CDS on ABS Documentation

1. CDS on ABS Documentation American Securitization Forum Sunset Seminar-CDS of ABS March 8, 2006 John J. McGreevy Director and Senior Counsel Merrill Lynch

2. CDS on ABS Overview

3. CDS on ABS Overview • The structured product synthetics market has experienced tremendous growth over the past year. Product development has been consistent with the growth pattern of the corporate credit derivatives market • CDS on ABS allows protection sellers to gain exposure to ABS assets that are not readily available in the cash market due to supply constraints • Allows protection buyers to hedge or take a short directional view in a more efficient manner than available in the cash market • Provides protection sellers leverage • Flexibility provides exposure types (index trades, tranche trades) not available before in the cash market

4. CDS on ABS Overview • Prior to 2005: • Trades were individually negotiated • No inter-dealer market • Broadly speaking, trades covered Interest Shortfalls and ultimate principle, but there was no standardization • Early 2005: standard terms crystallized very quickly. While the ISDA drafting process was not complete, there was consensus among dealers on basic terms • Many trades done on dealer docs pre-ISDA have been novated to the ISDA standard.

5. CDS on ABS Documentation

6. CDS on ABS Documentation Current forms • Credit Derivative Transaction on Mortgage Backed Security with Pay-As-You-Go and Physical Settlement (ISDA “Form I”) • Credit Derivative Transaction on Asset-Backed Security with Pay-As-You-Go Settlement (ISDA “Form II”) • Credit Derivative Transaction on Asset-Backed Security with Cash or Physical Settlement • ABX/ CMBX • To Come – ISDA CDO/Note form • To Come – ABX/CMBX tranche confirm?

7. CDS on ABS Documentation • Thus far, ISDA has developed 3 different forms (i) Pay-As-You-Go and Physical Settlement (“Form I”), (ii) Cash and Physical Settlement and (iii) Pay-As-You-Go Settlement (“Form II”) • Form I terms form the basis for ABX and CMBX • Form I is the dominant form in the U.S. dealer market and to date is the standard for trading

8. Form I: Pay-As-You-Go or Physical Settlement

9. Form I • Tenor • Effective Maturity Date (the earlier of the Scheduled Termination Date and Final Amortization Date) • The last Floating Rate Payer Payment Date • The last Delivery Date • The last Additional Fixed Amount Payment Date (up to one year after Effective Maturity Date if a Floating Event has occurred and remains un-reimbursed)

10. Form I • Reference Obligation Notional Amount: • Decreases upon Principal Payment • Decreases upon Writedown • Increases upon Writedown Reimbursement • Decreases upon Physical Settlement (part or whole)

11. Form I • Applicable Percentage • Percent covered of Outstanding Principal Amount - may be more than 100% of the face amount of the Reference Obligation • Adjusted by: (i) further issuance of fungible securities; (ii) cancellations of Outstanding Principal Amount resulting from purchases; (iii) Physical Delivery; and (iv) Implied Writedown (or reimbursements thereof)

12. Form I • Floating Events : A payment is made by Seller to Buyer, but the trade continues • Writedown (which includes “Implied Writedown”) • Failure to Pay Principal – at Legal Final or Final Amortization Date • Interest Shortfall – does cover PIK interest • Additional Fixed Payments • Writedown Reimbursements • Principal Shortfall Reimbursements • Interest Shortfall Reimbursements

13. Form I • Interest Shortfall Cap – election as “Applicable” or “Not Applicable” • If Not Applicable, seller is liable dollar for dollar for shortfalls in coupon payments • If Applicable: • “Fixed Cap”- Seller is liable for shortfalls only up to an amount equal to the Fixed Amount (i.e., Fixed Amount nets to zero) • “Variable Cap”- Fixed Amount nets to zero and seller must also pay Interest Shortfalls through LIBOR (maximum out of pocket exposure is LIBOR on the Notional Amount) • To Date, Fixed Cap is market standard

14. Form I WAC Cap Interest Provision – “Applicable” or “Not Applicable”. • If “Not Applicable”, then Interest Shortfalls are determined without regard to WAC caps. That is, if a cap kicks in to lower the amount of interest owed on the Reference Obligation, an Interest Shortfall DOES OCCUR under the CDS. • If “Applicable” and a cap kicks in to lower the amount of interest owed on the Reference Obligation, an Interest Shortfall DOES NOT OCCUR. • The original ISDA Form I had no such election but was drafted so that the application of WAC Caps and the like would always cause an Interest Shortfall. • This concept was only recently introduced, but based in early returns the market is sticking with “Not Applicable”

15. Form I • Credit Events • Notifying Party: Buyer only • Exercise in whole or in part • Credit Events: • Failure to Pay Principal: • Writedown; • Distressed Rating Downgrade to CCC or below or rating withdrawal (subject to reinstatement within 3 months) • Physical Settlement –Reference Obligation only

16. Form I • Reference Obligation Coupon Step-Up • “Applicable” or “Not Applicable” on a confirm by confirm basis • Fixed Rate increased by step-up amount of Reference Obligation • Buyer’s option: within five days after non-call, Buyer can terminate flat

17. Form I Documentation Issues • Recent updates to Form I • WAC Cap Applicable or Inapplicable • Maturity Extension eliminated as a Credit Event • Other technical fixes • Implied Writedown • Rating Agencies and natural protection sellers hate it. • Issue: an implied writedown may occur while the cash bond is still paying its full coupon. • Documentation work-around for trades with CDOs

18. Form I Documentation Issues • What does the future hold • Standard terms supplement and short form confirm, for trading via DTC? • Will individual firms’ systems build outs hold up when/if Floating Events and Credit Events occur?

19. Form II: Pay-As-You-Go

20. Form II • Based upon Form I, with amendments sought by a group of CDS end users • Intent of the amendments was to more closely mirror the cashflow of the Reference Obligation

21. Form II • PAUG Settlement only unless Optional Physical Settlement election is made at inception • If Physical Settlement option is included, Physical Settlement is “Seller Only” (Form I is “Buyer Only”) • No “Credit Events”. Floating Events trigger right to deliver notice of physical settlement, if applicable • No Interest Shortfall Cap concept • Implied Writedown eliminated • Distressed Rating Downgrade eliminated • Option to require pass through of Reference Obligation voting rights

22. Form II • Calculation of Expected Interest and Interest Shortfalls takes into account available funds caps. • In Form I terms, “WAC Cap” is always Applicable • Make - Whole payments as well as payments in consideration of amendments to the Reference Obligation are passed through to Protection Seller as Additional Fixed Payments • Such amounts, however, are not covered by Interest Shortfall provisions • PAUG Floating Events: • Writedown – actual applied loses or principal reductions only • Principal Shortfall • Interest Shortfall – deferring or capitalizing interest does not cause an Interest Shortfall

23. Form II Documentation Issues • Dealers won’t use it • Anecdotally - very few trades booked on this form

24. Cash or Physical Settlement

25. Cash or Physical Settlement • The form most similar to corporate CDS • Buyer pays Fixed Amounts, calculated by reference to an initial notional amount which fluctuates depending upon amortization etc. • Seller pays Floating Amount on day Final Price is determined or the Delivery Date • Synthetic Delivery Mechanic –parties may use bidding for a total return swap on the Reference Obligation to calculate Cash Settlement Amount

26. Cash or Physical Settlement Credit Events • Failure to Pay • Loss Event • Bankruptcy (optional) • Restructuring • Rating Downgrade to CC (optional)

27. Cash or Physical Settlement • Cash Settlement, unless, Seller receives Notice of Physical Settlement prior to first Valuation Date • Valuation Date. Seller selects a Business Day 120-140 calendar days after Event Determination Date • Physical Settlement - Reference Obligation Only • Payment of Floating Amount and accrued interest - 60 Business Day cap

28. Cash or Physical Documentation Issues • Primarily used in Europe, few trades in the U.S. • Rating agency issues make cash settlement difficult/uneconomical for trades with CDOs

29. ABX/CMBX

30. ABX/CMBX Documentation Issues • Both use a Standard Terms Supplement with short form confirm, for DTC Settlement • Both are based on ISDA’s Form I • No Physical Settlement, PAUG only • Fixed Cap always applies • An ABX Floating Amount Event has already occurred.

31. Future Documentation Issues • ISDA confirm for ABS other than RMBS/CMBS • Conjecture – the form will include PAUG, Physical and Cash Settlement • Draft expected soon • Tranche Confirms?