Structured Credit As Portfolio Management Tool

Structured Credit As Portfolio Management Tool
The Primary Analyst(s) identified above certify that the views expressed in this report accurately reflect his/her/their personal views about the
subject securities/instruments/issuers, and no part of his/her/their compensation was, is or will be directly or indirectly related to the specific views or
recommendations contained herein.
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institutional/research.
Please see additional important disclosures at the end of this report.
Primary Anal yst: Peter Polanskyj
Morgan Stanley & Co. Incorporated
New York: +1-212-761-1233
peter.v.polankskyj@morganstanley.com
2 Please see additional important disclosures at the end of this report.
Evolution of the Structured Credit Market
2004
Moody's adopts correlation
models for rating synthetic
CDOs
Industry standard Dow Jones
CDX index introduced
Fitch introduces correlation
model
Synthetic CDO-Squareds -
regular issuance begins
Synthetic HY index tranches
begin trading
Market adopts base correlation as
a standard
Correlation model on Bloomberg
introduced (CDSM)
First pure HY synthetic CDOs
Cash CDO issuance tops $100 Bn
Basel II published - regulatory
capital treatment for CDOs
Delta-adjusted bespoke issuance
$300 Bn
S
p
r
e
a
d

(
b
p
)
0
200
400
600
800
1000
1200
1998
First IG cashflow CBO
(Travelers Funding)
Russian default causes turmoil
in EMCDOs
2002
Synthetic Tracers launched
FASB addresses consolidation
issues relating to SPEs
HY default rates peak at 10.4%
for this cycle
First managed synthetic CDO
Largest managed synthetic
CDO ($4.5 billion)
First hedge fund CFO
Regular issuance of HY CBOs
ends in favor of CLOs
Regular issuance of IG CBOs
ends in favor of synthetics
2002 the only down year for
arbitrage CDO issuance
$280 billion notional credit
risk referenced in synthetic
structures
2000
IG cashflow CBOs - regular
issuance begins
First arbitrage synthetic
CDOs
Structured finance CDOs -
First trust preferred CDO
Default correlation models
gain popularity
FAS 133 becomes effective
1996
Moody's introduces Binomial
Expansion model for CDO
ratings
First balance sheet CLO
HY Loans - regular use in
CDOs
Annual arbitrage CDO issuance
tops $10 billion
Investment Grade
High Yield
Emerging Markets
2006
Leveraged loan CDS
standards emerge
SFAS 155 introduced,
increasing US insurance co.
and bank involvement
1997
EMCDOs - regular issuance
begins
First synthetic balance sheet
CDO
1999
Synthetic balance sheet CDOs -
regular issuance
First European HY CBO
(EuroCredit)
tops $50 billion
2001
First distressed debt CDO
Popular press addresses defaults
in HY CBOs
S&P adopts correlation models
for rating synthetic CDOs
1995
HY CBOs - regular issuance
begins
First sovereign EMCDO
2003
Portfolio liquidation gives
birth to an active cash CDO
secondary market
Synthetic TRACX Index
introduced (100 names)
Synthetic IG index tranches
begin trading
First structured credit hedge
funds emerge
referenced in synthetic
structures
2005
Auto sector stress spurs sell-off in index equity tranches
Collins & Aikman bankruptcy 1st industry-wide
settlement
Levered super senior products gain popularity
Delta Air Lines and Northwest file for bankruptcy within
minutes of each other
Delphi 1st significant fallen angel default since 2002, in
over 800 S&P rated synthetic CDOs
Hybrid cash/synthetic ABS CDOs gain popularity
High leveraged loan recoveries keep CLO ratings stable
S&P introduces significant changes to ratings model
Forward starting, self managed and CPPI structures emerge
Delta-adjusted bespoke issuance $600 Bn
2004
Moody's adopts correlation
models for rating synthetic
CDOs
Industry standard Dow Jones
CDX index introduced
Fitch introduces correlation
model
Synthetic CDO-Squareds -
Synthetic HY index tranches
begin trading
Market adopts base correlation as
a standard
Correlation model on Bloomberg
introduced (CDSM)
First pure HY synthetic CDOs
Basel II published - regulatory
capital treatment for CDOs
Delta-adjusted bespoke issuance
$300 Bn
S
p
r
e
a
d

(
b
p
)
0
200
400
600
800
1000
1200
1998
First IG cashflow CBO
(Travelers Funding)
Russian default causes turmoil
in EMCDOs
2002
Synthetic Tracers launched
FASB addresses consolidation
issues relating to SPEs
HY default rates peak at 10.4%
for this cycle
First managed synthetic CDO
Largest managed synthetic
CDO ($4.5 billion)
First hedge fund CFO
Regular issuance of HY CBOs
ends in favor of CLOs
Regular issuance of IG CBOs
ends in favor of synthetics
2002 the only down year for
arbitrage CDO issuance
risk referenced in synthetic
structures
2000
IG cashflow CBOs - regular
issuance begins
CDOs
Structured finance CDOs -
First trust preferred CDO
Default correlation models
gain popularity
FAS 133 becomes effective
1996
Moody's introduces Binomial
Expansion model for CDO
ratings
First balance sheet CLO
HY Loans - regular use in
CDOs
tops $10 billion
Investment Grade
High Yield
Emerging Markets
Investment Grade
High Yield
Emerging Markets
Investment Grade Investment Grade
High Yield High Yield
Emerging Markets Emerging Markets
2006
Leveraged loan CDS
standards emerge
SFAS 155 introduced,
increasing US insurance co.
and bank involvement
1997
EMCDOs - regular issuance
begins
First synthetic balance sheet
CDO
1999
Synthetic balance sheet CDOs -
regular issuance
First European HY CBO
(EuroCredit)
tops $50 billion
2001
First distressed debt CDO
Popular press addresses defaults
in HY CBOs
S&P adopts correlation models
for rating synthetic CDOs
1995
HY CBOs - regular issuance
begins
First sovereign EMCDO
2003
Portfolio liquidation gives
birth to an active cash CDO
secondary market
Synthetic TRACX Index
introduced (100 names)
Synthetic IG index tranches
begin trading
First structured credit hedge
funds emerge
referenced in synthetic
structures
2005
Auto sector stress spurs sell-off in index equity tranches
Collins & Aikman bankruptcy 1st industry-wide
settlement
Levered super senior products gain popularity
Delta Air Lines and Northwest file for bankruptcy within
minutes of each other
Delphi 1st significant fallen angel default since 2002, in
over 800 S&P rated synthetic CDOs
Hybrid cash/synthetic ABS CDOs gain popularity
High leveraged loan recoveries keep CLO ratings stable
S&P introduces significant changes to ratings model
Forward starting, self managed and CPPI structures emerge
Delta-adjusted bespoke issuance $600 Bn
Source: Morgan Stanley
Investment Grade
High Yield
Emerging Markets
2007 Investment Symposium
Jan-07
2007
30 year CDS gains
momentumin corporate
credit
1997
Long formconfirmation
document, previously trade
terms were individually
negotiated
Asian crisis increased CDS
volumes
Indonesia debt
rescheduling - motivated
working groups to discuss
standardization
First balance sheet
synthetic CDO
Dec-96 Jan-98
1999
ISDA Publishes 1999
Credit Derivatives
Definitions (first
comprehensive
market standard)
Jan-00 Jan-99
2001
Modified restructuring,
motivated by Conseco
Railtrack bankruptcy,
dispute over deliverability
of convertible bonds,
established standards
Enron bankruptcy - large
volume reference entity
and counterparty
Argentina default
Jan-02 Jan-01
2003
TRACX indices
(100 names) introduced
IBoxx indices introduced
Parmalat default, large
reference entity
ISDA 2003 definitions
published
Jan-04 Jan-03
2005
ISDA published template for
CDS on ABS
Collins &Aikman bankruptcy
1st ISDA-coordinated industry-
wide CDS settlement
Delphi bankruptcy 1st
significant fallen angel default
since 2002, large operational
test for the market
Delta Air Lines and Northwest
Airlines file for bankruptcy on
the same day
Calpine Bankruptcy ISDA
proposes solution to deliverable
convertibles debate through a
vote
Recoverylocks gain acceptance
Jan-06 Jan-05
0
50
100
150
200
250
300
1998
Russia default,
showed
shortcomings
of long form
confirmation
2002
HY trailing default rate
peaks for this credit cycle at
10.4%
CDSW pricing model introduced
on Bloomberg, increased
transparency
DTC trade matching increased
liquidity
WorldCombankruptcy, large
volume reference entity
Obligation acceleration and
repudiation/moratoriumdropped
as credit events for corporates
CFMA requires CDS to be
covered by anti-fraud provisions
Xerox restructuring
Standardized quarterlyend
dates begin trading
Alan Greenspan praises CDS for
spreading credit risk throughout
financial system
Synthetic TRACERS index (50
names) introduced
2000
CDO
Conseco restructuring
Armstrong default resulted in
reference entity
disagreement between
counterparties
2004
CDX index familybecomes
standard
Basel II regulatory relief for
CDS without restructuring
2006
ABX standardized
indices on US sub-prime
home equity begin
trading
Complex restructurings
create CDS succession
and deliverabilityissues
ISDA standardizes US
LCDS contract
ISDA standardizes CDO
CDS contract
LevX LCDS index
launches in Europe
CDS basis turns
meaningfullynegative in
most corporate credit
markets
CPDO products push
CDX and iTraxx indices
meaningfullytighter
I
G

C
o
r
p
o
r
a
t
e

S
p
r
e
a
d

(
b
p
)
Evolution of the Credit Derivatives Market
How Big Is the Synthetic Structured Credit Market?
Credit Risk (Delta Adjusted) Portfolio Style
Specified Currency
of Notional Notional
1,554,440 450,200 2006
635,195 38% 28% 34% 68% 32% 38% 56% 340,477 265,356 75,121 2005
338,553 24% 51% 25% 63% 37% 51% 43% 120,704 81,059 39,645 2004
Total
Senior +
Super Senior Mezzanine Equity Static Managed EUR USD Total Unfunded Funded Vintage
One of the most technical markets in the world. Understanding the supply/demand structure is
of crucial importance.
Tremendous growth over the past 3 years
Clear themes in capital structure, currency and maturity
Creditflux data based on dealer contributions and likely covers two-thirds of the market. Data
excludes the traded index tranche market.
Source: Morgan Stanley, Creditflux
Structured Credit Market Summary Bespoke Issuance ($ MM)
And Cash? - Structured Finance/CLOs Dominate 2006 Issuance
In USD million
2007 Jan-Feb 2006 2006 2007 Jan-Feb 2006 2006 2007 Jan-Feb 2006 2006
High Grade ABS 15,116 7,242 120,293 13,758 7,242 117,832 1,359 - 2,461
Mezzanine ABS 16,066 6,403 61,704 16,066 6,038 59,472 - 364 2,232
CMBS/REIT Debt 4,171 3,118 31,787 4,171 3,118 30,395 - - 1,232
Other SF 5,140 1,325 20,463 3,781 1,295 18,741 1,359 30 1,677
Total SF CDOs 40,493 18,088 234,246 37,775 17,694 226,440 2,718 394 7,602
CLOs 16,851 9,485 154,037 14,577 6,849 90,706 2,274 2,636 60,203
Middle Market CLOs 16,620 3,424 56,826 1,846 2,467 18,199 14,773 328 37,208
Synthetic Corporate Credit CDOs 4,023 3,290 19,167 2,622 402 8,844 1,340 2,694 9,147
Trust Preferred CDOs 537 1,754 15,005 537 1,754 14,622 - - 383
Other 2,319 6,582 21,421 455 3,518 13,295 506 2,797 6,009
Total 80,842 42,622 500,702 57,812 32,684 372,106 21,611 8,850 120,552
Global CDOs US Europe
Lots of Forms of CreditOutstanding
Always key in this environment to differentiate among corporate, residential, commercial credit
markets and vehicles. Some statistics more problematic than others.
CLO notional outstanding - $0.4 tn $0.5tn US Levered Loans
US LBOs in 2006 - $0.2tn $0.2tn Private Equity Uninvested Capital
RMBS outstanding - $5.5 tn $10 tn US Residential Mortgage Market
CMBS outstanding - $0.8 tn
$500 bn securitized in 2006
Bespoke CDO risk outstanding - $3 tn
HY unsecured collateral no longer packaged
CBOs no longer actively issued/traded
Structured Market Size & Comment Underlying Market
$20 tn Corporate Credit Derivs
$1 tn Subprime Mortgage Market
$3 tn US Commercial Mortgage Market
$1 tn
$4 tn
$17 tn US Equities
High Yield Bonds
Investment Grade Bonds
US Corporate Credit
Putting Some Size to the Markets
Source: Morgan StanleyResearch
What Does BespokeReally Mean?
Investment grade portfolio management
may be at an important crossroads today
Basel II and FASB proposals are very
supportive of taking credit risk in structured
form
Further, large corporate bond portfolios are
in need of tools to implement macro
strategies
So, what does bespoke really mean?
The US credit environment is becoming
more inviting to taking customized
structured credit solutions, taking a page
from Europe
Morgan Stanley2006
Banks and Basel II
Basel II has already had profound
implications on credit investing
Based on ratings approaches, risk
weightings fall dramatically, making
structured credit solutions fairly efficient
from a regulatory capital perspective
We see the impact of this event already on
senior tranche spread and record cash and
synthetic CDO issuance
12%
50%
50%
A
20%
50%
50%
A-
35%
100%
100%
BBB+
60%
100%
100%
BBB
100%
100%
100%
BBB-
10% 8% 7%
CDO Tranche
(Super Senior X-100%)
50% 20% 20% CDO Tranche
50% 20% 20% Corporate Bonds
A+ AA AAA
Source: Morgan Stanley, Basel II. Assumes RBA Approach
Basel II Risk Weightings Favor Structured Credit
Insurance and FASB
FASB guidelines related to changes in
MTM practices may represent a secular
shift in the use of synthetic structured credit
SFAS 155, Accounting for Certain Hybrid
Financial Instruments (2/06)
CLNs issued from an SPE are accounted
for similar to conventional corporate
bonds
No bifurcation of an embedded credit
derivative
To not MTM the underlying credit
derivative, an investor must not consolidate
SPE
100% ownership of QSPE (static or rules
based)
Up to 50% for actively managed
The following information contains a general, summary
discussion of certain select accounting issues. Any such
discussion is necessarily generic and may not be
applicable to or complete for any particular investors
specific facts and circumstances. Morgan Stanley is not
offering and does not purport to offer accounting advice
and this information should not and cannot be relied upon
as such. Morgan Stanley has prepared this information
based on our understanding of the issues following review
of materials prepared by third party accounting experts.
The positions of such third party experts may be reasoned
and the views of other third party experts may differ from
those summarized herein. Potential investors are urged to
consult their own accounting advisors before making any
investment decisions regarding any transaction.
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Global Corporate Credit
Derivatives = 3.6x Cash Markets
Total Corporate Credit Notional Outstanding ($b)
Source: BIS, ISDA
Global Corporate Cash Credit Global CDS Market
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
USD Rates
Derivatives = 10.7x Cash Markets
Total US Government Debt Notional Outstanding ($b)
Source: BIS, ISDA
US Government Debt Securities USD Interest Rate Swap Notional
Innovation As a Driver Of Markets
Innovation As a Driver of Markets
2005 Levered Super Senior
2006/7 Equity in Fashion; Watch the Styles
CPDO Friend or Foe?
Innovation in ABS CDOs
ABX TABX
2007 Morgan Stanley
Levered Super Senior Showed The Potential in 2005
Most important 2005 theme is the interplay
of equity and super senior, as the middle
has been much more stable
Supersenior pricing on investment grade
pools widened by 8-10 bp from starting
levels in the single to low double digit
range
Levered super senior products were a big
part of why spreads came rallying back in
late 2005
Implied Super Senior Pricing
Follows Actual Pricing
Implied 30-100% Spread (bp)
-10
-8
-6
-4
-2
0
2
4
6
8
Oct-04 J an-05 Mar-05 J un-05 Aug-05 Nov-05 J an-06
5yr DJ CDX 10yr DJ CDX
CDX3-4 Roll CDX4-5 Roll
0
5
10
15
20
25
30
Oct-
03
Apr-
04
Oct-
04
Apr-
05
Oct-
05
Mar-
06
Sep-
06
Mar-
07
Equity Products Reiterated The Potential in 2006
On-the-Run IG CDX 5-Year 0-3% Correlation
Despite much higher credit volatility, there
have been strong equity tranche flows
Non-traditional equity products have been
the main drivers
POs are very popular and are good ways
to play default risk when timing is
uncertain
IOs are better suited for a new-term low
default environment
Rated equity structures are based on the
excess spread framework and have the
characteristic of initial ratings being
sensitive to market levels
Spring 2005 -
Repricing with
Auto Stress
Spring 2006 -
Equity POs
Gain Popularity
Rated Equity Rationale
How Does Excess Spread Cover Losses
from Default?
Source: Morgan Stanley, Moodys. Note: 5-year excess spread
assumes that the notional is written down evenly over five years based
on Moodys 5-year losses.
Rating agency perspective
Excess spread provides enough coverage
for losses over time to warrant an
investment grade rating
Wider all-running premiums on equity
can result in higher ratings at initiation,
all else being equal
Market perspective
Rated equity provides absolute price
support for equity risk
Agencies do not assign a big weight for
JTD in IG; clearly this is a risk factor
45.3% 5-year Excess Spread
Baa Portfolio
38.3% 5 Year Excess Spread
10.0% Annual Excess Spread
38.87% Loss as % of 0-3% Tranche
1.17% Moody's 5-year Loss
10.0% Annual Excess Spread
15.80% Loss as % of 0-3% Tranche
0.47% Moody's 5-year Loss
IG Portfolio
CPDO Friend or Foe?
CPDOs have seized a disproportionate
amount of investor mindshare
There is a perception problem, since the
technology is nearly 100% associated
with just one example of its application
We have some issues with the original
index product, based on rebalancing risk
within the indices and mean-reversion
assumptions
We find other strategies much more
appealing, including managed structures
and tranches
Investment Strategy
Indices
Managed Portfolios
Curves Strategies
Long/Short Strategies
Tranches
Leverage Process
Trade NAV
Portfolio PV
Limits & Cash In Levels
Risk Management
Gap Risk
Cash Out Trigger
Fees
Credit Linked Note
Stable Coupons/Principal
Ratings
A CPDO Problem Rebalancing Risk
1.1 bp 0.15 bp 0.04 bp Citigroup
BIG
Credit
4.5 bp 0.71 bp -0.03 bp BBB
-1.2 bp -0.22 bp 0.03 bp A
-2.0 bp -0.34 bp 0.00 bp AAA/AA
Avg Six-Month
Spread
Widening
Due to
Rebalancing
Avg Monthly
Spread
Change
Due to
Rebalancing
Avg Monthly
Spread
Change of
Indices
Corporate
Bond
Sector
Measuring Index Rebalancing Risk (bp)
Source: Morgan Stanley, Yield Book.
Note: Based on Citigroup BIG Credit Index monthly data starting in
December 1994. Spread widening is based on OAS and is
due to rebalancing imputed frommonthlyexcess returns of
the indices.
Average One-Year Rating Migrations,
1970-2006 (%)
Source: Moodys
4.48 0.18 0.02 0.22 0.80 4.39 84.72 4.93 0.21 0.05 Baa
3.70 0.02 0.00 0.02 0.10 0.51 4.95 88.10 2.55 0.06 A
3.93 0.01 0.00 0.00 0.02 0.06 0.28 7.04 87.84 0.83 Aa
2.99 0.00 0.00 0.00 0.00 0.02 0.00 0.67 7.50 88.82 Aaa
WR Default Ca-C Caa B Ba Baa A Aa Aaa
Cohort
Rating
End of Period Rating
CPDO Roll and MTM Risk
0%
20%
40%
60%
80%
100%
0% 2% 4% 6% 8%
0
2
4
6
8
10
Cash-in Probability
Average Time to Cash-in
Impact of Rebalancing Risk on Performance
Cash-in Probability Time to Cash-in (years)
Cash-in Probability Recovery
Rebalancing impact (% of spreads)
0%
20%
40%
60%
80%
100%
0% 2% 4% 6% 8%
60%
70%
80%
90%
100%
Cash-in Probability
Recovery
CPDO MTM Risk: Distribution of
Worst NAVs
95-100
>70 75-80
85-90 90-95
80-85 70-75
10%
12%
17%
14%
18%
15%
20%
22%
11%
22%
14%
6%
7%
1% 3%
10%
24%
49%
2%
5% 6%
10%
11%
16%
21%
23%
8%
17%
2%
30%
25%
1%
29%
18%
0% 2% 4% 6% 8%
Distribution
CPDO Bullish or Bearish Trade?
Single-name products perform best in
modestly bearish environments
Curve strategies based on steepeners
are interesting given the theme that
forwards do not get realized but timing
is not great
CPDO on senior tranches is very
interesting but the agencies are not
ready to rate yet
There is a natural analogy with LSS
91% 5.15 96.3% 25bp
91% 5.27 97.8% 29bp
98% 6.06 99.9% 50bp
- 6.38 100.0% 60bp
- 6.58 100.0% 70bp
- 6.81 100.0% 80bp
Recovery
Average Cash-
in Period
(Years)
Probability
of Cash-in
Mean
Spread
Level
Modestl y Wider Spread Environments
Favor CPDOs
Some Recent Innovations in ABS CDOs
Interest Diversion Tests (BBB Turbo)
Typically paid after a coupon to the equity. Interest proceeds that would go to the equity are used to pay down
the balance of the BBB tranche. This shortens the WAL of the tranche and provides additional cashflows early
in the deals life
Pro-rata paydown of the principal waterfall for mezzanine deals
First introduced in high grade deals, a pro-rata paydown allows all classes of rated notes to be paid down in
proportion to their outstanding balances provided there has never been a breach of a coverage test and a certain
portion of the collateral balance is outstanding. This prevents the cost of funds from increasing as the deal
delevers and so boost the equity returns, and also shortens the WAL of mezzanine tranches
Synthetic Assets
Synthetic ABS assets have become more widespread as the market has standardized and the ISDA ABS
synthetic confirm was released in June 2005. This allows the manager to select from a wider range of assets than
the current new issue market
Hybrid Structures
Hybrid structures allow collateral to be sourced in cash or synthetic form
ABX and TABX Whats in it?
ABX Based on 20 underlying subprime home equity ABS transactions.
Indices with ratings AAA, AA, A, BBB, and BBB- are created to
reference the difference tranches in each of these 20 transactions. New
series of the index are created every six months; so far three series have
traded: ABX 06-1, 06-2 and 07-1
Recent volatility has been almost entirely confined to the BBB and BBB-
classes
Tranched ABX (TABX) launched on February 14, 2007. Two sets of
tranches will trade, referencing BBB and BBB-. Each of these, in turn, will
reference the 40 securities resulting in combining ABX 06-2 and ABX 07-1
While tranche trading has become a highly liquid and commoditized product
in corporate credit, TABX is a long way away from this status.
Concepts of Delta and Implied Correlation fraught with complications
But More Diversity in ABS CDOs Ratings, Vintage, etc
1%
4%
1%
4%
5%
17%
14%
11%
8%
4%
3%
6%
26%
4%
17%
17%
80%
65%
35%
37%
15%
11%
0% NA
1% B and lower
0% BB-
Ratings Composition of Select 2006 Mezzanine ABS CDOs
2% BB
4% BB+
37% BBB-
33% BBB
14% BBB+
5% A
3% AA
1% AAA
Std Dev Maximum Average Rating
Recall that ABX/TABX is either 100% BBB-, or 100% BBB and 2006 Collateral
Source: Morgan Stanley, Intex
Structured Credit Applications Secured and
Unsecured Corporate Credit
Who Puts the Lin LBOs?
Much of the L in LBOs is
furnished by leveraged loan market
CLO market has become the
primary support mechanism for
leveraged loans
Both US and European CLO
portfolios have significant and
growing exposure to LBOs
Risk implications of LBO exposure
vary significantly across CLO
tranches
What if Atlas shrugs?
Inverted Investment Pyramid
$1.1 Trillion High Yield Market
$480Bn Levered Loan Market
$125Bn Private Equity
Uninvested
Capital
$30-35Bn
~$250Bn CLO Market
CLO, Mezz & Equity
Private Equity Hunting Grounds
AA
A
BBB
BBB
BBB
BBB
BB
BB
BB
BB
B
B
B CCC
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2003 2004 2005 2006
BBBs Increasingly the LBO Hunting Ground
Top 20 LBO Deals
Note: Looks at the top 20 LBO deals each year as measured bytotal invested capital, and takes the S&P rating before the
deal was announced.
Source: Morgan Stanley, FactSet
Cheaper valuation multiples and PE consortium deals keep BBBs a target
The Top-Heaviness Problem
0
5,000
10,000
15,000
20,000
25,000
30,000
M
a
r
-
0
3
J
u
n
-
0
3
S
e
p
-
0
3
D
e
c
-
0
3
M
a
r
-
0
4
J
u
n
-
0
4
S
e
p
-
0
4
D
e
c
-
0
4
M
a
r
-
0
5
J
u
n
-
0
5
S
e
p
-
0
5
D
e
c
-
0
5
M
a
r
-
0
6
J
u
n
-
0
6
S
e
p
-
0
6
D
e
c
-
0
6
3.0
3.5
4.0
4.5
5.0
5.5
6.0
Source: Morgan Stanley Source: Morgan Stanley, S&P LCD
Private Issuance Volume Leverage
Other, 6%
Senior Debt,
59%
FY 2003 1H06
Sub Debt,
17%
Senior Debt,
37%
Equity,
39%
Other, 1%
Sub
Debt,
7%
Equity,
33%
Volume
($MM)
Leverage
(x)
All things being equal, recoveries will be lower in the next default cycle
More L in LBOs Less Pie for Subordinated Bondholders
Endless CLO Bid?
2006 global CLO issuance amounted to
$154 billion, more than two times entire
2005 issuance
Continued strong ratings performance
142 upgrades and 25 downgrades over the
last 32 months. Only two downgrades in
European CLOs. Bulk of the ratings
unchanged
Loan recoveries remain high even as
corporate defaults rise
Basel II regulatory capital regime favors
CLOs
0
20
40
60
80
100
120
140
160
180
2000 2001 2002 2003 2004 2005 2006 2007
YTD
USD Euro Other
Growth in Global CLO Issuance
Loan CDS J ust in Time?
SPL (Spread per Unit of Leverage ) is a
Morgan Stanley measure akin to a new
issue P/E for credit products
While leveraged loans may be more
attractive than high yield bonds given
valuations, absolute valuations have come a
long way
Additionally, LCDS premiums optically
trade well inside leveraged loan spreads
This stands in stark contrast to the early
days of the unsecured bond and ABS CDS
markets in which premiums were
significantly wider than their cash
counterparts
0
50
100
150
200
250
Dec-98 Nov-00 Sep-02 J ul-04 May-06
Source: Morgan Stanley, S&P LCD
Leveraged Loan Market SPL
Average: 111
Max: 206
Min: 52
Monthly Loan SPL
Hedging Isnt J ust for Gardeners
Curve flatteners using indices or single
names. Flatteners are tough trades from a
carry/rolldown perspective today, but they are
cheap default hedges, compared to owning
outright protection.
True forward starting tranches. Tranches
that forward start with a guaranteed amount
of subordination are trades that perform well
when there are near-term defaults, but are
long credit risk trades.
Variable cost structures. Motivated by
Basel II but with broader applications, there
are many zero-costtype protection
solutions, where protection premiums start
out very low and rise quickly with defaults.
Unlike other strategies, variable cost
structures benefit from defaults occurring
later in the cycle.
Junior mezzanine protection in unsecured
HY. We feel that when the credit cycle turns,
unsecured high yield will be the first shoe to
drop, and the technicals support this trade as
well, given a lack of strong structured credit
flow from the long side.
Principal protected hedging strategies. For
investors who are not able to hold protection
outright, principal protected strategies where
zero-coupon risk-free assets are mixed with
all-upfront positions in tranche protection can
be combined to create zero-coupon principal
protection that has upside if losses are
triggered in the tranche.
2nd-to-Default Baskets on financials. We
focus on financials, where 2nd-to-default
exposure appears to be a lower cost
alternative to hedge the industrys inherent
systemic characteristics.
OTM payer options in indices. While
implied volatility has moved significantly
higher, options on the indices provide a
strategy not subject to many of the technicals
that influence tranche pricing.
Hedging Default Risk Hedging Systemic Risk
The Case For Hedging Loan Exposures
Sub-prime housing and concomitant fears of the credit cycle turning are
beginning to be reflected in re-pricing of risk premia in corporate credit
markets
Wide ranging interest investors with exposure to loans through CLO
tranches, funds with loan exposures through private equity sponsored
transactions financed through leveraged loans
Leveraged loans have furnished the Lin LBOs, and CLO portfolios are the
primary support mechanisms for leveraged loans
LBO capital structures are loan-heavy. If the next set of defaults were to
come from LBO names, loan recoveries can be significantly lower than
historical experience
Exploding covenant-lite volumes do not bode well for loan recoveries
Substantial overlap of obligors and sectors across CLO portfolios
CLO Exposure to LBOs and Covenant-Lite Loans
Distribution of LBO Exposure in 2006
CLO Portfolios
0%
5%
10%
15%
20%
25%
30%
35%
5.0%-
7.5%
7.5%-
10.0%
10.0%-
12.5%
12.5%-
15.0%
15.0%-
17.5%
17.5%+
Distribution of Covenant-Lite Loans
in 2006 CLO Portfolios
Source: Morgan Stanley Research
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0%-2% 2%-4% 4%-6% 6%-8% 8%-
10%
10%+
CDS on CLOs: A New Arrow in a Hedgers Quiver
The broad chassis of ABS CDS also applies to cash CLOs (specific reference
obligation, amortization of notional, PAUG mechanics) but there are a few
key differences
A Better Fit for Hedging Loans:
Significant overlap of obligors across CLO portfolios
CLOs have sizeable second lien and unsecured bond buckets
PIK-ability of mezzanine tranches is helpful
Callability of CLOs. Protection when needed
At the moment, scale of transactions is a constraint.
What Is Correlation Trading Corporates
Versus ABS
Correlation and Minefields
Low
Correlation
High
Correlation
Correlation Intuition
Senior Tranches Subordinate Tranches
0
100
200
300
400
0% 20% 40% 60% 80% 100%
Correlation measures how risk is
distributed among tranches
Subordinate tranches
Spread decreases as correlation rises
Senior tranches
Spread increases as correlation rises
Fundamental Correlation Relationships
bp
Correlation Intuition Large Baskets
Each tranche resides somewhere on a
correlation sensitivity spectrum, ranging
from very long (3-7%) to very short (15-
30%)
For a given tranche, the level of correlation
sensitivity changes
When correlation changes
When spreads change
Spread (bp)
10% 20% 30% 40% 50% 60% 70% 80% 90%
3-7% 10-15% 15-30% 7-10%
Correlation
Sensitivity of Four Tranches of Dow
Jones CDX NA IG
Hidden Meaning of Default Correlation in Credit Markets
0.9x 0.7x 1.5x 1.0x 1.1x 0.1x 0.6x
Coefficient
of Variance*
Moody's
A & Baa
Moody's
Baa
Moody's
A
1000
Credits 20%
Correlation
50
Credits 20%
Correlation
1000
Credits 0%
Correlation
50
Credits 0%
Correlation
We have demonstrated that correlation affects the relationship between volatility and
portfolio size
We compare results from a 50-name and 1000-name portfolio with real world default
experience (using Moodys five year cumulative default statistics)
The volatility of expected losses for large portfolios is much greater for correlated
portfolios this is broadly consistent with real world default experience
* Standard deviation divided bymean
Volatility of Expected Losses In the Models and in the Real World
Correlation Impact on Portfolio Loss Distribution
When the names in a portfolio are
correlated, the expected portfolio loss
distribution is less concentrated in any one
single loss bucket
A portfolio that consists of correlated
names also has a fatter right tail
Probability
0%
10%
20%
30%
40%
50%
60%
0
-
2
%
2
-
4
%
4
-
6
%
6
-
8
%
8
-
1
0
%
1
0
-
1
2
%
1
2
-
1
4
%
1
4
-
1
6
%
1
6
-
1
8
%
1
8
-
2
0
%
2
0
-
2
2
%
Losses
Independent & Identical Independent Correlated
Correlation Creates Portfolio Loss
Distributions with Fatter Tails
Summary of Greeks
Change in tranche value due to the passage of time Theta ()
Change in tranche value due to changes in default correlation Rho ()
Tranche price sensitivity of a delta-neutral position to jump-to-default risk or changes in
spread distribution of the underlying portfolio. It represents a form of convexity to moves
in a single credit while all others remain constant (I =Idiosyncratic risk)
I-Gamma (i-)
Tranche price sensitivity of a delta-neutral position to parallel shifts in spreads of
underlying names. It represents a form of convexity (M =Market)
M-Gamma (m-)
Tranche price sensitivity to changes in underlying portfolio spreads, measured as a ratio
of tranche PV01 to index PV01 (PV10% is also used sometimes)
Delta ()
What does it measure? Greek
Delta or Sensitivity to Spread Changes
As spreads widen, a short protection position in
any of the tranches would experience a negative
mark-to-market
For small spread movements, the price impact can
be estimated using tranche delta (PV01 or
PV10%)
Tranches with higher deltas would move more
than tranches with lower deltas; tranches with
deltas less than 1x would move less than the index
(and vice versa)
Broadly speaking, junior tranches have higher
deltas than senior tranches due to higher default
risk, assuming both are quoted on a running
premium basis
For bigger moves in spreads, delta-based
calculations are only approximations, as tranche
convexity becomes more meaningful
-30%
-20%
-10%
0%
10%
20%
30%
50% 75% 100% 125% 150% 175% 200%
Spread Change Factor
P
&
L
(
%
)
0-3% 3-7% 7-10%
10-15% 15-30% 0-100%
Spread Sensitivity
I-Gamma or Sensitivity to Spread Distribution Changes

-0.20%
-0.15%
-0.10%
-0.05%
0.00%
0.05%
0-3% 3-7% 7-10% 10-15% 15-30%
AIG+16bps
MMC+240bps
The effect of changes in the distribution of the underlying spreads, especially when the overall portfolio average
remains unchanged, is subtle and worth exploring.
Tight trading names moving somewhat wider generally impact senior tranches, while wide or even average credits
moving significantly wider impact junior mezzanine and first-loss tranches, depending on the size of the move.
For example, in 2004, a 16 bp move in a tight trading name (AIG) increased risk in 15-30% type tranches, while
widening of Marsh & McLennan from 30 to over 250 bp shifted the risk from 15-30% type tranches to 0-3% tranches.
Tranche Pricing Impact:
Two Opposite Examples
Insurance Moves to the Right, Impacting
Both Senior and Subordinate Tranches
Number of Credits
0
5
10
15
20
25
30
0

-
1
0
1
0

-
2
0
2
0

-
3
0
3
0

-
4
0
4
0

-
5
0
5
0

-
6
0
6
0

-
7
0
7
0

-
8
0
8
0

-
9
0
9
0

-
1
0
0
1
0
0

-
1
1
0
1
1
0

-
1
2
0
1
2
0

-
1
3
0
1
3
0

-
1
4
0
1
4
0

-
1
5
0
1
5
0

-
1
6
0
1
6
0

-
1
7
0
1
7
0

-
1
8
0
1
8
0

-
1
9
0
1
9
0

-
2
0
0
Spread
15-30%
7-15%
3-7%
0-3%
Tranche Convexity or M-Gamma
-0.8%
-0.6%
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
50% 75% 100% 125% 150% 175% 200%
P
&
L
(
%
)
0-3% 3-7% 7-10%
10-15% 15-30%
-2%
-1%
0%
1%
2%
3%
4%
5%
50% 75% 100% 125% 150% 175% 200%
P
&
L
(
%
)
0-3% 3-7% 7-10%
10-15% 15-30%
The impact of wide spread moves is measured by M-Gamma, that is PV100 or 100*PV01
Delta neutral positions on in-the-money tranches are positivel y convex, while such positions on
out-of-the-money tranches are typicall y negativel y convex (from the perspective of the protection
seller)
5 Yr IG Tranche Convexity
(Delta Neutral)
10 Yr IG Tranche Convexity
(Delta Neutral)
J ump to Default Sensitivity Differs by Investor Type
-14.0%
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
0
-3
%
5
Y
r IG
3
-7
%
5
Y
r IG
7
-1
0
%
5
Y
r IG
1
0
-1
5
%
5
Y
r IG
1
5
-3
0
%
5
Y
r IG
In
d
e
x
5
Y
r IG
0
-3
%
1
0
Y
r IG
3
-7
%
1
0
Y
r IG
7
-1
0
%
1
0
Y
r IG
1
0
-1
5
%
1
0
Y
r IG
1
5
-3
0
%
1
0
Y
r IG
In
d
e
x
1
0
Y
r IG
0
-1
0
%
5
Y
r H
Y
1
0
-1
5
%
5
Y
r H
Y
1
5
-2
5
%
5
Y
r H
Y
2
5
-3
5
%
5
Y
r H
Y
3
5
-1
0
0
%
5
Y
r H
Y
In
d
e
x
5
Y
r H
Y
-8%
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
0
-3
%
5
Y
r IG
3
-7
%
5
Y
r IG
7
-1
0
%
5
Y
r IG
1
0
-1
5
%
5
Y
r IG
1
5
-3
0
%
5
Y
r IG
0
-3
%
1
0
Y
r IG
3
-7
%
1
0
Y
r IG
7
-1
0
%
1
0
Y
r IG
1
0
-1
5
%
1
0
Y
r IG
1
5
-3
0
%
1
0
Y
r IG
0
-1
0
%
5
Y
r H
Y
1
0
-1
5
%
5
Y
r H
Y
1
5
-2
5
%
5
Y
r H
Y
2
5
-3
5
%
5
Y
r H
Y
3
5
-1
0
0
%
5
Y
r H
Y
We divide the market into two broad camps
Community 1: Levered investors with long/short strategies and exposure to equity/junior
mezzanine type tranches
Community 2: Other institutional investors (banks, insurance, money managers) who are more
ratings-sensitive, higher up in the capital structure
Loss Due to 1 Default (% of Notional) Delta Neutral P/L Due to 1 Default (% of Notional)
The Unwind Risk Three Triggers
2006 2005
Avg Notches
for Downgrade
As a % of Rated
Universe*
Avg Notches
for Downgrade
As a % of
Rated Universe*
6.8%
7.7%
Downgrades
58
87
Upgrades
2.3%
8.2%
Upgrades
1.59
1.88
159
70
Upgrades
4.5%
6.6%
Upgrades
137
67
Downgrades Downgrades
S&P
Moody's
Downgrades
1.51 82 6.3%
1.39 238 5.3%
Synthetic CDO Rating Acti ons
A significant move wider in spreads, which if combined with equity correlation moving lower
could force the hand of many. A modest move wider is actually supportive of todays market
Significant downgrade activity at the tranche level, particularly AAAs and AAs
Jump to defaults, 2001/2002 style. Sudden shifts are not priced in
Our base case is for the structured credit bid at the rated tranche level to continue, but warning
flags about the risks have been raised
*2005 numbers calculated as a percentage of the rated tranches outstanding as of 1/1/2005. 2006 numbers
calculated as a percentage of the rated tranches outstanding as of 1/1/2005 for Moodys and 1/1/2006 for S&P.
Source: Morgan Stanley, S&P, Moodys.
Ratings Acti vity
Thinking About Zero Correlation
Low levels of implied correlation can be
interpreted as indicating an environment
in which defaults are driven more by
idiosyncratic events than by a
recessionary environment
The markets interpretation of the future
should be most evident in mezzanine
tranches
Based on this risk-neutral framework, 7-
10% in 7 years and 10-15% in 10 years
can go tighter
5 year 3-7% has traded near their zero
correlation level recently
Note: 5-Year CDX 6 tranches.
bp
0
50
100
150
200
250
300
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Correlation
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
bp
3-7% (LA) 7-10% (LA) 0-3% (RA)
0% Correlation Equals 0bp Spread Level
0% Correlation Above
0bp Spread Level
What Happens When Correlation Goes to Zero?
DAL +NWAC =Correlation Without a Model
The 2000-2001 spike in default rates was
driven by both industry specific events and
unrelated bankruptcies across multiple
industries
The sizeable telecom buildup and bust was
a noteworthy industry specific event that
increased default rates
Other unrelated bankruptcies, driven by the
prevalence of fraud, resulted in defaults
across industries
The Delta and Northwest bankruptcy was a
combination of an industry specific event
and a broader cross-sector dynamic; the
ability to fund pensions and other future
labor costs
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
1
9
7
0
1
9
7
3
1
9
7
6
1
9
7
9
1
9
8
2
1
9
8
5
1
9
8
8
1
9
9
1
1
9
9
4
1
9
9
7
2
0
0
0
Cohort
Moody's 5 Year Cumulative Default Rate
IG Universe
Pensions and Labor Costs Link Industries
Issues such as pension and labor costs that
have plagued the airline industry may
spread to other sectors
Similar issues could prove to be a driver in
determining default correlation across
sectors
This list highlights companies where
significant potential exists for a high
realized default correlation
It must be noted that the extent to which
pension and healthcare issues are addressed
through legislation will not reduce the
correlation these companies will experience
their fates are tied regardless of
exogenous risks
24% Mining AL Alcan Inc
29% Metal Fabricate/Hardware TKR Timken Co
22% Chemicals TRA Terra Industries Inc
22% Auto Parts &Equipment TRW TRW Automotive Holdings Corp
22% Chemicals HPC Hercules Inc
25% Auto Parts &Equipment DCN Dana Corp
27% Chemicals POL PolyOne Corp
29% Forest Products &Paper BOW Bowater Inc
32% Auto Parts &Equipment TEN Tenneco Automotive Inc
33% Forest Products &Paper ABY Abitibi-Consolidated Inc
33% Forest Products &Paper SSCC Smurfit-Stone Container Corp
34% Auto Manufacturers NAV Navistar International Corp
36% Computers UIS Unisys Corp
40% Auto Parts &Equipment ARM ArvinMeritor Inc
43% Auto Manufacturers GM General Motors Corp
62% Oil &Gas AEN Austral Pacific Energy Ltd
68% Auto Manufacturers F Ford Motor Co
73% Auto Parts &Equipment VC Visteon Corp
81% Auto Parts &Equipment DRRA Dura Automotive Systems Inc
102% Auto Parts &Equipment HAYZ Hayes Lemmerz Intl Inc
112% Auto Parts &Equipment GT Goodyear Tire &Rubber Co
145% Airlines AMR AMR Corp
147% Iron/Steel AKS AK Steel Holding Corp
215% Airlines CAL Continental Airlines Inc
256% Auto Parts &Equipment DPH Delphi Corp
266% Auto Parts &Equipment XIDE Exide Technologies
875% Airlines NWAC Northwest Airlines Corp
1
1235% Airlines DAL Delta Air Lines Inc
1
Funding Gap/
Mkt Cap Industry Group Ticker Issuer
(1) Market Cap based on the average of the 6 months prior to the bankruptcyfiling.
Not Onl y One Sector Unfunded Pension
Liabilities Relative to Equity Market
Capitalization
Visualizing Real-World Correlation
Recent moves in implied correlation seem
counterintuitive
The contradiction can be understood by
looking at 2 worlds
World A likelihood of 100 defaults are
equally related to one another
World B the default propensity of three
companies are highly correlated to each
other but not to the rest
The average correlation fails to acknowledge
that many of the names have different
relationships than this average indicator
Therefore, while one may see a lower
implied correlation, it could be a scenario of
high correlation for a small subset of
companies
50% 50% 10% 10% 10% 100

50% 50% 50% 10% 10% 10% 4
10% 10% 10% 90% 90% 3
10% 10% 10% 90% 90% 2
48% 10% 10% 10% 90% 90% 1
Average 100 5 4 3 2 1 Credit
WORLD B
50% 50% 50% 50% 50% 100

50% 50% 50% 50% 50% 5
50% 50% 50% 50% 50% 4
50% 50% 50% 50% 50% 3
50% 50% 50% 50% 50% 2
50% 50% 50% 50% 50% 50% 1
Average 100 5 4 3 2 1 Credit
WORLD A
Correlation Details Matter
ABX and TABX Whats in It?
ABX Based on 20 underlying subprime home
equity ABS transactions. Indices with ratings
AAA, AA, A, BBB, and BBB- are created to
reference the difference tranches in each of
these 20 transactions. New series of the index
are created every six months; so far three
series have traded: ABX 06-1, 06-2 and 07-1
Recent volatility has been mostly confined to
the BBB and BBB- classes
Tranched ABX (TABX) launched on February
14, 2007. Two sets of tranches will trade,
referencing BBB and BBB-. Each of these, in
turn, will reference the 40 securities resulting in
combining ABX 06-2 and ABX 07-1
While tranche trading has become a highly
liquid and commoditized product in corporate
credit, TABX is a long way away from this
status
40%-100% Tranche
25%-40% Tranche
15%-25% Tranche
10%-15% Tranche
5%-10% Tranche
0%-5% Tranche
ABX.HE BBB- Indices
60% Amortization on Underlying Indices
10% Writedown on Underlying Indices
Illustrative Flow ABX.HE BBB- Indices
65
70
75
80
85
90
95
100
J ul-06 Sep-06 Oct-06 Dec-06 Feb-07
ABX HE Indices Have Fallen Sharply
ABX 06-1 ABX 06-2 ABX 07-1
Sell-off has been dramatic, but traded volumes remain light.
Different technicals relative to single-name ABS CDS market.
$ Price of ABX HE BBB- Indices
Source: Mark-it
TABX Early Experience
Much of the trading activity has been in
the 40-100% tranches
Concepts of delta and implied
correlation fraught with complications
and significantly unlike corporate
investment grade index tranches
Implied losses from underlying spreads
suggest that with the possible
exception of the two senior tranches,
rest are deeply in-the-money
At current spread levels, re-tranching
of the 40-100% tranche ((tranche-lets)
offers an interesting correlation
market opportunity
TABX (BBB-) Price History (Feb 14 Mar 1)
30
40
50
60
70
80
90
100
2
/
1
4
/
2
0
0
7
2
/
1
5
/
2
0
0
7
2
/
1
6
/
2
0
0
7
2
/
1
7
/
2
0
0
7
2
/
1
8
/
2
0
0
7
2
/
1
9
/
2
0
0
7
2
/
2
0
/
2
0
0
7
2
/
2
1
/
2
0
0
7
2
/
2
2
/
2
0
0
7
2
/
2
3
/
2
0
0
7
2
/
2
4
/
2
0
0
7
2
/
2
5
/
2
0
0
7
2
/
2
6
/
2
0
0
7
2
/
2
7
/
2
0
0
7
2
/
2
8
/
2
0
0
7
3
/
1
/
2
0
0
7
40-100%
5-10%
15-25%
0-5% 10-15%
25-40%
Disclaimer
Credit Products Rating Distribution Table
(as of February 28, 2007)
Rating Count
%of
Total Count
%of
Total IBC
%of Rating
Category
Overweight 121 38% 69 38% 57%
Equal-weight 134 42% 77 42% 57%
Underweight 64 20% 38 21% 59%
Total 319 184
Equal-weight (E) Over the next 6 months, the fixed income instruments total return is expected to be in line with
the average total return of the relevant benchmark, as described in this report, on a risk adjusted basis.
Underweight (U) Over the next 6 months, the fixed income instruments total return is expected to be belowthe
average total return of the relevant benchmark, as described in this report, on a risk adjusted basis.
More volatile (V) The analyst anticipates that this fixed income instrument is likelyto experience significant price
or spread volatilityin the short term.
CoverageUniverse InvestmentBankingClients (IBC)
Coverage includes all companies that we currently rate. Investment Banking
Clients are companies fromwhomMorgan Stanley or an affiliate received
investment banking compensation in the last 12 months.
Analyst Ratings Definitions
Overweight (O) Over the next 6 months, the fixed income instruments total return is expected to exceed the
average total return of the relevant benchmark, as described in this report, on a risk adjusted basis.
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