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With thanks to Sivan Mahadevan, Pinar Onur, Peter Polanskyji, Andrew Sheets who produced many of the slides herein Are there Central Problems in Credit? Peter Cotton, Sep 2006

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Page 1: Peter Cotton

Nothing below this

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Nothing below this

pointWith thanks to Sivan Mahadevan, Pinar Onur, Peter Polanskyji, Andrew Sheets who produced many of the slides herein

Are there Central Problems in Credit? Peter Cotton, Sep 2006

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Why did Black commit suicide?

Dottore Turati - Alexander Luzhin (Black to Move)

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Table of Contents

Section 1: Synthetic CDOs

Section 2: Trading Correlation

Section 3: Problems

Section 4: Open Problems

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Section 1:Collateralized Debt

Obligations

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CDOs are Companies

Source: Morgan Stanley

Priority of Claim on Assets

Rises with Seniority

Corporate Capital Structure

Junior Senior

Senior Mezzanine

Junior Mezzanine

First Loss or Equity

CDO Capital Structure

Senior Debt

Subordinate Debt

Preferred Stock

Equity (Common)

Priority of Claim on

CollateralRises with Seniority

Senior

Priority of Claim on Assets

Rises with Seniority

Corporate Capital Structure

Junior Senior

Senior Mezzanine

Junior Mezzanine

First Loss or Equity

CDO Capital Structure

Senior Debt

Subordinate Debt

Preferred Stock

Equity (Common)

Priority of Claim on

CollateralRises with Seniority

Senior

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A Typical CDO Capital Structure

Source: Morgan Stanley

Super Senior Tranche (70%)

AAA Tranche (7.5%)

AA Tranche (3%) A Tranche (2.5%) BBB Tranche (4%)

Losses from

Reference Portfolio are borne

by tranches in reverse seniority

order

BB Tranche (3%)

Equity Tranche (10%)

0%

10%

19.5%%

30%

22.5%

13%

17%

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Copyright 2006 Morgan Stanley

Meet the Tranches…

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Growth in credit markets

Global Total Synthetic CDO Issuance (USD Billions)

0

50

100

150

200

250

300

350

2002 2003 2004 2005 Q1 2006

funded unfunded

Source: CreditFlux

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Other ways to invest

Single Name CDS

Small Baskets

TranchedCredit Risk

Credit Options

Indexation (TRAC-XSM Dow Jones CDX)

BasisTrades

CurveTrades

CapitalStructure

Trades

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Section 2:Trading Correlation

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Corporate defaults are not independent

BBs – 1 Yr and 5 Yr by Cohort

0%

5%

10%

15%

20%

25%

30%

1970 1975 1980 1985 1990 1995 2000 2005

Source: Morgan Stanley, Moody’s

Cohort

5 Year1 Year

(If history is to be believed)

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Corporate defaults are not independent

Zero Correlation Market Difference

Series CDX 4 CDX 5 CDX 6CDX

4 CDX 5 CDX 6 CDX 4 CDX 5 CDX 65 Yr

3-7% 6 13 24 42 51 70 36 38 46

7-10% 0 0 0 8 13 16 8 13 16

10-15% 0 0 0 4 6 8 4 6 8

7 Yr

3-7% 138 176 226 155 171 196 17 -5 -307-10% 0 0 1 32 37 44 32 37 43

10-15% 0 0 0 14 16 19 14 16 19

10 Yr

7-10% 37 53 75 93 99 107 56 46 32

10-15% 0 0 1 46 47 52 46 47 51

Source: Morgan Stanley

(If the market is to be believed)

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Correlation and Minefields

Low Correlation

High Correlation

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Correlation Intuition

Fundamental Correlation Relationships

bp

Source: Morgan Stanley

Senior Tranches Subordinate Tranches

0

100

200

300

400

0% 20% 40% 60% 80% 100%

Subordinate tranches Spread decreases as

correlation rises

Senior tranches Spread increases as

correlation rises

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Correlation example: Pensions and Labor Costs

Issues such as pension and labor costs that have plagued the airline industry may spread to other sectors

Similar issues could prove to be a driver in determining default correlation across sectors

This list highlights companies where significant potential exists for a high realized default correlation

Not Only One Sector – Unfunded Pension Liabilities Relative to Equity

Market Capitalization

1Market Cap based on the average of the 6 months prior to the bankruptcy filing

Source: Morgan Stanley

Issuer Ticker Industry Group Funding Gap/

Mkt Cap

Delta Air Lines Inc1 DAL Airlines 1235%

Northwest Airlines Corp1 NWAC Airlines 875%Exide Technologies XIDE Auto Parts & Equipment 266%Delphi Corp DPH Auto Parts & Equipment 256%Continental Airlines Inc CAL Airlines 215%AK Steel Holding Corp AKS Iron/Steel 147%AMR Corp AMR Airlines 145%Goodyear Tire & Rubber Co GT Auto Parts & Equipment 112%Hayes Lemmerz Int’l Inc HAYZ Auto Parts & Equipment 102%Dura Automotive Systems Inc DRRA Auto Parts & Equipment 81%Visteon Corp VC Auto Parts & Equipment 73%Ford Motor Co F Auto Manufacturers 68%Austral Pacific Energy Ltd AEN Oil & Gas 62%General Motors Corp GM Auto Manufacturers 43%ArvinMeritor Inc ARM Auto Parts & Equipment 40%Unisys Corp UIS Computers 36%Navistar International Corp NAV Auto Manufacturers 34%Smurfit-Stone Container Corp SSCC Forest Products & Paper 33%Abitibi-Consolidated Inc ABY Forest Products & Paper 33%Tenneco Automotive Inc TEN Auto Parts & Equipment 32%Bowater Inc BOW Forest Products & Paper 29%PolyOne Corp POL Chemicals 27%Dana Corp DCN Auto Parts & Equipment 25%Hercules Inc HPC Chemicals 22%TRW Automotive Holdings Corp TRW Auto Parts & Equipment 22%Terra Industries Inc TRA Chemicals 22%Timken Co TKR Metal Fabricate/Hardware 29%Alcan Inc AL Mining 24%

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Section 3:Problems

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Real-World Correlation?

World A – likelihood of 100 defaults are equally related to one another

- World B – the default propensity

of three companies are highly correlated to each other but not to the rest

Correlation – Details Matter

Source: Morgan Stanley

WORLD A

Credit 1 2 3 45

… 100 Average

1   50% 50% 50% 50% … 50% 50%

2 50% 50% 50% 50% … 50%

3 50% 50%   50% 50% … 50%

4 50% 50% 50%   50% … 50%

5 50% 50% 50% 50% … 50%

… … … … … …

100 50% 50% 50% 50% 50%

WORLD B  

Credit 1 2 3 45

… 100 Average

1   90% 90% 10% 10% … 10% 48%

2 90%   90% 10% 10% … 10%

3 90% 90%   10% 10% … 10%

4 10% 10% 10% 50% 50% … 50%

… … … … …

100 10% 10% 10% 50%50%

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Dynamics of a Static Model

TRACERS spread scenario with five defaults in the first two years

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Modeling correlation in spreads (intensity models)

(For illustration, we identify spreads with hazard rates)

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Problem 1: Model Construction

Build a dynamic credit model for hundreds of assets:

Consistent across sub-portfolios Internally consistent and computable dynamics Tractable pricing and estimation Can be calibrated to CDS, index, options, tranches

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Problem 2: Estimation

c.f. Specification analysis of affine term structure models

• Dai & Singleton• Duffie & Singleton• Gallant & Tauchen• Hansen

An efficiently simulated can be efficiently, consistently estimated…eventually

Advantages

• Elegant• Can include arbitrarily complex products• No likelihood function required

(5000 iterations)(1000 steps)(10,000 paths)(1 sec) = 2180 years

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Problem 3: Deal Dynamics

How will structured deals & companies evolve?

- Ratings stability - Contingent payments - Corporate events

- Optimal management

How will desks optimize their correlation trading operations?

- Monetization strategies - Contingent hedging costs - Risk management - Capital allocation

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Board Vision

Dottore Turati - Alexander Luzhin (Black to Move and Win)

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Raising the bar

Solve hard modeling & numerical problems

Leverage emerging technologies

Leverage advances in other fields

--> Enhance and challenge human decision making

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Important Disclosures

The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and/or one or more of its affiliates (collectively, “Morgan Stanley”) and the research analyst(s) named on page one of this report.

Morgan Stanley policy prohibits research analysts from investing in securities/instruments in their MSCI sub industry. Analysts may nevertheless own such securities/instruments to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition.

Morgan Stanley is involved in many businesses that may relate to companies or instruments mentioned in this report. These businesses include market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, investment services and investment banking. Morgan Stanley trades as principal in the securities/instruments (or related derivatives) that are the subject of this report. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report.

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Other Important DisclosuresThe securities/instruments discussed in this report may not be suitable for all investors. This report has been prepared and issued by Morgan Stanley primarily for distribution to market professionals and institutional investor clients. Recipients who are not market professionals or institutional investor clients of Morgan Stanley should seek independent financial advice prior to making any investment decision based on this report or for any necessary explanation of its contents. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. You should consider this report as only a single factor in making an investment decision.

Morgan Stanley fixed income research analysts, including those principally responsible for the preparation of this research report, receive compensation based upon various factors, including quality, accuracy and value of research, firm profitability or revenues (which include fixed income trading and capital markets profitability or revenues), client feedback and competitive factors. Analysts' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks.

This report is not an offer to buy or sell any security/instrument or to participate in any trading strategy. In addition to any holdings disclosed in the section entitled "Important Disclosures on Subject Companies," Morgan Stanley and/or its employees not involved in the preparation of this report may have investments in securities/instruments or derivatives of securities/instruments of companies mentioned in this report, and may trade them in ways different from those discussed in this report. Derivatives may be issued by Morgan Stanley or associated persons.

Morgan Stanley makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities/instruments transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

This report may include research based on technical analysis. Technical analysis is generally based on the study of trading volumes and price movements in an attempt to identify and project price trends. Technical analysis does not consider the fundamentals of the underlying issuer or instrument and may offer an investment opinion that conflicts with other research generated by Morgan Stanley. Investors may consider technical research as one input in formulating an investment opinion. Additional inputs should include, but are not limited to, a review of the fundamentals of the underlying issuer/security/instrument.

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Other Important DisclosuresTo our readers in Taiwan: Information on securities/instruments that trade in Taiwan is distributed by Morgan Stanley & Co. International Limited, Taipei Branch (the "Branch"). Such information is for your reference only. The reader should independently evaluate the investment risks and is solely responsible for their investment decisions. This publication may not be distributed to the public media or quoted or used by the public media without the express written consent of Morgan Stanley. Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to be construed as a recommendation or a solicitation to trade in such securities/instruments. The Branch may not execute transactions for clients in these securities/instruments.

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Certain information in this report was sourced by employees of the Shanghai Representative Office of Morgan Stanley Dean Witter Asia Limited for the use of Morgan Stanley Dean Witter Asia Limited.

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© 2006 Morgan Stanley

9.19.06 po

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