© 2007 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved. Selected Basel II Issues for Credit Derivative Structures Michael Mazzuchi Institute of International Bankers Seminar on the Impact Of Basel II on Financial Markets and Business Strategies December 11, 2007

2 Credit Swap Eligibility for CRM  Eligible credit derivative or guarantee must “cover all or a pro rata portion of all contractual payments of the obligor”.  Eligible credit derivative or guarantee must be “written and unconditional”.  Credit swap must be “not unilaterally cancelable by the protection provider for reasons other than breach of the contract by the beneficiary”.  Consider effect of optional termination rights.  Cannot be provided by an affiliate of the bank, other than certain regulated affiliates.

3 Credit Swap Eligibility for CRM, cont’d  Credit swap contract must “clearly identif[y] the parties responsible for determining whether a credit event has occurred.”  Cash settled credit swap must incorporate a “robust valuation process to estimate loss reliably” and “specif[y] a reasonable period for obtaining post-credit event valuations.”  If physical delivery is required, terms of at least one deliverable obligation must provide that any required consents for delivery of reference obligation cannot be unreasonably withheld.  Restructuring haircut.  “Pay as you go” credit swaps qualify. Consider Bankruptcy and Restructuring events in this context.

4 Credit Swaps as CRM for Wholesale Exposures  Eligible credit derivative or guarantee must “cover all or a pro rata portion of all contractual payments of the obligor”: wholesale financial exposures on which there is tranching of credit risk are securitization exposures.  Consider “Fixed Cap” CDS on ABS which covers less than full contractual interest payment.  Bank may use PD substitution approach or LGD adjustment approach to reflect credit risk of guarantor or credit swap seller.  “Pay as you go” swaps do not get benefit of lower LGD of hedged exposure in PD substitution approach or in double default treatment.

5 Credit Swaps as CRM for Securitization Exposures  Eligible securitization guarantors include:  Sovereigns, multilaterals, GSEs, banks and BHCs, and securities firms.  Any entity other than a “securitization SPE” that has an external or internal rating of A3/A- or above.  “Securitization SPE” Exclusion:  Guarantee or credit swap written by a “securitization SPE” is not CRM; it is itself a securitization exposure.  “Securitization SPE” definition is defined separately from “traditional securitization” but is similar.  “Traditional securitizations” exclude certain “operating companies” but not companies whose assets are primarily financial assets.  Exception is intended for certain hedge funds or private equity funds, but only those with “unfettered” operations and control over their capital structure: not CDOs or SIVs.  Consider status of DPCs.  A debt or equity interest in a “traditional securitization” is not a wholesale or equity exposure; it is a securitization exposure.

6 Credit Swaps as CRM for Securitization Exposures, cont’d  Treatment of guarantee differs depending on whether guarantor is internal or external to the securitization.  Internal guarantee results in ratings based category.  External guarantee or credit swap is treated as CRM of securitization exposure  Consider custody receipt structures.

7 Credit Swaps as CRM for Securitization Exposures, cont’d  CRM from qualifying full protection credit swap or guarantee results in bank being able to replace ratings based treatment of protected securitization exposure with risk weighted asset amount equal to a direct wholesale exposure to the guarantor, using the bank’s PD for the guarantor, ELGD and LGD for the guarantee or credit swap and EAD equal to the amount of the securitization exposure.  Securitization exposures exclude tranched credit risk in relation to non-financial exposures, such as project financings and real estate securitizations.

8 Double Default Treatment  “Double default” recognizes that, e.g., a “BBB” risk guaranteed by a “AA” guarantor is a lower risk than either the “BBB” risk or the “AA” risk alone.  But double default treatment is disallowed in many categories due to concerns regarding correlation and systemic risk.  Counterparty for a credit swap affording double default treatment must be a bank, BHC or securities firm, or an insurance company in the business of providing credit protection (e.g. a monoline), and cannot be an affiliate of the obligor of the hedged exposure.  Institution must address correlation risk through “a process (which has received the prior, written approval of the [agency]) to detect excessive correlation between the creditworthiness of the obligor of the hedged exposure and the protection provider.”

9 Double Default Treatment, cont’d  A non-U.S. based institution may qualify as a double default guarantor only if it is subject to consolidated supervision and regulation comparable to that imposed on U.S. banks, securities firms, or insurance companies (as applicable), or has an unsecured long-term debt security rated at least investment grade without credit enhancement.  No double default treatment where the obligor on the relevant exposure is:  A “retail” exposure.  A sovereign exposure.  A securitization exposure (but certain rated SPV-issued assets are not treated as “securitization exposures”).  A financial institution that would be eligible to write double default qualifying protection, or an affiliate of such an institution..

10 Operational Risk and Synthetics  Operational risk means “risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events (including legal risk but excluding strategic and reputational risk).”  Operational loss categories includes “operational losses resulting from the nature or design of a product or from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements).”  Agencies did not modify proposed boundaries between credit and operational risk.  Operational losses related to market risk are treated as operational risk.  Losses related to both credit and operational risk are treated as credit losses.

11 Operational Risk and Synthetics, cont’d  Agencies noted that one recent driver of operational risk is “proliferation of new and highly complex products”.  Agencies noted “a number of high-profile, high-severity operational losses across the banking industry, including those resulting from legal settlements, highlight operational risks as a major source of unexpected losses.”  Consider the “99.9 th percentile” of operational risk exposure in credit derivative products operations based on the experience of the last year..