Trust Preferred CDOs a Primer 11-11-04 (Merrill Lynch)

8/6/2019 Trust Preferred CDOs a Primer 11-11-04 (Merrill Lynch)

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Highlights of This Issue

Investors in trust preferred (TruPS) CDOs receive an attractive pick-up tocompeting cash CDO sectors while gaining exposure to the heavily regulatedbank and insurance sectors, which have outperformed corporates historically. Todate since mid-2000, 51 TruPS CDOs have been issued aggregating to$21.8 billion in rated notes and equity. The major obstacle to growth in this CDOsubsector is limited collateral supply. Risks for the TruPS CDO investor includeindustry concentration, interest deferral potential, auction-related extension risk

and collateral prepayment risk.On an expected loss-adjusted basis, TruPS CDOs are particularly attractive, asthis sector has experienced no downgrades and no collateral defaults over itsfour year existence. While historical losses for middle market banks and insurersare more comparable to crossover corporate credits, subordination in TruPSCDOs is more similar to that of a BB/B average HY CBO. Consequently, we thinkthat there is more than adequate structural protection against losses in TruPSCDOs. Although the longer maturity of the collateral vis--vis the CDO tranchetenor implies average life uncertainty, various structural mitigants provide ampleprotection against extension risk. TruPS CDOs offer a compelling and uniqueopportunity for investors to gain unlevered (AAA) or levered (AA or below)exposure to middle market bank and insurer debt.

Chart 1: The Market for Trust Preferred CDOs: Annual New Issuance Volume

3,376

4,3854,893 5,126

2,0491,038

55 3

34 4

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2000 2001 2002 2003 2004 YTD

$sinmillions

B a nk T ru P S * In s ur an c e T ru P S* *

6,164

6,942

4,729

3,376

553

Source: Merrill Lynch* All bank or bank-dominant collateral (e.g., hybrids) / ** 100% insurance collateral

FIXED INCOME STRATEGY

United States

C

DOR

esea

rch

11 November 2004

Lang GibsonDirector

(1) 212 [email protected]

Trust Preferred CDOs:

A Primer

Merrill Lynch CDO Primer Series

Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be awarthat the firm may have a conflict of interest that could affect the objectivity of this report.

Investors should consider this report as only a single factor in making their investment decision.

Refer to important disclosures on page 40. Analyst Certification on page 40.

Global Securities Research & Economics Group Fixed Income StrategRC#61431602


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Trust Preferred CDOs: A Primer 11 November 2004

2 Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer

Introduction

Trust Preferred (TruPS) CDOs were first issued in mid-2000, four years after the1996 Federal Reserve granted Tier 1 capital relief to banks issuing trust preferred

securities. Since 2000, there have been 51 TruPS CDOs (42 bank-dominant andnine pure insurance) issued aggregating to $21.8 billion in rated notes and equity(see Appendices 2 & 3 for full deal details). Whereas demand remains healthydue to the sectors highest yield among cash CDOs, the greatest obstacle to

growth is sourcing enough collateral to structure a sufficient number of

CDOs to meet this demand. Trust preferred securities (TruPS) have enabledissuers to raise capital on a tax advantaged basis to fund growth or repurchasestock without diluting shareholder wealth. CDOs allow small banks and insurersthat dont have access to the public capital markets ($25 to 300 million issues) toissue in $3-15 million sizes and to get the same benefits that larger issuers receivewithout the high fixed issuance costs. Bank issuers can deduct their TruPSdividendpayments for tax purposes and yet still obtain regulatory capital treatment (or, in thecase of insurers, statutory accounting and rating agency capital) up to a specified

limit. The most successful CDO originators have strong relationships with manysmall and medium sized financial institutions nationwide allowing them to sourcea geographically diverse pool of 25 to 40 credits with an optimal combination ofrisk and return. Our report is divided into the following six sections:

Page

n Trust Preferred Securities Overview 2

n TruPS CDO Overview 4

n Collateral Loss Trends: Banks and Insurers 5

n Structure 8

n Cash Flow Analysis 11

n Relative Value 15

n Overview of the Bank and Insurance Industries 18

n Appendix 1: Rating Agency Methodologies 25

n Appendix 2: TruPS CDO Deal List 28

n Appendix 3: TruPS CDO Database with Structure and Pricing 29

Trust Preferred Securities Overview

Trust preferred securities have the following general characteristics:

Subordinate to all debt on a companys balance sheet, but senior to both

preferred and common stock.

Generally thirty year in term, non-amortizing instruments that pay quarterlyor semi-annual interest.

Dividend payments may be deferred for up to five years.

Callable after five years for small institutions and ten years from issuance forlarge capital markets issues.

Dividends, which are typically floating rate for issuers into CDOs, are tax-deductible to the issuer.

While the focus of this primer is bank TruPS, we do address insurance TruPS

and surplus notes due to their increasing inclusion in bank deals.


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Refer to important disclosures on page 40. 3

n Bank TruPS

TruPS benefit from the tax advantages associated with debt and capital relief

associated with equity. Both the securities long-term nature (30 years) andthe issuers ability to defer dividends for up to five years contribute to bankregulators allowing TruPS to account for up to 25% of Tier 1 capital. Bankissuers are typically wholly-owned subsidiaries of bank holding companies, or

may be a subsidiary of the bank directly. The trust sells securities to investors anduses the proceeds to purchase subordinated debentures of its holding company.The trust uses the interest payments that it receives from the purchased debenturesto make payments to the holders of its preferred securities. The terms of thesubordinated debenture are identical to those of the issued TruPS (Chart 2).

Chart 2: Flows for a TruPS Security

Lim

itedGuara

ntee

100%C

ontro

l

Subordinated

Debt & Debt

Payments

Proceeds of Trust

Preferred Securities

offering

Trust Preferred

Securities & Dividend

Payments

Proceeds

of

Offering

Bank or

Bank Hold ing Compa ny

Specia l Purpos e Business Trus t (Iss uer)

Trust Preferred Investors

Source: Merrill Lynch

n Insurance TruPS and Surplus Notes

Both insurance TruPS and surplus notes, which are often also included in CDOpools, are hybrid instruments (much like bank TruPS) in the capital structure of anoperating insurance company. Their interest is tax deductible and they receivepartial credit for permanent equity capital by the rating agencies.


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There are also some important distinctions between insurance TruPS and surplusnotes. Insurance TruPS are typically issued at the holding company level; whereasinsurance surplus notes are issued from operating insurance companies.Furthermore, on GAAP balance sheets, insurance TruPS are accounted for aslong-term debt. By contrast, surplus notes are issued by the operating companyand are generally less subordinated than TruPS. Typically, surplus notes arenotched down 2x from the operating companys debt rating versus 4-5 notches forTruPS. Interest and principal payments on surplus notes are subject to priorregulatory approval. State regulators generally do not allow issuance of surplusnotes to exceed 15% of issuer surplus.

TruPS CDO Overview

The pooled CDO approach results in cheaper issuance costs and funding forissuers, while providing geographic diversification to investors. TruPSissuance prior to 2000 was strictly the domain of larger financial institutions withadequate economies of scale to issue on a standalone basis and whose securitieshad adequate secondary market liquidity. The trust preferred market is tapped viapooled issuance into a CDO by smaller regional and community banks andinsurance companies with no public market access. To date, we have seen

$21.8 billion of TruPS CDO issuance (42 bank or bank-dominant and ninepure insurance deals), making the TruPS CDO market the third largest newissue cash CDO subsector in the US (Chart 3).

Chart 3: Growth in TruPS CDO Issuance

20002001

20022003

2004 YTD

Insurance TruPS CDOs

Bank TruPS CDOs$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

Issuance ($mm)


TruPS CDOs provide investors with regionally diversified exposure to a new issuerbase with a solid performance history, particularly with respect to banks whosepeak historical failure experience is a fraction of the peak overall corporate defaultexperience. As well, they provide debt investors with exposure to bank originatedcommercial real estate (CRE) risk with more subordination than a direct investmentin CMBS, whose enhancement levels have significantly loosened as a result ofseveral factors including better-than-expected performance. Performance forTruPS CDOs, like that of the underlying collateral, has been excellent, with norating actions to date. Major risks include industry concentration, interestdeferral potential, auction-related extension risk and prepayment risk, whichare all key determinants of ultimate performance.


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n Enter the insurers

TruPS CDOs issued between 2000 and late-2002 were primarily backed by bankand thrift collateral with small buckets for insurers in some deals. The first TruPSCDO backed by 100% insurance collateral was issued in late 2002. Still, TruPSCDO issuance has been dominated by bank collateral. Pure insurance TruPSCDOs represent 15% of the total outstanding TruPS CDO market today. The

share of insurers in hybrid bank/insurance pools could grow to 50% withinthe next year, enabling originators to reach their spread and diversity targets.However, we expect bank collateral to dominate pool composition in the short-and medium-term. Whereas rating agencies and investors seem to generally viewbank collateral credit quality as stronger than insurers, they also recognize thediversity benefits of adding insurance credits to the pool. P&C insurers,particularly, tend to have disparate lines of businesses and geographic exposures.Robust TruPS CDO issuance over the past few years has driven small bank TruPSspreads to particularly tight, scarcity-driven levels. These tighter collateral spreadshave, in turn, diminished CDO volumes this year because there are fewer collateralissuers with adequate spreads and diversity to enable the arbitrage (Chart 4).

Chart 4: Monthly TruPS CDO volume vs. bank and insurer TruPS spreads: 2000-present

0

50

100

150

200

250

300

350

400

450

Mar-0

0

Jun-00

Sep-00

Dec-00

Mar-0

1

Jun-01

Sep-01

Dec-0

1

Mar-0

2

Jun-02

Sep-02

Dec-02

Mar-0

3

Jun-03

Sep-03

Dec-0

3

Mar-0

4

Jun-04

Sep-04

Spreads(bps)

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

Monthly Volume Bank Insurance

Source: Merrill Lynch, Cohen Brothers

The tightening in bank TruPS spreads has spurred originators to include a sizeablebucket for insurance TruPS, which provides several benefits, including a poolspread pickup and industry diversification. These mixed collateral pool deals,often referred to as hybrid TruPS CDOs, are becoming more prevalent. Inaddition to a blend of new issue small bank and insurance collateral, TruPSCDOs typically feature a bucket for secondary market TruPS, usually issuedby larger bank and insurer issuers, as well as subordinated bank debt.

Collateral Loss Trends: Banks and Insurers

n Bank loss trends

In order to assess the risk of default within the banking sector, we look to dataprovided by the FDIC, which, as the industrys main regulator, provides one of themost comprehensive sources of historical bank data. We examine bank failurerates as a conservative proxy for defaults. (In the case of a failure, there are otheroptions than default such as a merger into a larger institution.) Bank failures haveaveraged 0.24% historically, showing a spike in the Great Depression and thelate-1980s/early-1990s as the CRE-driven recession played out (Chart 5).


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Chart 5: Historical Bank Failures: 1934 2003

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

Source: FDIC

Between 1987 and 1989, the annual failure rate ranged between 1.43% and 2.04%;the 70-year and 35-year average bank failure rate is a respective 0.24% and0.38%. In order to develop a more tailored proxy for historical default rates forthe typical bank found in a CDO, we refer now to Fitch data, which stratifies theFDIC data further by asset size.

Chart 6: Cumulative BIF-Insured Bank Failure Rates by Size

0

2

4

6

8

10

12

14

1984

1986

1988

1990

1992

1994

1996

1998

>$10 billion

>$200 million and


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performance in the sector, in our opinion.The commercial bank failure rate history(a conservative proxy for defaults) compares favorably with historical globaldefaults as they relate to corporate bonds (Chart 7). Additionally, both banks andinsurers benefit from heavy regulation and the implicit government agency oversightthat this implies. This regulation gives these sectors an advantage and contributes totheir relatively low default rates versus non-bank corporates.

Chart 7: Commercial Bank Failures vs. Global Corp. Defaults

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Bank Fai lures Global Corporate Defaults*

Source: FDIC and Moodys* Based on Moodys 12-month trailing global corporate default rate. Includes both IG and HY issuers.

n Insurance loss trends

Property & Casualty (P&C) insurers generally command a higher premium in themarket as compared to life & health (L&H) companies due to the higher risk

associated with their lines of business. Actuarially, it is easier to predict death andhealth problems (L&H insurers) than the unexpected, multi-sigma events that aremore common with P&C businesses. Historical insurer default rates reflect thesedifferent risk profiles: L&H annual defaults have averaged 59 bp; whereasP&C defaults have averaged 79 bp (Chart 8). The historical default paths ofthese two segments have generally been correlated, with the exception of the pastfew years when P&C defaults rose to 1.25% in 2002 and the L&H rate fell to zeroin 2001, our most recent data point. The 1991 recession saw the peak default ratefor the L&H and P&C segments simultaneously rise to their historical highs of1.83% and 2.3%, respectively.


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Chart 8: Insurance Default Rates: P&C Versus L&H

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

P&C L/H

L&H Mean: 59 bp (1976 - 2001)

P&C Mean: 79 bp (1969 - 2002)

Source: AM Best

Structure

TruPS CDOs have historically been issued as static pools, with no discretionarytrading or reinvestment of principal proceeds (a typical funding mix for a bank-dominated deal is 63% AAA, 28% A, and 9% equity). AA and BBB tranches arerelatively rare for TruPS CDOs. However, there are typically several AAA and A-rated tranches both sequential and pro rata in the same deal. The structures usedare similar to those found in most other static pool cash CDOs, with some exceptions.We summarize the key collateral and structural considerations in Table 1.

Table 1: Generic TruPS CDO StructureClass Amount($mm) % of Total Rating Rated Coupon Avg. Life

A-1 $162.25 46% AAA/Aaa 3mL+52 7.5 - 8.5

A-2 $ 52.42 15% AAA/Aaa 3mL+70 10

A-3 $ 5.82 2% AAA/Aaa 3mL+70 10

B $ 98.49 28% A/A2 3mL+160 10

PS $ 31.01 9% NR/NR NA

$350.00


n Deferral of Interest

An important feature of TruPS is that an issuer may defer interest payments

for up to five years, and this can be done multiple times over their thirty-year life.Anecdotal evidence suggests that dividend or interest deferrals on TruPS in bothsectors have been rare, although exact figures are not available. The one knowncase of interest deferrals within a TruPS CDO occurred in the RegionalDiversified Funding I Ltd. transaction issued in March 2000. This was the firstTruPS CDO ever, and was backed by bank and thrift TruPS. Following dividenddeferral on two of the underlying securities in August 2004, Moodys put thesenior notes on negative watch. Moodys subsequently took the senior notes offwatch a month later when the first of the two deferring obligors receivedregulatoryapproval to resume payments, including all accrued and unpaid obligations.

We believe that credit deterioration would have to be substantial before abank or insurer would defer payment. The agencies point to the likelihood ofhigh correlation between bank TruPS interest deferrals and FDIC intervention. We


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note that if interest payments are deferred by the holding company, it must alsorefrain from paying common dividends an onerous structure that incents issuersto continue TruPS payments. For insurers, ongoing interest and principalpayments on surplus notes must be approved by the state regulators. Aspolicyholder confidence may be diminished by any perceived negative signalsfrom a deferral, we believe that regulators would exercise extreme caution, onlysuspending payments under dire conditions.

The ability of the obligors to defer interest clearly adds some uncertainty to thecash flows of the CDO. To offset this risk, TruPS in deferral are treated asdefaulted securities for purposes of the coverage tests with an assumedrecovery rate typically in the 2-5% range.Due to a lack of performance history,agencies use these conservative default and recovery assumptions. Additionally,some transactions feature a test that redirects cash flows to the senior-mosttranches as a way to cure the amount of the deferring asset. This is done untileither a percentage, or total par amount, of the deferred asset is covered or thesecurity resumes interest payments. In addition, TruPS CDOs typically featurereserve accounts designed to cover potential deferred interest payments.

n Pool Diversity

TruPS CDOs are unique in that they are concentrated in only one or two industries.However, there is clearly some diversification benefit from aggregating pools fromdefined regions across the nation. As such, diversity within bank TruPS pools isexamined by five distinct regions. Consequently, banks effectively represent fivedistinct industry categories for rating purposes. The assumption is that banks andinsurers are highly correlated intra-regionally, but are somewhat uncorrelated inter-regionally. The agencies adjust their default rate assumptions, applying penalties toexcess geographic concentration within the pool. In the case of hybrid TruPSCDOs, the issue of industry concentration is clearly lessened to the extent aninsurance bucket is included. Furthermore, the business mix varies a great dealamong middle market P&C issuers, which are more numerous than L&H companiesin these deals, implying some standalone diversity benefit from their inclusion.

The other consideration when examining pool concentration is obligor exposure.

Large single obligor exposures can increase loss severity in any CDO, particularlyfor subordinate noteholders. To account for this, rating agencies impose singleobligor limits and apply more punitive stresses to account for large exposures.

n Prepayments & Auction Calls

Prepayments

While many CDO subtypes require consideration of prepayment, or call, risk, it isa particularly important factor in analyzing TruPS CDOs because the lack ofobservable history makes prepays in this asset type difficult to predict. In TruPSCDOs, prepayment risk is more credit-related as opposed to interest rate relatedbecause credits are sourced into the pool at par as Libor floaters. The TruPSissuers call option, combined with the otherwise non-amortizing nature of theTruPS collateral, makes it difficult to forecast the weighted average life (WAL) ofthe notes, CDO auction calls and redemption features notwithstanding. Prepayscan be motivated by either opportunistic refinancing or regulatory changes:

Opportunistic call: If the issuer no longer desires the TruPS capital, forwhatever reason, it may decide to call the deal to reduce its funding cost afterthe non-call period typically five years for mid-market issues and ten yearsfor TruPS issued by large issuers in the secondary bucket. As well, an issuercan call the bond if it were able to issue a new TruPS at a tighter spread, anunlikely event in the current tight spread environment. Finally, the acquisitionof smaller banks by larger ones can lead to a call if the acquiring bankopts to use its own lower cost of funding. However, the acquired banksTruPS debt has historically gone unnoticed once it has been amalgamated intothe larger banks balance sheet.


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Regulatory call: Should regulatory rules be altered to remove the TruPSsTier 1 status for bank and thrifts or remove the tax deductibility status, theissuer may call the bond.

All TruPS CDOs issued to date have been static pools, such that proceeds fromprepayments cannot be used to reinvest in new collateral. Instead they immediatelyreduce the average lives of the senior-most notes. Prepayment risk is a particularly

important consideration given the homogeneous nature of the pool with respect toasset type.

In sizing credit enhancement, rating agencies stress CDO structure through variousprepayment timing scenarios. Larger and earlier prepayments are positive becauseprepaid assets cannot default and are used to pay down senior notes, resulting ina higher subordination percentage for all of the notes. However, prepaymentsare more likely to occur in the better performing names. Such cherry-pickingwould negatively impact the credit quality of the remaining pool. Thislong-dated tailrisk, combined with reduced absolute excess spread followingprepayments, may serveto increase the risk profile for the subordinate-most noteholder. As such, it isimportant for investors in these classes to be comfortable with the credits in thepool. Early TruPS transactions were blind pools, where investors did not haveaccess to collateral specifics. Although most TruPS CDO trustee reporting does

not include specifics on the collateral, it is common for originators to providecollateral information and analysis to investors in their deals.

Auction Calls

Investors, particularly those lower in the capital structure, do bear the riskthat the tranche average life extends past ten years if auctions repeatedly fail.However, the TruPS CDO structure mitigates the long maturity of the TruPScollateral with 1) the auction call and 2) sequential amortization in the case of afailed auction. The auction is designed to pay off the notes principal in its entiretystarting in year ten. Should the auction fail, a re-attempted auction call occursevery payment period until the auction is successful. Furthermore, until such timethat the auction is successful, a portion of excess spread (50% - 60%) isdiverted to amortize the notes sequentially. Consequently, the senior-mosttranche average life sensitivity is significantly less exposed to an auction failurethan the junior tranches. As the notes are amortized with this excess spread, thelikelihood for a successful auction call increases with each payment datebecause there are increasingly fewer liabilities to pay off. Furthermore, this featurecreates additional excess spread, as the same collateral pool is now supportingfewer rated notes.

An auction will only fail to the extent that the collaterals value is less than theprincipal amount of the notes. Therefore, a failed auction would likely onlyoccur if there is substantial credit deterioration, which would includewidespread TruPS collateral spread widening (systemic) and/or significantdeferrals or defaults (idiosyncratic). Furthermore, any fixed rate secondary bondspurchased at a premium could decline in value if the issuers call option (whichthe investor is short) goes in-the-money due to a spread and/or rate rally.

However, this call-related optionality risk is minimal in todays tight spread andlow rate environment, making it unlikely for spreads to tighten or rates to rallyenough to behoove issuers to call their TruPS issues.

In the cash flow sections, we evaluate the average life sensitivities across thecapital structure to determine relative extension risk in the tranches.


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n Interest Rate Hedging Considerations

To date, there has been minimal fixed/floating interest rate mismatch in TruPSCDOs, as the majority of both the assets and liabilities are floating rate. Themismatch is so minimal (or nonexistent) in some transactions that no hedgeprogram exists. To the extent that there has been hybrid collateral (TruPS that arefixed for a specific period and then switch to floating), most CDOs have a

similarly-priced subordinate hybrid liability, offsetting much of the interest ratemismatch. In general, the mismatch to hedge in these transactions has beensmall compared with other cash CDO sub-sectors, enabling some TruPS CDOissuers to easily afford hedges that are cancellable at the first auction call date.Cancellable calls are not economically feasible in other types of CDOs, such asstructured finance CBOs, due to the need for a large hedge to account for thepredominantly fixed rate assets versus floating rate liabilities. The need forlimited hedging is a strong positive for a CDO, as out-of-the-money hedges and/orover-hedging has exacerbated poor performance within other CDO sub-sectors.

n Credit Enhancement

Subordination

The conservative manner in which ratings agencies define bankdefaults leads toa conservative sizing of CDO subordination. The analysis includes several factors;1) defaults, 2) conservative recovery amounts and timing, 3) prepayment stresses,4) geographic concentrations and 5) single obligor concentrations (see Appendix 1for summary of Rating Agency Methodologies). Given the limited predictabilityof the collateral cash flows, the agencies stress their assumptions for collateralperformance to address the potential variability in cash flow timing. Thus, TruPSCDOs can have fairly high required subordination levels, as these stresses accountfor the limited historical performance of the collateral. In our opinion, theseconservative subordination levels will likely fall over time.

Excess Spread

Another unique aspect of TruPS CDOs is the amount of excess spread that canpotentially be generated over the life of a transaction and can cushion against losses.

The non-amortizing nature of the long-dated collateral can generate highexcess spread relative to other CDO sectors. The same features mean that excessspread is diminished only by prepayments and defaults, which can be difficult topredict. This is where cash flow scenarios (our next section), with varying prepayand default assumptions, can add value to the analysis of a TruPS CDO. The ratingagencies typically stress the CDO cash flows using front-loaded default stresses,which place pressure on excess spread early in the life of the transaction.

Cash Flow Analysis

We examine how various factors, such as defaults and prepayments, auctioncalls, and various structural features impact the tranches sensitivity to lossesand calls. One way to gauge the strength of the debt classes to withstand collateral

credit impairment is to simulate breakeven default rates. Breakevensdemonstrate how much collateral must default before a tranche experiences abreak in yield. Our case study deal in Table 2 is based on a $416 millionquarterly-pay bank and thrift TruPS CDO. The collateral has a weighted averagespread of 2.73% on the floating rate assets, a weighted average coupon of 7.43%on the fixed-rate assets, and a weighted average coupon/spread on the hybrid-ratecollateral of 6.23%/2.79%. Our sample pool is approximately 95% floating-rate,with the balance in fixed-rate or hybrid-rate collateral. The transaction has initialexcess spread of approximately 1.60% per annum.


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Table 2: Case Study TruPS CDOExample Capital Structure

Class Size Ratings (Fitch/MoodysS&P) Sub.* Price Avg. Life

A1 $195.00 AAA/Aaa/AAA 51.25% 3mL +48 8.7

A2 $ 63.00 AAA/Aaa/AAA 3mL +70 10

A3 $ 7.00 AAA/Aaa/AAA 33.75% 3mL +70** 10B1 $ 62.38 A/A2 3mL+1.65% 10

B2 $ 51.62 A/A2 3mL+1.65%*** 10

B3 $ 3.00 A/A2 4.50% 3mL+1.65%**** 10

PS $ 33.50 NR NA

Source:*Subordination based on $400mm of collateral supporting the notes.** Pays a FX coupon of 5.60% for the first 10 years.*** Pays a FX-rate coupon of 5.71% for the first 5 years.**** Pays a FX-rate coupon of 6 .60% for the first 10 years.

The class A1 notes are first in priority for interest and principal. The A2 and A3classes receive pro rata interest and principal distributions following the A1 notes.The class B notes are pro rata amongst themselves.

n Default sensitivities

The senior AAA class can withstand a constant annual default rate (CADR) of 11.9%before breaking its yield. The junior AAA and A classes can withstand CADRs of8.5% and 2.4%, respectively. These CADRs compare favorably with the 1970-2003historical average of 38 bp (peak of 204 bp). The coverage multiple above thehistorical average failure rate that the senior AAA- and A-rated tranches canwithstand before breaking yield is 29.8x and 5.9x, respectively (Table 3).

Table 3: Breakeven Default Rates (based on a break in yield)

Multiple of 35- Year Historic

Tranche Rating CADR* Avg. Failure Rate** Cumulative Defaults Cumulative Losses WAL

A1 AAA/Aaa/AAA 11.9% 29.8 62.3% 56.1% 7.86

A2 & A3 notes AAA/Aaa/AAA 8.5% 21.3 49.3% 44.4% 9.95

B notes A/A2 2.4% 6.0 16.8% 15.1% 9.95

Source: Merrill Lynch* CADR - Constant Annual Default Rate. Assumes a 10 year auction call, 10% CPR in year 6 and 2% therafter, 10% recoveries, 2-year recovery lag, forward LIBOR, no deferral of interest.** Coverage of CADR over the 35-year annual average historic bank failure rate of 0.40%.

n Average life sensitivities

In addition to tranche sensitivities to collateral defaults, weighted average lives(WALs) can vary as a function of prepayments and defaults, as well as the timingof the auction call and other call and redemption features (e.g., extension risk).Our example deal has a feature beginning in year 10 that redirects 60% of theexcess spread each period from the equity holder to amortize the senior-mostoutstanding class of notes. This amortization feature reduces the WAL of thenotes in the event of a failed auction call in year 10 and greatly minimizes theextension risk in the senior AAAs. For example, the WAL of the AAAsincreases only 0.43 years if we assume a 30-year auction call scenario instead of asuccessful auction in year 20 (Table 4).


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Table 4: WAL with Base Case Prepayments and Varying Auction Call Dates*

Class Auction Call Year 10 Auction Call Year 20 Auction Call Year 30

A1 8.8 13.0 13.4

A2 10.0 20.0 28.6

B 10.0 20.0 30.0

Source: Merrill Lynch* Assumes 10% CPR in year 6 and 2% thereafter, 40 bp CADR, 10% recoveries, 2-year recovery lag, forward LIBOR, nodeferral of interest.

In addition to the auction timing scenarios above, we examine WALsensitivity for various prepayment scenarios under both a 10-year and30-year auction call scenario (Tables 5 and 6). We begin with our base caseprepayment assumptions, including 10% prepayment rate in year 6, the first yearfollowing the non-call period. We then vary both the initial prepayment in year 6and the ongoing annual prepayments over the life of the transaction. We chose ayear 6 lump sum prepayment speed assumption as high as 50% to take into accountthe risk, however remote, that opportunistic refinancing could be the result ofextensive market-wide spread tightening, thus affecting a large portion of the pool.

Table 5: WAL Sensitivity to Prepayments by Tranche Year 10 Auction Call*

Class A1 Prepayment Speed in Year 6

CPR** 10% 20% 30% 40% 50%2% 8.8 7.9 7.1 6.2 5.54% 8.5 7.7 6.9 6.0 5.56% 8.3 7.5 6.7 5.9 5.5


CPR** 10% 20% 30% 40% 50%2% 10.0 10.0 10.0 10.0 9.54% 10.0 10.0 10.0 10.0 9.16% 10.0 10.0 10.0 9.9 8.7

Class B Prepayment Speed in Year 6

CPR** 10% 20% 30% 40% 50%2% 10.0 10.0 10.0 10.0 10.0

4% 10.0 10.0 10.0 10.0 10.06% 10.0 10.0 10.0 10.0 10.0

Source: Merrill Lynch* Assumes 40 bp CADR.** Assumed annual prepayment speed following year 6.


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Table 6: WAL Sensitivity to Prepayments by Tranche Year 30 Auction Call*


CPR** 10% 20% 30% 40% 50%2% 13.4 10.7 8.2 6.4 5.54% 10.6 8.7 7.2 6.0 5.56% 9.2 7.9 6.7 5.9 5.5


CPR** 10% 20% 30% 40% 50%2% 28.6 27.0 24.0 19.7 13.74% 21.6 19.7 17.3 14.4 10.66% 17.5 16.0 14.1 11.9 9.2

Class B Prepayment Speed in Year 6

CPR** 10% 20% 30% 40% 50%2% 30.0 30.0 30.0 29.9 28.94% 29.5 29.0 28.2 27.0 25.16% 26.9 26.1 25.0 23.5 21.6

Source: Merrill Lynch* Assumes 40 bp CADR.** Assumed annual prepayment speed following year 6.

Not surprisingly, moving down the capital structure, the tranche WALs areincreasingly less responsive to prepayments. Although relatively insensitive in theyear 10 auction call scenario, the WAL of the junior AAA class does shortenmeaningfully with increases in the year 6 lump-sum prepayment assumption(Table 5). In contrast, the WAL of the subordinate-most note demonstrates limitedsensitivity in the 30-year auction call scenario. Although a 30-year auction call isexceptionally unlikely, the stresses provide insight into how much more sensitiveall three tranche WALs could be to calls at the extreme (Table 6).

n Equity IRR Sensitivities

Equity IRRs for TruPS investors have fallen since the products inception, similarto most other CDO asset classes, as collateral spreads tighten to historical lows.Despite tighter TruPS spreads, TruPS CDO equity currently provides the highestIRR of the three major cash CDO sub-sectors (see the relative value section).CDOequity returns are robust regardless of the assumptions made for the auctioncall timing (Chart 9). Even in our worst-case prepayment scenario for equity,where 100% of the pool prepays in year 6, the equity still has positive returns upto a 1.2% CADR, three times the historical average annual bank failure rate.


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Chart 9: Equity Return Sensitivity to Defaults, Auction Calls, and Prepayments

-10.00%

-5.00%

0.00%

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0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40%

CDR

Return

10 Yr Auction Call* 30 Yr Maturity* Yr 6 100% Prepays Yr 6 30% CPR**

Source: Merrill Lynch* Assumes 10% CPR in year 6 and 2% therafter, 10% recoveries, 2-year recovery lag, forward LIBOR, no deferral of interest.

** Assumes 2% CPR following year 6, 10% recoveries, 2-year recovery lag, forward LIBOR, no deferral of interest.

Relative Value

n Debt Tranches

TruPS CDOs have the highest spread among all new issue cash CDOsubsectors, yet this four-year old asset class has yet to experience a singledowngrade. Unlike competing CDO subsectors, we believe that investors shouldachieve a comfort level with the deals extension risk, more so than principal lossrisk. In other words, significant collateral losses are far more likely to extendthe tranches average life than to touch principal, a function of the relativelylong-term non-amortizing nature of the collateral. In AAAs, TruPS CDOs have a

20 bp pickup to HY CLOs and a 29 bp pickup to the average of three non-CDOcompeting sectors (Chart 10). In As, the pickup is a respective 60 bp (versus HYCLOs) and 104 bp (versus our composite of three competing sectors) (Chart 11).

Chart 10: AAA-rated TruPS CDOs Versus Competing Spreads Versus Non-CDO Competing Sectors

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Source: Merrill Lynch Source: Merrill Lynch


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Chart 11: A-rated TruPS CDOs Versus Competing Spreads Versus Non-CDO Competing Sectors

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Source: Merrill Lynch Source: Merrill Lynch

We attribute the TruPS CDO spread pickup to the following four factors:

1) Relative investor sponsorship: Few investors are familiar with this collateralrelative to most CDO subsectors as it was not possible to invest in the debt ofmid-market banks and insurers prior to 2000. In fact, other banks and insurerswere, not surprisingly, the first investors across the capital structure of TruPSCDOs.

2) Extension risk: Although the average life is ten years atthe CDO level, thethirty-year legal final of the TruPS collateral can exceed maturity limits forsome investors. TruPS CDOs address the long maturity of the collateral withperiodic auction calls and delevering of the structure in case of repeated failedauctions.

3) Prepayment risk: Prepayments (e.g., calls) could reduce excess spreadresulting in a riskier pool to the extent that the best credits are prepaid first.Although this could have an adverse effect on the rating of the notes, webelieve that the market is overly backward looking when it comes to predictingfuture prepayments. Given the current spread environment, interest rate drivenprepayment risk is not significant. Instead, the main catalyst for prepaymentswould be credit driven opportunistic refinancing. However, as the pooledTruPS issuers have favorable credit quality when they enter the transactionand spreads are at historical tights, mergers are the more likely catalyst tocause prepayments. However, as bank failures often result in a mergerarranged by the regulator, we would much prefer a called bond to default.

4) Issuers option to defer dividends: The issuer has the right to defer TruPSdividends for up to five years. Although the deferred dividends are capitalizedand would eventually be paid should payments resume, deferral is clearly anegative for the issuers creditworthiness. However, three mitigating factorsexist to protect debt holders against deferrals:

Conservative Definition of Default: Debt holders are protected fromthis dividend deferral risk by the rating agencies conservative treatmentof any deferral as a default in the O/C test. Consequently, if enoughdeferrals exist to trip the O/C test, the senior-most note holders couldbegin amortizing before any defaults occur.

Recovery for O/C Test Purposes: For purposes of the O/C test,recoveries are assumed to be a conservative 2%-5%.

Reserve Accounts: TruPS CDOs have reserve accounts that collect aportion of excess spread so as to continue paying debt coupons in casedeferrals are significant enough to erode regular CDO debt coupon payments.


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n Equity Tranche

As with all CDO subsectors, TruPS CDO equity IRRs have fallen to historicallows over the past few years, although the week-to-week IRR volatility isrelatively muted. Our CDO equity IRR barometer measures the relativeattractiveness of buying the equity at any point in time. The barometer representsthe excess spread between the sectors asset and liability yield adjusted for

expected losses and expenses and then levers this excess spread to the gearing in ageneric TruPS CDO. The main drivers of week-to-week changes in the barometer,therefore, are changes in asset and liability spreads. Over the products history, theTruPS CDO equity IRR barometers have fallen 7.8 percentage points toapproximately 13% under base case assumptions of a 48 bp CADR (assuming75% banks and 25% insurer collateral) and 10% recoveries and to about 7% with astressed case assumption of a 95 bp CADR and 0% recovery rate (Chart 12).

Chart 12: TruPS CDO Equity IRR Barometer: Base Vs. Stressed Case

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PSCDOEqu

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Base case: 48 bp CADR; 10% Recovery Stressed case: 95 bp CADR; 0% Recovery

Source: Merrill Lynch, Cohen BrothersCADR = Constant Annual Default Rate.Note: Collateral = 75% Bank TruPS and 25% Insurance TruPS

We have seen a relatively greater tightening in asset spreads as compared toliability spreads over this period. Specifically, bank and insurer TruPS spreadshave tightened a respective 105 bp and 75 bp; whereas AAA and A liabilityspreads have tightened a lesser 48 bp and 45 bp.

Chart 13: Monthly TruPS CDO IRRs Versus Volume

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The barometers are intended to help investors detect relative value amongst CDOsub-sectors as well as other equity-like securities and to forecast CDO volume inthe relevant sector. The 13%-area base case IRR for TruPS CDO equity issignificantly higher than IRRs in the two competing cash CDO sub-sectors,which have recently ranged between 11% and 12%. This years steady decline inTruPS CDO equity IRRs, particularly since May (17.5%), has been associatedwith a falloff in volume (Chart 13). As defaults in TruPS collateral, if any, areexpected to be back-ended (we have seen only deferrals so far in this productshistory), investors receive particularly front-loaded cash flows in this CDOequity product. However, to the extent that there are enough deferrals in thecollateral to trip an O/C test, equity cash flows would be cut off until collateraldividend payments resume sufficiently correcting the O/C test.

Overview of the Bank and Insurance Industries

n Bank Fundamentals

Whereas large banks benefit from economies of scale and a relatively diverse businessline, the two main attractions for small banks is their stronger core deposit baseand the absence of lumpy commercial loan portfolios, which are typical for large

banks. We particularly like small banks strong core deposit bases in an environment ofrising rates. Contrary to popular myth, bank net interest income generally benefitsfrom rising rates as their core deposits re-price much more slowly than theirfloating rate loans. Whereas large banks depend more on wholesale funding, smallbanks rely predominately on core deposit funding. Therefore, we believe that risingrates are a positive for small banks net interest income. Lastly, whereas large bankslend to big companies at tight spreads in lumpy amounts to attract more lucrative, butvolatile, capital markets and related fee business; small banks concentrate more ontraditional residential and commercial mortgage lending.

Given the concentrated exposure to one industry in a bank-dominate TruPS CDO,it is worthwhile to consider some of the basic components of bank credit riskanalysis, including a look at trends in the various performance metrics specific tobanks. The analysis can be broken down into fairly simplistic terms. Bank credit

analysts review the basic health of a bank by examining several keyparameters including profitability, liquidity, loan quality, and capitaladequacy. Additionally, it is important to review trends in these metrics overtime, as well as general trends as observed in a particular banks financials.

TruPS investors focus on the stability of the banks performance over time, as thiswill lend predictability to the payment of trust preferred dividends. Banks withabove-average growth rates, return on equity (ROE) and return on assets (ROA)may be growing and earning above-trend by compromising underwriting standards,mismanaging interest rate risk and/or reaching for market share outside of theircore competency, either by business line and/or geography. TruPS CDO originatorstypically look for issuers with stable ROE maintained in the 15%-area and withsteady ROA of approximately 1%-1.2%. Additionally, a healthy, but controlledgrowth rate for a bank is positive, with real growth of 3-4% considered reasonable.

n Profitability - Net interest margins

A key metric for analyzing profitability and interest rate risk management overtime is the net interest margin (NIM) between interest earning assets and interestbearing liabilities. Bank NIMs have declined in recent years as a relatively flatteryield curve reducing the profitability of their core strategy of lending long andborrowing short. The NIMs of banks more representative of the TruPS CDOspace, (banks with $100 million to $1 billion in assets) have had wider NIMs ascompared with banks with assets in excess of $1 billion (Chart 14). NIMs ofsmaller banks tend to be higher as they rely more on cheap core depositfunding. Compared to the larger banks, they also do less corporate lending, whichtends to be lower yielding compared with alternatives such as CRE lending.


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Chart 14: Bank Net Interest Margin

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1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003NetInterestIncome/EarningA

ssets

Small Banks Large Banks

Source: FDIC

n Profitability Return on assets and equity

ROA has stabilized from the early 1990s, with small banks outperforminglarger banks until fairly recently, when ROA performance fell slightly behind.Large banks have more tools, such as securitization, to pare down their assets andthe ability to do more fee income business, without crimping profitability. Thus,small banks often have higher NIMs but lower ROAs and ROEs (Chart 15).Furthermore, large banks tend to have particularly outsized ROEs because theyfocus more extensively on artificially deflating their equity base.

Chart 15: Bank ROA and ROE

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NetOperatingIncome/TotalAssets

S mall Banks Large Banks

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NetIncome/EquityCapital

small banks l arge ban ks

Source: FDIC Source: FDIC


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n Loan performance

Another key component of bank analysis involves an examination of the loanbooks performance. It is important that loans are growing in tandem with deposits,and that there are adequate loan loss reserves to shield against potential charge-offs.Examining the history of loan delinquencies and charge-offs provide insight intobanks underwriting standards and can be used to judge the adequacy of loan loss

reserves. Loan quality for small banks, as measured here by % net charge-offs,has stabilized since 1994, and has been superior to that of larger banks(Chart 16). Charge-offs at large banks can be adversely impacted by lumpierexposures to individual corporations, particularly during the 2001-2002 corporaterecession. Additionally, the ratio of nonperforming loans to total assets can be usedas a leading indicator of future losses. This ratio has improved significantly sincethe early 1990s, and has been stronger for small banks, who were not significantlyeffected by the large number of corporate defaults in the recent recession.

n Liquidity and core deposits

Liquidity, as measured by core deposits to total assets, has stabilized for banks ingeneral since the early 1990s. Core deposits represent a significant portion of mid-size banks borrower base, and thus tend to be higher for small banks (Chart 17).

Chart 17: Core Deposits/Assets

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CoreDeposits/Total

Assets


Source: FDIC

Chart 16: Charge-Offs/Assets and Nonperforming Loans/Assets

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Smal l Ba nk s Large Ban ks

Source: FDIC Source: FDIC


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n Capital adequacy

Capital adequacy is an important gauge for banks, as a strong capital base providesstability to a financial institution. The ratio of equity capital to total assets hassteadily improved for banks since the early 1990s (Chart 18). Historically, smallerbanks have maintained greater capital adequacy versus large banks.

Chart 18: Capital/Assets

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1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

TotalCapital/TotalAssets


Source: FDIC

n CRE Lending

Finally, understanding the banks core lending business is a key consideration. Forsmaller banks, commercial real estate (CRE) lending comprises the bulk of theloan portfolios risk and return, although residential mortgages are the singlelargest loan category notionally. Bank failures of the late 1980s/early 1990s wereprimarily due to banks and thrifts aggressive underwriting standards for CRElending. We believe that history has taught banks to rely more on cash flow

generation than strictly collateral and to require larger upfront equity deposits.Additionally, the outlook for CRE, according to the forecasts of Torto WheatonResearch, is positive, in terms of both vacancy rates and rents (Chart 19).

Chart 19: Torto Wheaton Rent and Vacancy Rate Trends: Historical and Projected

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One can view investing in bank TruPS as an indirect investment in CRE.Given this, we think there is an interesting comparison to be made with CMBS.Cumulative losses for early CMBS transactions were stressed conservatively,using default rates that are higher than the lofty ones experienced during the early-1990s real estate recession. According to Fitch, excellent performance in theCMBS sector since inception, historically low mortgage rates, the inclusion oflarge loans in conduit transactions and improved collateral and sponsorship qualityhas led to lower rating agency credit enhancement requirements for CMBS, atrend that will likely continue.

Similar to the higher subordination requirements at the inception of the CMBSmarket, subordination offered in the TruPS CDO market is arguably conservative.As agency-required subordination for CMBS has declined (e.g., in 1995, BBBsrequired roughly 16% of hard support versus 5% today) in response to lower-than-expected defaults, we would expect TruPS CDO subordination to similarly declineover time, as losses remain nonexistent or insignificant. We believe that thegeographic diversity offered in TruPS CDO bank pools significantly mitigatespotential bubbles in certain commercial property markets, such as Atlanta,Dallas, and Los Angeles. Still, a 40% CRE loan portfolio in a small bank portfoliois generally riskier than the same 40% CRE concentration in a super-regional

bank, which is more diversified across geography.In sum, commercial banks have experienced low historical failure rates, and smallbanks have experienced steady improvement in overall loan quality, liquidity andcapital adequacy, particularly in comparison with larger banks. While there aremany advantages for smaller bank TruPS issuers to seek financing via CDOs,there is a limited supply of issuers, and available collateral, in the market. Thelimited supply of available collateral only further exacerbates the pressure on bankTruPS spreads. The increasing scarcity of bank collateral, investor demand fordiversification and need for yield in a generally tight spread environment hasled to an increased inclusion of insurance TruPS in bank-dominated TruPSpools, as we discuss below.

n Brief Overview of the US Insurance Sector

Over the past four years, the nations highly regulated US insurance industry hasfaced significant obstacles including a recession, the terrorist attacks of 9-11, aweak stock market and a continuation of weak earnings fundamentals.Fortunately, since 2000 and particularly in the aftermath of 9-11, premiumshave been increasing at a double-digit pace to keep pace with these costs.Prior to 2000, it was typical that premium rate increases would barely keep pacewith inflation, much less loss rates. Still, P&C impairments have more thandoubled from a 1994-1999 average of 54 bp to a 2000-2002 average of 122 bp,whereas L&H defaults have converged to zero.

The most recent shocks for the insurance sector have been a wave of hurricanes inFlorida and the initial announcement of the Spitzer probe, which caused theMerrill Lynch insurance index to widen 20 bp in the ensuing few weeks. Therelatively low average P&C impairment rate (54 bp) in the 1994-99 period was

buoyed by strong capital markets, a lack of major catastrophes and overcapitalization,which was the result of strengthened regulatory oversight and the introduction ofrisk-based capital standards. The insurance industry, particularly the commercialP&C segment, faces many challenges today that can best be summarized by ratingagency outlooks by line of business (Table 7). For an overview of pure insuranceTruPS CDOs and a general description of the collateral, we refer our readers toour June 2003 report,Insurance Trust Preferred CDOs.


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Table 7: Rating Agency Insurance Industry Outlook

LOB Moodys S&P Fitch

Life Insurance Stable Stable Stable

P&C Commerical Lines Negative Negative NegativePersonal Lines Stable Stable Stable


Our Fixed Income Research insurance analyst, Angelo Graci, maintains anOverweight recommendation on the Insurance sector, which was reiterated inhis October 25, 2004 report, Trade Ideas Amidst Insurance Sector Storm. In thisreport, Angelo writes, The Insurance sector is more likely to outperform thebroad index over the next few months due to:

1) The most significant Spitzer allegations (and greatest risks) should remainconcentrated with the large insurance brokers due to the nature of the conflictsof interest,

2) The rating implications on the insurance companies should remain modestdue to our expectations for manageable financial impact and minimal impacton business models,

3) The sector, overall, is very likely to remain a high quality sector. Theaverage rating in the Insurance sector is mid single-A. We expect the averagerating to remain in the single-A category.

Small versus large insurance models

As with banks, small and large insurers have very important differences. Smallinsurers have limited exposure to headline risks such as those related tocatastrophe and asbestos and domestic acts of terror. As these smaller insurerstend to be less well-known, mutually-owned cooperatives, their spreads aretechnically wide relative to larger insurers with the same rating. Our discussionswith various insurance analysts over the past month leads us to believe that theimpact from the Spitzer probe will have a neutral impact on middle market insurerTruPS for the following reasons:

1) The nations largest insurance insurers and brokers are Spitzers target forthese probes not the smaller issuers typically found in TruPS CDOs, despitethe fact that the latter category also engages in contingent commissions(heretofore an accepted practice). It is particularly the brokers that Spitzer isgoing after in this case due to their alleged practice of bid rigging (illegal) andtying. Even for the affected large insurers, most analysts expect the fallout tobe limited to potential fines and penalties, as opposed to a fundamental changein business model. Thus, it is expected that this will be a capital event not anongoing revenue event.

2) To the extent that contingent commissions are disallowed, this could actually

result in lower expenses for some period of time until brokers raise their feesto compensate. Still, contingent commissions are not a significant portion, ifany, of the smaller insurers business, which typically depends on smallerindependent agents for product distribution.

3) To date, the probe is mostly centered in New York, making the diversificationof smaller insurers a positive. However, regulators in the remaining states areexpected to also get tougher with their constituent insurance companies.

4) There may be some buying opportunities for the secondary market buckets ofTruPS CDOs due to market overreaction to the Spitzer probe with roughly 5%-15% buckets for secondary public paper issued by the largest insurers andbanks. Headline risk is likely to push spreads on some of the unaffected largeinsurers to attractively wide levels a technical spelling opportunity for CDOs.


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Conclusion

TruPS CDOs offer the highest spread among all cash CDO sectors. On an expectedloss-adjusted basis, they are particularly attractive, as this sector has experienced nodowngrades and no collateral defaults over its four year existence. While historicallosses for middle market banks and insurers are more comparable to crossover

corporate credits, subordination in TruPS CDOs is more comparable to that of aHY CBO backed by a BB/B portfolio of corporate bonds. Consequently, we thinkthat there is more than adequate structural protection against losses in TruPSCDOs. Although the longer maturity of the collateral vis--vis the CDO tranchetenor implies average life uncertainty, various structural mitigants provide ampleprotection against extension risk. Significant collateral losses, if any, are far morelikely to extend the tranches average life than to touch principal. TruPS CDOsoffer a compelling and unique opportunity for investors to gain unlevered (AAA)or levered (AA or below) exposure to middle market banks and insurer debt.

For a summary of each of the three rating agencys methodologies for TruPSCDOs, please see the appendix in our eminent release of our standaloneTruPS CDO Primer. Furthermore, in this same standalone primer report, wewill have full details on all TruPS CDO issued to date.

The author would like to thank Katie Lynch, CFA,Vice President, CDO Research Analyst for her contributions.


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Appendix 1: Rating Agency Methodologies

Fitch Bank TruPS CDO Methodology

n Collateral Credit Quality

Most TruPS issuers that pool securities into CDOs are small and unrated. To addressthis, Fitch uses its US Bank Scoring Model to evaluate the creditworthiness of eachissuing bank. Each bank is scored using its proprietary model, which accounts forrelative capital strength, earnings, liquidity and asset quality. The scoring system isbased on a half-point incremental scale of 1-5, with 1 being the highest possiblescore. Other factors outside of the model, such as operating history, bank size, andobligor concentration, may be used to further adjust the score.

n Default and Recovery Assumptions

Once a bank score has been derived for each issuer in the pool, each bank isassigned a default rate based on Fitchs Trust Preferred Default Matrix. Thedefault rate assigned to an issuer is a function of the issuers adjusted bank scoreand the desired liability rating for a given tranche to be rated. The Fitch default

matrix is based on Fitchs study of historical bank failures since 1970, and wasbased on a methodology similar to that used to construct the corporate defaultmatrix. Their rationale for excluding the period prior to 1970 is that there was littledefault experience then and because more recent data incorporates a more relevantbanking environment and regulatory conditions. In the study, Fitch focused onbanks and thrifts with between $200 million - $10 billion in assets, and with banktrack records in excess of five years. As a proxy for defaults, Fitch counted allbank failures reported by the FDIC as defaults. This is considered to be aconservative approach, given that bank failures do not always result in default.Furthermore, defaults were weighted on an occurrence basis, rather than byissuer size. Given that defaults are more frequent among the smaller issuers, thisapproach lends additional conservatism to the methodology.

Default rates for each issuer are determined at each desired liability rating level,

and from these the required minimum weighted-average default rate for each ofthe rated notes is calculated. With respect to recoveries, Fitch notes the lack ofempirical data, and uses a 10% recovery rate with a two-year lag. This rate, whileacknowledged by Fitch to be conservative, takes into account TruPS subordinateposition within the bank capital structure.

n Collateral Diversity

Fitch addresses industry concentration by requiring additional credit enhancementto serve as a default cushion against this risk. Fitch focuses on the regionaldiversification within the pool, citing a Salomon study on how the regionality ofbanks positively affects their default correlation. The study found that interregionalbanks, stratified into five regions nationally, are no more positively correlated thanany other five industries in the US. Fitch analyzes regional concentration within the

CDO pools and grants a limited amount of benefit for more diverse pools. Penaltiesare applied to obligor concentrations within a given region of greater than 28%.Other penalties may be applied as needed. Concentration penalties are used toadjust the pool weighted average default rate.

Fitch also addresses excess single obligor concentrations within the pool. Penaltiesfor such concentrations are factored into the individual banks score based on thequality of the bank and the amount of the concentration.

n Prepayments

With little history to suggest future prepayment behavior, Fitch uses variousprepayment timing scenarios in order to stress the cash flows.


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Moodys Bank TruPS CDO Methodology


For the rated portion of the pool, the default probability for a bank is estimated byreferencing Moodys senior unsecured ratings of the issuers. When TruPS in the

pool are unrated, Moodys has the following prescreening requirements for eachissuer:

Financial institution insured by the Bank Insurance Fund orSavings Insurance Fund.

Five years minimum of operating history.

Minimum asset size of $100 million.

Not under investigation by any regulatory body.

No restrictions placed on its operations by any regulatory body.

Each bank is run through Moodys Financial Institutions model, which considersvarious factors for each bank issuer, including earnings, capitalization, andconcentration in commercial real estate assets, among other financial variables.Moodys assumes that the credit quality of the pool used to determine defaultprobability is the higher of 1) a WARF of 480 (Baa2/Baa3), as corresponds toMoodys corporate bond default rate and their analysis of historical FDIC defaultdata on insured commercial banks and 2) the portfolio average WARF determinedby their model. The model is adjusted for barbelling, excessive issuerconcentration, and potentially unstable default estimates.


The higher of the two WARFs, as described above, determines the pool-widedefault rate. In order to arrive at a weighted average rating, recovery rates are thenestimated. Moodys uses what they describe as a stressed recovery rate assumptionof 5% to be applied to each issuer default, lagged five years, which is consistent

with how long a TruPS can defer interest without causing an event of default. Inmodeling default timing, Moodys extends its conventional CDO default curve inorder to account for the longer dated assets in the pool. Specifically, defaults arefront-loaded over the first eight years of the transaction, with 35% in the first yearand 9.3% in the remaining seven years. The exceptions are their 5-year 100%prepayment and 10-year auction call scenarios, where the default curve iscompressed to fit into the shorter time frame.


Moodys considers diversity by region, citing FDIC historical default data thatsuggests strong regional patterns in bank default data. The Moodys DiversityScore Methodology is used, whereby the US is divided into five regions. Theassumption is that banks are highly correlated intra-regionally but are somewhat

uncorrelated inter-regionally.With respect to single-obligor concentration within the pool, Moodys typicallylimits exposure to any unrated bank to 3% or less. The agency will typically applyadditional stresses to unrated banks with concentrations in excess of this. For ratedbanks, a higher concentration limit will be allowed, generally up to 5%.

n Prepayments

To account for the lack of history and potential across the pool for prepayments,Moodys assumes 100% pool prepays using 5-year, 10-year, and 30-year finalmaturities.


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S&Ps Bank TruPS CDO Methodology


S&P requires that any unrated issuance in the pool be assigned a credit estimate inorder to determine a default probability. Credit estimates are performed by S&Ps

Financial Institutions Group. In determining the credit quality of the individualissuers in order to derive a default rate assumption, S&P looks to the issue ratingas opposed to the bank issuers credit rating. In general, the issue rating tends to beseveral notches below the issuer credit rating, providing a more conservativestarting point for determining the overall credit quality of the pool and, ultimately,default rates.


The credit quality of each individual issuer is used as an input into Standard &Poors CDO Evaluator, which is used to generate scenario-based default rates forthe portfolio at each relevant rating level. With respect to default timing, S&P runsits standard CDO stresses over the life of the deal, in addition to saw-toothdefault patterns used to create periods of lumpy defaults over the life of the

transaction. For treatment in OC tests and any other triggers that are based ondefaulted assets, S&P takes the conservative view that TruPS in interest deferralmode must be treated as defaulted assets. For recoveries, while recognizing thatsome assets in deferral will ultimately recover 100%, S&P uses a stressedrecovery assumption of 10% for all assets treated as defaulted. Additionally, theyuse a lagged recovery, acknowledging that recoveries are likely to come in as apayment stream over time.


S&P has the view that the default stresses applied are conservative to the pointthat additional industry correlation stresses are unnecessary. Consideration ofgeographic diversity is handled on a deal-by-deal basis.


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Appendix 2

TruPS CDO Issuance History

Date Offered Issuer Manager Underwriter Collateral Size

03/31/2000 Regional D iversi fied Funding I Salomon Smith Barney Salomon Smith Barney Bank TruPS 241.70$

09/07/2000 Preferred Term Securities FT&KB FT&KB Bank TruPS 311.34$

02/22/2001 Preferred Term Securities II First Tennessee First Tennessee Bank TruPS 347.45$

03/28/2001 MMCapS Funding I Sandler ONeill Barclays Bank TruPS 293.50$

06/28/2001 MM Community Funding Sandler ONeill Salomon Smith Barney Bank TruPS 525.00$

07/31/2001 Preferred Term Securities III First Tennessee First Tennessee Bank TruPS 516.00$

11/28/2001 MM Community Funding II Sandler ONeill Salomon Smith Barney Bank TruPS 766.25$

12/18/2001 Preferred Term Sec. IV First Tennessee First Tennessee Bank TruPS 927.30$

03/20/2002 Preferred Term Sec. V FT&KB FT&KB Bank TruPS 513.00$

03/26/2002 MM Community Funding III Sandler ONeill Salomon Smith Barney Bank TruPS 539.50$

06/24/2002 Preferred Term Sec. VI FT&KB FT&KB Bank TruPS 500.00$

07/01/2002 T-PREF Funding Bear/Sandler/SSB Bear/Sandler/SSB Bank TruPS 581.90$

09/20/2002 Preferred Term Sec. VII FT&KB FT&KB Bank TruPS 532.10$

10/16/2002 TPREF Funding CDO II Bear/Sandler/SSB Bear/Sandler/SSB Bank TruPS 578.00$

10/29/2002 Trapeza I Trapeza Capital Mgt. CSFB Bank TruPS 337.20$11/18/2002 I-Preferred Term Sec. I FT&KB FT&KB Insurance TruPS 344.00$

12/19/2002 Preferred Term Sec. VIII FT&KB FT&KB Bank TruPS 534.10$

12/19/2002 T-PREF Funding III Bear/Sandler/SSB Bear/Sandler/SSB Bank TruPS 269.50$

02/19/2003 Trapeza II Trapeza Capital Mgt CSFB Bank TruPS 411.90$

03/18/2003 Preferred Term Sec. IX FT&KB FT&KB Bank TruPS 522.50$

03/31/2003 MM Community Funding IX SSB/Sandler SSB/Sandler Bank TruPS 314.00$

04/23/2003 Tropic CDO I BS BS Bank TruPS 310.00$

05/15/2003 I-Preferred Term Securities II FT&KB FT&KB Insurance TruPS 523.10$

05/23/2003 InCaps Funding I Citigroup Citigroup Insurance TruPS 385.60$

05/27/2003 Trapeza III Trapeza CSFB Bank TruPS 316.83$

06/26/2003 Preferred Term Securities X FT&KB FT&KB Bank TruPS 580.80$

08/27/2003 Dekania CDO I Dekania Capital Mgt. ML Insurance TruPS 306.90$

09/12/2003 Pref. Term Securities XI FT&KB FT&KB Bank TruPS 669.60$

09/18/2003 Alesco Preferred Funding I Cohen Brothers Merrill Lynch/Sandler Bank TruPS 344.10$

9/25/2003 Tropic CDO II BS BS Bank TruPS 344.00$

9/26/2003 Trapeza IV Trapeza CSFB Bank TruPS 421.80$

10/29/2003 I-Preferred Term Securities III FT&KB FT&KB Insurance TruPS 520.60$

12/02/2003 Trapeza V Trapeza CSFB Bank TruPS 308.50$

12/05/2003 InCaps Funding II Citigroup Citigroup Insurance TruPS 313.10$

12/12/2003 Alesco Preferred Funding II Cohen Brothers ML Bank TruPS 348.60$

02/05/2004 Regional Diversified Funding 2004-1 Citigroup Citigroup Bank TruPS 363.50$

02/05/2004 Tropic III Bear Stearns Bear Stearns Bank TruPS 345.00$

02/26/2004 U.S. Capital Funding I StoneCastle Advisors, LLC Sandler ONeill Bank TruPS 210.35$

03/09/2004 Preferred Term Securities 13 FTN/KBW FTN/KBW Bank TruPS 539.10$

03/18/2004 Alesco III Cohen Brothers Merrill Lynch/Sandler Bank TruPS 362.80$

03/26/2004 Dekania II Dekania Capital Merrill Lynch Insurance TruPS 414.70$

04/08/2004 Trapeza VI Trapeza Capital CSFB Bank TruPS 361.70$

04/23/2004 Icons Morgan Stanley Morgan Stanley Insurance TruPS 286.00$

04/30/2004 Alesco Preferred Funding IV Cohen Brothers Merrill Lynch Bank TruPS 415.50$

05/07/2004 I-PRETSL IV FTN/KBW FTN/KBW Insurance TruPS 337.50$

06/17/2004 Preferred Term Securities 14 FTN/KBW FTN/KBW Bank TruPS 504.00$

06/24/2004 U.S. Capital Funding II StoneCastle Advisors, LLC Sandler ONeill Bank TruPS 349.00$

08/19/2004 Alesco Preferred Funding V Cohen Bros Merrill Lynch Bank and Insurance TruPS 365.00$

09/16/2004 Preferred Term Securities XV FTN/KBW FTN/KBW 84% Bank and 16% Insurance TruPS 625.00$

10/01/2004 Trapeza VII Trapeza CSFB Bank TruPS 350.00$

11/02/2004 Tropic CDO IV Bear Stearns Bear Stearns Bank TruPS 335.00$



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Ref er t oi mpor t ant di scl osur esonpage4 0

29

Appendix 3

Trust Preferred CDO Issuance Database

DateOffered Issuer

Manager/Underwriter Collateral Class Size

AvgLife Mdys

03/31/2000 Regional Diversified Funding I Ltd. SSB Bank TruPs A $ 225.0 A1

Sub. Income Notes $ 16.7 NR

$ 241.7

09/07/2000 Preferred Term Securities, Ltd FT&KB Bank TruPs Senior $ 201.1 Aaa

Mezzanine $ 90.0 Baa2

Equity $ 20.3

$ 311.3

02/22/2001 Preferred Term Securities II First Tennessee Bank TruPs A $ 227.8 Aaa

(PreTSEL II) First Tennessee B $ 93.0 Baa2

Equity $ 26.7

$ 347.5

03/28/2001 MMCapS Funding I, Ltd. Sandler ONeill Bank TruPs A $ 191.5 Aaa

Barclays B $ 77.0 Baa2

C $ 25.0$ 293.5

06/28/2001 MM Community Funding Sandler ONeill Bank TruPs A $ 333.0 Aaa

SSB B $ 140.0 Baa2

Equity $ 52.0

$ 525.0

07/31/2001 Preferred Term Securities III First Tennessee Bank TruPS A $ 365.8 Aaa

(PreTSL III) First Tennessee B $ 114.1 Baa2

Equity $ 36.1

$ 516.0

11/28/2001 MM Community Funding II Sandler ONeill 85% new issue TruPS A $ 480.0 12.8 Aaa

SSB 5% secondary TruPS, 10% sub debt B $ 205.0 A3Equity $ 81.3

$ 766.3

12/18/2001 Preferred Term Sec. IV First Tennessee Bank TruPs A $ 506.0 12.8 Aaa

(PreTSL IV) First Tennessee B $ 341.0 A3

Equity $ 80.3

$ 927.3


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30


Trust Preferred CDO Issuance Database Continued

DateOffered Issuer


AvgLife Mdys

03/20/2002 Preferred Term Sec. V FT&KB TruPs and sub debts Senior $ 312.0 Aaa

(PreTSL V) from banks and thrifts Subs $ 201.0 A3

$ 513.0

03/26/2002 MM Community Funding III Sandler ONeill 95% new issue TruPS A $ 310.0 30.0 Aaa

SSB 5% secondary TruPS B $ 177.0 30.0 A3

from banks and thrifts C $ 52.5

$ 539.5

06/24/2002 Preferred Term Sec. VI FT&KB TruPs and sub debts A $ 325.0 10.0 Aaa

(PreTSL VI) from banks and thrifts B $ 135.0 10.0 A3

Income Notes $ 40.0 10.0

$ 500.0

07/01/2002 T-PREF Funding Bear, Salomon, 100% TruPS from banks and thrifts A-1 $ 222.0 Aaa

Sandler ONeill 95% new issued, 5% secondary A-2 $ 100.0 Aaa

B $ 201.0 A2

PS $ 58.9

$ 581.9

09/20/2002 Preferred Term Sec. VII FT&KB 95% TruPS and 5% sub. debt A1 $ 189.0 10.0 Aaa

(PreTSL VII) from banks and thrifts A1 (wrap) N/A 10.0

A2 (seq) $ 120.0 10.0 Aaa

Mezz $ 177.9 10.0 Aa1

Income Notes $ 45.2

$ 532.1

10/16/2002 TPREF Funding CDO II Bear/Sandler/SSB 90% new issue TruPS, A-1 $ 220.0 NA Aaa

Bear/Sandler/SSB 5% 2ndary TruPS and 5% sub debt A-2 $ 100.0 NA Aaa

from banks and thrifts B $ 196.0 NA A3

PS $ 62.0

$ 578.0


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31


DateOffered Issuer


AvgLife Mdys

10/29/2002 Trapeza ITrapeza

Capital Mgt. Static Pool of Trups, bank debts A-1 $ 161.5 7.0 Aaa

CSFB Baa2/Baa3 WAR A-2 $ 20.0 7.0 Aaa

B-1 $ 54.6 9.6 Aa1

B-2 $ 2.0 9.6 Aa1

B-3 $ 16.0 9.6 Aa1C-1 $ 29.6 10.0 A2

C-2 $ 10.0 10.0 A2

D $ 16.5 7.5 Baa2

Equity $ 27.0

$ 337.2

11/18/2002 I-Preferred Term Sec. I FT&KB 58% insurance TruPS; 37% surplus notes; A-1 $ 174.0 10.0

5% secondary TruPS A-2 $ 12.0

A-3 $ 24.0

B-1 $ 40.6 10.0

B-2 $ 33.2

B-3 $ 28.2

Equity $ 32.0

$ 344.0

12/19/2002 Preferred Term Sec. VIII FT&KB 80% new issue TruPS A-1 $ 225.0 Aaa

(PreTSL VIII) 9% new issue surplus notes A-2 $ 100.8 Aaa

11% sub. Debt from banks thrifts B-1 $ 58.7 A1

B-2 $ 30.7 A2

B-3 $ 75.0 A3

Equity $ 43.9

$ 534.1

12/19/2002 T-PREF Funding III Bear, Salomon, 89% new issue TruPS A-1 $ 115.0 Aaa

Sandler ONeill 8% secondary TruPS, 3% sub debt A-2 $ 80.0 Aaa

from banks and thrifts B-1 $ 24.3 A2

B-2 $ 11.8 A2

Equity $ 38.5

$ 269.5


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32



DateOffered Issuer


AvgLife Mdys

02/19/2003 Trapeza IITrapeza

Capital Mgt TruPS from various banks and thrifts A1a $ 132.0 6.0 Aaa

CSFB A1b $ 100.0 8.2 Aaa

B $ 27.0 10.0 Aa1

C1 $ 43.5 10.0 A2

C2 $ 54.8 10.0 A2D $ 18.7 8.5 Baa2

Equity $ 35.9

$ 411.9

03/18/2003 Preferred Term Sec. IX FT&KB TruPS from various banks and thrifts A-1 $ 245.0 Aaa

(PreTSL IX) FT&KB and some sub debts A-2 $ 42.0 Aaa

A-3 $ 33.0 Aaa

B-1 $ 86.0 A2

B-2 $ 16.3 A2

B-3 $ 66.3 A2

Income Notes $ 34.0

$ 522.5

03/31/2003 MM Community Funding IX, Ltd. SSB/Sandler TruPS from various banks and thrifts A-1 $ 126.0 8.9 Aaa

and subordinated bank debt A-2 $ 45.0 16.9 Aaa

B-1 $ 50.0 24.6 A3

B-2 $ 60.0 24.6 A3

Equity $ 33.0

$ 314.0

04/23/2003 Tropic CDO I Bear Stearns TruPS from various banks and thrifts A-1L $ 45.0 Aaa

Bear Stearns and subordinated bank debt A-2L $ 90.0 Aaa

A-3L $ 42.0 Aa1

A-4L $ 48.0 A2

A-4 $ 32.0 A2

B-1L $ 25.0 Baa2

Equity $ 28.0

$ 310.0


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34



DateOffered Issuer


AvgLife Mdys

08/27/2003 Dekania CDO IDekania

Capital Mgt. Insurance trust preferred A-1 $ 120.0 8.2

Merrill Lynch & surplus notes A-2 $ 69.0 10.0

B $ 40.0 10.0

C-1 $ 6.0 10.0

C-2 $ 30.0 10.0D $ 16.3 8.3

PS $ 25.6

$ 306.9

09/12/2003 Pref. Term Securities XI FT&KB TruPS from various banksand thrifts A-1 $ 343.0 Aaa

(PreTSL XI) FT&KB from insurance co. A-2 $ 70.0 Aaa

B-1 $ 124.5 A2

B-2 $ 13.0 A2

B-3 $ 65.5 A2

Sub Income Notes $ 53.6

$ 669.6

09/18/2003 Alesco Preferred Funding I Cohen Brothers Bank TruPS A1 $ 149.0 8.4 Aaa

Merrill/Sandler A2 $ 66.0 10.0 AaaB1 $ 56.7 10.0 A3

B2 $ 45.0 10.0 A3

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Trust Preferred CDOs a Primer 11-11-04 (Merrill Lynch)

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