Credit Derivatives Primer - Trade2Win · Credit Derivatives Primer 2 October 18, 2002 Introduction...

GLOBAL EQUITY RESEARCH

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Credit Derivatives Primer Advantages, Risks, Accounting, Regulation, and the Way Ahead

Credit derivatives are becoming increasingly popular as a means of offsetting traditional lending risk and enhancing returns. Although used virtually exclusively now at only the largest banks, we believe various derivative structures will increasingly migrate to smaller institutions across the industry over time.

��While the recent growth in the credit derivatives market has been explosive and future growth appears promising, there are several issues that still need to be addressed to foster wider acceptance by prospective participants. In this report, we focus on remaining legal hurdles, existing and future regulatory frameworks, the state of accounting standards governing bookkeeping, and a basic discussion of how different types of credit derivatives function.

��Credit derivatives are off-balance sheet financial instruments that allow investors to more efficiently transfer and repackage credit risk. Financial institutions use them to enhance equity capital allocation, augment returns, improve asset-liability management, and optimize credit exposure.

��The global credit derivatives market has grown from almost nothing in 1995 to more than $1 trillion in notional amount at the end of 2001, according to recent estimates, and is expected to grow to $5 trillion at the end of 2004.

��As of 2Q02 U.S. banks held credit derivative contracts with a notional amount of $500 billion, still this is just 1% of the notional amount of total derivatives held. Credit derivatives are concentrated among the largest banks with JP Morgan, Citigroup, and Bank of America comprising over 90% of the market. We believe that over time mid-sized and small banks are increasingly likely to hold these instruments as standardization lowers associated costs and management teams feel more comfortable with implied risks.

��The credit derivatives market is regarded as a more efficient gauge of pure default risk than the cash bond or equities markets as it is not as hampered by technical issues such as lack of liquidity or interest rate fluctuations. In addition, some investors view the market as more subject to speculative forces, and therefore more volatile, than the cash market.

Brock Vandervliet 1.212.526.8893

[email protected]

Juan Partida, CFA 1.212.526.5744

[email protected]

FINANCIAL SERVICES Large-Cap Banks UNITED STATES

Sector View: 3-NEGATIVE

October 18, 2002

http://www.lehman.com

Credit Derivatives Primer

2 October 18, 2002

Introduction

One of the issues that has arisen, particularly this year as credit problems at the largest banks have deepened, is the nature and impact of credit derivatives. Despite improving disclosure, it remains difficult to discern on an individual-bank basis the precise impact of credit derivatives let alone ascertain the specific mix of derivatives a bank may be employing. We thought it would be useful to publish an analysis of the credit derivatives market that lies within the broader category of derivatives. As shown in Figure 1 below, although the market continues to grow extremely rapidly, it remains a very small part of the overall derivatives market, which remains dominated by futures contracts and interest rate swaps.

Figure 1: Breakdown of Derivatives Held by U.S. Banks

Futures & Forwards

21%

Swaps58%

Options20%

Credit Derivatives

1%

Source: OCC 2Q02 Bank Derivatives Report

Figure 2: Growth in Derivatives by Type ($ Billion)

-5,000

10,00015,00020,00025,00030,00035,00040,00045,00050,00055,000

Futures & Forwards

SwapsOptions

Credit Derivatives

Total

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1Q02 2Q02



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As opposed to actionable research tied directly to trading or investment ideas, this analysis consists of a description of major types of credit derivatives, the size of the market, and major players, as well as both current and proposed regulatory and accounting treatment that may affect the speed with which the market grows. Although highly concentrated among the largest banks with JP Morgan Chase, Citigroup, and Bank of America comprising 93% of total notional value, we believe the characteristics and capabilities of these products will make them increasingly sought after by broader array of banks over time.

Particularly with respect to pooled credit derivative products where credit risk is offset against a pool of multiple loan exposures, we believe these structures will become a compelling means of offsetting risk and immunizing the loan portfolio. In many cases this can already be done more rapidly than individual secondary market loan sales which, for other than a relative handful of extremely large corporate borrowers, is an illiquid and inefficient market.

Figure 3: Market Share Credit Derivative Products in the Global Market

Single-name default swaps

45%

Portfolio/CLO's22%

Credit-linked Notes8%

Total Return Swaps7%

Asset Swaps7%

Credit Spread Options

5%

Basket Products6%

Source:BBA 2002 Credit Derivatives Survey; as a % of Total Notional Amount Outstanding. Includes all participants (banks, insurance companies, hedge funds. Figures as of 2001.

What are Credit Derivatives?

Credit derivatives are off-balance sheet financial instruments that allow one party (the risk seller or protection buyer) to transfer the credit risk of a ”reference asset,” which it normally owns, to another party (the protection seller or guarantor) without actually selling the asset. In other words, credit derivatives enable investors to efficiently transfer and repackage credit risk. Credit risk in this context is inclusive of all credit-related events ranging from a spread widening tied to a rating downgrade, for example, to actual default. Reference assets include across bank debt, corporate debt, as well as high-grade sovereign and emerging market sovereign debt. According to some estimates,


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approximately 60% of underlying assets are corporate, while the rest is split between banks and sovereign credits.

Size of the Market

The global credit derivatives market has grown from almost nothing in 1995, with only a few one-off structures, to more than $1trillion in notional amount at the end of 2001, according to recent estimates (British Bankers Association, 2002 Report on Credit Derivatives), and is expected to grow to $5 trillion at the end of 2004. Banks are currently the largest players in the market. However, hedge funds have strongly entered the market, particularly as buyers, and by 2004, insurance companies are expected to become the largest sellers of protection. As of 4Q01, single-name default swaps comprised 45% of the global market (See Figure 3)

Growth in these products is only bound by the size of the pool of reference assets (bonds and loans that underlie them). Specifically, banks use credit derivatives for the following purposes:

��To hedge credit risk;

��To reduce risk concentrations on their balance sheets; and

��To free up regulatory capital.

According to the 2Q02 Bank Derivatives Report of the OCC, banks in the United States have credit derivative contracts with a notional amount of $500 billion. This amount represents only 1% of the notional amount of all derivatives the banks’ hold (See Figure 1)

Credit derivatives are highly concentrated among a handful of players, as shown below. The five largest credit derivatives portfolios represent 96% of all derivatives held, while the largest 16 are virtually the entire market. These figures are similar to the statistics for the total derivatives bank portfolios. As shown in Figure 4, JP Morgan Chase clearly dominates in this area, holding 56.5% of total credit derivatives by notional amount, followed by 20.1% at Citibank, and 16.1% at Bank of America.


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Figure 4: Concentration of Credit Derivatives.

Top 16 Banks 2Q02 % Cumulative %1 JP Morgan Chase 278,104 56.5% 56.5%2 Citibank 99,072 20.1% 76.6%3 Bank of America 79,111 16.1% 92.7%4 Wachovia 9,631 2.0% 94.6%5 Fleet National Bank 7,898 1.6% 96.3%6 Bank One 6,716 1.4% 97.6%7 HSBC Bank USA 2,412 0.5% 98.1%8 Wells Fargo 2,268 0.5% 98.6%9 Bank of New York 1,841 0.4% 98.9%

10 Merrill Lynch Bank 1,565 0.3% 99.3%11 Deutsche Bank Americas 569 0.1% 99.4%12 Suntrust Bank 255 0.1% 99.4%13 First Tennessee Bank 240 0.0% 99.5%14 PNC Bank National 159 0.0% 99.5%15 Mellon Bank 19 0.0% 99.5%16 Comerica Bank 11 0.0% 99.5%

Largest 16 489,871 99.5%Other Banks 2,394 0.5% 100.0%Total Banks 492,265 100.0%


Similar to overall growth trends in the market, credit derivatives growth at U.S. banks has been explosive, boasting the largest growth rate for any of the generic types of derivatives. Growth rates declined in 2001, in line with the rest of the derivatives products, at least in part due to the introduction that year of FAS 133, Accounting for Derivatives, which generated uncertainty as to its impact on bank financial statements. In 2Q02 credit derivatives expanded 59.2%, the highest level since 1999. For 1H02 the growth rate was 55.1% annualized.

Uses of Credit Derivatives

In their simplest form, credit derivatives provide a more efficient way to replicate the credit risk that exists for a standard cash instrument. These transactions are sometimes called single-name credit derivatives, as the reference assets belong to a single exposure. For example, selling a default swap (providing protection) on a GM bond is similar to the direct purchase of the bond. If the bond defaults, then the losses are borne by the protection seller. If the bond does not default, the investor receives the credit spread periodically, which should be similar to the bond coupon minus the cost of funding the bond had it been purchased. The advantage is that the investor replicates the cash flows of the bond and at the same time circumvents any technical limitations, such as the bond not being available for purchase.

In their more complex form, credit derivatives allow investors to split up the credit profile of an entire group or pool of assets into tranches and redistribute them among a wide variety of investors, depending on credit risk tolerance. The more complicated instruments are sometimes referred to as multi-name credit derivatives, as they involve exposures to


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several names . These arrangements typically require the use of off- or on-balance sheet Special Purpose Entities (SPE’s), which purchase the risk from banks and resell it to investors. Banks normally have to retain a fraction of ownership called the “equity” portion (See Figure 13), which consists of the highest risk tranche.

The credit derivatives market is considered more efficient than the equivalent cash market as it is not as hampered by liquidity issues and other extraneous market forces. However, being a relatively new market, liquidity is still concentrated in the short maturities, normally five years, but longer maturities are slowly consolidating as well.

While the credit derivatives market moves more quickly than the cash market, and credit derivative risk spreads are typically more responsive to changes in the underlying fundamentals of the reference assets, there also tends to be a high level of concentration on the names generating news flow at a particular moment. A good example of this is shown below where we depict spreads on Citgroup’s bonds versus the spread on its default swaps. Perceived changes in the credit risk of a particular issuer tend to be followed by a flurry of trades from market participants to take short or long positions. This makes the market more volatile that the cash market, but directionally the same over any reasonable time horizon.

Figure 5: Evolution of Cash Spread Versus Default Swap Spread (Citigroup)

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Cash Spread Default Swap Spread

Source: Lehman Brothers

Greater Standardization as the Market Matures

Another characteristic of the derivatives market is its increasing standardization. Initially, credit derivative contracts were tailor made for each transaction. Now, the use of the International Swap Derivatives (ISDA) master agreement, which provides standardized language, has increased liquidity and reduced legal risk. According to some estimates, 91% to 98% of transactions in the derivatives market in 2001 were done using ISDA’s


October 18, 2002 7

standardized format. However, there remain significant documentation issues regarding restructuring credit event definitions that still need to be addressed.

Regulatory Uncertainty Hampers Growth

While the regulatory aspect of the market is somewhat lagging, regulators around the world are making great efforts to ensure appropriate accounting disclosure and suitable capital allocation requirements. Some of these changes will diminish some of the advantages of credit derivatives, particularly regarding regulatory capital arbitrage transactions (explained in more detail later in this report). However, it is unlikely that growth in these products will decline significantly as a result. That said, according to practitioners (BBA 2002 Survey), the single most important hindrance to credit derivatives growth is regulatory uncertainty, particularly regarding negotiations for the new regulatory capital requirement standards known as Basle II.

Types of Credit Derivatives

The following description of credit derivative products draws from research from a number of sources including: Lehman’s Structured Credit area, documents from U.S. regulators, including the Federal Reserve and the Office of the Comptroller of the Currency, and publications of the Basle Committee on Banking Supervision.

There are a number of products that can be classified under the broad umbrella of credit derivatives, ranging from asset swaps, the most popular instrument typically focused on relatively small single exposures ($10 million-$50 million) to the Synthetic Collateralized Loan Obligation (CLO), which covers pooled exposures and very large notional amounts ($2 billion-$5 billion) (See Figure 3).

Floating Rate Notes

Floating Rate Notes (FRNs) are technically not a credit derivative, but they serve as a benchmark of credit derivative pricing because their valuation is driven almost entirely by credit risk. An FRN is a bond that pays a coupon linked to a variable rate index. Because an FRN eliminates most of the interest rate sensitivity (changes in interest rates impact bond prices briefly, only until the interest rate is reset to market rate levels), variations in the value of the notes are almost exclusively tied to changes in the perceived credit risk of the issuer. These instruments are typically priced using LIBOR, and therefore the spread over LIBOR, when issued at par, reflects the credit quality of the issuer (including subordination of the notes). As the spread is fixed at issuance, the bond price will vary with changes in the credit risk of the issuer.

The fixed spread at issuance (and subsequently the spread calculated to value the bond, known as the par floater spread) is a function of the probability of default (P), and the expected recovery rate in the event of default (R), as shown in Figure 6. Simply stated, the spread will be higher, the higher the probability of default and lower with a higher expected recovery.


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Figure 6: The Credit Triangle

Spread (S)

Probability Recovery of Rate on Credit ( R ) Default (P)

Source: Lehman Brothers Structured Credit Research

Banks normally issue fixed maturity or perpetual FRNs to satisfy bank capital requirements. The advantage of these notes is that they have a low duration despite having infinite maturity, because the sensitivity of the price of these notes to changes in the interest rate is limited. Credit investors seek these bonds as a way to assume the credit risk of the bank without assuming interest rate risk. However, FRNs are a relatively small fraction of bonds outstanding, and therefore, credit investors typically have to buy fixed rate bonds, hedging away the interest rate risk using asset swaps.

Asset Swaps

An asset swap is a synthetic floating rate note. This structure allows an investor to turn a fixed rate bond into a floating rate bond. To create it, the investor typically buys the bond and simultaneously enters into a floating-for-fixed interest rate swap with the same notional value as the bond. This is similar to a regular interest rate swap with the important distinction that the investor is long the bond and therefore is bearing the full the investor is long the bond and therefore is bearing the full the investor is long the bond and therefore is bearing the full the investor is long the bond and therefore is bearing the full credit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the countercredit risk of the bond issuer, and not only the counter----party risk in the swap party risk in the swap party risk in the swap party risk in the swap transaction.transaction.transaction.transaction. The investor is compensated for taking this risk by means of an asset swap spread, which is also a widely used pricing reference in the credit derivatives market.

This is because, in the event the bond defaults, the investor will take an impairment on the bond (par value minus recovery), and will have to continuecontinuecontinuecontinue paying the coupon as part of the swap arrangement with its counterparty. Alternatively, the interest rate swap can be closed out at market value. If LIBOR plus the spread is higher than the coupon on the bond (i.e., if the bond is trading at a discount), then the investor will realize a gain on the swap and reduce the losses from the default on the bond. Conversely, if the


October 18, 2002 9

floating rate is lower than the coupon, the investor will realize a loss. Leveraged positions, such as when buying a bond trading at a premium, would command a higher spread, because the investors stands to lose more in the event of default.

Figure 7: Mechanics of a Par Asset Swap

At initiation Asset Swap buyer purchases bond at full price in return for par

Bond Worth P

Asset Swap Asset SwapSeller Buyer

100

And enters into an interest rate swap paying a fixed coupon in return for Libor plus spread

LIBOR + SAsset Swap Asset Swap Bond

Seller Buyer DefaultsCoupon Coupon is lost

If default occurs the asset swap buyer loses the coupon and principal redemption on the bond.The interest rate swap will continue until bond maturity or can be closed out at market value.

Source: Lehman Brothers Structured Credit

The primary use of this instrument for banks is for asset-liability management. Banks increase their credit exposure and at the same time limit increases in duration of assets, which is suitable given the floating rate nature (low duration) of deposits and other bank funding. Asset swaps can also be used to take advantage of mispricings in the floating rate note market. Tax and accounting reasons may also make it advantageous to buy and sell non-par assets at par through an asset swap.

Default Swaps

The default swap has become the standard credit derivative. According to the BBA Credit Derivatives Survey, it dominates the credit derivatives market with over 38% of the outstanding notional. It is a relatively simple product that opened a new set of possibilities not previously available in the cash market.

In a default swap (Figure 8), one counterparty agrees to make payments based on a notional amount, either quarterly or yearly in the event of a default of a prespecified reference asset (or name). The main purpose of using a reference asset is to specify exactly the capital structure seniority of the debt that is covered. It is also important in the determination of the recovery value should the default swap be cash settled. In addition, the maturity of the swap may not be the same as the maturity of the reference asset. It is common to specify a reference asset with a longer maturity than the swap.


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Figure 8: Mechanics of a Default Swap

Between trade initiation and default or maturity, protection buyermakes regular payments of default swap spread to protection seller

Protection Protection Buyer Seller

Following the credit event one of the following will take place:

Cash Settlement


Physical SettlementBond


100

Default Swap Spread

100 minus recovery rate


The payoff of a credit-default swap is contingent on a default event (bankruptcy, insolvency, restructuring, delinquency, or a credit-rating downgrade) and therefore would resemble more an option than a swap, but the convention is to call these transactions swaps. As usual, the default event is clearly defined in the contract, normally according to ISDA rules.

Upon default, however defined, the swap is terminated, and a default payment is calculated. The recovery rate is calculated by referencing dealer quotes or observable market prices over some prespecified period after default has occurred (normally 30 days). Alternatively, the default payment may be defined in advance as a percentage of notional amount (these are commonly referred to as binary or digital swaps).

The contract must also specify the payoff that is made following the credit event. This payment is the difference between par and the recovery value of the asset. This can be done either in a physical or cash-settled form:

��Physically deliver of a defaulted security to the protection seller in exchange for par in cash. The contract usually specifies a basket of obligations that are ranked pari passu and that may be delivered in place of the defaulted asset. All pari passu assets should be worth the same in the event of default, but this is not always the case. In effect, the protection buyer has a ”cheapest-to-deliver” option.


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��The protection buyer can receive par minus the default price of the reference asset settled in cash, calculated through a dealer poll or any other suitable method.

��Fixed cash settlement, which applies to notional amounts with a pre-established fixed recovery rate.

There are several uses for default swaps and are most frequently employed to hedge credit risk concentrations. For instance, a bank with a high concentration to a single client may swap out part of its exposure to an investor wishing to acquire exposure to that name in exchange for a premium. In many instances, regulators will accept the swap contract as a true hedge and allow the bank to reduce capital requirements, requiring capital to be held only against the “equity” portion that the bank retains. Another advantage of swaps is that they are private transactions between two counterparties, whereas selling a loan may require customer consent or notification. In addition, default swaps can be used to hedge credit exposures where no publicly traded debt market exists. This is critical given the poor liquidity of the bank loan market.

Conversely, default swaps are an unfunded way to take credit risk, making it easier for banks or other buyers to increase credit exposure efficiently. Default swaps can be customized to match an investor’s precise requirements in terms of maturity and seniority, and they can be used to take a view of both the deterioration or improvement in credit quality of the reference asset. Finally, dislocations between the cash and derivatives market can make the default swap a higher yielding investment than the equivalent cash instrument.

Credit-Linked Notes

A credit-linked note is a funded credit derivative. As opposed to an unfunded credit derivative, such as an default swap, credit-linked notes imply an investment in the cash instrument. These are notes issued by one issuer (say, a bank), which has a credit risk exposure to a second issuer (say, a corporation, which is known as the ”reference issuer”).

These notes pay an enhanced coupon, typically linked to LIBOR, to the investor for taking on the added credit risk of the second reference issuer. In case the note defaults the investor stands to lose some or all of their coupon income and principal.

In this case the investor is the protection seller, and the bank is the protection buyer. For example, the bank will typically have a corporate bond exposure, which it wants to hedge (See Figure 9). The investor pays par for the credit linked notes to the bank, and gets the floating coupons of the corporate bonds (Libor plus 10 basis points in this example), plus a credit spread paid by the bank (in this case 20 basis points) to compensate for the added default risk. Note that the investor has to be compensated for both the default risk of the bank and that of the corporation that issued the reference asset.


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If the bond defaults, then the note entitles the holder to receive the defaulted bonds and the bank keeps the proceeds originally paid by the investor for the note. Unlike an asset swap, there is no default contingent interest rate risk.

Figure 9: Structure of the “Racer”

Interest distributions LIBOR + 0.30% per annumInvestor gets a Fed Funds rate + 0.25% coupon investment at par.

If default occurs,100% - recovery

Investor Racers Issuer0.20% per annum

LIBOR + 0.10%

AAA AssetBacked

LIBOR + 0.30%

Source: Lehman Brothers Structured Credit.* Racers - Restructured Asset Certificates with Enhanced Returns

Repackaging Vehicles

These vehicles are used to convert or create credit risk structures in a securitized form accessible to a broad range of investors. They can be used to turn existing credit derivatives into a cash product required by some investors. The generic structure for doing this is the Special Purpose Vehicle (SPV). Prior to the Enron debacle, this was a little known structure. These vehicles are seen as an alternative to the credit-linked note. The main difference between the two is that the SPV is a legal trust or company that is bankruptcy remote from the sponsor, since a default by the sponsor would not affect payments on the issued note. If the SPV has entered into an interest rate swap, there is also potential counter-party risk. Notes issued can be exchange-listed and rated by a rating agency. Legally, an SVP is either a trust or a company. The trust form of SPV is most relevant to the U.S. market and is usually organized under the laws of Delaware or New York. The trustee is normally a highly rated bank with fiduciary duty to investors. This product has become highly standardized so that several investors, not only the arranger, can participate.

SVPs are typically used to securitize asset swaps. Due to internal restrictions many investment funds are not allowed to invest in interest rate swaps directly, and SVPs allow them to achieve a similar exposure. Suppose an investor wants to invest in a floating rate corporate bond, but only fixed rate bonds are outstanding. Since the investor is prevented from entering an interest rate swap directly, he would be unable to get his desired exposure. However, if an SVP purchases the underlying security and enters into the interest rate swap, the same investor can purchase notes in the SVP that represent the combined economics of the asset swap package (See Figure 10).


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Figure 10: Securitized Asset Swap Issued out of an SPV

Fixed Rate SPV IssuedAsset Note

LIBOR + spread Fixed Rate

SwapCounterparty

Fixed Rate LIBOR + spread


If the asset in the SVP defaults, the interest rate swap is closed out, with the swap counterparty usually having first recourse to the liquidation of proceeds of the defaulted asset, with the remainder going to the note investor. An SVP can also be used to issue credit-linked notes, which may embed several types of default swaps. Obviously, these notes would have no exposure to the sponsor, contrary to regular credit-linked notes. Instead, the note is collateralized using securities. The SVP purchases the underlying securities chosen by the investor as collateral. Concurrently, the SVP sells protection to a third party, say a bank. If a credit event occurs, the SPV liquidates the underlying securities, with the proceeds first going to pay the bank and any remainder going to the note investors.

Principal Protected StructuresPrincipal Protected StructuresPrincipal Protected StructuresPrincipal Protected Structures

Principal protected structures are instruments designed for investors who prefer to hold high-grade credits that guarantee to return the investor’s initial investment at par value. Credit derivatives are used to provide this protection. The note issuer can be a highly rated OECD bank. Other banks purchasing the notes would be allowed to use the BIS risk weighting of the issuing bank (20%), rather than that of the reference asset, which would normally be 100%. The principal protected structure is a funded credit derivative similar to a credit linked note. If a credit event occurs before maturity of the note, investors lose the remaining coupon payments, but at maturity they would receive principal in full.

Total Return Swaps

A Total Return Swap (TRS) is a contract that allows investors to receive the total return on an underlying reference asset, including coupon and principal payments, and eventually margin calls from marking the bonds to market. In exchange, the total return receiver will pay the investor a spread over LIBOR. Upon maturity of the swap, the total return payer pays the difference between the final market price of the asset and its initial price. If default occurs, the total return receiver must bear the loss. The asset is delivered or sold, and the price shortfall paid by the receiver. In some instances, the swap may continue with the receiver posting additional collateral.


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The total return receiver has naturally a bullish view. He is expecting credit quality of the reference asset to improve, while the payer is expecting deterioration.

Figure 11: Mechanics of a Total Return Swap

During Swap

Total Return Total Return Payer Receiver

At Maturity Any increase in the market value ofthe notional amount of the reference asset

Total Return Total Return Payer Receiver

Any Decrease in the market value ofthe notional amount of the reference asset

Coupons from reference asset

LIBOR + Fixed Spread


A TRS is viewed as an efficient way of transferring or acquiring credit risk in an unfunded manner (purchase of the reference asset is not necessary). As such, a TRS is more of a balance sheet management instrument than a credit derivative. However, given that the underlying asset can default, and the TRS protects the payer from this event, it usually is classified as a credit derivative. An investor acting as a swap payer may hedge itself by buying the underlying asset at the inception of the trade, funding it on balance sheet, and selling it at maturity of the contract.

TRS contracts allow investors to take a leveraged position to a credit. They also enable investors to obtain off-balance sheet exposure to assets they may otherwise not be allowed to invest in.

In addition, a TRS allowa investors to go short an asset without having to sell it. More importantly, these instruments can be used to create tailor-made assets with the specific maturity required by banks to fill gaps in a portfolio of credits.

Multi-name Credit Derivatives

Index Swaps

These instruments are Total Return Swaps linked to several securities in an index, rather than a single security. They can be structured in several ways according to the needs of the investor. For instance, the buyer of the index may receive the gain or loss in the value of the index, plus coupon accrual in return for floating rate payments.


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Index swaps are appealing to investors who wish to buy a more diversified portfolio than would be available in the cash market. These transactions are normally more liquid than the equivalent in the cash market. Index swaps can also be used to benchmark a portfolio to standard fixed income indexes more quickly and without the need for in-depth knowledge about specific companies in the index.

Basket Default Swaps

This instrument is similar to a regular default swap, only that the credit event is the default of some combination of exposures in a specified basket of credits. For instance, in a first-to-default basket, it is the first credit in the basket of reference credits whose default originates a payment to the protection buyer, which can be cash settled or involve physical delivery of the defaulted asset. First-to-default baskets have gained popularity recently because they enable investors to get credit risk and earn a premium in the process, while being exposed to high-quality names.

Investors selling protection do not actually increase downside risk, as they bear the same potential loss as if they had bought the asset in the first place. However, the premium collected can be much higher than in a single credit transaction, because it is calculated as a function of each individual credit in the portfolio. More risk-averse investors can build safer structures, such as second- or third-to-default contracts, and still earn attractive premiums. Baskets can also be designed in a funded form as a credit-linked note or issued as a security out of an SPV. They can also be issued in a principal protected form.

Investors like these arrangements because of the high premiums, which allow them to leverage credit exposures while taking on proportionally low risk. A downside is that the bank capital treatment for baskets is very conservative and complex, requiring banks to hold capital against each of the assets in the basket.

For this instrument, investors need to be mindful of the probability of each bond defaulting, and correlation of defaults within the portfolio. The higher the correlation, the more likely it is that the more senior tranches will experience a loss, because defaults at any given point may be more sizable, exceeding the protection afforded by the more junior tranches.

Portfolio Default Swaps

For many investors, the main alternative to baskets is the tranched portfolio default swap. They are similar to default baskets in the sense that they take a portfolio of credits and redistribute the credit risk into first and second tranche loss products. The main differences are, first, that the size of the portfolio is usually much larger, many times consisting of a basket of 40-100 names. Second, the redistribution of the risk is specified in terms of the percentage of the portfolio loss to which a particular investor is exposed, rather than the number of assets.


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For instance, consider a portfolio of 50 credits, with a face value of $5 million apiece, tranched into a 10% first loss tranche and a 90% loss piece. The investor in the first loss tranche will take all the defaults until they reach 10% of the value of the portfolio notional amount. The coupon on the tranche is paid based on the notional adjusted for defaults, while the spread paid remains a constant percentage of the notional tranche.

Portfolio default swaps are a new and powerful tool for investors to leverage or de-leverage their exposure to a large group of assets. This can be done in a funded or unfunded manner.

Portfolio default swaps are the building blocks for synthetic collateralized loan obligations (CLOs), which have become the technology of choice for balance sheet securitization. To understand how a synthetic CLO works, we will first look at the process of securitization of defaultable assets.

Collateralized Debt Obligations (CDO)

A CDO is a structure of fixed income securities whose cash flows are linked to the incidence of default in a pool of debt instruments. These credits may include loans, revolving lines of credit, other asset-backed securities, emerging market, and sovereign debt. When the collateral comprises mainly loans the structure is called a CLO.

CLOs are securitizations of large portfolios of secured or unsecured corporate loans made to commercial and industrial customers of one or several banks. These structures allow banks to achieve various objectives including the reduction of credit risks and regulatory capital requirements, access to an efficient funding source for lending, added liquidity, and increased returns on equity and assets. CLOs generally fall into one of two categories: cash-flow structures and market-value structures. In market-value structures credit enhancement is achieved through specific overcollateralization levels assigned to each underlying asset. Cash-flow structures are transactions in which the repayment and rating of the CLO debt securities depend on the cash flow of the underlying loans.

As part of a CLO transaction, loans are sold or assigned to a trust or other bankruptcy-remote special-purpose vehicle (SPV), which in turns issues securities, similar to what is done for single credit securities.

The securities issued by the trust normally consist of one or more classes of rated debt securities with different seniorities, including a residual equity tranche. They have different rates of interest, weighted average live, and credit ratings in some cases to appeal to different types of investors. Banks normally retain an equity interest to provide additional security to investors. CLOs normally require one or more additional credit enhancements to achieve the credit rating desired by investors. They include internal enhancements, such as subordination, excess spread, and cash collateral accounts, and also external enhancements, including insurance by monoline insurers. While the loans being securitized normally have an 8% capital charge, these equity tranches are normally


October 18, 2002 17

weighted on a one-to-one basis, meaning that each dollar of exposure has to be supported by a dollar of equity. However, the size of the tranche is normally around 2%-3%, so a securitization should result in a reduction in capital requirement for banks.

Theoretically, the assets in a CLO are only loans, but in practice they normally comprise a more diverse mix of assets including structured notes, participation interests, revolving credit facilities, and trust certificates.

Figure 12: Collateralized Loan Obligation

Source: Lehman Structured Credit Research

The Master Trust Structure for CLOs

Master trusts are widely used to structure a wide array of Asset Backed Securities (ABS) transactions. They are principally used to securitize credit card receivables. Banks like these structures because they allow them to issue notes with differing tenors and characteristics. Typically, banks will issue several series of notes under a single master trust.

In contrast to credit card trusts, however, CLO master trusts are viewed as more risky, because loans comprised in them are less diversified, have longer maturities, and more uneven cash flows than credit card receivables. Similar to ordinary credit card trusts, transferor banks in CLO trusts retain an interest in the assets of the trust (known as transferor interest) to align the bank interests with that of the investors and to furnish additional cash if flows allocated to investors are insufficient to cover interest and principal payments. However, the need to split cash flows between transferor bank and investors requires additional monitoring from the latter.


18 October 18, 2002

Figure 13: CLO Master Trust Structure

Source: Federal Reserve Board, Trading and Capital-Markets Activities Manual

To make the notes attractive to the largest number of investors, including other banks, mutual funds, and insurance companies, issuers normally have the notes rated. Rating agencies look at the credit history of the companies tied to the loans, the enhancements and the structure of the transaction.

Enhancements for CLOs are typically internal, relying much less on external insurance to improve ratings. As we mentioned, internal enhancements frequently used include the setting up of a cash-collateral account to smooth out cash flows in case of defaults. Also common is the availability of any excess spreads above and beyond those required to pay current interest to create an additional cushion rather than going to the transferor.

Of more interest to us is subordination, which consists of issuance by the trust of notes with different seniority. Issuing banks will typically keep the most junior tranche of the ininininvestor’svestor’svestor’svestor’s interest (which is different from the transferor’s interest that banks keep as part of the normal structure of the trust).

Therefore, in this example, the bank would retain the risk on the transferor’s interest, the junior-most tranche or equity interest, and would be responsible for the setting up of a cash collateral account from its own funds. It will also renounce claims on the excess spread on the loans transferred until securities in the trust mature and are paid.

Synthetic CLO SecuritizatiSynthetic CLO SecuritizatiSynthetic CLO SecuritizatiSynthetic CLO Securitizationsonsonsons

We have explained how a regular CLO securitization works, but we have not yet shown how credit derivatives come into play in these structures. Synthetic CLOs provide the link between the two.


October 18, 2002 19

Again, the intent of the transaction would be to transfer credit risk to the investors and lower the bank capital charge significantly below the customary 8% that applies to regular loans.

Figure 14: Synthetic CLO Securitization.

Source: Trading and Capital- Markets Activities Manual of the Federal Reserve, Lehman Brothers

As shown in Figure 14, the structure is very similar to that of an SPV for single exposures. The issuing bank pays a fee to the SPV for default protection on a pool of previously identified loans, using default swaps. The SVP then issues credit notes linked to the specific credits (see the description of Credit-Linked Notes (CLN) above) and sells the higher rated notes to investors, using the proceeds to buy Treasury securities. Since the Treasury securities are practically risk-free, the counter-party risk for the bank in the portfolio swap is negligible and can qualify to obtain a 0% risk weighting. CLNs are used in amounts sufficient to cover some percentage of expected losses, normally normally normally normally around 7%around 7%around 7%around 7%----8% of the notional amount of the reference portfolio. 8% of the notional amount of the reference portfolio. 8% of the notional amount of the reference portfolio. 8% of the notional amount of the reference portfolio. The remainder of the credit risk is hedged using a senior credit default swap with a highly rated (OECD) counterparty, for which the weighting would be 20%.

Figure 15: Example of a Regulatory Charge for a Synthetic CLO



20 October 18, 2002

As shown in Figure 15, the regulatory charge can be brought down substantially through the use of a CLO. There could be several layers of losses to participants: First, in case of default of some of the loans, the SPV would lose the spread between the revenue from the fees and the interest income on the Treasury securities, and the coupon interest paid on the note. The second layer of losses would accrue to investors in the CLNs, then losses would go to the senior default swap seller, and finally, the bank would endure the losses beyond the first and second layers.

A slightly different structure can be designed in which the SPV purchases single exposure CLNs from the bank seeking protection, and then the SPV issues floating rate notes to investors, collateralized by the individual CLNs. Therefore, the dollar amount of the notes issued to investors equals the notional amount of the reference portfolio. Similar to what happens in credit card securitizations, the bank has the option to remove CLNs from the pool, so long as they are replaced by similar notes.

The main differences between a regular CLO and a synthetic one is, first, that in the latter, loans are never transferred to the SPV, which allows the bank to avoid damaging client relationships. Not only that, the possibility open by synthetic CLOs to manage credit risk, in particular in those structures backed by CLNs rather than default swaps, can even help enhance client relationships. For instance, when a bank feels uncomfortable increasing exposure to a client, but is afraid of damaging the relationship by denying additional loans, it can issue a CLN on part of the exposure, sell it to the trust, and issue additional loans to its client. Finally, banks are normally able to fund the assets on balance sheet more cheaply than by structuring a regular CLO.

Risks of Credit Derivatives

In this section we analyze the basic risks involved in a credit derivatives transaction to show what the implications to banks are of engaging in them.

Credit Risk

Banks can acquire two types of credit risk through a credit derivatives transaction. First, if they sell protection, they will be taking on credit risk related to the reference assets, similar to what they would get through the outright purchase of the asset. Banks need to analyze the characteristics of the reference asset just as if they were going to buy it. Second, they also take on counter-party risk, the risk that the party that sold them credit protection will be unable to make good on its agreed obligation. In this case the risk is really the joint occurrence of a default of the reference asset and of the protection seller, which should be relatively low so long as the credit condition of the reference asset and the protection seller are not highly correlated.

Market Risk

Most of the risk borne by banks will be in the shape of credit risk. Market risk is clearly an issue if the bank engages in credit derivatives tradingtradingtradingtrading, as the pricing of the


October 18, 2002 21

instruments is a function of interest rates, the shape of the yield curve, and credit spreads. Outside of trading activities, market risk depends on the particular credit derivative being used. An asset swap requires the marking to market of the interest rate swap. For other derivatives with cash flows throughout the life of the product, such as total return swaps, the total return receiver may face margin calls that could affect its financial position. Another potential risk is that banks selling protection face a large probability that default will not occur and a small probability that it (and a substantial payout) will occur with unknown consequences. This type of risk is hard to hedge.

Liquidity Risk

Liquidity risk also applies more to those institutions that actively trade, as given the relative newness of the market sometimes there are pockets of illiquidity, particularly at longer maturities, that make it difficult for a bank to offset its position before maturity, although this is changing rapidly. In addition, it is important that banks include credit derivatives in their cash flow budgeting to avoid liquidity issues as defaults covered by the bank may require significant cash outlays.

Legal Risk

Until recently, the main issue hindering the development of the credit derivatives market had been the lack of standard documentation and agreement as to the definitions of a default event. This generated “legal basis risk,” the risk that definitions or the legal structure used in the purchase of protection differ from the hedge definitions, potentially eliminating or diminishing the effectiveness of the hedge. While this is still a risk, the adoption of ISDA Master Agreement, which requires the use of a standardized short-form confirmation, similar to that used in regular swap transactions, has simplified and homogenized the trading of credit derivatives. This has reduced the need for specialized (and expensive) legal expertise and opened the door to a wider range of participants. However, there appear to be significant documentation issues regarding restructuring and modified restructuring credit event definitions that still need to be addressed.

The most important legal issue affecting the market now is definition of what constitutes a default event (see Figure 16) and what is the ”obligation” (the type of defaulted security that can be delivered to a protection seller in the event of default). The basic categories of obligations are: bond, bond or loan, borrowed money, loan, payment, and reference obligations only. In Figure 17 we show eight additional characteristics used to refine the nature of the obligation.


22 October 18, 2002

Figure 16: ISDA-Specified Credit Events

Source: ISDA, Lehman Brothers Structured Credit Research

Figure 17: ISDA Obligation Characteristics

Source: ISDA, Lehman Brothers Structured Credit Research

Accounting for Credit Derivatives

To understand the accounting guidelines used to report derivatives, we believe it is important to analyze the framework to account for derivatives in general, in particular regarding hedges.

Derivative instruments are classified according to the following three categories:

��No hedge designation. Gains or losses on derivatives classified in this category have to be included in current income. In this case, the instrument is deemed not be reducing the risk of another exposure and therefore cannot be classified as a hedge.


October 18, 2002 23

��Fair-Value Hedge. A derivative would be classified in this category if it is deemed to be a hedge of exposures to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment. A good example is the hedging of a fixed coupon bond. The bond is subject to changes in fair value from movements in the market interest rate (including variations in the credit spread). Entering an interest rate swap to exchange fixed for floating rates would remove (fully or partially) the risk of changes in fair value. In this case, the fair-value gains or losses on the bond go against current net income, as would the offsetting gains or losses on the swap.

��Cash-Flow Hedge. Derivatives removing the uncertainty about future cash flows can be placed in this category. The obvious example is that of an investor who owns a floating rate bond (with low duration and therefore with small changes in fair value) and enters a floating-for-fixed interest rate swap transaction to hedge against changes in the periodic cash flows he receives. Fair-value gains or losses, derived from the interest rate swap, are included in other comprehensive income, without affecting net income. Only when the contract is terminated are gains or losses recognized through the income statement. The accounting guidelines allow for the gain-loss recognition deferral because the bond is assumed to be kept to maturity, and therefore any fair market losses or gains would eventually approach zero as the bond matures. In the mean time, the bond-holder diminished the uncertainty of cash flows.

This general framework is included in FASB’s Standard 133 (FAS 133). This was an important step toward the implementation of fair-value accounting for derivatives, but it is obviously a work in progress. Companies have been using this standard for close to two years, and already the FASB is working on amendments to it based on commentary received from users.

Treatment of Credit Derivatives under FAS 133

The most critical issue is to determine if the credit derivative qualifies as a derivative under FAS 133. In most of the cases the answer would be yes, and therefore the contract would have to be marked to market. Exceptions are default swaps that provide for payments to be made only to reimburse the guaranteed party for a loss incurred because the debtor fails to pay when payment is due (financial guarantees), and the contract specifies that the protection buyer must be exposed to the loss on the reference asset at all times.

Hedge accounting is allowed only when it is possible to identify fully the risk that the credit derivative would be hedging. When default swaps are used, FAS 133 requires that interest rate and credit risk be segregated. A fixed-rate note, covered with a suitable default swap would qualify for fair-value hedge treatment. Credit risk would be measured by the credit spread, the difference between the full rate on the bond minus the reference rate. For more complicated hedges, it may be more difficult to obtain hedge accounting treatment, and this may reduce the demand for more exotic credit derivative structures.


24 October 18, 2002

Bank Capital Regulation

The purpose of bank capital regulation is to ensure that banks possess enough capital to withstand expected or unexpected losses related to operations. Since credit derivatives are a means to modify the credit risk profile of financial institutions, it is important to look at the guidelines to determine risk capital weights for credit derivatives transactions. As such, we can better understand the current impact on capital of these transactions, as well as the effect of forthcoming international regulations.

BIS Capital Requirements

The current set of guidelines was established by the Basle Committee on Banking Supervision in July 1988. Those rules, known as the Basle Capital Accord, are still in use today, after several amendments. These guidelines are the blueprint for capital regulations all over the world. A new accord is currently being discussed and is expected to be in force in 2004. The current framework is based on a fixed 8% capital charge on risk assets, which may be adjusted multiplying them by fixed risk weightings, applied if the client or counterparty is deemed to have a low risk level.

In the case of derivatives, the first step to estimate a capital charge is the calculation of credit exposure, which would represent risk-weighted assets. Note there is a large disconnect between notional amounts and actual credit exposure that makes reference only to the notional amount misleadingly high. Notional amounts are just a reference to calculate the cash flows in a derivative contract, but this is not a good indication of the amount that is at risk. For instance, interest payments on an interest rate swap contract may be based on a $1 million notional amount, but onlyonlyonlyonly the interest payments are at risk, since principal does not have to be paid at maturity. As of 2Q02, the notional amount of derivatives held by U.S. banks was $50 trillion. However, the gross credit exposure was just $1.1 trillion. The exposure was further reduced by bilateral netting agreements of $580 billion, so that actual net credit exposure is only $525 billion (See Figure 18). A netting agreement is an arrangement between two parties in which they exchange only the net difference in their obligations to each other. The primary purpose of netting is to reduce exposure to credit/settlement risk.

Notional and credit exposure figures normally diverge, but they are much closer to each other in the case of credit derivatives than in the case of interest rate swaps. The notional amount for interest rate swaps is $29.5 trillion for U.S. banks as of 2Q02, while it is only $495 billion for credit derivatives, but the actual amount at risk is much closer than the notional amount the figures would suggest.

The method used by most major banks to calculate derivatives exposures (known as the current exposure method) is to mark each instrument to market, total the values of all instruments with positive values to establish the current replacement cost, and add to this an amount (known as add-on) for potential future exposure that is based on the notional underlying principal of each contract.


October 18, 2002 25

Figure 18: Notional Amounts and Credit Exposure ($Billion)

1,104 580

525

50,084

0

200

400

600

800

1000

1200

1400

NotionalAmount

GrossExposure

Master NettingAgreements

Net CreditExposure


Most exposures have a 100% weighting, meaning they require an 8% capital charge. Assets originated in transactions with OECD banks carry a 20% weight and transactions with OECD governments carry a 0% weight (See Figure 14) . One of the main criticisms against this system is that it is too coarse in reflecting operational risk. This sometimes results in perverse incentives for the institutions. For instance, since loans to a AAA-rated corporation are weighted the same as loans to a B-rated corporation, a bank is indifferent between lending to any of the two from a capital perspective. As a result, a bank may decide to move all its high-quality exposures off-balance sheet and leave the riskier loans on balance sheet, as those would presumably carry significantly higher yields. This is a form of ”regulatory arbitrage,” employed by banks to make their use of capital more efficient and was one of the principal motivations for banks to use credit derivatives.

If a bank determines that the potential losses from a given exposure are 2%, but capital regulations require 8%, it may engage in an asset swap with an OECD bank and reduce its capital charge. Under current BIS rules, when a bank is provided a guarantee on a loan the risk-weighting of the original obligor is substituted with the risk of the guarantor. In other words, the capital charge would be reduced from 8% (8% x 100% risk-weighting) to 1.6% (8% x 20%). The capital freed by the transaction can be used to make additional loans, normally with a risk level more consistent with the capital committed. Even then, it could be argued that the charge is still too high, because the risk is now that both the original obligor andandandand the protection seller default at the same time.


26 October 18, 2002

Figure 19: The BIS Risk Weightings

Source: Basle Committee on Banking Supervision

Current Treatment of Credit Derivatives

When the original accord was enacted in 1988, credit derivatives did not exist, so the treatment they normally get is that of guarantees. The capital treatment is as follows:

��Default Swaps. As we explained above, when the bank is the protection buyer, the swaps are treated as a guarantee and the weighting of the original obligor is replaced with the weighting of the ”guarantor.” A bank using the swap to sell protection will have to use the weighting it would apply to the reference asset.

��The treatment is similar for funded instruments like credit linked notes and SPVs. When the bank sells protection, the charge is the same as if it was long the loan. When the bank buys protection, the weighting is that of the collateral, which normally is OECD government paper, so the treatment is favorable. An interesting case is that of the fixed-rate recovery swaps, because the weighting is linked to the notional minus guaranteed recovery rate. That amount is a better reflection of the exposure to a credit. The fixed recovery portion may be weighted at the rate of the guarantees provided by the CLN or SPV.

��In a total return swap, the total return payer (the buyer of protection) uses the weight of the total return receiver, rather than that of the reference asset. The protection seller uses the weight of the reference asset. In other words, the treatment is similar to that of the default swap.

��For baskets of products the treatment varies, but it can go from requiring the use of the weight of the riskiest asset or the average of all weightings. In the United States, the protection buyer can replace the weighting on the asset with the smallest dollar amount to the risk weighting of the guarantor. A protection seller must hold capital using highest risk-weighted asset.

Forthcoming Regulatory Changes

The Basle Committee is currently working on a new set of fully revised guidelines that would remove performance inconsistencies for banks by aligning economic risk and capital requirement.


October 18, 2002 27

Figure 20: Credit Weightings Under Option 1


The Committee is working along three lines to compute the capital charges. In the simplest, known as the standard charge, the current ratings shown in Figure 19 would be replaced with risk weightings linked to external credit ratings (See Figure 20). Banks that satisfy certain technical requirements would be allowed to use their own internal ratings (See Figure 21). The end result is probably going to be a reduction in regulatory capital levels.

Figure 21: Risk Weights under Option 2 (Internal Classification Ratings)

Internal risk 1 2 3 4 to 6 7ScoresRisk 0% 20% 50% 100% 150%Weights


In addition, the removal of the perverse incentives from a regulatory capital perspective is likely to increase demand among banks for high quality credits and lower the appetite for low quality exposures. Our expectation is that if these rules are adopted, banks will keep high quality credits on-balance sheet, and will use credit derivatives to hedge exposures to riskier loans, contrary in some cases to what occurs today, because banks have the incentive to keep riskier exposures on-balance and securitize higher quality credits.

For credit derivatives, the treatment in principle would be similar. That is, protection buyers would use the weighting of the guarantor and protection sellers would use the weightings of the reference asset. The difference is that, for protection sellers, the weighting of the reference asset may be more or less than 100% depending on the internal rating of the bank or the rating from the rating agency.

For protection buyers, the weighting would be adjusted using the following formula:

r* = w x r + (1 – w) x g, or

r* = g + w x (r - g)


28 October 18, 2002

where r* is the effective risk weight, r is the risk weight of the obligor (reference asset), w is the weight applied to the underlying exposure, and g is the weight of the protection provider. While it allows a value of w = 0% for guarantees, the new Accord puts a floor on the weight for credit derivatives for hedging purposes at 15%. In our previous example of a hedging transaction using default swaps, g = 20%, the risk of a OCDE bank.

Assuming the bank is an A-rated institution (see Figure 20), under the new framework the weighting for the bank would still be 20%. It is clear from the formula that if the risk of the reference asset is greater than that of the guarantor, which is not unusual, the capital charge under the new rules will be higher. If the rules were approved under their current form, the higher capital charge could discourage the use of default swaps and reduce the liquidity of the credit derivatives market. However, given the flexibility the instruments afford banks to manage capital, we believe the impact would be modest.

Conclusion

In summary, we view credit derivatives as an efficient instrument for banks to potentially improve capital allocation, optimize asset and liability management, and enhance returns. In addition, credit derivatives markets may provide investors with a more accurate and responsive assessment of corporate credit risk, which should result in more efficient markets.

Although the use of credit derivatives is growing rapidly, they are still highly concentrated among only a very small group of the largest banks. We believe, however, that credit derivatives will begin to gain wider acceptance particularly those that offer a means to hedge credit risk on a pooled basis as opposed to individual exposures. Current factors affecting market depth are the impact of impending changes to accounting regulatory capital requirements and the need to refine default event definitions to eliminate legal uncertainty, particularly tied to restructuring events.

As with any other derivative, the use of credit derivatives implies banks assume credit, counter-party, market, and legal risks. Some instruments provide an easy way to take leveraged positions on basically any credit available in the market, equivalent to making a loan without having to fund it. The challenge for banks (and regulators) is to ensure that they assess correctly the risk of the reference asset, and that adequate monitoring and risk management systems are in place to ensure the risk assumed is consistent with an institution’s capitalization levels.


October 18, 2002 29

Figure 22: Valuation Table PricePricePricePrice PricePricePricePrice ActualActualActualActual Estimates Estimates Estimates Estimates P/E RatioP/E RatioP/E RatioP/E Ratio Relative P/E (S&P 500)Relative P/E (S&P 500)Relative P/E (S&P 500)Relative P/E (S&P 500)

AnalystAnalystAnalystAnalyst SymbolSymbolSymbolSymbol RatingRatingRatingRating 10/17/0210/17/0210/17/0210/17/02 TargetTargetTargetTarget 2001200120012001 2002200220022002 2003200320032003 2001a2001a2001a2001a 2002e2002e2002e2002e 2003e2003e2003e2003e For.For.For.For. 2001a2001a2001a2001a 2002e2002e2002e2002e 2003e2003e2003e2003e For.For.For.For.

INTEGRATED PROVIDERSINTEGRATED PROVIDERSINTEGRATED PROVIDERSINTEGRATED PROVIDERS NEGATIVENEGATIVENEGATIVENEGATIVE Vandervliet BANK ONE CORP. ONE 2 Equal weight $38.46 $43 $2.47 $2.77 $3.10 15.6 13.9 12.4 12.7 81 78 77 77Vandervliet Bank of America Corp.Bank of America Corp.Bank of America Corp.Bank of America Corp. BACBACBACBAC 1 Overweight1 Overweight1 Overweight1 Overweight $68.44$68.44$68.44$68.44 $82$82$82$82 $4.95$4.95$4.95$4.95 $5.68$5.68$5.68$5.68 $6.30$6.30$6.30$6.30 13.813.813.813.8 12.012.012.012.0 10.910.910.910.9 11.111.111.111.1 72727272 67676767 68686868 68686868Vandervliet Citigroup C 2 Equal weight $35.14 $43 $2.82 $2.90 $3.50 12.5 12.1 10.0 10.5 65 68 62 64Vandervliet J. P. Morgan Chase & Co. JPM 2 Equal weight $18.61 $20 $1.66 $1.80 $2.65 11.2 10.3 7.0 7.7 58 58 44 47

Integrated ProvidersIntegrated ProvidersIntegrated ProvidersIntegrated Providers 13.313.313.313.3 12.112.112.112.1 10.110.110.110.1 10.510.510.510.5 69696969 68686868 63636363 64646464

TRUST & PROCESSING BANKSTRUST & PROCESSING BANKSTRUST & PROCESSING BANKSTRUST & PROCESSING BANKS NEGATIVENEGATIVENEGATIVENEGATIVEVandervliet Bank of New York BK 2 Equal weight $26.31 $30 $2.01 $1.59 $2.13 13.1 16.5 12.4 13.2 68 93 77 80Vandervliet City National BankCity National BankCity National BankCity National Bank CYNCYNCYNCYN 1 Overweight1 Overweight1 Overweight1 Overweight $44.70$44.70$44.70$44.70 $65$65$65$65 $2.96$2.96$2.96$2.96 $3.53$3.53$3.53$3.53 $3.90$3.90$3.90$3.90 15.115.115.115.1 12.712.712.712.7 11.511.511.511.5 11.711.711.711.7 78787878 71717171 71717171 71717171Vandervliet Investors Financial IFIN Not Rated $29.10 NA $0.77 $1.02 $1.27 37.8 28.5 22.9 24.1 196 160 143 146Vandervliet Mellon Financial MEL 3 Underweight $26.26 $31 $1.57 $1.57 $2.00 16.7 16.7 13.1 13.9 87 94 82 84Vandervliet Northern Trust Corp. NTRS 3 Underweight $37.16 $40 $2.11 $2.05 $2.23 17.6 18.1 16.7 17.0 91 101 104 103Vandervliet PNC Financial Services Group PNC 3 Underweight $36.76 $42 $3.56 $4.21 $4.20 10.3 8.7 8.8 8.7 54 49 54 53Vandervliet State Street Corp. STT Not Rated $40.26 NA $2.00 $2.22 $2.47 20.1 18.1 16.3 16.7 105 102 101 101Vandervliet Wilmington Trust Corp. WL 3 Underweight $29.81 $34 $1.89 $2.06 $2.20 15.8 14.5 13.6 13.7 82 81 84 84

Trust & Processing BanksTrust & Processing BanksTrust & Processing BanksTrust & Processing Banks 18.318.318.318.3 16.716.716.716.7 14.414.414.414.4 14.914.914.914.9 95959595 94949494 90909090 90909090

SUPER REGIONALSSUPER REGIONALSSUPER REGIONALSSUPER REGIONALS NEUTRALNEUTRALNEUTRALNEUTRALGoldberg BB&T Corporation BBT 3 Underweight $35.35 $32 $2.40 $2.75 $2.95 14.7 12.9 12.0 12.2 77 72 75 74Goldberg Comerica Inc. CMA 2 Equal weight $41.24 $44 $4.72 $3.41 $4.85 8.7 12.1 8.5 9.2 45 68 53 56Goldberg Fifth Third Bancorp. FITB 2 Equal weight $65.36 $65 $2.37 $2.76 $3.10 27.6 23.7 21.1 21.6 143 133 131 132Goldberg FleetBoston Financial FBF 2 Equal weight $21.90 $25 $1.48 $1.49 $2.55 14.8 14.7 8.6 9.8 77 82 53 60Goldberg KeyCorp KEY 3 Underweight $24.79 $25 $0.74 $2.28 $2.45 33.5 10.9 10.1 10.3 174 61 63 63Goldberg National City Corp. NCC 2 Equal weight $28.05 $30 $2.27 $2.55 $2.65 12.4 11.0 10.6 10.7 64 62 66 65Goldberg SunTrust Banks STI 3 Underweight $60.11 $57 $4.79 $4.80 $4.95 12.5 12.5 12.1 12.2 65 70 76 74Goldberg U.S. BancorpU.S. BancorpU.S. BancorpU.S. Bancorp USBUSBUSBUSB 1 Overweight1 Overweight1 Overweight1 Overweight $20.01$20.01$20.01$20.01 $25$25$25$25 $1.32$1.32$1.32$1.32 $1.84$1.84$1.84$1.84 $2.02$2.02$2.02$2.02 15.215.215.215.2 10.910.910.910.9 9.99.99.99.9 10.110.110.110.1 79797979 61616161 62626262 61616161Goldberg Wachovia Corp. WB 3 Underweight $33.95 $35 $2.12 $2.78 $3.05 16.0 12.2 11.1 11.4 83 68 69 69Goldberg Wells FargoWells FargoWells FargoWells Fargo WFCWFCWFCWFC 1 Overweight1 Overweight1 Overweight1 Overweight $49.65$49.65$49.65$49.65 $60$60$60$60 $2.35$2.35$2.35$2.35 $3.32$3.32$3.32$3.32 $3.70$3.70$3.70$3.70 21.121.121.121.1 15.015.015.015.0 13.413.413.413.4 13.713.713.713.7 110110110110 84848484 84848484 84848484

Super RegionalsSuper RegionalsSuper RegionalsSuper Regionals 17.717.717.717.7 13.613.613.613.6 11.711.711.711.7 12.112.112.112.1 92929292 76767676 73737373 74747474 MID-CAP BANKSMID-CAP BANKSMID-CAP BANKSMID-CAP BANKS NEUTRALNEUTRALNEUTRALNEUTRAL

Goldberg AmSouth Bancorp ASO 3 Underweight $20.13 $20 $1.45 $1.68 $1.80 13.9 12.0 11.2 11.3 72 67 70 69Goldberg Charter One FinancialCharter One FinancialCharter One FinancialCharter One Financial CFCFCFCF 1 Overweight1 Overweight1 Overweight1 Overweight $30.14$30.14$30.14$30.14 $37$37$37$37 $2.10$2.10$2.10$2.10 $2.43$2.43$2.43$2.43 $2.70$2.70$2.70$2.70 14.314.314.314.3 12.412.412.412.4 11.211.211.211.2 11.411.411.411.4 74747474 69696969 69696969 69696969Goldberg Compass Bancshares CBSS 2 Equal-weight $32.11 $35 $2.11 $2.42 $2.60 15.2 13.3 12.4 12.5 79 74 77 76Goldberg First Tennessee National FTN 2 Equal weight $35.14 $38 $2.32 $2.75 $2.95 15.1 12.8 11.9 12.1 79 72 74 74

Lacoursiere Huntington Bancshares HBAN 3 Underweight $19.06 $22 $1.17 $1.33 $1.43 16.3 14.3 13.3 13.5 85 80 83 82Lacoursiere M&T Bank Corp MTB RS $81.60 - $3.87 $5.06 $5.50 21.1 16.1 14.8 15.1 110 90 92 92Goldberg Marshall & Ilsley Corp. MI 2 Equal weight $27.80 $30 $1.86 $2.18 $2.35 14.9 12.8 11.8 12.0 78 71 74 73Goldberg National Commerce Financial NCF 2 Equal weight $23.86 $28 $1.12 $1.58 $1.75 21.3 15.1 13.6 13.9 111 85 85 85Goldberg North Fork Bancorp.North Fork Bancorp.North Fork Bancorp.North Fork Bancorp. NFBNFBNFBNFB 1 Overweight1 Overweight1 Overweight1 Overweight $38.16$38.16$38.16$38.16 $45$45$45$45 $2.08$2.08$2.08$2.08 $2.58$2.58$2.58$2.58 $2.84$2.84$2.84$2.84 18.318.318.318.3 14.814.814.814.8 13.413.413.413.4 13.713.713.713.7 95959595 83838383 84848484 83838383Goldberg Regions Financial Corp. RF 3 Underweight $32.65 $30 $2.32 $2.73 $2.85 14.1 12.0 11.5 11.6 73 67 71 70Goldberg SouthTrust Corp. SOTR 2 Equal weight $24.10 $28 $1.61 $1.86 $2.02 15.0 13.0 11.9 12.1 78 73 74 74Goldberg Synovus Financial SNV 2 Equal weight $19.23 $24 $1.06 $1.21 $1.35 18.1 15.9 14.2 14.6 94 89 89 89Goldberg TCF Financial Corp.TCF Financial Corp.TCF Financial Corp.TCF Financial Corp. TCBTCBTCBTCB 1 Overweight1 Overweight1 Overweight1 Overweight $42.79$42.79$42.79$42.79 $52$52$52$52 $2.70$2.70$2.70$2.70 $3.15$3.15$3.15$3.15 $3.47$3.47$3.47$3.47 15.815.815.815.8 13.613.613.613.6 12.312.312.312.3 12.612.612.612.6 82828282 76767676 77777777 77777777Goldberg Union Planters UPC 3 Underweight $26.90 $28 $2.13 $2.59 $2.80 12.6 10.4 9.6 9.8 66 58 60 59

Lacoursiere UnionBanCal Corp. UB 2 Equal-weight $41.77 $52 $2.93 $3.30 $3.89 14.3 12.7 10.7 11.1 74 71 67 68Goldberg Zions Bancorp. ZION 2 Equal weight $38.93 $45 $3.20 $3.65 $4.00 12.2 10.7 9.7 9.9 63 60 61 60

Mid-Cap BanksMid-Cap BanksMid-Cap BanksMid-Cap Banks 15.815.815.815.8 13.213.213.213.2 12.112.112.112.1 12.312.312.312.3 82828282 74747474 75757575 75757575

SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B) NEGATIVENEGATIVENEGATIVENEGATIVELacoursiere Associated Banc-CorpAssociated Banc-CorpAssociated Banc-CorpAssociated Banc-Corp ASBCASBCASBCASBC 1 Overweight1 Overweight1 Overweight1 Overweight $32.27$32.27$32.27$32.27 $36$36$36$36 $2.45$2.45$2.45$2.45 $2.77$2.77$2.77$2.77 $3.05$3.05$3.05$3.05 13.113.113.113.1 11.611.611.611.6 10.610.610.610.6 10.810.810.810.8 68686868 65656565 66666666 66666666Lacoursiere Bank of Hawaii BOH 3 Underweight $29.40 $28 $1.46 $1.71 $2.05 20.1 17.2 14.3 14.9 105 96 89 91Lacoursiere Chittenden Corp. CHZ 2 Equal weight $27.93 $31 $1.80 $1.91 $2.03 15.5 14.6 13.8 13.9 81 82 86 85Lacoursiere Colonial BancGroup CNB 2 Equal weight $12.13 $14 $1.11 $1.17 $1.21 10.9 10.4 10.0 10.1 57 58 62 61Lacoursiere Commerce Bancorp CBH 2 Equal weight $45.76 $46 $1.51 $2.00 $2.28 30.3 22.9 20.1 20.6 157 128 125 126Lacoursiere Commerce BancsharesCommerce BancsharesCommerce BancsharesCommerce Bancshares CBSHCBSHCBSHCBSH 1 Overweight1 Overweight1 Overweight1 Overweight $40.95$40.95$40.95$40.95 $46$46$46$46 $2.73$2.73$2.73$2.73 $3.01$3.01$3.01$3.01 $3.30$3.30$3.30$3.30 15.015.015.015.0 13.613.613.613.6 12.412.412.412.4 12.712.712.712.7 78787878 76767676 77777777 77777777Lacoursiere Cullen/Frost BankersCullen/Frost BankersCullen/Frost BankersCullen/Frost Bankers CFRCFRCFRCFR 1 Overweight1 Overweight1 Overweight1 Overweight $34.85$34.85$34.85$34.85 $39$39$39$39 $1.76$1.76$1.76$1.76 $2.26$2.26$2.26$2.26 $2.63$2.63$2.63$2.63 19.819.819.819.8 15.415.415.415.4 13.313.313.313.3 13.713.713.713.7 103103103103 86868686 82828282 83838383Lacoursiere First Commonwealth FCF 3 Underweight $12.03 $13 $0.86 $0.88 $0.97 14.0 13.7 12.4 12.7 73 77 77 77Lacoursiere First Midwest Bancorp FMBI 2 Equal weight $27.19 $29 $1.63 $1.86 $2.03 16.7 14.6 13.4 13.6 87 82 83 83Lacoursiere FirstMerit Corp. FMER 3 Underweight $21.90 $23 $1.90 $1.85 $2.00 11.5 11.8 11.0 11.1 60 66 68 68Lacoursiere Greater Bay Bancorp GBBK 2 Equal weight $15.95 $26 $1.91 $2.32 $2.39 8.4 6.9 6.7 6.7 43 38 42 41Lacoursiere Hibernia Corp. HIB 2 Equal weight $18.95 $21 $1.35 $1.60 $1.76 14.0 11.8 10.8 11.0 73 66 67 67Lacoursiere Mercantile BanksharesMercantile BanksharesMercantile BanksharesMercantile Bankshares MRBKMRBKMRBKMRBK 1 Overweight1 Overweight1 Overweight1 Overweight $38.02$38.02$38.02$38.02 $44$44$44$44 $2.55$2.55$2.55$2.55 $2.72$2.72$2.72$2.72 $2.95$2.95$2.95$2.95 14.914.914.914.9 14.014.014.014.0 12.912.912.912.9 13.113.113.113.1 77777777 78787878 80808080 80808080Lacoursiere Provident Financial PFGI 2 Equal-weight $24.75 $30 $0.46 $2.33 $2.70 53.8 10.6 9.2 9.5 280 59 57 58Vandervliet Silicon Valley Bancshares SIVB 2 Equal-weight $16.82 $20 $1.76 $1.19 $1.35 9.6 14.1 12.5 12.8 50 79 78 78Lacoursiere Sky Financial Group Inc SKYF 2 Equal weight $19.17 $24 $1.45 $1.60 $1.78 13.2 12.0 10.8 11.0 69 67 67 67Vandervliet Southwest Bank of Texas SWBT 2 Equal weight $27.98 $37 $1.55 $1.69 $1.95 18.1 16.6 14.3 14.8 94 93 89 90Lacoursiere Valley National Bancorp VLY 3 Underweight $27.35 $27 $1.46 $1.59 $1.66 18.8 17.2 16.5 16.6 98 96 103 101Lacoursiere Westamerica Bancorp.Westamerica Bancorp.Westamerica Bancorp.Westamerica Bancorp. WABCWABCWABCWABC 1 Overweight1 Overweight1 Overweight1 Overweight $41.70$41.70$41.70$41.70 $47$47$47$47 $2.36$2.36$2.36$2.36 $2.62$2.62$2.62$2.62 $2.85$2.85$2.85$2.85 17.717.717.717.7 15.915.915.915.9 14.614.614.614.6 14.914.914.914.9 92929292 89898989 91919191 91919191

Small-Cap BanksSmall-Cap BanksSmall-Cap BanksSmall-Cap Banks 17.717.717.717.7 13.913.913.913.9 12.612.612.612.6 12.912.912.912.9 92929292 78787878 78787878 78787878

Bank CompositeBank CompositeBank CompositeBank Composite 16.916.916.916.9 13.913.913.913.9 12.412.412.412.4 12.712.712.712.7 88888888 78787878 77777777 77777777S&P 500S&P 500S&P 500S&P 500 869.29869.29869.29869.29 $45.16$45.16$45.16$45.16 $48.66$48.66$48.66$48.66 $54.10$54.10$54.10$54.10 19.219.219.219.2 17.917.917.917.9 16.116.116.116.1 16.416.416.416.4

3-tier industry sector rating system: Positive, Neutral, Negative Stock performance relative to an unweighted expected total Not Rated stocks carry consensus estimates. 3-tier stock rating system: 1 Overweight, 2 Equal-weight, 3 Underweight return of the industry over a 12 month investment horizon. Market cap, assets and revenues are aggregated. RS - rating suspended



30 October 18, 2002

Figure 23: Valuation Table (Cont’d) 12 Mo. Dividend 12 Mo. Dividend 12 Mo. Dividend 12 Mo. Dividend BookBookBookBook Price/Price/Price/Price/ SharesSharesSharesShares MarketMarketMarketMarket AssetsAssetsAssetsAssets RevenueRevenueRevenueRevenue YTDYTDYTDYTD 2001200120012001 2000200020002000

RateRateRateRate YieldYieldYieldYield ValueValueValueValue BookBookBookBook OutOutOutOut CapitalCapitalCapitalCapital 2Q022Q022Q022Q02 2Q022Q022Q022Q02 ReturnReturnReturnReturn ReturnReturnReturnReturn ReturnReturnReturnReturn

INTEGRATED PROVIDERSINTEGRATED PROVIDERSINTEGRATED PROVIDERSINTEGRATED PROVIDERS (mil.) (mil.) (mil.) (mil.) (bil.) (bil.) (bil.) (bil.) (bil.) (bil.) (bil.) (bil.) (mil.) (mil.) (mil.) (mil.)

BANK ONE CORP. $0.84 2.2% $18.37 209% $43 - $30 1184.0 $45.5 $270 $5,118 -1.5% 6.6% 14.2%Bank of America Corp.Bank of America Corp.Bank of America Corp.Bank of America Corp. $2.40$2.40$2.40$2.40 3.5%3.5%3.5%3.5% $31.47$31.47$31.47$31.47 217%217%217%217% $77$77$77$77 ---- $53$53$53$53 1592.31592.31592.31592.3 $109.0$109.0$109.0$109.0 $638$638$638$638 $8,668$8,668$8,668$8,668 8.7%8.7%8.7%8.7% 37.2%37.2%37.2%37.2% -8.6%-8.6%-8.6%-8.6%Citigroup $0.72 2.0% $16.47 213% $52 - $25 5185.8 $182.2 $1,083 $21,273 -25.4% -1.5% -1.4%J. P. Morgan Chase & Co. $1.36 7.3% $20.93 89% $41 - $15 2016.0 $37.5 $741 $7,574 -48.8% -20.0% -12.3%Integrated ProvidersIntegrated ProvidersIntegrated ProvidersIntegrated Providers 3.8%3.8%3.8%3.8% 182%182%182%182% $374.3$374.3$374.3$374.3 $2,732$2,732$2,732$2,732 $42,633$42,633$42,633$42,633 -16.7%-16.7%-16.7%-16.7% 5.6%5.6%5.6%5.6% -2.0%-2.0%-2.0%-2.0%

TRUST & PROCESSING BANKSTRUST & PROCESSING BANKSTRUST & PROCESSING BANKSTRUST & PROCESSING BANKSBank of New York $0.76 2.9% $9.09 289% $46 - $21 729.0 $19.2 $81 $1,271 -35.5% -26.1% 38.0%City National BankCity National BankCity National BankCity National Bank $0.78$0.78$0.78$0.78 1.7%1.7%1.7%1.7% $21.41$21.41$21.41$21.41 209%209%209%209% $56$56$56$56 ---- $39$39$39$39 52.152.152.152.1 $2.3$2.3$2.3$2.3 $11$11$11$11 $169$169$169$169 -4.6%-4.6%-4.6%-4.6% 20.7%20.7%20.7%20.7% 17.8%17.8%17.8%17.8%Investors Financial $0.05 0.2% $6.24 466% $39 - $20 66.6 $1.9 $7 $108 -12.1% -23.0% 273.9%Mellon Financial $0.52 2.0% $7.52 349% $41 - $20 441.0 $11.6 $34 $1,075 -30.2% -23.5% 44.4%Northern Trust Corp. $0.68 1.8% $12.60 295% $63 - $30 226.6 $8.4 $38 $552 -38.3% -26.2% 53.9%PNC Financial Services Group $1.92 5.2% $22.46 164% $63 - $33 285.0 $10.5 $67 $1,396 -34.6% -23.1% 64.2%State Street Corp. $0.19 0.5% $12.92 312% $58 - $32 328.3 $13.2 $80 $994 -22.9% -15.9% 70.0%Wilmington Trust Corp. $1.02 3.4% $11.03 270% $35 - $25 32.8 $1.0 $8 $135 -5.8% 2.0% 28.6%Trust & Processing BanksTrust & Processing BanksTrust & Processing BanksTrust & Processing Banks 2.2%2.2%2.2%2.2% 294%294%294%294% $68.1$68.1$68.1$68.1 $325$325$325$325 $5,699$5,699$5,699$5,699 -23.0%-23.0%-23.0%-23.0% -14.4%-14.4%-14.4%-14.4% 73.9%73.9%73.9%73.9%

SUPER REGIONALSSUPER REGIONALSSUPER REGIONALSSUPER REGIONALSBB&T Corporation $0.98 2.8% $14.99 236% $39 - $31 484.0 $17.1 $76 $1,112 -2.1% -3.2% 36.3%Comerica Inc. $1.92 4.7% $28.08 147% $66 - $35 178.0 $7.3 $51 $762 -28.0% -3.5% 27.2%Fifth Third Bancorp. $1.04 1.6% $14.10 464% $70 - $53 594.3 $38.8 $74 $1,195 6.6% 2.6% 22.1%FleetBoston Financial $1.40 6.4% $15.79 139% $39 - $18 1051.1 $23.0 $190 $2,882 -40.0% -2.8% 7.9%KeyCorp $1.20 4.8% $15.46 160% $29 - $20 431.9 $10.7 $82 $1,168 1.8% -13.1% 26.6%National City Corp. $1.22 4.3% $13.02 215% $34 - $25 616.8 $17.3 $98 $1,689 -4.1% 1.7% 21.4%SunTrust Banks $1.72 2.9% $31.41 191% $70 - $52 287.3 $17.3 $106 $1,393 -4.1% -0.5% -8.4%U.S. BancorpU.S. BancorpU.S. BancorpU.S. Bancorp $0.78$0.78$0.78$0.78 3.9%3.9%3.9%3.9% $8.70$8.70$8.70$8.70 230%230%230%230% $25$25$25$25 ---- $16$16$16$16 1926.91926.91926.91926.9 $38.6$38.6$38.6$38.6 $169$169$169$169 $3,097$3,097$3,097$3,097 -4.4%-4.4%-4.4%-4.4% -28.3%-28.3%-28.3%-28.3% 22.3%22.3%22.3%22.3%Wachovia Corp. $1.04 3.1% $22.15 153% $40 - $28 1375.0 $46.7 $314 $4,625 8.3% 12.8% -15.7%Wells FargoWells FargoWells FargoWells Fargo $1.12$1.12$1.12$1.12 2.3%2.3%2.3%2.3% $17.24$17.24$17.24$17.24 288%288%288%288% $53$53$53$53 ---- $38$38$38$38 1730.81730.81730.81730.8 $85.9$85.9$85.9$85.9 $311$311$311$311 $6,056$6,056$6,056$6,056 14.2%14.2%14.2%14.2% -21.9%-21.9%-21.9%-21.9% 37.7%37.7%37.7%37.7%Super RegionalsSuper RegionalsSuper RegionalsSuper Regionals 3.7%3.7%3.7%3.7% 222%222%222%222% $302.8$302.8$302.8$302.8 $1,470$1,470$1,470$1,470 $23,979$23,979$23,979$23,979 -5.2%-5.2%-5.2%-5.2% -5.6%-5.6%-5.6%-5.6% 17.7%17.7%17.7%17.7%

52-Wk52-Wk52-Wk52-WkRangeRangeRangeRange

MID-CAP BANKSMID-CAP BANKSMID-CAP BANKSMID-CAP BANKSAmSouth Bancorp $0.92 4.6% $8.53 236% $23 - $16 364.8 $7.3 $38 $572 6.5% 23.9% -21.0%Charter One FinancialCharter One FinancialCharter One FinancialCharter One Financial $0.84$0.84$0.84$0.84 2.8%2.8%2.8%2.8% $13.12$13.12$13.12$13.12 230%230%230%230% $35$35$35$35 ---- $23$23$23$23 239.1239.1239.1239.1 $7.2$7.2$7.2$7.2 $39$39$39$39 $400$400$400$400 16.6%16.6%16.6%16.6% -1.3%-1.3%-1.3%-1.3% 58.5%58.5%58.5%58.5%Compass Bancshares $1.00 3.1% $14.86 216% $36 - $24 130.2 $4.2 $23 $336 13.5% 18.5% 7.0%First Tennessee National $1.20 3.4% $12.36 284% $41 - $30 130.6 $4.6 $19 $516 -3.1% 25.3% 1.5%Huntington Bancshares $0.64 3.4% $9.68 197% $22 - $15 247.9 $4.7 $25 $360 10.9% 6.2% -25.4%M&T Bank Corp $1.20 1.5% $33.25 245% $90 - $65 92.0 $7.5 $34 $448 12.0% 7.1% 64.2%Marshall & Ilsley Corp. $0.64 2.3% $12.51 222% $32 - $23 221.3 $6.2 $28 $522 -12.1% 24.5% -19.1%National Commerce Financial $0.60 2.5% $12.58 190% $30 - $21 209.0 $5.0 $20 $284 -5.7% 2.2% 9.1%North Fork Bancorp.North Fork Bancorp.North Fork Bancorp.North Fork Bancorp. $1.00$1.00$1.00$1.00 2.6%2.6%2.6%2.6% $9.80$9.80$9.80$9.80 389%389%389%389% $43$43$43$43 ---- $27$27$27$27 162.5162.5162.5162.5 $6.2$6.2$6.2$6.2 $18$18$18$18 $250$250$250$250 19.3%19.3%19.3%19.3% 30.2%30.2%30.2%30.2% 40.4%40.4%40.4%40.4%Regions Financial Corp. $1.08 3.3% $17.81 183% $36 - $27 229.1 $7.5 $45 $682 9.1% 9.6% 8.7%SouthTrust Corp. $0.68 2.8% $12.45 194% $27 - $21 351.5 $8.5 $48 $590 -2.3% 21.3% 7.6%Synovus Financial $0.59 3.1% $6.12 314% $32 - $16 300.3 $5.8 $17 $424 -23.2% -7.0% 35.5%TCF Financial Corp.TCF Financial Corp.TCF Financial Corp.TCF Financial Corp. $1.15$1.15$1.15$1.15 2.7%2.7%2.7%2.7% $12.27$12.27$12.27$12.27 349%349%349%349% $55$55$55$55 ---- $35$35$35$35 74.374.374.374.3 $3.2$3.2$3.2$3.2 $11$11$11$11 $226$226$226$226 -10.8%-10.8%-10.8%-10.8% 7.7%7.7%7.7%7.7% 79.1%79.1%79.1%79.1%Union Planters $1.33 4.9% $15.95 169% $34 - $24 206.6 $5.6 $32 $496 -10.6% 26.2% -9.4%UnionBanCal Corp. $1.12 2.7% $24.22 172% $50 - $29 150.2 $6.3 $38 $575 9.9% 57.9% -39.0%Zions Bancorp. $0.80 2.1% $25.49 153% $60 - $34 92.6 $3.6 $26 $368 -26.0% -15.8% 5.5%Mid-Cap BanksMid-Cap BanksMid-Cap BanksMid-Cap Banks 3.0%3.0%3.0%3.0% 234%234%234%234% $93.2$93.2$93.2$93.2 $462$462$462$462 $7,049$7,049$7,049$7,049 0.2%0.2%0.2%0.2% 14.8%14.8%14.8%14.8% 12.7%12.7%12.7%12.7%

SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B)SMALL-CAP BANKS (<$3B)Associated Banc-CorpAssociated Banc-CorpAssociated Banc-CorpAssociated Banc-Corp $1.24$1.24$1.24$1.24 3.8%3.8%3.8%3.8% $16.84$16.84$16.84$16.84 192%192%192%192% $38$38$38$38 ---- $27$27$27$27 77.077.077.077.0 $2.5$2.5$2.5$2.5 $14$14$14$14 $182$182$182$182 0.6%0.6%0.6%0.6% 16.2%16.2%16.2%16.2% -2.4%-2.4%-2.4%-2.4%Bank of Hawaii $0.70 2.4% $17.05 172% $30 - $20 74.5 $2.2 $10 $142 13.6% 46.4% -5.4%Chittenden Corp. $0.80 2.9% $12.39 225% $34 - $23 32.2 $0.9 $5 $64 1.2% -8.9% 2.3%Colonial BancGroup $0.52 4.3% $8.52 142% $16 - $11 123.6 $1.5 $15 $142 -13.9% 31.1% 3.6%Commerce Bancorp $0.60 1.3% $12.19 375% $50 - $35 67.3 $3.1 $15 $223 16.3% 15.1% 77.5%Commerce BancsharesCommerce BancsharesCommerce BancsharesCommerce Bancshares $0.65$0.65$0.65$0.65 1.6%1.6%1.6%1.6% $20.09$20.09$20.09$20.09 204%204%204%204% $47$47$47$47 ---- $33$33$33$33 64.164.164.164.1 $2.6$2.6$2.6$2.6 $12$12$12$12 $197$197$197$197 5.0%5.0%5.0%5.0% -3.7%-3.7%-3.7%-3.7% 31.7%31.7%31.7%31.7%Cullen/Frost BankersCullen/Frost BankersCullen/Frost BankersCullen/Frost Bankers $0.88$0.88$0.88$0.88 2.5%2.5%2.5%2.5% $12.70$12.70$12.70$12.70 274%274%274%274% $41$41$41$41 ---- $24$24$24$24 53.653.653.653.6 $1.9$1.9$1.9$1.9 $8$8$8$8 $133$133$133$133 12.9%12.9%12.9%12.9% -26.1%-26.1%-26.1%-26.1% 62.4%62.4%62.4%62.4%First Commonwealth $0.60 5.0% $6.59 183% $14 - $11 58.9 $0.7 $5 $50 4.4% 15.2% -16.7%First Midwest Bancorp $0.68 2.5% $9.91 274% $32 - $23 48.8 $1.3 $6 $76 -6.9% 26.9% 8.5%FirstMerit Corp. $1.00 4.6% $11.28 194% $30 - $19 85.8 $1.9 $10 $151 -19.2% 1.3% 16.2%Greater Bay Bancorp $0.50 3.1% $10.50 152% $37 - $14 51.2 $0.8 $9 $130 -44.2% -30.3% 91.2%Hibernia Corp. $0.56 3.0% $10.29 184% $22 - $15 158.9 $3.0 $16 $267 6.5% 39.5% 20.0%Mercantile BanksharesMercantile BanksharesMercantile BanksharesMercantile Bankshares $1.20$1.20$1.20$1.20 3.2%3.2%3.2%3.2% $19.11$19.11$19.11$19.11 199%199%199%199% $45$45$45$45 ---- $32$32$32$32 69.669.669.669.6 $2.6$2.6$2.6$2.6 $11$11$11$11 $149$149$149$149 -11.7%-11.7%-11.7%-11.7% -0.3%-0.3%-0.3%-0.3% 35.2%35.2%35.2%35.2%Provident Financial $0.96 3.9% $19.70 126% $32 - $21 48.6 $1.2 $16 $185 -5.8% -29.9% 4.5%Silicon Valley Bancshares $0.00 0.0% $14.43 117% $34 - $14 47.0 $0.8 $4 $68 -37.1% -22.7% 39.6%Sky Financial Group Inc $0.76 4.0% $8.14 236% $24 - $17 83.0 $1.6 $10 $122 -5.8% 21.4% -8.4%Southwest Bank of Texas $0.00 0.0% $12.26 228% $39 - $24 34.4 $1.0 $5 $63 -7.6% -29.5% 116.7%Valley National Bancorp $0.90 3.3% $7.20 380% $29 - $22 94.6 $2.6 $9 $109 3.8% 3.9% 24.9%Westamerica Bancorp.Westamerica Bancorp.Westamerica Bancorp.Westamerica Bancorp. $0.88$0.88$0.88$0.88 2.1%2.1%2.1%2.1% $9.98$9.98$9.98$9.98 418%418%418%418% $46$46$46$46 ---- $33$33$33$33 33.633.633.633.6 $1.4$1.4$1.4$1.4 $4$4$4$4 $65$65$65$65 5.4%5.4%5.4%5.4% -8.0%-8.0%-8.0%-8.0% 53.9%53.9%53.9%53.9%Small-Cap BanksSmall-Cap BanksSmall-Cap BanksSmall-Cap Banks 2.8%2.8%2.8%2.8% 225%225%225%225% $33.6$33.6$33.6$33.6 $183$183$183$183 $2,518$2,518$2,518$2,518 -4.3%-4.3%-4.3%-4.3% 3.0%3.0%3.0%3.0% 29.2%29.2%29.2%29.2%

Bank CompositeBank CompositeBank CompositeBank Composite 3.0%3.0%3.0%3.0% 234%234%234%234% $872$872$872$872 $5,173$5,173$5,173$5,173 $81,878$81,878$81,878$81,878 -6.7%-6.7%-6.7%-6.7% 2.5%2.5%2.5%2.5% 26.6%26.6%26.6%26.6%S&P 500S&P 500S&P 500S&P 500 $15.20$15.20$15.20$15.20 1.7%1.7%1.7%1.7% $217$217$217$217 400%400%400%400% 1177117711771177 ---- 769769769769 -24.3%-24.3%-24.3%-24.3% -13.0%-13.0%-13.0%-13.0% -10.1%-10.1%-10.1%-10.1%

3-tier industry sector rating system: Positive, Neutral, Negative Stock performance relative to an unweighted expected total Market cap, assets and3-tier stock rating system: 1 Overweight, 2 Equal-weight, 3 Underweight return of the industry over a 12 month investment horizon. revenues are aggregated.RS - rating suspended



October 18, 2002 31

Important Disclosures: Important Disclosures: Important Disclosures: Important Disclosures:

The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which is generated by investment banking activities.

Key to Investment Opinions:Key to Investment Opinions:Key to Investment Opinions:Key to Investment Opinions:

Stock Ratings:Stock Ratings:Stock Ratings:Stock Ratings: 1111----Overweight Overweight Overweight Overweight ---- the stock is expected to outperform the unweighted expected total return of the industry sector over a 12-month investment horizon. 2222----Equal weight Equal weight Equal weight Equal weight ---- the stock is expected to perform in line with the unweighted expected total return of the industry sector over a 12-month investment horizon. 3333----Underweight Underweight Underweight Underweight - the stock is expected to underperform the unweighted expected total return of the industry sector over a 12-month investment horizon. RSRSRSRS----Rating Suspended Rating Suspended Rating Suspended Rating Suspended ---- The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Lehman Brothers is acting in an advisory capacity in a merger or strategic transaction involving the company.

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved by Lehman Brothers International (Europe), regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. © 2002 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction.

Complete disclosure information on companies covered by Equity Research is availabComplete disclosure information on companies covered by Equity Research is availabComplete disclosure information on companies covered by Equity Research is availabComplete disclosure information on companies covered by Equity Research is available at www.lehman.com/disclosures.le at www.lehman.com/disclosures.le at www.lehman.com/disclosures.le at www.lehman.com/disclosures.

US02-2676

GLOBAL EQUITY RESEARCH

New York 745 Seventh Avenue New York, NY 10019 USA 1.212.526.7000

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CURRENT RESEARCH DISCLOSURES, DISTRIBUTION OF RATINGS AND PRICE CHARTSCURRENT RESEARCH DISCLOSURES, DISTRIBUTION OF RATINGS AND PRICE CHARTSCURRENT RESEARCH DISCLOSURES, DISTRIBUTION OF RATINGS AND PRICE CHARTSCURRENT RESEARCH DISCLOSURES, DISTRIBUTION OF RATINGS AND PRICE CHARTS REGARDING REGARDING REGARDING REGARDING COMPANIES MENTIONED IN THIS DOCUMENTCOMPANIES MENTIONED IN THIS DOCUMENTCOMPANIES MENTIONED IN THIS DOCUMENTCOMPANIES MENTIONED IN THIS DOCUMENT

MAY BE OBTAINED BY GOING TO:MAY BE OBTAINED BY GOING TO:MAY BE OBTAINED BY GOING TO:MAY BE OBTAINED BY GOING TO: The Lehman Brothers Web siteThe Lehman Brothers Web siteThe Lehman Brothers Web siteThe Lehman Brothers Web site

http://www.lehman.com/disclosureshttp://www.lehman.com/disclosureshttp://www.lehman.com/disclosureshttp://www.lehman.com/disclosures

Sector View:Sector View:Sector View:Sector View: 1111----PositivePositivePositivePositive - sector fundamentals/valuations are improving. 2222----NeutralNeutralNeutralNeutral - sector fundamentals/valuations are steady, neither improving nor deteriorating. 3333----NegativeNegativeNegativeNegative - sector fundamentals/valuations are deteriorating.

Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist): Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist): Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist): Stock Ratings From February 2001 to August 5, 2002 (sector view did not exist):

This is a guide to expected total return (price performance plus diviThis is a guide to expected total return (price performance plus diviThis is a guide to expected total return (price performance plus diviThis is a guide to expected total return (price performance plus dividend) relative to the total return of the stock’s local dend) relative to the total return of the stock’s local dend) relative to the total return of the stock’s local dend) relative to the total return of the stock’s local market over the next 12 months.market over the next 12 months.market over the next 12 months.market over the next 12 months. 1111----Strong BuyStrong BuyStrong BuyStrong Buy - expected to outperform the market by 15 or more percentage points. 2222----BuyBuyBuyBuy - expected to outperform the market by 5-15 percentage points. 3333----Market PerformMarket PerformMarket PerformMarket Perform - expected to perform in line with the market, plus or minus 5 percentage points. 4444----Market UnderperformMarket UnderperformMarket UnderperformMarket Underperform - expected to underperform the market by 5-15 percentage points. 5555----SellSellSellSell - expected to underperform the market by 15 or more percentage points.

Stock RatStock RatStock RatStock Ratings Prior to February 2001 (sector view did not exist):ings Prior to February 2001 (sector view did not exist):ings Prior to February 2001 (sector view did not exist):ings Prior to February 2001 (sector view did not exist): 1111----BuyBuyBuyBuy - expected to outperform the market by 15 or more percentage points. 2222----OutperformOutperformOutperformOutperform - expected to outperform the market by 5-15 percentage points. 3333----NeutralNeutralNeutralNeutral - expected to perform in line with the market, plus or minus 5 percentage points. 4444----UnderperformUnderperformUnderperformUnderperform - expected to underperform the market by 5-15 percentage points. 5555----SellSellSellSell - expected to underperform the market by 15 or more percentage points. VVVV----VentureVentureVentureVenture - return over multiyear timeframe consistent with venture capital; should only be held in a well diversified portfolio.

Distribution of Ratings: Distribution of Ratings: Distribution of Ratings: Distribution of Ratings:

Lehman Brothers Equity Research has 1491 companies under coverage.

32% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Buy rating. 28% of companies with this rating are investment banking clients of the Firm.

40% have been assigned a 2-Equal weight rating which, for purposes of mandatory regulatory disclosures, is classified as a Hold rating. 11% of companies with this rating are investment banking clients of the Firm.

28% have been assigned a 3-Underweight rating which, for purposes of mandatory regulatory disclosures, is classified as a Sell rating. 39% of companies with this rating are investment banking clients of the Firm.

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