Credit Derivatives Strategy

Correlation Trading Strategies

See Disclosure Appendix A1 for the Analyst Certification and Other Disclosures

Jure SkarabotCredit Derivatives StrategyCitigroup212-816-5728jure.skarabot@citigroup.com

April 21, 2006

2

Outline

Structured Credit Markets

Correlation Trading

Investors: Hedge Funds versus Real Money

Outlook for Structured Credit Products

3

Structured Credit Markets are Evolving

Cash markets Synthetic markets

u 2005 global cash CDO issuance was $202 billion.

u Cash CDO market has grown by 84% from 2004 to 2005.

u Strong issuance in 2005 and robust pipeline.

u Index-linked tranche market is expanding.

u Bespoke tranche market is holding steady.

Source: Citigroup

Source: CreditFlux

Source: CreditFlux

Data as of Mar 200612.6 10.7

25.340.6

53.2

84.6

168.1

149.2

0

40

80

120

160

200

1Q 04 2Q 04 3Q 04 4Q 04 1Q 05 2Q 05 3Q 05 4Q 05

Inde

x Tra

nche

s ($ Billio

n) Index Tranches

280.6

948.9

1831.5

294.3196.3 125.3

0

500

1000

1500

2000

2002 2003 2004* 2005*

Portf

olio

Cre

dit S

wap

s ($

Billi

on)

Notional Risk distributed* doesn't include index tranches

57.8

16.7

5.8

20.1

13.1

75.3

4.3

14.5

0.44.6 3.8

29.3

2.64.7

0.02.6

3.71.50.0

3.52.3

0

10

20

30

40

50

60

70

80

ABS CLO CRE Others ABS CLO Others

$ Bi

llions

2005 Issuance2006 YTD IssuanceVisible Pipeline

US EUROPE

4

Investors: Hedge Funds versus Real Money

Hedge Funds

Real Money

5

Hedge FundsCredit hedge funds are driving the development and growth

u Credit derivatives products have been primarily in the domain of hedge funds and proprietary desks.

u Credit hedge funds have been expanding, searching for new relative value opportunities and opportunistic trades.

u Volatility increase in credit markets is opening the door for new strategies, although credit hedge funds are exposed to margin calls.

u Standardization and acceptance of credit portfolio models has been one of the main drivers of market growth, although current portfolio models have certain shortfalls.

u Correlation players are looking for opportunities in cash CDOs and other asset classes.

u Fundamental credit analysis is becoming important for hedge funds.

6

Real MoneyReal-money investors are entering the credit derivatives markets

u Real-money investors have started to focus on synthetic structured credit portfolio products.

u Narrow spreads and low volatility pushed investors to seek alternatives to traditional credit investments and to start focusing on single-tranches, CDO-squareds, and leveraged super-senior structures.

u Traditional investors started to use tranches to customize their directional views.

u Real-money accounts have been setting up internal “long/short” funds to explore “hedge fund – like” strategies with credit derivatives.

u Money managers have started to invest and to manage synthetic transactions.

u Mark-to-market accounting rules and regulations are one of the main roadblocks for real money investors, although FAS 155 should bring changes.

7

Correlation Trading

Directional and Relative Value Trades

Investment Strategies

The “Famous” Long/Short Tranche Trade

8

Investment Strategies

Credit derivatives markets provide variety of investment opportunities

u Taking long/short market positions:

• Liquid tools to quickly express long or short macro views in credit markets.

u Leverage strategies:

• Enhancing yield through the leverage provided by synthetic tranche products and cash CDOs.

u Directional strategies:

• Taking views on different types of risk (defaults, spreads changes, correlation…)

u Relative value strategies:

• Searching for value between different tranches, credit curves, correlation and volatilities.

u Hedging strategies:

• Hedging individual default risk and/or market spread risk, minimize mark-to-market volatility.

9

The “Famous” Tranche Trade Long equity tranche, short mezzanine tranche

u With the growth of synthetic tranche markets, hedge funds took large portion of the first-loss tranche risk from dealers.

u In 2004, many investors were comfortable holding default risk, but nervous about spread sell-off.

u Common strategy to hedge against the spread risk was to to buy the protection on mezzanine/senior tranches (which carry proportionally more spread risk than default risk versus the equity tranches).

u May 2005 turmoil in the tranche markets sparked by the GM/Ford downgrade was a painful lesson for number of market players that implemented this strategy.

10

What Went Wrong?

u Single-name shocks and the sell-off in the equity part hurt mark-to-market investors.

u Mezzanine/senior tranche didn’t widen as buy-and-hold investors held their positions.

0%-3% Tranche vs. Index 7%-10% Tranche vs. Index

25

30

35

40

45

50

55

60

65

3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05 6 Jun 05

Poin

ts U

pfro

nt (%

)

40

45

50

55

60

65

70

75

80

Spre

ad (b

p)

0%–3% (left)

5Y CDX (right)

40

50

60

70

80

90

100

3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05 6 Jun 05

Spre

ad (b

p)

40

45

50

55

60

65

70

75

80

Spre

ad (b

p)

7%–10% (left)

5Y CDX (right)

Equity and senior tranches reacted differently to single-name shocks

Source: Citigroup

11

Tranche Strategies

Directional and relative value trades

u Long the equity risk

u Dispersion tranche trades

u Tranche flatteners

u Tranche steepeners

u “January effect” trade

u Directional view on a sector

u Cost-efficient shorts

u Relative value between indexes

u Default-straddle tranche trades

u Tranches versus swaptions

12

Aftermath of May 2005 Bottom fishing in trade markets – long equity

u Effect of GM/Ford downgrade and the turmoil in tranche markets led to new investment opportunities.

u At the peak, five-year IG CDX equity tranche was cheap on a fundamental basis (trading above 60 points upfront).

u Bullish investors, who were able to move in quickly, were able to make a significant profit on the back of price adjustment.

Trade recommendation: “Bottom Fishing in Tranche Markets,” Arvind Rajan, Jure Skarabot Ji Hoon Ryu, Leverage, Citigroup, May 11, 2005. Trade unwind recommendation: “Unwind the Long Position in 0%-3% IG CDX Five-Year Tranche,” Arvind Rajan, Jure Skarabot Ji Hoon Ryu, Citigroup, Jun 22, 2005.

25

35

45

55

65

75

85

3/21/05 6/21/05 9/21/05 12/21/05 3/21/06

IG C

DX4

Inde

x (b

ps)

25

30

35

40

45

50

55

60

65

0%-3

% IG

CDX

4 Tr

anch

e (p

oint

s)

IG CDX4 Index 0%-3% IG CDX4

Source: Citigroup

13

Dispersion Tranche TradesDirectional trade after the index roll

u At the last index roll we recommended buying protection on the 3%-7% seven-year IG CDX 5 tranche and selling protection on the 10%-15% seven-year IG CDX 5 tranche (delta-neutral position) in addition to neutralizing the spread exposure to two widest credits in IG CDX 5.

u The Sep 2005 roll improved overall IG CDX credit quality, but blow-up risk has remained as some of the new names in the index appear to have considerable LBO risk.

u Dispersion trade position with seven-year IG CDX 5 tranches generated substantially smaller cost than the same trade with IG CDX 4 tranches.

Trade recommendation: ‘Dispersion Trades After the Index Roll,’ Jure Skarabot Gaurav Bansal, Leverage, Citigroup, Sep. 21, 2005. Trade unwind recommendation: ‘Unwind Tranche Dispersion Trade,’Jure Skarabot Gaurav Bansal, Citigroup, Oct 7, 2005.

-150

-125

-100

-75

-50

-25

0

25

50

11 Jul 05 4 Aug 05 28 Aug 05 21 Sep 05

Spre

ad P

rem

ium

(bp)

IG CDX 5

IG CDX 4

Notional ($ Million)

Spread (bp)

Delta/Hedge Ratio

Carry ($000)

Buy protection on 3%-7% 10 252 9 (252)Sell protection on 10%-15% 75 28 1.2 210

Net (tranches) (42)

Sell protection on American Axle 0.35 365 0.035 12.6 Sell protection on Albertsons 0.28 320 0.028 9.0

Net (tranches and single-name) (20.4)

Source: Citigroup

Dispersion Trade, Seven-Year IG CDX Series 5

14

Tranche Flatteners Go long ten-year mezz, hedge with the five-year

u Tranche flatteners have been some of the most popular trades in the correlation markets, mostly driven by the technical factors.

u At the time of trade recommendation, the 5s/10s IG CDX curve stayed unchanged, long-term tranche has initially tightened and later widened, while the five-year has stayed unchanged.

u Such dislocations are usually associated with variation in the synthetic pipeline across maturities and related dealers hedging needs.

Trade recommendation: “Sell Protection on the 7%-10% Ten-Year IG CDX, Hedge with the Five-Year,” Jure Skarabot Ji Hoon Ryu, Leverage, Citigroup, May 25, 2005. Trade unwind recommendation: “Unwind 5s/10s 7%-10% IG CDX Tranche Trade,” Jure Skarabot, Ji Hoon Ryu, Citigroup, Oct 7, 2005.

Source: Citigroup

44

54

64

74

84

94

104

3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05

40

45

50

55

60

65

70

75

807-10 (left) 5Y CDX (right)

140

160

180

200

220

240

260

280

3 Jan 05 2 Feb 05 4 Mar 05 5 Apr 05 4 May 05

55

60

65

70

75

80

85

90

95

100

105

7-10 (left)10Y CDX (right)

15

Opposite View: Tranche Steepener 5s/10s mezzanine tranche trade

u Technicals (anticipated synthetic pipeline and correlation positions of dealers and leveraged accounts) has been one of the the key drivers in index-tranche space in the recent past.

u Ten-year 7%-10% IG CDX tranche has been trading on top of five-year 3%-7% IG CDX tranche as the market was expecting stronger hedging needs in the longer-term maturity.

u At the time of trade recommendation, the new synthetic issuance has been less than anticipated and to capture that view we have recommend to sell protection on the five-year 3%-7% IG CDX tranche and buy protection on the same notional of the ten-year 7%-10% IG CDX tranche.

Trade recommendation: “5s/10s Mezzanine Tranche Trade,” Jure Skarabot, Leverage, Citigroup, Aug. 10, 2005Trade unwind recommendation: “Unwind 5s/10s Mezzanine Tranche Trade,” Jure Skarabot Gaurav Bansal, Citigroup, Aug 30, 2005.

50

100

150

200

250

300

21 Mar 05 21 May 05 21 Jul 05

Tran

che

Spre

ad (b

ps)

-100

-80

-60

-40

-20

0

20

40

Tran

che

Spre

ad D

iffer

ence

(bps

)

5s/10s Difference 3%–7% Five-Yr IG CDX7%–10% 10-Yr IG CDX

Source: Citigroup

16

Anticipated Demand For RiskPosition to benefit from the “January effect”

u In an anticipation of the possible “January effect” in the tranche markets, we recommended to sell protection on equity tranche and delta-hedge it with the index.

u This trade recommendation was based on the anticipation that after the start of the new year, leveraged accounts in credit space will be looking for positive-carry, high-yield strategies.

u The equity tranche has moved in direction we predicted, but the negative carry eliminated most of the profits after taking the bid/ask costs into the account.

Trade recommendation: “Position for a January Effect in the Tranche Markets,” Jure Skarabot, Gaurav Bansal, Leverage, Citigroup, Nov. 16, 2005Trade unwind recommendation: N/A

Source: Citigroup

0102030405060708090

Nov-03 Mar-04 Aug-04 Dec-04 Apr-05 Sep-05

IG C

DX 5

YR (b

ps)

0%

5%

10%

15%

20%

25%

0%-3

% IG

CDX

5YR

Cor

r. (%

)IG CDX 5YR 0%-3% IG CDX 5YR Correlation

y = 3E-14x + 5.5463

0

2

4

6

8

10

12

14

30 40 50 60 70 80 90

IG CDX 5YR (bp)

Net P

aym

ents

(%)

Long 0%-3% 5YR, Short IG CDX 5YR 14 Nov 05

17

Directional View on Auto SectorShort auto names with zero-carry

u For investors who want to express bearish views on the auto sector while avoiding the cost of an outright short, we recommended buying protection on IG CDX4 equity tranche and selling protection on IG CDX5 equity tranche.

u This trade had low exposure to the market-wide spread and correlation risks and it should benefit if auto sector spreads blow up.

u Soon after the recommendation, IG CDX5 tranches have rallied, but IG CDX4 equity tranchehas lagged behind.

Trade recommendation: “How to Short Auto Names Through a Zero-Carry Trade,” Jure Skarabot, Gaurav Bansal, Citigroup, Feb. 9 , 2006Trade unwind recommendation: “Unwind the CDX4/CDX5 Equity Tranche Trade,” Jure Skarabot Gaurav Bansal, Citigroup, Feb. 24, 2006

Source: Citigroup 1.00

2.00

3.00

4.00

5.00

6.00

7.00

11/1/2005 12/1/2005 1/1/2006 2/1/2006

0%-3

% T

ranc

he D

iff.(%

)/Ind

ex

Diff.

(bps

)

100

200

300

400

500

600

Spre

ad(b

ps)

CDX4/CDX5 0%-3% Diff CDX4/CDX5 Index Diff GMAC

18

Cost-Efficient Short in HY Short HY CDX through a carry-neutral trade

u For investors who are looking for cost-efficient shorting strategies in HY, we recommended buying protection on the HY CDX 15%-25% tranche and selling protection on the HY CDX index in an amount to create a carry-neutral trade.

u The trade should benefit if high yield spreads widen: The 15%-25% HY CDX tranche has higher sensitivity to the spread moves than the HY CDX index.

u The key risk in the trade is the exposure to a further rally in high yield. Also, after the roll of-the-run tranches could drop in liquidity.

Trade recommendation: “Short HY CDX Through a Carry-Neutral Trade,” Jure Skarabot, Gaurav Bansal, Citigroup, Feb 21, 2006Trade unwind recommendation: N/A

350

400

450

500

550

12/1/2005 1/1/2006 2/1/2006

15%

-25%

HY

CDX

(bps

)

300

320

340

360

380

400

HY C

DX

Inde

x (b

ps)

HY CDX Index 15%-25% HY CDX

y = 1.8687x - 182.04

R2 = 0.8497

350

400

450

500

550

600

320 340 360 380 400

HY CDX Index (bps)

15%

-25%

HY

CDX

(bps

)

Feb 21, 06

Source: Citigroup

19

iTraxx Versus CDX Tranches Relative value between different indexes

u Hedging activity led ten-year CDX and iTraxx mezz tranches to diverge.

u We recommended buying protection on ten-year 7%-10% IG CDX and selling protection on ten-year 6%-9% iTraxx.

u Main risk is the difference in portfolios and the continuation of the technical pressure.

Trade recommendation: “Long/Short iTraxx vs CDX 10yr Mezz Before the Roll,” Olivier Renault, Citigroup, Mar. 8, 2006Trade unwind recommendation: N/A

7 0

8 0

9 0

1 0 0

1 1 0

1 2 0

1 3 0

1 4 0

1 5 0

2 3 - S e p 28-Oc t 0 2 - D e c 0 6 - J a n 1 0 - F e b 1 7 - M a r 2 1 - A p r

7 - 1 0 % C D X

6 - 9 % i T r a x x

Source: Citigroup

20

Default Straddle Tranche TradeAnother take on tranche flatteners

u A combination of mezzanine tranches creates straddle-like trades on the range of cumulative defaults.

u Buying protection on the five-year 3%-7% and selling protection on the ten-year 3%-7% IG CDX tranche leads to positive-carry trade with a further payoff if realized default rate fallsoutside selected range.

Trade recommendation: Straddle Trades on Defaults, Ji Hoon Ryu, Jure Skarabot, Leverage, Citigroup, Jun 29, 2005Trade unwind recommendation: N/A

-2

-1

0

1

2

3

4

5

0.0% 1.6% 3.2% 4.8% 6.4%

Loss on Portfolio

P&L

at th

e en

d of

5Y

($M

M)

Now 1Y2Y 3Y4Y 5Y

Instantaneous Defaults Happen

-3

-2

-1

0

1

2

3

4

0.0% 0.8% 1.6% 2.4% 3.2% 4.0% 4.8% 5.6% 6.4% 7.2%

Loss on Portfolio

P&L

at th

e en

d of

5Y

($M

M)

Now 1Y2Y 3Y4Y 5Y

Instantaneous Defaults Happen

Sell Protection on 3%–7% IG CDX Ten-Year, Buy Protection on 3%–7% IG CDX Five-Year on $10 Million Equal Notional. Spread Unchanged (Left Panel), 50bp Parallel Spread Widening (Right Panel)

Source: Citigroup

21

Tranches Versus SwaptionsBuy HiVol payers to hedge equity tranches

u Equity tranches were relatively cheap (low correlation) and vol is cheap (low vol).

u We recommended selling protection on the 0%-% five-year iTraxx tranche and delta-hedge it with three-month HiVol payers.

u Features of the trade: positive theta, gain in case of spread tightening, profit if default in HiVol. Also, the drop in correlation should be offset by rise in vol.

Trade recommendation: Option Trades, Matt King et. al., Total Credit, Citigroup, Mar 24 2006Trade unwind recommendation: N/A

8

12

16

20

21-Mar-0623-Jan-0622-Nov-0526-Sep-0528-Jul-05

20%

33%

45%

58%

70%

Hivol implied Volatility

Equity 5Yrs iTraxx Base Correlation

Source: Citigroup

22

Outlook and Key Challenges for Structured Credit Markets

Opportunities in Structured Credit Markets

What We Expect In the Future?

23

Opportunities in Structured Credit Markets

State of the credit markets Convergence of synthetics and cash

Looking beyond the primary assets Low-cost market shorts

u Synthetic forms of traditional cash products (CLOs, CDOs of ABS)

u Cash CDO elements in synthetic structures

u Can you trade correlation in cash CDO markets? Can you hedge cash deals with syntehtics?

u Leveraged loans: CLOs, CDS referencing secured loans

u CDOs backed by alternative asset classes

u Single-name CDS, ABX and CMBX indexes

u Buying protection on indexes and senior tranches

u Buying “cheap” mezz protection

u Zero-carry shorts with tranches

u Zero-cost shorts with option (buy ATM payer and sell multiple OTM receivers)

u Tight credit spreads, but increased single-name and sector specific volatility

u Defaults rates low, but increasing leverage in sub-prime sectors

u Micro and macro risks

u Technicals in correlation markets and the role of synthetic pipeline

24

What We Expect In the Future?Development and changes in correlation markets

u Strong technicals continue.

u Traditional correlation investors less active, but strong interest from the new type of investors.

u Relative value trading of correlation skews less common, majority of investors look of opportunistic trades.

u Did the models fail? What is the future of correlation trading?

u What trades do we like?

25

DisclaimerDisclosure Appendix A1

ANALYST CERTIFICATION

Other DisclosuresADDITIONAL INFORMATION AVAILABLE UPON REQUEST

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Securities recommended, offered, or sold by the Firm : (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. Past performance is not a guarantee of future results. This report does not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should obtain advice based on their own individual circumstances before making an investment decision. Investing in non-U.S. securities, including ADR’s entails certain risks. The securities of non-U.S. issuers may not be registered with, nor be subject to the reporting requirements of, the U.S. Securities and Exchange Commission. There may be limited information available on foreign securities. 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I, Jure Skarabot, hereby certify that all of the views expressed in this research report accurately reflect my personal views about any and all of the subject issuer(s) or securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or views in this report.