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

FIXED INCOME STRATEGY
11 November 2004
Lang Gibson Director (1) 212 449-3942 lang_gibson@ml.com
Trust Preferred CDOs: A Primer

Merrill Lynch CDO Primer Series
United States
CDO Research
Highlights of This Issue

Investors in trust preferred (TruPS) CDOs receive an attractive pick-up to competing cash CDO sectors while gaining exposure to the heavily regulated bank and insurance sectors, which have outperformed corporates historically. To date 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 CDO subsector is limited collateral supply. Risks for the TruPS CDO investor include industry concentration, interest deferral potential, auction-related extension risk and collateral prepayment risk. On an expected loss-adjusted basis, TruPS CDOs are particularly attractive, as this sector has experienced no downgrades and no collateral defaults over its four year existence. While historical losses for middle market banks and insurers are more comparable to crossover corporate credits, subordination in TruPS CDOs is more similar to that of a BB/B average HY CBO. Consequently, we think that there is more than adequate structural protection against losses in TruPS CDOs. Although the longer maturity of the collateral vis--vis the CDO tranche tenor implies average life uncertainty, various structural mitigants provide ample protection against extension risk. TruPS CDOs offer a compelling and unique opportunity 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
8 ,0 0 0 6 ,9 4 2 7 ,0 0 0 6 ,0 0 0 4 ,7 2 9 $s in millions 5 ,0 0 0 344 4 ,0 0 0 3 ,0 0 0 2 ,0 0 0 1 ,0 0 0 553 553 2000 2001 B a n k T ru P S * 2002 2003 2004 YT D 4 ,3 8 5 3 ,3 7 6 4 ,8 9 3 5 ,1 2 6 3 ,3 7 6 2 ,0 4 9 6 ,1 6 4 1 ,0 3 8
In s u ra n c e T ru P S **
Source: Merrill Lynch * All bank or bank-dominant collateral (e.g., hybrids) / ** 100% insurance collateral
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that 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
RC#61431602
Fixed Income Strategy
Trust Preferred CDOs: A Primer 11 November 2004
Trust Preferred CDOs: A Primer

Introduction
Trust Preferred (TruPS) CDOs were first issued in mid-2000, four years after the 1996 Federal Reserve granted Tier 1 capital relief to banks issuing trust preferred securities. Since 2000, there have been 51 TruPS CDOs (42 bank-dominant and nine pure insurance) issued aggregating to $21.8 billion in rated notes and equity (see Appendices 2 & 3 for full deal details). Whereas demand remains healthy due 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 enabled issuers to raise capital on a tax advantaged basis to fund growth or repurchase stock without diluting shareholder wealth. CDOs allow small banks and insurers that dont have access to the public capital markets ($25 to 300 million issues) to issue in $3-15 million sizes and to get the same benefits that larger issuers receive without the high fixed issuance costs. Bank issuers can deduct their TruPS dividend payments for tax purposes and yet still obtain regulatory capital treatment (or, in the case of insurers, statutory accounting and rating agency capital) up to a specified limit. The most successful CDO originators have strong relationships with many small and medium sized financial institutions nationwide allowing them to source a geographically diverse pool of 25 to 40 credits with an optimal combination of risk and return. Our report is divided into the following six sections: n Trust Preferred Securities Overview n TruPS CDO Overview n Collateral Loss Trends: Banks and Insurers n Structure n Cash Flow Analysis n Relative Value n Overview of the Bank and Insurance Industries n Appendix 1: Rating Agency Methodologies n Appendix 2: TruPS CDO Deal List n Appendix 3: TruPS CDO Database with Structure and Pricing Page 2 4 5 8 11 15 18 25 28 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 quarterly or 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 for large capital markets issues. Dividends, which are typically floating rate for issuers into CDOs, are taxdeductible 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.
Refer to important disclosures on page 40.
Trust Preferred CDOs: A Primer 11 November 2004 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) and the issuers ability to defer dividends for up to five years contribute to bank regulators allowing TruPS to account for up to 25% of Tier 1 capital. Bank issuers are typically wholly-owned subsidiaries of bank holding companies, or may be a subsidiary of the bank directly. The trust sells securities to investors and uses the proceeds to purchase subordinated debentures of its holding company. The trust uses the interest payments that it receives from the purchased debentures to make payments to the holders of its preferred securities. The terms of the subordinated debenture are identical to those of the issued TruPS (Chart 2).
Chart 2: Flows for a TruPS Security
Bank or Bank Holding Company

dG ua ran tee
100% o Contr
mi te
Li
Subordinated Debt & Debt Payments
Proceeds of Trust Preferred Securities offering
Special Purpose Business Trust (Issuer)
Trust Preferred Securities & Dividend Payments
Proceeds of Offering
Trust Preferred Investors
Source: Merrill Lynch
n Insurance TruPS and Surplus Notes Both insurance TruPS and surplus notes, which are often also included in CDO pools, are hybrid instruments (much like bank TruPS) in the capital structure of an operating insurance company. Their interest is tax deductible and they receive partial credit for permanent equity capital by the rating agencies.
There are also some important distinctions between insurance TruPS and surplus notes. Insurance TruPS are typically issued at the holding company level; whereas insurance surplus notes are issued from operating insurance companies. Furthermore, on GAAP balance sheets, insurance TruPS are accounted for as long-term debt. By contrast, surplus notes are issued by the operating company and are generally less subordinated than TruPS. Typically, surplus notes are notched down 2x from the operating companys debt rating versus 4-5 notches for TruPS. Interest and principal payments on surplus notes are subject to prior regulatory approval. State regulators generally do not allow issuance of surplus notes to exceed 15% of issuer surplus.
TruPS CDO Overview

The pooled CDO approach results in cheaper issuance costs and funding for issuers, while providing geographic diversification to investors. TruPS issuance prior to 2000 was strictly the domain of larger financial institutions with adequate economies of scale to issue on a standalone basis and whose securities had adequate secondary market liquidity. The trust preferred market is tapped via pooled issuance into a CDO by smaller regional and community banks and insurance companies with no public market access. To date, we have seen $21.8 billion of TruPS CDO issuance (42 bank or bank-dominant and nine pure insurance deals), making the TruPS CDO market the third largest new issue cash CDO subsector in the US (Chart 3).
Chart 3: Growth in TruPS CDO Issuance
Issuance ($mm) $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 2000 2001
Bank TruPS CDOs 2002 Insurance TruPS CDOs 2003 2004 YTD
TruPS CDOs provide investors with regionally diversified exposure to a new issuer base with a solid performance history, particularly with respect to banks whose peak historical failure experience is a fraction of the peak overall corporate default experience. As well, they provide debt investors with exposure to bank originated commercial real estate (CRE) risk with more subordination than a direct investment in CMBS, whose enhancement levels have significantly loosened as a result of several factors including better-than-expected performance. Performance for TruPS CDOs, like that of the underlying collateral, has been excellent, with no rating actions to date. Major risks include industry concentration, interest deferral potential, auction-related extension risk and prepayment risk, which are all key determinants of ultimate performance.
Trust Preferred CDOs: A Primer 11 November 2004 n Enter the insurers TruPS CDOs issued between 2000 and late-2002 were primarily backed by bank and thrift collateral with small buckets for insurers in some deals. The first TruPS CDO backed by 100% insurance collateral was issued in late 2002. Still, TruPS CDO issuance has been dominated by bank collateral. Pure insurance TruPS CDOs represent 15% of the total outstanding TruPS CDO market today. The share of insurers in hybrid bank/insurance pools could grow to 50% within the next year, enabling originators to reach their spread and diversity targets. However, we expect bank collateral to dominate pool composition in the shortand medium-term. Whereas rating agencies and investors seem to generally view bank collateral credit quality as stronger than insurers, they also recognize the diversity 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 TruPS spreads to particularly tight, scarcity-driven levels. These tighter collateral spreads have, in turn, diminished CDO volumes this year because there are fewer collateral issuers 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
450 400 350 Spreads (bps) 300 250 200 150 100 50 0 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $-
Source: Merrill Lynch, Cohen Brothers
The tightening in bank TruPS spreads has spurred originators to include a sizeable bucket for insurance TruPS, which provides several benefits, including a pool spread pickup and industry diversification. These mixed collateral pool deals, often referred to as hybrid TruPS CDOs, are becoming more prevalent. In addition to a blend of new issue small bank and insurance collateral, TruPS CDOs typically feature a bucket for secondary market TruPS, usually issued by 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 data provided by the FDIC, which, as the industrys main regulator, provides one of the most comprehensive sources of historical bank data. We examine bank failure rates as a conservative proxy for defaults. (In the case of a failure, there are other options than default such as a merger into a larger institution.) Bank failures have averaged 0.24% historically, showing a spike in the Great Depression and the late-1980s/early-1990s as the CRE-driven recession played out (Chart 5).
ar Ju 00 nS e 00 p D -00 ec M 00 ar Ju 01 nS e 01 p D -01 ec M 01 ar Ju 02 nS e 02 p D -02 ec M 02 ar Ju 03 nS e 03 p D -03 ec M 03 ar Ju 04 nS e 04 p04

Monthly Volume Bank Insurance
Chart 5: Historical Bank Failures: 1934 2003

2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
46 54 50 86 82 58 78 90 42 66 19 74 38 70 94 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 19 98 34 02 62
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% and 0.38%. In order to develop a more tailored proxy for historical default rates for the typical bank found in a CDO, we refer now to Fitch data, which stratifies the FDIC data further by asset size.
Chart 6: Cumulative BIF-Insured Bank Failure Rates by Size
>$10 billion >$200 m illion and <$10 billion <$200 m illion 14 12 10 8 6 4 2 0 (% )
19 90
19 88
19 86
Note: By asset size of bank. Som e data m ay be estim ated. BIF Bank Insurance Fund.
Source: Fitch Ratings
The nations largest banks (>$10 billion assets) have historically outperformed the very smallest bank category (<$200 million assets), few of which are found in CDOs (Chart 6). The banks whose assets range between $200 million and $10 billion warrant our focus because these represent the majority of banks issuing into TruPS CDOs. Chart 5 illustrates that these mid-size banks have performed comparably if not better than the largest banks historically, with a cumulative gross default rate of 9.83%. In comparison, the chart demonstrates that the smallest banks have experienced cumulative default rates closer to 12%. Historically, troubled banks have been more likely to be acquired than default. Therefore, consolidation on the order of approximately 2% per year (net of start-ups) bodes well for future
19 94
19 96
19 84
19 98
19 92
performance in the sector, in our opinion. The commercial bank failure rate history (a conservative proxy for defaults) compares favorably with historical global defaults as they relate to corporate bonds (Chart 7). Additionally, both banks and insurers benefit from heavy regulation and the implicit government agency oversight that this implies. This regulation gives these sectors an advantage and contributes to their relatively low default rates versus non-bank corporates.
Chart 7: Commercial Bank Failures vs. Global Corp. Defaults
4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00%
78
76
74
72
70
80
82
84
86
88
90
92
94
96
98
00 20
19
19
19
19
19
Bank Failures
19
19
19
19
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 the market 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 and health problems (L&H insurers) than the unexpected, multi-sigma events that are more common with P&C businesses. Historical insurer default rates reflect these different risk profiles: L&H annual defaults have averaged 59 bp; whereas P&C defaults have averaged 79 bp (Chart 8). The historical default paths of these two segments have generally been correlated, with the exception of the past few years when P&C defaults rose to 1.25% in 2002 and the L&H rate fell to zero in 2001, our most recent data point. The 1991 recession saw the peak default rate for the L&H and P&C segments simultaneously rise to their historical highs of 1.83% and 2.3%, respectively.
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Global Corporate Defaults*
19
19
19
19
19
20
02
Chart 8: Insurance Default Rates: P&C Versus L&H

2.50% L&H Mean: 59 bp (1976 - 2001) P&C Mean: 79 bp (1969 - 2002) 2.00%
1.50%
1.00%
0.50%
0.00% 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002
P&C
Source: AM Best
L/H
Structure
TruPS CDOs have historically been issued as static pools, with no discretionary trading 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 are relatively rare for TruPS CDOs. However, there are typically several AAA and Arated tranches both sequential and pro rata in the same deal. The structures used are 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 Structure
Class A-1 A-2 A-3 B PS Amount($mm) $162.25 $ 52.42 $ 5.82 $ 98.49 $ 31.01 $350.00 % of Total 46% 15% 2% 28% 9% Rating AAA/Aaa AAA/Aaa AAA/Aaa A/A2 NR/NR Rated Coupon 3mL+52 3mL+70 3mL+70 3mL+160 NA Avg. Life 7.5 - 8.5 10 10 10
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 both sectors have been rare, although exact figures are not available. The one known case of interest deferrals within a TruPS CDO occurred in the Regional Diversified Funding I Ltd. transaction issued in March 2000. This was the first TruPS CDO ever, and was backed by bank and thrift TruPS. Following dividend deferral on two of the underlying securities in August 2004, Moodys put the senior notes on negative watch. Moodys subsequently took the senior notes off watch a month later when the first of the two deferring obligors received regulatory approval to resume payments, including all accrued and unpaid obligations. We believe that credit deterioration would have to be substantial before a bank or insurer would defer payment. The agencies point to the likelihood of high correlation between bank TruPS interest deferrals and FDIC intervention. We
note that if interest payments are deferred by the holding company, it must also refrain from paying common dividends an onerous structure that incents issuers to continue TruPS payments. For insurers, ongoing interest and principal payments on surplus notes must be approved by the state regulators. As policyholder confidence may be diminished by any perceived negative signals from a deferral, we believe that regulators would exercise extreme caution, only suspending payments under dire conditions. The ability of the obligors to defer interest clearly adds some uncertainty to the cash flows of the CDO. To offset this risk, TruPS in deferral are treated as defaulted securities for purposes of the coverage tests with an assumed recovery 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-most tranches as a way to cure the amount of the deferring asset. This is done until either a percentage, or total par amount, of the deferred asset is covered or the security resumes interest payments. In addition, TruPS CDOs typically feature reserve 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 from defined regions across the nation. As such, diversity within bank TruPS pools is examined by five distinct regions. Consequently, banks effectively represent five distinct industry categories for rating purposes. The assumption is that banks and insurers are highly correlated intra-regionally, but are somewhat uncorrelated interregionally. The agencies adjust their default rate assumptions, applying penalties to excess geographic concentration within the pool. In the case of hybrid TruPS CDOs, the issue of industry concentration is clearly lessened to the extent an insurance bucket is included. Furthermore, the business mix varies a great deal among middle market P&C issuers, which are more numerous than L&H companies in 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, particularly for subordinate noteholders. To account for this, rating agencies impose single obligor 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 is a particularly important factor in analyzing TruPS CDOs because the lack of observable history makes prepays in this asset type difficult to predict. In TruPS CDOs, prepayment risk is more credit-related as opposed to interest rate related because credits are sourced into the pool at par as Libor floaters. The TruPS issuers call option, combined with the otherwise non-amortizing nature of the TruPS collateral, makes it difficult to forecast the weighted average life (WAL) of the notes, CDO auction calls and redemption features notwithstanding. Prepays can be motivated by either opportunistic refinancing or regulatory changes: Opportunistic call: If the issuer no longer desires the TruPS capital, for whatever reason, it may decide to call the deal to reduce its funding cost after the non-call period typically five years for mid-market issues and ten years for TruPS issued by large issuers in the secondary bucket. As well, an issuer can call the bond if it were able to issue a new TruPS at a tighter spread, an unlikely event in the current tight spread environment. Finally, the acquisition of smaller banks by larger ones can lead to a call if the acquiring bank opts to use its own lower cost of funding. However, the acquired banks TruPS debt has historically gone unnoticed once it has been amalgamated into the larger banks balance sheet.
Regulatory call: Should regulatory rules be altered to remove the TruPSs Tier 1 status for bank and thrifts or remove the tax deductibility status, the issuer may call the bond.
All TruPS CDOs issued to date have been static pools, such that proceeds from prepayments cannot be used to reinvest in new collateral. Instead they immediately reduce the average lives of the senior-most notes. Prepayment risk is a particularly important consideration given the homogeneous nature of the pool with respect to asset type. In sizing credit enhancement, rating agencies stress CDO structure through various prepayment timing scenarios. Larger and earlier prepayments are positive because prepaid assets cannot default and are used to pay down senior notes, resulting in a higher subordination percentage for all of the notes. However, prepayments are more likely to occur in the better performing names. Such cherry-picking would negatively impact the credit quality of the remaining pool. This long-dated tail risk, combined with reduced absolute excess spread following prepayments, may serve to increase the risk profile for the subordinate-most noteholder. As such, it is important for investors in these classes to be comfortable with the credits in the pool. Early TruPS transactions were blind pools, where investors did not have access to collateral specifics. Although most TruPS CDO trustee reporting does not include specifics on the collateral, it is common for originators to provide collateral information and analysis to investors in their deals.
Auction Calls
Investors, particularly those lower in the capital structure, do bear the risk that the tranche average life extends past ten years if auctions repeatedly fail. However, the TruPS CDO structure mitigates the long maturity of the TruPS collateral with 1) the auction call and 2) sequential amortization in the case of a failed auction. The auction is designed to pay off the notes principal in its entirety starting in year ten. Should the auction fail, a re-attempted auction call occurs every payment period until the auction is successful. Furthermore, until such time that the auction is successful, a portion of excess spread (50% - 60%) is diverted to amortize the notes sequentially. Consequently, the senior-most tranche average life sensitivity is significantly less exposed to an auction failure than the junior tranches. As the notes are amortized with this excess spread, the likelihood for a successful auction call increases with each payment date because there are increasingly fewer liabilities to pay off. Furthermore, this feature creates additional excess spread, as the same collateral pool is now supporting fewer rated notes. An auction will only fail to the extent that the collaterals value is less than the principal amount of the notes. Therefore, a failed auction would likely only occur if there is substantial credit deterioration, which would include widespread TruPS collateral spread widening (systemic) and/or significant deferrals or defaults (idiosyncratic). Furthermore, any fixed rate secondary bonds purchased at a premium could decline in value if the issuers call option (which the 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 and low rate environment, making it unlikely for spreads to tighten or rates to rally enough to behoove issuers to call their TruPS issues. In the cash flow sections, we evaluate the average life sensitivities across the capital structure to determine relative extension risk in the tranches.
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Trust Preferred CDOs: A Primer 11 November 2004 n Interest Rate Hedging Considerations To date, there has been minimal fixed/floating interest rate mismatch in TruPS CDOs, as the majority of both the assets and liabilities are floating rate. The mismatch is so minimal (or nonexistent) in some transactions that no hedge program exists. To the extent that there has been hybrid collateral (TruPS that are fixed for a specific period and then switch to floating), most CDOs have a similarly-priced subordinate hybrid liability, offsetting much of the interest rate mismatch. In general, the mismatch to hedge in these transactions has been small compared with other cash CDO sub-sectors, enabling some TruPS CDO issuers 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 as structured finance CBOs, due to the need for a large hedge to account for the predominantly fixed rate assets versus floating rate liabilities. The need for limited hedging is a strong positive for a CDO, as out-of-the-money hedges and/or over-hedging has exacerbated poor performance within other CDO sub-sectors. n Credit Enhancement
Subordination
The conservative manner in which ratings agencies define bank defaults leads to a 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 1 for summary of Rating Agency Methodologies). Given the limited predictability of the collateral cash flows, the agencies stress their assumptions for collateral performance to address the potential variability in cash flow timing. Thus, TruPS CDOs can have fairly high required subordination levels, as these stresses account for the limited historical performance of the collateral. In our opinion, these conservative subordination levels will likely fall over time.
Excess Spread
Another unique aspect of TruPS CDOs is the amount of excess spread that can potentially be generated over the life of a transaction and can cushion against losses. The non-amortizing nature of the long-dated collateral can generate high excess spread relative to other CDO sectors. The same features mean that excess spread is diminished only by prepayments and defaults, which can be difficult to predict. This is where cash flow scenarios (our next section), with varying prepay and default assumptions, can add value to the analysis of a TruPS CDO. The rating agencies 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, auction calls, and various structural features impact the tranches sensitivity to losses and calls. One way to gauge the strength of the debt classes to withstand collateral credit impairment is to simulate breakeven default rates. Breakevens demonstrate how much collateral must default before a tranche experiences a break in yield. Our case study deal in Table 2 is based on a $416 million quarterly-pay bank and thrift TruPS CDO. The collateral has a weighted average spread 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-rate collateral 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 initial excess spread of approximately 1.60% per annum.
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Table 2: Case Study TruPS CDO Example Capital Structure

Class A1 A2 A3 B1 B2 B3 PS
Source:
Size $195.00 $ 63.00 $ 7.00 $ 62.38 $ 51.62 $ 3.00 $ 33.50
Ratings (Fitch/MoodysS&P) AAA/Aaa/AAA AAA/Aaa/AAA AAA/Aaa/AAA A/A2 A/A2 A/A2 NR
Sub.* 51.25% 33.75%
4.50%
Price 3mL +48 3mL +70 3mL +70** 3mL+1.65% 3mL+1.65%*** 3mL+1.65%****
Avg. Life 8.7 10 10 10 10 10 NA
*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 A3 classes 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 of 8.5% and 2.4%, respectively. These CADRs compare favorably with the 1970-2003 historical average of 38 bp (peak of 204 bp). The coverage multiple above the historical average failure rate that the senior AAA- and A-rated tranches can withstand before breaking yield is 29.8x and 5.9x, respectively (Table 3).
Table 3: Breakeven Default Rates (based on a break in yield)
Tranche A1 A2 & A3 notes B notes
* 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%.
Rating AAA/Aaa/AAA AAA/Aaa/AAA A/A2
CADR* 11.9% 8.5% 2.4%
Multiple of 35- Year Historic Avg. Failure Rate** 29.8 21.3 6.0
Cumulative Defaults 62.3% 49.3% 16.8%
Cumulative Losses 56.1% 44.4% 15.1%
WAL 7.86 9.95 9.95
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 timing of 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 the excess spread each period from the equity holder to amortize the senior-most outstanding class of notes. This amortization feature reduces the WAL of the notes in the event of a failed auction call in year 10 and greatly minimizes the extension risk in the senior AAAs. For example, the WAL of the AAAs increases only 0.43 years if we assume a 30-year auction call scenario instead of a successful auction in year 20 (Table 4).
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Table 4: WAL with Base Case Prepayments and Varying Auction Call Dates*
Class A1 A2 B Auction Call Year 10 8.8 10.0 10.0 Auction Call Year 20 13.0 20.0 20.0 Auction Call Year 30 13.4 28.6 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, no deferral of interest.
In addition to the auction timing scenarios above, we examine WAL sensitivity for various prepayment scenarios under both a 10-year and 30-year auction call scenario (Tables 5 and 6). We begin with our base case prepayment assumptions, including 10% prepayment rate in year 6, the first year following the non-call period. We then vary both the initial prepayment in year 6 and the ongoing annual prepayments over the life of the transaction. We chose a year 6 lump sum prepayment speed assumption as high as 50% to take into account the risk, however remote, that opportunistic refinancing could be the result of extensive 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 CPR** 2% 4% 6% Class A2 CPR** 2% 4% 6% Class B CPR** 2% 4% 6% 10% 10.0 10.0 10.0 10% 10.0 10.0 10.0 10% 8.8 8.5 8.3 Prepayment Speed in Year 6 20% 7.9 7.7 7.5 Prepayment Speed in Year 6 20% 10.0 10.0 10.0 Prepayment Speed in Year 6 20% 10.0 10.0 10.0 30% 10.0 10.0 10.0 40% 10.0 10.0 10.0 50% 10.0 10.0 10.0 30% 10.0 10.0 10.0 40% 10.0 10.0 9.9 50% 9.5 9.1 8.7 30% 7.1 6.9 6.7 40% 6.2 6.0 5.9 50% 5.5 5.5 5.5
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*

Class A1 CPR** 2% 4% 6% Class A2 CPR** 2% 4% 6% Class B CPR** 2% 4% 6% 10% 30.0 29.5 26.9 10% 28.6 21.6 17.5 10% 13.4 10.6 9.2 Prepayment Speed in Year 6 20% 10.7 8.7 7.9 Prepayment Speed in Year 6 20% 27.0 19.7 16.0 Prepayment Speed in Year 6 20% 30.0 29.0 26.1 30% 30.0 28.2 25.0 40% 29.9 27.0 23.5 50% 28.9 25.1 21.6 30% 24.0 17.3 14.1 40% 19.7 14.4 11.9 50% 13.7 10.6 9.2 30% 8.2 7.2 6.7 40% 6.4 6.0 5.9 50% 5.5 5.5 5.5
Source: Merrill Lynch * Assumes 40 bp CADR. ** Assumed annual prepayment speed following year 6.
Not surprisingly, moving down the capital structure, the tranche WALs are increasingly less responsive to prepayments. Although relatively insensitive in the year 10 auction call scenario, the WAL of the junior AAA class does shorten meaningfully with increases in the year 6 lump-sum prepayment assumption (Table 5). In contrast, the WAL of the subordinate-most note demonstrates limited sensitivity in the 30-year auction call scenario. Although a 30-year auction call is exceptionally unlikely, the stresses provide insight into how much more sensitive all 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, similar to most other CDO asset classes, as collateral spreads tighten to historical lows. Despite tighter TruPS spreads, TruPS CDO equity currently provides the highest IRR of the three major cash CDO sub-sectors (see the relative value section). CDO equity returns are robust regardless of the assumptions made for the auction call 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 up to 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

20.00%
15.00%
10.00% Return
5.00%
0.00% 0.00% -5.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40%
-10.00% CDR 10 Yr Auction Call* 30 Yr Maturity* Yr 6 100% Prepays Yr 6 30% CPR**

* 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 CDO subsectors, yet this four-year old asset class has yet to experience a single downgrade. Unlike competing CDO subsectors, we believe that investors should achieve a comfort level with the deals extension risk, more so than principal loss risk. In other words, significant collateral losses are far more likely to extend the tranches average life than to touch principal, a function of the relatively long-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-CDO competing sectors (Chart 10). In As, the pickup is a respective 60 bp (versus HY CLOs) and 104 bp (versus our composite of three competing sectors) (Chart 11).
Chart 10: AAA-rated TruPS CDOs Versus Competing Spreads
100 Libor Spread (bps) 90
Libor Spread (bps)
Versus Non-CDO Competing Sectors

100
80
80 70 60 50 40 30 May-02 Jul-02 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jan-02 Mar-02 Sep-01 Nov-01 Sep-02 Nov-02 Jan-03 Mar-03 Sep-04 Jul-01 Jul-04
60
40
20
Jul-01
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Nov-01
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Sep-01
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7yr SL
HY CLO
Tailored IG Synth.
Multisector
Hybrid TruPS
10 yr CMBS
TruPS CDO
10yr CC
3yr HEQ
Sep-04
Jan-02
Jan-03
Mar-02
Mar-03
Jan-04
Mar-04
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Chart 11: A-rated TruPS CDOs Versus Competing Spreads

240 Libor Spread (bps) 220 200 180 160 140 120 100 May-02 May-03 May-04 Jul-04 Jan-02 Mar-02 Jan-03 Mar-03 Jan-04 Mar-04 Sep-01 Sep-02 Sep-03 Nov-02 Nov-01 Nov-03 Sep-04 Jul-01 Jul-02 Jul-03
Versus Non-CDO Competing Sectors
200 Libor Spread (bps)
150
100
50
May-02
May-03
May-04
Mar-02
Jan-03 Mar-03
Nov-01
Nov-02
Nov-03
Sep-01
Sep-02
Sep-03
Mar-04
HY CLO
Tailored IG Synth.
Multisector
Hybrid TruPS
CMBS
TruPS CDO*
Corp
5yr HEQ
We attribute the TruPS CDO spread pickup to the following four factors: 1) Relative investor sponsorship: Few investors are familiar with this collateral relative to most CDO subsectors as it was not possible to invest in the debt of mid-market banks and insurers prior to 2000. In fact, other banks and insurers were, not surprisingly, the first investors across the capital structure of TruPS CDOs. 2) Extension risk: Although the average life is ten years at the CDO level, the thirty-year legal final of the TruPS collateral can exceed maturity limits for some investors. TruPS CDOs address the long maturity of the collateral with periodic auction calls and delevering of the structure in case of repeated failed auctions. 3) Prepayment risk: Prepayments (e.g., calls) could reduce excess spread resulting 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, we believe that the market is overly backward looking when it comes to predicting future prepayments. Given the current spread environment, interest rate driven prepayment risk is not significant. Instead, the main catalyst for prepayments would be credit driven opportunistic refinancing. However, as the pooled TruPS issuers have favorable credit quality when they enter the transaction and spreads are at historical tights, mergers are the more likely catalyst to cause prepayments. However, as bank failures often result in a merger arranged 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 TruPS dividends for up to five years. Although the deferred dividends are capitalized and would eventually be paid should payments resume, deferral is clearly a negative for the issuers creditworthiness. However, three mitigating factors exist to protect debt holders against deferrals: Conservative Definition of Default: Debt holders are protected from this dividend deferral risk by the rating agencies conservative treatment of any deferral as a default in the O/C test. Consequently, if enough deferrals exist to trip the O/C test, the senior-most note holders could begin 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 a portion of excess spread so as to continue paying debt coupons in case deferrals are significant enough to erode regular CDO debt coupon payments.
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Sep-04
Jul-01
Jul-02
Jul-03
Jan-02
Jan-04
Jul-04
Trust Preferred CDOs: A Primer 11 November 2004 n Equity Tranche As with all CDO subsectors, TruPS CDO equity IRRs have fallen to historical lows over the past few years, although the week-to-week IRR volatility is relatively muted. Our CDO equity IRR barometer measures the relative attractiveness of buying the equity at any point in time. The barometer represents the 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 a generic 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, the TruPS CDO equity IRR barometers have fallen 7.8 percentage points to approximately 13% under base case assumptions of a 48 bp CADR (assuming 75% banks and 25% insurer collateral) and 10% recoveries and to about 7% with a stressed case assumption of a 95 bp CADR and 0% recovery rate (Chart 12).
Chart 12: TruPS CDO Equity IRR Barometer: Base Vs. Stressed Case
TruPS CDO Equity IRR (%)
20
10
0 Apr-01 Apr-02 Apr-03 Jan-01 Jan-02 Jan-03 Jan-04 Apr-04 Jul-01 Jul-02 Jul-03 Oct-01 Oct-02 Oct-03 Jul-04
13.0
Base case: 48 bp CADR; 10% Recovery
Stressed case: 95 bp CADR; 0% Recovery
Source: Merrill Lynch, Cohen Brothers CADR = 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 to liability spreads over this period. Specifically, bank and insurer TruPS spreads have tightened a respective 105 bp and 75 bp; whereas AAA and A liability spreads have tightened a lesser 48 bp and 45 bp.
Chart 13: Monthly TruPS CDO IRRs Versus Volume
18.7
20
18.6 17.7 $1.3 $1.1 17.6 17.5 16.2 14.8 13.7 $0.9 13.0 12.9
1.5 Volume ($blns)
Oct-04
15 10 5 Base case IRR
1.0
$0.9
0.5
$0.3
$0.4
$0.4
$0.3
0.0 Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov
TruPS CDO Volume

TruPS CDO IRR
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The barometers are intended to help investors detect relative value amongst CDO sub-sectors as well as other equity-like securities and to forecast CDO volume in the relevant sector. The 13%-area base case IRR for TruPS CDO equity is significantly higher than IRRs in the two competing cash CDO sub-sectors, which have recently ranged between 11% and 12%. This years steady decline in TruPS CDO equity IRRs, particularly since May (17.5%), has been associated with a falloff in volume (Chart 13). As defaults in TruPS collateral, if any, are expected to be back-ended (we have seen only deferrals so far in this products history), investors receive particularly front-loaded cash flows in this CDO equity product. However, to the extent that there are enough deferrals in the collateral to trip an O/C test, equity cash flows would be cut off until collateral dividend 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 business line, the two main attractions for small banks is their stronger core deposit base and 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 of rising rates. Contrary to popular myth, bank net interest income generally benefits from rising rates as their core deposits re-price much more slowly than their floating rate loans. Whereas large banks depend more on wholesale funding, small banks rely predominately on core deposit funding. Therefore, we believe that rising rates are a positive for small banks net interest income. Lastly, whereas large banks lend to big companies at tight spreads in lumpy amounts to attract more lucrative, but volatile, capital markets and related fee business; small banks concentrate more on traditional 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 risk analysis, including a look at trends in the various performance metrics specific to banks. The analysis can be broken down into fairly simplistic terms. Bank credit analysts review the basic health of a bank by examining several key parameters including profitability, liquidity, loan quality, and capital adequacy. Additionally, it is important to review trends in these metrics over time, 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 this will lend predictability to the payment of trust preferred dividends. Banks with above-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 their core competency, either by business line and/or geography. TruPS CDO originators typically look for issuers with stable ROE maintained in the 15%-area and with steady ROA of approximately 1%-1.2%. Additionally, a healthy, but controlled growth 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 over time is the net interest margin (NIM) between interest earning assets and interest bearing liabilities. Bank NIMs have declined in recent years as a relatively flatter yield curve reducing the profitability of their core strategy of lending long and borrowing short. The NIMs of banks more representative of the TruPS CDO space, (banks with $100 million to $1 billion in assets) have had wider NIMs as compared with banks with assets in excess of $1 billion (Chart 14). NIMs of smaller banks tend to be higher as they rely more on cheap core deposit funding. Compared to the larger banks, they also do less corporate lending, which tends to be lower yielding compared with alternatives such as CRE lending.
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Chart 14: Bank Net Interest Margin
Net Interest Income/Earning Assets
5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Small Banks Large Banks
Source: FDIC
n Profitability Return on assets and equity ROA has stabilized from the early 1990s, with small banks outperforming larger banks until fairly recently, when ROA performance fell slightly behind. Large banks have more tools, such as securitization, to pare down their assets and the 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 they focus more extensively on artificially deflating their equity base.
Chart 15: Bank ROA and ROE
1.40% Net Operating Income/Total Assets 1.30%
Net Income/Equity Capital 16.00% 15.00% 14.00% 13.00% 12.00% 11.00% 10.00% 9.00%
1.20% 1.10% 1.00% 0.90% 0.80% 0.70% 0.60% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Small Banks Large Banks
8.00% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 small banks large banks
Source: FDIC
Source: FDIC
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Trust Preferred CDOs: A Primer 11 November 2004 n Loan performance Another key component of bank analysis involves an examination of the loan books 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 into banks 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 lumpier exposures to individual corporations, particularly during the 2001-2002 corporate recession. Additionally, the ratio of nonperforming loans to total assets can be used as a leading indicator of future losses. This ratio has improved significantly since the early 1990s, and has been stronger for small banks, who were not significantly effected by the large number of corporate defaults in the recent recession.
Chart 16: Charge-Offs/Assets and Nonperforming Loans/Assets
Non-Performing Loans/Total Assets
1.20% Net Charge-Offs/Total Assets 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Small Banks Large Banks
2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Small Banks
Large Banks
Source: FDIC
Source: FDIC
n Liquidity and core deposits Liquidity, as measured by core deposits to total assets, has stabilized for banks in general since the early 1990s. Core deposits represent a significant portion of midsize banks borrower base, and thus tend to be higher for small banks (Chart 17).
Chart 17: Core Deposits/Assets
110% Core Deposits/Total Assets 100% 90% 80% 70% 60% 50% 40% 30% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Small Banks
Large Banks
Source: FDIC
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Trust Preferred CDOs: A Primer 11 November 2004 n Capital adequacy Capital adequacy is an important gauge for banks, as a strong capital base provides stability to a financial institution. The ratio of equity capital to total assets has steadily improved for banks since the early 1990s (Chart 18). Historically, smaller banks have maintained greater capital adequacy versus large banks.
Chart 18: Capital/Assets
12%
Total Capital/Total Assets
11% 10% 9% 8% 7% 6% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Small Banks
Large Banks
Source: FDIC
n CRE Lending Finally, understanding the banks core lending business is a key consideration. For smaller banks, commercial real estate (CRE) lending comprises the bulk of the loan portfolios risk and return, although residential mortgages are the single largest loan category notionally. Bank failures of the late 1980s/early 1990s were primarily due to banks and thrifts aggressive underwriting standards for CRE lending. 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 Wheaton Research, is positive, in terms of both vacancy rates and rents (Chart 19).
Chart 19: Torto Wheaton Rent and Vacancy Rate Trends: Historical and Projected
20 Forecast 18 16 14 Vacancy rate 12 10 8 6 4 2 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2005 2007 2009 2011 2013 -1 -2 -3 -4 -5 3 2 1 0 Real rent growth (%) 4
Office vacancy rate Office rents (right)
Industrial vacancy rate Industrial rents (right)
Source: Torto Wheaton Research (TWR) Note: office and industrial two of the six CMBS property types are the only property types whose vacancy and rental data goes past the 1988-91 property recession.
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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 early1990s real estate recession. According to Fitch, excellent performance in the CMBS sector since inception, historically low mortgage rates, the inclusion of large loans in conduit transactions and improved collateral and sponsorship quality has led to lower rating agency credit enhancement requirements for CMBS, a trend that will likely continue. Similar to the higher subordination requirements at the inception of the CMBS market, subordination offered in the TruPS CDO market is arguably conservative. As agency-required subordination for CMBS has declined (e.g., in 1995, BBBs required roughly 16% of hard support versus 5% today) in response to lower-thanexpected defaults, we would expect TruPS CDO subordination to similarly decline over time, as losses remain nonexistent or insignificant. We believe that the geographic diversity offered in TruPS CDO bank pools significantly mitigates potential bubbles in certain commercial property markets, such as Atlanta, Dallas, and Los Angeles. Still, a 40% CRE loan portfolio in a small bank portfolio is 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 small banks have experienced steady improvement in overall loan quality, liquidity and capital adequacy, particularly in comparison with larger banks. While there are many advantages for smaller bank TruPS issuers to seek financing via CDOs, there is a limited supply of issuers, and available collateral, in the market. The limited supply of available collateral only further exacerbates the pressure on bank TruPS spreads. The increasing scarcity of bank collateral, investor demand for diversification and need for yield in a generally tight spread environment has led to an increased inclusion of insurance TruPS in bank-dominated TruPS pools, as we discuss below. n Brief Overview of the US Insurance Sector Over the past four years, the nations highly regulated US insurance industry has faced significant obstacles including a recession, the terrorist attacks of 9-11, a weak stock market and a continuation of weak earnings fundamentals. Fortunately, since 2000 and particularly in the aftermath of 9-11, premiums have 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 pace with inflation, much less loss rates. Still, P&C impairments have more than doubled 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 in Florida and the initial announcement of the Spitzer probe, which caused the Merrill Lynch insurance index to widen 20 bp in the ensuing few weeks. The relatively 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 of risk-based capital standards. The insurance industry, particularly the commercial P&C segment, faces many challenges today that can best be summarized by rating agency outlooks by line of business (Table 7). For an overview of pure insurance TruPS CDOs and a general description of the collateral, we refer our readers to our June 2003 report, Insurance Trust Preferred CDOs.
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Table 7: Rating Agency Insurance Industry Outlook

LOB Life Insurance P&C Commerical Lines Personal Lines Moodys Stable Negative Stable S&P Stable Negative Stable Fitch Stable Negative Stable
Our Fixed Income Research insurance analyst, Angelo Graci, maintains an Overweight recommendation on the Insurance sector, which was reiterated in his October 25, 2004 report, Trade Ideas Amidst Insurance Sector Storm. In this report, Angelo writes, The Insurance sector is more likely to outperform the broad index over the next few months due to: 1) The most significant Spitzer allegations (and greatest risks) should remain concentrated with the large insurance brokers due to the nature of the conflicts of interest, 2) The rating implications on the insurance companies should remain modest due to our expectations for manageable financial impact and minimal impact on business models, 3) The sector, overall, is very likely to remain a high quality sector. The average rating in the Insurance sector is mid single-A. We expect the average rating to remain in the single-A category.
Small versus large insurance models

As with banks, small and large insurers have very important differences. Small insurers have limited exposure to headline risks such as those related to catastrophe and asbestos and domestic acts of terror. As these smaller insurers tend to be less well-known, mutually-owned cooperatives, their spreads are technically wide relative to larger insurers with the same rating. Our discussions with various insurance analysts over the past month leads us to believe that the impact from the Spitzer probe will have a neutral impact on middle market insurer TruPS for the following reasons: 1) The nations largest insurance insurers and brokers are Spitzers target for these probes not the smaller issuers typically found in TruPS CDOs, despite the fact that the latter category also engages in contingent commissions (heretofore an accepted practice). It is particularly the brokers that Spitzer is going after in this case due to their alleged practice of bid rigging (illegal) and tying. Even for the affected large insurers, most analysts expect the fallout to be limited to potential fines and penalties, as opposed to a fundamental change in business model. Thus, it is expected that this will be a capital event not an ongoing 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 fees to compensate. Still, contingent commissions are not a significant portion, if any, of the smaller insurers business, which typically depends on smaller independent agents for product distribution. 3) To date, the probe is mostly centered in New York, making the diversification of smaller insurers a positive. However, regulators in the remaining states are expected to also get tougher with their constituent insurance companies. 4) There may be some buying opportunities for the secondary market buckets of TruPS CDOs due to market overreaction to the Spitzer probe with roughly 5%15% buckets for secondary public paper issued by the largest insurers and banks. Headline risk is likely to push spreads on some of the unaffected large insurers 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 expected loss-adjusted basis, they are particularly attractive, as this sector has experienced no downgrades and no collateral defaults over its four year existence. While historical losses for middle market banks and insurers are more comparable to crossover corporate credits, subordination in TruPS CDOs is more comparable to that of a HY CBO backed by a BB/B portfolio of corporate bonds. Consequently, we think that there is more than adequate structural protection against losses in TruPS CDOs. Although the longer maturity of the collateral vis--vis the CDO tranche tenor implies average life uncertainty, various structural mitigants provide ample protection against extension risk. Significant collateral losses, if any, are far more likely to extend the tranches average life than to touch principal. TruPS CDOs offer 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 TruPS CDOs, please see the appendix in our eminent release of our standalone TruPS CDO Primer. Furthermore, in this same standalone primer report, we will 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 address this, Fitch uses its US Bank Scoring Model to evaluate the creditworthiness of each issuing bank. Each bank is scored using its proprietary model, which accounts for relative capital strength, earnings, liquidity and asset quality. The scoring system is based on a half-point incremental scale of 1-5, with 1 being the highest possible score. Other factors outside of the model, such as operating history, bank size, and obligor 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 is assigned a default rate based on Fitchs Trust Preferred Default Matrix. The default rate assigned to an issuer is a function of the issuers adjusted bank score and 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 was based on a methodology similar to that used to construct the corporate default matrix. Their rationale for excluding the period prior to 1970 is that there was little default experience then and because more recent data incorporates a more relevant banking environment and regulatory conditions. In the study, Fitch focused on banks and thrifts with between $200 million - $10 billion in assets, and with bank track records in excess of five years. As a proxy for defaults, Fitch counted all bank failures reported by the FDIC as defaults. This is considered to be a conservative approach, given that bank failures do not always result in default. Furthermore, defaults were weighted on an occurrence basis, rather than by issuer size. Given that defaults are more frequent among the smaller issuers, this approach 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 of the rated notes is calculated. With respect to recoveries, Fitch notes the lack of empirical data, and uses a 10% recovery rate with a two-year lag. This rate, while acknowledged by Fitch to be conservative, takes into account TruPS subordinate position within the bank capital structure. n Collateral Diversity Fitch addresses industry concentration by requiring additional credit enhancement to serve as a default cushion against this risk. Fitch focuses on the regional diversification within the pool, citing a Salomon study on how the regionality of banks positively affects their default correlation. The study found that interregional banks, stratified into five regions nationally, are no more positively correlated than any 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. Penalties are applied to obligor concentrations within a given region of greater than 28%. Other penalties may be applied as needed. Concentration penalties are used to adjust the pool weighted average default rate. Fitch also addresses excess single obligor concentrations within the pool. Penalties for such concentrations are factored into the individual banks score based on the quality of the bank and the amount of the concentration. n Prepayments With little history to suggest future prepayment behavior, Fitch uses various prepayment timing scenarios in order to stress the cash flows.
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Moodys Bank TruPS CDO Methodology

n Collateral Credit Quality For the rated portion of the pool, the default probability for a bank is estimated by referencing Moodys senior unsecured ratings of the issuers. When TruPS in the pool are unrated, Moodys has the following prescreening requirements for each issuer: Financial institution insured by the Bank Insurance Fund or Savings 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 considers various factors for each bank issuer, including earnings, capitalization, and concentration in commercial real estate assets, among other financial variables. Moodys assumes that the credit quality of the pool used to determine default probability is the higher of 1) a WARF of 480 (Baa2/Baa3), as corresponds to Moodys corporate bond default rate and their analysis of historical FDIC default data on insured commercial banks and 2) the portfolio average WARF determined by their model. The model is adjusted for barbelling, excessive issuer concentration, and potentially unstable default estimates. n Default and Recovery Assumptions The higher of the two WARFs, as described above, determines the pool-wide default rate. In order to arrive at a weighted average rating, recovery rates are then estimated. Moodys uses what they describe as a stressed recovery rate assumption of 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. In modeling default timing, Moodys extends its conventional CDO default curve in order to account for the longer dated assets in the pool. Specifically, defaults are front-loaded over the first eight years of the transaction, with 35% in the first year and 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 is compressed to fit into the shorter time frame. n Collateral Diversity Moodys considers diversity by region, citing FDIC historical default data that suggests strong regional patterns in bank default data. The Moodys Diversity Score Methodology is used, whereby the US is divided into five regions. The assumption is that banks are highly correlated intra-regionally but are somewhat uncorrelated inter-regionally. With respect to single-obligor concentration within the pool, Moodys typically limits exposure to any unrated bank to 3% or less. The agency will typically apply additional stresses to unrated banks with concentrations in excess of this. For rated banks, 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 final maturities.
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S&Ps Bank TruPS CDO Methodology

n Collateral Credit Quality S&P requires that any unrated issuance in the pool be assigned a credit estimate in order to determine a default probability. Credit estimates are performed by S&Ps Financial Institutions Group. In determining the credit quality of the individual issuers in order to derive a default rate assumption, S&P looks to the issue rating as opposed to the bank issuers credit rating. In general, the issue rating tends to be several notches below the issuer credit rating, providing a more conservative starting point for determining the overall credit quality of the pool and, ultimately, default rates. n Default and Recovery Assumptions 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 for the portfolio at each relevant rating level. With respect to default timing, S&P runs its standard CDO stresses over the life of the deal, in addition to saw-tooth default 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 on defaulted assets, S&P takes the conservative view that TruPS in interest deferral mode must be treated as defaulted assets. For recoveries, while recognizing that some assets in deferral will ultimately recover 100%, S&P uses a stressed recovery assumption of 10% for all assets treated as defaulted. Additionally, they use a lagged recovery, acknowledging that recoveries are likely to come in as a payment stream over time. n Collateral Diversity S&P has the view that the default stresses applied are conservative to the point that additional industry correlation stresses are unnecessary. Consideration of geographic diversity is handled on a deal-by-deal basis.
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Appendix 2
TruPS CDO Issuance History
Date Offered 03/31/2000 09/07/2000 02/22/2001 03/28/2001 06/28/2001 07/31/2001 11/28/2001 12/18/2001 03/20/2002 03/26/2002 06/24/2002 07/01/2002 09/20/2002 10/16/2002 10/29/2002 11/18/2002 12/19/2002 12/19/2002 02/19/2003 03/18/2003 03/31/2003 04/23/2003 05/15/2003 05/23/2003 05/27/2003 06/26/2003 08/27/2003 09/12/2003 09/18/2003 9/25/2003 9/26/2003 10/29/2003 12/02/2003 12/05/2003 12/12/2003 02/05/2004 02/05/2004 02/26/2004 03/09/2004 03/18/2004 03/26/2004 04/08/2004 04/23/2004 04/30/2004 05/07/2004 06/17/2004 06/24/2004 08/19/2004 09/16/2004 10/01/2004 11/02/2004 Issuer Regional Diversified Funding I Preferred Term Securities Preferred Term Securities II MMCapS Funding I MM Community Funding Preferred Term Securities III MM Community Funding II Preferred Term Sec. IV Preferred Term Sec. V MM Community Funding III Preferred Term Sec. VI T-PREF Funding Preferred Term Sec. VII TPREF Funding CDO II Trapeza I I-Preferred Term Sec. I Preferred Term Sec. VIII T-PREF Funding III Trapeza II Preferred Term Sec. IX MM Community Funding IX Tropic CDO I I-Preferred Term Securities II InCaps Funding I Trapeza III Preferred Term Securities X Dekania CDO I Pref. Term Securities XI Alesco Preferred Funding I Tropic CDO II Trapeza IV I-Preferred Term Securities III Trapeza V InCaps Funding II Alesco Preferred Funding II Regional Diversified Funding 2004-1 Tropic III U.S. Capital Funding I Preferred Term Securities 13 Alesco III Dekania II Trapeza VI Icons Alesco Preferred Funding IV I-PRETSL IV Preferred Term Securities 14 U.S. Capital Funding II Alesco Preferred Funding V Preferred Term Securities XV Trapeza VII Tropic CDO IV Manager Salomon Smith Barney FT&KB First Tennessee Sandler ONeill Sandler ONeill First Tennessee Sandler ONeill First Tennessee FT&KB Sandler ONeill FT&KB Bear/Sandler/SSB FT&KB Bear/Sandler/SSB Trapeza Capital Mgt. FT&KB FT&KB Bear/Sandler/SSB Trapeza Capital Mgt FT&KB SSB/Sandler BS FT&KB Citigroup Trapeza FT&KB Dekania Capital Mgt. FT&KB Cohen Brothers BS Trapeza FT&KB Trapeza Citigroup Cohen Brothers Citigroup Bear Stearns StoneCastle Advisors, LLC FTN/KBW Cohen Brothers Dekania Capital Trapeza Capital Morgan Stanley Cohen Brothers FTN/KBW FTN/KBW StoneCastle Advisors, LLC Cohen Bros FTN/KBW Trapeza Bear Stearns Underwriter Salomon Smith Barney FT&KB First Tennessee Barclays Salomon Smith Barney First Tennessee Salomon Smith Barney First Tennessee FT&KB Salomon Smith Barney FT&KB Bear/Sandler/SSB FT&KB Bear/Sandler/SSB CSFB FT&KB FT&KB Bear/Sandler/SSB CSFB FT&KB SSB/Sandler BS FT&KB Citigroup CSFB FT&KB ML FT&KB Merrill Lynch/Sandler BS CSFB FT&KB CSFB Citigroup ML Citigroup Bear Stearns Sandler ONeill FTN/KBW Merrill Lynch/Sandler Merrill Lynch CSFB Morgan Stanley Merrill Lynch FTN/KBW FTN/KBW Sandler ONeill Merrill Lynch FTN/KBW CSFB Bear Stearns Collateral Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Insurance TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Insurance TruPS Insurance TruPS Bank TruPS Bank TruPS Insurance TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Insurance TruPS Bank TruPS Insurance TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Bank TruPS Insurance TruPS Bank TruPS Insurance TruPS Bank TruPS Insurance TruPS Bank TruPS Bank TruPS Bank and Insurance TruPS 84% Bank and 16% Insurance TruPS Bank TruPS Bank TruPS $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Size 241.70 311.34 347.45 293.50 525.00 516.00 766.25 927.30 513.00 539.50 500.00 581.90 532.10 578.00 337.20 344.00 534.10 269.50 411.90 522.50 314.00 310.00 523.10 385.60 316.83 580.80 306.90 669.60 344.10 344.00 421.80 520.60 308.50 313.10 348.60 363.50 345.00 210.35 539.10 362.80 414.70 361.70 286.00 415.50 337.50 504.00 349.00 365.00 625.00 350.00 335.00
28
Appendix 3
Trust Preferred CDO Issuance Database
Date Offered 03/31/2000 Issuer Regional Diversified Funding I Ltd. Manager/ Underwriter SSB Collateral Bank TruPs Class A Sub. Income Notes Size $ 225.0 $ 16.7 $ 241.7 $ 201.1 $ 90.0 $ 20.3 $ 311.3 $ 227.8 $ 93.0 $ 26.7 $ 347.5 $ 191.5 $ 77.0 $ 25.0 $ 293.5 $ 333.0 $ 140.0 $ 52.0 $ 525.0 $ 365.8 $ 114.1 $ 36.1 $ 516.0 $ 480.0 $ 205.0 $ 81.3 $ 766.3 12.8 Avg Life Mdys A1 NR S&P Fitch A+ NR Pricing
09/07/2000
Preferred Term Securities, Ltd
FT&KB
Bank TruPs
Senior Mezzanine Equity
Aaa Baa2
AAA BBB
8.79% 9.74%
02/22/2001
Preferred Term Securities II (PreTSEL II)
First Tennessee First Tennessee
Bank TruPs
A B Equity
Aaa Baa2
AAA BBB
3mL+100 9.55%
03/28/2001
MMCapS Funding I, Ltd.
Sandler ONeill Barclays
Bank TruPs
A B C
Aaa Baa2
AAA BBB
8.03% 9.48%
06/28/2001
MM Community Funding
Sandler ONeill SSB
Bank TruPs
A B Equity
Aaa Baa2
AAA BBB
6mL + 100 6mL + 310
07/31/2001
Preferred Term Securities III (PreTSL III)
Bank TruPS
A B Equity
Aaa Baa2
AAA BBB
3mL+100 3mL+290
11/28/2001
MM Community Funding II
Sandler ONeill SSB
85% new issue TruPS 5% secondary TruPS, 10% sub debt
A B Equity
Aaa A3
AA+ NR NR
AAA ANR
6mL + 100 6mL + 220
12/18/2001
Preferred Term Sec. IV (PreTSL IV)
Bank TruPs
A B Equity
$ 506.0 $ 341.0 $ 80.3 $ 927.3
12.8
Aaa A3
AAA NR
AAA A-
3mL + 100 3mL + 225
29
30
Trust Preferred CDO Issuance Database Continued

Date Offered 03/20/2002 Issuer Preferred Term Sec. V (PreTSL V) Manager/ Underwriter FT&KB Collateral TruPs and sub debts from banks and thrifts Class Senior Subs Size $ 312.0 $ 201.0 $ 513.0 $ 310.0 $ 177.0 $ 52.5 $ 539.5 $ 325.0 $ 135.0 $ 40.0 $ 500.0 07/01/2002 T-PREF Funding Bear, Salomon, Sandler ONeill 100% TruPS from banks and thrifts 95% new issued, 5% secondary A-1 A-2 B PS $ $ $ $ $ 222.0 100.0 201.0 58.9 581.9 10.0 10.0 10.0 10.0 Aaa Aaa A2 AAA AAA AAA AAA A NR 3mL + 90 3mL + 95 3mL + 185 Avg Life Mdys Aaa A3 S&P AAA A Fitch AAA APricing 3mL + 100 3mL + 210
03/26/2002
MM Community Funding III
Sandler ONeill SSB
95% new issue TruPS 5% secondary TruPS from banks and thrifts
A B C
30.0 30.0
Aaa A3
AAA NR
AAA A
6mL + 100 6mL + 205
06/24/2002
Preferred Term Sec. VI (PreTSL VI)
FT&KB
TruPs and sub debts from banks and thrifts
A B Income Notes
10.0 10.0 10.0
Aaa A3
AAA
AAA A+ NR
3mL + 70 3mL + 180 20% yld base case
09/20/2002
Preferred Term Sec. VII (PreTSL VII)
FT&KB
95% TruPS and 5% sub. debt from banks and thrifts
A1 A1 (wrap) A2 (seq) Mezz Income Notes
$ 189.0 N/A $ 120.0 $ 177.9 $ 45.2 $ 532.1 $ $ $ $ $ 220.0 100.0 196.0 62.0 578.0
Aaa Aaa Aa1
AAA AAA NR
AAA AAA A+
3mL + 80 3mL + 65 3mL + 90 3mL + 180
10/16/2002
TPREF Funding CDO II
Bear/Sandler/SSB Bear/Sandler/SSB
90% new issue TruPS, 5% 2ndary TruPS and 5% sub debt from banks and thrifts
A-1 A-2 B PS
NA NA NA
Aaa Aaa A3
AAA AAA NR
AAA AAA A-
3mL + 80 3mL + 95 3mL + 185 cpn

Date Offered 10/29/2002 Issuer Trapeza I Manager/ Underwriter Trapeza Capital Mgt. CSFB Collateral Static Pool of Trups, bank debts Baa2/Baa3 WAR Class A-1 A-2 B-1 B-2 B-3 C-1 C-2 D Equity Size $ 161.5 $ 20.0 $ 54.6 $ 2.0 $ 16.0 $ 29.6 $ 10.0 $ 16.5 $ 27.0 $ 337.2 $ 174.0 $ 12.0 $ 24.0 $ 40.6 $ 33.2 $ 28.2 $ 32.0 $ 344.0 $ 225.0 $ 100.8 $ 58.7 $ 30.7 $ 75.0 $ 43.9 $ 534.1 $ 115.0 $ 80.0 $ 24.3 $ 11.8 $ 38.5 $ 269.5 Avg Life 7.0 7.0 9.6 9.6 9.6 10.0 10.0 7.5 Mdys Aaa Aaa Aa1 Aa1 Aa1 A2 A2 Baa2 S&P AAA AAA NR NR NR NR NR NR Fitch AAA AAA AA+ AA+ AA+ A A BBB Pricing 6mL+78 4.9% cpn, S+80 6mL+105 6mL+120 5.9% cpn, S+125 6mL+180 6.4% cpn, S+180 6mL+265
11/18/2002
I-Preferred Term Sec. I
FT&KB
58% insurance TruPS; 37% surplus notes; 5% secondary TruPS
A-1 A-2 A-3 B-1 B-2 B-3 Equity
10.0
AAA
10.0
A-
AAA AAA AAA AAA-
3mL+125 4.3%/3mL+125 5%/3mL+125 3mL+210 5.15%/3mL+210 5.9%/3mL+210 NR
12/19/2002
Preferred Term Sec. VIII (PreTSL VIII)
FT&KB
80% new issue TruPS 9% new issue surplus notes 11% sub. Debt from banks thrifts
A-1 A-2 B-1 B-2 B-3 Equity
Aaa Aaa A1 A2 A3
AAA AAA NR NR NR
AAA AAA A A A
L+80 L+90 L+190 L+190 L+190
12/19/2002
T-PREF Funding III
Bear, Salomon, Sandler ONeill
89% new issue TruPS 8% secondary TruPS, 3% sub debt from banks and thrifts
A-1 A-2 B-1 B-2 Equity
Aaa Aaa A2 A2
AAA AAA
AAA AAA A A NR
3mL + 80 3mL + 90 3mL + 190 S+190 (5.34%) NA
31
32

Date Offered 02/19/2003 Issuer Trapeza II Manager/ Underwriter Trapeza Capital Mgt CSFB Collateral TruPS from various banks and thrifts Class A1a A1b B C1 C2 D Equity Size $ 132.0 $ 100.0 $ 27.0 $ 43.5 $ 54.8 $ 18.7 $ 35.9 $ 411.9 $ 245.0 $ 42.0 $ 33.0 $ 86.0 $ 16.3 $ 66.3 $ 34.0 $ 522.5 $ 126.0 $ 45.0 $ 50.0 $ 60.0 $ 33.0 $ 314.0 $ 45.0 $ 90.0 $ 42.0 $ 48.0 $ 32.0 $ 25.0 $ 28.0 $ 310.0 8.9 16.9 24.6 24.6 Avg Life 6.0 8.2 10.0 10.0 10.0 8.5 Mdys Aaa Aaa Aa1 A2 A2 Baa2 S&P AAA AAA NR NR NR NR Fitch AAA AAA AA+ A A BBB Pricing 6mL+65 6mL+88 6mL+70 6mL+190 Sw+190 6mL+265
03/18/2003
Preferred Term Sec. IX (PreTSL IX)
FT&KB FT&KB
TruPS from various banks and thrifts and some sub debts
A-1 A-2 A-3 B-1 B-2 B-3 Income Notes
Aaa Aaa Aaa A2 A2 A2
AAA AAA AAA NR NR NR
AAA AAA AAA A A A
3mL+75 3mL+85 Sw+85 3mL+180 3mL+180 3mL+180
03/31/2003
MM Community Funding IX, Ltd.
SSB/Sandler
TruPS from various banks and thrifts and subordinated bank debt
Aaa Aaa A3 A3
AAA AAA NR NR
AAA AAA AA-
3mL+75 3mL+90 3mL+180 Sw+180
04/23/2003
Tropic CDO I
Bear Stearns Bear Stearns
TruPS from various banks and thrifts and subordinated bank debt
A-1L A-2L A-3L A-4L A-4 B-1L Equity
Aaa Aaa Aa1 A2 A2 Baa2
AAA AAA NR NR NR NR
AAA AAA AA+ AABBB
3mL+80 3mL+90 3mL+130 3mL+185 3mL+190

Date Offered 05/15/2003 Issuer I-Preferred Term Securities II Manager/ Underwriter FT&KB FT&KB Collateral 75% new issue TruPS 22% new issue surplus notes 3% secondary TruPS and surplus note from insurance co. Class A-1 A-1A A-2 A-3 B-1 B-2 B-3 C Equity Size $ 76.8 $ 151.8 $ 68.0 $ 7.0 $ 86.5 $ 9.5 $ 52.3 $ 26.2 $ 45.0 $ 523.1 $ 209.8 $ 49.5 $ 75.0 $ 15.0 $ 36.4 $ 385.6 $ 108.5 $ 71.5 $ 25.0 $ 31.3 $ 31.3 $ 14.5 $ 8.0 $ 26.8 $ 316.8 $ 287.0 $ 67.0 $ 2.0 $ 88.0 $ 19.0 $ 70.5 $ 47.3 $ 580.8 5.9 8.3 10.0 10.0 10.0 7.9 Avg Life Mdys S&P AAA AAA AAA AAA AAABBB Fitch AAA AAA AAA AAA AAABBB Pricing 3mL+110 3mL+125 3mL+120 4.45% 3mL+200 4.35% 5.20% 3mL+325
05/23/2003
InCaps Funding I, Ltd
Citigroup Citigroup
Insurance TruPS (51%), surplus notes (35%) , and senior notes (14%)
A B-1 B-2 C Equity
Aaa
AAA AABBB
3mL+125 3mL+200 Sw+200 (4.85%) 3mL+325
05/27/2003
Trapeza III
Trapeza CSFB
TruPS from various banks and thrifts Baa2/Baa3 WAR; 3.3% per issuer
A1-A A1-B B C-1 C-2 D E PS
AAA AAA NR NR NR NR
AAA AAA AA+ A A BBB BB NR
6mL+63 6mL+85 6mL+105 6mL+175 Sw+175 (4.454%) 6mL+265 10%
06/26/2003
Preferred Term Securities X (PreTSL X)
FT&KB FT&KB
TruPS from various banksand thrifts and some sub debts
A-1 A-2 A-3 B-1 B-2 B-3 Income Notes
AAA AAA AAA A A A
3mL+72 3mL+86 3mL+86 3mL+170 3mL+170 3mL+170
33
34

Date Offered 08/27/2003 Issuer Dekania CDO I Manager/ Underwriter Dekania Capital Mgt. Merrill Lynch Collateral Insurance trust preferred & surplus notes Class A-1 A-2 B C-1 C-2 D PS Size $ 120.0 $ 69.0 $ 40.0 $ 6.0 $ 30.0 $ 16.3 $ 25.6 $ 306.9 $ 343.0 $ 70.0 $ 124.5 $ 13.0 $ 65.5 $ 53.6 $ 669.6 $ 149.0 $ 66.0 $ 56.7 $ 45.0 $ 27.4 $ 344.1 $ 145.0 $ 50.0 $ 35.0 $ 38.0 $ 30.0 $ 15.0 $ 31.0 $ 344.0 $ 145.0 $ 95.0 $ 33.0 $ 44.5 $ 44.5 $ 14.0 $ 10.0 $ 35.8 $ 421.8 8.4 10.0 10.0 10.0 Avg Life 8.2 10.0 10.0 10.0 10.0 8.3 Mdys S&P AAA AAA AA AABBB Fitch AAA AAA AA AABBB NR Pricing 6mL+75 6mL+110 6mL+149.3 6mL+207 S+207 6mL+400
09/12/2003
Pref. Term Securities XI (PreTSL XI)
FT&KB FT&KB
TruPS from various banksand thrifts from insurance co.
A-1 A-2 B-1 B-2 B-3 Sub Income Notes
Aaa Aaa A2 A2 A2
AAA AAA A A A
AAA AAA A A A
3mL+65 3mL+83 3mL+160 4.30% 5.30%
09/18/2003
Alesco Preferred Funding I
Cohen Brothers Merrill/Sandler
Bank TruPS
A1 A2 B1 B2 PS
Aaa Aaa A3 A3
AAA AAA NR NR
AAA AAA AANR
3mL+64 3ML+110 3mL+170 3mL+170 Fed funds
9/25/2003
Tropic CDO II Ltd.
Bear Stearns Bear Stearns
TruPS from various banksand thrifts and some sub debts
A-1L A-2L A-3L A-4L A-4 B-1L PS
7.1 10.0 10.0 10.0 10.0 10.0
AAA AAA NR NR NR NR
AAA AAA AA AABBB
3mL+75 3mL+90 3mL+125 3mL+180 3mL+180 3mL+300
9/26/2003
Trapeza IV
Trapeza CSFB
Bank TruPS
A1A A1B B C1 C2 D E Equity
5.9 8.3 10.0 10.0 10.0 7.9
AAA AAA NR NR NR NR
AAA AAA AA+ A A BBB BBB-
6mL+58 6mL+83 6mL+125 6mL+165 5.006%/6mL+165 6mL+260 10%
Trust Preferred CDO Issuance Database - Continued

Date Offered 10/29/2003 Issuer I-Preferred Term Securities III Manager/ Underwriter FT&KB FT&KB Collateral 53% new issue TruPS; 41% surplus notes; 6% secondary TruPS and surplus note from insurance co. Class A-1 A-2 A-3 A-4 B-1 B-2 B-3 C Equity Size $ 251.5 $ 40.0 $ 15.0 $ 10.0 $ 51.0 $ 27.7 $ 57.5 $ 24.5 $ 43.4 $ 520.6 $ 120.0 $ 50.0 $ 33.0 $ 25.0 $ 41.0 $ 13.0 $ 5.0 $ 8.0 $ 26.7 $ 321.7 $ 118.5 $ 50.5 $ 47.5 $ 47.0 $ 16.0 $ 33.6 $ 313.1 $ 150.0 $ 66.0 $ 64.3 $ 40.0 $ 28.3 $ 348.6 $ 144.0 $ 62.0 $ 22.0 $ 95.0 $ 40.5 $ 363.5 Avg Life Mdys Aaa Aaa Aaa Aaa A3 A3 A3 NR S&P AAA AAA AAA AAA AAABBB Fitch AAA AAA AAA AAA AAABBB Pricing 3mL+100 3mL+110 3.975%/3mL+1.10% 4.9%/3mL+1.10% 3mL+190 4.775%/3mL+190 5.7%/3mL+190 3mL+325
12/02/2003
Trapeza V
Trapeza CSFB
Bank Trust-Preferred
A1A A1B B C-1 C-2 D 1 Combo security 2 combo security PS
7.4 10.1 10.1 10.1 10.1 7.9
AAA AAA NR NR NR NR
AAA AAA AA+ A A BBB AAA BBB NR
6mL+58 6mL+83 NA 6mL+165 S+165 6mL+265 NA 4%
12/05/2003
InCaps Funding II, Ltd
Citigroup Citigroup
Insurance TruPS (45%), surplus notes (45%) , and senior notes (10%)
A-1 A-2 B-1 B-2 C Income Notes
Aaa Aaa Aa1 A2 A2
AAA AAA NR NR NR
AAA AAA AABBB
3mL+95 3mL+120 3mL+190 5.50% 3mL+325
12/12/2003 Alesco Preferred Funding II, Ltd./Inc.
Cohen Brothers Merrill Lynch
Bank TruPS
A-1 A-2 B-1 B-2 PS
Aaa Aaa A2 A2
AAA AAA NR NR
AAA AAA A A NR
3mL+58 3mL+110 3mL+165 5.135%/3mL+165
02/05/2004 Regional Diversified Funding 2004-1
Citigroup Citigroup
TruPs from 29 regional banks
A-1 A-2 B-1 B-2 Income Notes
Aaa Aaa A3 A3
AAA AAA NR NR
AAA AAA AANR
3mL+55 3mL+85 3mL+165 5.012%;3mL+165
35
36

Date Offered 02/05/2004 Issuer Tropic III Manager/ Underwriter Bear Stearns Bear Stearns Collateral Bank TruPs Class A-1L A-2L A-3L A-4L A-4A A-4B PS Size $ 158.0 $ 45.0 $ 31.0 $ 20.0 $ 41.0 $ 20.0 $ 30.0 $ 345.0 $ 100.0 $ 24.0 $ 45.0 $ 24.0 $ 17.4 $ 210.4 $ 276.3 $ 27.0 $ 7.8 $ 21.5 $ 98.4 $ 21.5 $ 44.0 $ 42.8 $ 539.1 $ 160.0 $ 70.0 $ 40.5 $ 63.5 $ 28.8 $ 362.8 $ 200.0 $ 12.5 $ 29.5 $ 60.0 $ 21.2 $ 30.0 $ 15.0 $ 5.0 $ 41.5 $ 414.7 8.4 10.0 10.0 10.0 Avg Life 7.6 9.9 9.9 9.9 9.9 9.9 Mdys Aaa Aaa Aa2 A3 A3 A3 S&P AAA AAA NR NR NR NR Fitch AAA AAA AA AAANR Pricing 3mL+65 3mL+88 3mL+120 3mL+170 S+170 (5.206%) 6.08%
02/26/2004
U.S. Capital Funding I, Ltd./Corp.
StoneCastle Advisors, LLC Sandler ONeill
TruPS of bank and thrift hlding co.s
Aaa Aaa A3 A3 NR
AAA AAA NR NR NR
AAA AAA AANR
3mL+62 3mL+88 3mL+170 3mL+170 NA
03/09/2004 Preferred Term Securities XIII Ltd./Inc. (PreTSL XIII)
FT&KB FT&KB
Trups from banks and thrifts and some sub debts
A-1 A-2 A-3 A-4 B-1 B-2 B-3 Income Notes
Aaa Aaa Aaa Aaa A2 A2 A2
AAA AAA AAA AAA NR NR NR
AAA AAA AAA AAA A A A NR
3mL+55 3mL+70 3mL+70 3mL+70 3mL+157 3mL+157 3mL+157
03/18/2004 Alesco Preferred Funding III Ltd./Inc.
Cohen Brothers Merrill/Sandler
Bank TruPS
Aaa Aaa A3 A3
AAA AAA NR NR
AAA AAA AANR
3mL+51 3mL+75 3mL+165 4.69%/3mL+165
03/26/2004
Dekania II
Dekania Capital Merrill Lynch
Insurance TruPS
A-1 A-2a A-2b B C-1 C-2 D-1 D-2 PS
8.6 10.0 10.0 10.0 10.0 10.0 8.3
Aaa NR NR NR NR NR NR
AAA AAA AAA AA AABBB
AAA AAA AAA AA AABBB BBB NR
3mL+65 3mL+100 Not Offered 3mL+135 3mL+190 S+190 (5.118%) 3mL+340 7.61%

Date Offered 04/08/2004 Issuer Trapeza VI Manager/ Underwriter Trapeza Capital CSFB Collateral Bank TruPS Class A-1A A-1B A-2 B-1 B-2 Combo 1 security Equity Size $ 155.0 $ 21.0 $ 59.4 $ 39.5 $ 56.5 $ 5.0 $ 30.4 $ 361.7 $ 172.0 $ 40.0 $ 8.0 $ 20.0 $ 6.0 $ 20.0 $ 20.0 $ 286.0 $ 195.0 $ 63.0 $ 7.0 $ 62.4 $ 51.6 $ 3.0 $ 33.5 $ 415.5 $ 162.5 $ 37.0 $ 13.9 $ 54.6 $ 25.5 $ 12.5 $ 6.2 $ 25.4 $ 337.5 Avg Life 7.6 10.1 10.1 10.1 10.1 Mdys Aaa Aaa Aaa A2 A2 S&P AAA AAA NR NR NR Fitch AAA AAA AAA A A BBB Pricing 6mL+45 6mL+65 NA 6mL+160 S+160 2%
04/23/2004
ICONS
Morgan Stanley Morgan Stanley
Insurance TruPS
A B C-1 C-2 C-3 D Equity
9.3 10.0 8.9 8.9 8.9 8.9
Aaa Aa1 A3 A3 A3 NR
AAA AA A A A BBB
AAA AA A A A BBB
3mL+88 3mL+125 3mL+185 S+185 S+185 S+325
04/30/2004
Alesco IV
80% Baa2/Baa3 Bank Trups and 20% subordinated debt
A1 A2 A3 B1 B2 B3 Equity
8.4 10.0 10.0 10.0 10.0 10.0
AAA AAA AAA A A A
3mL+48 3mL+70 5.6% fixed 3mL+165 5.7% fixed 6.6% fixed
05/07/2004
I-PRETSL IV
FTN/KBW FTN/KBW
Insurance TruPS
A-1 A-2 A-3 B-1 B-2 C D Equity
Aaa Aaa Aaa A3 A3 Baa2 Ba2
AAA AAA AAA AABBB NR
AAA AAA AAA AABBB BBB-
3mL+65 3mL+75 S+75 (4.91%) 3mL+175 S+175 (5.91%) 3mL+275 3mL+445
37
38

Date Offered 06/17/2004 Issuer Preferred Term Securities 14 Manager/ Underwriter FTN/KBW Collateral TruPS of bank and thrift hlding co.s Class A-1 A-2 B-1 B-2 B-3 C Income Notes Size $ 257.8 $ 62.0 $ 117.0 $ 10.8 $ 13.0 $ 4.0 $ 39.0 $ 503.6 Avg Life Mdys Aaa Aaa A2 A2 A2 NR NR S&P AAA AAA NR NR NR NR NR Fitch AAA AAA A A A BBB+ NR Pricing 3mL+48 3mL+60 3mL+157 3mL+157 3mL+157 3mL+240 NA
06/24/2004
U.S. Capital Funding II
StoneCastle Advisors, LLC Sandler ONeill
TruPS of bank and thrift hlding co.s
$ 171.0 $ 33.5 $ 70.0 $ 40.0 $ 34.1 $ 348.6 $ 189.0 $ 42.0 $ 10.0 $ 42.5 $ 37.6 $ 4.5 $ 6.3 $ 33.0 $ 364.8 $ 323.1 $ 63.4 $ 15.0 $ 114.5 $ 22.0 $ 36.0 $ 10.0 $ 41.4 $ 625.4 8.7 10.0 10.0 10.0 10.0 10.0 10.0
Aaa Aaa A3 A3 NR
AAA AAA NR NR NR
AAA AAA AANR
3mL+55 3mL+75 3mL+165 3mL+165 NA
08/19/2004
Alesco Preferred Funding V
Bank TruPS
A-1 A-2 B C-1 C-2 C-3 D PS
Aaa Aaa Aa2 A2 A2 A2 Baa2
AAA AAA AA NR NR NR NR
AAA AAA AA A A A BBB
3mL+48 3mL+65 3mL+130 3mL+165 5.49% 6.31% 3mL+300 NA
09/16/2004
Preferred Term Securities XV
FTN/KBW FTN/KBW
84% bank and 16% insurance TruPS
A-1 A-2 A-3 B-1 B-2 B-3 C PS
Aaa Aaa Aaa A2 A2 A2 NR NR
AAA AAA AAA A A A NR NR
AAA AAA AAA NA NA NA BBB NR
3mL+48 3mL+58 Swaps+58 3mL+157 Swaps+ 157 Swaps+157 3mL+250 NA

Date Offered 10/01/2004 Issuer Trapeza VII Manager/ Underwriter Trapeza CSFB Collateral Bank and thrift trust preferreds and subordinated debt Class A1 A2 B1 B2 PS Size $ 194.0 $ 32.0 $ 56.5 $ 37.5 $ 31.5 $ 351.5 $ 160.0 $ 40.0 $ 35.5 $ 28.0 $ 35.0 $ 20.0 $ 27.5 $ 346.0 8.2 10.2 10.2 10.0 10.0 10.2 NA Avg Life Mdys Aaa Aaa A2 A2 NA S&P AAA AAA NR NR NA Fitch AAA AAA A A NA Pricing L+41 NA L+155 5.38% NA
11/02/2004
Tropic CDO IV
Bear Stearns
Bank and thrift TruPS
A-1L A-2L A-3L A-4L A-4A B-1L PS
Aaa Aaa Aa1 A3 A3 Baa3 NR
AAA AAA AANR NR NR NR
AAA AAA AA AABBB NR
3mL+43 3mL+56 3mL+100 3mL+160 5.36% 3mL+300 NA
Source: FR Markets, MCM, Fitch Ratings, Moodys, Standard & Poors
39
Analyst Certification
I, Lang Gibson, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.
Important Disclosures
Copyright 2004 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). All rights reserved. Any unauthorized use or disclosure is prohibited. This report has been prepared and issued by MLPF&S and/or one of its affiliates and has been approved for publication in the United Kingdom by Merrill Lynch Pierce, Fenner & Smith Limited, which is authorized and regulated by the Financial Services Authority; has been considered and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ABN 65 006 276 795), licensed under the Australian Corporations Act, AFSL No 235132; has been considered and distributed in Japan by Merrill Lynch Japan Securities Co, Ltd, a registered securities dealer under the Securities and Exchange Law in Japan; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is regulated by the Hong Kong SFC; and is distributed in Singapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd (Company Registration No. 198602883D), which are regulated by the Monetary Authority of Singapore. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities (related investments). Officers of MLPF&S or one of its affiliates may have a financial interest in securities of the issuer(s) or in related investments. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. The bonds of the company are traded over-the-counter. Retail sales and/or distribution of this report may be made only in states where these securities are exempt from registration or have been qualified for sale. MLPF&S usually makes a market in the bonds of this company. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.
40

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

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

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FIXED INCOME STRATEGY

Trust Preferred CDOs: A Primer

Highlights of This Issue

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

Fixed Income Strategy

Trust Preferred CDOs: A Primer 11 November 2004

Trust Preferred CDOs: A Primer

Trust Preferred Securities Overview

Refer to important disclosures on page 40.

Bank or Bank Holding Company

Subordinated Debt & Debt Payments

Proceeds of Trust Preferred Securities offering

Special Purpose Business Trust (Issuer)

Trust Preferred Securities & Dividend Payments

Trust Preferred Investors

Source: Merrill Lynch

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

TruPS CDO Overview

Source: Merrill Lynch

Refer to important disclosures on page 40.

Source: Merrill Lynch, Cohen Brothers

Collateral Loss Trends: Banks and Insurers

ar Ju 00 nS e 00 p D -00 ec M 00 ar Ju 01 nS e 01 p D -01 ec M 01 ar Ju 02 nS e 02 p D -02 ec M 02 ar Ju 03 nS e 03 p D -03 ec M 03 ar Ju 04 nS e 04 p04

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Chart 5: Historical Bank Failures: 1934 2003

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Global Corporate Defaults*

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

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

Source: Merrill Lynch

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Refer to important disclosures on page 40.

Cash Flow Analysis

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Table 2: Case Study TruPS CDO Example Capital Structure

Size $195.00 $ 63.00 $ 7.00 $ 62.38 $ 51.62 $ 3.00 $ 33.50

Ratings (Fitch/MoodysS&P) AAA/Aaa/AAA AAA/Aaa/AAA AAA/Aaa/AAA A/A2 A/A2 A/A2 NR

Sub.* 51.25% 33.75%

Avg. Life 8.7 10 10 10 10 10 NA

Rating AAA/Aaa/AAA AAA/Aaa/AAA A/A2

CADR* 11.9% 8.5% 2.4%

Cumulative Defaults 62.3% 49.3% 16.8%

Cumulative Losses 56.1% 44.4% 15.1%

WAL 7.86 9.95 9.95

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

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

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer 11 November 2004

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

-10.00% CDR 10 Yr Auction Call* 30 Yr Maturity* Yr 6 100% Prepays Yr 6 30% CPR**

Source: Merrill Lynch