UVA-F-1577

Rev. Feb. 15, 2012

WESTERN ASSET ARBITRAGE

Jenny Kim was sitting at her desk late one afternoon in May 2007 and wondering how
many deals brought to her desk were born over a business lunch. Kim, an associate at Lehman
Brothers’ Debt Capital Markets desk, had spent the last week structuring and preparing a
proposal for a collateralized debt obligation (CDO) issuance. The deal was conceived at a
popular Thai restaurant in midtown Manhattan where her boss Jason Keyes had lunch with his
longtime friend Michael Stone, a senior collateral manager of Western Asset Management
Company (Western Asset). Just as any other deal that was drawn out on a cocktail napkin, this
one had too many open questions that Kim had to be prepared to answer the next day during the
meeting with the Western Asset team. She knew that Western Asset was not new to the
structured finance world, which made the task in front of her easier and harder at the same time.
Kim was anxious to ensure that the presentation went well.

Arbitrage Opportunity

In late April 2007, Western Asset had been contacted by a couple of commercial banks
that were eager to sell some of their assets. The value of the assets in question was falling and the
banks wanted to sell them in order to lower their capital reserve requirements and free up capital
for additional lending. The assets primarily consisted of senior secured bank loans and high-yield
corporate bonds (Exhibit 1). The proposal found its way to Stone’s desk. When he looked
through the list of assets, he noticed that the highest-rated asset on the list had a Standard &
Poor’s (S&P) credit rating of BBB–. Additional analysis suggested that the falling price of the
asset pool was mostly due to the imbalance in demand between “A-rated” (S&P rating of AAA,
AA, and A) and sub-investment-grade debt instruments (securities rated lower than BBB–).
While “A-rated” issuances were currently most in demand in the market, the lower-grade
instruments lagged behind, which was immediately reflected in the price imbalance. Stone knew
that Western Asset should buy the loans to cash in on this temporary mispricing. Without ado, he
started looking for other financial institutions that were willing to sell their sub-investment-grade
debt instruments. But he was wondering if they could do more with this arbitrage opportunity.
Western Asset participated in a number of deals aimed at repackaging the primarily sub-

This case was written by Rahul Prabhu (MBA ’08) and Professor Elena Loutskina based on publicly available
information as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright  2008 by the University of Virginia Darden School Foundation, Charlottesville,
VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this
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any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden
School Foundation.
 -2- UVA-F-1577

investment-grade assets into “A-rated” assets via a CDO. Stone was keen to explore the
opportunity and decided to talk to his friend Jason Keyes, managing director at Lehman
Brothers, who had structured and arranged CDOs for Western Asset in the past.

Stone and Keyes had gone to business school together, and over the years had built a
healthy professional and personal relationship. Keyes was the head of the Structured Finance
desk at Lehman Brothers. He had been with the investment bank for 15 years and had extensive
experience in the fixed-income markets. The weekly lunch they had was more of a friendly
meeting to talk about families, golf, and, recently, plans for a weekend getaway from the Big
Apple. Nevertheless, business issues and ideas always crept into the conversation. The lunch a
week earlier was not an exception. When Stone described his view of the demand imbalance,
Keyes immediately saw an opportunity for a CDO issuance as a way to capture the mispricing.
Their bet was that the cash inflows (interest and principal) from the commercial bank assets they
had purchased would leave a significant amount of money on the table after paying the interest
on the “A-rated” securities issued. By the end of lunch, although the specifics were not
discussed, they decided to pursue the transaction.

Western Asset Management Company (Western Asset)

Western Asset Management Company was founded in October 1971 by United

California Bank (which later became First Interstate, then Wells Fargo), and became an SEC-
registered investment advisor in December 1971. Through its life, Western Asset went through
numerous restructurings and changes in ownership, and by 2007, it had become one of the
world’s leading fixed-income managers. With offices in Pasadena (California), Hong Kong,
London, Melbourne, New York, São Paulo, Singapore, and Tokyo, the company provided
investment services for a wide variety of global clients, across an equally wide variety of
mandates. The long, high-performance track record and global presence positioned the company
to be one of the biggest players in fixed-income investments. In January 2007, Western Asset
was managing $575 billion in assets with a client base primarily comprising institutional
investors. Included in assets under management were 12 CDOs valued at approximately $6.5
billion. (For details of Western Asset’s composition of assets under management, see Exhibit 2.)

Western Asset devoted a lot of its resources to fixed income. Its objective was to provide
fixed-income clients with diversified portfolios that were tightly controlled and managed for the
long term. Western Asset believed that significant inefficiencies existed in the fixed-income
markets. By combining traditional analysis with innovative technology, the company aimed to
add value by exploiting these inefficiencies across eligible sectors. The firm employed a variety
of risk-reduction strategies, aiming to approximate a benchmark level of risk while exceeding its
return. Western Asset monitored portfolio concentrations and exposure to various sectors,
securities, duration levels, and changes in the yield curve. This focused approach had generated
positive returns in a variety of products with varying risk disciplines including CDOs and
structured finance.
 -3- UVA-F-1577

Collateralized Debt Obligations (CDOs)

A CDO was a corporate entity constructed to hold assets as collateral and to sell packages
of cash flows to investors. The CDO process started with a CDO issuer (typically an investment
bank) establishing a shell corporation, also known as a special purpose vehicle (SPV), that would
buy and hold the portfolio of cash-flow-generating debt securities (Exhibit 3). The SPV then
sold the participation in cash flow from this pool of securities to investors. This way, a CDO
investor took a position in the SPV and not in the underlying assets.

The underlying assets defined CDOs: They were usually based on commercial loans, real
estate loans, credit card debt, corporate bonds, and other debt obligations including other CDOs.
By pooling various debt obligations, the issuer effectively created a diversified portfolio of cash
flows that were later regrouped and dispersed across capital markets.

Once the pool of underlying assets was established, the issuer reallocated the risk borne
by these assets by creating a multilayer set of securities called tranches. Similar to senior debt,
subordinated debt, and equity layers in liabilities of a typical U.S. corporation, CDOs had senior
tranches (rated AAA), mezzanine tranches (AA- to BB-rated), and equity tranches (remained
unrated). Also similar to corporate debt and equity, the payout to the investors was structured
according to seniority. Following this “waterfall” structure, the senior notes were paid from the
cash flows before the junior notes and equity notes. The losses, on the other hand, were first
borne by the equity notes, next by the junior notes, and finally by the senior notes. This way the
senior tranche was protected by the subordinated security structure, which ensured its high
rating. The equity tranche (also known as the first-loss tranche or “toxic waste”) was most
vulnerable, and had to offer higher returns to compensate for the higher default risk.

While referencing the same pool of assets, each tranche had a unique risk profile
allowing the issuer to cater to investors’ needs. The wide variability of debt instrument
characteristics created through CDOs in turn allowed investors to customize their credit risk
exposure by risk, reward, and maturity.

The majority of CDO issuances were motivated by arbitrage where the transaction
attempted to capture for the equity investors the relative mispricing between the relatively high-
yield assets and the lower-yield liabilities represented by the rated bonds. The goal of such a
CDO structure was to get a rating higher than the average rating of the underlying assets. For
instance, CDOs made it possible to issue “A-rated” securities from a collateral pool consisting of
BBB– or lower-rated assets. The Securities Industry and Financial Markets Association
estimated the share of such CDO transactions at 86% in 2006 1 (Exhibit 4). The other significant
motivation for CDO issuance was issuing institutions’ desire to remove loans and other assets
from their balance sheets. An example of such a “balance sheet” CDO was a commercial bank
securitizing part of its loan portfolio and effectively converting loans to cash. These CDOs were

1
“Global CDO Market Issuance Data,” Securities Industry and Financial Markets Association, 2007,
http://archives1.sifma.org/assets/files/SIFMA_CDOIssuanceData2007q1.pdf (accessed November 20, 2008).
 -4- UVA-F-1577

aimed at reducing financial institution regulatory capital requirements and improving their return
on risk capital.

CDOs had come a long way since the first CDO was issued in 1987 by bankers at now-
defunct Drexel Burnham Lambert Inc. In recent years, CDOs had enjoyed remarkable growth on
a global level and had truly become a key component of the structured finance market. At the
turn of the millennium, CDO structures expanded with the emergence of the first structures to
repackage commercial mortgage-backed securities (CMBS), asset-backed securities (ABS), and
CDOs as assets in new CDOs (popularly known as CDOs of CDOs or CDO-squared). The
structures further evolved to include and repackage assets that did not have set payment terms,
such as distressed debt CDOs, CDOs of private equity funds, and CDOs of hedge funds. The
transaction structures had expanded from the basic cash-flow structures that passed through
principal and interest payments generated by the assets, to market value structures that looked at
the market value of the collateral, to payback investors, to the synthetic structures that passed on
to investors only the credit risk of the underlying assets. All these changes were motivated by the
demand of various investors, collateral managers, and sponsors. The ability to fine-tune and
customize the final product allowed a wide range of investors to capitalize on market
dislocations (arbitrage), diversify, and transfer credit risk.

Debt Capital Markets Desk at Lehman Brothers

Lehman Brothers was in the lead in creating such highly customized structured products.
It was a perfect candidate to provide the solution to the Western Asset deal. With a prominent
position as one of the world’s leading fixed-income franchises, the firm was globally reputed for
its securitization services and was recognized by the International Financing Review as the
“Securitisation House of the Year” in 2006. Lehman ranked third in the league tables for ABS
and public mortgage issuances that same year (Exhibit 5). Their Debt Capital Markets desk
offered full-service sales, trading, research, and origination services. It was well known for its
efficient deal structures, strong execution capabilities, and ability to attract global investors.
Lehman Brothers also invested in CDOs through its Structured Credit Investments group, which
had specific expertise in the equity tranches of CDO transactions. The group aimed to maximize
returns by opportunistically investing in CDO transactions across rated and unrated tranches.

Jenny Kim was a rising star in the CDO group at Lehman. She had been with the group
for three years since getting her MBA from a prominent southeastern business school. Kim spent
more than a year in training at Lehman (see Exhibit 6 for her training notes) and now was
emerging from the shadows of her senior colleagues. With a set of deals recently completed, she
was a natural candidate to prepare and manage the structuring and underwriting of the CDO
issuance for Western Asset. When Jason Keyes made her responsible for coordinating and
managing the CDO issuance, she started to develop an appropriate structure for the deal.
Alongside devising the structuring strategy that would best fit Western Asset’s current needs,
Kim also initiated the back-office process. She knew that if the deal were to be approved the day
after her presentation, Lehman would have to move quickly. She contacted the affiliated law firm
 -5- UVA-F-1577

to prepare the legal documentation for the deal and for the SPV, a corporate shell that would hold
the CDO’s assets and liabilities and distribute the cash flows from the asset pool to the CDO
investors.

The biggest challenge ahead was to structure the deal to the liking of Western Asset. As
collateral manager, Western Asset would play a key role in the CDO transaction. It would bring
its experience in both the construction and maintenance of the CDO’s portfolio. Western Asset
would actively monitor the portfolio and manage its credit quality through trades and would use
its extensive experience to maximize recovery rates in the event defaults occurred in the
portfolio. The second biggest question to be decided was a marketing strategy for the securities.
The latter would be reflected in the detailed investor pitch book and the statutory prospectus.

Structuring the Deal

Kim had to manage several aspects while determining an optimal structure for the CDO:

 Market demand: Assessing the market demand for the various classes of securities to be
issued was critical to ensure that money could be raised to purchase the assets. This
would include estimating the demand for the rated tranches as well as the demand for the
unrated or equity tranche.
 Asset quality and security pricing: The credit quality and weighted average coupon of the
asset pool would need to be estimated to determine the composition of securities to be
issued.
 Rating requirements: The CDO issuance would have to meet the rating agencies’ criteria,
as most investor groups would not invest in unrated securities.

Market demand

First, Kim followed up on Michael Stone’s hunch regarding the demand imbalance. The
Sales desk at Lehman confirmed the plentiful demand for the highly rated bonds. The sales
associates were confident that that they would be able to place all the AAA paper the deal could
generate without a hitch. In fact, they wanted more of such products to satisfy their long-term
clients. The lower-rated products were a different story. Though the Sales desk had some
customized requests for securities rated between AA and BBB, the demand in this sector was
fairly unstable and required more active involvement of the Lehman sales force. They confirmed,
however, that $70 million to $80 million of such securities could be placed without significant
discount relative to current market yields.

With the placing solution for the senior and junior tranches in her pocket, Kim got down
to finding the placing solution for the equity tranche. Given the arbitrage motivation for the deal,
Kim was relatively positive that Western Asset would like to retain the equity tranche. Lehman’s
specialized arm, the Structured Credit Investments Group, primarily invested in the equity
 -6- UVA-F-1577

tranches of CDOs. At the meeting with the group, Kim sought a commitment to buy into the
CDO equity tranche, but the results were not very promising. Though the group was ready to buy
the residual tranche, the price they offered was not one Kim could easily sell to Western Asset.
The group understood the risks of the “toxic waste” too well to leave any money on the table for
the asset management company.

Asset quality and pricing

The asset pool of senior secured bank loans and high-yield corporate bonds that Western
Asset would purchase from the commercial banks had a weighted average rating of B+, and the
weighted average coupon was a floating rate of 3 month LIBOR plus 2.45%. The objective was
to redistribute the given risk (BBB–) and interest among CDO investors using the waterfall
structure so that the new securities would maintain their high (relative to the asset pool) rating.

Kim looked up the current market yields on AAA, AA, A, and BBB for corporate debt
with terms comparable to the proposed issue. Based on this information and her demand
estimates from the Sales desk at Lehman, she drafted a memo where she outlined the sources and
uses of capital for the proposed CDO issuance (Exhibit 7). And she drew up the priority of
payments, also referred to as the interest and principal “waterfall” (Exhibit 8). The waterfall
determined how the cash inflows from the assets of the SPV would be used to pay the interest
and principal obligations on the different classes of securities to be issued.

Rating requirements

In the structure, there was clearly excess spread. While the assets on average would
generate LIBOR + 2.840%, only LIBOR + 0.525% was required to service the liabilities. This
indicated an excess spread of 2.315% that would accrue to the unrated equity tranche and the
asset manager. The problem was that this excess spread was only feasible if the senior and junior
tranches could receive the desired rating and sustain it. The average credit quality of the asset
pool was only B+, significantly lower than the securities to be issued, and the probability that
some of the underlying assets would default had to be factored into the pricing equation. She had
to project cash flows of the CDO and simulate the performance of the pool of assets to ensure
that it would be able to support the securities being issued while meeting the criteria of the rating
agencies. Thankfully, S&P (a leading rating agency), provided its rating methodologies to the
investment banks to facilitate the banks’ ability to estimate the appropriate rating for different
instruments in-house.

Kim proceeded with the cash-flow modeling exercise to determine whether the proposed
structure could be supported by the asset pool. The main inputs to her model were:

1. The assets purchased by Western Asset including the coupons, maturities, and expected
default rates
2. The various liabilities to be issued, including the proposed coupons (based on the spreads
of bonds with comparable ratings) and maturities
 -7- UVA-F-1577

3. The waterfall that she had drawn up for the deal

4. The requirements of the credit-rating agency S&P

Kim ran her model to calculate the default rates for each tranche of rated securities
proposed to be issued. She also used a proprietary S&P model to compute the default rates under
different scenarios. The results confirmed that the tranches were very likely to receive the
desired rating. But Kim did not stop there. She wanted to have all possible scenarios on the table
the next day. Following standard practice, she included around $80 million of loans in the CDO
structure that were marked to be purchased by Western Asset. With such a buffer, the issuer of a
CDO had the flexibility to change the structure and ratings of the tranches before the transaction
was complete. If Western Asset wanted a higher share of the AAA-rated tranche, it could get it
by buying a higher-quality debt and bumping up the average rating of the asset pool. Kim
simulated the default rates of the whole pool for various scenarios of quality (rating) of this $80
million of assets to be purchased.

The Meeting Ahead

With the memo outlining the proposed structure of the CDO in hand, Kim was ready to
meet with her managing director and the senior collateral manager the following day. While
reviewing her results, Kim noticed a significant cushion for the various tranches of rated
securities being issued: The estimated default rates for rated tranches were lower than the
maximum default rates required to receive a particular rating. This made Kim question whether
the structure was too conservative. She wondered if it would be possible to squeeze more AAA
notes into the offering thereby increasing the spread between the assets and liabilities and the
possible returns to the equity investors. She was aware that both investors in the rated securities
and the rating agencies would feel more comfortable if they were to see a bigger cushion, which
would help maintain the ratings even if there were small (expected) fluctuations in the collateral
pool. But the equity investors and collateral managers would like to see as small a cushion as
possible.

Kim looked out of the 41st floor of her office across Seventh Avenue and wondered what
other questions might come up during the meeting.
 -8- UVA-F-1577

Exhibit 1
WESTERN ASSET ARBITRAGE
List of Assets Identified by Western Asset

S&P Credit Maturity Current

Obligor Rating Date Balance
Acosta, Inc. B– 28-Jul-13 $2,987,462
Adesa, Inc. (KAR Holdings, Inc.) B– 20-Oct-13 $3,000,000
Advanced Micro Devices, Inc. B+ 31-Dec-13 $2,716,513
Affinion Group Inc. B+ 16-Oct-16 $3,863,014
Alpha Natural Resources, LLC BB– 25-Oct-16 $2,000,000
Altivity Packaging LLC (fka Bluegrass Container Company) B+ 30-Jun-13 $2,000,000
Aramark Corporation B+ 26-Jan-14 $3,685,154
Aramark Corporation B+ 26-Jan-14 $263,366
Ashmore Energy International B+ 30-Mar-14 $3,535,912
Ashmore Energy International B+ 30-Mar-14 $464,088
Associated Materials Incorporated B– 28-Aug-14 $2,500,000
Butler Animal Health Supply, LLC B 30-Jun-15 $1,350,000
Cardinal Health 409, Inc. B+ 10-Apr-14 $3,000,000
Carmike Cinemas, Inc. B– 18-May-16 $3,494,924
CCM Merger Inc. (Motor City Casino) B 12-Jul-16 $2,979,793
Cedar Fair L.P. B+ 29-Aug-16 $3,582,975
Centennial Cellular Operating Co. B– 8-Feb-15 $3,000,000
CMP Susquehanna Corp. B– 5-May-17 $3,210,483
Coffeyville Resources, LLC. B+ 27-Dec-14 $324,324
Coffeyville Resources, LLC. B+ 28-Dec-13 $1,671,486
CSC Holdings Inc (Cablevision) BB– 28-Mar-17 $3,974,925
David’s Bridal, Inc. B 31-Jan-14 $2,500,000
Delphi Corporation BBB– 29-Dec-15 $3,000,000
Denny’s, Inc. (Advantica) B+ 30-Mar-16 $2,311,348
Denny’s, Inc. (Advantica) B+ 14-Dec-15 $400,000
Emmis Operating Company B 1-Nov-13 $3,000,000
Fenwal, Inc. B+ 28-Feb-14 $500,000
Fenwal, Inc. B+ 28-Feb-14 $3,000,000
Ford Motor Company B 16-Dec-13 $2,992,500
Ford Motor Credit Company B 12-Jan-16 $2,000,000
FR Brand Acquisition Corp. B 7-Feb-14 $3,000,000
Freeport-McMoRan Copper & Gold Inc. B+ 1-Apr-15 $2,400,000
Freescale Semiconductor, Inc. B 15-Dec-14 $3,000,000
General Motors Corporation B+ 29-Nov-13 $2,992,500
Georgia Gulf Corp. B+ 3-Oct-13 $3,985,969
Georgia-Pacific LLC BB– 19-Dec-16 $3,974,862
Graham Packaging Company, L.P. B 6-Oct-15 $4,000,000
Graphic Packaging International, Inc. B+ 13-Apr-14 $4,000,000
Hanesbrands Inc. BB– 5-Sep-13 $2,778,214
Hanger Orthopedic Group, Inc. B 25-May-17 $1,736,875
Hawaiian Telcom Communications, Inc. B 29-Apr-16 $3,000,000
HCA Inc. B+ 15-Nov-16 $3,140,000
HCA Inc. B+ 18-Nov-13 $4,488,750
Health Management Associates, Inc B+ 28-Feb-14 $5,342,765
Hexion Specialty Chemicals, Inc. B 4-May-17 $1,221,022
Hexion Specialty Chemicals, Inc. B 4-May-17 $2,015,241
HVHC Inc. BB 1-Aug-13 $3,965,038
 -9- UVA-F-1577

Exhibit 1 (continued)

IAP Worldwide Services, Inc. B 29-Dec-16 $1,484,991

Iconix Brand Group, Inc. B+ 1-May-17 $3,000,000
Idearc Inc (Verizon) BB 17-Nov-14 $3,990,000
Insight Midwest Holdings, LLC BB– 7-Apr-14 $4,500,000
Intelsat Corporation (fka PanAmSat Corporation) BB– 3-Jan-14 $3,810,888
Itron, Inc. B+ 18-Apr-14 $3,000,000
Keystone Automotive Operations, Inc. B 11-Jan-16 $2,992,500
Leiner Health Products, Inc. CCC+ 26-May-15 $3,000,000
Lodgenet Entertainment Corporation B+ 4-Apr-14 $4,000,000
Lyondell Chemical Company BB– 16-Aug-13 $2,977,500
MGM Holdings II, Inc./Metro-Goldwyn-Mayer Inc. BB 7-Apr-16 $4,000,000
Michaels Stores, Inc. B– 31-Oct-13 $4,000,000
NACCO Materials Handling Group, Inc. BB– 20-Mar-17 $2,977,500
National CineMedia, LLC B+ 13-Feb-15 $3,000,000
Neiman Marcus Group Inc., The B+ 5-Apr-17 $1,360,000
NewPage Corporation B 1-May-15 $2,992,386
Nielsen Finance LLC B 9-Aug-13 $3,482,500
Niska Gas Storage Canada ULC BB– 12-May-15 $425,054
Niska Gas Storage Canada ULC BB– 11-May-17 $2,230,441
Niska Gas Storage US, LLC BB– 11-May-17 $386,692
Niska Gas Storage US, LLC BB– 11-May-17 $261,941
Nortek, Inc. B 26-Aug-15 $3,225,191
NRG Energy, Inc. B+ 31-Jan-17 $3,000,000
NXP BV BB 15-Oct-13 $3,000,000
Oceania Cruises Inc B 29-Apr-17 $3,500,000
OSHKOSH TRUCK CORPORATION BB 6-Dec-13 $3,990,000
OSI Restaurant Partners, Inc. B+ 9-May-14 $3,000,000
PetCo Animal Supplies, Inc B 28-Oct-13 $3,992,500
Pharmaceutical Technologies & Services B+ 10-Apr-14 $1,000,000
QCE, LLC (Quiznos) B 4-May-17 $2,977,500
RCN Corporation B 29-May-17 $4,000,000
ReAble Therapeutics Finance, LLC (Encore Medical) B 4-Nov-13 $2,985,019
Realogy Corporation B+ 10-Oct-13 $848,485
Realogy Corporation B+ 10-Oct-13 $3,151,515
Regal Cinemas Corporation BB– 9-Nov-14 $2,000,000
Rent-A-Center, Inc. BB 29-Jun-16 $1,948,596
Rental Service Corporation B+ 30-Nov-13 $2,000,000
Royalty Pharma Finance Trust BB+ 15-Apr-17 $4,000,000
Sagittarius Restaurants, LLC (Del Taco) B 28-Mar-17 $2,970,019
Sally Holdings, LLC B 18-Nov-13 $3,980,000
Select Medical Corporation B 23-Feb-16 $3,000,000
Standard Aero Holdings, Inc. B+ 23-Aug-16 $2,143,162
Sturm Foods, Inc. B 31-Jan-14 $2,000,000
SunGard Data Systems Inc (Solar Capital Corp) B+ 28-Feb-14 $3,491,250
Sun Healthcare Group, Inc. B 19-Apr-14 $2,850,575
Sun Healthcare Group, Inc. B 19-Apr-14 $505,747
Sun Healthcare Group, Inc. B 19-Apr-14 $643,678
Swift Transportation Co., Inc. B+ 10-May-14 $3,000,000
Transdigm Inc. B+ 22-Jun-17 $3,250,000
Univision Communications Inc. B 29-Sep-14 $362,416
Univision Communications Inc. B 29-Sep-14 $5,637,584
UPC Financing Partnership B 31-Dec-14 $4,000,000
 -10- UVA-F-1577

Exhibit 1 (continued)

US Investigations Services, Inc. B+ 13-Oct-16 $500,000

US Investigations Services, Inc. B+ 13-Oct-16 $2,985,000
Vanguard Car Rental USA Holdings, Inc. BB– 13-Jun-17 $1,885,027
Vanguard Health Systems B 22-Sep-15 $2,977,556
Verso Paper Holdings LLC BB– 1-Aug-13 $1,724,590
Vangent, Inc. (fka PGS Solutions, Inc.) B+ 13-Feb-17 $2,000,000
Visteon Corporation B+ 13-Dec-13 $3,500,000
Volnay Acquisition Co. I (CGG) B 12-Jan-14 $3,992,500
Wesco Aircraft Hardware Corp. B+ 30-Sep-13 $3,467,917
West Corporation B+ 24-Oct-13 $4,242,500
Wimar Opco LLC (Tropicana) B+ 2-Jan-16 $3,960,847
Wimar Landco, LLC (Tropicana) B+ 1-Jul-16 $2,000,000
WM. Bolthouse Farms, Inc. B+ 16-Dec-16 $2,984,887
To Be Purchased $77,223,988
Total $386,119,942
 -11- UVA-F-1577

Exhibit 2
WESTERN ASSET ARBITRAGE
Western Asset’s Composition of Assets under Management

Data source: http://www.westernasset.com/us/en/about/ (accessed November 20, 2008).

 -12- UVA-F-1577

Exhibit 3
WESTERN ASSET ARBITRAGE
CDO Structure

Asset Management

Asset Management
Portfolio of Fixed- Fees CDO Investors
Income Securities
•Senior Debt
•High-Yield Bonds Special Purpose Vehicle
Purchase Sell •Junior Debt
•Mortgage-Backed (SPV)
Securities •Equity
•Loans Service &
•Other CDOs Origination Fees
•Etc. Cash flow from
the pool of Cash flow to
assets investors

Issuer & Servicing Agent

(Investment Bank)
 -13- UVA-F-1577

Exhibit 4
WESTERN ASSET ARBITRAGE
Global CDO Issuances
(figures in billions of dollars1)

1
Data Source: “Global CDO Market Issuance Data,” Securities Industry and Financial Markets Association,
2007, http://archives1.sifma.org/assets/files/SIFMA_CDOIssuanceData2007q1.pdf (accessed November 20, 2008).
 -14- UVA-F-1577

Exhibit 5
WESTERN ASSET ARBITRAGE
Leading Asset-Backed-Securities Issuers (2006)

Market Number
Rank Manager $ billions
Share of Issues
1 RBS $ 335 20% 292
2 Deutsche Bank AG $ 279 17% 252
3 Lehman Brothers $ 269 16% 248
4 Banc of America Securities LLC $ 260 15% 257
5 Credit Suisse $ 248 15% 245
6 JP Morgan $ 242 14% 228
7 Merrill Lynch $ 222 13% 205
8 Bear Stearns & Co Inc $ 218 13% 218
9 Citi $ 215 13% 206
10 Morgan Stanley $ 201 12% 175
11 Goldman Sachs & Co $ 182 11% 166
12 Barclays Capital $ 161 10% 145
13 Countrywide Securities Corp $ 135 8% 168
14 UBS $ 129 8% 140
15 Wachovia Corp $ 112 7% 72
16 Washington Mutual Inc $ 73 4% 64
17 HSBC Holdings PLC $ 63 4% 65
18 Nomura $ 36 2% 30
19 General Motors Corp $ 33 2% 58
20 Blaylock & Co Inc $ 29 2% 37

Source: SDC Platinum, Thomson Financial

 -15- UVA-F-1577

Exhibit 6
WESTERN ASSET ARBITRAGE
Kim’s Associate Training Notes

Cash Flow CDO: Cash flow CDOs are structured vehicles that issue different tranches of
liabilities and use the net proceeds to purchase the pool of assets. The cash flows generated by
the assets are then used to pay back investors generally in sequential order from the senior
investors that hold the highest-rated (typically ‘AAA’) securities, to the “equity investors” that
bear the first-loss risk and generally hold unrated securities.

Synthetic CDO: In the simplest synthetic CDO structure, the SPV issues notes to the investors
and sells credit protection on a reference pool of credits. The money paid by the investors is then
held by the SPV to either repay the investors or to pay the buyer of the credit protection should
an asset in the reference pool default. The credit-protection buyer pays a periodic premium to the
SPV that, together with the interest earned on the money held by the SPV, is used to pay interest
to the investors. If and as assets in the reference pool default, the SPV settles with the credit-
protection buyer and makes payments. At the end of the transaction, the remaining money held
by the SPV is paid back to the investors.

Closing Date: The closing date is the date on which the CDO transaction structure and terms are
officially finalized and the deal related documents are signed.

Ramp-up Period: A CDO transaction usually involves an initial period of time post transaction
closing during which the manager acquires the underlying collateral from the proceeds of the
rated securities. This period during which the portfolio assets are purchased in the market or are
originated is called the ramp-up period. This is most prevalent in cash flow transactions.
Typically, in cash flow arbitrage transactions, 50% to 70% of the assets are accumulated by the
closing date, with the balance acquired during the ramp-up period which generally ranges from
three to six months after closing.

Effective Date: The effective date occurs after the last day of the ramp-up period or earlier if the
required amount of collateral has been purchased. Typically, for the transaction to become
effective the ratings of the transaction must be affirmed by the credit rating agency. For this to
occur, the rating agency requires the manager to provide information on the composition of the
portfolio and to verify that the portfolio default rate is lower than the break-even default rate
shown by the cash flow analyses prior to closing.

Over Collateralization Ratio: The over collateralization ratio is essentially a ratio of assets to
liabilities. It is computed as follows: (Net Collateral Principal Balance / Aggregate Outstanding
Amount of Rated Notes)

Interest Coverage Ratio: The interest coverage ratio is a ratio of interest received to interest
payable. It is computed as follows: (Net Collateral Interest Proceeds / Interest Payable on Notes)
 -16- UVA-F-1577

Exhibit 6 (continued)

Defaulted Interest: Any interest (other than deferred interest) due and payable in respect of any
senior note that is not punctually paid or duly provided for on the applicable payment date or at
stated maturity and remains unpaid.

Rating Confirmation Failure: Rating agencies requires the collateral manager to periodically
provide information on the composition of the portfolio in order to verify that the portfolio
default rate is lower than the break-even default rate and that the portfolio collateral eligibility
and coverage test are being met. If the transaction does not meet all the tests of the rating agency,
it results in a rating confirmation failure. The rating agency will then have to assess if the ratings
can be maintained.

Excess Spread: The excess spread is the difference between the all-in interest rate earned on the
assets and the all-in interest and fees paid on the rated CDO securities. The difference,
commonly seen in arbitrage structures, occurs because the bond and loan assets are rated lower,
on average, than the rated debt, and thus earns higher coupon or spread.

Reinvestment Period: The period during which portfolio assets may be traded under specified
conditions is called the reinvestment period. During this time, asset cash flows can be reinvested
or used to purchase eligible assets as long as certain tests are met, mainly coverage, collateral
quality and portfolio profile tests. This period of trading allows the collateral managers to use
their market experience to actively manage the portfolio.
 -17- UVA-F-1577

Exhibit 7
WESTERN ASSET ARBITRAGE
Proposed CDO Structure Memo

Cayman Islands, Inc., will be a $400 million cash-flow CDO. The underlying assets will
primarily consist of senior secured loans (90%) and high-yield bonds (10%), with target portfolio
rating of B+ and a weighted average life of 5.5 years. The CDO will have four rated tranches and
a subordinated or first-loss tranche. The rated tranches will comprise AAA-, AA-, A-, and BBB-
rated notes.

Uses of Capital
Security $ millions Coupon Type Coupon
B+ (leveraged loans) 360 Float LIBOR1 + 2.35%
B (high-yield bonds) 40 Fixed 8.50%

Total 400

Sources of Capital
Security $ millions Coupon Type Coupon
AAA (A-1) 238 Float LIBOR + 0.23%
AAA (A-2) 60 Float LIBOR + 0.34%
AA 18 Float LIBOR + 0.45%
A 24 Float LIBOR + 1.00%
BBB 32 Float LIBOR + 2.75%
Equity 28
Total 400

1
In May 2007, the 3 month LIBOR was 5.18%.
 -18- UVA-F-1577

Exhibit 8
WESTERN ASSET ARBITRAGE
Priority of Payments: Interest and Principal Waterfall

Interest Waterfall:
1. Taxes, registration, filing fees, if any
2. Accrued & unpaid fees to trustee, then collateral manager
3. Administrative expenses (capped)
4. Senior asset management fee
5. Class A interest
6. Class B interest (including defaulted interest on Class B, if any)
7. Senior coverage tests (Class A & B): if fail, pay principal sequentially to Class A, then Class B until tests
satisfied
8. Rating confirmation failure: pay principal sequentially (including deferred interest, if any) until ratings reinstated
9. Class C interest (including interest on deferred interest; and after Class A & B Notes paid in full, Class C
defaulted interest)
10. Class C deferred interest until paid in full
11. Class D interest (including interest on deferred interest; and after Class A, B, C Notes paid in full, Class D
defaulted interest)
12. Class D deferred interest until paid in full
13. Subordinate asset management fees, unpaid deferred asset management fee, then any other amounts payable to
collateral manager
14. Unpaid trustee and collateral fees not paid in 2 above, then admin expenses not paid in 3 above
15. With respect to any remaining interest, 80% to subordinated note holders and 20% to collateral manager
incentive fees

Principal Waterfall:
1. Clauses 1–6 of interest waterfall in order of priority (Class B), to extent not paid in full from interest
2. Senior coverage test (Class A & B) after payments of clause 7 of interest waterfall: if fail, pay Class A then B
until satisfied
3. If ratings confirmation failure, pay principal sequentially (including deferred interest where applicable) until
ratings of Senior Notes reinstated
4. Clause 9 of interest waterfall, to extent not paid
5. Clause 11 of interest waterfall, to extent not paid
6. If tax event or optional redemption: pay total redemption amount sequentially to Class A, B, C (including
deferred interest), D, subordinated notes, then remaining funds, after reasonable reserve determined by collateral
manager, to subordinated note holders
7. During reinvestment period, either purchase new collateral or pay sequentially for special amortization
8. After reinvestment period, at discretion of collateral manager, may reinvest unscheduled principal payments &
disposition proceeds of credit risk & credit improved obligations
9. After reinvestment period, Class A principal
10. After reinvestment period, Class B principal
11. After reinvestment period, Class C deferred interest
12. After reinvestment period, Class C principal
13. After reinvestment period, Class D deferred interest
14. After reinvestment period, Class D principal
15. After reinvestment period, subordinated asset management fee, to extent not already paid
16. After reinvestment period, unpaid trustee & collateral manager fees not already paid in 2 if interest waterfall, and
other fees from 14 of interest waterfall
17. After reinvestment period, distribution to subordinated note holders to extent necessary to meet specified rate of
return
18. With respect to any remaining principal, 80% to subordinated note holders, 20% to collateral manager as
incentive asset management fee.