process involved in surveillance of cdo

8/8/2019 Process Involved in Surveillance of CDO

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557.85 Million Senior And Subordinated Deferrable Fixed- And Floating-Rate Notes This presale report is based on information as of March 9, 2006. The credit ratings shown are preliminary.This report does not constitute a recommendation to buy, hold, or sell securities. Subsequent informationmay result in the assignment of final credit ratings that differ from the preliminary credit ratings.

Class Prelim. rating*Prelim. amount (Mil.

)Available credit support**(%) Interest Legal final maturity

A AAA 364.75 33.68Six-month EURIBOR plus a

margin2021

B AA 65.00 21.86Six-month EURIBOR plus a

margin2021

C-1 A 35.75 15.36Six-month EURIBOR plus a

margin2021

C-2*** A TBD TBD TBD 2021

D-1 BBB 20.60 11.62Six-month EURIBOR plus a

margin2021

D-2**** BBB TBD TBD TBD 2021

E-1 BB 13.75 9.12Six-month EURIBOR plus a

margin2021

E-2***** BB TBD TBD TBD 2021

F NR 58.00 N/A N/A 2021

*The rating on each class of securities is preliminary as of March 9, 2006 and subject to change at any time. Final credit ratings are

expected to be assigned on the c losing date and affirmed on the effective date subject to a satisfactory review of the transaction

documents and legal opinions. Standard & Poor's ratings address timely interest and ultimate principal on the class A and B notes.

Standard & Poor's ratings address ultimate interest and principal on the class C, D, and E notes. **Available credit support is calculated on

the initial target par amount of 550 million. ***The principal breakdown between the class C-1 and class C-2 notes will be determined at

closing. ****The principal breakdown between the class D-1 and class D-2 notes will be determined at closing. *****The principal

breakdown between the class E-1 and class E-2 notes will be determined at closing. NRNot rated. N/ANot applicable. TBDTo be

determined.

Transaction Participants

Portfolio manager Mizuho Corporate Bank Ltd.

Arranger Merrill Lynch International

Trustee Deutsche Trustee Co. Ltd.

Collateral administrator Deutsche Bank AG London

Custodian Deutsche Bank AG London

Interest rate swap counterparty To be determined

Currency swap counterparty To be determined

Bank account provider Deutsche Bank AG (London branch)

Paying agent Deutsche Bank AG (London branch)

Underwriter Merrill Lynch International

Supporting ratings

Institution/role Ratings

The London branch of Deutsche Bank AG as bank account provider AA-/Stable/A-1+

Interest rate swap provider An entity with a rating of at least 'A-1'


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Currency swap provider An entity with a rating of 'A-1+'

Transaction Key Features

Expected closing date April 2006

CDO asset type Loans

Structure type Cash

Portfolio composition Corporate names

Purpose of transaction Arbitrage

Rating approach Statistical

Portfolio management type Managed

Level of management Fully managed

Liability structure Fully funded

Collateral descriptionA portfolio of senior secured loans, senior unsecured loans, mezzanine

obligations, and synthetic securities

Reinvestment period (years) 7

Ramp-up period (months) 12

Noncall period (years) 5

Portfolio weighted-average rating B+/B

Maximum weighted-average life of the portfolio (years) 12.4

Default measure (DM) (%) 3.61

Variability measure (VM) (%) 1.99

Correlation measure (CM) 1.41

Minimum weighted-average margin (dependent on Standard &

Poor's test matrix) (%)2.65

Minimum weighted-average recovery rate (dependent onStandard & Poor's test matrix) (%) 55.99

Size of trading bucket (annual %) 20

Transaction SummaryCredit ratings were assigned to the 557.85 million senior and subordinated deferrable fixed- and floating-rate notes to be issued by Harvest CLO III PLC.

This transaction will be a securitization of a portfolio of leveraged loans selected and managed by MizuhoCorporate Bank Ltd. The portfolio is expected to be 55% ramped up at closing. Mizuho, as portfoliomanager, will be responsible for acquiring the target par amount within 12 months of the closing date. The

loans acquired will typically be either senior secured loans or mezzanine loans to borrowers based mainlyin continental Europe and the U.K. Leveraged loans typically contain certain levels of security thathistorically have been shown to yield higher recovery rates than senior unsecured obligations.

Key to the analysis of this transaction is the good asset cover provided by the par value ratios. Theseratios track the degree to which the performing collateral is sufficient to cover the return of principal to thedebt investors. Once the par value ratios fall below certain minimum levels, available interest andprincipal proceeds will be redirected to the extent required toward the redemption of senior liabilities.
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The numerator of the par value ratios will be adjusted to reflect the quality of the performing assets. Forexample, loans rated 'CCC' (above a certain threshold), loans purchased below 85% of par, and loansthat have defaulted will be included in the numerator of the par value ratios at less than full par value.

The structure of the transaction is shown in chart 1.

Notable FeaturesThe main difference between this transaction and Harvest CLO II S.A. will be the introduction of amaximum bucket for offsetting obligations and credit short obligations, whereby the issuer, or thecollateral manager on its behalf, may enter into CDS transactions with an adequately rated financialinstitution selling protection. Through this process, the issuer will buy protection for a specified referenceobligation that it already owns (an offsetting obligation) or one it does not (a credit short obligation).

Under each offsetting or credit short obligation, the issuer will be required to pay an ongoing premium.Entry into short CDSs will be subject to the minimum spread test being satisfied and the cash outflowsbeing taken into account in the interest coverage test. For offsetting obligations, each premium will benetted off against the spread received from the cash obligation owned by the issuer. In addition, theaggregate of offsetting and credit short obligations may not account for more than 10% and 5% of thecollateral balance, respectively. The issuer does not expect to enter into any credit short obligation in thefirst two years following the effective date.

The transaction allows the manager to acquire non-euro-denominated assets. The currency risk has to behedged through either asset-specific swaps or, in the case of sterling-denominated assets, can behedged through a portfolio hedge. The portfolio hedge gives the manager the flexibility to acquire and


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substitute sterling-denominated assets. Under the portfolio hedge, the issuer will hedge the foreignexchange risk by entering into a portfolio of currency swaps and purchasing various foreign exchangeoptions.

The collateral consists of up to 20% mezzanine loans, which are typically contractually subordinated witha subordinated equity piece. The mezzanine loans usually bear interest by reference to a floating-rate

index plus a spread. Mezzanine loans will generally either have a combination of a timely pay couponelement and a deferrable element, known as payment-in-kind (PIK). The deferred interest on mezzanineloans will be added to the principal balance of the loan and will only be realized at the earlier of the legalmaturity of the loan and the date of prepayment. For loans that have a PIK feature, the accrued interestup to acquisition by the issuer is considered to be part of the principal balance for the purpose of thetransaction. However, any rolled-up margin that has been capitalized after acquisition of the loan can,when realized, be treated as either interest or principal proceeds at the discretion of the portfoliomanager.

Assuming mezzanine loans meet the prescribed margin conditions, Standard & Poor's will give benefit tothe rolled-up interest in its cash flow analysis. The breakeven analysis is designed to compare the currentrating-specific portfolio default rate with a loss rate sustainable under the capital structure. Thisbreakeven analysis is calculated in circumstances in which the mezzanine loans meet the required

minimum deferred coupon conditions and when these coupon conditions are not met.

Strengths, Concerns, And Mitigating Factors

Strengths The quality of the portfolio will be closely monitored throughout the reinvestment period by par

value tests and interest coverage tests. Failure of these tests will cause a diversion of interestproceeds to pay down the notes sequentially, until the failure is cured.

The portfolio manager has a strong credit culture with experience in the European senior andmezzanine leveraged loan sectors.

Structural features are in place, such as applying haircuts to calculate the par value ratio forexcesses of 'CCC' rated assets and assets that have been purchased below 85% of par. An

additional reinvestment test also allows for up to 50% of available interest proceeds, due to bepaid to the class F subordinated note holders, to be invested in new collateral upon breach ofthis test.

The quality of the portfolio will be monitored throughout the reinvestment period usingStandard & Poor's CDO Monitor model.

Any cash settlement amount received by the issuer under a credit short obligation would flowthrough the principal or interest priority of payments, thereby providing additional cash flow tothe transaction. Standard & Poor's did not give credit to these amounts when calculating theminimum breakeven default rate. Similarly, the credit risk associated with an obligation ownedby the issuer subject to an offset will be neutralized. Any protection payment received underan offsetting CDS would flow through the principal priority of payments.

Concerns Up to 30% of the portfolio may be non-euro denominated. The transaction has a reinvestment period, in which sale proceeds and scheduled and

unscheduled principal proceeds may be used to purchase additional collateral. As with anyCDO transaction, there is a concern that during the reinvestment period the portfolio's qualitymight decline through the purchase of poorer quality collateral.

After the reinvestment period, the collateral manager can reinvest using unscheduled principalproceeds and proceeds from the sale of credit-improved obligations

The transaction allows no limit for special situation investments (SSI). A SSI is an investment


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in existing collateral obligations held by the collateral manager. The collateral manager willhave the option to inject additional capital to an obligor of a collateral debt obligation if in themanager's business judgment the investment would improve the financial condition of theobligor.

Mitigating factors The manager is required to ensure that all assets not denominated in either sterling or euros

are hedged through an asset-specific hedge. For sterling-denominated assets, the currencyrisk is mitigated through a portfolio hedge. In rating this transaction, Standard & Poor's hasmodeled the hedge and applied certain stresses and biases to ensure that the transactionwould continue to meet the payment of principal and interest on the notes.

The risk of a deteriorating portfolio is addressed in the structure. Reinvestment criteria exist tomaintain asset quality and rating volatility. Standard & Poor's specific tests include the CDOMonitor test and the minimum weighted-average recovery rate test. These tests must be metbefore ratings can be affirmed on the effective date. If the tests are not met, all principal will beused to amortize the notes until the tests are in compliance. Additional tests include theminimum weighted-average spread test and coverage tests. The reinvestment criteria must bemet before and after reinvestment.

Any reinvestments after the end of the reinvestment period will still be subject to meeting theportfolio reinvestment criteria, plus additional rating and maturity limitations.

The transaction will incorporate a par preservation test that will need to be satisfied as acondition to enter into an SSI. The par preservation test will require the netting out of principalproceeds used to purchase any SSI while maintaining the original par amount as of the closingdate.

Collateral Pool CharacteristicsThe collateral pool will comprise performing senior secured loans, unsecured loans, and mezzanineobligations. At the time of purchase the collateral debt obligation must have a minimum rating of 'B-'.

The stratifications of the expected closing portfolio are shown in charts 2 and 3.


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The target portfolio distribution by rating is shown in table 1.

Table 1 Target Portfolio Distribution By Rating


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D 107.15 113.15 101/110 148.98

E 105.03 110.03 101/105 139.61

Additional

reinvestment test106.28 110.03

*The first number indicates the required ratio for the first two periods and the second number indicates the required ratio thereafter.

Payment PrioritiesBoth interest and principal priority of payments are standard. Principal allocation is sequential oncecertain fees and interest on the senior notes, which have not been paid in the interest priority ofpayments, have been paid. Interest proceeds are first used to pay senior fees and expenses, followed bythe coupons on the notes sequentially. If interest coverage and par coverage ratio triggers are breached,available interest proceeds and, if required, principal proceeds will be used to amortize the notessequentially until the ratios are in compliance.

Hedging

The portfolio tests require that no more than 30% of the outstanding portfolio can consist of noneuroobligations. The structure is expected to rely on two different approaches to mitigate currency risk. Theissuer is expected to use a portfolio hedge for its exposure to currency risk associated with any sterling-denominated assets. The portfolio hedge will consist of swaps and options. The notional amount of theportfolio hedge must not exceed 110 million. The notional balance can reduce if any of the hedgedassets are sold, prepaid, or default. The foreign exchange options will be exercised to allow the issuer toreduce the portfolio hedge's notional amount at no additional cost to itself. In its rating analysis, Standard& Poor's stress-tested the structure's ability to continue making payments under the swap and to meet itsobligation to pay the rated liabilities.

Before acquiring any assets not denominated in euros or sterling, the issuer must enter into an asset-specific swap that hedges its currency risk. The issuer will also purchase options, which will allow themanager to terminate the swaps if these assets prepay or default.

The notes bear interest based on six-month EURIBOR, while the collateral debt securities will consistprimarily of floating-rate obligations that bear interest at one, three, six, and 12 months over the relevantcurrent indices. The mismatch has been addressed in the cash flow analysis by modeling the extremeinterest scenarios and to generate the impact of a potential spread compression as a result of movementsin the interest rates. If the portion of the collateral that pays interest less frequently than semiannuallyexceeds 5%, the issuer may enter into interest rate swaps to hedge the mismatch.

Cash Flow Assumptions

Default stress scenariosTo determine the default risk of a proposed portfolio, Standard & Poor's CDO Evaluator model

analyzes the following information:

The number of obligors and obligations in the pool; The obligor credit rating;

The principal amount outstanding; The maturity date of each obligation; and

The amortization schedules for amortizing assets.
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Once the default frequency is calculated by Standard & Poor's model, the resulting default frequencyis used as one of the key assumptions in cash flow modeling. The capital structure of the transaction isthen subjected to various cash flow stress scenarios incorporating alternative default patterns, levels,and timing of default scenarios for each rating category. The cash flow stresses have been appliedassuming the worst-case portfolio that is permitted under the eligibility criteria and portfolio profiletests.

Different default timing scenarios are used to stress a transaction's internal or external hedgingmechanics, and to analyze the interaction between the underlying assets and the prospective ratedliabilities.

The default rate for each rating category is applied in conjunction with the interest rate stressscenarios and the respective recovery rates to analyze the structure's ability to withstand cumulativedefaults and, as a result, its ability to pay timely interest on the class A and B notes and ultimateinterest on the class C, D, and E notes by the legal final maturity of the rated liabilities.

The default rate for each rating category is distributed across the curves shown in table 4.

Table 4 Default Timing PatternYear Scenario I (%) Scenario II (%) Scenario III (%) Scenario IV (%) Scenario V (%) Scenario VI (%) Scenario VII (%)

1 15 25 20 40 8.3 20 25

2 30 25 20 20 8.3

3 30 25 20 20 8.3 20

4 15 25 20 10 8.3 25

5 10 20 10 8.3 20

6 8.3

7 8.3 20 25

8 8.3 9 8.3 20

10 8.3 25

11 8.3

12 8.7

For scenarios I to IV, each default pattern is lagged to begin at the end of years one, two, three, four,five, six, seven, and eight of the transaction, respectively, for the 'AAA' and 'AA' rated notes.

Each of these default timing patterns is applied together with the interest rate stress scenarios and therespective recovery rates to analyze the structure's ability to withstand cumulative defaults and its

ability to pay timely interest on the class A and B notes only, and ultimate interest on the class C, D,and E notes by the legal final maturity of the rated notes.

Interest Rate Stress ScenariosIn addition to incorporating the default stress scenarios, different interest rate stress scenarios are used inthe cash flow analysis evaluated by Standard & Poor's to test the impact of different interest rateenvironments on the structure's ability to pay timely interest (as required) and ultimate principal on therated liabilities. Standard & Poor's interest rate assumptions are based on the historical levels and


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changes in these rates to determine interest rate floors, caps, and spikes over various periods.

The expected breakeven default rate that the transaction can withstand under Standard & Poor's cashflow assumptions must exceed results from Standard & Poor's CBO/CLO default model to provide asufficient cushion.

Transaction Management

Portfolio manager (Mizuho Corporate Bank Ltd.)This is the third European transaction to be sponsored by Mizuho, the corporate bank of the MizuhoFinancial Group. The Mizuho Financial Group has total assets of $1.23 trillion as at year ending March31, 2005. The group was constituted in September 2000 to facilitate the merger of and corporate re-organization among the following three Japanese financial institutions: The Dai-Ichi Kangyo Bank Ltd.,The Fuji Bank Ltd., and The Industrial Bank of Japan Ltd. The merger was finalized on April 1, 2002,on which date the London branch of Mizuho Financial Group assumed the business previouslyconducted by the London branches of Dai-Ichi Kangyo Bank, Fuji Bank, and Industrial Bank of Japan.The leveraged finance group of Mizuho actively manages a portfolio of 3.3 billion of Europeanleveraged loans (as at Feb. 28, 2006), including both the purchase and sale of assets (excluding

Harvest CLO I S.A., Harvest CLO II S.A., and Harvest CLO III PLC).

Mizuho has been active in the leveraged loan market since 1987, both as underwriter and investor insenior and mezzanine leveraged loan transactions. Mizuho has a strong credit culture and hascapitalized on the key relationships it has developed in the market with private equity houses, giving itgood access to collateral.

Standard & Poor's has performed an on-site visit to review the operations of Mizuho. The transactiondocuments place appropriate trading restrictions on the portfolio manager. In addition, the portfoliomanager's role includes providing advisory services in connection with:

The selection and credit evaluation of underlying assets for inclusion in the portfolio;

The monitoring of the performance and credit quality of the underlying assets in the portfolio; The management of underlying assets to assure compliance with the parameters set forth in

the transaction documents; and Compliance with certain notice requirements.

Sales and reinvestment of collateralThe transaction documents permit the portfolio manager to sell loans at any time when the collateraldebt security:

Is a defaulted security; Is an exchanged equity security; or

Is deemed a credit-impaired or credit-improved security by the portfolio manager.

The reinvestment criteria do not have to be met at the time of sale.

The transaction also allows the investment manager to sell collateral debt securities outside therequirements set out above, if the total volume of these sales does not exceed 20% of the aggregateprincipal balance of the collateral debt securities for a given year. During the reinvestment period, theinvestment manager may reinvest all scheduled repayment, unscheduled prepayment, and saleproceeds. After the reinvestment period, only unscheduled principal proceeds and the proceeds of thesale of credit-improved securities can be reinvested. This is provided that all coverage tests and a


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number of the collateral quality tests are in compliance, in particular the purchased collateral having anequal or higher Standard & Poor's rating, and equal or earlier maturity than the collateral it replaces.

Redemption Of The Notes

Optional redemptionThe rated notes may be redeemed in whole in the following circumstances: (i) on any payment date if,following a change in tax law, withholding tax is applied to the interest that is paid on the notes; (ii) onany payment date if withholding tax is applied to interest that is received on the collateral and that isnot grossed up by the obligor; or (iii) on any payment date after the end of the non-call period fiveyears after closing.

Optional redemption for circumstance (i) is at the option of the class F noteholders and the holders ofthe most senior notes outstanding, requiring a two-thirds majority of both. Optional redemption forcircumstances (ii) and (iii) is at the option of the class F subordinated noteholders only and alsorequires a two-thirds majority.

Mandatory redemptionThe class A, B, C, D, and E notes will be sequentially redeemed by the issuer on any payment datebefore final legal maturity if any of the par value or interest coverage tests are not satisfied as of therelated calculation date. This mandatory redemption pays down the rated notes sequentially with theavailable interest cash in the interest priority of payments and available principal cash in the principalpriority of payments, if necessary, to satisfy all of the coverage tests.

After the end of the reinvestment period, principal proceeds, to the extent not allowed and designatedto be reinvested, will be used to redeem the class A, B, C, D, and E notes sequentially.

Key Performance IndicatorsKey performance indicators for this transaction include:

Potential rating migration of the collateral and the extent this can lead to defaults;

The coverage tests; The level of recoveries achieved in case of defaults; The degree of trading gains and/or losses; The ability to source and reinvest in suitable collateral; and The extent to which loans prepay and the potential negative or positive effect this can have on

excess spread.

Criteria Referenced

"CDO Spotlight: General Cash Flow Analytics for CDO Securitizations" (published on Aug. 25,2004).

"Global Interest Rate and Currency Swaps: Calculating the Collateral Required Amount"(published on Feb. 26, 2004).

"Standard & Poor's Global Interest Rate and Swap Counterparty Rating Criteria Expanded"(published on Dec. 17, 2003).

"Criteria Regarding Legal Opinions in the Context of CDOs" (published on May 12, 2003). "European Legal Criteria for Structured Finance Transactions" (published on March 23, 2005).

"Global Cash Flow and Synthetic Criteria" (published on March 21, 2002).
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"Global CBO/CLO Criteria" (published on June 1, 1999).

Related Articles "ROC Report" (published monthly). "European CDOs of Leveraged Loans Review" (published quarterly). "Rating Transitions 2005: Activity More Muted But Upgrades Still Dominate In European

Structured Finance" (published on Jan. 11, 2006).

All criteria and related articles are available on RatingsDirect, Standard & Poor's Web-based creditanalysis system, at www.ratingsdirect.com. The criteria can also be found on Standard & Poor's Web siteat www.standardandpoors.com.

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