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Credit Derivatives Primer

Advantages, Risks, Accounting, Regulation, and the Way Ahead
Sector View: 3-NEGATIVE

Brock Vandervliet
1.212.526.8893 bvanderv@lehman.com

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.

Juan Partida, CFA

1.212.526.5744 jpartida@lehman.com

n While the recent growth in the credit derivatives market has been explosive and future growth appears promising, there are several issues that still need to be addressed to foster wider acceptance by prospective participants. In this report, we focus on remaining legal hurdles, existing and future regulatory frameworks, the state of accounting standards governing bookkeeping, and a basic discussion of how different types of credit derivatives function. n Credit derivatives are off-balance sheet financial instruments that allow investors to more efficiently transfer and repackage credit risk. Financial 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 2Q02 U.S. banks held credit derivative contracts with a notional amount of $500 billion, still this is just 1% of the notional amount of total derivatives held. Credit derivatives are concentrated among the largest banks with JP Morgan, Citigroup, and Bank of America comprising over 90% of the market. We 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 risk than the cash bond or equities markets issues such as lack of liquidity or interest investors view the market as more subject to volatile, than the cash market.
a more efficient gauge of pure default as it is not as hampered by technical rate fluctuations. In addition, some speculative forces, and therefore more

October 18, 2002



Credit Derivatives Primer

One of the issues that has arisen, particularly this year as credit problems at the largest banks have deepened, is the nature and impact 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. We thought it would be useful to publish an analysis of the credit derivatives market that lies within the broader category of derivatives. As shown 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

Credit Derivatives 1% Options 20% Futures & Forwards 21%

Swaps 58%
Source: OCC 2Q02 Bank Derivatives Report

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

1991 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1Q02 2Q02

Fu tu


Sw ap & Fo rw ar

Op t

io n

Cr ed

it D

To ta er iv at ive


Source: OCC 2Q02 Bank Derivatives Report

October 18, 2002

Credit Derivatives Primer

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 among the largest banks with JP Morgan Chase, Citigroup, and Bank of America comprising 93% of total notional value, we believe the characteristics and 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

Basket Products 6% Credit Spread Options 5% Asset Swaps 7% Total Return Swaps 7% Single-name default swaps 45%

Credit-linked Notes 8%

Portfolio/CLO's 22%

Source:BBA 2002 Credit Derivatives Survey; as a % of Total Notional Amount Outstanding. Includes all participants (banks, insurance companies, hedge funds. Figures as of 2001.

What are Credit Derivatives? Credit derivatives are off-balance sheet financial instruments that allow one party (the risk seller 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 highgrade sovereign and emerging market sovereign debt. According to some estimates,

October 18, 2002

Credit Derivatives Primer

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 $1trillion in notional amount at the end of 2001, 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 4Q01, single-name default swaps comprised 45% of the global market (See Figure 3) Growth in these products is only bound by the size of the pool of reference assets (bonds and loans that underlie them). Specifically, banks use credit derivatives for the following 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 2Q02 Bank Derivatives Report of the OCC, banks 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 figures are similar to the statistics for the total derivatives bank portfolios. As shown in Figure 4, JP Morgan Chase 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.

October 18, 2002

Credit Derivatives Primer

Figure 4: Concentration of Credit Derivatives.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Top 16 Banks JP Morgan Chase Citibank Bank of America Wachovia Fleet National Bank Bank One HSBC Bank USA Wells Fargo Bank of New York Merrill Lynch Bank Deutsche Bank Americas Suntrust Bank First Tennessee Bank PNC Bank National Mellon Bank Comerica Bank Largest 16 Other Banks 2Q02 278,104 99,072 79,111 9,631 7,898 6,716 2,412 2,268 1,841 1,565 569 255 240 159 19 11 489,871 2,394 492,265 % Cumulative % 56.5% 56.5% 20.1% 76.6% 16.1% 92.7% 2.0% 94.6% 1.6% 96.3% 1.4% 97.6% 0.5% 98.1% 0.5% 98.6% 0.4% 98.9% 0.3% 99.3% 0.1% 99.4% 0.1% 99.4% 0.0% 99.5% 0.0% 99.5% 0.0% 99.5% 0.0% 99.5% 99.5% 0.5% 100.0% 100.0%

Total Banks
Source: OCC 2Q02 Bank Derivatives Report

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 was 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 GM 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

October 18, 2002

Credit Derivatives Primer

several names . These arrangements typically require the use of off- or on-balance 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 market as 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. While the credit derivatives market moves more quickly than the cash market, and credit 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 reasonable time horizon.

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

180 160 140 120 100 80 60 40 20 0 2/15/01 3/15/01 4/15/01 5/15/01 6/15/01 7/15/01 8/15/01 9/15/01 1/15/02 2/15/02 3/15/02 4/15/02 5/15/02 6/15/02 7/15/02 8/15/02 10/15/01 11/15/01 12/15/01 9/15/02

Cash Spread
Source: Lehman Brothers

Default Swap Spread

Greater Standardization as the Market Matures Another characteristic of the derivatives market is its increasing standardization. Initially, credit derivative contracts were tailor made for each transaction. Now, 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

October 18, 2002

Credit Derivatives Primer

standardized format. However, there remain significant documentation issues regarding restructuring credit event definitions that still need to be addressed. Regulatory Uncertainty Hampers Growth While the regulatory aspect of the market is somewhat lagging, regulators around the world are making great efforts to ensure appropriate accounting disclosure and suitable capital 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 Derivatives The following description of credit derivative products draws from research from a number of sources including: Lehmans Structured Credit area, documents from U.S. regulators, including the Federal Reserve and the Office 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 Obligation (CLO), which covers pooled exposures and very large notional amounts ($2 billion-$5 billion) (See Figure 3). Floating Rate Notes Floating Rate Notes (FRNs) are technically not a credit derivative, but they serve as a benchmark of credit derivative pricing because their valuation is driven almost entirely by credit risk. An FRN is a bond 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 credit risk of the issuer. These instruments are typically priced using LIBOR, and therefore the spread over LIBOR, when issued at par, reflects the credit quality of the issuer (including subordination of the notes). As the spread is fixed at issuance, the bond price will 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 default (R), as shown in Figure 6. Simply stated, the spread will be higher, the higher the probability of default and lower with a higher expected recovery.

October 18, 2002

Credit Derivatives Primer

Figure 6: The Credit Triangle

Spread (S)

Probability of Default (P)

Source: Lehman Brothers Structured Credit Research

Recovery Rate on Credit ( R )

Banks normally issue fixed maturity or perpetual FRNs to satisfy bank capital 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. However, FRNs 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 full countercredit risk of the bond issuer, and not only the counter -party risk in the swap 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 continue 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 is 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 and reduce the losses from the default on the bond. Conversely, if the

October 18, 2002

Credit Derivatives Primer

floating rate is lower than the coupon, the investor will realize a loss. spread, because the investors stands to lose more in the event of default.


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

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 Seller 100 And enters into an interest rate swap paying a fixed coupon in return for Libor plus spread LIBOR + S Asset Swap Seller Coupon Asset Swap Buyer Bond Defaults Coupon is lost Asset Swap Buyer

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 with 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.

October 18, 2002

Credit Derivatives Primer

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

Default Swap Spread Protection Protection Buyer Seller Following the credit event one of the following will take place: Cash Settlement 100 minus recovery rate Protection Buyer Physical Settlement Bond Protection Buyer 100 Protection Seller Protection Seller

Source: Lehman Brothers Structured Credit

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 worth the same in the event of default, but this is not always the case. In effect, the protection buyer has a cheapest-to-deliver option.


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Credit Derivatives Primer

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 enhanced coupon, typically 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. For example, 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 added default risk. Note that the investor has to be compensated for both the default risk of the bank and that of the corporation that issued the reference asset.

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Credit Derivatives Primer

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 Racers 0.20% per annum LIBOR + 0.10% Issuer

LIBOR + 0.30% Investor

AAA Asset Backed

Source: Lehman Brothers Structured Credit.* Racers - Restructured Asset Certificates with Enhanced 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 is bankruptcy 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 potential counter-party risk. Notes 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 New York. The trustee is normally a highly rated bank 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 10).


October 18, 2002

Credit Derivatives Primer

Figure 10: Securitized Asset Swap Issued out of an SPV

Fixed Rate Fixed Rate Asset SPV LIBOR + spread Issued Note

LIBOR + spread

Fixed Rate

Swap Counterparty

Source: Lehman Brothers Structured Credit Research

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 swaps. Obviously, 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 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 OECD bank. Other banks purchasing the notes would be allowed to use the BIS risk weighting of the issuing bank (20%), rather than that of the reference asset, which would normally be 100%. The principal protected structure is a funded credit derivative similar to a credit linked note. principal in full. Total Return Swaps A Total Return Swap (TRS) is a contract that allows investors to receive the total 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 pay the investor a spread over LIBOR. Upon 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 additional collateral. If a credit event occurs before maturity of the note, investors lose the remaining coupon payments, but at maturity they would receive

October 18, 2002


Credit Derivatives Primer

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 Coupons from reference asset Total Return Payer LIBOR + Fixed Spread Total Return 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 of the notional amount of the reference asset

Source: Lehman Brothers Structured Credit

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 allowed to invest in. In addition, a TRS allowa investors to go short an asset without having to sell it. More 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.


October 18, 2002

Credit Derivatives Primer

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 firstto-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 same potential 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 individual credit in the portfolio. More 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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Credit Derivatives Primer

For instance, consider a portfolio of 50 credits, with a face value of $5 million apiece, tranched into a 10% first loss tranche and a 90% 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, while the spread paid remains a constant percentage of the notional tranche. Portfolio default swaps are a new and powerful tool for investors to leverage or deleverage 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 (CLOs), which have become the technology of choice for balance sheet securitization. To understand how a synthetic CLO works, we will first look at the process of securitization of defaultable assets. Collateralized Debt Obligations (CDO) A CDO 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 debt. When the collateral comprises mainly loans the structure is called a CLO. CLOs are securitizations of large portfolios of secured or unsecured corporate 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 liquidity, and increased returns on equity and assets. CLOs generally 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 debt securities depend on the cash flow of the underlying loans. As part of a CLO transaction, loans are sold or assigned to a trust or other bankruptcyremote 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. CLOs normally require one or more additional credit 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 monoline insurers. While the loans being securitized normally have an 8% capital charge, these equity tranches are normally


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Credit Derivatives Primer

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, revolving credit facilities, and trust certificates.

Figure 12: Collateralized Loan Obligation

Source: Lehman Structured Credit Research

The Master Trust Structure for CLOs Master trusts are widely used to structure a wide array of Asset 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, however, CLO master trusts are viewed as more risky, because loans comprised in them are less diversified, have longer maturities, and more uneven cash flows than credit card receivables. Similar to ordinary credit card trusts, transferor banks in CLO trusts retain an interest in the assets of the trust (known 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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Credit Derivatives Primer

Figure 13: CLO Master Trust Structure

Source: Federal Reserve Board, Trading and Capital-Markets 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 CLOs are typically 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 to pay current interest to create an additional cushion rather than going to the transferor. Of more interest to us is subordination, which consists of issuance by the trust of notes with different seniority. Issuing banks will typically keep the most junior tranche of the investors investors 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 excess spread on the loans transferred until securities in the trust mature and are paid. Securitizations Synthetic CLO Securitizati ons We have explained how a regular CLO securitization works, but we have not yet shown how credit derivatives come into play in these structures. Synthetic CLOs provide the link between the two.


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Credit Derivatives Primer

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: Trading and Capital- Markets Activities Manual of the Federal Reserve, Lehman Brothers

As shown in Figure 14, the structure is very similar to that of an SPV for single 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 credits (see the description of Credit-Linked Notes (CLN) above) and sells the higher 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 negligible and can qualify to obtain a 0% risk weighting. CLNs are used in amounts sufficient to cover some percentage of expected losses, normally 7%around 7% -8% of the notional amount of the reference portfolio. The remainder of the credit risk is hedged using a senior credit default swap with a highly rated (OECD) counterparty, for which the weighting would be 20%.

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

Source: Lehman Brothers Structured Credit Research

October 18, 2002


Credit Derivatives Primer

As shown in Figure 15, the regulatory charge can be brought down substantially through the use of a CLO. There could be several layers of losses to participants: 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 CLNs, then losses would go to the senior default swap seller, and finally, the bank would endure the losses beyond the first and second layers. A slightly different structure can be designed in which the SPV purchases single exposure CLNs from the bank seeking protection, and then the SPV issues floating rate notes to investors, collateralized by the individual CLNs. Therefore, the dollar amount of the notes issued to investors equals the notional amount of the reference portfolio. Similar to what happens in credit card securitizations, the bank has the option to remove CLNs from the pool, so long as they are replaced by similar notes. The main differences between a regular CLO 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. Not only that, the possibility open by synthetic CLOs to manage credit risk, in particular in those structures backed by CLNs rather than default 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 additional loans, it can issue a CLN on part 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 cheaply than by structuring a regular CLO. 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 Most of the risk borne by banks will be in the shape of credit risk. Market risk is clearly an issue if the bank engages in credit derivatives trading as the pricing of the trading,


October 18, 2002

Credit Derivatives Primer

instruments is a function of interest rates, the shape of the yield curve, and credit spreads. Outside of trading 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 default will 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 hedge. While this is still a risk, the adoption of ISDA Master Agreement, which 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 obligation.

October 18, 2002


Credit Derivatives Primer

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 Derivatives 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 No hedge designation. Gains 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.


October 18, 2002

Credit Derivatives Primer

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 of changes 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. Only when the contract is terminated are 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 the credit derivative would be hedging. When default swaps are used, FAS 133 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.

October 18, 2002


Credit Derivatives Primer

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, as well 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 1988. Those rules, known as the Basle Capital 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 2004. The current framework is based on a fixed 8% capital 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, which would represent risk-weighted assets. Note there is a large disconnect between notional amounts and actual credit exposure that makes reference only to the notional amount misleadingly high. Notional 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 only the interest payments are at risk, since principal does not have to be paid at maturity. As of 2Q02, the notional amount of derivatives held by U.S. banks was $50 trillion. However, the gross credit exposure 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 credit/settlement risk. Notional and credit exposure 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 swaps is $29.5 trillion for U.S. banks as of 2Q02, while 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.


October 18, 2002

Credit Derivatives Primer

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

1400 50,084 1200 1000 800 525 600 400 200 0
Notional Amount
Source: OCC 2Q02 Bank Derivatives Report



Gross Exposure

Master Netting Agreements

Net Credit Exposure

Most exposures have a 100% weighting, meaning they require an 8% capital charge. Assets originated in transactions with OECD banks carry a 20% weight and transactions with OECD governments carry a 0% weight (See Figure 14) . One 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 engage in an asset swap with an OECD 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% riskweighting) 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 and the protection seller default at the same time.

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Credit Derivatives Primer

Figure 19: The BIS Risk Weightings

Source: Basle Committee on Banking Supervision

Current Treatment of Credit Derivatives When the original accord was enacted in 1988, 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 credit linked notes and SPVs. When

the bank sells protection, the charge is the same as if it was long the loan. When the bank buys protection, the weighting is that of the collateral, which normally is OECD 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 provided by the CLN or SPV.
n In a total return swap, the total return payer (the buyer of protection) uses the weight

of 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 swap.
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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Credit Derivatives Primer

Figure 20: Credit Weightings Under Option 1

Source: Basle Committee on Banking Supervision

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 Scores Risk Weights

1 0%

2 20%

3 50%

4 to 6 100%

7 150%

Source: Basle Committee on Banking Supervision

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 quality exposures. Our expectation is that if these rules are adopted, banks will keep 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 weighting would be adjusted using the following formula: r* = w x r + (1 w) x g, r* = g + w x (r - g) or

October 18, 2002


Credit Derivatives Primer

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. While it allows 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 hedging transaction using default swaps, g = 20%, the risk of a OCDE bank. Assuming the bank is an A-rated institution (see Figure 20), under the new framework 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 addition, credit derivatives markets may provide investors with 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. We believe, however, that credit derivatives will begin to gain wider acceptance particularly those that offer a means to hedge credit risk on a pooled basis as opposed to individual 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, particularly 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.


October 18, 2002

Credit Derivatives Primer

Figure 22: Valuation Table

Price Analyst Vandervliet Vandervliet Vandervliet Vandervliet INTEGRATED PROVIDERS BANK ONE CORP. Bank of America Corp. Citigroup J. P. Morgan Chase & Co. Integrated Providers TRUST & PROCESSING BANKS Bank of New York City National Bank Investors Financial Mellon Financial Northern Trust Corp. PNC Financial Services Group State Street Corp. Wilmington Trust Corp. Trust & Processing Banks SUPER REGIONALS BB&T Corporation Comerica Inc. Fifth Third Bancorp. FleetBoston Financial KeyCorp National City Corp. SunTrust Banks U.S. Bancorp Wachovia Corp. Wells Fargo Super Regionals
MID-CAP BANKS AmSouth Bancorp Charter One Financial Compass Bancshares First Tennessee National Huntington Bancshares M&T Bank Corp Marshall & Ilsley Corp. National Commerce Financial North Fork Bancorp. Regions Financial Corp. SouthTrust Corp. Synovus Financial TCF Financial Corp. Union Planters UnionBanCal Corp. Zions Bancorp. Mid-Cap Banks SMALL-CAP BANKS (<$3B) Associated Banc-Corp Bank of Hawaii Chittenden Corp. Colonial BancGroup Commerce Bancorp Commerce Bancshares Cullen/Frost Bankers First Commonwealth First Midwest Bancorp FirstMerit Corp. Greater Bay Bancorp Hibernia Corp. Mercantile Bankshares Provident Financial Silicon Valley Bancshares Sky Financial Group Inc Southwest Bank of Texas Valley National Bancorp Westamerica Bancorp. Small-Cap Banks Bank Composite S&P 500 3-tier industry sector rating system: Positive, Neutral, Negative 3-tier stock rating system: 1 Overweight, 2 Equal-weight, 3 Underweight RS - rating suspended


Rating NEGATIVE 2 Equal weight 1 Overweight 2 Equal weight 2 Equal weight


Price Target $43 $82 $43 $20

Actual 2001 $2.47 $4.95 $2.82 $1.66

Estimates 2003 2002 $2.77 $5.68 $2.90 $1.80 $3.10 $6.30 $3.50 $2.65

2001a 15.6 13.8 12.5 11.2 13.3

P/E Ratio 2002e 2003e 13.9 12.0 12.1 10.3 12.1 12.4 10.9 10.0 7.0 10.1

For. 12.7 11.1 10.5 7.7 10.5

Relative P/E (S&P 500) 2001a 2002e 2003e For. 81 72 65 58 69 78 67 68 58 68 77 68 62 44 63 77 68 64 47 64

$38.46 $68.44 $35.14 $18.61

Vandervliet Vandervliet Vandervliet Vandervliet Vandervliet Vandervliet Vandervliet Vandervliet


NEGATIVE 2 Equal weight 1 Overweight Not Rated 3 Underweight 3 Underweight 3 Underweight Not Rated 3 Underweight

$26.31 $44.70 $29.10 $26.26 $37.16 $36.76 $40.26 $29.81

$30 $65 NA $31 $40 $42 NA $34

$2.01 $2.96 $0.77 $1.57 $2.11 $3.56 $2.00 $1.89

$1.59 $3.53 $1.02 $1.57 $2.05 $4.21 $2.22 $2.06

$2.13 $3.90 $1.27 $2.00 $2.23 $4.20 $2.47 $2.20

13.1 15.1 37.8 16.7 17.6 10.3 20.1 15.8 18.3

16.5 12.7 28.5 16.7 18.1 8.7 18.1 14.5 16.7

12.4 11.5 22.9 13.1 16.7 8.8 16.3 13.6 14.4

13.2 11.7 24.1 13.9 17.0 8.7 16.7 13.7 14.9

68 78 196 87 91 54 105 82 95

93 71 160 94 101 49 102 81 94

77 71 143 82 104 54 101 84 90

80 71 146 84 103 53 101 84 90

Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg


NEUTRAL 3 Underweight 2 Equal weight 2 Equal weight 2 Equal weight 3 Underweight 2 Equal weight 3 Underweight 1 Overweight 3 Underweight 1 Overweight

$35.35 $41.24 $65.36 $21.90 $24.79 $28.05 $60.11 $20.01 $33.95 $49.65

$32 $44 $65 $25 $25 $30 $57 $25 $35 $60

$2.40 $4.72 $2.37 $1.48 $0.74 $2.27 $4.79 $1.32 $2.12 $2.35

$2.75 $3.41 $2.76 $1.49 $2.28 $2.55 $4.80 $1.84 $2.78 $3.32

$2.95 $4.85 $3.10 $2.55 $2.45 $2.65 $4.95 $2.02 $3.05 $3.70

14.7 8.7 27.6 14.8 33.5 12.4 12.5 15.2 16.0 21.1 17.7

12.9 12.1 23.7 14.7 10.9 11.0 12.5 10.9 12.2 15.0 13.6

12.0 8.5 21.1 8.6 10.1 10.6 12.1 9.9 11.1 13.4 11.7

12.2 9.2 21.6 9.8 10.3 10.7 12.2 10.1 11.4 13.7 12.1

77 45 143 77 174 64 65 79 83 110 92

72 68 133 82 61 62 70 61 68 84 76

75 53 131 53 63 66 76 62 69 84 73

74 56 132 60 63 65 74 61 69 84 74

Goldberg Goldberg Goldberg Goldberg Lacoursiere Lacoursiere Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Goldberg Lacoursiere Goldberg


NEUTRAL 3 Underweight 1 Overweight 2 Equal-weight 2 Equal weight 3 Underweight RS 2 Equal weight 2 Equal weight 1 Overweight 3 Underweight 2 Equal weight 2 Equal weight 1 Overweight 3 Underweight 2 Equal-weight 2 Equal weight

$20.13 $30.14 $32.11 $35.14 $19.06 $81.60 $27.80 $23.86 $38.16 $32.65 $24.10 $19.23 $42.79 $26.90 $41.77 $38.93

$20 $37 $35 $38 $22 $30 $28 $45 $30 $28 $24 $52 $28 $52 $45

$1.45 $2.10 $2.11 $2.32 $1.17 $3.87 $1.86 $1.12 $2.08 $2.32 $1.61 $1.06 $2.70 $2.13 $2.93 $3.20

$1.68 $2.43 $2.42 $2.75 $1.33 $5.06 $2.18 $1.58 $2.58 $2.73 $1.86 $1.21 $3.15 $2.59 $3.30 $3.65

$1.80 $2.70 $2.60 $2.95 $1.43 $5.50 $2.35 $1.75 $2.84 $2.85 $2.02 $1.35 $3.47 $2.80 $3.89 $4.00

13.9 14.3 15.2 15.1 16.3 21.1 14.9 21.3 18.3 14.1 15.0 18.1 15.8 12.6 14.3 12.2 15.8

12.0 12.4 13.3 12.8 14.3 16.1 12.8 15.1 14.8 12.0 13.0 15.9 13.6 10.4 12.7 10.7 13.2

11.2 11.2 12.4 11.9 13.3 14.8 11.8 13.6 13.4 11.5 11.9 14.2 12.3 9.6 10.7 9.7 12.1

11.3 11.4 12.5 12.1 13.5 15.1 12.0 13.9 13.7 11.6 12.1 14.6 12.6 9.8 11.1 9.9 12.3

72 74 79 79 85 110 78 111 95 73 78 94 82 66 74 63 82

67 69 74 72 80 90 71 85 83 67 73 89 76 58 71 60 74

70 69 77 74 83 92 74 85 84 71 74 89 77 60 67 61 75

69 69 76 74 82 92 73 85 83 70 74 89 77 59 68 60 75

Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Lacoursiere Vandervliet Lacoursiere Vandervliet Lacoursiere Lacoursiere


NEGATIVE 1 Overweight 3 Underweight 2 Equal weight 2 Equal weight 2 Equal weight 1 Overweight 1 Overweight 3 Underweight 2 Equal weight 3 Underweight 2 Equal weight 2 Equal weight 1 Overweight 2 Equal-weight 2 Equal-weight 2 Equal weight 2 Equal weight 3 Underweight 1 Overweight

$32.27 $29.40 $27.93 $12.13 $45.76 $40.95 $34.85 $12.03 $27.19 $21.90 $15.95 $18.95 $38.02 $24.75 $16.82 $19.17 $27.98 $27.35 $41.70

$36 $28 $31 $14 $46 $46 $39 $13 $29 $23 $26 $21 $44 $30 $20 $24 $37 $27 $47

$2.45 $1.46 $1.80 $1.11 $1.51 $2.73 $1.76 $0.86 $1.63 $1.90 $1.91 $1.35 $2.55 $0.46 $1.76 $1.45 $1.55 $1.46 $2.36

$2.77 $1.71 $1.91 $1.17 $2.00 $3.01 $2.26 $0.88 $1.86 $1.85 $2.32 $1.60 $2.72 $2.33 $1.19 $1.60 $1.69 $1.59 $2.62

$3.05 $2.05 $2.03 $1.21 $2.28 $3.30 $2.63 $0.97 $2.03 $2.00 $2.39 $1.76 $2.95 $2.70 $1.35 $1.78 $1.95 $1.66 $2.85

13.1 20.1 15.5 10.9 30.3 15.0 19.8 14.0 16.7 11.5 8.4 14.0 14.9 53.8 9.6 13.2 18.1 18.8 17.7 17.7 16.9 19.2

11.6 17.2 14.6 10.4 22.9 13.6 15.4 13.7 14.6 11.8 6.9 11.8 14.0 10.6 14.1 12.0 16.6 17.2 15.9 13.9 13.9 17.9

10.6 14.3 13.8 10.0 20.1 12.4 13.3 12.4 13.4 11.0 6.7 10.8 12.9 9.2 12.5 10.8 14.3 16.5 14.6 12.6 12.4 16.1

10.8 14.9 13.9 10.1 20.6 12.7 13.7 12.7 13.6 11.1 6.7 11.0 13.1 9.5 12.8 11.0 14.8 16.6 14.9 12.9 12.7 16.4

68 105 81 57 157 78 103 73 87 60 43 73 77 280 50 69 94 98 92 92 88

65 96 82 58 128 76 86 77 82 66 38 66 78 59 79 67 93 96 89 78 78

66 89 86 62 125 77 82 77 83 68 42 67 80 57 78 67 89 103 91 78 77

66 91 85 61 126 77 83 77 83 68 41 67 80 58 78 67 90 101 91 78 77





Stock performance relative to an unweighted expected total return of the industry over a 12 month investment horizon.

Not Rated stocks carry consensus estimates. Market cap, assets and revenues are aggregated.

Source: Lehman Brothers

October 18, 2002


Credit Derivatives Primer

Figure 23: Valuation Table (Contd)

12 Mo. Dividend Yield Rate INTEGRATED PROVIDERS BANK ONE CORP. Bank of America Corp. Citigroup J. P. Morgan Chase & Co. Integrated Providers TRUST & PROCESSING BANKS Bank of New York City National Bank Investors Financial Mellon Financial Northern Trust Corp. PNC Financial Services Group State Street Corp. Wilmington Trust Corp. Trust & Processing Banks SUPER REGIONALS BB&T Corporation Comerica Inc. Fifth Third Bancorp. FleetBoston Financial KeyCorp National City Corp. SunTrust Banks U.S. Bancorp Wachovia Corp. Wells Fargo Super Regionals
MID-CAP BANKS AmSouth Bancorp Charter One Financial Compass Bancshares First Tennessee National Huntington Bancshares M&T Bank Corp Marshall & Ilsley Corp. National Commerce Financial North Fork Bancorp. Regions Financial Corp. SouthTrust Corp. Synovus Financial TCF Financial Corp. Union Planters UnionBanCal Corp. Zions Bancorp. Mid-Cap Banks SMALL-CAP BANKS (<$3B) Associated Banc-Corp Bank of Hawaii Chittenden Corp. Colonial BancGroup Commerce Bancorp Commerce Bancshares Cullen/Frost Bankers First Commonwealth First Midwest Bancorp FirstMerit Corp. Greater Bay Bancorp Hibernia Corp. Mercantile Bankshares Provident Financial Silicon Valley Bancshares Sky Financial Group Inc Southwest Bank of Texas Valley National Bancorp Westamerica Bancorp. Small-Cap Banks Bank Composite S&P 500

Book Value $18.37 $31.47 $16.47 $20.93

Price/ Book 209% 217% 213% 89% 182%

52-Wk Range $43 $77 $52 $41 $30 $53 $25 $15

Shares Out

Market Capital

Assets 2Q02

Revenue 2Q02

YTD Return -1.5% 8.7% -25.4% -48.8% -16.7%

2001 Return 6.6% 37.2% -1.5% -20.0% 5.6%

2000 Return 14.2% -8.6% -1.4% -12.3% -2.0%

$0.84 $2.40 $0.72 $1.36

2.2% 3.5% 2.0% 7.3% 3.8%

1184.0 1592.3 5185.8 2016.0

$45.5 $109.0 $182.2 $37.5 $374.3

$270 $638 $1,083 $741 $2,732

$5,118 $8,668 $21,273 $7,574 $42,633

$0.76 $0.78 $0.05 $0.52 $0.68 $1.92 $0.19 $1.02

2.9% 1.7% 0.2% 2.0% 1.8% 5.2% 0.5% 3.4% 2.2%

$9.09 $21.41 $6.24 $7.52 $12.60 $22.46 $12.92 $11.03

289% 209% 466% 349% 295% 164% 312% 270% 294%

$46 $56 $39 $41 $63 $63 $58 $35

$21 $39 $20 $20 $30 $33 $32 $25

729.0 52.1 66.6 441.0 226.6 285.0 328.3 32.8

$19.2 $2.3 $1.9 $11.6 $8.4 $10.5 $13.2 $1.0 $68.1

$81 $11 $7 $34 $38 $67 $80 $8 $325

$1,271 $169 $108 $1,075 $552 $1,396 $994 $135 $5,699

-35.5% -4.6% -12.1% -30.2% -38.3% -34.6% -22.9% -5.8% -23.0%

-26.1% 20.7% -23.0% -23.5% -26.2% -23.1% -15.9% 2.0% -14.4%

38.0% 17.8% 273.9% 44.4% 53.9% 64.2% 70.0% 28.6% 73.9%

$0.98 $1.92 $1.04 $1.40 $1.20 $1.22 $1.72 $0.78 $1.04 $1.12

2.8% 4.7% 1.6% 6.4% 4.8% 4.3% 2.9% 3.9% 3.1% 2.3% 3.7%
4.6% 2.8% 3.1% 3.4% 3.4% 1.5% 2.3% 2.5% 2.6% 3.3% 2.8% 3.1% 2.7% 4.9% 2.7% 2.1% 3.0%

$14.99 $28.08 $14.10 $15.79 $15.46 $13.02 $31.41 $8.70 $22.15 $17.24

236% 147% 464% 139% 160% 215% 191% 230% 153% 288% 222%
236% 230% 216% 284% 197% 245% 222% 190% 389% 183% 194% 314% 349% 169% 172% 153% 234%

$39 $66 $70 $39 $29 $34 $70 $25 $40 $53

$31 $35 $53 $18 $20 $25 $52 $16 $28 $38

484.0 178.0 594.3 1051.1 431.9 616.8 287.3 1926.9 1375.0 1730.8

$17.1 $7.3 $38.8 $23.0 $10.7 $17.3 $17.3 $38.6 $46.7 $85.9 $302.8
$7.3 $7.2 $4.2 $4.6 $4.7 $7.5 $6.2 $5.0 $6.2 $7.5 $8.5 $5.8 $3.2 $5.6 $6.3 $3.6 $93.2

$76 $51 $74 $190 $82 $98 $106 $169 $314 $311 $1,470
$38 $39 $23 $19 $25 $34 $28 $20 $18 $45 $48 $17 $11 $32 $38 $26 $462

$1,112 $762 $1,195 $2,882 $1,168 $1,689 $1,393 $3,097 $4,625 $6,056 $23,979
$572 $400 $336 $516 $360 $448 $522 $284 $250 $682 $590 $424 $226 $496 $575 $368 $7,049

-2.1% -28.0% 6.6% -40.0% 1.8% -4.1% -4.1% -4.4% 8.3% 14.2% -5.2%
6.5% 16.6% 13.5% -3.1% 10.9% 12.0% -12.1% -5.7% 19.3% 9.1% -2.3% -23.2% -10.8% -10.6% 9.9% -26.0% 0.2%

-3.2% -3.5% 2.6% -2.8% -13.1% 1.7% -0.5% -28.3% 12.8% -21.9% -5.6%
23.9% -1.3% 18.5% 25.3% 6.2% 7.1% 24.5% 2.2% 30.2% 9.6% 21.3% -7.0% 7.7% 26.2% 57.9% -15.8% 14.8%

36.3% 27.2% 22.1% 7.9% 26.6% 21.4% -8.4% 22.3% -15.7% 37.7% 17.7%
-21.0% 58.5% 7.0% 1.5% -25.4% 64.2% -19.1% 9.1% 40.4% 8.7% 7.6% 35.5% 79.1% -9.4% -39.0% 5.5% 12.7%

$0.92 $0.84 $1.00 $1.20 $0.64 $1.20 $0.64 $0.60 $1.00 $1.08 $0.68 $0.59 $1.15 $1.33 $1.12 $0.80

$8.53 $13.12 $14.86 $12.36 $9.68 $33.25 $12.51 $12.58 $9.80 $17.81 $12.45 $6.12 $12.27 $15.95 $24.22 $25.49

$23 $35 $36 $41 $22 $90 $32 $30 $43 $36 $27 $32 $55 $34 $50 $60

$16 $23 $24 $30 $15 $65 $23 $21 $27 $27 $21 $16 $35 $24 $29 $34

364.8 239.1 130.2 130.6 247.9 92.0 221.3 209.0 162.5 229.1 351.5 300.3 74.3 206.6 150.2 92.6

$1.24 $0.70 $0.80 $0.52 $0.60 $0.65 $0.88 $0.60 $0.68 $1.00 $0.50 $0.56 $1.20 $0.96 $0.00 $0.76 $0.00 $0.90 $0.88

3.8% 2.4% 2.9% 4.3% 1.3% 1.6% 2.5% 5.0% 2.5% 4.6% 3.1% 3.0% 3.2% 3.9% 0.0% 4.0% 0.0% 3.3% 2.1% 2.8% 3.0% 1.7%

$16.84 $17.05 $12.39 $8.52 $12.19 $20.09 $12.70 $6.59 $9.91 $11.28 $10.50 $10.29 $19.11 $19.70 $14.43 $8.14 $12.26 $7.20 $9.98

192% 172% 225% 142% 375% 204% 274% 183% 274% 194% 152% 184% 199% 126% 117% 236% 228% 380% 418% 225% 234% 400%

$38 $30 $34 $16 $50 $47 $41 $14 $32 $30 $37 $22 $45 $32 $34 $24 $39 $29 $46

$27 $20 $23 $11 $35 $33 $24 $11 $23 $19 $14 $15 $32 $21 $14 $17 $24 $22 $33

77.0 74.5 32.2 123.6 67.3 64.1 53.6 58.9 48.8 85.8 51.2 158.9 69.6 48.6 47.0 83.0 34.4 94.6 33.6

$2.5 $2.2 $0.9 $1.5 $3.1 $2.6 $1.9 $0.7 $1.3 $1.9 $0.8 $3.0 $2.6 $1.2 $0.8 $1.6 $1.0 $2.6 $1.4 $33.6 $872

$14 $10 $5 $15 $15 $12 $8 $5 $6 $10 $9 $16 $11 $16 $4 $10 $5 $9 $4 $183 $5,173

$182 $142 $64 $142 $223 $197 $133 $50 $76 $151 $130 $267 $149 $185 $68 $122 $63 $109 $65 $2,518 $81,878

0.6% 13.6% 1.2% -13.9% 16.3% 5.0% 12.9% 4.4% -6.9% -19.2% -44.2% 6.5% -11.7% -5.8% -37.1% -5.8% -7.6% 3.8% 5.4% -4.3% -6.7% -24.3%

16.2% -2.4% 46.4% -5.4% -8.9% 2.3% 31.1% 3.6% 15.1% 77.5% -3.7% 31.7% -26.1% 62.4% 15.2% -16.7% 26.9% 8.5% 1.3% 16.2% -30.3% 91.2% 39.5% 20.0% -0.3% 35.2% -29.9% 4.5% -22.7% 39.6% 21.4% -8.4% -29.5% 116.7% 3.9% 24.9% -8.0% 53.9% 29.2% 3.0% 2.5% -13.0% 26.6% -10.1%



1177 - 769 Stock performance relative to an unweighted expected total return of the industry over a 12 month investment horizon.

3-tier industry sector rating system: Positive, Neutral, Negative 3-tier stock rating system: 1 Overweight, 2 Equal-weight, 3 Underweight RS - rating suspended

Market cap, assets and revenues are aggregated.

Source: Lehman Brothers


October 18, 2002

Credit Derivatives Primer

Important Disclosures: The analysts responsible for preparing this report have received compensation based upon various factors including the Firms total revenues, a portion of which is generated by investment banking activities. Key to Investment Opinions: Stock Ratings: 1- Overweight - the stock is expected to outperform the unweighted expected total return of the industry sector over a 12-month investment horizon. 2- Equal weight - the stock is expected to perform in line with the unweighted expected total return of the industry sector over a 12month investment horizon. 3- Underweight - the stock is expected to underperform the unweighted expected total return of the industry sector over a 12-month investment horizon. RSRS- Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Lehman Brothers is acting in an advisory capacity in a merger or strategic transaction involving the company.

October 18, 2002




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Sector View: 1- Positive - sector fundamentals/valuations are improving. 2- Neutral - sector fundamentals/valuations are steady, neither improving nor deteriorating. 3- Negative - sector fundamentals/valuations are deteriorating. Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist): dividend) This is a guide to expected total return (price performance plus dividend) relative to the total return of the stocks local market over the next 12 months. 1- Strong Buy - expected to outperform the market by 15 or more percentage points. 2- Buy - expected to outperform the market by 5-15 percentage points. 3- Market Perform - expected to perform in line with the market, plus or minus 5 percentage points. 4- Market Underperform - expected to underperform the market by 5-15 percentage points. 5- Sell - expected to underperform the market by 15 or more percentage points. Stock Ratings Prior to February 2001 (sector view did not exist): Ratings 1- Buy - expected to outperform the market by 15 or more percentage points. 2- Outperform - expected to outperform the market by 5-15 percentage points. 3- Neutral - expected to perform in line with the market, plus or minus 5 percentage points. 4- Underperform - expected to underperform the market by 5-15 percentage points. 5- Sell - expected to underperform the market by 15 or more percentage points. V- Venture - return over multiyear timeframe consistent with venture capital; should only be held in a well diversified portfolio. Distribution of Ratings: Lehman Brothers Equity Research has 1491 companies under coverage. 32% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Buy rating. 28% of companies with this rating are investment banking clients of the Firm. 40% have been assigned a 2-Equal weight rating which, for purposes of mandatory regulatory disclosures, is classified as a Hold rating. 11% of companies with this rating are investment banking clients of the Firm. 28% have been assigned a 3-Underweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Sell rating. 39% of companies with this rating are investment banking clients of the Firm. This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (Lehman Brothers) and has been approved by Lehman Brothers International (Europe), regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 2002 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction. Complete disclosure information on companies covered by Equity Research is available at www.lehman.com/disclosures. available

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