severity of the credit situation. If the deferral occurs but credit quality is expected to improve quickly (as in the case of the Riggs Bank example above), losses on deferral should be limited. In the case of a deferral that precedes a default by a short period, losses will likely be substantial.
Figure 4. Effect on the PCDSSM Premium
PCDS Regulated Entity Deteriorating Non-Financial High Jump-to Default Probability Mandatory Deferral High Recovery Differential Low Recovery Differential
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Premium Lower

Higher

PCDSSM VALUATION VERSUS CASH Valuing PCDSSM versus cash securities is not as straightforward as with traditional CDS, because additional structural factors present in preferred securities drive the basis. For more information on the cash-CDS basis, see Explaining the Basis: Cash Versus Default Swaps, written by Quantitative Credit Research.
Tax Treatment. Many preferred securities benefit from the DRD2 and the QDI,3 while PCDSSM does not. This feature can cause cash to trade tighter than CDS. Having said this, most offshore investors are subject to 30% withholding tax on true preferreds, making them more likely to sell PCDSSM than buy cash.4 Extension Risk. While many cash preferreds have features that increase their spreads/coupons after a certain date, encouraging redemptions, most preferreds are

Recovery Rates on Defaulted Corporate Bonds and Preferred Stocks, 1982-2003, Moodys Investors Service, December 2003. DRD refers to dividends received deductible. Qualifying dividends received by U.S. corporations are usually 70 percent tax exempt. 3 QDI refers to qualifying dividend income. Qualifying dividends are taxed at a preferential rate for individuals. 4 Counterparties are advised to make an independent review and reach their own conclusions regarding the economic risks and benefits of a proposed transaction and the legal, credit, tax, accounting, and other aspects of such transaction in relation to their particular circumstances. Lehman Brothers enters over-the-counter derivatives transactions with counterparties on an arms length basis and does not act as an advisor or fiduciary to its counterparties except where a law, rule, or written agreement expressly provides otherwise.
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perpetual in nature and subject to extension on credit deterioration. As a result, they typically trade wide of PCDSSM, which is bullet risk in nature. Negative Rate and Spread Convexity. Most preferreds are callable and, as a result, have negative rate and spread convexity. Therefore, cash should, all other things being equal, trade wider than PCDSSM. Caps and Floors. Some preferred securities have caps and/or floors on coupons. This could have a positive or negative effect on the basis depending on the structure.

Figure 5. PCDSSM-Cash Comparisons

Call Date Bullet Dec-07 Nov-09 Feb-10 Dec-34 Cap/ Floor N Floor Floor N N Tax Treatment N/A DRD DRD N/A QDI LIBOR Spread 66 0 80 23* 115 Taxable Equivalent Spread* 66 255* 291* 23* 305 PCDS Spread 43 68 58 60 37

Ticker BAC FNM MER NRU BACR

Coupon 5.625 10yr CMT + 237 L+75 5.95 6.278

Maturity 3/8/35 Perpetual Perpetual 2/15/45 Perpetual

Step N N N N Y

Price $99.2 $55.5* $25.0* $24.5* $101.4

Basis -23 68 -22 37 -78

As of August 2, 2005. * For MER and NRU, par is $25, For FNM, par is $50. * LIBOR OAS is used for NRU and LIBOR spread-to-call is used for FNM and MER * Taxable equivalent assumes a 1.38x gross up for DRD-eligible investors

PCDSSM CAN BE USEFUL TO BOTH INVESTORS AND HEDGERS PCDSSM offers many advantages for investors looking to take preferred-level risk.
Bullet exposure without extension risk. All traditional preferreds are perpetual, and some are callable by the issuer. While trust preferred securities offer final maturities, most are callable, and some have a coupon reset feature in the event that the issue is not called. As a result of the call feature, many preferred securities offer limited upside while leaving uncertainty about the final maturity. By selling Preferred CDSSM, investors can eliminate these risks. Subordinate exposure without negative rate or spread convexity. The majority of preferreds issued have fixed-rate callable structures that are negatively convex to rates. PCDSSM allows investors to couple the preferred-level risk with a bullet fixed- or floating-funded asset to create positive credit and rate convexity. Tax Neutral for Offshore Investors. While investors located in non-tax-friendly countries face a 30% withholding tax on preferred stock, PCDSSM is not subject to this tax.5

Preferred CDSSM also offers advantages to investors looking to hedge or get short preferred level risk.

Counterparties are advised to make an independent review and reach their own conclusions regarding the economic risks and benefits of a proposed transaction and the legal, credit, tax, accounting, and other aspects of such transaction in relation to their particular circumstances. Lehman Brothers enters over-the-counter derivatives transactions with counterparties on an arms length basis and does not act as an advisor or fiduciary to its counterparties except where a law, rule, or written agreement expressly provides otherwise

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Efficient and available short. Approximately two-thirds of traditional preferred securities are NYSE listed. Shorting these securities can be difficult as a result of the NYSE locate to borrow rule. While some trust preferred securities can be shorted, there is always the potential for a short squeeze. By buying PCDSSM protection, investors can get short preferred-level risk without this short squeeze risk. In addition, call and reset features can make it tougher to hedge interest rate risk in most preferreds. PCDSSM eliminates these difficulties and lets investors take a pure credit view. Efficient hedge that may allow investors to maintain the tax benefits of cash preferreds. For the reasons mentioned above, PCDSSM also serves as an effective tool for investors looking to hedge preferred risk. In addition, in certain scenarios, investors can continue to receive the DRD or QDI while hedging their positions with Preferred CDS.6

PCDSSM RISKS Like all new derivative products, in addition to credit risk, PCDSSM brings with it a number of risks that must be considered before trading:
Documentation RiskAs with any new credit derivative product, PCDSSM documentation has not been tested through a deferral or default event. As a result, there is a risk that the contract may not behave as the counterparties expect. This is partially mitigated by the PCDSSM documentations being built on the well-seasoned CDS contract, which has gone through a number of credit events. Liquidity RiskAs with most new derivative products, PCDSSM has more limited liquidity than regular CDS markets. Having said that, as of press time, additional dealers have started making markets in PCDSSM. Investors can mitigate liquidity concerns by trading shorterdated maturities in higher-quality credits until the PCDSSM market becomes more seasoned. Cheapest to Deliver RiskAs a derivative instrument, PCDSSM is subject to many of the same risks as CDS when it comes to the choice of instrument a protection buyer wishes to deliver. In the case of a deferral trigger, it is important to note that buyers can deliver optionally convertible preferred stock of par value equal to that of the contract. They cannot, however, deliver mandatory preferreds. Buyers of PCDSSM can also deliver any instrument more senior in the capital structure in the case of a default or deferral trigger, just as with CDS. Squeeze RiskFor buyers of PCDSSM protection, an important risk to consider is that of deliverable squeeze risk. Deliverable squeezes occur when buyers of protection scramble for limited deliverable securities following a trigger event. For issuers with limited preferred deliverables outstanding, this is mitigated somewhat by allowing delivery of more senior obligations in the case of deferral, as is the case in CDS.

STRUCTURES FOR INVESTMENT Preferred CDSSM is a building block for many other types of investment structures. All of these can be tailored to meet an investors investment needs.
6 Counterparties are advised to make an independent review and reach their own conclusions regarding the economic risks and benefits of a proposed transaction and the legal, credit, tax, accounting, and other aspects of such transaction in relation to their particular circumstances. Lehman Brothers enters into over-the-counter derivatives transactions with counterparties on an arms length basis and does not act as an advisor or fiduciary to its counterparties except where a law, rule or written agreement expressly provides otherwise

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Credit-linked notes provide bullet preferred exposure for investors who cannot use derivatives. First-to-Default Baskets provide enhanced yield for investors looking to take leveraged exposure to preferreds. Synthetic CDOs. It is likely that PCDSSM will be included in synthetic CDOs in the future. Given current spreads on some names, their inclusion in synthetic CDOs appears to be attractive from a ratings efficiency perspective.

KEY PCDSSM TECHNICALS As with the CDS market a few years ago, technicals will affect PCDSSM spread levels and create buy and sell opportunities in the market for investors with fundamental credit views. Key PCDSSM technicals are likely to be the same ones observed in the CDS market:
Convert Hedging. Many convertible securities are issued at the preferred level. Hedging of these securities will push spreads wider. New Issuance/Dealer Hedging. Dealer hedging of new issues and secondary risk will also drive spreads wider Synthetic CDO issuance. As dealers issue synthetics CDOs and first-to-default baskets with PCDSSM, they sell protection to hedge their positions. This technical should drive spreads tighter.

CONCLUSION In the past, the preferred market has been driven by issuers needs. The bullet maturity, lack of tax penalty, and the simplified structured of PCDSSM will make this market more homogeneous and allow many more investors to participate. This growth will create new trading opportunities in the preferred market, similar to those present in the senior market, including basis, curve, and senior-preferred trades. Trading is likely to focus on higherquality names in which investors are more comfortable stepping down the capital structure and names that are more liquid in the cash preferred market, as dealers and investors may need to hedge risk. Increased issuance of leveraged structures such as first-to-default baskets will likely cause compression and curve steepening as investors dip their toes into shorter maturities.

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The views expressed in this report accurately reflect the personal views of Ashish Shah, the primary analyst(s) responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst(s) compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 44-(0)207-102-8035). Lehman Brothers Inc. and any affiliate may have a position in the instruments or the companies discussed in this report. The firms interests may conflict with the interests of an investor in those instruments. The research analysts responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work, firm revenues, including trading, competitive factors and client feedback. Lehman Brothers usually makes a market in the securities mentioned in this report. These companies are current investment banking clients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.
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