Lehman Brothers - Fixed Income - Structured Credit Trading

Default Baskets

Default basket swaps are products whose returns are typically linked to the first to default of a group of issuers (the "Reference Issuers"). The Buyer of "first to default" protection pays a premium to another counterparty (the "Seller" of protection) for taking risk on the underlying credits. If any one of the Reference Issuers suffers a "credit event," then the Seller of protection pays the loss on the Reference Security to the Buyer and the transaction terminates.

Default baskets provide a number of benefits over investing in a single currency or multiple un-leveraged positions. They include:

•	Spread: Typically, a default basket will yield more than a cash bond with a similar probability of default.
•	Capital: For insurance companies and banks, the capital required for holding securities in each of the reference credits can be quite large. The return on capital for the default basket will generally be much less for taking comparable risk.
•	Funding: For investors with a higher cost of funds, the earnings from holding several credits at tight spreads will not be much. The default basket offers these investors a better risk/return profile.
•	Credit Curve Rolldown: The default basket generates a better total return in a stable credit spread environment, including better roll down the curve. Compared to a single issuer trade with equivalent spread, a default basket gets the mark to market rolldown for each one of its reference credit curves rather than just a single curve.
•	Worst Case Losses: Default baskets only expose the investor to one default rather than the possibility of multiple defaults or spread widening from buying all of the Reference Securities.

Example:
Investor enters into a swap for 3 years that creates credit exposure to 5 Reference Issuers. Upon the occurrence of a Credit Event with respect to any one Reference Issuer, the Buyer of default protection delivers to the investor a security issued by the defaulted issuer, at which time the transaction shall terminate.

Reference Issuers:

Airline Company
Household Appliances Company
Communications Company
Transport Services Company
Machinery Company

(Baa2/BBB-)
(Baa2/BBB)
(Baa2/BBB+)
(Baa2/BBB)
(A3/A-)

The spread earned by the Investor is significantly higher than the spread he could earn by investing in any one of the credits.

This material is being provided for informational purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy any product. Structured products are not appropriate for all investors. Clients are advised to make an independent review and reach their own conclusions regarding the economic risks and benefits of any structured transaction and the legal, credit, tax, accounting and other aspects of such transaction in relation to their particular circumstances. The examples provided are based on certain assumptions that may or may not reflect all potential variables that could effect the value of a structured product. This information has been obtained from various sources. Lehman Brothers does not warrant the accuracy, completeness, timeliness, reliability, fitness for a particular purpose or merchantability of this information.