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CDO Summit 2006

Workshop II: linderstanding amllJsing CDS in a CDO Strategy
Monday, June 19th, 2006,

Anthon)' R. G. Nolan
Partner, Goodwin IProcter LLP, New York

I) The Structure of ISDA Swap Documentation

a) ISDA Documentation

(i) ISDA documentation architecture; 2002 v. 1992 master

(ii) Events of Default, including:

1. Bankruptcy

2. Default under Specified Transaction

3. Cross Default (specified indebtedness; threshold; X-acceleration
option)

(iii) Termination Events, including:

1. Credit Event upon Merger
2. Automatic Early Termination
3. Additional Termination Events

(iv) Payments on early termination

1. Payment following event of default:
2. Payment following termination event (One and Two Affected
Parties)

(v) Credit Support Annex and Credit Support Documents

(vi) Miscellaneous Issues

I. Netting
2. Effect of designation as a "multi-branch party"
 3. Documentation delivery requirements
4. Assignment

5. Set-off

6. Treatment of swaps under the Bankruptcy Code and FIRREA

b) Mark-to-market credit support documentation

2) Credit Default Swaps - Overview of 2003 Credit Derivatives Definitions

a) What does CDS do? Illustration of trade, terminology

(i) Bilateral agreement

(ii) Confusing terminology

(iii) Disaggregate credit risk from interest rate, currency risk etc.

(iv) Five Basic Terms for CDS contracts address 4 basic concerns: Who,
What, Where, When and How Much

I. Whom are you buying protection on?

A. Reference entity Whom are you buying/selling
protection on? i.e. whom is the
buyer shorting?
B. Reference Obligation, other Obligations, guarantees What parts of the capital structure
are you buying/selling protection
on?

2. What are you buying protection against

A Credit Events What causes of credit impairment
are you buying/selling protection
against?
3. Where is the reference entity?

A. Transaction Type Different conventions for

Obligations, Credit Events and
settlement depending on which
market

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4. } does protection expire?
When} are notices required to be given?
} are premium payments made?
A. Maturity 5 year typical; Scheduled Maturity
Date GMT, not subject to BD
conventions

B. Fixed Rate Payment Dates Usually quarterly

C. Notice deadlines Notices must be give by 4PM in
Calculation Agent City

5. } protection is being sold?

How Much}
} does it cost?
A. Notional Amount Risk exposure
B. Price Fixed Rate and Up-front Premium or
Discount

b) Reference entity

(i) Reference entity. It is critical that the exact legal name ofthe Reference
Entitybe given. Consider using Edgar, state registries.

(ii) Successors. Pursuant to § 2. I of the 2003 definitions, Reference Entity

includes any successors. Therefore it is not necessary 0 specify
successsors. Section 2.2 of the 2003 definitions specifies a method for
determining successors for reference entities under a wide variety of
fact patterns

(iii) Sovereign Successors - successor is defined broadly as any direct or

indirect successor to the reference entity irrespective of whether such
successor assumes any of the Obligations of the reference entity.

(iv) Timing peculiarity. Following a succession event the calculation agent

is required to determine which entity or entities is the successor entity
based on the Best Available Information, which is obtained through
publicly available regulatory filings or, if not available, the best publicly
available information. However, information that is made available
more than 14 calendar days after the succession event shall not
constitute Best Available Information, even if it corrects earlier
inaccurate information.

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c) Obligations.

(i) Reference Obligations specified in confirm

1. Unique qualities

2. Taken into account both for determining whether a Credit Event has
occurred and for settlement

3. Guarantee restrictions are irrelevant

4. RO determines valuation in cash settlement and Deliverable

Obligation in physical settlement where "Reference Obligation only"
is specified as the Deliverable Obligation

5. It is necessary to specify a Reference Obligation only with respect to

cash-settled trades for the purposes of valuation. It is not necessary for
physically settled trades, but it is the standard market practice.

6. Obligations that are subjectto Obligation Category and Obligation

Characteristics specified in the confirm --tests are applied as of the
date of the Credit Event.

(ii) Obligation Meeting Specified Categories and Characteristics:

I. Obligation Categories: Payment, Borrowed Money, Bond,

Reference Obligation Only, Bond, Loan, Bond or Loan.

(1) Borrowed money is market standard in North America, Europe,

Japan

(2) Bond or Loan is market standard in non-Japan Asia

(3) Bond is market standard in Latin America

2. Obligation Characteristics: Not Subordinated, Specified Currency,

Not Sovereign Lender, Not Domestic Currency, Not Domestic Law,
Listed and Not Domestic Issuance

(1) Not Subordinated --If a Reference Obligation is specified, the Not

Subordinated characteristic relates to the Reference Obligation.
Otherwise, if a Reference Obligation is not specified, Not
Subordinated relates to all unsubordinated borrowed money
Obligations of the Reference Entity.

(2) Specified Currency - standard specified currencies include Euro

and currencies of Canada, Japan, Switzerland, UK and US

(3) Not Sovereign Lender - No Paris Club debt

4
 (4) Not Domestic Currency - Domestic currency is specified as such
in the confirm. If no Domestic Currency is specified § 2.29
specifies the currency of the Reference Entity's jurisdiction as a
fallback Domestic Currency fallback. May 2003 Supplement (in
guarantee context) indicates that the Euro and the USD will not be
considered Domestic Currency.

(5) Not Domestic Law -- May 2003 Supplement (in guarantee context)
indicates that NY and English law will not be considered Domestic
Law.

(6) Listed --

(7) Not Contingent - in 1999definitions, excluded from 2003

definitions, but retained as Deliverable Obligation Characteristic.

--
(8) 2.I4( c) - opportunity to add other Obligations Taken into
account only for purposes of determining whether a Credit Event
has occurred, not for purposes of settlement.

(iii) Not Excluded Obligations. Parties must specify any excluded Obligation.

(iv) Treatment of Guarantees: There are two choices for how a particular
transaction relates to Obligations guaranteed by the Reference Entity.

I. If the confirm specifies "Qualifying Affiliate Guarantees only" (or is

silent), Obligations will include only Qualifying Guarantees that are
downstream guarantees of Obligations of entities that are 50% or more
subsidiaries of the reference entity. Under the May 2003 supplement the
downstream ownership is measured at the time that the guarantee is
issued; otherwise, ownership is measured at the time of the event giving
rise to the Credit Event.

(I) If "All Guarantees" is specified in the confirm, then any

Qualifying Guarantee of the Reference Entity will be included as
an Obligation if it satisfies the following requirements confirm

(2) Market convention: NA - all guarantees is not applicable.

Everywhere else - all guarantees ~ applicable.

2. Qualifying Guarantee requirements:

(I) Must be in writing.

(2) No surety bond, financial guarantee, letter of credit or similar

instrument;

5
 (3) Obligation of the Reference Entity under the guarantee ay not be
reduced other than by payment

(4) Benefit of the guarantee must be delivered along with the

Underlying Obligation.

(5) Obligation Characteristics of Underlying Obligation and/or

Guarantee.

(6) Under the May 2003 supplement, both the Qualifying Guarantee
and the Underlying Obligation must satisfy the following
Characteristics if they are specified as applicable: Not
Subordinated, Specified Currency, Not Sovereign Lender, Not
Domestic Currency and Not Domestic Law.

(7) If the May 2003 Supplement is not applicable, the Qualifying

Guarantee must satisfy the Not Subordinated characteristic.

d) Credit Events - i.e. What events are you buying protection against?

] . Credit Events covered by the CDS are those that occur with respect to any of
the Obligations that occur within a specified period of time and that meet
specified criteria.

2. Credit Events must occur between ]2:0] pm GMT on the effective date of the
trade and] ]:59 pm GMT on the Scheduled Termination Date - not subject to
business day convention
3. What are the Credit Events?

]. Bankruptcy.

(i) Standard definition

(ii) 30-day period for stay/dismissal of involuntary petition

2. Failure to Pay.

(i) This includes the concept of a payment not being made in excess
of the Payment Requirement when and where due before the
expiration of any applicable or deemed grace period.

(ii) Payment Requirement- default is $]MM

(iii) Failure to pay is subject to any grace period specified in the

underlying Obligation (as of the trade date or the date of issuance),
but not beyond the Scheduled Termination Date unless grace
period extension is applicable.

6
 (iv) If Grace Period Extension is applicable-
I. If the underlying Obligation does not provide for a grace
period, a grace period will be added on equal to the lesser
of (a) 3 BD and (b) the number of days between the
potential Failure to Pay and the Scheduled Termination
Date

II. If the potential Failure to Pay occurred before the

Scheduled Termination Date but the contractual grace
period extends beyond the Scheduled Termination Date, the
protection will remain outstanding for the lesser of the full
contractual grace period or the period specified in the
confirm, with a default of 30 days if the confirm does not
specify a period.
III. The notice delivery period is extended until 14 days after
the grace period extension date.
IV. Grace Period Extension is not market convention except for
Latin America.

3. Restructuring

(i) What is a Restructuring

i. Amendment of an Obligation (i) in a manner that binds all

holders and (ii) that results in a reduction or postponement of
payment, a change in ranking resulting in the subordination of
the Obligation to other Obligations, a change in the currency of
payment other than to a Permitted Currency where (iii) such
change results from a deterioration in the creditworthiness or
financial condition of the reference entity and does not arise
simply as a result of tax adjustments or other technical
adjustments arising in the ordinary course of business or
accession to the Euro.

ii. For Qualifying Guarantees the relevant event or amendment

must occur with respect to the Underlying Obligation, but the
deterioration of creditworthiness is measured with respect to
the guarantor.

iii. Limitation to Multiple Holder Obligations.

I. The amendment described above is not a Restructuring

unless either (i)the Obligation is a Multiple Holder
Obligation or (ii) Multiple Holder Obligation is
specifically made inapplicable.

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 2. Multiple Holder Obligation:

Held by 4 or more non-affiliated holders;

66 2/3% consent is required for the

amendment

May 2003 Supplement - Bonds are not MHO.

(ii) Four choices for restructuring:

i. Restructuring not applicable. Banks buying protection

typically must have restructuring in order to obtain
regulatory capital relief under Basel II.
ii. Full restructuring applicable,
iii. Modified Restructuring applicable -- Restructuring
Maturity Limitation and Fully Transferable Obligation
Applicable (North American standard),
IV. Mod Mod Restructuring applicable - Modified
Restructuring Maturity Limitation and Conditionally
Transferable Obligation Applicable.

(iii) Points about Modified Restructuring

i. Background: Restructuring controversy following Cisco

and other restructurings. Difference between NY and
London market/ banks v. broker dealers.

ii. The three variants of Restructuring do not affect whether

the Credit Event has occurred but affect what Deliverable
Obligations can be delivered.

iii. Mod R and Mod Mod R are applicable only if:

Physical settlement applies

Restructuring is the only Credit Event

The Buyer invokes it

4. Obligation Default/Obligation Acceleration

(I) Obligation Acceleration = "have become due and payable"

(2) Obligation Default = "capable of being declared due"

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 (3) Must exceed Default Requirement - standard is $]MM

(4) Exclude Failure to Pay

(5) Very rarely used, except for Obligation Acceleration in the

emerging market context.
5. Repudiation/moratorium.

]. Used for sovereigns, but very rarely used for non-sovereigns.

2. Two elements:

J. Reference Entity or governmental authority disaffirms,

challenges validity of or imposes a moratorium on
Obligations not less than the Default Requirement
("Potential Repudiation / Moratorium") and
II. Failure to Payor Restructuring occurs in any amount
with respect to any Obligations on or prior to the date
that is 60 days after the Potential Repudiation /
Moratorium, or in the case of bonds, the later of 60
days and the next scheduled payment date.
Ill. Repudiation / Moratorium Extension extends the
period for giving notice of the occurrence of a
Repudiation / Moratorium Credit Event. However,
note that this extension still requires Buyer to give
notice within ]4 calendar days after the scheduled
termination event.

e) Settlement terms

(i) Settlement method: The parties must specify cash or physical settlement -
although the 2003 definitions cover both types of settlement they do not
provide a fallback settlement method.

(ii) Conditions to settlement -- Upon the occurrence of a Credit Event and

satisfaction of all Conditions to Settlement the parties shall perform their
respective Obligations in accordance with the applicable settlement method.
Conditions to settlement are satisfied by the following:
1. Event determination date

(I) Credit Event Notice effective and notice of publicly

available information (if applicable) must be effective no
later than 14 calendar days after (i) Scheduled Termination

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 Date, (ii) grace period extension date (if applicable) and
(iii) repudiation moratorium extension date (if applicable)

(2) Credit Event Notice must relate to a Credit Event that

occurred before midnight GMT on the Scheduled
Termination Date
~Des
2. for physical settlement only, notice of physical settlement must
also be given within 30 days after the event determination date
3. Notices are effective at 4PM in the Calculation Agent City.

(iii) Settlement terms for cash settlement:

1. Cash Settlement Amount

(1) The Cash Settlement Amount is equal to the greater of (a) zero
and (b) the reference price of the valuation Obligation (usually
par) and the final price obtained through valuation of the
valuation Obligation.

(2) Settlement occurs on the Cash Settlement Date, which s a

specified number of days following the determination of the
final price. If no period is specified in the confirm the Cash
Settlement Date is 3 BD following the determination of the final
price.
2. Valuation Date and Time.

(I) Ifno Valuation Method is specified in the confirm, the

fallback provision is for the first Valuation Date to occur 5
BD following satisfaction of all Conditions to Settlement,
with subsequent Valuation Dates occurring every 5 BD
after the first Valuation Date and with 5 Valuation Date in
total.

(2) If no Valuation Time is specified, the fallback is II :00 am

in the principal trading market for the Reference
Obligation.

(3) Note Fitch study about recoveries and length of valuation

periods in index Credit Events.

3. Valuation Method

(I) Elections for Valuation Method depend on whether there is

one Reference Obligation or multiple Reference

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 Obligations and whether valuations are scheduled to take
place on one date or on several dates.

(2) Where there is a single Reference Obligation, Valuation

Method is typically Highest for single Valuation Dates and
Average Highest if there are multiple Valuation Dates.

(3) Highest means the highest quotation obtained, and average

highest means the average of the highest quotation obtained
on each Valuation Date.

(4) Valuations are subject to the "cheapest to deliver"

convention. Unless otherwise specified in the confirm,
quotations are obtained on the basis of "bid" only.

(iv) Settlement terms for physical settlement

a. Physical settlement period - the longest number of days following the

delivery of the NOPS that is customary in the market to settle any
Deliverable Obligation being delivered. The NOPS must be delivered
within 30 calendar days of the Event Determination Date.

b. Portfolio. The notice of physical settlement must specify if the

Deliverable Obligations to be delivered included accrued but unpaid
interest. The fallback approach is to exclude accrued interest.

c. Settlement Currency. Unless otherwise specified, the fallback

settlement currency is USD or Euro, and the calculation agent is
required to select the rate source in a commercially reasonable manner
after consultation with the parties. The FX rate is set on the date of the
last notice of physical settlement.

d. Buy-in of Undelivered Bonds

(I) 5-day ping pong - seller gives 2 BD notice of buy-in

specifying bonds to be bought in, principal amount of same,
date of buy-in Seller has 5 BD to execute the buy-in by getting
quotes from 5 dealers and taking the lowest price. If Seller has
bought in bonds, it Seller pays buyer difference between
notional amount and price for which it bought the bonds. If
seller cannot buy-in buyer's right to deliver the bonds is
reinstated for 5BD. There is no corresponding provision in
1999 definitions

(2) This process continues indefinitely under the 2003 definitions.

This is market for contracts with North American reference
entities. European names have a 60 day cap on buy-in.

11
 (3) 60 day cap on settlement.

Background - relatively greater importance of CLN market

in Europe and Asia. CLNs are a major product area in
Europe and Asia because the corporate bond market is not
as broad or as deep as it is in the US and CLNs provide
arbitrage opportunities and synthetic investment
opportunities.

Indefinite buy-in procedures pose challenges for CLN

structures because they make it difficult for the structurer /
buyerto manage its risks given that the CLN itself has a
finite life.

Market convention in Europe and Asia is to specify a 60

BD cap on settlement, with the contract terminating and the
part of the contract that is not settled by the 60th day
effectively expiring worthless notwithstanding the
occurrence of a Credit Event

(4) Alternative Settlement Procedure Relating to Loans Not

Delivered

If loans specified in the NOPS are not delivered 5 SD after

the Physical Settlement Date because the consent to
transfer could not be obtained from the borrower,
provisions are made for delivery of alternate bonds or
loans.

At any time later than 20 SD after Physical Settlement

Date, if loans have not been delivered the seller can require
the buyer to deliver a particular bond (transferable and not
bearer) or loan (assignable) provided that it complies with
the Deliverable Obligation characteristics
Seller can source and select the bond or loan to be
delivered as long as it can identify a willing seller of the
instrument.

There is no time cap on this alternative settlement

procedure.

(v) Deliverable Obligations

]. Determines what is Deliverab]e in physical settlement or what is used

as the basis for valuation in cash settlement following the occurrence ,
of a Credit Event with respect to Obligations..

]2
2. Generally similar methodology for determining "Obligations" that can
be affected by Credit Events.

3. Deliverable Obligation Categories are the same as the Obligation

Categories

4. Deliverable Obligation Characteristics are broader than Obligation

Characteristics: Include the same characteristics and also include the
following: Not Contingent, Assignable Loan, Consent Required Loan,
Direct Loan Participation, Transferable, Maximum Maturity,
Accelerated or Matured and Note Bearer.

I. See description of Obligation Characteristics above.

2. Not Contingent - This focuses on the relevant Obligation

having an outstanding principal balance that cannot be
reduced other than by payment. If a Deliverable Obligation
has a contingent return above par, you ignore the
contingent amount for purposes of determining the
principal amount of the Deliverable Obligation.
3. Assignable Loan - A loan that may be assigned or novated
to commercial banks or financial institutions outside of the
initial syndicate without consent of the borrower.

4. Consent Required Loan -- A loan that may be assigned or

novated to commercial banks or financial institutions
outside of the initial syndicate with the consent of the
borrower or agent. Not permitted for Mod R.

5. Direct Loan Participation -- A loan in which the Seller may

acquire a participation interest from the Buyer or from a
Qualifying Participation Seller.
6. Transferable - An Obligation is transferable if it can be
transferred to institutional investors without restriction
other than those arising under Rule 144A, Regulation A or
permitted investment rules.
7. Maximum Maturity - If this applies the maturity must be
specified in the confirm. No fallback is provided. For Mod
R and Mod Mod R the ability to specify a maximum
maturity may be limited by Restructuring Maturity
Limitation.

8. Accelerated,or Matured - All amounts owing under the

Obligation other than default interest will have become due
and payable on or prior to the Delivery Date.

I3
 9. Not Bearer - Not a bearer instrument unless interests are
cleared through a an internationally recognized clearing
system.

5. Sovereign Restructured Deliverable Obligations. An obligation of a

sovereign Reference Entity that is restructured pursuant to a
Restructuring Credit Event qualifies as a Deliverable Obligation so
long as it satisfied the Deliverable Obligation Category and
Characteristic requirements immediately prior to the effectiveness of
the restructuring.

6. Additional restrictions on Deliverable Obligations if Mod

Restructuring or Mod Mod R applies:
1. Rationale is to limit the "cheapest to deliver" option.
2. For Mod R (i.e. New York style):

30-month maturity limitation --The maturity of the

Deliverable Obligation cannot be more than 30
months after the Scheduled Termination Date

Fully Transferable Loan -- the Deliverable

Obligation must be fully transferable to "eligible
transferees" (i.e. institutional investors) without any
consent required

No Consent Required Loans allowed.

3. For Mod Mod R (i.e. European style)

--
60-month maturity limitation The maturity of the
Deliverable Obligation cannot be more than 30
months after the Scheduled Termination Date

Conditionally Transferable Loans --- Loan must be

transferable to any bank, financial institution or
other entity which is regularly engaged in or
established for the purpose of making, purchasing
or investing in loans, securities and other financial
assets.

Consent Required Loans are OK as long as consent

may not be unreasonably withheld.

4. Restrictions are applicable only if (i) Physical settlement

applies, (ii) restructuring is the only Credit Event and (iii)
the buyer invokes it.

]4
(vi) Recent Developments Affecting Settlement

I. ISDA Net Physical Settlement Template

(1) ISDA is preparing a draft Net Physical Settlement

Supplement to the 2003 ISDA Credit Derivatives
Definitions.

(2) The protocol wiII be used on an interim basis for

any Credit Events that occur globaIly, as discussed
more fuIly below.

(3) The proposed protocol and auction methodology

wiII be structuraIly identical to the past three North
American credit derivative index protocols. The
notable difference is that single name trades wiII be
covered going forward, rather than just index trades
as in the past protocols. The proposed protocol wil\
permit entities that desire physical settlement to
submit market orders. In addition, the proposed
protocol wil\ allow any entity that desires cash
settlement to cash settle their trades at the Final
Price generated by the auction. This approach is
different than that under net physical settlement
where an entity could request cash settlement, but
was not guaranteed to receive it unless its position
was less than $IMM.

(4) ISDA has indicated that once ISDA membership

has had an opportunity to review and comment on
the proposed protocol, it wiII be utilized for at least
one or two Credit Events to determine how the
inclusion of single name trades impacts the
calculation ofthe Open Interest, settlement in
general and other related issues. Following this,
members wil\ be asked to indicate whether they felt
that the approach worked and if so, ISDA will then
convert this approach into either a Supplement to
the 2003 ISDA Credit Derivatives Definitions or
wil\ proceed to revise the 2003 ISDA Credit
Derivatives Definitions in order to produce a new
definitions booklet.

2. Recent Second Circuit decision in Aon v. Societe Generale

(1) The Southern District Court of New York in February ruled that
the French bank Societe Generale ("SG") as protection seller in

15
 a CDS transaction, should pay the protection buyer and plaintiff
Aon Financial Products, A division of Aon Corp., $] 0.] million
despite its failure to deliver bonds to SG. According to industry
professionals, the decision was based on an entirely separate
derivatives contract and viewed SG as more of a guarantor than
a CDS party.

(2) Facts --- In ]999, Aon had purchased $10 million in credit
default protection from SG on $500 million of debt issued by the
Republic of the Philippines. Aon did so in order to hedge a
separate transaction in which it sold $10 million in credit
protection to Bear Steams on a surety bond issued by the
Philippine Government Service Insurance System. According to
court filings, Aon argued that because the SG transaction was
made in connection with the Bear transaction in order to hedge
against potential losses, the SG swap therefore guaranteed
payment if losses were incurred in the Bear transaction - despite
there having been two completely different CDS contracts. "The
basic error," according to SG's appeal, was "the finding that the
two swaps hedged against the same risk on the same terms.

(3) SG filed an appeal to the decision in March, and oral argument

is expected to begin in late August or September. Some market
participants are concerned because they fear that a complete
misunderstanding by a district court judge of credit derivatives
contracts and settlement mechanics is causing some to question
the clarity of credit default swap documentation.

(4) ISDA has filed an amicus brief in the case arguing that the court
erred in two respects. The first error aIleged was in finding that
SG was liable to pay Aon based on the derivatives transaction
Aon had with Bear even though the only material similarities
between the transactions was that they were each credit default
swaps with the same notional amount. The second error aIleged
is that, after finding SG liable to pay Aon in the CDS, the court
ignored the contract's settlement provisions. The CDS provided
for physical settlement, but SG was ordered to pay Aon the fuIl
principal amount of the underlying security, even though the
deliverable obligation was never delivered by Aon.

(5) In its amicus brief ISDA has stated that the District Court's
errors in this case are of such a fundamental nature that they cast
significant doubt on the operation of credit default swap
contracts because the rulings are directly contrary to the
-- settlement mechanics set forth in ISDA's standard
documentation that is used in this $] 7.1 trillion market. If this
decision is left to stand, it could weaken confidence in credit

]6
 default swaps by exposing participants in the swaps market to
legal uncertainty with respect to settlement obligations and
could undermine the importance of CDS as a credit risk
mitigant.
f
r/<..\.'(o{~l \ ~ ~f~
3) Asset-backed CDS, including the various forms of pay-as-you-go confirmations
LA./-c.L
a) Drivers of growth of ABS CDS market include (i) Increasing demand for
SF assets, (ii) Constraints of the cash market and (iii) investor demand for
CM~ / fk ]>

unfunded exposure to asset classes or sectors.

J ")' , ~, , r
L-" )) (~~." t. v""'"'
b) Corporate and ABS CDS are very different because of the differences in
( p.h\~' )
the credit risks of the reference entities and Obligations. For example,
(
bankruptcy and restructuring are not meaningful risks for ABS. In ,~. r. ,
addition, settlement conventions for corporate CDS, such as assuming y ot~ Uv- ~ l-,--,'U\ 1-4 ( "'"

fungibility and liquidity of Deliverable Obligations, are not appropriate to

ABS CDS.

c) Owing to the complex cash flow and structural features of asset-backed

securities, ABS CDS must reference specific tranches of specific
Reference Obligations. The nuances of cash flow dependency in asset-
backed securities transaction may result in the possibility of distressed
scenarios where the cash flows of the asset-backed securities may be
affected without triggering an event of default.

(6) E.g. in asset-backed securities transactions it is typical for

the Failure to Pay principal not to give rise to a default until
the legal final maturity date.

(7) E.g. in , residential and commercial mortgage backed

securities generally pay through all available cash flow, but
provide that if there is not enough cash flow to pay the full
coupon, unpaid interest will be deferred without there being
an event of default.

(8) Often, where the issuer is a grantor trust or a partnership for

tax purposes, losses on the underlying pool of assets will be
passed directly to investors, giving rise to realized losses
and writedowns.

(9) Other features that are important to asset-backed securities

but that are not reflected in the standard Credit Events for
corporate names include rating downgrades, extension of
maturity and "soft bullets" that trigger step-ups in the
interest rate if the underlying securitization has not been
redeemed in a "clean-up call" in accordance with its terms.

17
 d) Development of the forms

1. Initially the ABS CDS template with cash or physical settlement

similar to corporate CDS was used, primarily in Europe. This
modified Credit Events to reflect the unique risk characteristics of
ABS, but settlement was very similar to settlement of corporate
CDS.

2. The pay-as-you-go format has emerged as a global standard. At

the heart of the PAUG concept are floating payments made by the
seller and the buyer resulting from floating amount events,
consisting of writedowns, principal or interest shortfalls and
Failure to Pay principal before the final amortization of the
Reference Obligation.
3. The currently used form of PAUG confirm has been published by
ISDA in January 2006. It makes minor changes to the previous
form, which was published in June 2005. Another form has been
promulgated by a group representing the end-user community.
4. The PAUG for of credit default swap combines certain features of
corporate CDS physical settlement with the two way cash
settlement features of the PAUG,.

a. The protection buyer assumes the risk profile of a short

position in a Reference Obligation consisting of a particular
asset-backed security. The seller assumes the risk profile of a
long position in the Reference Obligation.

b. The buyer pays a fixed premium and it receives floating

payments in the event of writedowns, principal shortfalls or
interest shortfalls on the Reference Obligation. If any
writedowns, principal shortfalls or interest shortfalls are
subsequently reversed, the buyer pays an additional fixed
amount in respect of such reimbursements.

c. The seller pays floating payments in the event of writedowns,

principal shortfalls or interest shortfalls. It receives the fixed
premium and any additional fixed amounts if any writedowns,
principal shortfalls or interest shortfalls are subsequently
reversed.

5. The PAUG form was initial developed for use with Reference
Obligations backed by home equity loans. Recently templates
have been modified for used with CMBS and with other asset-
backed securities, including CDOs. -"..
-'!r;-~

18
iv. Credit Events and Floating Amount Events
a. Floating amount events are intended to capture any default or non-
default events that affect the cash flow ofthe Reference
Obligation. Some floating amount events can also give rise to
Credit Events at the option of the buyer.

b. The floating amount events are:

(I) Writedown -

(a) Writedown refers to a reduction of the outstanding

principal amount of the Reference Obligation as
defaulted loans are liquidated and losses are realized
and allocated to the bonds in the applicable
securitization.

(b) If the securitization does not provide for writedowns, an

implied writedown may be calculated based on
inferrred undercollateralization of the Reference
Obligation based on the amount of any shortfall
between the pool balance backing the Reference
Obligation and the aggregate principal balance of all
securities backed by the same asset pool and ranking
pari passu with or senior to the Reference Obligation.

(c) At the buyer's option writedown can be a Credit Event

or a floating amount event. As a Credit Event it permits
the buyer to demand physical settlement of all or part of
the CDS.

5. Principal shortfall / Failure to Pay principal

(a) This occurs if the principal of the Reference

Obligation is not paid of in full by its legal final
maturity date or the earlier date when the Reference
Obligation is amortized in full by the liquidation
and distribution of all of the underlying collateral.

(b) This is equivalent to a principal default of an asset-

backed security.

(c) At the buyer's option principal shortfall / Failure to

Pay principal can be a Credit Event or a floating
amount event. As a Credit Event it permits the
buyer to demand physical settlem~nt of all or part of
the CDS.

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 6. Interest shortfall

(a) This occurs if the interest on the assets backing the

Reference Obligation is insufficient to pay the
interest that has accrued on the Reference
Obligation. This may be caused by a distress
situation with respect to the Reference Obligation or
may arise because the Reference Obligation is
subject to an "available funds cap" or "weighted
average coupon cap."

(b) The dealer form allows the parties to select the

"weighted average coupon cap" ("WAC Cap") as
being applicable or not applicable.

i) If WAC Cap does apply, the expected

interest is calculated after giving effect to
the "weighted average coupon cap"
provisions of the securitization documents
for the Reference Obligation, and the
seller does not compensate the buyer for
any interest shortfall caused by such a cap.

ii) On the other hand, if WAC Cap does not

apply to the CDS, then the expected
interest is calculated on the interest
entitlement of the Reference Obligation
without taking the "weighted average
coupon cap" mechanism into account, and
consequently buyer is fully compensated
for an interest shortfall caused by such a
cap, subject to the option.

iii) Under the end-user form WAC Cap is

automatically applicable.

(c) In addition to Wac Cap, the dealer form ofPAUG

swap offers three options for quantifyingthe
amount of protection that the seller will provide to
the buyer for interest shortfalls. These are: (i)
Fixed Cap Applicable; (ii) Variable Cap Applicable;
(iii) Not Applicable.
A. Fixed Cap: If Interest Shortfall Cap is
applicable and the interest shortfall cap basis
~ is Fixed Cap, the seller will be required to
cover interest shortfalls in anamountup to

20
 the fixed premium. Practically, this means
that the seller will not be required to go out
of pocket to cover this because the buyer
will simply offset the interest shortfall
amount from the fixed premium that it pays.
B. Variable Cap: If Interest Shortfall Cap is
applicable and the interest shortfall cap basis
is Variable Cap, the seller will be required to
cover interest shortfalIs in an amount up to
the sum of (a) the fixed premium plus (b)
LIBOR. This can require the seller to come
out of pocket to provide protection to the
buyer because the covered amount of
interest shortfalls could exceed the fixed
premium.
c. Cap Not Applicable. IfInterest Shortfall
Cap is not selected,the seller is liable for the
entire amount of an interest shortfall.

(d) Market preference appears to be for Interest

Shortfall Cap - Fixed Cap to be applicable. This
appears to reflect the difficulty that sellers have of
determining the risk, and thus accurately pricing,
the Variable Funds Cap and the No Cap, which
expose the seller to varying levels to interest rate
risk and could result in the seller having to come out
of pocket to pay floating amounts when there has
not been any credit impairment of the Reference
Obligation.

3. Distressed ratings downgrade is a Credit Event but not a floating

amount event.

a) If distressed ratings downgrade is applicable and is the only

event, and if the buyer gives a notice of physical settlement,
then the entire transaction must be physically settled.

b) A distressed rating is triggered by the downgrade of the

Reference Obligation below "CC" or its equivalent by
S&P, Moody's and/or Fitch or a withdrawal of such rating,
and such rating has not in either case not been reinstated
within five business days of such downgrading or
withdrawal (a "distressed ratings downgrade"). ~"

21
 c) Notwithstanding the foregoing, the withdrawal of a rating
of a Reference Obligation that was rated investment grade
by the relevant rating agency will not constitute a distressed
ratings downgrade if the Reference Obligation is assigned
a rating not less than CCC+ or its equivalent by that rating
agency within three calendar months of the withdrawal.

d) Market participants may wish to disapply distressed ratings

downgrades for several reasons.

i. Footnote II of the dealer form ofPAUG swap indicates

that parties may wish to disapply the distressed ratings
downgrade Credit Event where the Reference
Obligation is a commercial mortgage backed security.
The rationale for this is that by excluding this Credit
Event traders can avoid introducing interest-rate risk to
a trade that is priced exclusively on the basis of credit
spread risk. This is less likely to be a concern in the
case of subprime residential mortgage-backed
securities, which have tended to be popular for
inclusion in COO vehicles in recent years.

ii. Fitch has expressed its preference that distressed ratings

downgrade not be included as a Credit Event in pay-as-
you-go credit default swaps that are included in CDOs,
citing both the undesirability of exposing the rated
notes to contingent interest rate risk exposure and the
other inherent risks that are inherent with taking
physical delivery of a fixed asset. See Fitch Ratings,
"Fitch Examines Effect of Pay-As-You-Go (COO and
Single Name)", November 11,2005.
4. Buyer's settlement options

(I) If a floating amount event that is also a Credit Event (i.e. a

writedown, principal shortfall or Failure to Pay principal)
occurs with respect to the Reference Obligation, the buyer
has the option to treat those amounts as Credit Events or as
floating amount events.

(2) If it treats such event as a Credit Event it can give a notice

of physical settlement with respect to all or part of the
swap. If and to the extent that the transaction is not
physically settled with respect to such event, the seller is
required to make a floating payment to the buyer based on
". the writedown or the shortfall, scaled by the Applicable
Percentage in order to account for any difference between

22
 the notional amount of the ABS CDS and the size of the
Reference Obligation.

(3) The "Applicable Percentage" is the ratio between the initial

face amount of the Reference Obligation that is referenced
for purposes of the trade and the original principal amount
of the Reference Obligation, in each case as scaled down to
reflect the outstanding principal amount of the Reference
Obligation at the effective date of the trade (the "initial
factor"). The percentage is adjusted over time to take into
account the principal amount of the Reference Obligation
that is delivered in physical settlement of the credit default
swap, as adjusted to reflect the amount (the "relevant
amount") of any effective reductions in principal that have
not been timely reflected in a servicer's report and also to
take into account fungible issuances and redemptions of the
Reference Obligation.

f) Events Affecting the Fixed Amount

I. Fixed Amount; Coupon Step-up

(1) As in any credit default swap, the buyer pays periodic fixed
amounts representing the premium for the credit protection.

(2) The fixed amount may be affected by a feature on some

ABS and European CMBS known as "coupon step-up."
This feature is triggered if a security is not called for
redemption before a certain date that occurs prior to its
final maturity, analogous to a clean-up call.
iii. If the swap transaction provides that coupon step-up
is NOT applicable to the transaction, the step-up in
the coupon of the underlying Reference Obligation
will have no effect on the fixed amount that the
buyer is required to pay.

iv. If coupon step-up IS s applicable to the transaction,

the fixed rate will increase by the same number of
basis points as the coupon step-up in the Reference
Obligation. However, the buyer will have an option
to terminate the transaction, and thus avoid having
to pay an increased premium.

v. Under the end-user form, coupon step-up would be

applicable in all events and the buyer would not
have the option to terminate the transaction if the
coupon of the Reference Obligation increased.

23
 2. Additional Fixed Amount

(1) Interest shortfalls and principal writedowns that have been

allocated to an asset-backed security may be reversed in a
subsequent period. In the case of a reversal of a principal
writedown, the principal balance of the security would be
written back up. If an interest shortfall is reversed it would
be applied to pay accrued and unpaid interest on the
security .

(2) Reflecting the notion that the seller has the risk profile of a
long investor in the Reference Obligation, if a writedown or
shortfall for which the seller has previously compensated
the buyer by paying a floating amount is reversed, the
buyer of protection is required to repay the seller the
amount previously received from the seller in respect of
that writedown or shortfall. The amount of the
reimbursement is called an "additional fixed payment.

(3) Generally, the Obligation to make reimbursements is

effective for one year after the earlier ofthe Scheduled
Termination Date of the CDS transaction, the legal final
maturity of the Reference Obligation and the date on which
the Reference Obligation has been amortized to zero
through liquidation and distribution of the underlying
collateral.

(4) This is designedto perform the seller to receive

reimbursement on a successful workout or final liquidation
of a defaulted loan. The end-user form ties the one-year
tail more closelyto the Reference Obligation by making it
independent of the Scheduled Maturity Date.

4) Modifications for CDX Index Trades

a) Index trading has accompanied significant growth in liquidity

b) Benchmark indices

(i) NA.lG - 125 North American investment grade names

(ii) NA.HVOL - 30 names - subset ofNA IG

(iii)HA.HY - 100 North American non-investment grade names

(iv)NA.XO - 35 North Americanpossovers - some are in NA.HY.

(v) EM -- 15 sovereigns

24
c) Credit Events and documentation

d) Trading conventions

(i) Price Conventions

I. HG, HVOL, XO - quoted in basis points

2. HY, EM - quoted in price terms

(ii) Maturities (3, 5, 7, 10 year)

(iii)Credit Events - BK, Failure to Pay (No restructuring)

(iv)Upfront payment

e) Settlement after Credit Event

(i) Factoring of notional amount

(ii) Physical settlement with de minimis cash settlement

(iii)Cash settlement

1) Index protocols

(i) Growth issues in Credit Events

I. Potential for market disruption as participants must physically settle huge

volume of individual contracts

2. Index market exacerbates this because one lOX trade theoretically implies
up to 125 settlements and because it has increased trading in CDS

3. Short squeeze concerns - CDS convergence to cash market post-Credit

Event (E.G. Delphi)

4. Uncertainty re what constitutes Deliverable Obligations (e.g. Calpine)

(ii) Index protocols consist of standardized valuation and cash settlement

procedures to determine the post-Credit Event price of a Deliverable
Obligation through a dealer auction

(iii)Protocols alleviate need to provide Credit Event Notices and notices of

publicly available information

(iv)95% market adherence

25
 (v) Six protocols have been entered into for Collins & Aikman, Delta, Northwest,
Delphi, Calpine and Dana Corp

(vi) Protocols

5) Modifications ofPAUG for ABX and CMBX

a) The ABX.HE index began trading in January 2006. It consists of20 home equity
loan ABS tranches, Additional indices for other ABS asset classes, such as credit
card ABS, are planned for the near future.

b) CMBX indices began trading in March 2006.

c) ABX.HE and CMBX both use the standardized template based on the PAUG
template.

d) The floating amounts under CMBX are writedown, principal shortfall and interest
shortfall with Fixed Cap.

e) Ratings downgrade and maturity extension are not applicable as Credit Events, thus
ensuring that a CMBX contract will not terminate before the Reference Obligations
mature.

f) Coupon step-up of the fixed amount is not applicable.

g) Each series is rolled every six months (in April and October). Before the roll date
Markit sends out a list of25 eligible CMBS deals to dealers. Unlike in the case of
ABX.HE, a new series can include deals that are already in the previous series of
the CMBX index. Based on dealer pool, deals with 75% or more vote for removal
will be eliminated from the list.

6) Inherent risks of CDS, including basis risk in ABS CDS

a) As CDS become more central to financial markets, investors have been spending
much effort determining the relationship between CDS and bond spreads.
Although CDS and bonds measure equivalent credit risk, many factors can cause
one to trade more tightly or more widely than the other.
I. Some of the factors that contribute to basis differences between CDS and
bonds are macro factors, such as liquidity differences, segmentation
among markets, bond market supply, demand for structured credit
products and the like.

2. Some of these factors are credit specific factors, such as documentation,

convertible issuances and market views regarding debt buybacks by
specific issuers.

26
3. Documentation related issues include:

(i) Derivative Reliance on Bond Covenants. In general, CDS are

commoditized instruments with standard documentation and are not
tailored to the reference credit. On the other hand, bonds tend to be
more customized. Although CDS investors may price the credit risk
based on covenants in a reference entity's bond documents, CDS
investors are at risk that changes of those covenants may change the
risk profile of the reference entity. This may be particularly true in the
case of bonds that have conditional puts and calls. For example, if a
CDS investor has sold protection on a reference entity based in part on
robust negative pledge clauses in the reference entity's bond
documentation, the early redemption of the bonds containing those
covenants would expose the CDS (along with other bonds of the
reference entity containing less restrictive language) at greater credit
risk. This risk increases the longer the maturity of the CDS is.

(ii) Basis Differential Between Credit Events and Events of Default.

(a) While bankruptcy and failure to pay should have identical

impact on bonds and on CDS, certain credit events may not
have an economic equivalent in standard bond or loan
documentation. Consequently, a CDS may entitle the
protection buyer to receive a payout in circumstances where it
would not have been entitled to receive anything if it held the
cash bond. Restructuring is one example of this, although the
arbitrage opportunities have been reduced with Mod Rand
Mod Mod R. As discussed below, the PAUG form of CDS
provides many opportunities for the protection buyer to receive
a payout in circumstances where it would not have been
entitled to receive anything if it held the Reference Obligation
in cash form.

(b) This is a particular issue in the case ofPAUG. Even though

the PAUG form is generally intendedto place the seller in the
same position that it would have been in had it owned the
applicable percentage of the Reference Obligation outright,
there are many subtle ways in which the seller may be required
to make a payment when it would not have suffered a loss as
the owner of the bond.

E.g. in each of the variants of Interest Shortfall Cap,

there is no necessary correlation between the amount
that the buyer would have been entitled to receive if it
owned the cash Reference Obligation and the seller's
entitlement to receive protection payments from the
seller.

27
 E.g. by tying the one year cap on additional fixed
amounts to the Scheduled Termination Date of the CDS
the holders of securities issued in the CDO are exposed
to a risk that would not exist if the CDO held the
Reference Obligation directly in cash form.

E.g. there are several instances where the seller can be

required to make a payment to the buyer where it would
not have been exposed to a loss if the Reference
Obligation were held in cash form. These include
implied writedown and distressed ratings downgrade.

E.g. the rights of the protection selIer to receive servicer

reports is less absolute than would be the case if the
Reference Obligation were held in cash form.

E.g. there are several instances where the complexity of

the CDS language may hide potential traps. One
example of such a trap in the June 2005 version of the
dealer form was in the definition of "Current Period
Implied Writedown Amount" , which did not include
the concept of a floor based on the pari passu amount
(b) Specific issues in using CDS in CDO.

(1) Counterparty risk. In a cash CDO the collateral pool and hedging
contracts represent the source of repayment of the bonds. However, in
a synthetic ASS CDO the CDO relies on the premium income from
the counterparty as a significant source of payments on the bonds. In
order to minimize this risk the rating agencies impose minimum CDS
counterparty rating requirements, such that if the counterparty on a
CDS contract that is an asset of the CDO ceases to have the required
rating it is obligated to fmd a replacement counterparty, obtain a
guaranty of its Obligations or post collateral equal to at least one
month's premium

(2) Treatment of market discounts and premiums on the Reference

Obligation. Where the Reference Obligation is trading at a premium
or a discount from par, the spread on the CDS can be adjusted to par or
alternatively can be set at a rate equal to the underlying loan spread,
with the premium or discount being represented by an initial exchange
of cash. Adjusting the premium makes it easier to include a CDS
referencing a premium asset in a CDO because the CDO as protection
selIer does not have to pay cash up-front. However, doing this may
reduce the liquidity of the CDS if the CDO were to seek to sell or
assign it, because by setting the premium to mimic that of a par-priced
instrument at the time that the instrument is trading at apremiumor

28
discount it could be difficult to value the CDS using standard tools like
Bloomberg etc. This also could have important implications for
PAUG CDS depending on whether WAC Cap is applicable and
whether interest shortfall cap is applicable and on which cap has been
elected.

# # #

29