corporate-backed trust securities

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THE BOND M A RK ET A SSO CIA TIO N D iscussion w ith the Staffofthe U nited StatesSecuritiesand Exchange Com mission Concerning certain aspectsof Proposed A BS Rules Septem ber22, 2004

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Similarities Credit exposure to the underlying issuer Credit decision based on public information Underlying issuer is the only payment source. Corporate-Backed Trust Securities. Secondary Market. XYZ bond. XYZ bond. Trust*. Retail / Institutional Investors. - PowerPoint PPT Presentation

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Page 1: Corporate-Backed Trust Securities

THE BOND MARKET ASSOCIATION

Discussion with the Staff of the United States Securities and Exchange Commission

Concerning certain aspects of Proposed ABS Rules

September 22, 2004

Page 2: Corporate-Backed Trust Securities

2

Introduction

This presentation is intended to provide background for a dialogue on certain industry concerns raised in The Bond Market Association’s comment letter dated July 12, 2004:

The requirement in proposed Item 1100(c)(2) to terminate a repackaging transaction if the obligor of the underlying security stops reporting under the Exchange Act penalizes rather than benefits investors.

ABS transactions that use swaps or other “synthetics” to pay investors based on the Consumer Price Index or similar indices are not qualitatively different from common publicly-issued investments and should not be prohibited as synthetic instruments.

Securitizations that employ credit derivatives should be permitted as ABS transactions (with appropriate disclosure guidance), and should not be effectively barred from public issuance (as under current practice and the proposed rule).

Page 3: Corporate-Backed Trust Securities

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Reopening/upsizing existing repackaging transactions does not raise the concerns that adding new assets to traditional ABS transactions does, and should be permitted because it benefits investors.

The materiality of a derivative contract for purposes of proposed Item 1113(b)(2) should be determined based on a reasonable good-faith estimate of maximum probable exposure, made in a manner consistent with that used in the sponsor’s internal risk management process.

Page 4: Corporate-Backed Trust Securities

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Corporate-Backed Trust Securities

In its most common form a corporate-backed trust security is a simple pass-through of the cash-flows of the underlying security and no credit risk is added to the structure

Trust*

Retail Investors

Retail /Institutional

Investors

SecondaryMarket

XYZ bond

Corporate-backed trust certificates

XYZ bond

• Similarities – Credit exposure to the

underlying issuer– Credit decision based on

public information– Underlying issuer is the only

payment source• Differences

– Recovery upon an event of default

– Voting rightsInstitutional

Investors

Interest-only certificates

* This is typical of a CorTS (CITI), CBTCS (LEH) or PPLUS (ML) transaction.

1

Page 5: Corporate-Backed Trust Securities

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Corporate-Backed Trust Securities Market Characteristics

• The corporate-backed trust securities market emerged in 1999 and has grown significantly since that time

• 260 transactions executed to date • Total market volume of over $12.4 billion

• The most active participants are: • Citigroup (CorTS®)• Lehman Brothers (CBTCS)• Merrill Lynch (PPLUS)• Morgan Stanley (SATURNSM)• 5 other participants

• Mostly sold through internal brokerage network but there is a significant amount sold by participants to third party dealers

2

Page 6: Corporate-Backed Trust Securities

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Impact of Cessation of Reporting

• Direct holders– No impact on the quality

of credit– Possible positive technical

impact on the price due to scarcity

– Bonds continue to trade freely

Despite their similarities, a cessation of reporting has a very different and negative impact on a repackaged transaction

• Repackaging investors– No impact on the quality of

credit– Supply from trust

termination(s) may have a negative impact on the price of the underlying securities and the resulting proceeds to investors

– Repackaged securities stop trading

3

Page 7: Corporate-Backed Trust Securities

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CPI-Based Transactions

CPI-linked repackaged securities are very similar to directly-issued CPI-linked securities

Investors

XYZ

MonthlyCPI-linked payment

CPI bond

Directly-issued CPI bond

Trust

Investors

Secondary Market

XYZ CPI bond

CPI-linked trust

certificates

Monthly CPI-linked payment

Monthly CPI-linked payment

Repackaging of directly-issued CPI bond

Trust

Investors

Swap Counterparty

SecondaryMarket

XYZ bond

Monthly CPI-linked

payment

Semi-annual interest on XYZ bond

Monthly CPI-linked payment

CPI-linked trust

certificates

CPI-linked repackaged security

4

Page 8: Corporate-Backed Trust Securities

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Comparison to Interest Rate Swaps

Like a floating rate repackaged security, a CPI-linked repackaged security reduces the investor’s fixed interest rate exposure

Trust

Investors

Swap Counterparty

SecondaryMarket

Monthly CPI-linked payment

Semi-annual fixed interest on XYZ bond

Monthly CPI-linked payment

CPI-linked trust

certificates

Trust

Investors

Swap Counterparty

Secondary Market

XYZ fixed- rate bond

Quarterly LIBOR-linked

payment

Semi-annual fixed interest on XYZ bond

Quarterly LIBOR-linked

payment

Floating rate trust

certificates

XYZ fixed- rate bond

5

Page 9: Corporate-Backed Trust Securities

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3MO Libor vs. CPI-Index Adjustment

3-month LIBOR and CPI levels have had similar trends since 1985, highlighting the similarity between the two indices

Source: Citigroup and Bureau of Labor Statistics

As of 09/13/04

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

03/01/85 05/26/88 08/21/91 11/15/94 02/09/98 05/06/01 08/01/04

CPI Index Adjustment 3MO LIBOR

6

Page 10: Corporate-Backed Trust Securities

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CPI-Based Transactions

• Since 1997, issuers including the US Treasury (TIPS) have issued bonds with principal and interest payments linked to the CPI– 15 TIPS issues for a total of approximately $211 billion

• Greater liquidity in the TIPS market combined with the potential for rising inflation rates have strengthened both issuer and investor interest in CPI bonds

• Corporate issuers may have limited interest in issuing CPI-linked debt

• However, investors wish to obtain additional yield for credit risk in an inflation-protected format– Repackaged transactions can meet this desire

CPI is an excellent example of a “synthetic” that should be included in the definition of “Asset-Backed Securities”

7

Page 11: Corporate-Backed Trust Securities

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Default Swaps and Credit Linked Notes

Page 12: Corporate-Backed Trust Securities

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Default Swaps and Credit Linked Notes

Table of Contents

1. Repackaging Examples

Appendices Appendix A - Credit Derivatives Market Overview Appendix B - Introduction to Single-Name Credit Default Swaps and Credit Linked Notes Appendix C - Introduction to the Dow Jones CDX.NA.IG

Page 13: Corporate-Backed Trust Securities

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1. Repackagings Examples

Page 14: Corporate-Backed Trust Securities

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– Investors assume credit exposure to a single bond of the underlying issuer

– Underlying bond is the only payment source

– Hundreds of existing public deals

Example 1 - Single Bond

Secondary Market

Trust

Single Bond Issued by XYZ Corp.

RetailInvestors

Institutional Investors

In its most common form, a corporate-backed trust security is a simple pass-through of the cash-flows of a single underlying security and no credit risk is added to the structure

Page 15: Corporate-Backed Trust Securities

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• Investors assume two separate credit risks.

• The risk transfer with respect to the single bond is equivalent to “Example 1 -- Single Bond”

• Default swap contract transfers no greater credit risk than the risk of a single bond that investors assumed in Example 1.

• Difference compared with “Example 1 -- Single Bond”: investors also assume credit risk of the Swap Counterparty

• Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed).

Example 2 - Single BondRisk Transfer Via Default Swap (No Collateral)

Swap Counterparty

Trust

Default Swap Contract on Single Bond Issued by XYZ Corp.

RetailInvestors

Trust Certificates

Page 16: Corporate-Backed Trust Securities

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Example 3 - Multiple Bonds of a Single Issuer

Secondary Market

Trust

Multiple Bonds Issued by XYZ Corp.

RetailInvestors

Institutional Investors

• The risk transfer is equivalent to “Example 1 -- Single Bond”, except that investors assume risk with respect to multiple bonds of an issuer.

• Underlying cash bonds are the only payment source

• Existing public deals

Page 17: Corporate-Backed Trust Securities

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• The risk transfer with respect to the single bond is equivalent to “Example 3 -- Multiple Bonds of a Single Issuer”

• Default swap contract transfers no

greater credit risk than the risk of the bonds that investors assumed in Example 3.

• Difference compared with “Example 3 -- Multiple Bonds of a Single Issuer”: investors also assume credit risk of the Swap Counterparty

• Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed).

Example 4 - Multiple BondsRisk Transfer Via Default Swap (No

Collateral)

Swap Counterparty

Trust

Default Swap Contract on Multiple Bonds Issued by XYZ Corp.

RetailInvestors

Trust Certificates

Page 18: Corporate-Backed Trust Securities

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Example 5 - Multiple Bonds and Loans of a Single Issuer

Swap Counterparty

Trust

Default Swap Contract on Multiple Bonds and Loans of XYZ Corp.

RetailInvestors

Corporate-backedtrust certificates

Risk Transfer Via Default Swap (No Collateral)• The risk transfer with respect to the XYZ bonds is

equivalent to “Example 3 -- Multiple Bonds of a Single Issuer”, except that loans entered into by the issuer are also included.

• Default swap contract transfers (i) the risk of the bonds that investors assumed in Example 3, plus (ii) the risk of loans entered into by the issuer.

• Difference compared with “Example 3 -- Multiple Bonds of a Single Issuer”: investors also assume credit risk of the Swap Counterparty

• Trust not needed -- Swap Counterparty could issue Credit Linked Note directly to investors (in which case no separate default swap contract is needed).

Page 19: Corporate-Backed Trust Securities

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• Investors assume two separate credit risks (assuming de minimis exposure to Swap Counterparty).

• Default swap contract may transfer no greater credit risk than the risk illustrated in Examples 1, 3 or 5.

• Difference compared with Examples 2 and 4: investors assume credit risk of the Collateral.

• In some cases, Swap Counterparty exposure must be considered.

SwapCounterparty

Trust

Default Swap Contract -- see Examples 1, 3 and 5

RetailInvestors

Example 6 - Risk Transfer Via Default Swap (With Collateral)

IssuingEntity

$100

$100

Corporate-backedtrust certificates

Collateral

Page 20: Corporate-Backed Trust Securities

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• Only the size of the trust assets changes.

• Certificates are fungible.

• Requiring a new issuance imposes unnecessary transaction costs on investors and results in reduced liquidity of new issue.

Upsizings of Transactions Should be Permitted

Upsizings

Page 21: Corporate-Backed Trust Securities

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Appendix A - Credit Derivatives Market Overview

Page 22: Corporate-Backed Trust Securities

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• The Credit Derivatives market is one of the largest, fastest growing sectors of the financial industry

• The Credit Derivatives market is forecasted to reach a size of approximately 4.8 trillion by the end of 2004(1)

• Credit Default Swaps account for 67% of the Credit Derivatives market(2)

• The default swap market presents the opportunity to: – increase returns generated from the credit markets– diversify and broaden the sources of credit investment opportunities– achieve more specialized exposure aligned with investment goals– create credit investments with attractive yields

• Participation by a wide range of market participants

Credit Derivatives Market Overview

Introduction

____________________(1) BBA Credit Derivatives Report 2001/2002(2) Fitch Ratings

Page 23: Corporate-Backed Trust Securities

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Credit Derivatives Market Size Composition of the Market as of End 2003

____________________Source: ISDA

____________________Source: Fitch Ratings

Market Overview

Mkt (Ex Asset Swaps) US $bn

0

500

1000

1500

2000

2500

3000

3500

4000

Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03

Single-Name CDS67%

Cash CDO3%

Credit Linked Notes1%

Portfolio Products

24%

Total Return Sw aps

2%

Other3%

Page 24: Corporate-Backed Trust Securities

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Appendix B - Introduction to Credit Default Swaps

and Credit Linked Notes

Page 25: Corporate-Backed Trust Securities

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• Payment is contingent on triggering a Credit Event and satisfaction of the Conditions to Settlement with respect to a Reference Entity. Upon satisfaction of such requirement, Credit Protection Buyer selects Bonds or Loans of the Reference Entity to deliver to the Credit Protection Seller and Credit Protection Seller pays par for such Bonds or Loans.

Premium

Contingent PaymentCredit

ProtectionBuyer

CreditProtectio

nSeller

Terms: Standard Credit Default Swap

Reference Entity

•Physical Settlement.

•No Credit Event occurs: payout=0.

Page 26: Corporate-Backed Trust Securities

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Example: Ford Default Swap

CreditProtection

Buyer

CreditProtection

Seller

Reference EntityFord

[Premium bps]

Notional = $10 MM

Contingent: Payment

Upon occurrence of a Credit Event with respect to Ford, Credit Protection Buyer selects Bonds or Loans issued or guaranteed by Ford with a faceamount equal to 10MM USD and Credit Protection Seller pays par even thoughBonds may have a market value of 40%.

Page 27: Corporate-Backed Trust Securities

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• “Bankruptcy” - Reference Entity (Ford) goes bankrupt.

• “Failure To Pay” - Reference Entity (Ford) fails to pay on a “Borrowed Money Obligation”.

Credit Events

Page 28: Corporate-Backed Trust Securities

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Deliverable Obligations: Bond or Loan

Credit Protection Buyer delivers “Bonds Or Loans” issued by Reference Entity (Ford) or guaranteed by Reference Entity (Ford) that:

- Not Subordinated to Reference Obligation

- Not Contingent

- Not Bearer

- Maximum Maturity 30 Years

- Standard Currency

- Assignable/Consent Required Loan

Page 29: Corporate-Backed Trust Securities

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• A CLN is a fully collateralized credit default swap, in the form of a note issuance by a bankruptcy-remote issuer.

• Why Collateralize?– Eliminates the protection buyer’s credit exposure to the

individual investor– Offers investor credit exposure in a familiar bond-like form

Credit Linked Notes (“CLNs”) Definition

Introduction to Credit Linked Notes

Page 30: Corporate-Backed Trust Securities

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• Advantages of CLNs versus bonds: – maturity, coupon, and reference entity can be customized– flexible coupon (fixed, floating, monthly, quarterly,

semiannually)– still maintains bond features and convenience

• DTC settlement; separate CUSIP; Bloomberg listing; can be rated by the ratings agencies

• CLN considerations:– liquidity may be less than a benchmark bond

Credit Linked Notes (“CLNs”) vs. Bonds

Introduction to Credit Linked Notes

Page 31: Corporate-Backed Trust Securities

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• The investor is exposed to the Reference Entity and the underlying trust collateral (in the case of an SPV issuer) or Dealer (in the case of Dealer as issuer).

• Upon the occurrence of a Credit Event with respect to the Reference Entity, the CLNs are redeemed and the protection Buyer (Dealer) delivers to investors the par amount of defaulted debt obligations of the Reference Entity to the total principal amount of CLNs. When a Credit Event occurs, investors in a credit linked note end up in the same position as they would have been if they had bought senior debt of the Reference Entity directly.

Credit Linked Note Basics

Introduction to Credit Linked Notes

Page 32: Corporate-Backed Trust Securities

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Fixed rate “x” bps

Default Protection

Protection Buyer(Dealer)

Investor

Trust(SPV Issuer)

L + “y” bps

$10mm

Highly Rated Collateral

$10mmL + x + y bps Default

CLNs: Special Purpose Vehicle as Issuer• For investors looking for a floating rate coupon….

Introduction to Credit Linked Notes Example CLN Structures

Page 33: Corporate-Backed Trust Securities

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Fixed rate “x” bps

Default Protection

Protection Buyer(Dealer)

Investor

Trust(SPV Issuer)

L + “y” bps

$10mm

Highly Rated Collateral

$10mmFixed Rate Default

CLNs: Special Purpose Vehicle as Issuer

Swap Counterparty

L + x + y bpsFixed Rate

• …or a fixed rate coupon:

Introduction to Credit Linked Notes Example CLN Structures

Page 34: Corporate-Backed Trust Securities

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Appendix C - Introduction to the Dow

Jones CDX.NA.IG

Page 35: Corporate-Backed Trust Securities

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Overview

Introduction to the Dow Jones CDX.NA.IG

• The Dow Jones CDX.NA.IG is the New US Benchmark for tradable 5yr and 10yr index products• Liquidity

– Proven liquidity track record from the market making group– Multiple market maker platform

• Transparency– A transparent rules-based approach to portfolio construction

• Standardization documentation• Globalization

– The Dow Jones CDX.NA.IG is a pillar in the Dow Jones platform

Page 36: Corporate-Backed Trust Securities

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Introduction to the Dow Jones CDX.NA.IG

Key Features

Clear rules for portfolio construction Pricing via Bloomberg Standardization and multi-market

maker platform to ensure transparency

Active participation of Dow Jones Ltd as Administrator

Track record in:

– CDS flow market

– Other credit indexes

– Dow Jones Notes in Europe The largest platform of leading

market makers

Dow Jones CDX.NA.IG is the New US Benchmark

Unfunded or in CLN form Tradable sector swaps

Standardized documentation 5 and 10 year maturities No fees Static portfolio of 125 diverse names

Liquidity & Track Record Transparency Product Breadth

GlobalizationStructure

Page 37: Corporate-Backed Trust Securities

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Introduction to the Dow Jones CDX.NA.IG

Benchmark Tradability• Standardized CDS contracts

• Sector trading

– Financials

– TMT

– Energy

– Industrials

– Consumers

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Introduction to the Dow Jones CDX.NA.IG

Credit Event Example - Counterparty buys $100m Dow Jones CDX.NA.IG Exposure in Unfunded / CDS Form

• No Credit Event– The fixed rate of the Dow Jones

CDX.NA.IG is [70] basis points per annum quarterly

– Market maker pays to counterparty [70] bps per annum quarterly on notional amount of $100m

– With no Credit Events, the counterparty will continue to receive premium on original notional amount until maturity

• Credit Event– The fixed rate of the Dow Jones CDX.NA.IG is

[70] basis points per annum quarterly– Market maker pays to counterparty [70] bps per

annum quarterly on notional amount of $100m – A Credit Event occurs on Reference Entity, for

example, in year 3– Reference Entity weighting is 0.8%– Counterparty pays to market maker (0.008 x

100,000,000)= $800,000, and market maker delivers to counterparty $800,000 principal amount of Deliverable Obligations of the Reference Entity

– Notional amount on which premium is paid reduces by 0.8% to $99,200,000

– Post Credit Event, counterparty receives premium of [70] bps on $99.2m until maturity

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The materiality of a derivative contract for purposes of proposed Item 1113(b)(2) should be determined based on a reasonable good-faith estimate of maximum probable exposure, made in a manner consistent with that used in the sponsor’s internal risk management process.

---Maximum contingent liability is not a realistic measure of materiality and in many cases is infinite.

---For their own risk management purposes, market participants make credit and collateral decisions based on probable maximum liability, modeled under various market conditions to a high degree of statistical certainty.

---In other contexts, the SEC requires that disclosures be based on measures used in internal evaluations because that is deemed the best available approach (e.g., segment reporting).

---The SEC has recognized the validity of internal estimates of derivative exposure (e.g., “value-at-risk” modeling) by permitting those estimates to be used to calculate net capital requirements of broker-dealers that are part of consolidated supervised entities.