See Disclosure Appendix A1 for the Analyst

Certification and Other Disclosures.

US Fixed Income Quantitative Strategy

June 19, 2006

CDO Strategy Notes

Ratul Roy

ratul.roy@citigroup.com

(212) 816-8631

Credit Default Swaps on CDOs

Explaining the New ISDA Confirmation
Summary Points
- The International Swaps and Derivatives Association (ISDA) published a template for credit default
swaps last week, referencing CDO debt tranches with ongoing pay-as-you-go settlement and with
physical settlement following a credit event.
-

In addition to events of failure to pay interest or principal, protection payments can be triggered by
actual writedown of CDO tranches (and implied writedown if so elected by counterparties) and by certain
ratings downgrades.
Using numerical examples, we illustrate the mechanics of the working of the confirmation.
In certain restricted circumstances, the pay-as-you-go settlement mechanism results in payments to and
from protection sellers that mirror those of payments received by cash CDO buyers.

Key Features of the Confirmation

The confirmation has several standard features and two main points of election by counterparties (the use
of implied writedown for CDO tranches and of caps for any shortfall in interest). These are described here:
The risk buyer or protection seller (Floating Rate Payer) and the protection buyer (Fixed Rate
Payer) agree to the periodic premium rate that will be charged (Fixed Rate) and the initial notional
amount of the CDO tranche for the purpose of the transaction (Reference Obligation Notional
Amount). The CDS transaction notional amount will change during the transaction life (usually the
legal maturity of the CDO), depending on whether there have been principal repayments on the CDO
tranche and whether there has been an actual or implied (see below) writedown of the CDO tranche.
The CDS transaction notional amount does not change if part of the CDO tranche represents
capitalization of deferred interest.

Separate from two-directional payments under the pay-as-you go settlement process, a credit event has
to occur, along with appropriate notice of such an event, for protection payments to be made in
exchange for physical delivery of the reference obligation. Credit events are failure to pay principal or
interest (note that if the CDO is PIK-able, usually 360 days have to elapse without the interest shortfall
being reimbursed), a writedown of the CDO tranche, or a downgrade of the CDO tranche to distressed
rating levels Credit events, along with subsequent settlements, can occur several times during the life
of a transaction.

Writedowns of the CDO tranche can be either actual (uncommon) or, if so elected by the protection
buyer and seller, implied. An Implied Writedown Payment has to be made from the protection seller
to the buyer if the current period writedown amount exceeds that of the previous period. The current
period writedown amount is the product of (1) the sum of the CDO tranche (including any pari passu
tranches) and all tranches senior to it within the CDO transaction, and (2) one minus the
overcollateralization (OC) ratio of the CDO tranche. Importantly, writedown amounts are not paid if
Citigroup Global Markets

the overcollateralization ratio exceeds one. If the current period writedown amount falls below that of
the previous period, the protection buyer has to reimburse the seller by a corresponding amount. When
calculating the amount to be paid, the higher of the two OCs is capped at one. This is also the case with
the payment from seller to buyer.

In connection with pay-as-you-go settlement, payments by the protection seller to the buyer (Floating
Payments) are made if there has been a failure to pay principal, a shortfall of interest on the CDO
tranche, or a writedown. (Writedown payments amounts are as described above.) Payments must be
made whether or not a defined credit event has occurred. A shortfall in interest occurs when the current
expected interest amount exceeds the actual interest paid. If there is no Interest Shortfall Cap elected
within the contract (discussed in more detail below), the shortfall amount that the seller pays the buyer
is the difference (the Interest Shortfall Payment Amount). For PIK-able CDO tranches, the expected
interest amount is calculated without considering any part of the tranche notional that represents
deferred interest. The actual interest will, however, include any return of notional of the CDO tranche
representing deferred interest. Conversely, if the actual interest amount exceeds the expected amount,
the difference is reimbursed by the buyer of protection to the seller. Finally, a Principal Shortfall
Payment is made when the expected principal amount at maturity or final amortization date (which
will account for the effect of all previous writedowns and subsequent payments) falls below the actual
principal amount.

Payments made by the protection buyer to the seller (Fixed Payments) are the premium for the cost
of protection, and any appropriate reimbursements (as described above) of interest and principal
shortfall previously made by the seller. The premium is calculated on the CDS notional amount at the
beginning of the last payment period or on a weighted average amount for the related period.

The ISDA confirmation allows capping the amount of shortfall in interest that the protection seller
makes good to the protection buyer (if so elected by the buyer and seller). The cap, described in the
Interest Shortfall Cap Annex of the confirmation, can be a Fixed Cap or a Variable Cap. In the
case of a Fixed Cap, the maximum amount paid by the protection seller in the case of a shortfall in
interest is the premium paid by the protection buyer to the seller. In the case of a Variable Cap, the
maximum amount is the premium plus any funding rate (Relevant Rate) on the CDS notional amount
at the beginning of the last payment period or on an average amount. Any reimbursements made by the
protection buyer to the seller will factor the existence of the cap in the amounts previously made by the
seller.

Participants can also agree to include an Interest Shortfall Compounding option. This requires the
calculation agent to determine accrued interest on previously unpaid interest on the CDO tranche (this
amount is zero if the compounding option is not selected). Likewise, if the reimbursement option is
elected, it will include a compounding factor greater than one (the factor is one without the option) on
cumulative interest shortfall amounts.

Settlement is physical only for the specific CDO tranche. In case the protection buyer is unable to
physically deliver the entire outstanding CDS notional amount of security, a partial Exercise Amount
will be delivered. For the remainder, the transaction will continue and the buyer can deliver any time
thereafter.

Economics for Buyer Versus Seller

Transactions without Implied Writedown will be more favorable for the protection seller from a timing
perspective (note that Implied Writedown only advances loss payments to the protection buyer; it does not
lead to greater nominal payments per se). Likewise, protection sellers will prefer situations where interest
shortfall amounts are capped at the premium they receive from buyers (Fixed Cap). The absence of the
Citigroup Global Markets

Interest Shortfall Compounding option, though its magnitude may be small, will be more attractive for
buyers. In summary, a transaction with all these three features that is, no Implied Writedown, a Fixed
Cap, and no Interest Shortfall Compounding poses the least potential payout from protection sellers.
Conversely, protection buyers will receive the most payout by opting for Implied Writedown (from a
timing perspective), no cap, or the Variable Cap alternative combined with Interest Shortfall
Compounding. It is expected that as the market develops the premium paid by buyers will reflect the
appropriate differences in risk among these various alternatives.
Some Numbers
To illustrate the likely mechanics of the confirmation, we choose a simple example of a seven-year annualpay CDO tranche. The CDS starts on the issue date of the tranche. LIBOR is assumed constant throughout
the transaction life and premium is calculated on the CDS Reference Obligation Notional Amount at the
beginning of the interest period (that is, without accounting for any intraperiod change). The features of the
transaction are shown in Figure 1.
Figure 1. Assumptions
Assumption

Variable

A0
A1
A2
A3
A4
A5
A6
A7
A8
A9
A10
A11
A12
A13

CDO Issue Date

CDS Effective Date
CDO Tranche Original Principal Amount
CDO Outstanding Principal on Effective Date
Senior Tranches above CDO Tranche
CDS Initial Face Amount
Applicable Percentage
CDS Reference Obligation Notional Amount
Fixed Rate for CDS premium
CDO Tranche Spread Over Libor
Constant LIBOR
CDO Tranche Coupon
Borrowing Cost to Fund CDO Tranche
Rate for Interest Shortfall Compounding

Value

4/1/2006
4/1/2006
40,000
40,000
160,000
10,000
0.25
10,000
3%
3%
4%
7%
4.0%
7%

Source: Citigroup.

In addition, certain key events occur in the life of the transaction. These are listed in Figure 2.
Figure 2. Diary in Life of Example CDO Tranche
Number

Event

E1
E2
E3
E4
E5
E6
E7
E8

Issued with notional $40,000

Pays principal of $4,000 (new outstanding of $36,000)
Defers full interest (PIKs)
Defers interest (PIKs) again
Pays full interest and repays all PIK balance
Overcollateralization goes down below 1 (to 91.8%)
Overcollateralization increases to 96.9%
At legal maturity, repays only $24,000 of $36,000 balance

Date

4/1/2006
4/1/2007
4/1/2008
4/1/2009
4/1/2010
4/1/2011
4/1/2012
4/1/2013

Source: Citigroup.

The payout under the CDS contract is shown in Figure 3. Periodic payments for a CDS contract with no
interest shortfall cap and with Implied Writedown are shown in row C16. The impact of a Fixed Cap are
shown in rows C19 and C20 (much lower shortfall payments) while the periodic cash flows as a result of a
Variable Cap, but with no Implied Writedown, are exhibited in row C26.

Citigroup Global Markets

Figure 3. Payout of CDS Contract on CDO Tranche Under Assumptions of Figures 1 and 2 (in Dollars)
4/1/2006 4/1/2007 4/1/2008 4/1/2009 4/1/2010 4/1/2011 4/1/2012 4/1/2013
Row
C0
C1
C2
C3
C4
C5
C6
C7
C8
C9
C10
C11
C12
C13
C14
C15
C16

CREDIT DEFAULT SWAP

Implied writedown amount (see CDO tranche)
Principal amount for expected interest
Expected interest amount
Actual interest amount
Expected principal amount for CDS
Actual principal amount
Ref Obligation Not Amt (Implied Writedown)
Ref Obligation Not Amt (No Implied Writedown)
Principal shortfall amount (Implied Writedown)
Implied Writedown Amount payment
Implied Writedown Amount reimbursement
Interest Shortfall Payment Amount (no Cap)
Interest Shortfall Reimbursement Amount (no Cap)
Fixed Premium (Implied Writedown)
Total Fixed Payment
Total Floating Payment
Net Economics to Seller (No Cap, Implied Writedown)

C17
C18

Principal shortfall amount (No Implied Writedown)

Fixed Premium (No Implied Writedown)

C23
C24
C25
C26

Fixed Cap, No Implied Writedown, Compounding

Interest Shortfall Payment Amount
Interest Shortfall Reimbursement Amount
Cum Interest Shortfall Amount (Compounding)
Cum Interest Shortfall Payment
Variable Cap, No Implied Writedown, Compounding
Interest Shortfall Payment Amount
Interest Shortfall Reimbursement Amount
Cum Interest Shortfall Payment
Net Economics to Seller

B0
B1
B2
B3
B4
B5
B6
B7
B8
B9
B10
B11
B12
B13

CDO TRANCHE
Asset Par
OC (Senior Tranche stays 160,000)
Outstanding Notional w/o PIK
Outstanding Notional incl PIK
Tranche Payout before legal
Coupon Due
Coupon Paid
Coupon Shortfall
Coupon Capitalized
Coupon Capitalized Cumulative
PIK Paid
Net cash for 10,000 Tranche position
Borrowing to Pay for 10,000 Tranche
Net Economics to Tranche holder

C19
C20
C21
C22

0
40,000

10,000
10,000

210,000
105.0%
40,000
40,000

0
36,000
2,800
2,800
0
0
9,000
9,000
0
0
0
0
0
300
300
0
300

0
36,000
2,520
0
0
0
9,000
9,000
0
0
0
630
0
270
270
630
-360

0
36,000
2,520
0
0
0
9,000
9,000
0
0
0
630
0
270
270
630
-360

0
36,000
2,520
8,101
0
0
9,000
9,000
0
0
0
0
1,395
270
1,665
0
1,665

16,000
36,000
2,520
2,520
0
0
5,000
9,000
0
4,000
0
0
0
270
270
4,000
-3,730

6,000
36,000
2,520
2,520
0
0
7,500
9,000
0
0
2,500
0
0
150
2,650
0
2,650

6,000
36,000
2,520
2,520
30,000
24,000
7,500
9,000
1,500
0
0
0
0
225
225
1,500
-1,275

0
300

0
270

0
270

0
270

0
270

0
270

3,000
270

0
0
0
0

270
0
630
270

270
0
1,304
559

0
598
0
0

0
0
0
0

0
0
0
0

0
0
0
0

0
0
0
300

630
0
630
-360

630
0
1,304
-360

0
1,395
0
1,665

0
0
0
270

0
0
0
270

0
0
0
-2,730

210,000
107.1%
36,000
36,000
4,000
2,800
2,800
0
0
0
0
700
400
300

210,000
107.1%
36,000
38,520
0
2,520
0
2,520
2,520
2,520
0
0
360
-360

210,000
107.1%
36,000
41,216
0
2,696
0
2,696
2,696
5,216
0
0
360
-360

210,000
107.1%
36,000
36,000
0
2,885
2,885
0
-5,216
0
5,216
2,025
360
1,665

180,000
91.8%
36,000
36,000
0
2,520
2,520
0
0
0
0
630
360
270

190,000
96.9%
36,000
36,000
0
2,520
2,520
0
0
0
0
630
360
270

190,000
96.9%
36,000
36,000
0
2,520
2,520
0
0
0
0
630
3,360
-2,730

Source: Citigroup

Some other important points are worth noting.

The payout of 10% of the CDO tranche notional ($4,000 for a $40,000 initial notional, rows B4,
B2) leads to the CDS Reference Obligation Notional decreasing from $10,000 to $9,000 (row C6,
C7).

Calculation of expected interest amount (row C2) for the purposes of the CDS contract does not
take into account any increase in CDO tranche outstanding due to PIK-ing (row B3). However, the
Citigroup Global Markets

actual interest amount (row C3) reflects return of capitalized deferred (PIK) interest (row B10).
Row C12 for April 1, 2010 = 1,395 = 25% (since the $9,000 CDS notional is only 25% of the
$36,000 CDO tranche notional) of $8,101 (row C3) less $2,520 (row C2). This excess interest is
reimbursed by the protection buyer to the seller in return for the interest shortfall amounts that the
buyer previously received (row C11). The difference between the two amounts ($1,395 versus
$1,260) represents interest on unpaid interest that the protection seller advanced to the buyer.

The Implied Writedown option serves to advance protection payments to the buyer in its
absence, the buyer would have received this amount only at maturity. Compare rows C8 and C16
with rows C17 and C26. The CDO tranche with an outstanding of $36,000 was only repaid
$24,000 at maturity, implying a $3,000 loss for the holder of a $9,000 tranche. This is the loss the
protection seller pays the buyer at the legal maturity (row C17). However, under the Implied
Writedown option, the seller has already paid the buyer $1,500 (paid $4,000 on April 1, 2011, row
C9, and was reimbursed $2,500 on April 1, 2012). Therefore, the payment for a principal shortfall
under this option was only $1,500 (row C8). The net cash payout for the seller was much more
front-loaded (row C16) than in the case without the option (row C26).

The Implied Writedown also reduces the premium payments received by the seller (compare C13
with C18).

Cash Bond Versus CDS Investing

Credit default swaps are attractive to credit buyers because of the unfunded nature of the investment no
need for upfront cash! Exact economics, though, available to a CDS protection seller will generally vary
from those available to a bond buyer who is able to purchase the asset on an unfunded basis, even without
any haircuts. There may be some limited circumstances where the two mirror each other as shown in row
B13 of Figure 3 (the last row) when compared with row C26. In this situation, the CDS contract does not
include an Implied Writedown option, but it does include an Interest Shortfall Variable Cap and Interest
Shortfall Compounding option (for unpaid interest), which is meant to replicate interest on unpaid interest
commonly available to CDO PIK-able tranche holders. Furthermore, the cash buyer is able to borrow the
entire notional amount of the investment at the same funding rate (LIBOR) as the index rate on the CDO
tranche (assumptions A9 and A12 in Figure 1). If, however, the investors funding cost is at a spread over
LIBOR, the net payments in row B13 will be commensurately reduced, in which case the investor may be
willing to seek exposure at a lower premium than the spread available on the physical CDO tranche
(compare row A8 with A9 in Figure 1).

Citigroup Global Markets

Disclosure Appendix A1
ANALYST CERTIFICATION
I, Ratul Roy, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the
subject securities, issuers, currencies, commodities, futures, options, economies or strategies. I also certify that no part of my
compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) expressed in this report.

Other Disclosures
ADDITIONAL INFORMATION AVAILABLE UPON REQUEST
Citibank, N.A., London Branch and Citigroup Global Markets Inc, including its parent, subsidiaries, divisions and/or affiliates (the
Firm), may make a market in the securities discussed in this report and may sell to or buy from customers, as principal, securities
recommended in this report. The Firm may have a position in securities or options of any issuer recommended in this report. The
Firm may be regular issuers of, and trade in (including position taking), financial instruments linked to securities, which may have
been reported on in this research report. The Firm may perform or solicit investment banking or other services from any issuer
recommended in this report. An employee of the Firm may be a director of an issuer recommended in this report. Within the past
three years, the Firm may have acted as manager or co-manager of a public offering of the securities of any issuer recommended in
this report. Securities recommended, offered, or sold by the Firm : (i) are not insured by the Federal Deposit Insurance Corporation;
(ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment
risks, including the possible loss of the principal amount invested. Past performance is not a guarantee of future results. This report
does not take into account the investment objectives, financial situation or particular needs of any particular person. Investors should
obtain advice based on their own individual circumstances before making an investment decision. Investing in non-U.S. securities,
including ADRs entails certain risks. The securities of non-U.S. issuers may not be registered with, nor be subject to the reporting
requirements of, the U.S. Securities and Exchange Commission. There may be limited information available on foreign securities.
Foreign companies are generally not subject to uniform audit and reporting standards, practices and requirements comparable to
those in the U.S. Securities of some foreign companies may be less liquid and their prices more volatile than securities of
comparable U.S. companies. In addition, exchange rate movements may have an adverse effect on the value of an investment in a
foreign securities and its corresponding dividend payment for U.S. investors. Net dividends to ADR investors are estimated, using
withholding tax rates conventions, deemed accurate, but investors are urged to consult their tax advisor for exact dividend
computations. Although information has been obtained from and is based upon sources the Firm believes to be reliable, we do not
guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute the Firm 's judgement as of the
date of the report and are subject to change without notice. This report is for informational purposes only and is not intended as an
offer or solicitation for the purchase or sale of a security. This research report does not constitute an offer of securities. Any decision
to purchase securities mentioned in this research must take into account existing public information on such security or any registered
prospectus. Investing in non-US securities by US persons may entail certain risks. Investors who have received this report from the
Firm may be prohibited in certain US States from purchasing securities mentioned in this report from the Firm; please ask your
Financial Consultant for additional details. This report is distributed in the United Kingdom by Citibank, N.A. London Branch or
Citigroup Global Markets Limited, Citigroup Centre, Canada Square, Canary Wharf, London E14 5LB, UK. This material is directed
exclusively at market professional and institutional investor customers in the United Kingdom and is not for distribution to private
customers in the United Kingdom, as defined by the rules of the Financial Services Authority, who should not rely on this material.
Moreover, any investment or service to which the material may relate will not be made available to such private customers. This
material may relate to investments or services of a person outside of the United Kingdom or to other matters which are not regulated
by the Financial Services Authority and further details as to where this may be the case are available upon request in respect of this
material. If this publication is being made available in certain provinces of Canada by Citigroup Global Markets (Canada) Inc. ("The
Firm Canada"), the Firm Canada has approved this publication. If this report was prepared by the Firm (excluding Nikko Citigroup
Limited) and distributed in Japan by Nikko Citigroup Limited, it is being so distributed under license. This report is made available in
Australia, to non-retail clients through Citigroup Global Markets Australia Pty Limited (ABN 64 003 114 832 and AFSL No. 240992), a
participant of the ASX Group and a participant of the Sydney Futures Exchange Limited and to retail clients through Smith Barney
Citigroup Australia Pty Ltd (ABN 10 009 145 555 and AFSL No. 240813), a participant of the ASX Group. In New Zealand it is made
available through Citigroup Global Markets New Zealand Limited, a member firm of the New Zealand Stock Exchange. Citigroup
Global Markets (Pty) Limited is incorporated in the Republic of South Africa (company registration number 2000/025866/07) and its
registered office is at Citibank Plaza, 145 West Street, Sandown, Sandton, 2196, Republic of South Africa. The investments and
services contained herein are not available to private customers in South Africa. This publication is made available in Singapore
through Citigroup Global Markets Singapore Pte Ltd, a Capital Markets Services license holder. This report is being distributed in
Hong Kong by or on behalf of, and is attributable to Citigroup Global Markets Asia Limited, 20th Floor, Three Exchange Square, Hong
Kong. Citigroup Global Markets Inc. is a member of the Securities Investor Protection Corporation (SIPC). Citigroup Global Markets
Inc., 2006. All rights reserved Smith Barney is a division and service mark of Citigroup Global Markets Inc. and its affiliates and is
used and registered throughout the world. Citigroup and the Umbrella Device are trademarks and service marks of Citicorp and its
affiliates and are used and registered throughout the world. CitiFx is a service mark of Citicorp. Any unauthorized use, duplication
or disclosure is prohibited by law and may result in prosecution. Nikko is a service mark of Nikko Cordial Corporation.