Lehman Brothers - Credit Derivatives Primer

8/6/2019 Lehman Brothers - Credit Derivatives Primer

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G LO BAL EQ UITY RESEA

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Credit Deriva tives PrimerAdvantages, Risks, Accounting, Regulation, and the W ay Ahead

Credit derivatives are becoming increasingly popular as a means of offsetting

traditional lending risk and enhancing returns. Although used virtually exclusively

now at only the largest banks, we believe various derivative structures will

increasingly migrate to smaller institutions across the industry over time.

n W hile the recent grow th in the credi t deriva tives market has been explosive and

future growth appears promising, there are several issues that still need to be

addressed to foster w ider ac ceptance by p rospective participa nts. In this repo rt,

we focus on remaining legal hurdles, existing and future regulatory frameworks, the

state of accounting standards governing bookkeeping, and a basic discussion ofhow different types of credit derivatives function.

n Credit derivatives are off-balance sheet financial instruments that allow investors to

more efficiently transfer and repa ckag e credi t risk. Financ ial institutions use them to

enhance equity capital allocation, augment returns, improve asset-liability

management, and optimize credit exposure.

n The global credit derivatives market has grown from almost nothing in 1995 to

more than $1 trillion in notional amount at the end of 2001, according to recent

estimates, and is expected to grow to $5 trillion at the end of 2004.

n As of 2Q 0 2 U.S. banks held credit derivative contracts w ith a notional a mount of

$500 billion, still this is just 1% of the notional amount of total derivatives held.

Credi t derivatives are concentrated among the largest banks w ith JP M organ,

C itigroup, and Bank of America comprising over 9 0 % of the market. W e believe

that over time mid-sized and small banks are increasingly likely to hold these

instruments as standardization lowers associated costs and management teams feel

more comfortable with implied risks.

n The credit derivatives market is regarded as a more efficient gauge of pure default

risk than the cash bond or equities markets as it is not as hampered by technical

issues such as lack of liquidi ty or interest rate fluctuations. In ad di tion, some

investors view the market as more subject to speculative forces, and therefore more

volatile, than the cash market.

Brock Vandervliet1 .212 .526 .8893

[email protected]

Juan Partida, CFA1 .212 .526 .5744

[email protected]

FIN AN CIAL SERVICES

Large-Cap Banks UNITED STATES

Sector View: 3-NEGATIVE

October 18, 2002

http:/ / www.lehman.com


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Credit Derivatives Primer

2 October 18, 20 02

Introduction

O ne of the issues that has arisen, pa rticularly this year as credit problems at the largest

ba nks have deep ened, i s the nature and imp act of credit derivatives. Despite improving

disclosure, it remains difficult to discern on an individual-bank basis the precise impact of

credit derivatives let alone ascertain the specific mix of derivatives a bank may be

employing. W e thought it w ould be useful to publish an ana lysis of the credit derivatives

market that lies w ithin the broa der category of derivatives. As show n in Figure 1 below,

although the market continues to grow extremely rapidly, it remains a very small part of

the overall derivatives market, which remains dominated by futures contracts and interest

rate swaps.

Figure 1: Breakdown of Derivatives Held by U.S. Banks

Futures &

Forwards

21%

Swaps

58%

Options

20%

Credit

Derivatives

1%

Source: O CC 2Q 02 Bank Derivatives Report

Figure 2: Growth in Derivatives by Type ($ Billion)

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

Futures &Forwards

Swaps

Options

CreditDerivatives

Total

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1Q02 2Q02



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As opposed to actionable research tied directly to trading or investment ideas, this

analysis consists of a description of major types of credit derivatives, the size of the

market, and major players, as well as both current and proposed regulatory and

accounting treatment that may affect the speed with which the market grows. Although

highly concentrated a mong the largest banks w ith JP M organ Cha se, C itigroup, a nd

Bank of America comprising 93% of total notional value, we believe the characteristicsand capabilities of these products will make them increasingly sought after by broader

array of banks over time.

Particularly with respect to pooled credit derivative products where credit risk is offset

against a pool of multiple loan exposures, we believe these structures will become a

compelling means of offsetting risk and immunizing the loan portfolio. In many cases

this can already be done more rapidly than individual secondary market loan sales

which, for other than a relative handful of extremely large corporate borrowers, is an

illiquid and inefficient market.

Figure 3: Market Share Credit Derivative Products in the Global Market

Single-name

default swaps

45%

Portfolio/CLO's

22%

Credit-linked Notes

8%

Total Return Swaps

7%

Asset Swaps

7%

Credit Spread

Options

5%

Basket Products

6%

Source:BBA 20 02 Credi t Derivatives Survey; as a % of Total N otional Amount O utstandi ng. Includes all participa nts

(banks, insurance companies, hedge funds. Figures as of 2001.

W hat a re Credit Derivatives?

Credit derivatives are off-balance sheet financial instruments that allow one party (the riskseller or protection buyer) to transfer the credit risk of a reference asset, which it

normally owns, to another party (the protection seller or guarantor) without actually selling

the asset. In other words, credit derivatives enable investors to efficiently transfer and

repackage credit risk. Credit risk in this context is inclusive of all credit-related events

ranging from a spread widening tied to a rating downgrade, for example, to actual

default. Reference assets include across bank debt, corporate debt, as well as high-

grade sovereign and emerging market sovereign debt. According to some estimates,


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approximately 60% of underlying assets are corporate, while the rest is split between

banks and sovereign credits.

Size of the Market

The global credit derivatives market has grown from almost nothing in 1995, with only a

few one-off structures, to more than $ 1 trillion in notional amount at the end of 2 0 0 1 ,according to recent estimates (British Bankers Association, 2002 Report on Credit

Derivatives), and is expected to grow to $5 trillion at the end of 2004. Banks are

currently the largest players in the market. However, hedge funds have strongly entered

the market, particularly as buyers, and by 2004, insurance companies are expected to

become the largest sellers of protection. As of 4 Q 0 1 , single-name default swaps

comprised 4 5 % of the glob al market (See Figure 3 )

G rowth in these products is only bound by the size of the pool o f reference assets (bonds

and loans that underlie them). Specifically, banks use credit derivatives for the follow ing

purposes:

n To hedge credit risk;

n To reduce risk concentrations on their balance sheets; and

n To free up regulatory capital.

According to the 2Q 0 2 Bank Derivatives Report of the O CC , b anks in the United States

have credit derivative contracts with a notional amount of $500 billion. This amount

represents only 1% of the notional amount of all derivatives the banks hold (See Figure

1 )

Credit derivatives are highly concentrated among a handful of players, as shown below.

The five largest credit derivatives portfolios represent 96% of all derivatives held, while

the largest 16 are virtually the entire market. These fig ures are similar to the statistics for

the total derivatives ba nk portfolios. As show n in Figure 4 , JP M orga n Cha se clearly

dominates in this area, holding 56.5% of total credit derivatives by notional amount,

followed by 20.1% at Citibank, and 16.1% at Bank of America.


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Figure 4: Concentration of Credit Derivatives.

Top 16 Banks 2Q02 % Cumulative %

1 JP Morgan Chase 278,104 56.5% 56.5%

2 Citibank 99,072 20.1% 76.6%

3 Bank of America 79,111 16.1% 92.7%

4 Wachovia 9,631 2.0% 94.6%

5 Fleet National Bank 7,898 1.6% 96.3%6 Bank One 6,716 1.4% 97.6%

7 HSBC Bank USA 2,412 0.5% 98.1%

8 Wells Fargo 2,268 0.5% 98.6%

9 Bank of New York 1,841 0.4% 98.9%

10 Merrill Lynch Bank 1,565 0.3% 99.3%

11 Deutsche Bank Americas 569 0.1% 99.4%

12 Suntrust Bank 255 0.1% 99.4%

13 First Tennessee Bank 240 0.0% 99.5%

14 PNC Bank National 159 0.0% 99.5%

15 Mellon Bank 19 0.0% 99.5%

16 Comerica Bank 11 0.0% 99.5%

Largest 16 489,871 99.5%

Other Banks 2,394 0.5% 100.0%

Total Banks 492,265 100.0%


Similar to overall growth trends in the market, credit derivatives growth at U.S. banks has

been explosive, boasting the largest growth rate for any of the generic types of

derivatives. Growth rates declined in 2001, in line with the rest of the derivatives

products, at least in part due to the introduction that year of FAS 133, Accounting for

Derivatives, which generated uncertainty as to its impact on bank financial statements. In

2Q02 credit derivatives expanded 59.2%, the highest level since 1999. For 1H02 the

growth rate w as 55 .1 % annualized.

Uses of Credit Derivatives

In their simplest form, credit derivatives provide a more efficient way to replicate the

credit risk that exists for a standard cash instrument. These transactions are sometimes

called single-name credit derivatives, as the reference assets belong to a single exposure.

For example, selling a default swap (providing protection) on a G M bond is similar to

the direct purchase of the bond. If the bond defaults, then the losses are borne by the

protection seller. If the bond does not default, the investor receives the credit spread

periodically, which should be similar to the bond coupon minus the cost of funding the

bond had it been purchased. The advantage is that the investor replicates the cash flows

of the bond and at the same time circumvents any technical limitations, such as the bond

not being available for purchase.

In their more complex form, credit derivatives allow investors to split up the credit profile

of an entire group or pool of assets into tranches and redistribute them among a wide

variety of investors, depending on credit risk tolerance. The more complicated instruments

are sometimes referred to as multi-name credit derivatives, as they involve exposures to


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several names . These arrang ements typica lly require the use of o ff- or on-ba lance sheet

Special Purpose Entities (SPEs), which purchase the risk from banks and resell it to

investors. Banks normally have to retain a fraction of ownership called the equity

portion (See Figure 13), which consists of the highest risk tranche.

The credit derivatives market is considered more efficient than the equivalent cash marketas it is not as hampered by liquidity issues and other extraneous market forces. However,

being a relatively new market, liquidity is still concentrated in the short maturities,

normally five years, but longer maturities are slowly consolidating as well.

W hile the credit derivatives market moves more quickly than the cash market, and cred it

derivative risk spreads are typically more responsive to changes in the underlying

fundamentals of the reference assets, there also tends to be a high level of concentration

on the names generating news flow at a particular moment. A good example of this is

shown below where we depict spreads on Citgroups bonds versus the spread on its

default swaps. Perceived changes in the credit risk of a particular issuer tend to be

followed by a flurry of trades from market participants to take short or long positions. This

makes the market more volatile that the cash market, but directionally the same over any

reasonab le time horizon.

Figure 5: Evolution of Cash Spread Versus Default Swap Spread (Citigroup)

0

20

40

60

80

100

120

140

160

180

2/15/01

3/15/01

4/15/01

5/15/01

6/15/01

7/15/01

8/15/01

9/15/01

10/15/01

11/15/01

12/15/01

1/15/02

2/15/02

3/15/02

4/15/02

5/15/02

6/15/02

7/15/02

8/15/02

9/15/02

Cash Spread Default Swap Spread

Source: Lehman Brothers

Greater Standardization as the Market Matures

Another characteristic of the derivatives market is its increasing standardization. Initially,

credit derivative contracts were tailor mad e for each transaction. N ow , the use of the

International Swap Derivatives (ISDA) master agreement, which provides standardized

language, has increased liquidity and reduced legal risk. According to some estimates,

91% to 98% of transactions in the derivatives market in 2001 were done using ISDAs


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standardized format. However, there remain significant documentation issues regarding

restructuring credit event definitions that still need to be addressed.

Regulatory Uncertainty Hampers Growth

W hile the regulatory aspect of the market is somew hat lagging , regulators around the

world are making great efforts to ensure appropriate accounting disclosure and suitablecapital allocation requirements. Some of these changes will diminish some of the

advantages of credit derivatives, particularly regarding regulatory capital arbitrage

transactions (explained in more detail later in this report). However, it is unlikely that

growth in these products will decline significantly as a result. That said, according to

practitioners (BBA 2002 Survey), the single most important hindrance to credit derivatives

growth is regulatory uncertainty, particularly regarding negotiations for the new

regulatory capital requirement standards known as Basle II.

Types of Credit Der ivatives

The following description of credit derivative products draws from research from anumber of sources including: Lehmans Structured Credit area, documents from U.S.

regulators, including the Federal Reserve and the O ffice of the Comptroller of the

Currency, and publications of the Basle Committee on Banking Supervision.

There are a number of products that can be classified under the broad umbrella of credit

derivatives, ranging from asset swaps, the most popular instrument typically focused on

relatively small single exposures ($10 million-$50 million) to the Synthetic Collateralized

Loan O bliga tion (CLO ), which covers poo led exposures and very large notional amounts

($ 2 billion-$ 5 billion) (See Figure 3 ).

Floating Rate Notes

Floating Rate N otes (FRN s) are technica lly not a credit derivative, b ut they serve as a

benchmark of credit derivative pricing because their valuation is driven almost entirely by

credit risk. An FRN is a bo nd that pays a coupon linked to a variable rate index.

Because an FRN eliminates most of the interest rate sensitivity (changes in interest rates

impact bond prices briefly, only until the interest rate is reset to market rate levels),

variations in the value of the notes are almost exclusively tied to changes in the perceived

cred it risk of the issuer. These instruments are typ ica lly priced using LIBO R, and therefore

the spread over LIBOR, w hen issued a t pa r, reflects the cred it quality of the issuer

(including subordination of the notes). As the spread is fixed at issuance, the bond pricewill vary with changes in the credit risk of the issuer.

The fixed spread at issuance (and subsequently the spread calculated to value the bond,

known as the par floater spread) is a function of the probability of default (P), and the

expected recovery rate in the event of d efault (R), as show n in Figure 6 . Simply stated,

the spread will be higher, the higher the probability of default and lower with a higher

expected recovery.


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Figure 6: The Credit Triangle

Spread (S)

Probability Recovery

of Rate on Credit ( R )

Default (P)

Source: Lehman Brothers Structured Credit Research

Banks normally issue fixed maturity or perpetual FRN s to satisfy bank ca pita l

requirements. The advantage of these notes is that they have a low duration despite

having infinite maturity, because the sensitivity of the price of these notes to changes in

the interest rate is limited. Credit investors seek these bonds as a way to assume the

credit risk of the bank without assuming interest rate risk. H ow ever, FRN s are a relatively

small fraction of bonds outstanding, and therefore, credit investors typically have to buy

fixed rate bonds, hedging away the interest rate risk using asset swaps.

Asset Swaps

An asset swap is a synthetic floating rate note. This structure allows an investor to turn a

fixed rate bond into a floating rate bond. To create it, the investor typically buys the

bond and simultaneously enters into a floating-for-fixed interest rate swap with the same

notional value as the bond. This is similar to a regular interest rate swap with the

important distinction that the investor is long the bond and therefore is bearing the fullthe investor is long the bond and therefore is bearing the fullthe investor is long the bond and therefore is bearing the fullthe investor is long the bond and therefore is bearing the full

credit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the counter----party risk in the swapparty risk in the swapparty risk in the swapparty risk in the swap

transaction.transaction.transaction.transaction. The investor is compensated for taking this risk by means of an asset swap

spread, which is also a widely used pricing reference in the credit derivatives market.

This is because, in the event the bond defaults, the investor will take an impairment on

the bond (par value minus recovery), and will have to continuecontinuecontinuecontinue paying the coupon as

part of the swap arrangement with its counterparty. Alternatively, the interest rate swap

can be closed out at market value. If LIBOR plus the spread i s higher than the coupon on

the bond (i.e., if the bond is trading at a discount), then the investor will realize a gain

on the swap a nd reduce the losses from the default on the bond . Conversely, if the


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floating rate is low er than the coupon, the investor w ill realize a loss. Leveraged

positions, such as when buying a bond trading at a premium, would command a higher

spread, because the investors stands to lose more in the event of default.

Figure 7: Mechanics of a Par Asset Swap

At initiation Asset Swap buyer purchases bond at full price in return for par

Bond

Worth P

Asset Swap Asset Swap

Seller Buyer

100

And enters into an interest rate swap paying a fixed coupon in return for Libor plus spread

LIBOR + S

Asset Swap Asset Swap Bond

Seller Buyer Defaults

Coupon Coupon is lost

If default occurs the asset swap buyer loses the coupon and principal redemption on the bond.The interest rate swap will continue until bond maturity or can be closed out at market value.

Source: Lehman Brothers Structured Credit

The primary use of this instrument for banks is for asset-liability management. Banks

increase their credit exposure and at the same time limit increases in duration of assets,

which is suitable given the floating rate nature (low duration) of deposits and other bank

funding. Asset swaps can also be used to take advantage of mispricings in the floating

rate note market. Tax and accounting reasons may also make it advantageous to buy

and sell non-par assets at par through an asset swap.

Default Swaps

The default swap has become the standard credit derivative. According to the BBA

Credit Derivatives Survey, it dominates the credit derivatives market wi th over 38 % of the

outstanding notional. It is a relatively simple product that opened a new set of

possibilities not previously available in the cash market.

In a default swap (Figure 8), one counterparty agrees to make payments based on a

notional amount, either quarterly or yearly in the event of a default of a prespecified

reference asset (or name). The main purpose of using a reference asset is to specify

exactly the capital structure seniority of the debt that is covered. It is also important in the

determination of the recovery value should the default swap be cash settled. In addition,

the maturity of the swap may not be the same as the maturity of the reference asset. It is

common to specify a reference asset with a longer maturity than the swap.


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Figure 8: Mechanics of a Default Swap

Between trade initiation and default or maturity, protection buyer

makes regular payments of default swap spread to protection seller

Protection Protection

Buyer Seller

Following the credit event one of the following will take place:

Cash Settlement

Protection Protection

Buyer Seller

Physical Settlement

Bond

Protection ProtectionBuyer Seller

100

Default Swap Spread

100 minus recovery rate


The payoff of a credit-default swap is contingent on a default event (bankruptcy,

insolvency, restructuring, delinquency, or a credit-rating downgrade) and therefore would

resemble more an option than a swap, but the convention is to call these transactions

swaps. As usual, the default event is clearly defined in the contract, normally according

to ISDA rules.

Upon default, however defined, the swap is terminated, and a default payment is

calculated. The recovery rate is calculated by referencing dealer quotes or observable

market prices over some prespecified period after default has occurred (normally 30

days). Alternatively, the default payment may be defined in advance as a percentage of

notional amount (these are commonly referred to as binary or digital swaps).

The contract must also specify the payoff that is made following the credit event. This

payment is the difference between par and the recovery value of the asset. This can be

done either in a physical or cash-settled form:

n Physically deliver of a defaulted security to the protection seller in exchange for par in

cash. The contract usually specifies a basket of obligations that are ranked pari passu

and that may be delivered in place of the defaulted asset. All pari passu assets

should be w orth the same in the event of default, but this is not alw ays the case. In

effect, the protection buyer has a cheapest-to-deliver option.


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n The protection buyer can receive par minus the default price of the reference asset

settled in cash, calculated through a dealer poll or any other suitable method.

n Fixed cash settlement, which applies to notional amounts with a pre-established fixed

recovery rate.

There are several uses for default swaps and are most frequently employed to hedge

credit risk concentrations. For instance, a bank with a high concentration to a single

client may swap out part of its exposure to an investor wishing to acquire exposure to

that name in exchange for a premium. In many instances, regulators will accept the swap

contract as a true hedge and allow the bank to reduce capital requirements, requiring

capital to be held only against the equity portion that the bank retains. Another

advantage of swaps is that they are private transactions between two counterparties,

whereas selling a loan may require customer consent or notification. In addition, default

swaps can be used to hedge credit exposures where no publicly traded debt market

exists. This is critical given the poor liquidity of the bank loan market.

Conversely, default swaps are an unfunded way to take credit risk, making it easier for

banks or other buyers to increase credit exposure efficiently. Default swaps can be

customized to match an investors precise requirements in terms of maturity and seniority,

and they can be used to take a view of both the deterioration or improvement in credit

quality of the reference asset. Finally, dislocations between the cash and derivatives

market can make the default swap a higher yielding investment than the equivalent cash

instrument.

Credit-Linked Notes

A credit-linked note is a funded credit derivative. As opposed to an unfunded credit

derivative, such as an default swap, credit-linked notes imply an investment in the cash

instrument. These are notes issued by one issuer (say, a bank), which has a credit risk

exposure to a second issuer (say, a corporation, which is known as the reference

issuer).

These notes pay an enha nced coupon, typica lly linked to LIBOR, to the investor for taking

on the added credit risk of the second reference issuer. In case the note defaults the

investor stands to lose some or all of their coupon income and principal.

In this case the investor is the protection seller, and the bank is the protection buyer. Forexample, the bank will typically have a corporate bond exposure, which it wants to

hedge (See Figure 9). The investor pays par for the credit linked notes to the bank, and

gets the floating coupons of the corporate bonds (Libor plus 10 basis points in this

example), plus a credit spread paid by the bank (in this case 20 basis points) to

compensate for the ad ded default risk. N ote that the investor has to be co mpensated for

both the default risk of the bank and that of the corporation that issued the reference

asset.


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If the bond defaults, then the note entitles the holder to receive the defaulted bonds and

the bank keeps the proceeds originally paid by the investor for the note. Unlike an asset

swap, there is no default contingent interest rate risk.

Figure 9: Structure of the Racer

Interest distributions LIBOR + 0.30% per annum

Investor gets a Fed Funds rate + 0.25% coupon investment at par.

If default occurs,

100% - recovery

Investor Racers Issuer

0.20% per annum

LIBOR + 0.10%

AAA Asset

Backed

LIBOR + 0.30%

Source: Lehman Brothers Structured C redi t.* Race rs - Restructured Asset Ce rtifica tes w ith Enhance d Returns

Repackaging Vehicles

These vehicles are used to convert or create credit risk structures in a securitized form

accessible to a broad range of investors. They can be used to turn existing credit

derivatives into a cash product required by some investors. The generic structure for

doing this is the Special Purpose Vehicle (SPV). Prior to the Enron debacle, this was a

little known structure. These vehicles are seen as an alternative to the credit-linked note.

The main difference between the two is that the SPV is a legal trust or company that isbankruptcy remote from the sponsor, since a default by the sponsor would not affect

payments on the issued note. If the SPV has entered into an interest rate swap, there is

also po tential co unter-pa rty risk. N otes issued can be exchange-listed and rated by a

rating agency. Legally, an SVP is either a trust or a company. The trust form of SPV is

most relevant to the U.S. market and is usually organized under the laws of Delaware or

N ew York. The trustee is normally a h ighly rated ba nk with fiduciary duty to investors.

This product has become highly standardized so that several investors, not only the

arranger, can participate.

SVPs are typically used to securitize asset swaps. Due to internal restrictions many

investment funds are not allowed to invest in interest rate swaps directly, and SVPs allow

them to achieve a similar exposure. Suppose an investor wants to invest in a floating rate

corporate bond, but only fixed rate bonds are outstanding. Since the investor is

prevented from entering an interest rate swap directly, he would be unable to get his

desired exposure. However, if an SVP purchases the underlying security and enters into

the interest rate swap, the same investor can purchase notes in the SVP that represent the

combined economics of the asset swap package (See Figure 1 0 ).


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October 18, 2 00 2 13

Figure 10: Securitized Asset Swap Issued out of an SPV

Fixed Rate SPV Issued

Asset Note

LIBOR + spread Fixed Rate

Swap

Counterparty

Fixed Rate LIBOR + spread


If the asset in the SVP defaults, the interest rate swap is closed out, with the swap

counterparty usually having first recourse to the liquidation of proceeds of the defaulted

asset, with the remainder going to the note investor. An SVP can also be used to issue

credit-linked notes, which may embed several types of default swap s. O bviously, these

notes would have no exposure to the sponsor, contrary to regular credit-linked notes.

Instead, the note is collateralized using securities. The SVP purchases the underlying

securities chosen by the investor as collateral. Concurrently, the SVP sells protection to a

third party, say a bank. If a credit event occurs, the SPV liquidates the underlying

securities, with the proceeds first going to pay the bank and any remainder going to the

note investors.

Principal Protected StructuresPrincipal Protected StructuresPrincipal Protected StructuresPrincipal Protected Structures

Principal protected structures are instruments designed for investors who prefer to hold

high-grade credits that guarantee to return the investors initial investment at par value.

Credit derivatives are used to provide this protection. The note issuer can be a highly

rated O ECD ba nk. O ther banks purchasing the notes would be allow ed to use the BIS

risk weighting of the issuing b ank (20 %), rather than that of the reference asset, w hich

w ould normally be 1 0 0 %. The principa l p rotected structure is a funded credit derivative

similar to a credi t linked note. If a cred it event occurs before maturity of the note,

investors lose the remaining coupon payments, but at maturity they would receive

principal in full.

Total Return Swaps

A Total Return Swap (TRS) is a contract that allows investors to receive the tota l return on

an underlying reference asset, including coupon and principal payments, and eventually

margin calls from marking the bonds to market. In exchange, the total return receiver will

pa y the investor a spread over LIBOR. Upo n maturity of the swap , the total return payer

pays the difference between the final market price of the asset and its initial price. If

default occurs, the total return receiver must bear the loss. The asset is delivered or sold,

and the price shortfall paid by the receiver. In some instances, the swap may continue

with the receiver posting add itional collateral.


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14 October 18, 20 02

The total return receiver has naturally a bullish view. He is expecting credit quality of the

reference asset to improve, while the payer is expecting deterioration.

Figure 11: Mechanics of a Total Return Swap

During Swap

Total Return Total Return

Payer Receiver

At Maturity Any increase in the market value of

the notional amount of the reference asset

Total Return Total Return

Payer Receiver

Any Decrease in the market value ofthe notional amount of the reference asset

Coupons from reference asset

LIBOR + Fixed Spread


A TRS is viewed as an efficient way of transferring or acquiring credit risk in an unfunded

manner (purchase of the reference asset is not necessary). As such, a TRS is more of a

balance sheet management instrument than a credit derivative. However, given that the

underlying asset can default, and the TRS protects the payer from this event, it usually is

classified as a credit derivative. An investor acting as a swap payer may hedge itself by

buying the underlying asset at the inception of the trade, funding it on balance sheet,

and selling it at maturity of the contract.

TRS contracts allow investors to take a leveraged position to a credit. They also enable

investors to obtain off-balance sheet exposure to assets they may otherwise not be

allow ed to invest in.

In add ition, a TRS allow a investors to go short an asset wi thout having to sell it. M ore

importantly, these instruments can be used to create tailor-made assets with the specific

maturity required by banks to fill gaps in a portfolio of credits.

Multi-name Credit Derivatives

Index Swaps

These instruments are Total Return Swaps linked to several securities in an index, rather

than a single security. They can be structured in several ways according to the needs of

the investor. For instance, the buyer of the index may receive the gain or loss in the value

of the index, plus coupon accrual in return for floating rate payments.


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October 18, 2 00 2 15

Index swaps are appealing to investors who wish to buy a more diversified portfolio than

would be available in the cash market. These transactions are normally more liquid than

the equivalent in the cash market. Index swaps can also be used to benchmark a

portfolio to standard fixed income indexes more quickly and without the need for in-depth

knowledge about specific companies in the index.

Basket Default Swaps

This instrument is similar to a regular default swap, only that the credit event is the default

of some combination of exposures in a specified basket of credits. For instance, in a first-

to-default basket, it is the first credit in the basket of reference credits whose default

originates a payment to the protection buyer, which can be cash settled or involve

physical delivery of the defaulted asset. First-to-default baskets have gained popularity

recently because they enable investors to get credit risk and earn a premium in the

process, while being exposed to high-quality names.

Investors selling protection do not actually increase downside risk, as they bear the samepotential loss as if they had bought the asset in the first place. However, the premium

collected can be much higher than in a single credit transaction, because it is calculated

as a function of each individ ual credit in the portfolio . M ore risk-averse investors can

build safer structures, such as second- or third-to-default contracts, and still earn attractive

premiums. Baskets can also be designed in a funded form as a credit-linked note or

issued as a security out of an SPV. They can also be issued in a principal protected form.

Investors like these arrangements because of the high premiums, which allow them to

leverage credit exposures while taking on proportionally low risk. A downside is that the

bank capital treatment for baskets is very conservative and complex, requiring banks to

hold capital against each of the assets in the basket.

For this instrument, investors need to be mindful of the probability of each bond

defaulting, and correlation of defaults within the portfolio. The higher the correlation, the

more likely it is that the more senior tranches will experience a loss, because defaults at

any given point may be more sizable, exceeding the protection afforded by the more

junior tranches.

Portfolio Default Swaps

For many investors, the main alternative to baskets is the tranched portfolio default swap.

They are similar to default baskets in the sense that they take a portfolio of credits and

redistribute the credit risk into first and second tranche loss products. The main differences

are, first, that the size of the portfolio is usually much larger, many times consisting of a

basket of 40-100 names. Second, the redistribution of the risk is specified in terms of the

percentage of the portfolio loss to which a particular investor is exposed, rather than the

number of assets.


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16 October 18, 20 02

For instance, consider a portfolio of 50 credits, with a face value of $5 million apiece,

tranched into a 1 0 % first loss tranche a nd a 9 0 % loss piece. The investor in the first loss

tranche will take all the defaults until they reach 10% of the value of the portfolio notional

amount. The coupon on the tranche is paid based on the notional adjusted for defaults,

w hile the spread pa id remains a constant percentag e of the notional tranche.

Portfolio default swaps are a new and powerful tool for investors to leverage or de-

leverage their exposure to a large group of assets. This can be done in a funded or

unfunded manner.

Portfolio default swaps are the building blocks for synthetic collateralized loan obligations

(CLO s), which have become the technology of choice for ba lance sheet securitization.

To understand how a synthetic C LO works, w e w ill first look at the process of

securitization of defaultable assets.

Collateralized Debt Obligations (CDO)

A C DO is a structure of fixed income securities whose cash flows are linked to the

incidence of default in a pool of debt instruments. These credits may include loans,

revolving lines of credit, other asset-backed securities, emerging market, and sovereign

deb t. W hen the colla teral comprises mainly loans the structure is called a C LO .

CLO s are securitizations of large portfolios of secured or unsecured corpora te loans

made to commercial and industrial customers of one or several banks. These structures

allow banks to achieve various objectives including the reduction of credit risks and

regulatory capital requirements, access to an efficient funding source for lending, added

liquid ity, and increased returns on equity and assets. C LO s genera lly fall into one of two

categories: cash-flow structures and market-value structures. In market-value structures

credit enhancement is achieved through specific overcollateralization levels assigned to

each underlying asset. Cash-flow structures are transactions in which the repayment and

rating of the CLO deb t securities dep end on the cash flow o f the underlying loa ns.

As part of a C LO transaction, loans are sold or assigned to a trust or other bankruptcy-

remote special-purpose vehicle (SPV), which in turns issues securities, similar to what is

done for single credit securities.

The securities issued by the trust normally consist of one or more classes of rated debt

securities with different seniorities, including a residual equity tranche. They have different

rates of interest, weighted average live, and credit ratings in some cases to appeal to

different types of investors. Banks normally retain an equity interest to provide additional

security to investors. CLO s normally require one o r more ad ditional cred it enhancements

to achieve the credit rating desired by investors. They include internal enhancements,

such as subordination, excess spread, and cash collateral accounts, and also external

enhancements, including insurance by mono line insurers. W hile the loans being

securitized normally have an 8% capital charge, these equity tranches are normally


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October 18, 2 00 2 17

weighted on a one-to-one basis, meaning that each dollar of exposure has to be

supported by a dollar of equity. However, the size of the tranche is normally around 2%-

3%, so a securitization should result in a reduction in capital requirement for banks.

Theoretically, the assets in a CLO are only loans, but in practice they normally comprise

a more diverse mix of assets including structured notes, participation interests, revolvingcredit facilities, and trust certificates.

Figure 12: Collateralized Loan Obligation

Source: Lehman Structured Credit Research

The Master Trust Structure for CLOs

M aster trusts are w idely used to structure a w ide array of A sset Backed Securities (ABS)

transactions. They are principally used to securitize credit card receivables. Banks like

these structures because they allow them to issue notes with differing tenors and

characteristics. Typically, banks will issue several series of notes under a single master

trust.

In contrast to credit card trusts, how ever, C LO master trusts are view ed as more risky,

because loans comprised in them are less diversified, have longer maturities, and moreuneven cash flows than credit card receivables. Similar to ordinary credit card trusts,

transferor banks in C LO trusts retain an interest in the assets of the trust (know n as

transferor interest) to align the bank interests with that of the investors and to furnish

additional cash if flows allocated to investors are insufficient to cover interest and

principal payments. However, the need to split cash flows between transferor bank and

investors requires additional monitoring from the latter.


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18 October 18, 20 02

Figure 13: CLO Master Trust Structure

Source: Federal Reserve Board, Tradi ng and Ca pital-Ma rkets Activities Manual

To make the notes attractive to the largest number of investors, including other banks,

mutual funds, and insurance companies, issuers normally have the notes rated. Rating

agencies look at the credit history of the companies tied to the loans, the enhancements

and the structure of the transaction.

Enhancements for CLO s are typica lly internal, relying much less on external insurance to

improve ratings. As we mentioned, internal enhancements frequently used include the

setting up of a cash-collateral account to smooth out cash flows in case of defaults. Also

common is the availability of any excess spreads above and beyond those required topay current interest to create an additional cushion rather than going to the transferor.

O f more interest to us is subord ination, which consists of issuance by the trust of notes

with different seniority. Issuing banks will typically keep the most junior tranche of the

ininininvestorsvestorsvestorsvestors interest (which is different from the transferors interest that banks keep as part

of the normal structure of the trust).

Therefore, in this example, the bank would retain the risk on the transferors interest, the

junior-most tranche or equity interest, and would be responsible for the setting up of a

cash collateral account from its own funds. It will also renounce claims on the excessspread on the loans transferred until securities in the trust mature and are paid.

Synthetic C LO SecuritizatiSynthetic C LO SecuritizatiSynthetic C LO SecuritizatiSynthetic C LO Securitizatio nsonsonsons

W e have explained how a regular CLO securitization works, but we have not yet show n

how credit derivatives come into pla y in these structures. Synthetic C LO s provide the link

between the two.


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October 18, 2 00 2 19

Again, the intent of the transaction would be to transfer credit risk to the investors and

lower the bank capital charge significantly below the customary 8% that applies to

regular loans.

Figure 14: Synthetic CLO Securitization.

Source: Trad ing and Ca pital- M arkets Activities Ma nual of the Federal Reserve, Lehman Brothers

As show n in Figure 14 , the structure is very similar to that of a n SPV for sing le exposures.

The issuing bank pays a fee to the SPV for default protection on a pool of previously

identified loans, using default swaps. The SVP then issues credit notes linked to the

specific c redits (see the description of C redit-Linked N otes (CLN ) above) and sells thehigher rated notes to investors, using the proceeds to buy Treasury securities. Since the

Treasury securities are practically risk-free, the counter-party risk for the bank in the

portfolio swap is negligib le and ca n qualify to ob tain a 0 % risk weig hting. CLN s are

used in amounts sufficient to cover some percentage of expected losses, normallynormallynormallynormally

around 7%around 7%around 7%around 7%----8% of the notional amount of the reference portfolio.8% of the notional amount of the reference portfolio.8% of the notional amount of the reference portfolio.8% of the notional amount of the reference portfolio. The remainder of the

credit risk is hedg ed using a senior credit default swap w ith a highly rated (O ECD)

counterparty, for which the weighting would be 20%.

Figure 15: Example of a Regulatory Charge for a Synthetic CLO



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20 October 18, 20 02

As shown in Figure 15, the regulatory charge can be brought down substantially through

the use of a CLO . There could b e several la yers of losses to pa rticip ants: First, in case of

default of some of the loans, the SPV would lose the spread between the revenue from

the fees and the interest income on the Treasury securities, and the coupon interest paid

on the note. The second layer of losses would accrue to investors in the CLN s, then

losses would go to the senior default swap seller, and finally, the bank would endure thelosses beyond the first and second layers.

A slightly different structure can be designed in which the SPV purchases single exposure

CLN s from the bank seeking p rotection, a nd then the SPV issues floating rate no tes to

investors, co llateralized by the indi vidual CLN s. Therefore, the dolla r amount of the notes

issued to investors equals the notional amount of the reference portfolio. Similar to what

hap pens in credit ca rd securitizations, the ba nk has the op tion to remove CLN s from the

poo l, so long as they are replaced by similar notes.

The main d ifferences between a regular C LO and a synthetic one is, first, that in the

latter, loans are never transferred to the SPV, which allows the bank to avoid damaging

client relationships. N ot only that, the possibi lity open by synthetic C LO s to manag e

credit risk, in pa rticular in those structures ba cked by CLN s rather than defa ult swaps,

can even help enhance client relationships. For instance, when a bank feels

uncomfortable increasing exposure to a client, but is afraid of damaging the relationship

by denying a dd itional loans, it can issue a CLN on pa rt of the exposure, sell it to the

trust, and issue additional loans to its client. Finally, banks are normally able to fund the

assets on balance sheet more chea ply than b y structuring a regular C LO .

Risks of Credit Derivatives

In this section we analyze the basic risks involved in a credit derivatives transaction to

show what the implications to banks are of engaging in them.

Credit Risk

Banks can acquire two types of credit risk through a credit derivatives transaction. First, if

they sell protection, they will be taking on credit risk related to the reference assets,

similar to what they would get through the outright purchase of the asset. Banks need to

analyze the characteristics of the reference asset just as if they were going to buy it.

Second, they also take on counter-party risk, the risk that the party that sold them credit

protection will be unable to make good on its agreed obligation. In this case the risk is

really the joint occurrence of a default of the reference asset and of the protection seller,

which should be relatively low so long as the credit condition of the reference asset and

the protection seller are not highly correlated.

Market Risk

M ost of the risk borne by banks will be in the shape of cred it risk. M arket risk is clearly

an issue if the bank engages in credit derivatives tradingtradingtradingtrading, as the pricing of the


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October 18, 2 00 2 21

instruments is a function of interest rates, the shape of the yield curve, and credit spreads.

O utside of trad ing activities, market risk depends on the particular credit derivative being

used. An asset swap requires the marking to market of the interest rate swap. For other

derivatives with cash flows throughout the life of the product, such as total return swaps,

the total return receiver may face margin calls that could affect its financial position.

Another potential risk is that banks selling protection face a large probability that defaultwill not occur and a small probability that it (and a substantial payout) will occur with

unknown consequences. This type of risk is hard to hedge.

Liquidity Risk

Liquidity risk also applies more to those institutions that actively trade, as given the

relative newness of the market sometimes there are pockets of illiquidity, particularly at

longer maturities, that make it difficult for a bank to offset its position before maturity,

although this is changing rapidly. In addition, it is important that banks include credit

derivatives in their cash flow budgeting to avoid liquidity issues as defaults covered by

the bank may require significant cash outlays.

Legal Risk

Until recently, the main issue hindering the development of the credit derivatives market

had been the lack of standard documentation and agreement as to the definitions of a

default event. This generated legal basis risk, the risk that definitions or the legal

structure used in the purchase of protection differ from the hedge definitions, potentially

eliminating or diminishing the effectiveness of the hedg e. W hile this is still a risk, the

ad op tion of ISDA M aster Ag reement, w hich requires the use of a standardized short-form

confirmation, similar to that used in regular swap transactions, has simplified and

homogenized the trading of credit derivatives. This has reduced the need for specialized(and expensive) legal expertise and opened the door to a wider range of participants.

However, there appear to be significant documentation issues regarding restructuring

and modified restructuring credit event definitions that still need to be addressed.

The most important legal issue affecting the market now is definition of what constitutes a

default event (see Figure 16) and what is the obligation (the type of defaulted security

that can be delivered to a protection seller in the event of default). The basic categories

of obligations are: bond, bond or loan, borrowed money, loan, payment, and reference

obligations only. In Figure 17 we show eight additional characteristics used to refine the

nature of the ob ligation.


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22 October 18, 20 02

Figure 16: ISDA-Specified Credit Events

Source: ISDA, Lehman Brothers Structured Credit Research

Figure 17: ISDA Obligation Characteristics

Source: ISDA, Lehman Brothers Structured Credit Research

Accounting for Credit Deriva tives

To understand the accounting guidelines used to report derivatives, we believe it is

important to analyze the framework to account for derivatives in general, in particular

regarding hedges.

Derivative instruments are classified according to the following three categories:

n N o hedge designation. G ains or losses on derivatives classified in this category have

to be included in current income. In this case, the instrument is deemed not be

reducing the risk of another exposure and therefore cannot be classified as a hedge.


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October 18, 2 00 2 23

n Fair-Value Hedge. A derivative would be classified in this category if it is deemed to

be a hedge of exposures to changes in the fair value of a recognized asset or liability

or an unrecognized firm commitment. A good example is the hedging of a fixed

coupon bond. The bond is subject to changes in fair value from movements in the

market interest rate (including variations in the credit spread). Entering an interest rate

swap to exchange fixed for floating rates would remove (fully or partially) the risk ofchanges in fair value. In this case, the fair-value gains or losses on the bond go

against current net income, as would the offsetting gains or losses on the swap.

n Cash-Flow Hedge. Derivatives removing the uncertainty about future cash flows can

be placed in this category. The obvious example is that of an investor who owns a

floating rate bond (with low duration and therefore with small changes in fair value)

and enters a floating-for-fixed interest rate swap transaction to hedge against changes

in the periodic cash flows he receives. Fair-value gains or losses, derived from the

interest rate swap, are included in other comprehensive income, without affecting net

income. O nly when the contract is terminated a re gains or losses recognized through

the income statement. The accounting guidelines allow for the gain-loss recognition

deferral because the bond is assumed to be kept to maturity, and therefore any fair

market losses or gains would eventually approach zero as the bond matures. In the

mean time, the bond-holder diminished the uncertainty of cash flows.

This general framework is included in FASBs Standard 133 (FAS 133). This was an

important step toward the implementation of fair-value accounting for derivatives, but it is

obviously a work in progress. Companies have been using this standard for close to two

years, and already the FASB is working on amendments to it based on commentary

received from users.

Treatment of Credit Derivatives under FAS 133

The most critical issue is to determine if the credit derivative qualifies as a derivative

under FAS 133. In most of the cases the answer would be yes, and therefore the

contract would have to be marked to market. Exceptions are default swaps that provide

for payments to be made only to reimburse the guaranteed party for a loss incurred

because the debtor fails to pay when payment is due (financial guarantees), and the

contract specifies that the protection buyer must be exposed to the loss on the reference

asset at all times.

Hedge accounting is allowed only when it is possible to identify fully the risk that thecredit derivative would be hedg ing. W hen default sw aps are used, FAS 1 3 3 requires

that interest rate and credit risk be segregated. A fixed-rate note, covered with a suitable

default swap would qualify for fair-value hedge treatment. Credit risk would be measured

by the credit spread, the difference between the full rate on the bond minus the reference

rate. For more complicated hedges, it may be more difficult to obtain hedge accounting

treatment, and this may reduce the demand for more exotic credit derivative structures.


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24 October 18, 20 02

Bank Capital Regulation

The purpose of bank capital regulation is to ensure that banks possess enough capital to

withstand expected or unexpected losses related to operations. Since credit derivatives

are a means to modify the credit risk profile of financial institutions, it is important to look

at the guidelines to determine risk capital weights for credit derivatives transactions. As

such, we can better understand the current impact on capital of these transactions, aswell as the effect of forthcoming international regulations.

BIS Capital Requirements

The current set of guidelines was established by the Basle Committee on Banking

Supervision in July 19 8 8 . Those rules, known as the Basle C ap ital Accord, are still in use

today, after several amendments. These guidelines are the blueprint for capital

regulations all over the world. A new accord is currently being discussed and is

expected to be in force in 2 0 0 4 . The current framew ork is based on a fixed 8 % cap ital

charge on risk assets, which may be adjusted multiplying them by fixed risk weightings,

applied if the client or counterparty is deemed to have a low risk level.

In the case of derivatives, the first step to estimate a capital charge is the calculation of

credit exposure, w hich w ould represent risk-weighted assets. N ote there is a large

disconnect between notional amounts and actual credit exposure that makes reference

only to the notiona l amount mislead ingly hig h. N otiona l amounts are just a reference to

calculate the cash flows in a derivative contract, but this is not a good indication of the

amount that is at risk. For instance, interest payments on an interest rate swap contract

may be based on a $1 million notional amount, but onlyonlyonlyonly the interest payments are at

risk, since principal do es not have to be p aid at maturity. As of 2Q 0 2 , the notional

amount of derivatives held by U.S. banks was $50 trillion. However, the gross creditexposure was just $1.1 trillion. The exposure was further reduced by bilateral netting

agreements of $580 billion, so that actual net credit exposure is only $525 billion (See

Figure 18). A netting agreement is an arrangement between two parties in which they

exchange only the net difference in their obligations to each other. The primary purpose

of netting is to reduce exposure to cred it/ settlement risk.

N otiona l and credi t expo sure figures normally diverge, but they are much closer to each

other in the case of credit derivatives than in the case of interest rate swaps. The notional

amount for interest rate sw aps is $2 9 .5 trillion for U.S. ba nks as of 2Q 0 2 , w hile it is

only $495 billion for credit derivatives, but the actual amount at risk is much closer than

the notional amount the figures would suggest.

The method used by most major banks to calculate derivatives exposures (known as the

current exposure method) is to mark each instrument to market, total the values of all

instruments with positive values to establish the current replacement cost, and add to this

an amount (known as add-on) for potential future exposure that is based on the notional

underlying principal of each contract.


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October 18, 2 00 2 25

Figure 18: Notional Amounts and Credit Exposure ($Billion)

1,104 580

525

50,084

0

200

400

600

800

1000

1200

1400

Notional

Amount

Gross

Exposure

Master Netting

Agreements

Net Credit

Exposure


M ost exposures have a 1 0 0 % weighting, meaning they require an 8 % cap ital charge.

Assets orig inated in transactions w ith OECD banks carry a 2 0 % weig ht and transactions

with OECD g overnments carry a 0 % weight (See Figure 14 ) . O ne of the main criticisms

against this system is that it is too coarse in reflecting operational risk. This sometimes

results in perverse incentives for the institutions. For instance, since loans to a AAA-rated

corporation are weighted the same as loans to a B-rated corporation, a bank is

indifferent between lending to any of the two from a capital perspective. As a result, a

bank may decide to move all its high-quality exposures off-balance sheet and leave the

riskier loans on balance sheet, as those would presumably carry significantly higher

yields. This is a form of regulatory arbitrage, employed by banks to make their use of

capital more efficient and was one of the principal motivations for banks to use credit

derivatives.

If a bank determines that the potential losses from a given exposure are 2%, but capital

regulations require 8%, it may enga ge in a n asset swap w ith an O ECD bank and reduce

its capital charge. Under current BIS rules, when a bank is provided a guarantee on a

loan the risk-weighting of the original obligor is substituted with the risk of the guarantor.

In other words, the capital charge would be reduced from 8% (8% x 100% risk-

weighting) to 1.6% (8% x 20%). The capital freed by the transaction can be used to

make additional loans, normally with a risk level more consistent with the capital

committed. Even then, it could be argued that the charge is still too high, because the risk

is now that both the original obligor andandandand the protection seller default at the same time.


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26 October 18, 20 02

Figure 19: The BIS Risk Weightings

Source: Basle Committee on Banking Supervision

Current Treatment of Credit Derivatives

W hen the original accord w as enacted in 1 9 8 8 , credit derivatives did not exist, so the

treatment they normally get is that of guarantees. The capital treatment is as follows:

n Default Swaps. As we explained above, when the bank is the protection buyer, the

swaps are treated as a guarantee and the weighting of the original obligor is

replaced with the weighting of the guarantor. A bank using the swap to sell

protection will have to use the weighting it would apply to the reference asset.

n The treatment is similar for funded instruments like cred it linked no tes and SPVs. W hen

the bank sells protection, the charge is the same as if it was long the loan. W hen the

bank buys protection, the weig hting is that of the collateral, w hich normally is O ECD

government paper, so the treatment is favorable. An interesting case is that of the

fixed-rate recovery swaps, because the weighting is linked to the notional minus

guaranteed recovery rate. That amount is a better reflection of the exposure to a

credit. The fixed recovery portion may be weighted at the rate of the guarantees

provid ed b y the CLN or SPV.

n In a total return swap, the total return payer (the buyer of protection) uses the weightof the total return receiver, rather than that of the reference asset. The protection seller

uses the weight of the reference asset. In other words, the treatment is similar to that of

the default sw ap .

n For baskets of products the treatment varies, but it can go from requiring the use of the

weight of the riskiest asset or the average of all weightings. In the United States, the

protection buyer can replace the weighting on the asset with the smallest dollar

amount to the risk weighting of the guarantor. A protection seller must hold capital

using highest risk-weighted asset.

Forthcoming Regulatory Changes

The Basle Committee is currently working on a new set of fully revised guidelines that

would remove performance inconsistencies for banks by aligning economic risk and

capital requirement.


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October 18, 2 00 2 27

Figure 20: Credit W eightings Under Option 1


The Committee is working along three lines to compute the capital charges. In the

simplest, known as the standard charge, the current ratings shown in Figure 19 would be

replaced with risk weightings linked to external credit ratings (See Figure 20). Banks that

satisfy certain technical requirements would be allowed to use their own internal ratings

(See Figure 21). The end result is probably going to be a reduction in regulatory capital

levels.

Figure 21: Risk Weights under Option 2 (Internal Classification Ratings)

Internal risk 1 2 3 4 to 6 7

Scores

Risk 0% 20% 50% 100% 150%

Weights


In addition, the removal of the perverse incentives from a regulatory capital perspective is

likely to increase demand among banks for high quality credits and lower the appetite

for low q uality exposures. O ur expectation is that if these rules are ad op ted, b anks w illkeep high quality credits on-balance sheet, and will use credit derivatives to hedge

exposures to riskier loans, contrary in some cases to what occurs today, because banks

have the incentive to keep riskier exposures on-balance and securitize higher quality

credits.

For credit derivatives, the treatment in principle would be similar. That is, protection

buyers would use the weighting of the guarantor and protection sellers would use the

weightings of the reference asset. The difference is that, for protection sellers, the

weighting of the reference asset may be more or less than 100% depending on the

internal rating of the bank or the rating from the rating agency.

For protection buyers, the w eighting w ould b e adjusted using the follow ing formula:

r* = w x r + (1 w) x g, or

r* = g + w x (r - g)


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28 October 18, 20 02

where r* is the effective risk weight, r is the risk weight of the obligor (reference asset), w

is the weight applied to the underlying exposure, and g is the weight of the protection

provider. W hile it allow s a value of w = 0 % for guarantees, the new Accord puts a floor

on the weight for credit derivatives for hedging purposes at 15%. In our previous

example of a hedg ing transaction using default swaps, g = 2 0 %, the risk of a O CDE

bank.

Assuming the bank is an A -rated institution (see Figure 20 ), under the new framew ork the

weighting for the bank would still be 20%. It is clear from the formula that if the risk of the

reference asset is greater than that of the guarantor, which is not unusual, the capital

charge under the new rules will be higher. If the rules were approved under their current

form, the higher capital charge could discourage the use of default swaps and reduce

the liquidity of the credit derivatives market. However, given the flexibility the instruments

afford banks to manage capital, we believe the impact would be modest.

Conclusion

In summary, we view credit derivatives as an efficient instrument for banks to potentially

improve capital allocation, optimize asset and liability management, and enhance

returns. In ad dition, credit derivatives markets may provid e investors w ith a more

accurate and responsive assessment of corporate credit risk, which should result in more

efficient markets.

Although the use of credit derivatives is growing rapidly, they are still highly concentrated

among only a very small group of the largest banks. W e believe, how ever, that credit

derivatives will begin to gain wider acceptance particularly those that offer a means to

hedg e credit risk on a poo led ba sis as oppo sed to individ ual exposures. Current factors

affecting market depth are the impact of impending changes to accounting regulatory

capital requirements and the need to refine default event definitions to eliminate legal

uncertainty, pa rticularly tied to restructuring events.

As with any other derivative, the use of credit derivatives implies banks assume credit,

counter-party, market, and legal risks. Some instruments provide an easy way to take

leveraged positions on basically any credit available in the market, equivalent to making

a loan without having to fund it. The challenge for banks (and regulators) is to ensure that

they assess correctly the risk of the reference asset, and that adequate monitoring and

risk management systems are in place to ensure the risk assumed is consistent with an

institutions capitalization levels.


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October 18, 2 00 2 29

Figure 22: Valuation TablePricePricePricePrice PricePricePricePrice Actua lActualActualA ctua l Esti ma te sEstimatesEstimatesEstimates P/ E RatioP/ E RatioP/ E RatioP/ E Ratio Relative P/ E (S&P 5 0 0 )Relative P/ E (S&P5 00 )Relative P/ E (S&P5 00 )Relative P/ E (S&P5 00 )

AnalystAnalystAnalystAnalyst SymbolSymbolSymbolSy mb ol Ra ti ngRatingRatingRating 1 0 / 1 7 / 0 21 0 / 1 7 / 0 21 0 / 1 7 / 0 21 0 / 1 7 / 0 2 TargetTargetTargetTa rget 2 0 0 12 0 0 12 0 0 12 0 0 1 2 0 0 22 0 0 22 0 0 22 0 0 2 2 0 0 32 0 0 32 0 0 32 0 0 3 2 0 0 1 a2 0 0 1 a2 0 0 1 a2 00 1a 2 00 2e2 0 0 2 e2 0 0 2 e2 00 2e 2 00 3e2 0 0 3 e2 0 0 3 e2 00 3e For.For.For.For. 2 0 0 1 a2 0 0 1 a2 0 0 1 a2 00 1a 2 00 2e2 0 0 2 e2 0 0 2 e2 00 2e 2 00 3e2 0 0 3 e2 0 0 3 e2 00 3e Fo r.For.For.For.

IN TEGRATED PRO VIDERSIN TEGRATED PRO VIDERSIN TEGRATED PRO VIDERSIN TEG RATED PRO VIDERS N EG ATIVEN EGATIVEN EGATIVEN EGATIVE

Vandervliet BAN K O N E CO RP. O N E 2 Equal weight $38 .4 6 $43 $2 .4 7 $2 .7 7 $3 .1 0 15 .6 13 .9 12 .4 1 2 .7 81 78 77 77

Vandervliet Bank of America Corp.Bank of America Corp.Bank of America Corp.Bank of America Corp. BACBACBACBAC 1 O verw eight1 Overweight1 Overweight1 O verw eight $ 68 .4 4$ 6 8 . 4 4$ 6 8 . 4 4$ 6 8 .4 4 $ 8 2$8 2$8 2$ 8 2 $ 4 .9 5$ 4 . 9 5$ 4 . 9 5$ 4 .9 5 $ 5.6 8$ 5 . 6 8$ 5 . 6 8$ 5 .6 8 $ 6.3 0$ 6 . 3 0$ 6 . 3 0$ 6 .3 0 1 3 .813 .813 .81 3 .8 1 2 .01 2 . 01 2 . 01 2 .0 1 0 .91 0 . 910 .91 0 .9 1 1 .111 .111 .11 1 .1 7 272727 2 6 767676 7 6 868686 8 6 8686868

Vandervliet Citigroup C 2 Equal w eight $ 35 .1 4 $ 43 $2 .8 2 $2 .9 0 $3 .5 0 12 .5 12 .1 1 0 .0 10 .5 65 68 62 64

Vandervliet J. P. M organ Chase & Co. JPM 2 Equal w eight $ 18 .6 1 $ 20 $1 .6 6 $1 .8 0 $2 .6 5 11 .2 10 .3 7 .0 7 .7 58 58 44 47

Integrated ProvidersIntegrated ProvidersIntegrated ProvidersIntegrated Providers 1 3 .313 .313 .31 3 .3 1 2 .11 2 . 11 2 . 11 2 .1 1 0 .11 0 . 110 .11 0 .1 1 0 .510 .510 .51 0 .5 6 969696 9 6 868686 8 6 363636 3 6 4646464

TRUST & PROC ESSIN G BA N KSTRUST & PROC ESSING BAN KSTRUST & PROC ESSIN G BA N KSTRUST & PRO CESSIN G BAN KS N EG ATIVEN EGATIVEN EGATIVEN EGATIVEVandervliet Bank of N ew York BK 2 Equal w eight $ 26 .3 1 $ 30 $2 .0 1 $1 .5 9 $2 .1 3 13 .1 16 .5 1 2 .4 13 .2 68 93 77 8 0

Vanderv liet City Nat ional BankCity National BankCity National BankC ity N ational Bank C YNCYNCYNC YN 1 O verw eig ht1 Overweight1 Overweight1 O verw eight $ 44 .7 0$ 4 4 . 7 0$ 4 4 . 7 0$ 4 4 .7 0 $ 6 5$6 5$6 5$ 6 5 $ 2 .9 6$ 2 . 9 6$ 2 . 9 6$ 2 .9 6 $ 3.5 3$ 3 . 5 3$ 3 . 5 3$ 3 .5 3 $ 3.9 0$ 3 . 9 0$ 3 . 9 0$ 3 .9 0 1 5 .115 .115 .11 5 .1 1 2 .712 .71 2 . 71 2 .7 1 1 .51 1 . 511 .51 1 .5 1 1 .711 .711 .71 1 .7 7 878787 8 7 171717 1 7 171717 1 7 1717171

Vandervliet Investors Financial IFIN N ot Rated $29 .1 0 N A $0 .7 7 $1 .0 2 $1 .2 7 37 .8 28 .5 22 .9 2 4 .1 1 96 1 60 1 43 1 46

Vandervliet M ellon Financial M EL 3 Underweight $26 .2 6 $ 31 $1 .5 7 $1 .5 7 $2 .0 0 16 .7 16 .7 1 3 .1 13 .9 87 94 82 84

Vandervliet N orthern Trust Corp. N TRS 3 Underweight $ 37 .1 6 $ 40 $2 .1 1 $2 .0 5 $2 .2 3 17 .6 18 .1 16 .7 17 .0 91 1 01 1 04 1 03

Vandervliet PN C Financial Services G roup PN C 3 Underweight $36 .7 6 $ 42 $3 .5 6 $4 .2 1 $4 .2 0 10 .3 8 .7 8 .8 8 .7 54 49 54 53

Vandervliet State Street Corp. STT N ot Rated $ 40 .2 6 N A $2 .00 $2 .22 $2 .47 20 .1 18 .1 16 .3 1 6 .7 10 5 1 02 1 01 1 01

Vandervliet W ilmington Trust Corp. W L 3 Underweight $ 29 .8 1 $ 34 $1 .89 $2 .06 $2 .20 15 .8 14 .5 13 .6 1 3 .7 82 81 84 84

Trust & Processing BanksTrust & Processing BanksTrust & Processing BanksTrust & Processing Banks 1 8 .318 .318 .31 8 .3 1 6 .716 .71 6 . 71 6 .7 1 4 .41 4 . 414 .41 4 .4 1 4 .914 .914 .91 4 .9 9 595959 5 9 494949 4 9 090909 0 9 0909090

SUPER REGION ALSSUPER REGIO N ALSSUPER REGION ALSSUPER REG IO N ALS N EUTRALN EUTRALN EUTRALN EUTRAL

Goldberg BB&T Corporation BBT 3 Underweight $35 .3 5 $32 $2 .4 0 $2 .7 5 $2 .9 5 14 .7 12 .9 1 2 .0 12 .2 77 72 75 7 4

Goldberg Comerica Inc. CM A 2 Equal w eight $ 41 .2 4 $ 44 $4 .7 2 $3 .4 1 $4 .8 5 8 .7 12 .1 8 .5 9 .2 45 68 53 5 6

Goldberg Fifth Third Bancorp. FITB 2 Equal w eight $ 65 .3 6 $ 65 $2 .37 $2 .76 $3 .10 27 .6 23 .7 21 .1 2 1 .6 14 3 1 33 1 31 1 32

Goldberg FleetBoston Financial FBF 2 Equal w eight $ 21 .9 0 $ 25 $1 .4 8 $1 .4 9 $2 .5 5 14 .8 1 4 .7 8 .6 9 .8 77 82 53 6 0

Goldberg KeyCorp KEY 3 Underweight $24 .79 $25 $0 .7 4 $2 .2 8 $2 .4 5 33 .5 1 0 .9 1 0 .1 10 .3 1 74 61 63 6 3

Goldberg N ational City Corp. N CC 2 Equal weight $ 28 .0 5 $ 30 $2 .2 7 $2 .5 5 $2 .6 5 12 .4 11 .0 10 .6 10 .7 64 62 66 65

Goldberg SunTrust Banks STI 3 Underweight $60 .11 $57 $4 .7 9 $4 .80 $4 .95 1 2 .5 1 2 .5 1 2 .1 12 .2 6 5 7 0 7 6 7 4

G o ldber g U .S. Banc o rpU.S. BancorpU.S. BancorpU.S. Bancorp USBUSBUSBUSB 1 O verw eight1 Overweight1 Overweight1 O verw eight $ 20 .0 1$ 2 0 . 0 1$ 2 0 . 0 1$ 2 0 .0 1 $ 2 5$2 5$2 5$ 2 5 $ 1 .3 2$ 1 . 3 2$ 1 . 3 2$ 1 .3 2 $ 1.8 4$ 1 . 8 4$ 1 . 8 4$ 1 .8 4 $ 2.0 2$ 2 . 0 2$ 2 . 0 2$ 2 .0 2 1 5 .215 .215 .21 5 .2 1 0 .910 .91 0 . 91 0 .9 9 .99. 99. 99 .9 1 0 .110 .110 .11 0 .1 7 979797 9 6 161616 1 6 262626 2 6 1616161

Goldberg W achovia Corp. W B 3 Underweight $33 .9 5 $ 35 $2 .1 2 $2 .7 8 $3 .0 5 16 .0 12 .2 1 1 .1 11 .4 83 68 69 69

G o ldber g We l ls Fa rgoW ells FargoW ells FargoW ells Farg o W FCW FCW FCW FC 1 Overw eig ht1 Overweight1 Overweight1 O verw eight $ 49 .6 5$ 4 9 . 6 5$ 4 9 . 6 5$ 4 9 .6 5 $ 6 0$6 0$6 0$ 6 0 $ 2 .3 5$ 2 . 3 5$ 2 . 3 5$ 2 .3 5 $ 3.3 2$ 3 . 3 2$ 3 . 3 2$ 3 .3 2 $ 3.7 0$ 3 . 7 0$ 3 . 7 0$ 3 .7 0 2 1 .121 .121 .12 1 .1 1 5 .01 5 . 01 5 . 01 5 .0 1 3 .41 3 . 413 .41 3 .4 1 3 .713 .713 .71 3 .7 1 1 01 1011 01 1 0 8 484848 4 8 484848 4 8 4848484

Super RegionalsSuper RegionalsSuper RegionalsSuper Regiona ls 1 7 .717 .717 .71 7 .7 1 3 .61 3 . 61 3 . 61 3 .6 1 1 .71 1 . 711 .71 1 .7 1 2 .112 .112 .11 2 .1 9 292929 2 7 676767 6 7 373737 3 7 4747474

MID-CAP BANKSMID-CAP BANKSMID-CAP BANKSM ID-C AP BAN KS N EUTRALN EUTRALN EUTRALN EUTRALGoldberg AmSouth Bancorp ASO 3 Underweight $20 .1 3 $20 $1 .4 5 $1 .6 8 $1 .8 0 13 .9 1 2 .0 1 1 .2 11 .3 72 67 70 6 9

Goldberg Char ter One FinancialCharter One FinancialCharter One FinancialC harter O ne Financial C FCFCFC F 1 O verw eight1 Overweight1 Overweight1 O verw eight $ 30 .1 4$ 3 0 . 1 4$ 3 0 . 1 4$ 3 0 .1 4 $ 3 7$3 7$3 7$ 3 7 $ 2 .1 0$ 2 . 1 0$ 2 . 1 0$ 2 .1 0 $ 2.4 3$ 2 . 4 3$ 2 . 4 3$ 2 .4 3 $ 2.7 0$ 2 . 7 0$ 2 . 7 0$ 2 .7 0 1 4 .314 .314 .31 4 .3 1 2 .412 .41 2 . 41 2 .4 1 1 .21 1 . 211 .21 1 .2 1 1 .411 .411 .41 1 .4 7 474747 4 6 969696 9 6 969696 9 6 9696969

Goldberg Compass Bancshares CBSS 2 Equal-w eight $ 32 .1 1 $ 35 $2 .1 1 $2 .4 2 $2 .6 0 15 .2 13 .3 1 2 .4 12 .5 79 74 77 7 6

Goldberg First Tennessee N ational FTN 2 Equal w eight $ 35 .14 $3 8 $2 .32 $2 .75 $2 .95 15 .1 12 .8 11 .9 1 2 .1 79 72 74 74

Lacoursiere Huntington Bancshares HBAN 3 Underweight $19 .06 $22 $1 .1 7 $1 .33 $1 .43 1 6 .3 1 4 .3 13 .3 13 .5 8 5 8 0 8 3 82

Lacoursiere M &T Bank Corp M TB RS $8 1 .60 - $3 .8 7 $5 .0 6 $5 .5 0 21 .1 1 6 .1 1 4 .8 15 .1 1 10 90 92 9 2

Goldberg M arshall & Ilsley Corp. M I 2 Equal weight $27 .8 0 $30 $1 .8 6 $2 .1 8 $2 .3 5 14 .9 12 .8 1 1 .8 12 .0 78 71 74 73

Goldberg N ational Commerce Financial N CF 2 Equal weight $ 23 .8 6 $ 28 $1 .1 2 $1 .5 8 $1 .7 5 21 .3 15 .1 1 3 .6 13 .9 1 11 85 85 8 5

Goldberg Nor th Fork Bancorp.N orth Fork Bancorp.N orth Fork Bancorp.N orth Fork Bancorp. N FBN FBN FBN FB 1 O verw eight1 Overweight1 Overweight1 O verw eight $ 38 .1 6$ 3 8 . 1 6$ 3 8 . 1 6$ 3 8 .1 6 $ 4 5$4 5$4 5$ 4 5 $ 2 .0 8$ 2 . 0 8$ 2 . 0 8$ 2 .0 8 $ 2.5 8$ 2 . 5 8$ 2 . 5 8$ 2 .5 8 $ 2.8 4$ 2 . 8 4$ 2 . 8 4$ 2 .8 4 1 8 .318 .318 .31 8 .3 1 4 .814 .81 4 . 81 4 .8 1 3 .41 3 . 413 .41 3 .4 1 3 .713 .713 .71 3 .7 9 595959 5 8 383838 3 8 484848 4 8 3838383

Goldberg Regions Financial Corp. RF 3 Underweight $32 .65 $30 $2 .3 2 $2 .7 3 $2 .8 5 1 4 .1 1 2 .0 1 1 .5 11 .6 73 67 71 7 0

Goldberg SouthTrust Corp. SO TR 2 Equal weight $ 24 .1 0 $ 28 $1 .6 1 $1 .8 6 $2 .0 2 15 .0 13 .0 1 1 .9 12 .1 78 73 74 74

Goldberg Synovus Financial SN V 2 Equal weight $19 .2 3 $ 24 $1 .0 6 $1 .2 1 $1 .3 5 18 .1 15 .9 1 4 .2 14 .6 94 89 89 89

Goldberg TCF Financial Corp.TCF Financial Corp.TCF Financial Corp.TC F Financial C orp . TC BTCBTCBTC B 1 O verw eight1 Overweight1 Overweight1 O verw eight $ 42 .7 9$ 4 2 . 7 9$ 4 2 . 7 9$ 4 2 .7 9 $ 5 2$5 2$5 2$ 5 2 $ 2 .7 0$ 2 . 7 0$ 2 . 7 0$ 2 .7 0 $ 3.1 5$ 3 . 1 5$ 3 . 1 5$ 3 .1 5 $ 3.4 7$ 3 . 4 7$ 3 . 4 7$ 3 .4 7 1 5 .815 .815 .81 5 .8 1 3 .613 .61 3 . 61 3 .6 1 2 .31 2 . 312 .31 2 .3 1 2 .612 .612 .61 2 .6 8 282828 2 7 676767 6 7 777777 7 7 7777777

Goldberg Union Planters UPC 3 Underweight $26 .9 0 $ 28 $2 .1 3 $2 .5 9 $2 .8 0 12 .6 10 .4 9 .6 9 .8 66 58 60 59

Lacoursiere UnionBanCal C orp. UB 2 Equal-w eight $41 .7 7 $ 52 $2 .9 3 $3 .3 0 $3 .8 9 14 .3 12 .7 1 0 .7 11 .1 74 71 67 6 8

Goldberg Zions Bancorp. ZIO N 2 Equal weight $38 .9 3 $ 45 $3 .2 0 $3 .6 5 $4 .0 0 12 .2 10 .7 9 .7 9 .9 63 60 61 60

Mid-Cap BanksMid-Cap BanksMid-Cap BanksM id -Cap Banks 1 5 .815 .815 .81 5 .8 1 3 .21 3 . 21 3 . 21 3 .2 1 2 .11 2 . 112 .11 2 .1 1 2 .312 .312 .31 2 .3 8 282828 2 7 474747 4 7 575757 5 7 5757575

SMALL-CAPBAN KS (


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30 October 18, 20 02

Figure 23: Valuation Table (Contd)12 Mo. Dividend12 Mo. Dividend12 Mo. Dividend1 2 M o. Divid end BookBookBookBo ok Pri ce / Price/Price/Price/ SharesSharesSharesSh ares M a rketMarketMarketM arket AssetsAssetsAssetsA sse ts Re ve nueRevenueRevenueRevenue YTDYTDYTDYTD 2 0 0 12 0 0 12 0 0 12 0 0 1 2 0 0 02 0 0 02 0 0 02 0 0 0

RateRateRateRate YieldYieldYieldYield Va lueValueValueValue BookBookBookBook O utO utO utO ut C ap italCapitalCapitalCap ita l 2 Q 0 22 Q 0 22 Q 0 22 Q 0 2 2 Q 0 22 Q 0 22 Q 0 22 Q 0 2 ReturnReturnReturnReturn ReturnReturnReturnRe tur n Re turnReturnReturnReturn

IN TEGRATED PROVIDERSIN TEGRATED PROVIDERSIN TEGRATED PROVIDERSIN TEGRATED PROVIDERS (mil.)(mil.)(mil.)(mil.) (bil.)(bil.)(bil.)(bil.) (bil.)(bil.)(bil.)(bil.) (mil.)(mil.)(mil.)(mil.)

BAN K O N E CO RP. $ 0 .8 4 2 .2 % $1 8 .37 2 0 9 % $4 3 - $3 0 1 1 84 .0 $ 4 5 .5 $ 2 7 0 $ 5,1 1 8 -1 .5% 6 .6 % 1 4 .2 %

Bank of America Corp.Bank of America Corp.Bank of America Corp.Bank of America Corp. $ 2 .4 0$ 2 . 4 0$ 2 . 4 0$ 2 .4 0 3 .5 %3 . 5 %3 . 5 %3 .5 % $ 3 1 .4 7$ 3 1 . 4 7$ 3 1 . 4 7$ 3 1 .4 7 2 1 7 %2 1 7 %2 1 7 %2 1 7 % $ 7 7$ 77$ 7 7$ 7 7 ---- $ 53$ 5 3$ 5 3$ 5 3 1 5 9 2 .31 5 9 2 . 31 5 9 2 . 31 59 2 .3 $ 10 9.0$ 1 0 9 . 0$ 1 0 9 . 0$ 1 0 9 .0 $ 6 3 8$ 6 3 8$ 6 3 8$ 6 3 8 $ 8 ,6 6 8$ 8 , 6 6 8$ 8 , 6 6 8$ 8 ,6 6 8 8 .7 %8 . 7 %8 . 7 %8 .7 % 3 7 .2 %3 7 . 2 %3 7 . 2 %3 7 .2 % -8 .6 %-8.6%-8.6%-8.6%

Citigroup $0 .7 2 2 .0 % $ 1 6 .47 2 1 3 % $ 5 2 - $2 5 51 8 5 .8 $ 1 8 2 .2 $ 1 ,0 8 3 $ 2 1,2 7 3 -2 5 .4 % -1 .5 % -1 .4 %

J. P. M organ Chase & Co. $ 1 .3 6 7 .3 % $ 2 0 .93 89 % $ 4 1 - $1 5 20 1 6 .0 $ 3 7 .5 $ 7 4 1 $ 7,5 7 4 -4 8 .8 % -2 0 .0 % -1 2 .3 %

Integrated ProvidersIntegrated ProvidersIntegrated ProvidersIntegrated Providers 3 .8 %3 . 8 %3 . 8 %3 .8 % 1 8 2 %1 8 2 %1 8 2 %1 8 2 % $ 3 7 4 . 3$ 3 7 4 . 3$ 3 7 4 . 3$ 3 7 4 .3 $ 2 ,7 3 2$ 2 , 7 3 2$ 2 , 7 3 2$ 2, 73 2 $ 42 ,6 33$ 4 2 , 6 3 3$ 4 2 , 6 3 3$ 4 2 , 6 3 3 -16 .7%-16.7%-16.7%-1 6 .7 % 5 .6 %5 . 6 %5 . 6 %5 .6 % -2 .0 %-2.0%-2.0%-2.0%

TRUST & PRO CESSING BAN KSTRUST & PROCESSING BAN KSTRUST & PRO CESSING BAN KSTRUST & PROCESSING BAN KS

Bank of N ew York $ 0 .7 6 2 .9 % $ 9 .09 2 8 9 % $ 4 6 - $2 1 7 2 9 .0 $ 1 9 .2 $ 8 1 $ 1,2 7 1 -3 5 .5 % -2 6 .1 % 3 8 .0 %

City Na tional BankCity Na tional BankCity Na tional BankCity N ational Bank $ 0 .7 8$ 0 . 7 8$ 0 . 7 8$ 0 .7 8 1 .7 %1 . 7 %1 . 7 %1 .7 % $ 2 1 .4 1$ 2 1 . 4 1$ 2 1 . 4 1$ 2 1 .4 1 2 0 9 %2 0 9 %2 0 9 %2 0 9 % $ 5 6$ 56$ 5 6$ 5 6 ---- $ 39$ 3 9$ 3 9$ 3 9 5 2 .15 2 . 15 2 . 15 2 .1 $ 2 .3$ 2 . 3$ 2 . 3$ 2 .3 $ 1 1$ 1 1$ 1 1$ 1 1 $ 1 6 9$ 1 6 9$ 1 6 9$ 1 6 9 -4 .6 %-4.6%-4.6%-4 .6 % 2 0 .7 %2 0 . 7 %2 0 . 7 %2 0.7 % 1 7.8 %1 7 . 8 %1 7 . 8 %1 7 . 8 %

Investors Financial $ 0 .0 5 0 .2 % $ 6 .24 4 6 6 % $ 3 9 - $ 2 0 6 6 .6 $ 1 .9 $ 7 $ 1 0 8 -1 2 .1 % -2 3 .0 % 2 7 3 .9 %

M ellon Financial $ 0 .5 2 2 .0 % $ 7 .52 3 4 9 % $ 4 1 - $2 0 4 4 1 .0 $ 1 1 .6 $ 3 4 $ 1,0 7 5 -3 0 .2 % -2 3 .5 % 4 4 .4 %

N orthern Trust Corp. $ 0 .6 8 1 .8 % $ 1 2 .60 29 5 % $ 6 3 - $3 0 2 2 6 .6 $ 8 .4 $ 3 8 $ 5 5 2 -3 8 .3 % -2 6 .2 % 5 3 .9 %

PN C Financial Services G roup $ 1.9 2 5 .2 % $ 2 2 .46 1 6 4 % $ 6 3 - $ 3 3 2 8 5 .0 $ 1 0 .5 $ 6 7 $ 1,39 6 -3 4 .6 % -2 3 .1 % 6 4 .2 %

State Street Corp. $ 0 .1 9 0 .5 % $ 1 2 .92 3 1 2% $ 5 8 - $3 2 3 2 8 .3 $ 1 3 .2 $ 8 0 $ 9 9 4 -2 2 .9 % -1 5 .9 % 7 0 .0 %

W ilmington Trust Corp. $ 1 .0 2 3 .4 % $ 1 1 .03 2 7 0 % $ 3 5 - $ 2 5 3 2 .8 $ 1 .0 $ 8 $ 1 3 5 -5 .8 % 2 .0 % 2 8 .6 %

Trust & Processing BanksTrust & Processing BanksTrust & Processing BanksTrust & Processing Banks 2 .2 %2 . 2 %2 . 2 %2 .2 % 2 9 4 %2 9 4 %2 9 4 %2 9 4 % $ 6 8 . 1$ 6 8 . 1$ 6 8 . 1$ 6 8 .1 $ 3 2 5$ 3 2 5$ 3 2 5$ 3 2 5 $ 5 ,6 9 9$ 5 , 6 9 9$ 5 , 6 9 9$ 5 , 6 9 9 -23 .0%-23.0%-23.0%-2 3. 0% -1 4. 4%-14.4%-14.4%-1 4. 4% 7 3.9 %7 3 . 9 %7 3 . 9 %7 3 . 9 %

SUPERREGIO N ALSSUPERREGION ALSSUPERREGIO N ALSSUPERREGION ALS

BB&T Corporation $ 0 .9 8 2 .8 % $ 1 4 .99 2 3 6 % $ 3 9 - $3 1 4 8 4 .0 $ 1 7 .1 $ 7 6 $ 1,1 1 2 -2 .1 % -3 .2 % 3 6 .3 %

Comerica Inc. $ 1 .9 2 4 .7 % $ 28 .08 1 4 7 % $ 6 6 - $ 3 5 1 7 8 .0 $ 7 .3 $ 5 1 $ 7 6 2 -2 8 .0 % -3 .5 % 2 7 .2 %

Fifth Third Bancorp. $ 1 .0 4 1 .6 % $ 1 4 .10 4 6 4 % $ 7 0 - $5 3 5 9 4 .3 $ 3 8 .8 $ 7 4 $ 1,1 9 5 6 .6 % 2 .6 % 2 2 .1 %

FleetBoston Financial $ 1 .4 0 6 .4 % $ 1 5 .79 1 3 9 % $ 39 - $1 8 10 5 1 .1 $ 2 3 .0 $ 1 9 0 $ 2,8 82 -4 0 .0 % -2 .8 % 7 .9 %

KeyCorp $ 1 .2 0 4 .8 % $ 1 5 .46 1 6 0 % $ 2 9 - $ 2 0 4 3 1 .9 $ 1 0 .7 $ 8 2 $ 1,1 6 8 1 .8 % -13 .1 % 2 6 .6 %

N ational City Corp. $ 1 .2 2 4 .3 % $ 1 3 .02 2 1 5 % $ 3 4 - $2 5 6 1 6 .8 $ 1 7 .3 $ 9 8 $ 1 ,6 8 9 -4 .1% 1 .7 % 2 1 .4 %

SunTrust Banks $ 1 .7 2 2 .9 % $ 3 1 .41 1 9 1 % $ 7 0 - $ 5 2 2 8 7 .3 $ 1 7 .3 $ 1 0 6 $ 1,3 9 3 -4 .1 % -0 .5 % -8 .4 %

U.S. BancorpU.S. BancorpU.S. BancorpU.S. Bancorp $ 0 .7 8$ 0 . 7 8$ 0 . 7 8$ 0 .7 8 3 .9 %3 . 9 %3 . 9 %3 .9 % $ 8 .7 0$ 8 . 7 0$ 8 . 7 0$ 8 .7 0 2 3 0 %2 3 0 %2 3 0 %2 3 0 % $ 2 5$ 25$ 2 5$ 2 5 ---- $ 16$ 1 6$ 1 6$ 1 6 1 9 2 6 .91 9 2 6 . 91 9 2 6 . 91 9 2 6 .9 $ 3 8 .6$ 3 8 . 6$ 3 8 . 6$ 3 8 .6 $ 1 6 9$ 1 6 9$ 1 6 9$ 1 6 9 $ 3 ,0 9 7$ 3 , 0 9 7$ 3 , 0 9 7$ 3 ,0 9 7 -4 .4 %-4.4%-4.4%-4 .4 % -2 8. 3%-28.3%-28.3%-2 8. 3% 2 2.3 %2 2 . 3 %2 2 . 3 %2 2 . 3 %

W achovia Corp. $ 1 .0 4 3 .1 % $ 2 2 .15 1 5 3 % $ 4 0 - $2 8 13 7 5 .0 $ 4 6

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