Abs CDS

ABS CDS: The Next Frontier
March 2006 Update
US Securitization Research
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ABS CDS: The Next Frontier

Inna Koren Joseph Astorina Elena Warshawsky +1 212 412 1080 +1 212 412 5435 +1 212 412 3661 [email protected] [email protected] [email protected]
Technicals Continue to Drive Spread Volatility

The derivatization of the ABS market continues with the recent initiations of ABX.HE and CMBX index trading. Following the surge of activity in single-name ABS credit default swaps (CDS) late last year, the index launches complete the triumvirate of cash, synthetic, and index products in the home equity ABS (HEL) and commercial mortgage-backed securities (CMBS) arenas. However, we believe this is just the beginning for the broader ABS market. Additional asset classes are expected to come on line soon, with standardized International Swaps and Derivatives Association (ISDA) ABS CDS documentation for other consumer ABS sectors, as well as CDOs. Depending on market reception, additional indices may soon follow. The much-anticipated introduction of the ABX.HE index in January was met with great fanfare. Though the index initially served to drain liquidity from the single-name market, both sectors have continued to garner interest. Evidence of continued support comes from the release of a revised dealer form of the ABS CDS template confirmation (Form I) and the so-called End-User template confirmation (Form II). While differences continue to exist between the two forms, the majority of trading to date has been transacted with Form I, a trend we expect to continue. We believe strong demand from structured finance CDOs, combined with portfolio managers actively engaging in the subordinate HEL market during H1 06, will anchor interest in synthetics. Growth in the ABS CDS market has exploded since the standardization of documentation and the pay-as-you-go (PAUG) settlement procedures for such transactions in June 2005. The markets embrace of the synthetic product has realigned spread drivers in the HEL arena. Whereas previously cash HEL spreads were largely correlated with the depth and breadth of the new issue pipeline, fundamental collateral performance, and the strong CDO bid for collateral, the increased use of ABS CDS has led to a more volatile and technically oriented market. This trend is likely to continue for the near term as the synthetic ABS market grows and matures. Nevertheless, savvy investors can capitalize on this volatility, putting on cash, synthetic, and/or index basis and relative value trades, as can CDO managers, by changing allocations between cash and synthetic collateral as warranted.
This report published March 20, 2006. Barclays Capital US Securitization Research 1
Opportunities in Single-Name CDS and ABX.HE

Single-name ABS CDS allows execution of a variety of new trading strategies The growth in single-name ABS CDS provides numerous new trading and hedging opportunities to ABS market participants seeking to express an opinion on the underlying credit of a reference obligation or the market as a whole. Prior to the advent of this product, a bearish investor could at most reduce a cash position to zero, wait for spreads to widen, and then buy back in at the wider spread levels because there was no efficient method of creating a short position. In addition, an investor who could not find a specific tranche from a particular deal in the secondary market had to consider an alternative investment. However, single-name ABS CDS have changed this dynamic by allowing a variety of leveraged trades and hedges to be executed with minimal, or no, upfront costs. These strategies enable investors to: Express a bearish view by effectively replicating a short position (ie, buy protection) and profiting if the referenced ABS tranche experiences a credit event, or the protection buyer unwinds the trade once spreads widen. Source scarce collateral by synthetically replicating a long position (ie, sell protection) in an underlying reference obligation. This feature is particularly attractive to some investors given the fact that the long position created synthetically can be greater than the outstanding balance of the ABS tranche being referenced. Engage in cash, synthetic, and/or index basis and relative value trades. Take a view on the credit curve by buying and selling protection on differently rated tranches within the same securitization (ie, capital structure trades), or take a view on vintage performance by buying and selling protection on different vintage years (ie, vintage trades). Engage in issuer basis trades by buying and selling protection on different originators. Lock in a spread by hedging exposure to long cash positions without having to liquidate (perhaps into an inhospitable market). Hedge underlying ABS included in a CDO during the ramp-up period or ABS issuer warehouse facilities in anticipation of term ABS transactions.
New Spread Dynamics in Cash, CDS and ABX.HE

The growth and acceptance of ABS CDS has altered the cash/synthetic spread paradigm The volatility in subordinate HEL spreads in late 2005 was uncharacteristic of the muted reaction and general stability the market has observed over the last few years in response to negative headlines regarding the state of the US housing market (eg, disappointing homebuilder earnings announcements, lower housing starts, and expectations of significantly higher mortgage rates). While HEL spread levels had largely been driven by the depth and breadth of the new issue pipeline, fundamental collateral performance, and the strong SF CDO bid for collateral, the growth and acceptance of standardized ABS CDS has altered this paradigm. The recent volatility was mainly a result of new market forces acting in the HEL sector, causing supply/demand imbalances that magnified cash and synthetic ABS spread movements.
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Although there was sporadic synthetic ABS activity prior to, and just after, the ISDA introduced the standardized template for PAUG ABS CDS referencing HEL and CMBS in June 2005, full-fledged, two-way trading did not take hold until late summer/early fall as investors comfort level with the product slowly rose. Nevertheless, the standardization of ABS CDS paved the way for increased liquidity in the synthetic sector and invited new and veteran ABS market players alike to use CDS as a risk-management tool and an investment vehicle. In particular, standardized ABS CDS allow investors to express their views on the HEL sector and the US housing market in ways never before possible with cash products, leading to explosive growth in synthetics.
Figure 1: Baa3 HEL Cash, Synthetic and ABX.HE.BBB- Spreads

400 HEL Baa3 CDS Baa3 ABX.HE.BBB-
350
300
250
200
150 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06 Feb 06 Mar 06
Source: Markit, Barclays Capital.
Baa3 ABS CDS led cash spreads wider at end-2005
From September to November 2005, a number of large macro hedge funds plowed into the ABS CDS sector, buying protection on Baa3 HEL in large volume. Additional protection buying emanated from investors placing capital structure arbitrage and other relative value or hedging trades that required a liquid vehicle to go short. These buyers of protection far outstripped sellers (CDOs and dealers), resulting in a hit ratio on ABS CDS OWICs (offer wanted in comp) as low as 20%. In addition, hedge funds shorted primarily weaker (based on either collateral or structure) Baa3 names, while protection sellers, primarily synthetic CDOs and cash CDOs filling synthetic buckets, gravitated towards selling protection on stronger names. This led to dramatic tiering between stronger and weaker HEL names. The supply/demand dynamic in the CDS market induced spread widening and affected the cash market, albeit with a few weeks lag (Figure 1). At the worst levels, both ABS CDS and cash spreads gapped out almost 200 bp in lower-rated tranches. In late December, Baa3 tranches traded in the mid- to high300 bp range, with 20 bp swings in one day being common.
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Figure 2: Synthetic HEL ABS Spread Levels and Basis

400 350 300 250 200 150 100 50 Oct 05 Nov 05 Dec 05 Jan 06 Feb 06 Mar 06 Baa1 Baa2 Baa3
120 100 80 60 40 20 0 -20 -40 -60 Oct 05 Nov 05 Dec 05 Jan 06 Feb 06 Mar 06 CDS Basis
Source: Barclays Capital.
Cash versus CDS Basis

The ABS CDS basis has been volatile of late The Baa3 ABS CDS/cash basis exhibited high volatility from October to December, fluctuating some 140 bp (Figure 2). The spread movements reflected the supply and demand technicals of the emerging ABS CDS sector rather than credit fundamentals of the underlying HEL, which remain solid by all measures. The ABS CDS basis in the subordinate market is constrained by i) the CDO bid that arises when CDS spreads widen significantly to cash and ii) savvy investors who will buy cash HEL and protection on the same name if cash trades significantly wider than CDS. In the former case, SF CDOs will shift allocations to synthetic ABS, while, in the latter, investors can lock in a risk-free spread subject to counterparty risk on floating payments. Accordingly, demand from CDO managers to sell mezzanine protection in late November and December placed tightening pressure on synthetic spreads. The strong CDO bid late in the year also provided support to cash HEL spreads, reversing the widening observed earlier in the quarter. The tightening trend continues in 2006, supported by the strong cash bid in the first quarter. In addition to supply and demand dynamics, other factors driving the basis between cash ABS and single-name ABS CDS include: Cost of Funds: CDS premium reflects the unfunded nature of the swap. The funding cost component of the CDS premium is dictated by the ABS CDS market participants cost of funds, whereby investors ability to finance at sub-LIBOR levels drives CDS spreads tighter and their above-LIBOR financing costs push CDS spreads wider. The cost of funds component of the CDS basis should reflect the equilibrium cost of funds among ABS CDS investors. Counterparty Risk: ABS CDS subject buyers and sellers to counterparty risk. In a cash ABS bond, investors are paid from cash flows of the underlying assets. In ABS CDS, protection sellers rely on the protection buyers ability to make the monthly fixed payment (ie, the premium). The protection seller is at risk to the extent the buyer is unable to make those payments. The reverse is also true: the protection buyer is exposed to the risk of the protection sellers not being able to make floating payments as required under the ABS CDS contract.
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Available Funds Cap: The extent of AFC risk transference (full, fixed, or variable) has implications for the basis. Other things being equal, as the degree of AFC risk rises, protection sellers will demand incrementally more spread (ie, full cap transfer trades wider than variable cap, which, in turn, trades wider than fixed cap). Coupon Step-Up Provision: Optional termination of the contract if the underlying reference obligations coupon steps-up offers additional flexibility to the CDS protection buyer. The protection seller will require incremental premium for the added optionality considering no similar feature exists in cash ABS. Implied Writedown: Inclusion (or exclusion) of implied write-down language in the CDS contract that is not applicable to the reference obligation can contribute to the CDS basis. Liquidity: Cash and ABS CDS demand different liquidity premiums, reflecting the fact that cash and synthetic ABS are not yet completely fungible. With additional acceptance of the product, less liquidity premium will be required, particularly since ABS CDS offer the ability to reference collateral in amounts greater than available in the cash market. Additionally, the basis between single-name ABS CDS and ABX.HE is driven largely by structural (namely the fact that the indices trade with a fixed cap, no physical settlement and no coupon step-up while single-name CDS terms can vary) and liquidity differences between the products. The ABS CDS basis is generally negative from AAA to A and positive for Baa1 and below In general, single-name ABS CDS trade inside of cash bonds at the Aaa to A rating levels and wide to cash bonds at rating levels of Baa1 and below; however, currently all rating levels of CDS are trading through cash. While there has not been much synthetic trading activity at rating levels above Baa1, Aaa last cash flow seniors trading in the high twenties in the cash market are quoted in the low teens in the ABS CDS market. Baa3 mezzanine tranches trading at +210 to +230 bp in the cash market are quoted +190 to +220 bp in the ABS CDS market. Note that this basis has changed in the past and can change very quickly in the future depending on market sentiment and technicals.
Liquidity Ebbs and Flows, but Continues to Grow

Improved bid/ask spreads indicate growing liquidity Liquidity in the sector continues to improve, as more investors get comfortable with this product and gain an understanding of the many intricacies of the ABS CDS market. The bid/offer spread on single-name ABS CDS is typically as tight as 5-10 bp for Aaa to A3 reference obligations and upwards of 20-50 bp for the Baa stack. The wide bid-ask in the lower-rated ABS CDS indicates that the liquidity in this segment, while improved, is still growing. This compares with a bid/offer spread of 1-3 bp and 5-15 bp on cash Aaa to A2 and Baa1 to Baa3, respectively, and 2-5 bp on the full ABX.HE index (AAA to BBB-). Single-name ABS CDS typically trade with notional amounts of $5-10mn in lower-rated classes but can be substantially larger higher up in the capital structure. Protection can be bought and sold on notional amounts that are significantly greater than the original principal amount of the reference obligation. ABX.HE notional amounts are typically $25100mn for the AAA, AA, and A indices, and $10-25mn for the BBB and BBB- indices. Most single-name and index trading in todays market occurs at the Baa2/BBB and Baa3/BBBlevels, though the AAA and AA indices have seen decent volume as well.
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Market technicals, rather than fundamentals, are the main spread drivers currently
The relative novelty of the ABS CDS market, with a rapidly expanding, though still limited investor base, makes it a technical-, rather than fundamental-driven, sector at the moment. Late last year, hedge funds were able to capitalize by creating a snowball effect: through voraciously seeking to buy protection, they were able to push synthetic, and ultimately cash, Baa3 HEL spreads wider. Until the market develops broader support, technical inefficiencies will likely continue to spill over into the cash market and cause sporadic bouts of volatility. However, if tiering persists and credit fundamentals remain sound, the magnitude is likely to be less severe. Nevertheless, savvy buy and hold investors can find opportunities in this volatility, as can CDO managers. The former can put on cash, singlename, and/or index basis or relative value trades, while the latter will change allocation strategies between cash and synthetic collateral depending on behavior of the basis.
Dueling Templates: Form I vs. Form II

When ISDA released the original PAUG standardized confirmation (also known as the Dealer Form, or Form I, as its creation was largely driven by the dealer community), there was much debate whether it was more favorable to buyers or sellers of protection. On December 19, 2005, ISDA published the End-User template (Form II), which, though designed primarily for use with HEL and CMBS like the Dealer Form, incorporates several changes related to the treatment of implied writedown, coupon step-up, interest shortfall, and optional physical settlement as shown in Figure 3.
Figure 3: Key Differences between Form I and Form II

Form I / Dealer Form Implied Writedown Includes implied writedown provision whereby seller makes a floating payment to buyer in the amount of undercollateralization on the reference obligation. Gives buyer the option to terminate the contract under the coupon step-up provision. Form II / End-User Form Eliminates implied writedowns. Includes actual writedown only as described in the underlying reference obligation transaction documents. Does not provide for an optional termination of the contract upon coupon step-up. Fixed rate increases with the coupon on the reference obligation following a non-call event. Gives effect to AFC provisions on the underlying instrument.
Coupon Step-Up
Interest Shortfall
Has an option to account for AFC of the underlying instrument for the purposes of determining interest shortfall. Contains Full, Fixed and Variable cap risk transfer provisions.
Credit Events
Failure to Pay. Writedown. Distressed Rating Downgrade (optional).
Not applicable, though writedowns result in floating payments. Not applicable as there are no credit events in Form II.
Physical Settlement Allowed. Source: ISDA, Barclays Capital.
The creation of this template was driven in large part by mono-line insurers seeking to counter the influence of the dealer community in the synthetic space. Currently, however, the substantial majority of single-name ABS CDS are transacted using Form I, a trend we expect to continue.
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The ABX.HE Index Debuts

The ABX.HE index is the next step in the evolution of the ABS market Single-name ABS CDS technology has quickly become a building block for ABS market innovations, generating new investing, hedging, and trading strategies. The acceptance and proliferation of the ABS CDS technology have paved the way for the next logical step in the evolution of the ABS market: creation of an index of ABS CDS. Amid much anticipation, the ABX.HE indices began trading in January (see Appendix II on page 25 for details of the current composition of the ABX.HE indices). In conjunction with the commencement of trading, a revised set of index rules and a trade confirmation for ABX.HE were issued with minor changes from the drafts released on November 2, 2005. The ABX.HE indices are administered and published by Markit Group Limited, an organization formed in 2001 to improve transparency in the credit derivatives market. The ABX.HE indices create opportunity for new relative value trading and hedging strategies. The product provides investors with the ability to express a macro-level view on the housing market and its impact on home equity credit, place relative value trades (based on index tranche and/or vintage), hedge the systematic risk of an existing portfolio, or hedge production pipelines. Should they choose, investors can segregate spread risk from credit risk by rolling into new index series on the semiannual roll dates. Additionally, the index allows investors to offset the risk of a position that may otherwise be difficult to hedge with single-name ABS CDS. Although an imperfect hedge, an investor can trade in and out of the ABX.HE index more easily than single-name ABS CDS on illiquid reference obligations. Also CDO issuers are equipped with a way to hedge new issue spread risks (by buying protection on ABX.HE) during the CDO ramp-up period.
The index created new trading and hedging opportunities
Figure 4: ABX.HE 06-1 Implied Spreads

60 AAA AA A 325 300 50 275 40 250 225 30 200 20 175 150 10 125 0 Jan 13 Jan 27 Feb 10 Feb 24 Mar 10 100 Jan 13 Jan 27 Feb 10 Feb 24 Mar 10 BBB BBB-
Index spreads have tightened on stabilized trading volumes
As Figure 4 demonstrates, spreads on all index tranches have tightened since inception and are currently trading above par. On a spread basis, the AAA index trades through cash, but in line with single-names; the AA index trades between cash and single-names; and the A index trades wide to single-names, but in line with cash. The lower-rated (ie, BBB and BBB-) index tranches currently trade wide to both cash and single-name ABS CDS. Daily transaction volume is approximately $1bn, which is down slightly from the substantial
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volume seen in the first few days of index trading. Paradoxically, the introduction of the ABX.HE index initially reduced liquidity in single-name ABS CDS. However, this situation did not persist for long because synthetic structured finance CDO demand for subordinate HEL exposure remained strong. Although we expect trading volume to remain robust, we do not believe that the ABX.HE indices are a substitute for single-name ABS CDS in hybrid and synthetic CDOs. As this segment of the CDO market continues to grow, we expect singlename ABS CDS to gain greater liquidity, concurrent with the ABX.HE index.
Index Cash Flows

Each index transaction (a master transaction) is equivalent to separate independent ABS CDS transactions on each reference obligation (each a component transaction) in the index. Entering into a confirm for an index transaction is equivalent to entering into a confirm for each component transaction. Each component transaction is independent of, and unaffected by, the others. However, the component transactions are treated as a group for purposes of determining monthly payments between buyer and seller, as well as for trade assignment or unwind. The ABX.HE index contracts are designed to mirror the risk profile of an aggregate cash position in a portfolio of the HEL included in the index. The index contract is structured similarly to a standard single-name ABS CDS contract (See Appendix I on page 15 for a detailed description of the structure of single-name ABS CDS) with the following exceptions: No Distressed Rating Downgrade credit event; No coupon step-up if a reference obligation is not called; No physical settlement option; Available funds cap risk is always transferred using the Fixed Cap Applicable standard; and The indices trade on a dollar price basis (ie, the spread is set at creation of the index and the dollar price fluctuates as reference obligation spreads move). Initially, all reference obligations are weighted equally in the index, regardless of actual cash principal balances outstanding. The notional amount of the index changes as the underlying reference obligations principal balance is reduced (through scheduled or unscheduled payments, or write-downs), or as floating amounts related to principal are reversed and reimbursed to the protection seller. Since, in all likelihood, the 20 underlying index reference obligations will have different principal payment experiences, the index weight of the assets is likely to change over time. The change in index weightings will affect pricing, which will become more pronounced in off-the-run indices as reference obligations become more seasoned.
The Structure of the Index

ABX.HE references 20 HEL issuers and is priced daily and rolled every six months According to the Index Methodology for the ABX.HE Index (the index rules), the index is constructed from reference obligations issued by twenty issuers of HEL ABS (ie, the reference entities) that meet specific criteria. The index is broken into five sub-indices, each consisting of one tranche rated Aaa/AAA, Aa2/AA, A2/A, Baa2/BBB, and Baa3/BBB- (ie, the reference obligations) from each of the twenty issuers. The composition of the ABX.HE index is determined by the index administrator and dealer firms designated as ABX.HE participants in accordance with the index rules. The index composition rules give priority to issuers with the
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largest issuance volumes over the previous six months and are subject to originator and servicer concentration limits. A new ABX.HE index, and each sub index, will be launched on January 19 and July 19 (each an index roll date) of each year. ABX.HE participants must provide daily pricing on the index and rank the list of issues for inclusion in the index when required.
Figure 5: ABX.HE Index Roll Process

Ten Business Days Prior to Roll
Initial List Creation

- 25 largest issuers over the past six months - Two largest eligible transactions from each issuer
Seven Business Days Prior to Roll
ABX.HE Participants Rank Issues

- Each ABX.HE participant ranks their preference between the two eligible transactions from the 25 issuers
Master List Defined

- The 20 top-ranked transactions from the 20 largest issuers comprise the Master List - If more than one deal of the same issuer has the same ranking, preference is given to the larger deal - If two or more deals have the same ranking and deal size, preference is given to the latest transaction
Concentration Tests
- Same Originator: no more than four deals - Same Servicer: no more than six deals
Fail
with different originators/servicers
Substitute Deals
Pass
Four Business Days Prior to Roll
Index Composition Released

- Issuers of the 20 deals on the master list constitute the reference entities for the next six months - The five sub-indices will consist of the tranches of the master list transactions with the applicable rating
One Business Day Prior to Roll
Fixed Rate Determination

- Each participant provides an average spread for each sub-index - The top and bottom quartiles are excluded - Sub-index spreads are set at the average of the remaining values
Creation of the ABX.HE index entails four general phases: identification of the index universe; rank ordering of transactions within the universe; determining the index composition; and pricing of the index by ABX.HE participants (Figure 5 provides a graphical representation of the process). The roll process is initiated by Markit no fewer than 10 business days before the index roll date with the index administrator creating a list of the 25 largest issuers of HEL ABS over the past six months ranked by issuance volume (the initial list). Each issuer on the initial
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list must have priced at least one transaction within the last six months which meets selection criteria outlined in Figure 6. The initial list will include sub-lists consisting of the two largest eligible transactions from each of the 25 issuers. No later than seven business days prior to the roll date, the initial list is sent to the participating dealers, and each participant ranks its preference between the two transactions for each of the 25 issuers on the list.
Figure 6: ABX.HE Index Eligibility Criteria

Criteria Rating Collateral Qualifier Offering must include AAA, AA, A, BBB and BBB- tranches rated by both Moody's and S&P. The lowest of split ratings will determine the rating of a tranche. Debt or pass-through securities backed by a discrete pool of residential mortgages with weighted average FICO score not greater than 660. At least 90% of the pool of loans must be first lien mortgages. Aggregate deal principal amount of at least $500mn at issuance. Eligible AAA tranche size must be at least $50mn at issuance. Other than for AAA tranches, weighted average life of the tranche must be greater than four years at time of issuance. AAA tranches must have an expected average life of greater than five years at the time of issuance, and must be the longest AAA tranche in the transaction. Floating rate payment based on one-month Libor, disbursed on the 25th of the month. Issued and settled within six months of the index roll. Description of each tranche should be available on Bloomberg, though cash flows need not be. At least four of the tranches with the required ratings must be registered under U.S. Securities Act of 1933. No more than four transactions may have the same originator (where originator is defined as having originated more than 60% of the receivables pool), and no more than six transactions may have the same servicer (where servicer is defined as the master servicer or the entity that services more than 60% of the receivables pool).
Size Term
Coupon Deal Age Bloomberg Registration Concentrations
Source: Markit, Barclays Capital.
The 20 top-ranked transactions from the 20 largest issuers, subject to concentration limits, comprise the master list
The 20 top-ranked transactions from the 20 largest issuers by issuance volume comprise the master list of reference entities for the next six months. When more than one deal of the same issuer has the same aggregate ranking, preference is given to the deal with the largest deal size. If two or more transactions have the same ranking and deal size, the transaction with the later issuance date is given preference. In addition, the 20 topranked transactions must satisfy originator and servicer concentration limits. No more than four deals may be from the same originator, and no more than six transactions may have the same servicer. When these limits are exceeded, the administrator replaces the transaction of the lowest-ranking issuer that violates the originator concentration limit with the largest other transaction by the same issuer but with a different originator. If the lowest-ranking originator does not have any transactions with a different originator, the administrator repeats the process with the next lowest-ranking issuer that violates the originator concentration limit until a suitable substitution is found. If a substitution is still not possible, the administrator selects the largest qualifying transaction from the largest issuer included in the initial list but not on the master list, until the originator concentration limit is satisfied. The same procedure is then applied to correct any servicer concentration violations. Once all concentration limits are met, the issuers of the transactions on the master list constitute the reference entities for the ABX.HE index for the next six months. The five subindices (ABX.HE.AAA, ABX.HE.AA, ABX.HE.A, ABX.HE.BBB, and ABX.HE.BBB-) consist of the tranches of the transactions on the master list with the respective rating. For example, the class rated at least A2/A (ie, A2 or higher by Moodys and A by S&P, or A2 by Moodys and
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A or higher by S&P) from each of the 20 reference entities comprises the ABX.HE.A subindex. If more than one class meets this rating definition, only the more junior class is included in the sub-index. The index composition and current list of ABX.HE participants for the next six-month period are disclosed simultaneously to the ABX.HE participants and the public at least four business days prior to the index roll. The ABX.HE participants determine the spreads (ie, the fixed rates) on all the sub-indices one business day prior to index roll. Each dealer provides the index administrator with an average fixed rate spread for each sub-index; the top and bottom quartiles are excluded, and the sub-index spread is set at the mean of the remaining dealer spreads. Each sub-index is repriced daily, based upon closing mid-prices submitted by the ABX.HE participants. Again, the top and bottom quartiles are discarded, and the closing price is the mean of the remaining values.
Conclusion
Although the ABS CDS market is in the infancy of its product cycle, we believe it is poised for significant growth over the next few years, as more investors become comfortable with the intricacies of ABS CDS mechanics and the new relationship among the cash, singlename ABS CDS, and ABX.HE products. We see strong pockets of demand for synthetic ABS, specifically from structured finance CDOs, hedge funds, and dealers, as well as traditional cash HEL investors. We believe the synthetic HEL sector opens the next frontier in the evolution of the ABS market and paves the way for the introduction of standardized ABS CDS referencing other consumer ABS and CDOs. The rise of synthetic ABS has introduced technical volatility and interrelationships among cash and synthetics heretofore unseen. While liquidity has shown some signs of improvement (eg, tighter bid/ask spreads on single-name ABS CDS and ABX.HE), technical factors remain the primary driver of spreads. We expect this phenomenon to continue for the near term, until liquidity grows sufficiently. Nevertheless, investors should take comfort from the fact that this is a similar development path to that taken by the corporate CDS market, which also witnessed greater spread volatility in its early days.
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Appendices
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Appendix I: Single-Name ABS CDS 101

Corporate and ABS CDS are very different animals The origins of the single-name ABS CDS market can be traced to the corporate CDS market, which has grown exponentially over the past few years. While there are some similarities between the corporate and ABS CDS markets, many differences exist. Figure 7 highlights the structural differences between the two CDS markets, such as variations in reference entities/obligations, credit events, contract maturities, and settlement procedures owing to the complex nature of ABS product relative to unsecured corporate bond obligations.
Figure 7: Structural Differences Between ABS CDS and Corporate CDS

ABS CDS Reference Entity Reference Obligation Credit Events(1) Issuer of the asset-backed security referenced by the ABS CDS (eg, SABR) Specific tranche of a specific deal from the Reference Entity (eg, SABR 2005-OP1 B1) Failure to pay principal Writedown Distressed ratings downgrade(2) Corporate CDS Generally, unsecured corporate bond issuer (eg, Ford or General Motors) In some instances, limited to specific debt obligations of the reference entity Bankruptcy of the reference entity Failure to pay (either principal or interest) Repudiation/moratorium Obligation acceleration Obligation default Restructuring Settlement Pay-As-You-Go monthly until maturity of the Reference Obligation or physical settlement. Protection buyer has option for physical settlement upon Credit Event. Same as legal final maturity of Reference Obligation. Generally, physical upon Credit Event. Cash settlement occurs primarily in index trades.
Term
Typically between one and 10 years, with five being the most common.
Note: (1) Maturity Extension was removed as Credit Event in the latest version of the ISDA PAUG Dealer Form template released on January 23, 2006. (2) Optional where the reference obligation is a CMBS. Source: ISDA, Barclays Capital.
Due to the complex cash flow and structural features of ABS, reference entities for ABS CDS must be tranche specific
Reference Entity and Obligation: The reference entity in corporate CDS is typically a corporation that issues unsecured bonds; for example, Ford Motor Co., General Motors Corp., General Electric Co., MBIA Insurance Inc., and Altria Group. The performance of the reference entitys debt obligations generally reflects the health of the entity itself, and, as such, its various debt obligations of a given rating, maturity, and seniority level ought to trade similarly in a distressed situation. As a result, the debt is fungible in terms of availability for delivery against physical settlement of a corporate CDS. However, ABS transactions are conducted primarily through discrete trusts, with each deal backed by a distinct collateral pool. In ABS, it is possible that one transactions collateral pool is performing adequately, while anothers is not, even if both pools have been originated and are serviced by the same entity. Also, within a specific transaction, senior and subordinate classes can experience vastly different credit performance. For example, a subordinated tranche could see losses (ie, be written down), while the more senior tranches may perform satisfactorily. Thus, while the reference entity for an ABS CDS is generally the issuer (eg, SABR), the reference obligation must drill down deeper than the issuer or even the transaction level to a specific tranche of a specific transaction (eg, SABR 2005-OP1 B1) identified by a unique CUSIP/ISIN.
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Credit events had to be customized for ABS CDS
Credit Events: Corporate CDS are governed by well-defined credit events, the occurrence of which results in settlement. Standard ISDA documents list six credit events for corporate CDS, of which bankruptcy of the reference entity, failure to pay principal or interest, and restructuring of a reference entitys debt obligation have emerged as the most common and important. However, these events are not readily applicable to ABS CDS in all instances. For example, ABS transactions are issued by special purpose bankruptcy remote entities, meaning that a bankruptcy of the issuing trust is highly unlikely and making a credit event based on such an occurrence insignificant. Also, for ABS, the events that should constitute a failure to pay are not always clear-cut. Such transactions typically are rated to pay timely interest and full principal by the legal final maturity date. However, some are structured to allow for subordination and deferment of junior class interest to pay senior class principal, while others allow for the writedown of note balances without triggering an event of default. In these instances, the underlying ABS reference obligation could be considered distressed without an actual failure-to-pay-event that constitutes a default. To accommodate the subtleties of using ABS as underlying reference obligations, ISDA modified the credit events for ABS CDS to include failure to pay principal (by the legal final maturity date), writedown (of the reference obligation), and distressed ratings downgrade (to Caa2, CCC, or CCC by Moodys, S&P, or Fitch, respectively), which is an optional credit event as defined in the most recent ISDA pay-as-you-go template released on January 23, 2006 to accommodate for fixed-rate CMBS reference obligations. Unlike corporate CDS, the occurrence of a credit event in ABS CDS does not automatically result in settlement of the contract. Instead, the PAUG characteristics give the protection buyer the option of full, or partial, physical settlement or continuation of the ABS CDS contract. Contract Maturity: Corporate CDS typically have maturities between one and 10 years, with five years being the most common. Maturities are negotiated between buyers and sellers of protection to allow for risk exposure over a customizable time frame. In contrast, the term of an ABS CDS matches the legal final maturity date of the reference obligation. However, the buyer of protection in an ABS CDS contract has the option to exercise full or partial physical delivery upon occurrence of a credit event. In this instance, should the protection buyer choose to settle fully the ABS CDS with physical delivery, the contract will mature. On the other hand, partial physical settlement only serves to reduce the notional amount of the ABS CDS contract; maturity remains tied to the legal final of the reference obligation. In addition, in certain instances, the protection buyer has the option to terminate the ABS CDS if the reference obligation is not called when eligible. Settlement Procedures: In the corporate CDS market, the occurrence of a credit event triggers either cash or physical settlement of the contract. Cash settlement (most common in derivative products such as indices and tranche trades) involves payment from the seller of protection to the buyer of the difference between the contracted notional amount of the CDS and the value of the reference obligation as determined by dealer poll. As the reference obligation is likely distressed when settlement is occurring, obtaining price quotes from a sufficient number of dealers may be difficult, especially if liquidity in the reference entitys bonds has dried up. Under physical settlement, the protection buyer delivers the distressed reference obligation to the protection seller and receives par. The buyer in the corporate CDS can deliver any bond (subject to certain restrictions) issued by the reference entity at the same rating and seniority level of the security referenced in the CDS.
Maturity of ABS CDS is dictated by the legal final of the reference obligation
Corporate CDS can have either cash or physical settlement
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although neither is completely appropriate for structured products
Although these settlement procedures have worked well for corporate CDS, they are not the most effective for the ABS market, given the complexity of structured product and the unique collateral and structural characteristics of each transaction. Class sizes of most ABS reference obligations tend to be small relative to the amount of CDS referencing them. As such, sourcing the collateral in the secondary ABS market can prove difficult unless the protection buyer is hedging a long position. Moreover, in a distressed scenario (ie, upon triggering a credit event requiring settlement), it may be difficult to generate sufficient price quotes through a dealer poll to satisfy the needs of a cash settlement. To address these differences, the dealer community has devised the unique PAUG settlement method for ABS CDS, which avoids a dealer poll altogether.
Pay-As-You-Go Settlement Unique to ABS CDS

To understand PAUG, forget most of what you know about corporate CDS settlement As ABS CDS trading volume grew and the market potential became clearer, participants recognized the need for standardized documentation. On June 21, 2005, ISDA published its first standardized confirmation for ABS CDS entitled Credit Derivative Transaction on Asset-Backed Security with Pay-As-You-Go or Physical Settlement (Dealer Form), which lays out the law of the land, including structure, credit events, and settlement procedures for ABS CDS. This document supports CDS with home equity ABS (HEL) and commercial mortgage-backed securities (CMBS) as reference obligations, and has led to explosive growth in ABS CDS referencing HEL subordinate tranches. On January 23, 2006, ISDA published an update to the previously released template with changes mainly geared to incorporate fixed rate CMBS securities. In addition to HEL and CMBS, ISDA anticipates the future publication of one or more template confirmations that will reference other types of ABS such as credit card ABS or CDO notes. To better accommodate the unique characteristics of ABS as reference obligations, the document combines certain features of traditional corporate CDS physical settlement with PAUG settlement procedures. PAUG is designed to mirror the risk profile of a long (via selling protection) or short (via buying protection) position in the underlying reference obligation. Each month, payments are exchanged between the buyer and seller of protection, depending on certain events and conditions resulting in the PAUG designation. In general, payments made by the buyer of protection are referred to as fixed payments, and those made by the seller are called floating payments.
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Figure 8: Pay-As-You-Go Settlement for ABS CDS

Reference Entity Reference Obligation Risk Transfer
Reference Obligation Protection Buyer: - Assumes risk profile of a Short position in the underlying Pays - Fixed Payment (ie, CDS Premium) - Additional Fixed Payments in the event of reversal of writedowns, principal shortfalls or interest shortfalls Receives - Floating Payments in event of writedowns, principal shortfalls, or interest shortfalls Source: Barclays Capital.
Fixed Amount and Additional Fixed Payments
Protection Seller: - Assumes risk profile of a Long position in the underlying Receives - Fixed Payment (ie, CDS Premium) - Additional Fixed Payments in the event of reversal of writedowns, principal shortfalls or interest shortfalls Pays - Floating Payments in the event of writedowns, principal shortfalls, or interest shortfalls
Floating Payments
Absent a credit event, the protection buyer pays the spread until the reference obligation matures
Figure 8 details the PAUG settlement process for ABS CDS. As in corporate CDS, the most regularly occurring payment in an ABS CDS is the fixed amount, or the premium paid by the buyer, to purchase protection. The fixed amount is calculated as the product of the fixed rate, the average notional balance of the ABS CDS, and the actual number of days in the calculation period divided by 360. For example, if an investor purchases $1mn notional protection on a Baa2 HEL mezzanine tranche at +185 bp, the fixed amount (assuming a 31day calculation period in this example) per month would be $1,593.06 (1.85% x $1mn x 31/360). In the absence of a credit event, the buyer is obligated to pay 185 bp on the notional amount until the reference obligation matures or the contract is otherwise terminated. At the heart of the PAUG concept are floating payments made by the seller of protection to the buyer resulting from writedowns, principal shortfalls, or interest shortfalls. Writedowns are both a credit and a floating payment event. As a credit event, the occurrence of a writedown gives the protection buyer the right, but not the obligation, to effect full or partial physical settlement. If the buyer chooses not to settle fully, the protection seller is required to make a floating payment to the buyer in the amount of the writedown (unlike in the corporate CDS market, where it is all or none). This amount is scaled by the notional amount of the ABS CDS divided by the original tranche size of the reference obligation (ie, the applicable percentage) to account for any difference between the notional on the ABS CDS and the size of the reference obligation. Similarly, if a principal or interest shortfall occurs in a given month, the protection seller is obligated to make a floating payment in the amount of such shortfall (again, scaled by the applicable percentage) to the buyer. If a writedown, or principal or interest shortfall, is subsequently recovered in a later payment period, the protection buyer will make what is referred to as an additional fixed payment to the seller. This payment (plus accrued interest at LIBOR + the spread for interest shortfalls) is designed to reverse floating payments made from the seller to the buyer.
Periodic floating payments by the protection seller are at the heart of PAUG
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Figure 9: Fixed and Floating Payment Cash Flows in PAUG Settlement

Period One: Assume 50 bp interest shortfall Protection Buyer
Pays Premium Receives Interest Shortfall Net cash outflow 150 bp 50 bp 100 bp Premium 150 bp Interest Shortfall 50 bp
Protection Seller
Receives Premium Pays Interest Shortfall Net cash inflow 150 bp 50 bp 100 bp
Period Two: The 50 bp interest shortfall is recovered Protection Buyer

Pays Premium Pays Shortfall Reimbursement Net cash outflow 1 150bp 50bp 200bp Premium 150 bp Shortfall Reimbursement 50 bp
Protection Seller
Receives Premium 150bp Receives Shortfall Reimbursement 50bp Net cash inflow 1 200bp
Note: 1Excludes accrued interest on cumulative interest shortfall reimbursement amount. Source: Barclays Capital.
Figure 9 provides a simplified example of the fixed and floating payment cash flows in PAUG. By way of example, we assume an ABS CDS with a fixed rate of +150 bp. In period one, the reference obligation experiences an interest shortfall of 50 bp. The protection buyer pays the fixed payment of 150 bp, but the protection seller is required to make a floating payment of 50 bp to cover the interest shortfall of the reference obligation. Thus, the net cash outflow of the buyer is 100 bp. If, in a subsequent period, the reference obligation recovers the interest shortfall, the protection buyer must make an additional fixed payment of 50 bp (plus accrued interest) as reimbursement to the seller. Under PAUG, a credit event does not necessitate settlement Unlike in corporate CDS, under PAUG, if a credit event occurs, settlement is not automatically triggered. Rather, the protection buyer has the option, but not the obligation, to effect full or partial physical settlement of the ABS CDS. Nevertheless, owing to the relatively small tranche sizes referenced in ABS CDS, physical settlement, though allowed, should be a rare occurrence. The corporate CDS concept of cash settlement after a credit event and the potentially cumbersome dealer poll process does not exist under the standardized ABS CDS contract.
Available Funds Cap The Protection Seller Assumes the Risk

Noteholder interest payments on HEL ABS transactions backed by hybrid ARMs are typically subject to an available funds cap (AFC), meaning that note interest payable is limited to the lesser of index plus spread (on the ABS note) and the net weighted average interest rate of the collateral. AFC risk arises from the fact that the coupon on the HEL collateral is fixed for two to three years, while note coupons float on a monthly basis. In many ABS transactions, however, this risk is mitigated by the presence of internal hedges (via caps, swaps, etc). In the absence of an internal hedge, if the amount of interest due noteholders is greater than the amount of interest collections available to pay such interest, the AFC is hit, resulting in the effective reduction of the investors spread over the benchmark.
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The new Form I template provides the option of including AFC in the expected interest calculation
In the cash ABS market, the available funds shortfall is tracked and paid to investors in subsequent months to the extent that funds are then available. For example, if an HEL ABS had an AFC shortfall of 200 bp for three-consecutive months, the cumulative interest shortfall at the end of month three would be 600 bp. The noteholders spread has effectively been decreased by 200 bp in each period. To the extent that funds become available in subsequent periods, the AFC shortfall (plus accrued interest) is paid back to noteholders. The recently revised Form I template incorporates language whereby the buyer and seller of protection choose whether to include weighted average coupon (WAC) cap provisions (ie, available funds caps) in the calculation of expected interest payments for purposes of determining if an interest shortfall on the ABS CDS has occurred. If the WAC cap provision is applicable, the effect of AFCs is included in calculating expected interest. However, if the WAC cap provision is not applicable (as is predominantly the case currently), expected interest is calculated without giving effect to any AFCs on the underlying reference obligation. In this instance, to mimic the risk profile of a cash position in the reference obligation, the ABS CDS protection seller is obligated to compensate the buyer for AFC interest shortfalls, thereby reducing the sellers spread. The extent of the protection sellers liability under the AFC depends upon whether there is full or partial cap risk transfer, as shown in Figure 10
With full cap risk transfer, the seller fully assumes available funds cap liability
Full Cap Risk Transfer: Under full cap risk transfer, the seller of protection in an ABS CDS agrees to assume the full AFC risk. In other words, any shortfalls in interest are the responsibility of the protection seller and will result in floating payments to the protection buyer. In practice, such payments are netted against the fixed amount paid by the buyer, resulting in a reduction of funds received by the seller. However, in the extreme scenario of a shortfall so large that the floating payments owed by the seller of protection exceed the fixed payments of the buyer of protection, the seller would have to make out-of-pocket cash payments to the buyer (a situation that may not be palatable to all investors).
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Figure 10: Handling the Available Funds Cap in ABS CDS

Available Funds Cap Risk
Full Cap Risk Transfer
Partial Cap Risk Transfer
Fixed Cap Applicable
Variable Cap Applicable
Protection Seller liable for full amount of available funds shortfall
Protection Sellers liability for available funds shortfall limited to the Fixed Rate
Protection Sellers liability for available funds shortfall limited to the Fixed Rate plus LIBOR
Partial cap risk transfer can be fixed or variable, but both limit the sellers exposure
Partial Cap Risk Transfer Fixed Cap Applicable: In the fixed cap form of partial cap risk transfer, the protection seller agrees to pay interest shortfalls up to the fixed rate. Thus, the maximum liability of the seller is limited to the fixed rate. Under this form of risk transfer, the protection seller is never required to make a net cash payment to the buyer, resulting in wide acceptance as some counterparties have limited ability to make out-of-pocket payments (eg, CDOs). Partial Cap Risk Transfer Variable Cap Applicable: Under the variable cap form of partial cap risk transfer, the protection seller agrees to pay interest shortfalls up to the fixed rate of the contract plus LIBOR (the inclusion of LIBOR in the calculation simulates funding the bond). Under the variable cap form, the maximum net payment that the seller will ever have to make is LIBOR. Not surprisingly, ABS CDS with variable cap risk transfer trade wider than those with fixed cap because the seller is taking on more interest rate risk.
Protection seller takes a first loss position on AFC risk
Under both full and partial cap risk transfer, any reimbursements of AFC-related shortfalls in later periods result in an additional fixed payment by the protection buyer to the protection seller. However, the timing of the reimbursements depends on the magnitude of the shortfall and the method of AFC risk transfer since the protection seller effectively takes the first loss position with regard to AFC risk. Under full cap risk transfer, additional fixed payments must be made by the protection buyer to the protection seller when any AFC shortfall reimbursements occur on the reference obligation. On the other hand, with a partial AFC risk transfer (either fixed or variable), the buyer of protection is only obligated to make additional fixed payments to the seller after cumulative AFC shortfall amounts on the cash ABS in excess of the ABS CDS cumulative shortfalls have been repaid.
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An example will help illustrate this point. Assume that an HEL ABS with a coupon of 700 bp is referenced in an ABS CDS with a fixed rate of 200 bp and fixed AFC risk transfer. If the reference obligation experiences an AFC interest shortfall of 50 bp in period one, the protection seller makes a floating payment of 50 bp to the buyer as shown in Figure 11. This results in a net payment of 150 bp from the protection buyer to protection seller. If in period two the reference obligation has a 300 bp AFC interest shortfall, the protection sellers floating payment is 200 bp since the sellers liability under the fixed cap risk transfer is limited to the fixed rate on the ABS CDS. The cumulative AFC interest shortfall on the reference obligation is 350 bp, which is 100 bp greater than the 250 bp of cumulative floating payments made by the protection seller. In period three, if the reference obligation has a 200 bp AFC interest shortfall reimbursement, the protection buyer is not required to make an additional fixed payment until the underlying HEL ABS referenced in the ABS CDS first recovers 100 bp of the AFC shortfall (ie, the difference between the cumulative AFC shortfalls on the reference obligation and ABS CDS). In other words, the first 100 bp of AFC shortfall reimbursement in this example does not flow through to the protection seller. Instead, it is only after the first 100 bp has been recovered that the protection buyer is obligated to make additional fixed payments to the seller.
Figure 11: ABS CDS Cash Flow Diagram with Fixed Cap Risk Transfer
Period One: Interest Shortfall on reference obligation of 50 bp:
Pays Premium Receives Interest Shortfall Net cash outflow
Protection Buyer
Premium 200 bp 200 bp 50 bp 150 bp
Interest Shortfall 50 bp
Receives Premium Pays Interest Shortfall Net cash inflow
Protection Seller
200 bp 50 bp 150 bp
Period Two: Interest Shortfall on reference obligation of 300 bp:

Pays Premium Receives Interest Shortfall up to cap Net cash outflow
Protection Buyer
Premium 200 bp 200 bp 200 bp zero
Interest Shortfall Cap 200 bp
Receives Premium Pays Interest Shortfall up to the cap Net cash inflow
Protection Seller
200 bp 200 bp zero
Period Three: Interest Shortfall Reimbursement on reference obligation of 200 bp: Protection Buyer
Premium 200 bp 200 bp 100 bp 300 bp Cumulative Shortfall Reimbursement 100 bp
Pays Premium Pays Int. Shortfall Reimbursement Net cash outflow 1
Receives Premium Receives Int. Shortfall Reimbursement Net cash inflow 1
Protection Seller
200 bp 100 bp 300 bp
Note: 1 Excludes accrued interest on cumulative interest shortfall reimbursement amount. Source: Barclays Capital.
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Reference Obligations Trading at Premium or Discount

Currently, most singlename ABS CDS are executed with par pricing and fixed cap risk transfer There are two ways to enter into an ABS CDS referencing an obligation that is trading at a premium or discount in the cash market. Either an initial payment exchange can occur or the fixed rate (ie, ABS CDS premium) can be adjusted so that the underlying reference obligation is effectively priced at par. If there is an initial exchange of cash, the protection buyer pays the seller in the case of a reference obligation trading at a discount or the protection seller pays the buyer in the case of a premium reference obligation. Alternatively, the fixed rate could be decreased for premium-priced reference obligations and increased for a discount underlying. While both approaches result in the same return on a discounted cash flow basis, entering into a par-priced ABS CDS eliminates the upfront payment, which is potentially important for protection sellers not able, or willing, to make out-of-pocket payments (eg, CDOs). In the current market environment, most ABS CDS are entered into as par contracts with no initial payment exchange and fixed cap risk transfer.
Step-Up Coupons
A coupon step-up provision is commonly found in HEL ABS transactions whereby the coupon on the outstanding tranches of a deal increases if the issuer fails to redeem a transaction subject to an optional cleanup call. This feature is incorporated to incentivize issuers to call transactions when eligible and to compensate cash investors should the notes maturity extend beyond the cleanup call date. ABS CDS employing the PAUG Form I (but not Form II) template allows the transacting parties to accommodate for the coupon step-up provision. In the event the reference obligation is not redeemed when eligible for cleanup, the ABS CDS contract can continue, with the fixed rate increasing by the amount the reference obligation coupon is increased due to the step-up. However, the protection buyer has the option to terminate the contract effective as of the expected maturity date (ie, the expected cleanup call date). This is a notable difference between the cash and ABS CDS markets: a cash ABS investor always will receive the stepped-up coupon if a deal is not called. However, the protection seller in an ABS CDS may see its contract terminated rather than receive the stepped-up fixed rate.
Unwinding the Trade

There are three methods for unwinding an ABS CDS position: termination, assignment, or taking an offsetting position. Termination: Generally, to terminate an ABS CDS trade, the original counterparties must agree on the compensation required to tear up the contract. The cost of unwinding the trade in this manner is equal to the net present value of the difference between the fixed rate on the original ABS CDS contract and the fixed rate on the offsetting contract (ie, with the same terms) in the current market. Assignment: ABS CDS trades can be assigned from one party to another. In accordance with the standard ISDA convention, the original counterparty must be notified and the spread and stipulations of the trade, as well as the identity of the original counterparty, must be disclosed to the new counterparty to effect assignment. In addition, payment of the net present value of the difference between the fixed rate on the original ABS CDS contract and the fixed rate on the offsetting contract in the current market is required to assign an ABS CDS trade.
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Taking an Offsetting Position: Investors may enter into an offsetting position (either cash or synthetic) to unwind an ABS CDS trade. In either case, the ABS CDS contract remains on the investors books until the ABS CDS matures. As a result, counterparty risk remains a factor.
Buyers and Sellers of Protection

Traditional cash ABS investors are candidates for selling protection Figure 12 details the many buyers and sellers of protection in the ABS CDS market. Intuitively, any traditional cash ABS investor is a candidate for selling protection provided the investor is able to engage in derivative transactions. This is especially true for subordinate HEL ABS buyers as demand in this sector has been very strong, led by the insatiable appetite from the CDO sector. Also, the unfunded nature of ABS CDS is appealing to hedge funds, given their funding costs and more limited capital base.
Figure 12: PAUG ABS CDS Market Players

Protection Seller Hedging Money managers, dealers, hedge funds and banks hedging their inventory. Dealers providing secondary market liquidity. Protection Buyer Investing/ Speculation Synthetic CDO managers and dealers with synthetic CDO mandates. Hedge funds, dealers, and money managers taking positions in scarce bonds, increasing exposure to certain sectors or rating categories, or capitalizing on cash/ CDS/index basis opportunities. Hedge funds, dealers engaging in capital structure, vintage or name play trades. Dealers hedging their inventory and providing secondary market liquidity. Cash ABS originators/issuers hedging production pipelines. CDOs and dealers hedging portfolio ramp ups. Money managers and hedge funds expressing bearish views on an issuer or a sector. Hedge funds and dealers engaging in capital structure, vintage or name play trades, or expressing negative view of US housing. Hedge funds, dealers, and money managers capitalizing on cash/ CDS/index basis opportunities.
Hedging long positions or expressing bearish sentiment are prime motivations for buying protection
Buyers of protection, while not as obvious, are still plentiful. For example, investors who want to hedge an exposure to a long position without having to liquidate that position can be buyers of ABS CDS protection. Bearish investors may buy protection in the hopes that spreads widen or the underlying reference obligation becomes distressed. Hedge funds looking to put on capital structure, vintage, or issuer basis trades can both buy and sell protection. Also, broker-dealers are buyers and sellers of protection based on the needs of their ABS cash and CDS secondary trading desks. Moreover, dealers provide liquidity to the market as appropriate, acting as both buyers and sellers of protection.
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Appendix II: ABX.HE 06-1 Constituent Detail

Figure 13: ABX.HE 06-1 Index Constituent List (Ratings as of January 19, 2006)
Index Constituent ACE 2005-HE7 AMSI 2005-R11 ARSI 2005-W2 BSABS 2005-HE11 CWL 2005-BC5 FFML 2005-FF12 GSAMP 2005-HE4 HEAT 2005-8 JPMAC 2005-OPT1 LBMLT 2005-WL2 MABS 2005-NC2 MLMI 2005-AR1 MSAC 2005-HE5 NCHET 2005-4 RAMP 2005-EFC4 RASC 2005-KS11 SABR 2005-HE1 SAIL 2005-HE3 SASC 2005-WF4 SVHE 2005-4 Source: Markit. Class A2D A2D A2C A3 3A3 A2C A2C 2A4 A4 3A4 A4 3A4 A2C A2C A3 AI4 A3C A5 A4 2A4 ABX.HE AAA Mdy Aaa Aaa Aaa Aaa Aaae Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaa Aaae S&P AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA Ftch Class M2 M2 M2 M2 M2 M2 M2 M2 M2 M2 M2 M1 M2 M2 M2 M2 M1 M2 M2 M2 ABX.HE AA Mdy Aa2 Aa2 Aa2 Aa2 Aa2e Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2 Aa2e S&P AA+ AA AA+ AA AA AA+ AA+ AA+ AA AA AA+ AA+ AA+ AA AA+ AA+ AA+ AA AA AA AA+ AA AA AA+ AA+ AA AA+ AA AA AA AA+ AA+ AA+ Ftch Class M5 M5 M5 M4 M5 M5 M5 M5 M5 M5 M5 M2 M5 M5 M5 M5 M2 M5 M5 M5 ABX.HE A Mdy A2 A2 A2 A2 A2e A2 A2 A2 A2 A2 A2 A2 A2 A2 A2 A2 A2 A2 A2 A2e S&P AAA+ AAA A+ A+ A+ A+ A A+ AA AA A+ A A+ AA A+ A A A+ A+ A A A+ A+ A A+ A A A AA A+ AAFtch Class M8 M8 M8 M7 M8 B2 B2 M8 M8 M8 M8 B2 B2 M8 M8 M8 B2 M8 M8 M8 ABX.HE BBB Mdy Baa2 Baa2 Baa2 Baa2 Baa2e Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2 Baa2e S&P A AABBB BBB+ BBB+ BBB+ ABBB BBB+ A+ ABBB+ BBB BBB+ A BBB+ BBB+ BBB BBB+ BBB+ BBB+ BBB BBB+ BBB+ BBB BBB+ BBB+ BBB BBB+ BBB+ BBB+ AFtch Class M9 M9 M9 M8 B B3 B3 B1 M9 M9 M9 B3 B3 M9 M9 M9 B3 M9 M9 M9 ABX.HE BBBMdy Baa3 Baa3 Baa3 Baa3 Baa3e Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3 Baa3e S&P BBB+ BBB+ BBB+ BBBBBB BBB BBB BBB+ BBBBBB A BBB+ BBB BBBBBB BBB+ BBB BBB BBBBBB BBB BBB BBBBBB BBB BBBBBB BBB BBBBBB BBB BBB BBB+ Ftch
26 US Securitization Research Barclays Capital
Figure 14: ABX.HE 06- 1 Collateral C omposition (as of January 19, 2006)
ARM Subtype Avg Loan Balance 199,735 179,277 187,211 134,448 189,956 213,743 169,726 188,452 183,777 195,788 267,115 210,980 167,009 205,009 166,196 150,869 215,896 194,126 141,400 182,629 187,167 177,036 Fixed (%) 14.9 19.3 19.9 23.8 25.5 10.4 15.9 10.0 16.4 8.7 0.0 16.5 12.1 18.2 13.6 19.9 11.6 19.5 25.6 17.0 15.9 21.3 2/28 (%) 68.6 55.2 54.3 59.6 62.4 68.3 75.6 80.8 79.1 76.4 74.6 61.6 82.1 71.9 73.8 72.9 79.6 65.5 70.1 61.0 69.7 62.6 3/27 (%) 13.8 23.9 25.8 15.5 10.6 17.5 7.6 8.1 4.0 12.7 25.4 22.0 3.9 8.6 12.6 6.1 6.5 14.3 4.3 20.4 13.2 14.0 5/25 (%) 2.4 1.6 0.0 1.0 0.5 3.5 0.8 0.7 0.0 1.3 0.0 0.0 1.9 1.3 0.0 0.8 1.7 0.7 0.0 1.3 1.0 1.5 Wtd. Avg. LTV (%) 82.1 77.7 79.6 84.7 78.6 80.1 82.7 80.7 78.8 80.9 80.2 86.7 82.3 81.0 84.1 80.8 81.9 85.7 81.3 83.3 81.6 81.5 % LTV >80 33.1 45.8 27.0 65.3 30.8 17.6 40.0 30.9 35.1 27.6 22.5 71.3 37.0 42.1 46.1 38.1 31.6 65.4 49.3 42.8 40.0 42.8 WAC (%) 7.2 7.8 7.4 7.4 7.1 6.8 7.5 7.2 7.3 7.3 6.6 7.2 7.1 7.2 6.9 7.4 6.9 7.3 7.1 7.1 7.2 7.3 Owner Cashout Occupied % % 95.8 96.7 91.0 90.6 97.6 96.9 93.5 95.3 93.1 90.6 94.9 93.8 96.0 89.7 97.0 91.4 96.7 89.2 98.2 94.6 94.1 93.3 42.1 93.9 53.2 60.1 59.4 28.5 44.7 48.0 62.3 38.8 32.1 61.7 41.5 52.0 54.6 42.1 42.3 58.4 70.7 53.8 52.0 56.4 Loan Purpose Purchase % 55.7 2.7 42.1 34.0 30.9 68.7 52.0 47.0 28.6 57.7 59.3 34.9 51.5 40.6 42.1 41.7 53.6 37.6 23.0 41.5 42.2 37.8 Rate / term Refi % 2.2 3.4 4.8 5.9 9.7 2.8 3.3 5.1 9.2 3.5 8.7 3.4 7.0 7.4 3.3 16.2 4.2 4.1 6.4 4.8 5.8 5.8 Full Doc % 36.8 72.5 51.6 60.1 62.8 62.6 57.0 53.1 58.5 56.9 40.2 54.2 50.5 55.6 75.3 64.7 40.4 57.3 92.7 50.0 57.6 59.4 Documentation Stated (%) 52.0 9.8 43.7 37.0 37.5 36.9 40.1 27.9 39.8 41.2 58.2 36.6 41.4 43.3 0.0 0.0 28.0 35.1 4.7 45.5 32.9 32.8 Limited (%) 11.1 17.7 4.8 2.9 0.0 0.5 2.6 18.8 0.6 1.9 1.6 9.2 8.1 1.1 24.7 35.3 31.6 7.2 2.6 2.1 9.2 7.0
Deal ACE 2005-HE7 AMSI 2005-R11 ARSI 2005-W2 BSABS 2005-HE11 CWL 2005-BC5 FFML 2005-FF12 GSAMP 2005-HE4 HEAT 2005-8 JPMAC 2005-OPT1 LBMLT 2005-WL2 MABS 2005-NC2 MLMI 2005-AR1 MSAC 2005-HE5 NCHET 2005-4 RAMP 2005-EFC4 RASC 2005-KS11 SABR 2005-HE1 SAIL 2005-HE3 SASC 2005-WF4 SVHE 2005-4 ABX Average 2005 Universe Avg.
Other % 0.1 0.0 0.0 0.0 0.0 0.0 0.3 0.2 1.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.5 0.0 2.5 0.2 1.6
Source: Company reports, Barclays Capital.
Figure 14: ABX.HE 06- 1 Collateral C omposition (as of January 19, 2006) (continued)
Residential Type Single Family % ACE 2005-HE7 AMSI 2005-R11 ARSI 2005-W2 BSABS 2005-HE11 CWL 2005-BC5 FFML 2005-FF12 GSAMP 2005-HE4 HEAT 2005-8 JPMAC 2005-OPT1 LBMLT 2005-WL2 MABS 2005-NC2 MLMI 2005-AR1 MSAC 2005-HE5 NCHET 2005-4 RAMP 2005-EFC4 RASC 2005-KS11 SABR 2005-HE1 SAIL 2005-HE3 SASC 2005-WF4 SVHE 2005-4 ABX Average 2005 Universe Avg. 71.2 85.9 70.5 76.9 78.2 67.5 79.0 82.0 77.0 70.4 68.0 72.8 78.4 73.6 88.4 71.4 70.9 69.9 89.2 71.0 75.6 74.5 PUD % 14.9 5.8 17.0 11.1 13.1 19.7 7.0 7.1 7.5 13.5 16.5 10.3 8.6 11.7 0.9 14.2 14.4 11.0 3.3 16.6 11.2 11.9 Condo % 8.5 3.4 5.3 5.7 4.9 8.4 5.7 5.9 4.7 6.7 10.5 7.6 7.0 7.4 5.1 5.9 8.8 8.2 4.5 6.1 6.5 6.1 Prepay Penalty % 73.5 57.6 64.5 73.2 79.5 78.1 76.9 81.6 70.6 69.9 83.1 71.6 76.4 72.2 75.9 72.5 71.8 69.5 73.2 71.5 73.1 71.0 Interest Only % 30.0 15.4 10.0 30.0 30.7 65.7 29.4 31.2 20.7 9.1 100.0 46.4 25.0 39.3 26.3 17.3 51.6 33.2 14.5 41.1 33.3 24.5 1st Lien % 92.3 100.0 98.8 96.5 100.0 100.0 95.4 97.1 99.0 100.0 100.0 100.0 94.4 97.7 98.7 96.1 93.4 96.3 95.1 96.7 97.4 96.6 38.2 30.4 26.7 33.1 17.7 53.8 60.1 1.6 19.5 23.4 MI Silent 2nd 40 Year Covered Lien Loan % 3.5 25.7 0.4 1.5 48.4 36.5 CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA CA Top 3 State Concentrations
FICO 639 624 618 628 619 656 627 627 613 630 657 632 638 626 630 619 651 628 617 629 630.4 627
#1 47.9 15.1 23.6 26.4 28.2 38.4 25.9 31.2 20.6 35.1 55.3 32.3 36.7 39.4 15.7 17.4 50.9 38.5 14.2 32.0 31.2 29.4 FL FL FL FL FL FL FL FL FL FL FL FL FL FL MD FL FL IL MD FL -
#2 8.4 10.5 15.1 8.7 9.4 7.2 10.4 12.2 8.9 8.3 6.6 13.1 6.9 9.1 8.0 9.8 6.0 7.4 9.9 9.4 NY NY IL MN MD IL IL IL TX IL NV NY MD NY FL AZ NY NY FL NY -
#3 4.2 9.2 8.2 7.4 5.2 5.4 6.5 4.2 5.5 6.2 4.9 9.1 3.6 6.2 7.4 7.5 4.9 7.2 9.6 6.9 -
Source: Company reports, Barclays Capital.
Appendix III: Glossary

ABX.HE An index of ABS CDS referencing HEL ABS and administered by Markit Group Limited. The index and its five rating-based sub-indices reference twenty sub-prime HEL asset-backed securities that satisfy certain selection criteria. ABX.HE is priced daily by designated participating dealers and rolled every six months. The ABX.HE index family consists of five distinct ratings based sub-indices. Each sub-index references a pool of twenty HEL ABS tranches included in the main ABX.HE index. The composition of each sub-index is based on the tranches rating. The ABX.HE Index subindices are ABX.HE.AAA, ABX.HE.AA, ABX.HE.A, ABX.HE.BBB, and ABX.HE.BBB-. Broker-dealer designated by the Index Administrator to provide daily price fixing for the ABX.HE Index and assist in the selection of securities for inclusion in the ABX.HE index. The roll involves an iterative process whereby the administrator and ABX.HE Participants collectively determine the new index composition and pricing levels. The ABX.HE index rolls every six months. The amount of interest paid to the reference obligation during the related period. Payment from buyer of protection to seller of protection to reverse a previous Floating Payment in respect of a Writedown, Principal Shortfall or Interest Shortfall from a prior period. The Additional Fixed Payment is scaled by the Applicable Percentage to account for size differences between the ABS CDS notional and the principal balance of the reference obligation. The occurrence of a Writedown, Principal Shortfall, or Interest Shortfall Reimbursement on the reference obligation, requiring an Additional Fixed Payment from buyer to seller of protection. The initial notional amount of the ABS CDS as a percentage of original principal balance of the reference obligation. Used to scale Floating and Additional Fixed Payments to account for size differences between the ABS CDS notional and the principal balance of the reference obligation. ABS CDS trades can be assigned from one party to another granted notification is given in accordance with the standard ISDA convention. The original counterparty, spread, and stipulations of the trade must be disclosed to the new counterparty in order to effect assignment. Refers to the fact that the coupon on a floating rate bond is limited to the weighted average coupon on the collateral pool minus expenses. Approximately 75-80% of underlying loans in the home equity sector are hybrid arms, where the coupon is fixed for two to three years. Buying and selling protection through ABS CDS on different tranches within the same transaction in the hopes of profiting from inefficiencies in pricing of different parts of the deals capital structure. In corporate CDS, cash settlement entails a payment from the seller of protection to the buyer of protection for an amount equal to the difference between the par on the reference obligation and the reference obligations current market value as determined by dealer poll (under the specified valuation method). Used where physical settlement would be inconvenient or impracticable.
ABX.HE Sub-indices
ABX.HE Participant ABX.HE Roll
Actual Interest Amount Additional Fixed Payment
Additional Fixed Payment Event Applicable Percentage
Assignment
Available Funds Cap (AFC) Capital Structure Trade
Cash Settlement
28
Barclays Capital
Component Transaction Credit Event
A separate independent ABS CDS transaction on each reference obligation within the relevant ABX.HE sub-index. For pay-as-you-go ABS CDS, credit events typically include: (1) Failure to pay principal; (2) Writedown; and (3) Distressed rating downgrade (optional for fixed-rate CMBS).
Cumulative Interest Shortfall Amount Cumulative Interest Shortfall Payment Amount Dealer Poll
The sum of all previous Interest Shortfalls plus compound interest on such shortfalls minus any Interest Shortfall Reimbursement Amounts. The sum of the Interest Shortfall Payment Amount plus compound interest on such shortfalls minus any Interest Shortfall Reimbursement Amounts. In corporate CDS, in the event of cash settlement, dealers are solicited to provide price levels on the underlying reference obligation to determine the true market value of the reference obligation. In ABS CDS, a credit event occurs when the reference obligation is downgraded to ratings of Caa2, CCC, or CCC by Moodys, Standard & Poors or Fitch, respectively. The amount of current interest that would accrue on the reference obligation during the related calculation period. The dollar amount of CDS premium paid by the protection buyer to the protection seller on a monthly basis. The amount is calculated as a product of the Fixed Rate, the average daily Reference Obligation Notional Amount, and the accrual factor based on an actual/360-day count convention. A form of Partial Available Funds Cap Risk Transfer whereby the protection seller is obligated to pay interest shortfalls to the protection buyer up to the Fixed Rate. The spread or premium on an ABS CDS contract. Equals the percentage of a reference obligations notional amount that the protection buyer pays to the protection seller on annual basis. Protection buyer. The sum of any Writedown, Principal Shortfall or Interest Shortfall. The occurrence of a Writedown, a failure to pay principal or an interest shortfall. Payment of the Floating Amount from protection seller to protection buyer in the event of a Writedown, principal shortfall, or an interest shortfall. Protection seller. Also know as the Dealer Template, this template for PAUG ABS CDS was originally released by ISDA in June 2005 and was updated in January 2006. Form I is used most commonly in the ABS CDS market today. Also know as the End-User Template, Form II was released by ISDA in December 2005 with several changes to the Dealer Template (Form I). Most notably, Form II eliminates the concept of Implied Writedown, does not provide for physical settlement of the CDS contract, calculates interest shortfalls after giving effect to AFC provisions of the Reference Obligation, and eliminates Distressed Ratings Downgrade as a Credit Event.
Distressed Ratings Downgrade Expected Interest Amount Fixed Amount
Fixed Cap Applicable Fixed Rate
Fixed Rate Payer Floating Amount Floating Amount Event Floating Payment Floating Rate Payer Form I
Form II
Barclays Capital
Full Available Funds Cap Risk Transfer Implied Writedown Implied Writedown Reimbursement Index Administrator
In reference to available funds cap risk, the seller of protection assumes complete liability for all interest shortfalls on the reference obligation without limit. If an underlying reference obligation does not provide for Writedowns, the amount of undercollateralization on the reference obligation, resulting in a Floating Payment. If an underlying reference obligation does not provide for Writedowns, the Additional Fixed Payment from the protection buyer to the protection seller in the event previous Implied Writedowns are reversed. Markit Group Limited, an organization formed in 2001 to improve transparency in the credit derivatives marketplace, currently administers and serves as a calculation agent of the Dow Jones CDX Indices. The amount by which interest due to noteholders is greater than the amount of interest collections available to pay such interest. If the interest shortfall cap is applicable, it may be either fixed or variable. The cap limits the protection sellers exposure to interest shortfalls. It is equal to the Fixed Rate if the fixed cap is applicable and to LIBOR plus the Fixed Rate if the variable cap is applicable. The maximum liability owed in an interest shortfall scenario. Under fixed cap, the Interest Shortfall Cap Amount equals the Fixed Amount. Under variable cap, it equals the product of LIBOR + Fixed Rate, the average daily Reference Obligation Notional Amount, and the accrual factor based on an actual/360-day count convention. The Floating Amount due from the protection seller to the protection buyer with respect to interest shortfalls on the reference obligation. The repayment of prior periods Interest Shortfall on a reference obligation.
Interest Shortfall Interest Shortfall Cap
Interest Shortfall Cap Amount
Interest Shortfall Payment Amount Interest Shortfall Reimbursement Interest Shortfall Reimbursement Payment Amount ISDA
Additional Fixed Payment from protection buyer to protection seller for an amount equal to the difference, if any, between the current and previous Cumulative Interest Shortfall Payment Amount. This payment results when the reference obligation repays a prior periods interest shortfall. International Swaps and Derivatives Association, Inc. ISDA is the global trade association representing participants in the privately negotiated derivatives industry, a business covering swaps and options across all asset classes (interest rate, currency, commodity and energy, credit and equity). Buying and selling protection through ABS CDS on different issuers to exploit expected divergence in performance between reference obligations of the issuers. Markit Group Limited is the administrator, calculation agent, and marketing agent for the CDX and ABX.HE indices. The company was formed in 2001 to improve transparency in the credit derivatives marketplace. A list of 20 ABS transactions, the issuers of which constitute the reference entities for the ABX.HE Index for the next six months. An individual ABS CDS transaction in an ABX.HE index deemed to be comprised of Component Transactions on each reference obligation within the index.
Issuer Basis Trade Markit
Master List Master Transaction
30
Barclays Capital
Partial Available Funds Cap Risk Transfer
Limits the protection sellers exposure to interest shortfalls on the underlying reference obligation. Can be either Fixed Cap Applicable (the protection seller is obligated to pay interest shortfalls to the protection buyer up to the Fixed Rate) or Variable Cap Applicable (the protection seller is obligated to pay interest shortfalls to the protection buyer up to LIBOR plus the Fixed Rate). Pay-As-You-Go. Monthly settlement procedures designed by dealers to support ABS CDS referencing HEL ABS or CMBS. PAUG settlement mirrors the risk profile of a long (selling protection) or short (buying protection) position in the reference obligation. Each month payments are exchanged between the buyer and the seller of protection depending on certain events, resulting in the PAUG designation. Delivery of the reference obligation by the buyer to the seller of protection owing to a credit event in exchange for par. In corporate CDS, the reference obligation or any similar obligation (within certain parameters) can be delivered, essentially creating a cheapest to deliver option. In ABS CDS (but only under Form I of the template), the occurrence of a credit event gives the protection buyer the right but not the obligation to affect full or partial physical delivery. However, only the reference obligation may be presented for delivery. Partial physical settlement in respect of an ABS CDS will result in a reduction in the Reference Obligation Notional Amount. Physical delivery is not allowed under Form II of the template. The difference between expected principal and the actual principal amount paid on the Reference Obligation during the related period. An amount equal to the Principal Shortfall scaled by the Applicable Percentage to account for size differences between the ABS CDS notional and the principal balance of the reference obligation. The repayment of prior periods Principal Shortfall on a reference obligation.
PAUG
Physical Settlement
Principal Shortfall Principal Shortfall Amount Principal Shortfall Reimbursement Principal Shortfall Reimbursement Amount Principal Shortfall Reimbursement Payment Amount Protection Buyer
The amount of Principal Shortfall Reimbursement scaled by the Applicable Percentage to account for size differences between the ABS CDS notional and the principal balance of the reference obligation. An additional Fixed Payment in an amount equal to the sum of all Principal Shortfall Reimbursement Amounts for a calculation period.
Purchases credit protection on a Reference Obligation. Protection buyer agrees to pay the Fixed Amount on a periodic, usually monthly, basis in exchange for potential future Floating Payments resulting from the occurrence of Writedowns, Principal Shortfalls or Interest Shortfalls. The Protection Buyer also agrees to make Additional Fixed Payments in the event of Writedown, Principal Shortfall or Interest Shortfall Reimbursements. The Protection Buyers risk position is equivalent to taking short position in the Reference Obligation. Sells credit protection on a Reference Obligation. Protection seller agrees to pay Floating Payments resulting from the occurrence of Writedowns, Principal Shortfalls or Interest Shortfalls in exchange for the Fixed Amount on a periodic basis. The Protection Sellers risk position is equivalent to taking a long position in the Reference Obligation. Issuer of the asset-backed security referenced in the ABS CDS contract. A specific tranche of a specific transaction, as identified by a unique CUSIP/ISIN, issued by the Reference Entity.
Protection Seller
Reference Entity Reference Obligation
Barclays Capital
Reference Obligation Notional Amount
On the date the ABS CDS is entered into, the Reference Obligation Notional Amount equals the product of the outstanding balance of the Reference Obligation and the Applicable Percentage. Thereafter, the Reference Obligation Notional Amount will be decreased by the amount of principal payments made on the Reference Obligation as well as the amount of Principal Shortfalls or Writedowns, all scaled by the Applicable Percentage. In addition, the Reference Obligation Notional Amount will increase by the amount of any Writedown Reimbursements. An increase in the coupon of the Reference Obligation resulting from the failure of the issuer or a third party to call the transaction containing the Reference Obligation. The feature is designed to motivate issuers to call transactions when eligible. If the Step-up Provisions are applicable, the Fixed Rate on an ABS CDS would increase by the amount of the Step-up in the Reference Obligation. However, under Form I, the Protection Buyer has the option to terminate the ABS CDS through Physical Settlement rather than pay the increased Fixed Rate. In reference to ABS CDS, the legal final maturity of the reference obligation. A form of Partial Available Funds Cap Risk Transfer whereby the protection seller is obligated to pay interest shortfalls to the protection buyer up to LIBOR plus the Fixed Rate. Buying and selling protection through ABS CDS on different vintages, either within a single issuer or among several issuers, to exploit perceived pricing inefficiencies arising from the divergences in performance among vintages. Provision in the updated Form I template that if applicable causes calculation of Expected Interest Amount to be made after giving effect to any AFC in the Reference Obligation. Reduction of a Reference Obligations principal balance, whether actual or implied. The amount of any Writedown scaled by the Applicable Percentage to account for size differences between the ABS CDS notional and the principal balance of the reference obligation. The reversal of prior Writedowns of a Reference Obligations principal balance, whether actual or implied. The product of all Writedown Reimbursements and the Applicable Percentage (to account for size differences between the ABS CDS notional and the principal balance of the reference obligation). An additional Fixed Payment in an amount equal to the sum of all Writedown Reimbursement Amounts for a calculation period.
Step-up
Step-up Provision
Term Variable Cap Applicable Vintage Trade
WAC Cap Interest Provision Writedown Writedown Amount
Writedown Reimbursement Writedown Reimbursement Amount Writedown Reimbursement Payment Amount
32
Barclays Capital
200 Park Avenue New York NY 10166
Inna Koren Head of US Securitization Research +1 212 412 1080 [email protected] Joseph Astorina CDOs, ABS CDS, Autos +1 212 412 5435 [email protected] Michael Gleeson HEL ABS/Mortgages +1 212 412 5107 [email protected] Juliet Jones Credit Card & Consumer ABS +1 212 412 2514 [email protected] Hassan Ahmed HEL ABS/Mortgages +1 212 412 5101 [email protected] Elena Warshawsky CDOs, ABS CDS, Autos +1 212 412 3661 [email protected] Arunava Biswas HEL ABS/Mortgages +1 212 412 1371 [email protected]
5 The North Colonnade London E14 4BB

Phil Adams Residential Mortgage-backed Securities +44 (0)20 7773 2229 [email protected] Hans Vrensen, CFA Commercial Mortgage-backed Securities +44 (0)20 7773 3502 [email protected] Maddi Patel Residential Mortgage-backed Securities +44 (0)20 7773 1371 [email protected] John Keane Whole Business Securitisation +44 (0)20 7773 8748 [email protected] Paul Geertsema Consumer and Other ABS +44 (0)20 7773 2347 [email protected] Anca Badea Analyst +44 (0)20 7773 9874 [email protected]
IRS Circular 230 Prepared Materials Disclaimer: Barclays Capital and its affiliates do not provide tax advice and nothing contained herein should be construed to be tax advice. Please be advised that any discussion of U.S. tax matters contained herein (including any attachments) (i) is not intended or written to be used, and cannot be used, by you for the purpose of avoiding U.S. tax-related penalties; and (ii) was written to support the promotion or marketing of the transactions or other matters addressed herein. Accordingly, you should seek advice based on your particular circumstances from an independent tax advisor. This publication has been prepared by Barclays Capital (Barclays Capital) - the investment banking division of Barclays Bank PLC. This publication is provided to you for information purposes only. Prices shown in this publication are indicative and Barclays Capital is not offering to buy or sell or soliciting offers to buy or sell any financial instrument. The information contained in this publication has been obtained from sources that Barclays Capital believes are reliable but we do not represent or warrant that it is accurate or complete. The views in this publication are those of Barclays Capital and are subject to change, and Barclays Capital has no obligation to update its opinions or the information in this publication. Barclays Capital and its affiliates and their respective officers, directors, partners and employees, including persons involved in the preparation or issuance of this document, may from time to time act as manager, co-manager or underwriter of a public offering or otherwise, in the capacity of principal or agent, deal in, hold or act as market-makers or advisors, brokers or commercial and/or investment bankers in relation to the securities or related derivatives which are the subject of this publication. Neither Barclays Capital, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The securities discussed in this publication may not be suitable for all investors. Barclays Capital recommends that investors independently evaluate each issuer, security or instrument discussed in this publication, and consult any independent advisors they believe necessary. The value of and income from any investment may fluctuate from day to day as a result of changes in relevant economic markets (including changes in market liquidity). The information in this publication is not intended to predict actual results, which may differ substantially from those reflected. This communication is being made available in the UK and Europe to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2001. It is directed at persons who have professional experience in matters relating to investments. The investments to which it relates are available only to such persons and will be entered into only with such persons. Barclays Capital - the investment banking division of Barclays Bank PLC, authorised and regulated by the Financial Services Authority (FSA) and member of the London Stock Exchange. BARCLAYS CAPITAL INC. IS DISTRIBUTING THIS MATERIAL IN THE UNITED STATES AND, IN CONNECTION THEREWITH, ACCEPTS RESPONSIBILITY FOR ITS CONTENTS. ANY U.S. PERSON WISHING TO EFFECT A TRANSACTION IN ANY SECURITY DISCUSSED HEREIN SHOULD DO SO ONLY BY CONTACTING A REPRESENTATIVE OF BARCLAYS CAPITAL INC. IN THE U.S., 200 Park Avenue, New York, New York 10166. Non-U.S. persons should contact and execute transactions through a Barclays Bank PLC branch or affiliate in their home jurisdiction unless local regulations permit otherwise. Barclays Bank PLC Frankfurt Branch is distributing this material in Germany under the supervision of Bundesanstalt fuer Finanzdienstleistungsaufsicht. Copyright Barclays Bank PLC (2006). All rights reserved. No part of this publication may be reproduced in any manner without the prior written permission of Barclays Capital. Barclays Bank PLC is registered in England No. 1026167. Registered office 1 Churchill Place, London, E14 5HP. Additional information regarding this publication will be furnished upon request. US6971
For disclosures on issuers in this report see: https://ecommerce.barcap.com/research/cgi-bin/public/disclosuresSearch.pl The person/s named as the author/s of this report hereby certify that: (i) all of the views expressed in the research report accurately reflect the personal views of the author/s about the subject securities and issuers; and (ii) no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report. Investors should assume that Barclays Capital intends to seek investment banking or other business relationships for which it will receive compensation from the companies that are the subject of this report.

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ABS CDS: The Next Frontier

March 2006 Update

ABS CDS: The Next Frontier

Technicals Continue to Drive Spread Volatility

Opportunities in Single-Name CDS and ABX.HE

New Spread Dynamics in Cash, CDS and ABX.HE

Figure 1: Baa3 HEL Cash, Synthetic and ABX.HE.BBB- Spreads

Source: Markit, Barclays Capital.

Baa3 ABS CDS led cash spreads wider at end-2005

Figure 2: Synthetic HEL ABS Spread Levels and Basis

Source: Barclays Capital.

Cash versus CDS Basis

Liquidity Ebbs and Flows, but Continues to Grow

Dueling Templates: Form I vs. Form II

Figure 3: Key Differences between Form I and Form II

Failure to Pay. Writedown. Distressed Rating Downgrade (optional).

Physical Settlement Allowed. Source: ISDA, Barclays Capital.

The ABX.HE Index Debuts

The index created new trading and hedging opportunities

Figure 4: ABX.HE 06-1 Implied Spreads

Source: Barclays Capital.

Index spreads have tightened on stabilized trading volumes

Index Cash Flows

The Structure of the Index

Figure 5: ABX.HE Index Roll Process

Initial List Creation

Seven Business Days Prior to Roll

ABX.HE Participants Rank Issues

Master List Defined

with different originators/servicers

Index Composition Released

One Business Day Prior to Roll

Fixed Rate Determination

Source: Barclays Capital.

Figure 6: ABX.HE Index Eligibility Criteria

Coupon Deal Age Bloomberg Registration Concentrations

Source: Markit, Barclays Capital.

Appendix I: Single-Name ABS CDS 101

Figure 7: Structural Differences Between ABS CDS and Corporate CDS

Credit events had to be customized for ABS CDS

Corporate CDS can have either cash or physical settlement

although neither is completely appropriate for structured products

Pay-As-You-Go Settlement Unique to ABS CDS

Figure 8: Pay-As-You-Go Settlement for ABS CDS

Fixed Amount and Additional Fixed Payments

Figure 9: Fixed and Floating Payment Cash Flows in PAUG Settlement

Period Two: The 50 bp interest shortfall is recovered Protection Buyer

Available Funds Cap The Protection Seller Assumes the Risk

Figure 10: Handling the Available Funds Cap in ABS CDS

Full Cap Risk Transfer

Partial Cap Risk Transfer

Fixed Cap Applicable

Variable Cap Applicable

Protection Seller liable for full amount of available funds shortfall

Source: Barclays Capital.

Protection seller takes a first loss position on AFC risk

Premium 200 bp 200 bp 50 bp 150 bp

Receives Premium Pays Interest Shortfall Net cash inflow

Period Two: Interest Shortfall on reference obligation of 300 bp: