Trust Preferred CDO Primer

Highlights of This Issue

Investors in trust preferred (TruPS) CDOs receive an attractive pick-up tocompeting cash CDO sectors while gaining exposure to the heavily regulatedbank and insurance sectors, which have outperformed corporates historically. Todate since mid-2000, 51 TruPS CDOs have been issued aggregating to$21.8 billion in rated notes and equity. The major obstacle to growth in this CDOsubsector is limited collateral supply. Risks for the TruPS CDO investor includeindustry concentration, interest deferral potential, auction-related extension riskand collateral prepayment risk.On an expected loss-adjusted basis, TruPS CDOs are particularly attractive, asthis sector has experienced no downgrades and no collateral defaults over itsfour year existence. While historical losses for middle market banks and insurersare more comparable to crossover corporate credits, subordination in TruPSCDOs is more similar to that of a BB/B average HY CBO. Consequently, we thinkthat there is more than adequate structural protection against losses in TruPSCDOs. Although the longer maturity of the collateral vis-à-vis the CDO tranchetenor implies average life uncertainty, various structural mitigants provide ampleprotection against extension risk. TruPS CDOs offer a compelling and uniqueopportunity for investors to gain unlevered (AAA) or levered (AA or below)exposure to middle market bank and insurer debt.

Chart 1: The Market for Trust Preferred CDOs: Annual New Issuance Volume

3,3764,3854,8935,1262,0491,038553344 -1,0002,0003,0004,0005,0006,0007,0008,00020002001200220032004 YTD

$ s i n m i l l i o n s

Bank TruPS*Insurance TruPS**

6,1646,9424,7293,376553

Source: Merrill Lynch* All bank or bank-dominant collateral (e.g., hybrids) / ** 100% insurance collateral

FIXED INCOME STRATEGY

United States

C D O R e s e a r c h

11 November 2004

Lang GibsonDirector(1) 212 449-3942lang_gibson@ml.com

Trust Preferred CDOs: A Primer

Merrill Lynch CDO Primer Series

Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be awarethat the firm may have a conflict of interest that could affect the objectivity of this report.Investors should consider this report as only a single factor in making their investment decision.Refer to important disclosures on page 40. Analyst Certification on page 40.

Global Securities Research & Economics GroupFixed Income Strategy

RC#61431602

Trust Preferred CDOs: A Primer – 11 November 2004

2

Refer to important disclosures on page 40.

Trust Preferred CDOs: A Primer

Introduction

Trust Preferred (TruPS) CDOs were first issued in mid-2000, four years after the1996 Federal Reserve granted Tier 1 capital relief to banks issuing trust preferredsecurities. Since 2000, there have been 51 TruPS CDOs (42 bank-dominant andnine pure insurance) issued aggregating to $21.8 billion in rated notes and equity(see Appendices 2 & 3 for full deal details).

Whereas demand remains healthydue to the sector’s highest yield among cash CDOs, the greatest obstacle togrowth is sourcing enough collateral to structure a sufficient number of CDOs to meet this demand.

Trust preferred securities (TruPS) have enabledissuers to raise capital on a tax advantaged basis to fund growth or repurchasestock without diluting shareholder wealth. CDOs allow small banks and insurers

that don

’

t have access to the public capital markets ($25 to 300 million issues) toissue in $3-15 million sizes and to get the same benefits that larger issuers receive

without the high fixed issuance costs. Bank issuers can deduct their TruPS

dividendpayments for tax purposes and yet still obtain regulatory capital

treatment (or, in thecase of insurers, statutory accounting and rating agency capital) up to a specifiedlimit. The most successful CDO originators have strong relationships with manysmall and medium sized financial institutions nationwide allowing them to sourcea geographically diverse pool of 25 to 40 credits with an optimal combination of risk and return. Our report is divided into the following six sections:

Page

n

Trust Preferred Securities Overview2

n

TruPS CDO Overview4

n

Collateral Loss Trends: Banks and Insurers5

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Structure8

n

Cash Flow Analysis11

n

Relative Value15

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Overview of the Bank and Insurance Industries18

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Appendix 1: Rating Agency Methodologies25

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Appendix 2: TruPS CDO Deal List28

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Appendix 3: TruPS CDO Database with Structure and Pricing29

Trust Preferred Securities Overview

Trust preferred securities have the following general characteristics:

•

Subordinate to all debt on a company

’

s balance sheet, but senior to bothpreferred and common stock.

•

Generally thirty year in term, non-amortizing instruments that pay quarterlyor semi-annual interest.

•

Dividend payments may be deferred for up to five years.

•

Callable after five years for small institutions and ten years from issuance forlarge capital markets issues.

•

Dividends, which are typically floating rate for issuers into CDOs, are tax-deductible to the issuer.

While the focus of this primer is bank TruPS, we do address insurance TruPSand surplus notes due to their increasing inclusion in bank deals.

Trust Preferred CDOs: A Primer

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11 November 2004

Refer to important disclosures on page 40.

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n

Bank TruPS

TruPS benefit from the tax advantages associated with debt and capital relief

associated with equity. Both the securities

’

long-term nature (30 years) andthe issuer

’

s ability to defer dividends for up to five years contribute to bankregulators allowing TruPS to account for up to 25% of Tier 1 capital

. Bank issuers are typically wholly-owned subsidiaries of bank holding companies, ormay be a subsidiary of the bank directly. The trust sells securities to investors anduses the proceeds to purchase subordinated debentures of its holding company.The trust uses the interest payments that it receives from the purchased debenturesto make payments to the holders of its preferred securities. The terms of thesubordinated debenture are identical to those of the issued TruPS (Chart 2).

Chart 2: Flows for a TruPS Security

L i m i t e d G u a r a n t e e

1 0 0 % C o n t r o l

SubordinatedDebt & DebtPaymentsProceeds of TrustPreferred SecuritiesofferingTrust PreferredSecurities & DividendPaymentsProceedsof Offering

Bank or Bank Holding Company

Special Purpose Business Trust (Issuer)

Trust Preferred Investors

Source: Merrill Lynch

n

Insurance TruPS and Surplus Notes

Both insurance TruPS and surplus notes, which are often also included in CDOpools, are hybrid instruments (much like bank TruPS) in the capital structure of anoperating insurance company. Their interest is tax deductible and they receivepartial credit for permanent equity capital by the rating agencies.