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
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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).
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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.
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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 rights
InstitutionalInvestors
Interest-only certificates
* This is typical of a CorTS (CITI), CBTCS (LEH) or PPLUS (ML) transaction.
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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
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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
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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
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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
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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
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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”
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Default Swaps and Credit Linked Notes
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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
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1. Repackagings Examples
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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
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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
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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
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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
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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).
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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
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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
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Appendix A - Credit Derivatives Market Overview
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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
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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 Notes
1%
Portfolio Products
24%
Total Return Sw aps
2%
Other3%
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Appendix B - Introduction to Credit Default Swaps
and Credit Linked Notes
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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.
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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%.
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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
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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
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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
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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
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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
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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
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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
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Appendix C - Introduction to the Dow
Jones CDX.NA.IG
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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
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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
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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.