Morgan Stanley & Co. International Ltd European Leveraged Loan CDS Trading.

Morgan Stanley & Co. International LtdMorgan Stanley & Co. International Ltd

European Leveraged Loan CDS Trading

2

Please see additional important disclosures at the end of this report.

Leveraged LCDS: Introduction

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European Leveraged Loan CDS Market

• Morgan Stanley has led the development of the European Leveraged Loan CDS market

• Leveraged Loan CDS has enabled European bank loan portfolio managers to transfer leveraged loan risk efficiently to investors whilst still remaining a lender of record and retaining crucial client/sponsor relationships

• Since launching the business in July 2005, Morgan Stanley has traded approximately $3.5 bn in notional contracts value

• More than three dozen investors, both buy- and sell-side, have signed into the Morgan Stanley documentation

• Six other European dealers have agreed to use standard documentation that is substantially similar to the document created by Morgan Stanley

• We anticipate the launch of the first purely synthetic CLO once the liquidity in the market develops

• Morgan Stanley was instrumental in the development of the European Leveraged Loan index product (iTraxx LevX) which launched recently

Executive Summary

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Leveraged Loan Asset Class

5


High Yield Bonds Leveraged Loans

Interest Fixed/Floating Floating

Coupon/Margin Unchanged Margin Ratchet (e.g., Leverage)

Rated Yes Not usually public

Seniority Senior or subordinated Senior

Security Unsecured Secured

Covenants Incurrence covenants Maintenance covenants

Callability Call protections, premiums Not customary

Investors Funds, Pension Funds, Insurance Companies

Banks, Funds

Volatility High Low

Recovery Low (~20-50%) High (~60-80%)

Leveraged Loan Asset ClassEuropean High Yield Bonds vs. Leveraged Loans

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Leveraged Loan Asset Class

Type Repayment Maturity (years) Margin (bps)

Senior Debt

Tranche A Term Loan Amortising 7 225

Tranche B Term Loan Bullet 8 275

Tranche C Term Loan Bullet 9 325

Revolver Bullet 7 225

Other potential senior tranches: Acquisition, Integration, Capex

Subordinated Debt

2nd Lien Term Loan Bullet 9-9.5 400-700

Mezzanine(1) Term Loan Bullet 10 9-12% (incl. PIK), plus warrants

High Yield Bond(1) Details depend on the Issuer and market conditions at time of issue. More typical for the larger deals

Note: (1) Subordinated debt will either comprise mezzanine or a high yield bond, not customary for both

European Leveraged Loan Capital Structures

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US High Yield

Shareholders

Operating Subsidiaries

Support Package (incl. guarantees and security)

Hold Co

HY

Senior Facilities

European Mezzanine

Shareholders

Operating Subsidiaries Support Package (incl.

guarantees and security over all assets)

Hold Co

Mezzanine

Senior Facilities

(1st Lien over assets)

(2nd Lien over assets)

Inter-company loan

European High Yield

Shareholders

Operating Subsidiaries

Hold Co

Intermediate Hold Co

HY

Senior Facilities

Support Package (Guarantees on subordinated basis by operating subsidiaries with fall away provision)

Leveraged Loan Asset ClassLeveraged Structures: Contractual and Structural Subordination

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Source: S&P LCD

3360 79

40 48 68123

37

242 196 156

133 131

195

246

90

276256

234

173 179

262

369

127

$0B

$100B

$200B

$300B

$400B

1999 2000 2001 2002 2003 2004 2005 1Q06

Europe US

Leveraged Loan MarketOverall New-Issue Leveraged Loan Volume

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Leveraged Loan MarketAverage Contributed Equity to Leveraged Buyouts

Source: S&P LCD

34% 34% 34%32%

34% 33% 33%31%32%

34% 35%37%

35%33%

30%33%

0%

10%

20%

30%

40%

50%

1999 2000 2001 2002 2003 2004 2005 1Q06

Europe US

Equity as a Percent of Total Sources

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Leveraged Loan MarketAverage Leveraged Buyout Purchase Price Multiple

Source: S&P LCD

7.67

7.327.06 6.99

6.81

7.567.29

7.57

8.318.718.79

7.09

6.62

5.99

7.40

6.63

5.00

6.00

7.00

8.00

9.00

1999 2000 2001 2002 2003 2004 2005 1Q06

Europe US

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Leveraged Loan MarketMoving Up The Capital Structure

L+150

L+250

L+350

L+450

L+550

L+650

L+750

L+850

L+950

L+1050

1Q97

4Q97

3Q98

2Q99

1Q00

4Q00

3Q01

2Q02

1Q03

4Q03

3Q04

2Q05

1Q06

EUR HY Loans EUR HY Bonds US HY Loans

Source: S&P LCD, Morgan Stanley

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Convergence of MarketsInstitutional Investors’ Share of the Primary Market for Leveraged Loans

0%

15%

30%

45%

60%

75%

1999 2000 2001 2002 2003 2004 2005 LTM 1Q06

Europe US

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Leveraged LCDS: Introduction

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• CDS terminates upon full repayment of underlying loan – No Basis Risk

• Ability to hedge the right part of the capital structure – No Recovery Risk

• Ability to hedge private leveraged loans

• Ability to mitigate risk without risking sponsor / company relationship

• Ability to trade out of protection and recover cost of hedge over remaining life of loan

• Free up regulatory capital

• Ultimately improved liquidity over the cash market

Morgan Stanley has developed a trade confirmation for use with European leveraged loans

Intention is to create a different CDS market for each level of the capital structure: i.e., senior secured, second lien and mezzanine loans

Users can now mitigate risk on private leveraged loans, without crystallizing losses

Restructuring as a credit event will enable bank loan portfolio managers to efficiently reduce regulatory capital usage

Tenor of hedge can be chosen by protection buyer

Benefits to Buyers of Protection

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• Ability to access credits that no longer are trading in the cash market

• Ability to access private transactions (i.e., that have no public securities)

• No prepayment risk – if loan is fully repaid, CDS terminates

• No margin ratchet concerns

• Ability to sell in GBP, USD or EUR, regardless of underlying currency of loan

• CLO managers can add more recent transaction exposure to vintage vehicles

• Cash settlement option available to Seller only

• Capital efficient means of gaining exposure to credits given leveraged nature of product

Seller of protection can access credits that no longer actively trade in the secondary market, without the risk of early prepayment

Seller can choose the currency of exposure, regardless of underlying currency of loan

Cash settlement option available to Seller if unable to take delivery of loan on a Credit Event

Tenor of exposure can be chosen by Seller of protection

Benefits to Sellers of Protection

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• Ability to close trades on T + 1 vs. T + 10 (par) vs. T + 20 (distressed)

• Ability to choose tenor of credit exposure (1 – 10 years)

• Tax efficient means of exposure to credits

• Avoids borrower / agent consent issues

• Avoids transfer fees

More efficient trading and risk/reward transfer through: T + 1 settlement Tax efficient Consent avoidance Fee avoidance Ultimately greater liquidity

Benefits to Buyers and Sellers of Protection

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• Reference Entity – all obligors

• Reference Obligation – Reference Credit Agreement, plus, New Tranches (permits the ability to add tranches, for e.g., in the instance of a recapitalization, provided certain tests are met)

• Termination Event – full refinancing of all tranches relating to CDS

• Any tranche within credit agreement can be delivered – cheapest to deliver concept

• Credit Events:1) Failure to Pay2) Bankruptcy3) Restructuring:

- Restrictions apply only if Buyer triggers under Restructuring- Maturity limited to later of Mod Mod R or longest dated tranche before Restructuring- Security diminished in Restructuring causes credit event, but cannot be delivered by Buyer

• Physical settlement is the default, however, Seller has cash settlement option if unable to receive physical or unwilling to accept participation

Morgan Stanley has developed the leveraged loan CDS from the standard ISDA form as a baseline

The CDS is not linked to any single tranche, rather to a ranking within the capital structure

Adjustments were made to accommodate the unique nature of the loan product and to enable the ISDA form to deal with security and ranking

Voting rights were added to ensure the Seller had the ability to influence any future creditor decisions

Key Features of Trade Confirmation

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PhysicalSettlement

Date

EventDetermination

Date

Noticeof PhysicalSettlement

(NOPS)

30 calendar days 30 Business Days afterNOPS Fixing Date

Protection Buyer must deliver NOPS by the 30th calendar day after the Event Determination Date (NOPS Fixing Date)

Voting Rights pass on delivery of NOPS

Cash Settlement

Election Date

(Participation)

Participation Settlement

Decision Date

5 Business Days 5 Business Days

• Protection Buyer notifies Seller of its intention to create a Participation (with elevation rights) OR• Transaction terminates• No time limit to close Participation if so elected

Cash Settlement

Election Date

Seller notifies Buyer of intention to cash settle no later than 5 Business Days after the NOPS Fixing Date

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ValuationDate

Cash Settlement

Decision Date

Cash Settlement

Date

3 Business Days

Later of (i) 5 Business Days after Cash Settlement Election Dateand (ii) 10 Business Days after the NOPS Fixing Date

• Final Price = highest bid• If no firm quotations obtained then Physical Settlement applies

Cash Settlement Mechanics

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Differences Between: European & US LCDS and European Bond CDS

European Bond CDS European LCDS US LCDS

Reference Entity • ABC plc and anySuccessor

• Any borrower/guarantor/obligor or surety under the credit agreement

• Successor provisions do not apply

• ABC plc and anySuccessor

Reference Obligation

• Typically a Bond • All tranches or facilities under the credit agreement (including new tranches)

• Loan of the Designated Priority specified on the Reference Obligation Secured List

Obligation • Borrowed Money • Reference Obligation Only • Borrowed Money

Credit Event • Bankruptcy

• Failure to Pay

• Modified Modified Restructuring

• Bankruptcy

• Failure to Pay

• Modified Modified Restructuring

• Bankruptcy

• Failure to Pay

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• Trade terminates if no Substitute Reference Obligation is identified

• Trade terminates if all of Reference Obligations are redeemed/repaid



Deliverable Obligation

• Bond or Loan• Not Subordinated• Specified Currency• Not Contingent• Assignable Loan• Consent Required Loan• Transferable• Maximum Maturity: 30 yrs• Not Bearer

• Reference Obligation or any obligation of the Reference Entity that is senior to the Reference Obligation and secured on same assets

• Loan• Not Subordinated• Specified Currency• Not Contingent• Assignable Loan• Consent Required Loan• Participation Loan• Maximum Maturity: 30 yrs• Syndicated Secured

Excluded Deliverable Obligations

• None. Usually the Reference Obligation is a Deliverable Obligation

• The Reference Obligation if security is released and materially diminished following a Restructuring credit event exercised by the Buyer

• Reference Obligation if it fails the Syndicated Secured or Specified Currency characteristic

Early Termination • Not Applicable

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• Buyer delivers DO with an outstanding principal balance equal to the Physical Settlement Amount

• Seller can elect for Cash Settlement to apply if assignment/participation not completed within the required time period

• Buyer/Seller may elect settlement at any time in a form which reflects the economics of the trade



Physical Settlement • Buyer delivers Deliverable Obligations with an outstanding principal balance equal to the Physical Settlement Amount

• Buyer delivers Deliverable Obligations with an outstanding principal balance equal to the Physical Settlement Amount

• Seller can elect for Cash Settlement to apply in relation to all/part of the Deliverable Obligations

Delivery Timeline • Notice of Physical Settlement (“NOPS”) must be sent within 30 calendar days of Event Determination Date (credit event notice and notice of publicly available information)

• NOPS must be sent within 30 calendar days of the Event Determination Date

• NOPS must be sent within30 calendar days of theEvent Determination Date

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Delivery Timeline (continued)

• Deliverable Obligations must be delivered within 30 business days of satisfaction of Conditions to Settlement (i.e., delivery of NOPS)

• Deliverable Obligations must be delivered within 30 business days of the day that is 30 calendar days after the Event Determination Date

• Deliverable Obligations must be delivered within 30 business days of satisfaction of Conditions to Settlement

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Leveraged LCDS:Trading Strategies

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Please see additional important disclosures at the end of this report.Source: Morgan Stanley

Back-of-the envelope Pricing

Two possible approaches:

• Calculate premium/discount of loan in basis points (i.e., loan trading at 101 = 100bps premium)• Divide premium/discount by number of years to maturity/repayment (i.e., assuming 2yr takeout: 100/2 = 50bps)• Add discount to or subtract premium from spread of underlying loan (i.e., 225 – 50 = 150bps) OR

• Assume bond CDS and Loan CDS have same default probability and the recovery rate for LCDS is 70% and for bond CDS is 40%• Spread LCDS/Spread bond CDS = 1-R/1-R (where R is the recovery rate)• 1-70%/1-40% = 30/60 = 0.5 (LCDS spreads should be 0.5 times bond CDS spreads)

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Please see additional important disclosures at the end of this report.Source: Morgan Stanley

What Views Do You Express in Long/Short Trades?

Capital Structure Trades and Curve Trades

Senior vs. Sub Sub vs. Senior Curve Steepener Curve Flattener

Trade Strategies

Long 1st Lien vs. Short 2nd Lien

Long Unsecured vs. Short 2nd Lien

Long 3yr vs. Short 5yr 1st Lien

Long 5yr vs. Short 3yr 1st Lien

Rationale • Defensive trade, positive carry.

• Benefits from rising default probability and wider recovery rate spread

• Bullish trade on deleveraging and IPO

• Long convexity

• LBO-exit play• Assumes average

life of LBO ~36mths

• Long credit, positive carry but also positiveJTD risk

Hedge-Ratio • Loss-given-default neutral

• Carry-neutral • Carry-neutral • Flat notional

Economics • Positive carry• LGD neutral

• Flat carry • Flat carry• LGD negative

• Positive carry• DV01 long

Risks • Sharp deleveraging, IPO

• Wide recovery rate differential

• Default • Limited spread widening

• Debt repayment• Curve steepening

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Leveraged Loan CDS: Relative ValueComparing Value Across Capital Structures

0

100

200

300

400

500

600

700

800

900

1,000bps

KBW Unity Basell ATU WDAC KDG Rexel Cognis ONO Telenet Grohe Invensys

Spread to 1st Lien

Spread to 2nd Lien

Unsecured

Source: Morgan Stanley

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European LeveragedLoan CDS Market

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* Public Transactions

AA

Ahold Supermercados

Ahlsell

Amadeus

ATU*

Autobar

Balta

Basell*

Brenntag

BSN Medical

Cognis*

Debenhams

Debitel

Demag

Elior

Elis

Credits Available to Trade

eircom*

Eutelsat*

EWT

Frans Bonhomme

Focus*

Gala

Gambro

Gardena

Gerresheimer*

Global Garden

Grohe*

Ineos*

Invensys*

ISS*

KBW*

KDG*

Kloeckner Pentaplast*

Kwik-Fit

Linpac

M. Greisheim

Man Utd

Moeller

MTU Friedrich.

Multikabel

New Look*

NTL B’Cast

NTL/Telewest

Numericable

ONO*

Ontex

Pirelli Cable

Rexel*

Rockwood

Ruhrgas

Saga

Sanitec

SBS

Seat*

SigmaKalon

Smurfit Kappa*

Springer/KAP

SSP

Stabilus

Sulo

Symrise

TDC*

TDF

Telenet*

TMD Friction

Travelex

TUI*

United Biscuits*

UPC*

Vendex*

Vetco

Vivarte

Waste Recycling*

WDAC*

Weetabix

Wind*

Xsys

Yell

Yellow Brick Road

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Leveraged LCDS: Future Developments

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• Tradable Senior Secured, Second Lien and Mezzanine iTraxx indexes

• Macro hedging instruments for portfolio management

• CLO tranche hedging

• Synthetic CLO vehicles

• Constant Proportion Portfolio Insurance (CPPI)

• Recovery Trading

• First to Default Baskets

Once the single-name trading business develops, the market should follow the recent development of the traditional investment grade and HY bond CDS markets

Future Developments

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European Leveraged Loan Indexes

1) Lev X – Senior• 35 1st lien credits only

2) Lev X – Subordinated• 35 2nd and 3rd lien credits only• Weighting of 2nd and 3rd lien between 40% and 60%

• June 2011 maturity

• Traded on price-basis with fixed coupon – only premium or discount exchanged

• Zero factor applied to credits refinanced or credits defaulted; coupon paid on remaining

• Physical settlement

LevX Indexes

The underlying contract will be similar to the single-name contract

Trading on a price basis allows for easy inter-dealer assignments and unwinds

Index will roll and re-balance March 20 and September 20, in line with other European indexes

Physical settlement is initially intended, however, a cash settlement protocol may be adopted in future

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Recovery Trading: Recovery Is Only 40% on AverageRecovery Varies a Great Deal Sector to Sector

Source: Morgan Stanley

0

10

20

30

40

50

60

70

80

90

100

Rec

ove

ry R

ate

(%)

0

10

20

30

40

50

60

70

80

90

100

Median

Minimum

Maximum

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Appendix AEuropean Loan Trading Process

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The Loan Market does not benefit from a central clearinghouse

Key trade issues are negotiated on each trade

Standard documentation has been developed by the LMA, but it is not the only method to document a trade

Trade settlement process can be drawn out and require close supervision

Anatomy of a Trade Bank Debt Bond Credit Default Swap T-x Buyer and Seller exchange

Confidentiality Letter (if necessary)

T Trade Date (telephone or otherwise) Trade Date (telephone or otherwise) Trade date (telephone or otherwise)

Seller sends Confirmation to Buyer

T+1 Seller sends:

Confirmation to Buyer

Request to Agent for Borrower consent (if required)

Credit Documentation to Buyer (unless sent prior to the Trade Date)

Effective Date, Buyer now protected

Buyer returns Confirmation to Seller

T+2 Buyer returns Confirmation to Seller; Agent sends consent request to Borrower

T+3 Seller sends draft Completion Documents to Buyer

Settlement Date Date on which any assignment, unwind or upfront fees are made

T+2 - T+7 Buyer's due diligence on Credit Documentation (unless completed prior to Trade Date)

T+5 Signing of Completion Documents (subject to any necessary consents) and delivery to Agent (if required)

T+7 Borrower's approval of trade (or failure to approve trade)

T+10 Settlement Date

T+11 Giving of any necessary notices

Not earlier than T+1m First premium cashflow (for trades not paid for with an upfront fee). Premium is paid quarterly in arrears aligned with the maturity date. First cashflow period long if it would otherwise have been shorter than one month.

European High Yield Credit Sales & Trading

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The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated ("Morgan Stanley"). Morgan Stanley does not undertake to advise you of changes in its opinion or information. Morgan Stanley and others associated with it may make markets or specialize in, have positions in and effect transactions in securities or instruments of companies mentioned and may also perform or seek to perform investment banking services for those companies.

Morgan Stanley & Co. Incorporated, Morgan Stanley DW Inc. and/or their affiliates will deal as principal in the securities recommended herein.

Morgan Stanley & Co. Incorporated, Morgan Stanley DW Inc. and/or their affiliates or their employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of issuers mentioned herein.

The investments discussed or recommended in this report may not be suitable for all investors. Investors must make their own investment decisions based on their specific investment objectives and financial position and using such independent advisors as they believe necessary. Where an investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of, or income derived from the investment. Past performance is not necessarily a guide to future performance. Income from investments may fluctuate. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. Price and availability are subject to change without notice.

To our readers in the United Kingdom: This publication has been issued by Morgan Stanley & Co. Incorporated and approved by Morgan Stanley & Co. International Limited solely for the purposes of section 21 of the Financial Services and Markets Act 2000. Morgan Stanley & Co. International Limited and/or its affiliates may be providing or may have provided significant advice or investment services, including investment banking services, for any company mentioned in this report. NOT FOR DISTRIBUTION TO PRIVATE CUSTOMERS AS DEFINED BY THE U.K. FINANCIAL SERVICES AUTHORITY LIMITED.

This publication is disseminated in Japan by Morgan Stanley Japan Limited and in Singapore by Morgan Stanley Asia (Singapore) Securities Pte Ltd.

To our readers in Australia: This publication has been issued by Morgan Stanley & Co. Incorporated but is being distributed in Australia by Morgan Stanley Dean Witter Australia Limited, a licensed dealer, which accepts responsibility for its contents. Any person receiving this report and wishing to effect transactions in any security discussed in it may wish to do so with an authorized representative of Morgan Stanley Dean Witter Australia Limited.

To our readers in Canada: This publication has been prepared by Morgan Stanley & Co. Incorporated and is being made available in certain provinces of Canada by Morgan Stanley Canada Limited. Morgan Stanley Canada Limited has approved of, and has agreed to take responsibility for, the contents of this publication in Canada.

To our readers in Spain: Morgan Stanley Dean Witter, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission (CNMV), hereby states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations.

Past performance is not indicative of future returns. Certain assumptions may have been made in this analysis which have resulted in any returns detailed herein. No representation is made that any returns indicated will be achieved. Transaction costs (such as commissions) are not included in the calculation of returns. Changes to the assumptions may have a material impact on any returns detailed.

Disclaimer

Morgan Stanley & Co. International Ltd European Leveraged Loan CDS Trading.

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