JP Morgan CDO Handbook

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Structured Finance CDO Handbook

Global Structured Finance ResearchCDO ResearchJ.P. Morgan Securities Inc.New YorkFebruary 19, 2004

www.morganmarkets.com

Contents

Overview 2

Whats In an SF CDO? 3

SF CDO Assets: 101 12

Does SF Collateral Work for CDOs? 24

SF CDO Structure 32

Should SF CDOs be Managed or Static? 44

SF CDO Rating Methodologies 48

Appendix A: Rating Transition Matrices 51

Appendix B: Rating Agency Classification

of Structured Products 53Appendix C: SF CDOs from

Seasoned Issuers 54

Christopher FlanaganAC

(1-212) [email protected]

Rishad Ahluwalia (London)(44-207) 777-1045

[email protected]

Ryan Asato(1-212) [email protected]

Benjamin J. Graves(1-212) [email protected]

Edward Reardon (London)(44-207) [email protected]

The certifying analyst(s) is indicated by a superscript AC. See last page of thereport for analyst certification and important legal and regulatory disclosures.

Overview

Structured Finance (SF) CDOs are leveraged investment vehicles that invest

primarily in the senior and mezzanine tranches of structured products (ABS,

RMBS, CMBS, and CDOs). They utilize the same technology as traditional

credit CDOs with the only difference being their underlying collateral.

SF CDOs issue securities to fund the purchase of collateral or assume risk

synthetically via credit derivatives.

Highlights SF CDOs are designed to exploit arbitrage opportunities by taking advantage

of liquidity/complexity premiums and the credit curve, to be a source of

funding, or to manage balance sheet exposures. They have been growing

as a portion of total CDO issuance.

Overall, the SF CDO underlying collateral makeup largely mirrors the

structured products market. Some adjustments are made to enhance arbitrage.

Structured product collateral offers a spread pick-up, lower event risk, and

comparable default/recovery rates versus like-rated corporates, as well as

diversification opportunities.

Rating agency structured product default and recovery assumptions areconservative compared with actual collateral performance.

SF CDOs have several variables, including quality of collateral (AAA/AA or

BBB) and form of exposure (cash or synthetic). Each type has unique

structural features.

Manager/issuer selection is critical in both actively managed and static deals.

Chart 1

Structural Overview of a Typical SF CDO

Source: J.P. Morgan Securities.

AAA

A

Equity

BBB

AA

CDO SPV

ABS

RMBS

CMBS

CDOs

Asset Manager

or Issuer

Trustee &

Custodian

Hedge

Counterparties

Asset Pool CDO Liabilities


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February 19, 2004 Global Structured Finance ResearchCDO Research

Analyst Structured Finance CDO HandbookChristopher FlanaganAC

[email protected]

2

Overview

SF CDOs have been growing as a portion of total CDO issuance in both the US

(currently about 45% of total) and Europe (currently about 20% of total).

SF CDOs offer a spread pick-up to most like-rated securities. This pick-up can be

attributed to liquidity, complexity, and a new asset class premium.

Table 1

Spread to Swaps/Libor (bp)*

5-8 Yr 10 Yr 10 Yr UK 5 Yr 7-12 Yr IG Syn 6-10 Yr RMBS 10 Yr 3-5 Yr Floating Sterling 10 yr SF CDO CDO HY CLO Jumbo CMBS HEL Cards RMBS Industrial

AAA 60** 70 46 30 25 18 15 -8AA 125 125 90 100 38 50 34 6A 175 175 140 120 45 105 61 28BBB 375 375 265 175 88 170 105 107 60

*As of 1 February 2004.

**Indicative weighted average AAAspread for traditional SF CDO.

Source: JPMS.

This spread pick-up, as well as the opportunity to diversify exposures, is attracting a

growing investor base, which varies by position in the SF CDO capital structure.

Senior investors include banks, conduits, SIVs, and finance companies. Equityinvestors are typically banks, pension funds, endowments, private banks, insurance

companies, fund managers, and hedge funds.

SF CDO asset managers are keen to become involved in this market as a way to

increase assets under management, build their franchise, and receive fee income. On

the other hand, balance sheet transactions can enable entities to reduce economic and

regulatory capital, manage credit risk, and achieve long term funding.

Chart 2

Funded CDO Issuance: 1996-2003*US $ Billion (bar graph) % SF CDO (black line) Europe $ Billion (bar graph) % SF CDO (black line)

*Funded issuance includes all cash issuance and the funded (i.e. non super senior) portion of synthetics.

Source: JPMS, IFR Markets, MCM, Bloomberg, CreditFlux.

0

10

20

30

40

50

60

70

80

90

1996 1997 1998 1999 2000 2001 2002 2003

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0

5

10

15

20

25

30

35

1996 1997 1998 1999 2000 2001 2002 2003

0%

5%

10%

15%

20%

25%

SF CDOs are Growingas a Percentage of

Total CDO Issuance

SF CDOs Offer a SpreadPick-Up to Most Like

Rated Securities

Growing Cadre ofMarket Participants


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3



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Whats In an SF CDO?

SF CDOs source collateral from several distinct sectors of the broader structuredproducts market, including CMBS, RMBS, CDOs, ABS, and REITs. Collateral

composition varies by deal, with individual deals sourcing from 0% to 100% of their

collateral from each of the above sectors. Several factors, including asset manager

experience, issuance volume, region, and arbitrage opportunity influence collateral

composition. Despite differences between deals, US/European SF CDOs can be

broadly characterized into two sub-sectors1.

Real Estate SF CDO: Greater than 60% of collateral is backed by residential or

commercial real estate (RMBS, CMBS, or REITs). In 2003, Real Estate CDOs

accounted for approximately 45% of funded SF CDO volume.

Diversified SF CDO: Also referred to as multisector or ABS CDOs. Dealsin this category consist of a diversified mix of structured finance assets and, as

such, dont exhibit asset concentration (in Real Estate) described above. In 2003,

Diversified CDOs accounted for approximately 55% of funded SF CDO volume.

In addition to the two broad categories

above, SF CDOs may be distinguished

by several other characteristics, includ-

ing: Cash/Synthetic, Arbitrage/Balance

Sheet, or US/Europe. Chart 4 to Chart 9

on the following page show the aggre-

gate collateral composition (Consumer

ABS, Commercial ABS, RMBS, CMBS,CDO, REIT) for deals completed in

2003. Chart 10 to Chart 14 detail the

collateral breakdown within each of the

aforementioned sectors. We stress, how-

ever, that different types of SF CDOs

hold these underlying asset classes in

materially different proportions.

Chart 3

2003 SF CDO Collateral Distribution (total)

Source: JPMS, IFR Markets, MCM, S&P, Fitch, Moodys.

CDO

15%

CMBS

19%

Consumer

ABS

16%

Other ABS

2%

Corp ABS

6%

REIT

3%

RMBS

39%

SF CDOs can be classifiedas Real Estate or Diversified

SF CDO Sectors - Some Definitions

CDO: CLO, CBO, SF CDO, IG Synthetic CDO, Small-to-Medium Entity CDO, Other CDO

CMBS: Conduit, Large Loan, Credit Tenant LeaseConsumer ABS: Student Loan, Auto, Card, Consumer LoanCorporate ABS: Equipment, Health Care, Small Business Loan, Structured Settlement, Aircraft,Aerospace, Trade Receivables, FranchiseREIT: Unsecured corporate debt of company that invests in Regional Malls, Shopping Centers, OfficeBuildings, WarehousesRMBS: Prime* (Jumbo, Alt A), Home Equity (Subprime or B/C, 2nd Lien), NIMS, ManufacturedHousing, Prime European Mortgages (UK, Netherlands, Spain, Italy, Portugal)

*Note: Prime RMBS also traditionally includes the conforming Agency (Fannie Mae, Freddie Mac) paper, which is out of the scope

of this paper because it is guaranteed and not typically included in SF CDOs.

1. CDOs-of-CDOs (majority of collateral is tranches of other CDOs) can also be considered SF CDOs, but they

are beyond the scope of this paper.


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4

2003 US/Europe SF CDO Collateral Distribution: By Deal Type

($billion notional)*

Chart 4

Cash: 16 Euro, 35 US deals ($29.1)

RMBS

48%

CDO

6%

REIT

5%

CMBS

33%

Corp ABS

4%

Corporate

0%

Consumer

ABS

4%

Chart 5

Synthetic: 22 Euro, 4 US deals ($39.8)

RMBS

34%

CDO

23%

CMBS7%

Corp ABS

8%

Consumer

ABS

28%

Chart 6

Arbitrage: 19 Euro, 33 US deals ($32.5)

RMBS

44%

CDO

11%

REIT

5%

CMBS

31%

Corp ABS

4%Corporate

0%

Consumer

ABS

5%

Chart 7

Balance Sheet: 19 Euro, 6 US deals ($36.4)

RMBS

37%

CDO

19%

Corp ABS

8%

Consumer

ABS

27%

REIT

0%

CMBS

9%

Chart 8

US: 39 deals ($25.2)

RMBS

43%

CDO

9%

REIT

5%

CMBS

34%

Corp ABS

4%Corporate

0%

Consumer

ABS

5%

Chart 9

Europe: 38 deals ($43.6)

RMBS

39%

CDO

19%

REIT

1%

CMBS

11%

Corporate

0%

Corp ABS

7%

Consumer

ABS

23%

* As a percent of total notional value.

Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.


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2003 US/Europe SF CDO Collateral Distribution: By Sub Sector

($billion notional)*

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Chart 10

RMBS ($27.4)

Prime

43%

HEL

55%

MH

2%

Chart 11

CMBS ($13.5)

Conduit

76%

CTL

2%

Large Loan

22%

Chart 12

Corp ABS ($4.0)

Aerospace

1%

Small Business

Loan

61%

Structured

Settlement

7%

Aircraft

1%

Equipment

28%

Health Care

2%

Chart 13

Consumer ABS ($10.9)

Auto

34%

Card

44%

Student Loan

2%

Consumer Loan

20%

Chart 14

All


0%

5%

10%

15%

20%

25%

RMBS

:HEL

RMBS

:Prim

e

CMBS

:Conduit

CDO

Consum

erABS

:Card

Consum

erABS

:Auto

CMBS

:LgL

oan

Consum

erABS

:Consumer

Loan

Corp

ABS

:SmlB

usiness

REIT

Corp

ABS

:Equipm

ent

RMBS

:MH

Other

* As a percent of total notional value.


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The SF CDO collateral concentrations shown above are largely representative of the

underlying collateral markets as a whole. That is, SF CDOs tend to source collateral

from the largest sectors, such as home equities (HELs) and CMBS. The one possibleexception (at least with US collateral) is the large prime RMBS market, from which

SF CDOs source smaller amounts of collateral. This is due to both the relatively

larger rate component of this sector (CDO technology is better equipped to take credit

risk than rate risk), as well as the smaller supply of subordinates (due to relatively low

credit enhancement associated with the prime quality collateral). European SF CDOs

tend to source larger portions of Consumer ABS, Prime RMBS, and CDOs2, as these

sectors represent a significant portion of the European structured products market.

The tables below provide a breakdown of recent collateral issuance for the US

and European markets, as well as JPMorgans 2004 forecast as of year-end 2003 3.

Table 2 and Table 3 provide volumes for the overall markets. Table 4 and Table 5

provide volumes for subordinate tranches and indicate the percentage of the totalstructure that is non-AAA.

Table 2

US Structured Product Supply and Forecast ($Billion)

2001 2002 2003 2004 Forecast% of % of % of % of

$bn Total $bn Total $bn Total $bn Total

RMBS: Prime 152.6 27.1% 228.9 32.7% 350.0 38.2% 325.0 36.6%RMBS: HEL 94.2 16.7% 159.0 22.7% 219.9 24.0% 200.0 22.5%Consumer ABS: Autos 70.2 12.5% 88.2 12.6% 77.2 8.4% 75.0 8.5%Consumer ABS: Credit Cards 59.3 10.5% 65.8 9.4% 64.8 7.1% 75.0 8.5%CMBS 67.2 11.9% 52.1 7.4% 77.9 8.5% 70.0 7.9%CDO 62.8 11.1% 58.5 8.4% 66.4 7.3% 69.1 7.8%

Consumer ABS: Student Loans 9.5 1.7% 19.5 2.8% 30.7 3.4% 40.0 4.5%Other 23.7 4.2% 6.6 0.9% 12.0 1.3% 12.0 1.4%REIT 9.8 1.7% 10.6 1.5% 9.2 1.0% 10.0 1.1%Corp ABS: Equipment 7.0 1.2% 5.9 0.8% 6.8 0.7% 8.0 0.9%RMBS: MH 6.8 1.2% 4.6 0.7% 0.8 0.1% 3.0 0.3%


Table 3

Europe Structured Product Supply and Forecast ($Billion)

2001 2002 2003 2004 Forecast% of % of % of % of

$bn Total $bn Total $bn Total $bn Total

RMBS: Euro (non-UK) 27.7 21.0% 34.6 24.2% 83.8 37.5% 80.0 35.0%CDO 29.0 22.0% 22.2 15.6% 28.8 12.9% 28.0 12.3%RMBS: Aussie 9.5 7.2% 11.0 7.7% 21.5 9.6% 25.0 10.9%

RMBS: UK 8.8 6.7% 11.6 8.1% 19.6 8.7% 20.0 8.8%CMBS 14.3 10.8% 13.7 9.6% 15.5 6.9% 17.0 7.4%Corp ABS: Whole Business 7.8 6.0% 10.7 7.5% 14.2 6.3% 12.0 5.3%Consumer ABS: Student Loans 0.0 0.0% 0.5 0.4% 4.5 2.0% 11.0 4.8%Other 12.0 9.1% 10.4 7.3% 12.3 5.5% 9.0 3.9%Consumer ABS: Autos 4.4 3.3% 8.9 6.2% 4.7 2.1% 8.0 3.5%Other: Sov/Ag 11.8 9.0% 9.9 6.9% 9.8 4.4% 8.0 3.5%Consumer ABS: Credit Cards 3.3 2.5% 5.8 4.1% 5.9 2.6% 7.5 3.3%Corp ABS: Equipment 3.0 2.2% 3.3 2.3% 3.2 1.4% 3.0 1.3%




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6

SF CDO CollateralMirrors the Overall Market

2. A significant portion of CDOs re-securitized in European SF CDOs are Small to Medium Entity (SME) CDOs,which are collateralized by receivables on a large number (typically thousands) of small business loans. Thegranular collateral pool makes arguably makes these CDOs more akin to ABS than to a traditional CDO.

3. Other includes Dealer Floorplan, Stranded Asset, RV, Boat, Consumer, EETC, Aircraft, Small Business Loan,Non-Performing, and Aircraft.


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Table 4

US Subordinate (non-AAA) Structured Product Supply

2001 2002 2003$bn % Sub $bn % Sub $bn % Sub

RMBS: HEL 9.5 10.1% 18.4 11.6% 32.4 14.7%CMBS 13.0 19.3% 9.6 18.4% 10.5 13.5%CDO 12.5 19.9% 12.4 21.3% 10.1 15.3%Consumer ABS: Credit Cards 10.0 16.8% 10.5 16.0% 9.6 14.8%REIT 9.8 100.0% 10.6 100.0% 9.2 100.0%RMBS: Prime 5.0 3.3% 6.4 2.8% 8.8 2.5%Consumer ABS: Autos 2.4 3.4% 3.2 3.7% 2.5 3.2%Consumer ABS: Student Loans 0.3 2.8% 0.6 3.2% 1.3 4.3%Other 6.9 28.9% 2.0 30.8% 1.2 9.9%Corp ABS: Equipment 1.3 17.9% 0.6 9.7% 0.6 9.1%RMBS: US MH 1.4 21.2% 1.1 23.5% 0.2 26.7%


Table 5

Europe Subordinate (non-AAA) Structured Product Supply

2001 2002 2003$bn % Sub $bn % Sub $bn % Sub

Corp ABS: Whole Business 5.0 63.6% 6.3 59.0% 6.1 43.1%CDO 5.8 20.0% 4.4 20.0% 5.8 20.0%CMBS 7.3 51.4% 3.8 28.0% 5.6 36.3%RMBS: Euro (non-UK) 2.5 9.2% 2.4 7.0% 5.6 6.7%Other 4.9 40.4% 1.8 17.5% 2.7 22.2%RMBS: UK 1.4 15.8% 0.9 7.9% 2.7 13.8%RMBS: Aussie 0.7 7.8% 0.9 7.8% 1.9 8.9%Other: Sov/Ag 5.6 47.6% 1.6 16.6% 1.4 13.9%Consumer ABS: Credit Cards 0.1 3.5% 0.6 9.6% 1.2 19.8%Consumer ABS: Autos 0.2 4.1% 0.4 5.0% 0.2 5.1%

Corp ABS: Equipment 0.2 8.0% 0.3 10.1% 0.1 4.3%Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.

Seasoned SF CDOs under-performed in 2003 due largely to exposures in esoteric

ABS sectors such as manufactured housing, tobacco, aircraft, mutual fund fees, and

franchise loans. With the possible exception of manufactured housing, exposure in

esoteric ABS was generally limited to a small portion of the portfolio, but it was

enough to impair performance in many deals.

These small (and sometimes new) sectors were included in older vintage SF CDOs

(2000-2002) because they offered some of the highest yields and added diversity to

the portfolio. However, the drawback is that they were often unseasoned, with

potentially flawed business models that take time to uncover. For example, franchiseloan amounts were typically based on the business value, rather than the real estate

value, leaving loans under-collateralized in the event of business failure. Another

example is mutual fund fees, which were based on the assumption of a growing share

of assets invested in equity funds, and did not anticipate the negative fund flows

during the market downturn.

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What's Not inSF CDOs and Why


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The manufactured housing sector accounts for the bulk of structured products

tranches that have defaulted. The sector was severely hit with loose underwriting,

irrational competition, overproduction, and high exposure to the weakest sectors ofthe economy in the past few years. The result was a perfect storm where external

forces totally changed the rules of the industry causing performance to significantly

diverge from original expectations. This was combined with deals that were

structured with lower initial required loss coverage ratios from the rating agencies

and lower excess spread requirements.

Todays next-generation SF CDOs contain less exposure to these esoteric sectors,

and have instead substituted established sectors such as HELs and CMBS. Although

trading is allowed in SF CDOs, all collateral concentrations are subject to

limits/prohibitions set at the inception of the deal.

Another exposure that caused problems in early SF CDOs was exposure to CDOs,

many of which have performed poorly (especially US HY CBOs) over the last

several years. As a result, most traditional US mezzanine SF CDOs have scaled back

CDO collateral concentrations (e.g. from a 20% bucket to a 5-10% bucket). Others

continue to allocate to this sector, reasoning that newer CDOs benefit from the debt-

friendly structures that characterize todays CDO market. European SF CDOs still

often have moderate-sized CDO buckets, but these are typically concentrated in SME

CDOs, which have developed a positive performance track-record. High grade SF

CDOs may have 10-15% concentrations in non-PIKable AAA and AA tranches. We

think that while a general reduction in CDO exposure is an understandable response

to current investor sentiment, CDOs still make sense for the SF CDO structure, and

there is no compelling reason to avoid CDO exposures once investor sentiment turns.

Table 16 shows migration of the

Weighted Average Rating Factor

(WARF) versus the trigger WARF as

set in the indenture for all SF CDOs

rated by Moodys between 1999

and 2002. The chart illustrates the

problems in 1999 and 2000-vintage

SF CDOs, which have rapidly

deteriorating ratings on the

underlying collateral. In contrast,

2001 and 2002-vintage SF CDOshave had far less rating deterioration.

Whereas many esoteric ABS sectors

are collateralized by business value

or depreciating assets, most sectors

in recent SF CDO transactions are

securitized by real estate, which

should provide a backstop on losses (the property value) in the event of default.

Those assets not secured by real-estate (cards, autos, equipment) are some of the



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8

Far Less Deterioration inLater-Vintage SF CDOs

Chart 15

Weighted Average Ratings Factor vs. Ratings Trigger(% compliance, negative number indicates non-compliance)

Source: Moodys.

-250

-200

-150

-100

-50

0

50

May-02 Aug-02 Nov-02 Feb-03 May-03 Aug-03 Nov-03

1999 2000 2001 2002


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most seasoned in the ABS market (although investors should still be diligent in

evaluating the servicer risk in these sectors) and have well-established performance

track records.

SF CDO allocations to various structured product sectors change according to deal

vintage, and deals are designed to capitalize on a market anomaly or arbitrage

opportunity at issuance. To illustrate this point, we look at the HELs minus CMBS

spread differential for the 2002-2003 period (Chart 16). Chart 17 illustrates the

change in SF CDO collateral breakdown during this same period.

During 2002, the exceptionally stable CMBS sector was pricing nearly in line with

HELs, and SF CDOs concentrated 40% of their collateral in CMBS versus 18% in

HELs. However, as spreads on HELs gapped out in 2003 (partially due to large

issuance volumes), new SF CDOs altered their collateral makeup to exploit the

opportunity, reducing CMBS exposure to 31% and increasing HEL exposure to

46%. As relative spreads and issuance continue to change in the structured products

markets, we expect that new SF CDOs will adjust to achieve maximum advantage for

investors. Of course, investors should perform appropriate due diligence to ensure

that asset managers are staying within their area of expertise.

Table 6 illustrates the substitution of HELs for CMBS as well as the decline inesoteric assets in four deals issued by Declaration Management and Research4

between 2000 and 2003. We selected this manager because they have been a repeat

issuer in the market, with a transparent history dating back several years. Note the

dramatic rise in HELs and decline in CMBS. Also note the significant decline in

manufactured housing, aircraft, and other smaller structured product sectors.

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SF CDOs Capitalize onArbitrage Opportunities

Chart 16

Chart 17

BBB Spread Differential: HEL minus CMBSGlobal SF CDO Collateral Distribution by FundedVolume: 2002 & 2003

bp


0

50

100

150

200

250

Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03

0%

5%

10%

15%

20%

25%

30%

35%

40%45%

RMBS CMBS ABS CDO REIT

2002 2003

Shifting Asset Allocation:A Real Life Example

4. Formerly known as Independence Fixed Income LLC.


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10

Table 6

Investment Portfolios by Structured Product Sector

Independence I Independence II Independence III Independence IV(2000) (2001) (2002) (2003)

Current Avg Rating/Trigger Avg Rating Baa3/Baa2 Baa3/Baa2 Baa2/Baa2 Baa2/Baa2

% of Total Portfolio

RMBS: HEL 18.92 22.44 25.09 55.48RMBS: Prime 10.63 11.56 13.14 13.73CMBS 20.14 31.35 32.29 9.88RMBS: MH 13.31 14.09 11.61 5.28CBO (Baa) 4.92 3.95 4.01 4.97REIT 1.71 1.65 4.75Corporates 2.50Corp ABS: Structured Settlements 0.63 1.32 1.25Corp ABS: Aircraft Lease 12.29 7.50 2.48 1.16Corp ABS: Small Business Loan 3.62 0.61 1.55 0.99

Other 4.15 3.47 2.95 0.01Consumer ABS: Auto 2.41 2.00Consumer ABS: Credit Card 4.66 2.19 1.10Corp ABS: Entertainment 0.05Corp ABS: Equipment Leasing 0.81 0.37Corp ABS: Franchise Loans 3.85 0.50 0.44RMBS: Property Tax Liens 0.24

Source: Fitch.

Since each of the aforementioned asset classes may issue notes of various ratings and

with various levels of subordination, the quality of collateral is at least as important

as the type of collateral. While traditional SF CDOs typically used collateral with

weighted average ratings in the BBB vicinity (relatively higher spreads created

attractive arbitrage), the advent of new securitization technology has allowed the

development of high grade SF CDOs, which typically source AAA/AA collateral.

Chart 18 and Chart 19 show weighted average ratings for cash and synthetic SF CDOs

issued in 2003. Note that synthetics, with lower overall funding costs due to the

presence of a large super senior tranche, are overwhelmingly high grade SF CDOs.

Although cash deals remain largely backed by BBB collateral, the number of cash

high grade deals has grown to 22%. This growth has been helped by the development

of short term money market eligible tranches at the top of the capital structure.

The advent of high grade SF CDOs bodes well for SF CDO supply, since there is

a much larger supply of AAA/AA collateral, which typically makes up 80-85% of the

capital structure in many structured product transactions. Supply of the (relativelysmaller notional) subordinate tranches may be limited, especially in higher interest

rate environments5. Potential lack of mezzanine structured products supply creates

reinvestment risk in traditional managed mezzanine SF CDOs. Investors should

insure that asset managers have sufficient access to collateral during both the ramp-

up and reinvestment periods.

5. Although higher interest rates would also impact senior tranche supply, the reduction would have less impact onSF CDOs because supply is much larger in the first place.

Collateral Quality:Weighted Average Rating


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SF CDO Assets: 101

Most structured products share certain similarities (ownership in a pool of

receivables, subordination, sequential pay structure, overcollateralization), but there

are also key differences across asset classes (specific assets, weighted average life,

structural variations). The following pages provide an introduction to the elementary

characteristics of structured products typically found in SF CDOs, including

collateral, market participants, structure, and principal risks. This section may be

skipped by investors that already possess a strong understanding of the structured

products markets or used as a reference guide for those with a strong understanding

of some sectors but not others.

We cover four of the largest SF CDO collateral components (HEL, CMBS, US Prime

RMBS, and UK RMBS) in some detail, and provide a brief overview of other

structured products. To begin, Table 7 provides an overview of four key sectors.Table 7

Structure Comparison

HEL CMBS UK RMBS US Prime RMBS

Major Currencies USD USD USD, GBP, EUR, USDCHF

Typical New Issue Size $750mm $1bn $6-$7bn $750mm - $1bn

Weighted Avg. life 3 - 5 years 5 - 10 years 1.0 - 5.5 years 7 years

Spread Indices Libor, Swaps Swaps Libor, Euribor Treasuries

Coupon Type Fixed and Floating Primarily Fixed Fixed and Floating Fixed and Floating

Rating Stability Relatively more Very stable and Very stable and Very stable andvolatile due to sector marked by upgrades marked by upgrades marked by upgradesconsolidat ion and in seasoned in seasoned in seasonedtransformation transactions transactions transactions

Typical Structure AAA - 15.0% sub. AAA - 16% sub. AAA - 8% sub. AAA - 2.5% sub.AA - 10.0% sub. AA - 13% sub. AA - 5% sub. AA - 1.25% sub.A - 6.0% sub. A - 10% sub. BBB 1.5% sub. A - .85% sub.BBB 2.5% sub. BBB - 6% sub. (plus Reserve Fund) BBB - .50% sub.(overcollateralization) BB - 3% sub.

Liquidity Medium liquidity; Very High High; one of the Very High

largest issuers have most liquid sectors

the best liquidity in Europe

Key Issuers Ameriquest, Chase, CSFB, Goldman, Abbey Nat ional, Chase, Countrywide,

Countrywide, Lehman, Morgan HBOS, Northern Washington Mutual,

GMAC/RFC, Stanley Rock Wells Fargo

Option One

Source: JPMS.



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12


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The largest SF CDO collateral sector is RMBS. Chart 20 illustrates the difference

between the most common forms of prime and subprime RMBS to appear in SF

CDOs. There are also regional differences. Below, we explore several RMBSsectors in detail.

Chart 20

Types of RMBS

Source: JPMS.

RMBS: Home Equity Loans (HEL)

HELs are secured by residential real estate property, primarily first mortgages to

borrowers unable to obtain prime funding due to the borrowers credit (sometimes

referred to as B/C loans). Second-lien loans are also included under the HEL

moniker, although these are a much smaller proportion of the market. HELs are the

largest sector in the public ABS market. Volumes have increased dramatically due to

the current low interest rate environment and home price appreciation. Chart 21

below provides a brief overview of the HEL market.

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Home Equity Prime

Borrower

Lien

LTV

WAC

FICO

Originators

B&C 2nd

Lien Alt-A

Prime

Jumbo

Credit

Impaired

Prime Documentation

Property Type

Pristine

Credit

1st 2nd 1st 1st

80% 90% 75% 75%

7.5% 9%-10% 6.5% 6.0%

630 715 715 725

Chase

Countrywide

GMAC/RFC

Countrywide

GMAC/RFC

First Franklin

Countrywide

IndyMac

GMAC/RFC

Chase

Countrywide

GMAC/RFC

Well Fargo

Prime

Ameriquest

Option One

Subprime ARM

Chase


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Chart 21

Overview of the HEL Market

Source: JPMS.

Chart 20 provides an overview of different types of HELs. Note that Alt A and Prime

Jumbos (addressed later on under the Prime RMBS heading) are included here for

purposes of comparison.

HELs may be floating rate (Adjustable Rate Mortgage or ARM) or fixed rate (Fixed

Rate Mortgage or FRM). ARMs currently account for approximately 75% of HEL

volume. Most ARMs are indexed off 6-month LIBOR. Typically, ARMs are fixed

for a period of time before resetting and are referred to as Hybrid ARMs. Types of

Hybrid ARMs include 1/29, 2/28, 3/27, 4/26, or 5/25 loans, where the first number

references the period the loan rate is fixed and the second references the period the

loan rate is floating. Over the years, the majority of ARMs originated have shifted

towards the Hybrid ARM product, with 2/28s the most popular. After the initial

fixed period, ARM rates are determined by adding the loans margin to the

benchmark. On each reset date thereafter, typically every 6 months, the new rate is

calculated and principal payments are adjusted so that the loan fully amortizes over

its remaining life.



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14

Certificates

Residential homeownersborrow funds which arecollateralized by realproperty. Loan typesinclude:

Subprime B/C:

Fixed rate mortgage(FRMs)

Adjustable-rate

mortgages (ARMs)

2nd Lien Mortgage:

Closed-end fixed rate

Revolving homeequity lines of credit(HELOCs)

Home improvementloans (HILs)

High LTV loans(125s)

Lenders include banks andfinance companies. Tosecuritize, lenders sell apool of receivables into atrust. They generally retainservicing of the loans.

Lenders may alternativelysell the receivables to bepackaged by Wall Street

conduits. In this case,servicing responsibility isgenerally not retained bythe lender.

Certificates are sold in thepublic and/or privatemarkets and are securedby trust receivables.These certificates canhave a variety ofstructures:

Fixed vs. floating coupon

Wrapped vs. senior/sub

Multi-tranche vs. singletranche

Bond structure will dependon the underlyingcollateral, trust structure,and credit enhancement.

Most HELs areFloating Rate


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Excess spread is the first line of defense against losses. It is composed of excess

funds from interest paid on the HELs after expenses. Depending on deal structure, it

may be (a) used to cover payment shortfalls in the current period, (b) used tomaintain target overcollateralization levels, or (c) flow out of the structure to the

residual class holder.

Overcollateralization. Overcollateralization is equal to the par value of collateral

minus the par value of issued securities. Overcollateralization may exist at inception

or be built over time using excess spread. The overcollateralization cushion may

be used to absorb principal losses as they occur. If overcollateralization levels are

not in compliance with test levels, excess spread is used to accelerate principal

payments to bondholders, thereby rebuilding overcollateralization levels.

Subordination. More senior securities have principal/interest payments subordinated

to their own, which provides a natural layer of protection because they are not

impacted by loss that is absorbed by the layer or layers below them.

HELs typically amortize over their term-to-maturity. Some loans require balloon

payments (more common for 2nd lien) and others may have an interest only period.

Loans may prepay in advance of the scheduled maturity due to voluntary prepayments

(refinancing or sale of home) or involuntary prepayments (repossession or loss of

home). When a prepayment occurs, principal is paid through to the security holders,

thus retiring that portion of principal that is attributable to the loan that has prepaid.

HELs exhibit much less interest rate sensitivity as compared to Conforming and

Jumbo MBS. Contributing to the greater prepayment stability are: higher baseline

speeds due to credit curing and the equity take-out component of the market, as well

as prepayment penalties. Both FRMs and Hybrid ARMs have significant prepaymentpenalties. Penalties typically last 3-5 years for FRMs and the initial fixed period for

Hybrid ARMs. An example of a typical prepayment penalty is 6 months interest on

any prepayments in excess of 20% of the outstanding loan balance.

NIMs are typically securitizations of front-end residual cashflows (after bond

coupons, fees, and losses) from a single unseasoned HEL deal. They are also entitled

to overcollateralization releases after the step-down date as well as prepayment

penalty income. NIMs typically achieve ratings of BBB by discounting the expected

cash flow stream and applying various default, interest rate, and prepayment stresses.

The notes have a weighted average life of 0.8 to 1.5 years and offer a spread

premium of 250-300bp to like-rated ABS. The high spread premium is the primary

reason that NIMs appear in CDOs. NIM performance has been excellent over thepast few years due to declines in floating rate funding costs associated with an

accommodative Fed policy.

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Credit Enhancement

Prepayments/Prepayment Penalties

Net Interest MarginSecuritizations


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RMBS: Prime6

Chart 22 below provides an overview of the Prime RMBS market.

Chart 22

Overview of the Prime RMBS Market

Source: JPMS.

The earliest, simplest of MBS classes, sequentials split pass-through cash flows into

classes with different average lives. Sequentials are sensitive to prepayments, with

all classes extending or shortening simultaneously.

Floating-rate MBS may have a variety of average life profiles, some stable and some

volatile. Coupons typically reset monthly based on a fixed spread over a specific

index rate (often LIBOR). The maximum coupon (cap), spread over index, and

average life profile are main determinants of yield. Floaters, due to their shorter

duration, generally have less price volatility than fixed-rate MBS (unless rates rise

and the coupon reaches its cap).

Borrowers have the right to prepay at any time without penalty in effect calling

their loans away from investors prepayments may be partial or complete. Timing

and rate of prepayments vary and produce non-level, less-predictable cash flows.

Given current interest rate expectations and following rapid prepayments over the last

few years, prepayments are generally expected to slow in the coming years.

RMBS: UK

UK RMBS is one of the fastest growing sectors of the ABS market. UK RMBS is

the largest sector in the European securitization market and a widely held asset class



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16

6. A special thanks to Rajan Dabholkar and Eliza Hay for their help with the US Prime RMBS portion ofthis publication.

Residentialhomeowners borrowfunds, collateralized byreal property. Including:

Conforming: Meet USGovernment SponsoredEnterprise (e.g. FannieMae, Freddie Mac)criteria. CDOs donttypically have exposureto GSE loans.

Non-Conforming:Jumbo: Exceed thesingle-family loan limitfor GSEs ($333,700 in2004).Alt A: Issued to primeborrowers that havedocumentation or othernon-standard loancharacteristics.

Wall Street dealerspurchase pools of loansand structure securitiesbased on demand

Mortgage cashflows arecarved up to address:

Prepayment Risks & Cash FlowUncertaintyCall and/or Extension Risk

Negative ConvexitySpecific client needsDifferent Targets: Average Life,Yield, Duration, Credit Quality

Certificates

Structure

Prepayments


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among European investors. It also provides an opportunity for investors to diversify

away from US consumer credit into high quality secured asset-backed product.

Chart 23 above provides an overview of the UK RMBS market.

Despite the growth in new product types, UK mortgages typically have a number of

common characteristics, including a term of 25 to 40 years, a floating interest rate, full

amortization over the life of the loan, and a first charge (i.e., lien) on the property. The

mortgages interest rate (the standard variable rate, or SVR) is set at the discretion of

the lender and is loosely tied to the central bank rate.

UK residential mortgages have historically been marked by stable mortgage

prepayments. In recent years, the introduction of a number of flexible mortgage

products and increased competition among mortgage lenders have led to increased

remortgage activity among existing lenders. In turn, this remortgaging activity has

pushed prepayment speeds marginally higher.

For investors familiar with the mechanics of a credit card ABS master trust structure,

the UK RMBS master trust uses a similar technology to create a soft bullet repay-

ment profile. Because the total amount of mortgage collateral in the trust exceeds the

size of any RMBS tranche due, prepayment leverage ensures the trust can create a

bullet payment in a short accumulation period. An issuer can issue additional series

from the master trust by either adding new mortgage collateral to the trust or

transferring part of the sellers share to the investor share (since the sellers share is

very large when the master trust is first established). In anticipation of notes

becoming due, principal payments are accumulated for the purpose of creating a

bullet repayment for that series.

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Chart 23

Overview of the UK RMBS Market

Source: JPMS.

The underlying collateral is prime UKmortgages for owner-occupied

homes. Mortgage brokers are a vitalsource of new mortgage origination(up to 60% of new loans for somelenders), branches and telephonedistribution are also important.

UK Mortgage ProductStandard variable rate mortgages(capital repayment over 25 year life).Flexible mortgages haveexperienced dramatic growth in thepast few years. Allow borrowers toprepay their principal and featurepayment holidaysFixed rate or hybrid mortgages.Initial fixed rate reverts to floatingafter specified time period (2-5 yrs).

UK mortgage lenderscan be divided into

three basic categories:banks, buildingsocieties (operateunder the principle ofmutual ownership), andspecialized mortgagelenders (a focus onnon-conformingborrowers). The UKmarket is dominated bythe largest lenders,which are primarilybanks.

The master trust structureused in global UK RMBS

creates a clean bulletrepayment profile similar tothat of credit cards.

An issuer can issuemultiple series of Notesfrom the master trust andprincipal payments fromeach series (as in creditcards) may be sharedamong series to create abullet or meet a repaymentschedule for an individualseries.

Certificates

Master TrustStructure


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The sellers share represents the total interest in the trust collateral retained by the

seller and is set to a minimum amount. The sellers share does not represent a form

of credit enhancement, as it ranks pari passu with the investor share. Excess sellerinterest is the interest in the collateral retained by the seller that exceeds the required

minimum seller interest. Excess seller interest absorbs temporary fluctuations in the

collateral balance of the trust (i.e., higher than normal redraws).

Collections on the mortgage pool are split between interest charges and principal

repayments. Interest income is allocated on a pro rata basis among each series of the

master trust. The allocation of principal collections depends on the cash flow stage

of each series. Principal repayments may be used to 1) amortize pass-through notes

or to accumulate principal for a bullet repayment, 2) pay the seller and reduce the

size of the trust (provided the seller maintains a minimum sellers interest, or 3)

purchase new mortgage receivables from the seller during the revolving period.

UK RMBS typically issue a portion of their liabilities (typically shorter term) as US$

denominated, SEC registered securities. This is due in part to lower short term rates

in the US, with more aggressive pricing in the US on securities inside three years.

US$ tranches also help to diversify the UK RMBS investor base.

UK RMBS use a senior/subordinate structure with credit enhancement provided by

subordination and excess spread. In general, reserve funds provide liquidity and credit

enhancement to the structure. The reserve fund provides liquidity in that it can be used

to cover any interest shortfall on the notes and acts as credit enhancement in that it

absorbs any losses in a calculation period to the extent that excess spread is insufficient.

For master trusts with structured bullets, the reserve fund can also provide liquidity topay AAAbullet principal (again, to the extent necessary). Additional structural features

(eg, cash reserves and liquidity facilities) interact with the priority of payments to help

ensure the timely payment of interest and principal to the notes.

RMBS: UK Non-Conforming

UK non-conforming mortgages are analogous to US HELs. Like HELs, non-

conforming RMBS are secured by residential real estate property, primarily first lien

mortgages to borrowers unable to obtain funding from conventional mortgage lenders.

Borrowers in the non-conforming market include self-employed (without sufficient proof

of income and financial history), foreign nationals working in the UK (no credit record),

and those with County Court Judgements (CCJs). In the UK, County Court Judgments

are recorded when an individual has not repaid some form of debt, ranging from creditcard bills to an unpaid mortgage. As of year-end 2003, the largest originators are

GMAC RFC (RMAC), Kensington Group plc, and Britannia Building Society.

RMBS: Continental Europe

Together, German, Dutch, Spanish and Italian RMBS represent a large source of

European structured products issuance. While mortgage characteristics (e.g., loan-to-

value, prepayments, fixed/floating, mortgage features, etc.) vary by country, the

collateral is considered prime in that mortgage borrowers have not experienced

past credit problems. The mortgages are typically first-lien (except Germany),



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18

US$ Securities

Credit Enhancement


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owner-occupied properties. Mortgage credit performance has been strong, and the

sector has experienced a number of upgrades due to better-than-expected

performance and prepayments (i.e., deleveraging of the structure). Highly ratedEuropean banks seeking diversified funding and regulatory capital relief have been

the primary source of these deals. While structures also vary by country, continental

RMBS transactions typically pay down senior tranches sequentially and may only

amortize subordinate tranches provided that certain performance criteria are met.

CMBS7

The CMBS market emerged in the last decade as a response to the real estate cycle in

the United States, as traditional lenders (commercial banks, insurance companies)

avoided real estate exposure during the real estate downturn of the late 80s and early

90s. CMBS allows lenders to spread underwriting risk, diversify geographically, and

increase liquidity. It has also increased funding options for developers and large owners

of commercial property. Chart 24 below provides an overview of the CMBS market.

Chart 24

Overview of the CMBS Market

Source: JPMS.

Credit enhancement is achieved mainly through subordinated bond classes (AA to

unrated classes). Default risk is a function of the initial LTV (Loan-to-Value) and

DSCR (debt-service-coverage-ratio).

Newly originated fixed rate loan pools carry significantly less prepayment risk, as

there are large prepayment penalties to the individual borrowers, typically in the form

of strong loan-level call protection and a lock-out period followed by defeasance.

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7. A special thanks to Pat Corcoran and Yuriko Iwai for their help with the CMBS portion of this publication.

CMBS are backed by mortgages oncommercial and multifamilyproperties that are income-producing and operated foreconomic profit. CMBS are backedby a wide range of property types(total portion of issuance inparentheses):

rental apartments (22.4%)

shopping centers and other retailfacilities (36.2%)

office buildings (25.2%)

hotels (1.8%)

warehouse/industrial (7.9%)

nursing homes, mobile home parksand self-storage (6.5%)

Wall Street firms & other conduitoperators securitize portfolios ofnewly originated loans to empty the

warehouse and take profits

Banks, thrifts and insurancecompanies securitize seasoned loansto clear the balance sheet, adjustexposures, or exit the sector

Wall Street firms and real estate"opportunity" funds acquire andsecuritize portfolios of seasonedloans to finance the acquisitionand/or cash out of the investment

Owners of large commercialproperties and pools of smallercommercial properties secureattractive financing as an alternativeto a portfolio lender

Conduit/Fusion (67.9%): Conduitdeals are well-diversified, about$1billion in total size. Fusion dealsare conduit deals that include somelarge loans (>$50MM), which aretypically high quality, shadow-ratedinvestment grade loans but posesome concentration risk.

Multi-borrower floater (19.3%):Backed by floating rate loans fromseveral borrowers. They aregenerally shorter term deals withsome adverse selection risk.

Single asset/single borrower (9.8%):Either backed by a single propertyor a single borrowers portfolio.

Certificates

Structure/CreditEnhancement

Prepayments/ Extension


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Extension risk is created when not enough income and equity are available to pay the

balloon payment. CMBS with low LTVs have less extension risk.

European CMBS can be differentiated from US CMBS by several factors. First,

US issuance is typically more standardized and uses the conduit structure. In

Europe, different countries have different underlying lease terms and the Conduit

market is smaller because banks have (historically) been able to fund real estate on

balance sheet very cheaply. This is changing over time. Broadly, the European cash

CMBS market can be broken up into the following categories:

Single borrower, single property (mostly UK based deals, with trophy assets).

Single borrower, single tenant with no disposal strategy on the properties

(typically linked to rating of underlying corporate).

Single borrower, single tenant with a disposal strategy on the properties (i.e. sellthe properties to pay the principal on the bonds).

Multi-borrower

CMBS: Interest Only Strips

IOs are coupons stripped from an underlying pool of commercial mortgages. They

allow an issuer to sell near par priced securities, even if the coupon on the underlying

mortgages is greater than the bond coupons. A single IO strip (traditional form) is

defined as the adjusted WAC of the loans minus the WAC of the principal bonds. An

alternative form is two IO strips (PAC and Support). The PAC IO is stripped from

the traditional IO. Its notional amount and size is determined assuming certain

default and prepayment scenarios. PAC IOs generally have a WAL of 7.0 years. TheSupport IO is the leftover and bears most of the brunt in the event of early

prepayment. CMBS IOs are typically limited to at most 5% of the SF CDO collateral

pool. They are not included in diversity score or WARF calculation and are typically

haircut for purposes of par value tests.

CMBS: Non-Performing Loan (Europe)

Following the introduction of the Italian Securitization Law in 1999, non-performing

loans (NPLs) represented a large percentage of the Italian securitization market. A

key driver behind NPL securitization was the favorable tax treatment that allowed

Italian banks to amortize any losses (over a five year period) arising from sale or

securitization of NPLs. However, this special tax provision was terminated in mid-

2001, which has caused Italian NPL securitization to decline. NPL securitizations aretypically backed by commercial real estate properties. NPL securitizations frequently

depend on a property disposal strategy for the repayment of bond principal and

interest. Because the loans are non-performing, the loan servicer plays an important

role in transaction performance (i.e., ensuring that the loans move quickly through

any court proceedings). Going forward, German banks may begin securitizing non

performing loan portfolios as well.



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20

Regional Differences


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Real Estate Investment Trusts (REITs)

REITs are companies that own and (in most cases) operate income-producing real

estate, with assets in the $300 billion area. Common REIT property types include

diversified pools of regional malls, shopping centers, office buildings, warehouses,

and residential facilities. REITs are typically financed using about half debt and half

equity (equity pays out at least 90% of its taxable income as dividends). This is a

significant improvement versus the early 1990s, when individual properties were

typically financed by mortgages with LTVs in the 90% area, leaving companies less

flexibility and more exposed to interest rate risk. There have been no REIT bond

defaults in the last 10 years. Positive performance can be attributed to conservative

debt ratios, the ability to access the secured market in times of distress, and the

property cycle upswing.

SF CDOs invest in unsecured fixed rate REIT debt, the majority of which is ratedBBB. In addition to an interest rate swap, the CDO structure typically also includes a

timing swap to match semi-annual REIT payments to quarterly CDO payments. With

BBB REITs typically pricing within +/- 20bp of CMBS BBBs (T+120 ten year

average), the inclusion of REITs in a SF CDO is not yield enhancement. Rather, it

helps to improve diversity, since rating agencies give some diversification credit

versus CMBS.

Consumer ABS: Auto and Credit Card

Auto ABS securitize secured consumer installment loans or leases used to finance

new and used car purchases. Receivables carry a fixed interest rate and usually have

a 36, 48, or 60 month term. Receivables are originated by captive manufacturer

finance subsidiaries (GMAC, Ford, DaimlerChrysler, Honda, Toyota), banks (Chase,M&I, Regions, USAA), and specialty finance companies (AmeriCredit, Onyx, WFS).

Auto ABS typically use the Owner Trust structure, which provides flexibility in

structuring cashflows, permitting multiple senior tranches, as well as floating rate

tranches. Credit enhancement to senior notes are typically provided by subordinated

certificates supplemented with a reserve account. Loans may prepay in advance of

the scheduled maturity due to voluntary prepayment (refinancing or sale of vehicle)

or involuntary prepayment (repossession or loss of vehicle).

Credit Card ABS are backed by receivables from unsecured consumer loans. Types

of cards include revolving lines of credit (Visa and Master Card) as well as retail

cards from issuers such as Macys and Neiman Marcus. Non-revolving charge cards

from AMEX are also common. Large issuers include Chase, Capital One, Citibank,

and MBNA. Nearly every Credit Card ABS issuer uses the master trust structure,

similar to the UK RMBS structure discussed above. Structures include a revolving

period of 1-10 years (where monthly principal collections are used to purchase new

receivables), followed by an accumulation period. Notes may be fixed or floating,

typically with a 5yr expected life. Excess spread, early amortization triggers, and

subordination are key forms of credit enhancement.

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Auto and Credit Card ABS are two of the largest, most mature, most liquid sectors in

the ABS market. Both typically are priced at or near the tightest spreads in the ABS

market. Because low spreads reduce CDO arbitrage opportunities, CDOs tend to limitexposure to most Auto and Credit Card ABS (although some is typical as a means of

increasing diversity).

Consumer ABS: Consumer Loan (Europe)

Credit card penetration among Europeans remains low compared to the US and

amortizing term loans represent a large part of unsecured lending in many countries.

Unsecured consumer loans may be used for an auto purchase, home improvement,

or other reasons, although the loans purpose does not always need to be stated.

Consumer loan ABS transactions frequently have a revolving period, during which

prepayments are used to purchase new loan collateral. Cumulative loss rates for

consumer loan ABS have remained very low (less than 2%), while excess spread hasremained healthy (e.g., over 5%). Italian consumer loan performance varies

according to the region where the loans are originated, with southern regions

frequently experiencing higher default rates.

Corporate ABS: Equipment

Equipment ABS is backed by loan or lease receivables including agricultural,

computer, industrial, medical, small ticket office, and trucking. Lessors include

both independent leasing companies and captive subsidiaries of large manufacturing

firms. Credit analysis includes a review of the projected remaining cashflows and

underwriting standards. Leasing company receivables are typically diversified across

geography, industry, and obligors, and additional analysis and credit enhancement are

required in cases where concentrations are high.

Lease payments typically cover over 90% of equipment costs and 75% of the useful

life for financing leases (essentially a monthly payment plan). Operating lease

payments cover less than 90% of equipment value. Residual value (estimated value

at the end of the lease term) can be realized via a buyout option or sale, and may

be given some credit in rating agency analysis. Credit enhancement includes

subordination, reserve funds, and de-leveraging performance triggers. SF CDOs

typically purchase the single-A tranche. Bonds are typically fixed-rate, with a spread

pick-up of 6-8bp to like-rated autos, and have a weighted average life of two to three

years and experience low prepayment volatility. Equipment ABS supply is typically

correlated with performance of the overall economy, with businesses willing to

add/replace equipment in robust economies. In Europe, large Italian lease companies

have originated the majority of equipment lease ABS. To date, equipment, vehicles

and real estate leases have backed these transactions.

Corporate ABS: Whole Business Securitization (Europe)

Whole business securitizations are bonds that are backed by the cash flows from a

company. WBS companies typically have very stable cash flows and usually benefit

from regulation or other protections that make it unlikely that these cash flows will

change. For example, water utilities, funeral homes, and pubs are all types of

operating companies that have been securitized. Whole business securitizations



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22


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achieve higher ratings than unsecured debt through covenants (e.g. bondholders right

to replace management) and committed liquidity. WBS may also include property

or high profile assets that have real value for WBS bondholders. To date, wholebusiness securitizations have been a UK phenomenon, due to the favorable legal

status afforded to WBS bondholders.

CDOs

Other CDOs may be included in the SF CDO structure. Unlike CDOs-of-CDOs, where

nearly 100% of the collateral pool is other CDOs, SF CDOs typically source a limited

amount of other CDOs as collateral. This number was often 20% in earlier deals, but

has been closer to 5-10% in more recent deals. The purpose for including CDOs in the

collateral pool may be either yield enhancement or diversification. In addition to

overall CDO concentration limits, SF CDOs also have limits on PIKable collateral.

CDOs of small- and medium-sized enterprise (SME) loans are common in Europe.

SME CLOs are not arbitrage-driven, and the primary motivation for banks to do these

deals is balance sheet relief. SME loan pools usually offer a very large number of

underlying obligors and thus a high degree of granularity in the portfolio. Germany,

the Netherlands, Spain and the UK have all contributed to SME CLO volume.

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Does SF Collateral Work for CDOs?

There is a good case, we think, for applying CDO technology to structured product

collateral. Structured products offer a spread pick-up to like rated corporates, as well

as comparable default and recovery rates. Low event risk, a relatively stable arbitrage

opportunity, and low correlation with traditional CDO collateral are also positive.

Spread Pick-Up

The rise in SF CDO issuance was primarily the result of a sharp widening in

structured products spreads in the fall of 1998. At that point, there was a severe

dislocation in many non-government markets that injected huge liquidity premiums

into spreads and presented attractive arbitrage opportunities. The resulting

exploitation of these opportunities resulted in the take-off of SF CDOs. Fortunately

(for arbitrage purposes), structured products spreads have remained relatively wide,

explaining their continued growth as an asset of choice in CDOs.

We make the case later in this section that structured product performance has been

in line with like rated corporates. As such, we believe the spread pick-up arises from

relatively less liquidity and higher barriers to entry (complexity) in the structured

products markets. SF CDOs, in essence, monetize this premium, which arises from

several factors:

Small size of the subordinate structured product market8

Small size of individual subordinate tranches

Small size of the subordinate structured product buyer base

Complex structures that require more sophisticated analysis

To illustrate, Chart 25 shows a significant spread pick-up for BBB and single-AHELs to like rated finance corporates. By contrast, the most liquid structured

products sector, Credit Cards, prices much closer to the corporate market (Chart 26).

For this reason, SF CDOs typically have larger allocations to HELs and other less

liquid sectors than to Cards.



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24

Chart 25

HEL vs. Finance Spread Differentials

Source: JPMS.

-150

-100

-50

0

50

100

150

200

250

300

350

Jan-98

Jul-98

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

HEL Minus Fin ance (A ) H EL Minu s Fin an ce (B BB)

Chart 26

Credit Card vs. Banks Spread Differentials

Source: JPMS.

-60

-40

-20

0

20

40

60

80

Jan-98

Jul-98

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Credit Card minus Banks (A 5-year)

Credit Card minus Banks (BBB 5-year)

8. Small size of both the subordinate market and individual subordinate tranches also (arguably) leads to scarcity,which has the impact of tightening spreads. This effect is in most cases outweighed by the liquidity premium.


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Stability/Event Risk

The CDO universe can be roughly divided into moderately leveraged sectors (HY

CLOs at 12x, HY CBOs at 8x) and more highly leveraged sectors (investment grade

corporate CDO at 25x, SF CDO at 20x). In general, highly leveraged sectors are able

to apply greater leverage because they are backed by relatively more stable high grade

assets. The problem with applying greater leverage to stable assets, however, is

that these sectors become more exposed to single names and tail risk, where

unusual (based on historical experience) scenarios can quickly eat through the small

amount of equity subordination in the structure. Note that leverage can vary greatly

across SF CDOs (8-25x), with less levered structures less exposed to event risk.

The experience of IG CDOs in 2002 and 2003 when incidents of fraud, defaults,

and fallen angel 9 corporates were high is illustrative. These unusual events

(fraud in particular) were painful for IG CDOs. For example, in an IG CDO backed

by 100 equally weighted corporates, a 4% equity tranche would be wiped out by four

defaults (assuming zero recoveries). Although IG CDO portfolios may not have

exposure to every case of fraud (e.g. Enron, WorldCom, Parmalat), exposure to even

a few of these cases leaves little room for error.

Although SF CDOs employ similar leverage to IG CDOs, they are less exposed to

event risk. This can be largely attributed to the higher levels of granularity in the

underlying structured products, which are often referenced to a large number of

individual consumers. In addition, the underlying structured products are themselves

credit enhanced to withstand multiples of base case scenarios. Some idiosyncratic

risk is clearly present in the form of issuer concentrations (model risk) and servicer

risk. These risks, however, can be mitigated by concentration limits, limiting

exposure to established sectors with proven models, and investing in sectors with

adequate back-up servicing capability.

Stable Arbitrage Opportunity

The subordinate ABS and CMBS markets are particularly dependent on the

CDO bid. We use the US HEL and CMBS market as an example, although a

parallel argument could be made for Europe, where the CDO market has a similar

importance. Weve calculated that newly issued cash SF CDOs purchased

approximately $10.2 billion in HEL subs and $7.9 billion in CMBS subs in 2003. In

terms of 2003 issuance, this equates to approximately 32% of HEL subs and 80% of

CMBS subs. The percentage of HEL subs was probably even higher in late 2003.

Although CDOs purchase a significant portion of their collateral from the secondarymarket, these figures help put the CDO bid in context of the collateral market size.

However, as we hope this paper makes clear, we believe the SF CDO market is

here to stay, meaning the CDO bid is not expected to go away.

As such, the SF CDO bid can exert significant technical pressure on collateral spread

levels. When collateral is cheap, CDOs will enter the market, supplying additional

demand and effectively putting a cap on spreads. This effect is enhanced due to the

lumpy (not smoothed over the year) nature of SF CDO supply, as large numbers of deals

tend to begin ramping up collateral simultaneously when the arbitrage looks attractive.

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9. Defined as a investment grade security (BBB and above) falling to high yield (below BBB) or default.

SF CDOs ExertTechnical Pressure On

Collateral Markets


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When collateral is rich, CDO demand decreases. Since the structured products

markets are dependent on the CDO bid for subordinate paper, SF CDOs effectively put a

floor on subordinate spreads at the point where the CDO arbitrage disappears.

To a certain extent, this phenomenon

can also be observed in the institutional

leveraged loan market, where CDOs are

significant buyers. In contrast, the CDO

bid is less influential in investment grade

CDS, due to the size of that market

(approximately $5 trillion).

Chart 27 shows arbitrage levels in terms

of the CDO funding gap (by definition,

spread on assets minus cost of debt) forboth SF and IG CDOs. Because SF

CDOs put caps and floors on

collateral spreads, the arbitrage has been

much less volatile in this sector over the

last several years.

Correlation

Exposure to structured finance offers strong diversification benefits for CDO investors.

This is because SF CDOs have exposure to several different asset classes (CMBS, Prime

RMBS, HEL) that each have low correlation to traditional CDO asset classes (High

Yield Bonds, Leveraged Loans, Investment Grade Corporates). Higher diversification

reduces risks since it implies lower correlation in the variability of returns. Please notethat correlation in this sense means spread correlation, and not default correlation.

Table 8

US Monthly Spread Correlation (2000-2003): AAA/AA Structured Products & Traditional CDO Collateral

10 Yr AAA 10 Yr AA 5 Yr AAA JPM USD 5 Yr BB/BB- 10 Yr BBBCMBS MBS HEL HY Index Lev Loan Industrial

10 Yr AAA CMBS 1.0 0.5 0.2 0.4 0.4 0.410 Yr AA Prime RMBS 1.0 0.3 0.4 0.4 0.15 Yr AAA HEL 1.0 0.1 0.3 -0.1JPM USD HY Index 1.0 0.1 0.75 Yr BB/BB- Lev Loan 1.0 0.210 Yr BBB Industrial 1.0

Source: JPMS, S&P LCD.

Table 9

US Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral

10 Yr AAA 10 Yr AA 5 Yr BBB JPM USD 5 Yr BB/BB- 10 Yr BBBCMBS MBS HEL HY Index Lev Loan Industrial

10 Yr BBB CMBS 1.0 0.4 0.4 0.3 0.5 0.310 Yr BBB Prime RMBS 1.0 0.1 0.4 0.2 0.15 Yr BBB HEL 1.0 -0.1 0.1 -0.1JPM USD HY Index 1.0 0.1 0.75 Yr BB/BB- Lev Loan 1.0 0.210 Yr BBB Industrial 1.0




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Chart 27

Normalized CDO Funding Gap10

Source: JPMS.

-3

-2-1

0

1

2

3

4

5

6

7

8

9

10

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Sep-02

Dec-02

Mar-03

Jun-03

Sep-03

Dec-03

IG CDO SF CDO

10. Note: The actual funding gap values are normalized at 10. It is the yield on CDO collateral minus the costof CDO liabilities, fees, and expected loss.


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Table 10

Euro Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral

Dutch 5-7 Yr UK 5 Yr BBB Euro Leveraged JPM EURBBB RMBS Dollar RMBS Loan HY Index

Dutch 5-7 Yr BBB RMBS 1.0 0.3 0.0 0.1UK 5 Yr BBB Dollar RMBS 1.0 0.2 0.0Euro Leveraged Loan 1.0 0.0JPM EUR HY Index 1.0


Table 11

Euro Monthly Spread Correlation (2000-2003): AAA Structured Products & Traditional CDOCollateral

Dutch 5 Yr UK 5 Yr AAAAAA RMBS Sterling RMBS Pfandbriefe AA Financials

Dutch 5 Yr AAA RMBS 1.0 0.5 0.1 0.2

UK 5 Yr AAA Sterling RMBS 1.0 0.3 0.1Pfandbriefe 1.0 0.4

AA Financials 1.0

Source: JPMS.

Default and Recovery Performance

Any analysis of default and recovery in the structured product markets is challenged

by a lack of historical data. Nevertheless, now that the structured products markets

have matured and been tested through several economic cycles, we do have some

(limited) history and experience to start examining defaults in the market and to

assess the ultimate recovery on these bonds. Ultimately, default and recovery data

allows investors to evaluate current SF CDO portfolio assumptions, and should help

guide investment decisions, as defaults and recoveries play a key role in thestructuring processes.

Unlike corporates, where a default is caused by a discrete event like a bankruptcy or

a missed coupon payment, structured products typically suffer principal losses over

time as loans default and as those move through the cashflow waterfall. Thus, it may

take months or even years before losses eat through the credit enhancement and

bonds take their first dollar loss of principal. Even after the bond starts taking

principal losses, it still may take months, or even to the end of the deal, before the

ultimate loss of principal can be determined. In addition, missed interest and

principal may sometimes be deferred to the next period or a later period. Missed

payments may also sometimes be capitalized and repaid over the remaining life of

the transaction.

For our analysis of structured products defaults and recoveries, we use a recent

Moodys study of material impairment rates11, a concept that Moodys has

introduced to address the vagaries of default discussed in the paragraph above. One

of the downsides of this study is that it addresses US structured products only, and

nothing of its kind yet exists for the European market (largely due to the relative

youth of the market). Nevertheless, we think the conclusions reached using the

Moodys US data are broadly applicable to European structured products given that

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11. Payment Defaults and Material Impairments of US Structured Finance Securities: 1993-2002, MoodysInvestors Service, December 2003.


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A concentration of distressed sectors gives the ABS rate an upward bias. Table

13 shows that a large number of ABS Material Impairments come from sectors such

as healthcare, franchise, and manufactured housing. Problems in these storysectors have been addressed in previous sections of this report, and, importantly, they

are typically not included in todays SF CDO collateral pools. At the risk of stating

the obvious, material impairment rates would be significantly lower if these sectors

were excluded from the calculation.

Table 13

Number and Percentage of US ABS Material Impairments, 1993 - 2002

ABS # Rated ABS # Rated # Of Collateral Securities # Of Material % Collateral Securities Material %Type in Sample Impairments Impaired Type in Sample Impairments Impaired

HealthcareReceivables 30 12 40.0% Equipment 70 0 0.0%

FranchiseLoans 136 31 22.8% Floor-plans 105 0 0.0%

Manufactured Sml BusinessHousing 661 80 12.1% Loans 108 0 0.0%

Autos 623 9 1.4% Student Loans 343 0 0.0%

HEL 2,320 31 1.3% Other 68 0 0.0%Receivables

Leases 368 3 0.8% Other ABS 418 4 1.0%

Credit Cards 1,272 4 0.3%

Source: Moodys.

Structures and assumptions have been tested. As we have seen in our analysis,

bonds have taken losses primarily when unforeseen market forces have severely

impacted an industry (MH), rating agency assumptions about losses were inadequate

(MH and HELs), and/or structures were ill equipped to handle losses (HELs). In

addition, prime RMBS material impairment rates are inflated by losses in Quality

Mortgage transactions, which are backed by assets that were arguably closer to

subprime than prime at origination. While we cannot protect against unforeseen

events, the market today is in better shape as the rating agencies have additional

history to more accurately project losses and structures have been tested through

several economic cycles.

The market is now dominated by investment grade, well capitalized players.

Many downgrades can be attributed to problem issuers that have since exited the

business. HELs are a good example of a sector that has consolidated into stronger

hands. Industry consolidation has weeded out the weakest players. Aggressiveunderwriting was a main cause of the downfall for many issuers (e.g. extending down

to low quality borrowers, overstated appraisals, insufficient credit enhancement).

Consolidation has left stronger, higher quality and well-capitalized players with more

focused and disciplined business strategies (e.g., tighter underwriting, stepped up

collections efforts). As a result, the industry is much healthier today with more

resilient issuers to better handle the expected rise in losses in the context of weakening

consumer credit. To whit, Chart 28 shows the top 10 home equity issuers in 1997 and

2003. Only three issuers were rated single-A or higher in 1997 vs. six in 2003.

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Chart 28

Top 10 HEL Issuers in 1997 and 2003

Source: JPMS, MCM.

All of the aforementioned factors point to the conclusion that the default rates

implied by Moodys material impairment study are probably conservative, and we

dont think its a far stretch to use slightly more aggressive (i.e. lower default rates)

base-case assumptions for SF CDOs. However, we point out that the Moodys data

covers only a short credit cycle (albeit one that includes a severe downturn), and

that it takes a few cycles to fully assess default risk. As such, a bit of conservatism

is certainly healthy for CDO structures.

Moodys defines structured product loss severity as the present value of periodic

losses (including both interest and principal shortfalls) as of the origination date.

Defaulted securities accumulate their losses gradually, so complete information onrecoveries is only available for a small sample of securities that have been paid down

or permanently written-down (84 tranches). Recovery rates for these securities are

shown in the Zero Outstanding Balance (i.e. actual final recovery rates) column in

Table 14. Nevertheless, we can get a good idea of expected recoveries on a larger



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30

Issuer Rating $mm % Market

GMAC A3 30,714 15.6%

Ameriquest NR 23,302 11.9%

New Century NR* 17,369 8.8%

Countrywide A3 15,721 8.0%

Lehman Aa3 14,482 7.4%

Option One BBB+ 11,008 5.6%

CSFB Aa3 6,692 3.4%

Washington Mutual A2 6,674 3.4%

JPMorgan Chase Aa3 6,482 3.3%

NovaStar NR* 5,694 2.9%

*No debt outstanding

1997 Top 10 Issuers1997 Top 10 Issuers

Issuer Rating $mm % Market

ContiMortgage Ba1 5,685 9.0%

Money Store A1 5,505 8.5%

IMC NR 4,857 7.5%

Advanta Ba2 3,150 4.9%

FirstPlus BB- 2,983 4.6%

Conseco Finance Baa1 2,734 4.2%

UCFC Ba1 2,725 4.2%

GMAC Aa1 2,685 4.2%

Bank of America A1 2,674 4.1%

Amresco B1 2,291 3.5%

2003 Top 10 Issuers2003 Top 10 Issuers

Recovery Rates

Table 14

Recovery Rates by Sector, 1993-2002

Yr. After OriginationZero

Out-standing> 6yr* > 8yr* Balance

ABS (including HEL)Mean Recovery 81.6% 66.1% 59.4%

Standard Dev 27.4% 33.7% 33.0%# Observations 55 24 20CMBSMean Recovery 100.0% 100.0% 100.0%Standard Dev 0.08% 0.00% 0.00%# Observations 6 4 4RMBS (Prime)Mean Recovery 73.0% 67.5% 54.5%Standard Dev 29.2% 31.1% 32.5%# Observations 136 102 60

Source: Moodys, JPMS.

* In addition to those with zero outstanding balance. includes impaired

securities >n years past origination.

Table 15

Projected Recovery Rate on HEL13

# of TranchesRecovery Original Original(%) Rtg. A Rtg. BBB

0%-10% 310%-20% 2

20%-30% 330%-40% 040%-50% 1 150%-60% 1 060%-70% 1 470%-80% 2 080%-90% 1 290%-100% 1 3100% 7Average 70% 56%

Source: JPMS, Intex Solutions.

13. ABS Monitor, JPMS, 16 September 2003.


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sample by looking at current loss-implied recovery rates on impaired securities that

are far away from their origination date (>6yr and >8yr column). Note that eventual

recoveries will inevitably be lower than these implied numbers since losses willcontinue to accumulate over time.

There is significant recovery rate volatility within each sector, as evidenced by

standard deviations of 27% - 33% for ABS and RMBS. Table 15 looks explicitly at

expected recoveries on HEL subordinates, and suggests similar conclusions about

recovery volatility. Moodys offers several explanations for recovery variation across

deals. Among these is that securities with higher recoveries typically defaulted late,

after much of the principal balance had been paid down. Securities with lower

recoveries typically defaulted earlier or had quicker loss accumulation. For this

reason, Moodys notes that the recoveries on securities with zero outstanding balance

are probably more severe than can be expected on a going forward basis, since this

population represents the deals that were written down over a short period of time,and represents the more risky set of defaulters.

Subordinate tranches are likely to have lower recoveries (less subordination and

smaller overall size) than senior tranches. Table 15 supports this axiom for HELs.

Because the Moodys data set is largely representative of subordinate tranches (few

seniors have defaulted), recovery rates may reasonably be adjusted upward for

senior tranches.

Now that weve looked at both default and recovery rates for structured products, the

question becomes what is a reasonable loss assumption for a SF CDO model. The

answer, of course, depends on both the rating and the collateral. In Table 16 below,

we work through an example for a hypothetical SF CDO with a Baa weightedaverage rating and collateral allocated as follows: 50% ABS, 30% CMBS, 20%

RMBS. Note that we are using the annual material impairment rates from Table 12

and recovery rates from the zero balance column in Table 14.

Table 16

Annualized Loss Rate for a Hypothetical SF CDO

Portfolio Annual Material Recovery Loss AggregateWeight Impairment Rate Rate Rate Annual Loss Rate

ABS (including HEL) 50% 0.89% 59.4% 0.36%CMBS 30% 0.17% 100.0% 0.00% 0.29%RMBS 20% 1.23% 54.5% 0.56%

Source: JPMS, Moodys.

We stress that the loss rate derived here stems directly from Moodys studies.Undoubtedly, investors and SF CDO originators should make modifications to these

assumptions. For example, at the risk of stating the obvious, the assumption of 100%

recoveries for CMBS will likely prove unrealistic over a larger sample. In addition, we

have already made a case that the annual material impairment rate may be overstated,

particularly for ABS. These are but two examples, and other modifications are possible.

Ultimately, our purpose for this study is to give investors and issuers the best

information available regarding performance to date. This current reality check

will prove particularly useful in evaluating the rating agency assumptions (see Rating

Agencies section) used to structure SF CDOs.

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Putting It All Together:Annualized Loss Rates


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SF CDO Structure

To begin our analysis of SF CDO structures, Table 17 provides a comparison to

traditional term ABS transactions, as well as CLOs (the most popular CDO sector).

As seen, SF CDOs have longer average lives than traditional ABS, ranging from 6 to

14 years. While expected losses on the underlying collateral are expected to be fairly

minimal, due to the leveraged nature of the transactions, triple-A credit enhancement

levels are substantially higher than traditional structured products.

Table 17

Structural Comparison: Traditional SF CDOs v Other CDOs & Structured Products

SF CDOs HY CLOs IG Syn CDO Credit Cards HEL

Collateral Mezzanine ABS BB/BB- Lev

Documents

JP Morgan CDO Handbook