Cross-Product Research
January 25, 2008
Glen Taksler
(212) 933 2559
The CDS market has
never settled a Credit
Event on a monoline
insurer.
Each time an important
new issue arises in CDS,
the market learns that it
should have written the
contracts governing CDS
contracts somewhat
differently.
The protection Buyer may
deliver debt which is
wrapped by the monoline,
in addition to bonds and
loans.
Should an investor want
to deliver a CDO tranche,
2
In Europe, the CDS market now uses Modified-Modified Restructuring. For details, please see our Credit Default Swap Primer:
Third Edition, February 28, 2007.
3
Convertible ranks pari passu or better in seniority to the reference obligation.
35
Credit Strategy
Monolines: A Potential CDS Settlement Disaster?
With the exception of ACA, monolines are rallying on news of a potential private
sector solution. Nonetheless, should a Credit Event occur in a monoline (for example,
ACA), we see huge potential problems for settling CDS contracts. Even a Credit Event
for a relatively small monoline, such as ACA, could have significant implications,
because protection holders on larger monolines may demand a higher premium, to
compensate for lessons learnt.
At an intuitive level, the CDS market has never seen a monoline Credit Event before.
Each time an important new issue arises in CDS, the market learns that it should have
written the contracts governing CDS contracts somewhat differently. For example,
following the Conseco Restructuring in 2000, protection Buyers delivered long bonds
whose value was significantly below par. This eventually resulted in the CDS market
implementing Modified Restructuring, which limits the maturity date of bonds that may
2
be delivered following a Restructuring. Similarly, following the Railtrack Bankruptcy
in 2000, there was a debate as to whether convertible bonds were deliverable into CDS
contracts. This eventually resulted in changes to the ISDA Credit Derivatives
Definitions, which explicitly state circumstances under which convertible bonds are
3
deliverable .
Monoline CDS contracts are governed by the usual 2003 ISDA Credit Derivatives
Definitions, plus a 2005 Monoline Supplement. This supplement allows the protection
Buyer to deliver debt which is wrapped (guaranteed) by the monoline insurer, such as a
municipal bond or super senior CDO tranche. These Deliverable Obligations are in
addition to the direct debt of a Reference Entity—i.e., bond or loan—which is
deliverable under standard CDS contract language.
Should an investor want to deliver a CDO tranche—for example, a super senior—that
tranche must be guaranteed directly by the monoline, so that the insured instrument
(i.e., the tranche) is Borrowed Money. Quoting from the ISDA 2005 Monoline
Supplement (emphasis added):
“Qualifying Policy” means a financial guaranty insurance policy or similar
financial guarantee pursuant to which a Reference Entity irrevocably guarantees
Situation Room 5
Cross-Product Research
January 25, 2008
Typically, monolines
issued a financial
guarantee on CDS on
CDO tranches, not the
underlying tranche.
4
Source: Company website.
35
or insures all Instrument Payments … of an instrument that constitutes
Borrowed Money … for which another party … is the obligor ...”
Typically, monolines issued a financial guarantee (wrap) on CDS on super senior
tranches, not the underlying super senior tranche. This was done for two main reasons.
First, dealers were not in the business of marking and trading financial guarantees,
whereas they are accustomed to trading CDS. More importantly, CDS is typically
marked-to-market daily, whereas our understanding is that financial guarantees need
not be re-marked unless they become impaired—that is, unless the tranche suffers a
loss of principal. Since dealers owned the underlying CDO tranche and wanted to be
able to offset potential (now actual) mark-to-market losses, CDS was more attractive
than a direct financial guarantee.
Figure 2 shows a sample structure which would allow for effective insurance from a
monoline, but would not be deliverable into CDS contracts. In this structure, a bank
owns a CDO tranche. The bank buys protection from a special purpose vehicle (SPV).
In exchange, the bank receives CDS protection from the SPV. At the same time, a
premium is paid to the monoline, in exchange for a financial guarantee on the CDS.
The bank is thus protected against lost of principal and interest payments.
MBIA provides this description of the process:
LaCrosse Financial Products, LLC (LaCrosse) was created in December 1999 to act
as a counterparty for structured derivative products, primarily pooled credit default
swaps. While MBIA does not have a direct ownership interest in LaCrosse, it is
consolidated in the financial statements of the Company on the basis that substantially
all risks and rewards are borne by MBIA. MBIA's guarantees of synthetic CDOs are
typically executed through LaCrosse, which enters into a credit default swap with the
counterparty. MBIA Insurance Corp., through a financial guarantee policy, then
4
guarantees the obligations of LaCrosse under the credit default swap.
However, because the wrap is not on the CDO tranche itself, the CDO tranche would
not be deliverable into CDS contracts referencing the monoline insurer.
Figure 2. Example of CDO Tranche Which Would Not Be Deliverable into Monoline CDS
Monoline Financial Guarantee Is on CDS Written by the SPV on the Tranche, Not on the Tranche Itself
Bank, which CDS Premium
owns CDO SPV
tranche
CDS Protection
Financial Financial
Guarantee Guarantee
Premium on CDS
Monoline
insurer
Source: Banc of America Securities LLC.
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Cross-Product Research
January 25, 2008
Standard CDS language
specifies physical
settlement, and we think
it would be difficult
(though not necessarily
impossible) to cash
settle a monoline.
Before the beginning of
the auction, a list of
Deliverable Obligations is
established. That is far
more straightforward for
non-monolines, where
only bonds and loans are
deliverable.
Moreover, if even a small
portion of Deliverable
Obligations have a very
low recovery rate, the
auction could result in a
very low cash settlement
price.
5
Even under cash settlement, parties are able to request to physical settlement, should they desire to do so, and are granted such
requests to the extent that another party is willing to take the opposite position. For details, please see our Credit Default Swap
Primer: Third Edition, February 28, 2007.
6
This is only an approximate, and incomplete, description of the CDS (“cash”) settlement process. For further details, please see
our Credit Default Swap Primer: Third Edition, February 28, 2007.
35
Do Not Assume Cash Settlement for Monolines
Since several companies filed for bankruptcy in 2005 including prominently Delphi
(October '05), investors have come to expect cash settlement of CDS contracts. Under
standard CDS language, which still specifies physical settlement, the burden is on the
protection Buyer to find a Deliverable Obligation (bond or loan for non-monolines)
into the CDS contract. That is, according to standard confirms, the protection Buyer
(generally) is only entitled to receive the notional value of protection (e.g., $10 million)
if he delivers a bond or loan to the Seller. Accordingly, as CDS notional grew to exceed
5
cash bond notional, short squeezes developed post-Credit Event.
Currently, cash settlement is only an expectation, not a requirement. If a monoline were
to suffer a Credit Event, we think it would be very difficult to cash settle. The reason is
that CDS settlement protocols (commonly called “cash settlement”) are actually an
auction, the mechanics of which resemble a Treasury auction. Roughly speaking,
approximately 15 dealers submit a market on, say, $10 million bonds, with a 2-point
bid-offer spread. Dealers may be required to trade bonds at their submitted levels,
6
which provides incentive for the submission of reasonable quotes.
Before the beginning of the auction, a list of Deliverable Obligations is established, and
any of those obligations may be delivered/received if a dealer is required to trade. For
example, in the Delphi auction, the 6.55% June 2006, 6.50% May 2009, 6.50% August
2013, and 7 .125% May 2009 all were Deliverable Obligations. Similar to CDS, dealers
participating in the auction quote markets assuming they will exchange the cheapest-to-
deliver.
Deliverable Obligation Challenges
To assemble a list of Deliverable Obligations for a monoline:
1. The dealer community would have to agree that the each proposed Deliverable
Obligation is indeed deliverable into CDS contracts. This is possible but time-
consuming.
2. Each dealer then would have to value each Deliverable Obligation to
determine the cheapest-to-deliver obligation. This would be a time-consuming
and difficult process, which could exceed the 30 calendar days within which
parties normally settle credit default swaps.
Recovery Rate Risk
Moreover, suppose that the bulk of Deliverable Obligations have a price of $70 to $80,
but a few Deliverable Obligations have a price of $10 to $20. To clarify, these figures
are just an example, not a recovery value estimate. Then, the CDS settlement auction
would likely result in a cash settlement price in the $10 to $20 range, because each
dealer would recognize that he may receive the lowest-price Deliverable Obligation. As
such, a CDS settlement protocol would have a substantial risk of realizing in a very low
recovery rate, in our view.
Situation Room 7
Cross-Product Research 35
January 25, 2008

Outlook
To be clear, we think that To be clear, we think that CDS (“cash”) settlement protocols are generally a good, and
CDS (“cash”) settlement necessary, part of the CDS market. We would prefer to see a protocol following a
protocols are generally a potential monoline Credit Event, but express concern that the methodology may need
good, and necessary, to be changed substantially for monolines to be successful and to avoid forcing all
part of the CDS market. parties into physical settlement.

Situation Room 8
Cross-Product Research 35
January 25, 2008

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16 Situation Room
Cross-Product Research 35
January 25, 2008

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BANC OF AMERICA SECURITIES RATINGS DISCLOSURES

BAS High Grade and High Yield Research employ a Buy/Neutral/Sell rating system, and these recommendations carry a time horizon of six months.
Buy: Spreads and / or total returns are likely to outperform sector averages over the next six months; the company has improving credit fundamentals and/or it is
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Rating Distribution*
Coverage Investment
Universe Recommendations Pct. Banking Clients Recommendations Pct.**
Buy 263 35 Buy 107 41
Hold 360 49 Hold 163 45
Sell 118 16 Sell 65 55
* For the purposes of this Rating Distribution, “Hold” is equivalent to our “Neutral” rating.
** Percentage of recommendations in each rating group that are investment banking clients.
As of 01/01/2008.
Further information on any security or financial instrument mentioned herein is available upon request.

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January 25, 2008

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19 Situation Room
 Banc of America Securities — Debt Research Directory
Paula Dominick, Global Head of Debt and Equity Research (212) 847 5322
Credit Strategy Research High Grade Research High Yield Research
Jeffrey A. Rosenberg, CFA (212) 933 2927 Dennis P. Coleman, CFA (212) 847 6224 Larry Bland (212) 847 6502
Head of Credit Strategy Research Head of High Grade Research Head of High Yield Research
Michael Contopoulos (212) 933 3372 Energy, Pipelines, Master Limited Partnerships Healthcare, Deathcare
Lighthouse Portfolio Strategy & Analytics Michael J. Barry (212) 933 2547 Andrew Brausa (212) 847 6481
Ivy Li, CFA +852 2847 6346 Insurance Building Materials, Homebuilding
Asian Credit Strategy, BASAL Andrew Bressler, CFA (202) 442 7454 Ana Goshko (212) 847 5936
Hans Mikkelsen (212) 847 6468 Washington Healthcare Telecommunications, Towers
High Grade Kevin Christiano (212) 933.2485 Bo Hunt (212) 847 5435
Clemens Mueller (212) 933 2577 Media, Telecommunications Chemicals
High Yield Todd Duvick, CFA (704) 388 5053 Lionel Jolivot (212) 583 8399
Olivera Radakovic (212) 933 2496 Food & Beverage, Supermarkets, Consumer Aerospace & Defense, Industrials, Services
Lighthouse Data Analysis & Indices Gerardo Fuentes (212) 847 6208 Douglas Karson (212) 933 2405
Glen Taksler (212) 933 2559 Technology Autos
Derivatives Strategy John Guarnera (704) 683 4878 James Kayler, CFA (212) 847 5223
Domestic Banks, Finance Companies Gaming, Lodging & Leisure, Restaurants
Douglas Karson (212) 933 2405 Kelly J. Krenger (212) 847 6410
Aerospace/Defense, Manufacturing, Autos Energy
Marisa B. Moss (212) 583 8493 William M. Reuter (212) 933 3363
Transportation Consumer, Retail
David K. Peterson, CFA (704) 386 9419 Peter D. Quinn, CFA (212) 583 8284
Healthcare Electric Utilities & Power
Peter D. Quinn, CFA (212) 583 8284 Eric Toubin, CFA (212) 847 6498
Electric Utilities & Power Technology, Food & Beverage
Beth Slade (212) 933 2469 Stephen Weiss (212) 933 2298
Building Materials Cable/Satellites, Broadcasting/Publishing, Theaters
Justin Starnes (704) 386 5466
Healthcare REITs

The persons listed on this directory have the
title “research analyst”. Unless otherwise
noted, any other contributors named on the
front cover of this report but not indicated
above have the title “research associate”.
All research analysts are employed by Banc of
America Securities LLC (BAS) except as noted
above.

BAS (United States) BASL (United Kingdom) BASAL (Hong Kong)

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