Disseminated from RatingsDirect
Publication date: 11-Apr-2001

Analysts: Takenari Yamamoto, Tokyo (81) 3-3593-8656; Tomoyoshi Omuro, Tokyo (81) 3-3593-8584; Kim S Diamond, New York (1) 212-438-2446; Clayton Hunt, New York (1) 212-438-2492

?31.5 billion nonperforming loan-backed notes

Preliminary ratings as of April 12, 2001
This presale report is based on information as of April 12, 2001. The ratings shown are preliminary. This report does not constitute a recommendation to buy, hold, or sell securities. Subsequent information may result in the assignment of final ratings that differ from the preliminary ratings.
Class	Preliminary rating*	Preliminary amount
Class A	AAA	?20.5 billion
Class B	AA	?4.8 billion
Class C	A	?3.9 billion
Class D	BBB	?2.3 billion
*The rating of each class of securities is preliminary and subject to change at any time.

Profile
Expected closing date: May 2001

Lead manager: Morgan Stanley & Co. International Ltd.

Sponsor: Morgan Stanley Realty Inc.

Special servicer: Lombard Special Servicing Co. K.K.

Trustee: Chase Manhattan Bank Ltd.

Cap counterparty: Morgan Stanley Capital Services Inc.

Legal advisor: Mori Sogo Law Office

Clifford Chance

Rationale
Standard & Poor's expects to assign ratings to International Credit Recovery - Japan III Ltd.'s (ICRJ-III) ¥31.5 billion floating-rate structured notes, classes A-D.

Standard & Poor's ratings address the full and timely payment of interest and the ultimate repayment of full principal by the legal final maturity date in 2006.

The preliminary ratings are based on:

• The quality of the mortgage and fee assets in the property portfolio that ultimately secures the rated notes;
• The credit support provided by the subordinate classes of notes;
  The ability of the servicers and asset managers to realize proceeds from the liquidation of the assets in a timely manner;
• The liquidity provided by the reserve account; and
  The soundness of the legal structure.

Standard & Poor's analysis of the transaction includes a conservative assessment of the value of the real estate portfolio that ultimately secures the notes, the diversity of real estate asset types within the portfolio, a resolved cash balance of approximately ¥5.27 billion generated from income from portfolio properties and resolutions of assets as of March 31, 2001, and an evaluation of the management strategy and operations of Morgan Stanley Realty Inc.'s (MSRI) subsidiaries, affiliates, and indirectly held entities (MSRI entities). The analysis also takes into consideration the experience of the servicers and asset managers, and the strong performance to date in the resolution of assets from prior portfolios, including the performance of International Credit Recovery-Japan One Ltd. (ICRJ One) and International Credit Recovery-Japan II Ltd. (ICRJ-II), both of which were rated by Standard & Poor's. ICRJ One closed in December 1999, and was fully redeemed in November 2000.

Strengths.

• The proven experience of MSRI entities in purchasing and disposing of nonperforming loan (NPL) portfolios as well as fee assets, and a fee structure that provides incentives for the participants to achieve faster resolutions at higher proceeds;
• A liquidating, fast-pay transaction structure in which excess proceeds remaining after interest payments on the notes will be used to repay principal sequentially and distribution to TK investors is withheld until amortization targets are satisfied;
• Conservative underwriting on the underlying assets, which were purchased at a steep discount to original book value;
• MSRI's proven success in Japan with workout strategies and its strong track record of recovery to date;
• Stable cash flow from fee and real estate-owned (REO) assets, which comprise 34.9% of the total allocated purchase price;
• A diversified portfolio by property type, with residential properties, which are relatively more liquid than other property types, accounting for the highest concentration at 40% of the total allocated purchase price;
• Geographic diversification in the asset pool, with the heaviest concentration of assets in Tokyo, the most stable real estate market in Japan;
• The presence of many smaller assets in the securitized portfolio, which have a very high recovery potential stemming from existing demand for these types of assets mainly due to the broad range of prospective buyers;
• Many completed resolutions, with estimated cash proceeds of about ¥5.27 billion, or 17% of the initial rated debt;
• The predictability of the timing and proceeds of resolutions sought through the Japanese court auction system;
• Stabilization in some real estate values and increasing financial liquidity in the Japanese market overall, which supports potential real estate buyers; and
• Cash reserves and an interest liquidity facility.
  

Concerns.

• Assets refinanced from previous securitizations, which could be more difficult to liquidate, representing 53% of the total allocated purchase price for the portfolio;
• The concentration of large assets that tend to have less liquidity in the market, with the 30 largest assets accounting for approximately 41% of the portfolio value as determined by Standard & Poor's;
  
• The concentration of borrowers, with the top five borrowers representing 39% of the allocated purchase price;
  
• A heavier concentration of assets that tend to be more difficult to liquidate, in particular entertainment-related properties and golf courses, which respectively account for about 17% and 4% of the total allocated purchase price;
  
• Unpredictable cash flow streams stemming from the potential for delays in resolutions, or the receipt of lower-than-expected sale proceeds;
  
• A complicated collateral structure involving various types of security arrangements; and
  
• A complicated transaction structure in which multiple entities hold the assets.
  

Mitigating factors.

• Less uncertainty over the resolution of refinanced assets as a result of borrower negotiations and asset marketing already performed to date and underwriting values that were revised accordingly;
  
• Extensive flexibility in determining exit strategies as a result of the low purchase price-to-book value ratio of the portfolio;
  
• The speedy resolution of assets of under ¥50 million, which to date far exceeds the business plan's projected proceeds and timing;
  
• Additional stress to resolution timing for assets with complicated workout strategies;
  
• Additional discounts made by Standard & Poor's to the value of assets that are deemed to lack adequate legal protection for noteholders; and
  
• Appropriate legal and structural arrangements to minimize legal risks and issues concerning lack of perfection.

Transaction Overview
The ¥31.5 billion rated notes will be issued by ICRJ-III, a special-purpose, bankruptcy-remote, limited-liability company incorporated in the Cayman Islands. The notes are primarily secured by a ¥31.5 billion bond issued by ICRJ Gamma Ltd., also a bankruptcy-remote limited-liability company established in the Cayman Islands, and by various reserve accounts held by ICRJ Gamma and ICRJ-III. The bond is secured by cross-collateralized and cross-defaulted loans made to nine bankruptcy-remote entities —RP Properties Y.K., DP Properties Y.K., KS Properties Y.K., Lanikea Ltd., Build Ltd., KGI-A Y.K., KGI-B Y.K., KGI-C Ltd., and KGI-L Ltd. The loans to the nine MSRI entities are ultimately secured by the pool of nonperforming mortgage loans, REO assets, and fee assets.

The notes will pay quarterly interest based on the three-month yen LIBOR plus a spread for each rated class. The payment of note interest and principal is ultimately dependent on cash flow from the liquidation of the portfolio of nonperforming assets and fee assets. To mitigate the risk of shortfalls, a reserve account will be established at closing to cover approximately nine months of interest payments on the rated notes, and will be replenished throughout the transaction using surplus cash in the deal. Interest rate risk is further mitigated by an interest rate cap agreement. Under the agreement, the LIBOR strike rate steps up each year, beginning with an initial rate of 2%. Principal will be paid sequentially, starting with the 'AAA' rated class, using cash flow from the asset resolutions.

Collateral
Portfolio information.
The collateral portfolio comprises 307 mortgage loans, 572 fee assets, and 24 REO assets. Overall, 44.3% of the total allocated purchase price comprising 103 properties consists of newly acquired assets, 38.3% consists of assets refinanced from ICRJ One, 14.6% consists of assets refinanced from a previous securitization of properties purchased from Daikyo Inc., and 2.8% consists of the others.

Property type.
The securitized portfolio is well-diversified by property type. Unlike the two previous ICRJ transactions, which had higher levels of standard office and retail commercial real estate, this portfolio contains a higher concentration of multifamily properties, including apartments with weekly leases, and a higher concentration of entertainment-related properties and golf courses. In total, residential properties accounted for about 40.1% of the total allocated purchase price as of the portfolio cutoff date. Compared with other property types, residential properties are more liquid and benefit from more stable demand in the market. In addition, the historical performance of MSRI entities provided considerable assurance that they would be able to sell these assets very quickly and at higher proceeds.

The presence of residential properties was offset to some extent by the concentration of entertainment-related properties and golf courses. Entertainment-related properties, such as social clubs and karaoke bars, represented 16.5% of the allocated purchase price as of the cutoff date, with golf courses accounting for 4%. Social clubs in particular tend to have complicated tenant arrangements and limited marketability, which can delay or prolong the resolution process. However, MSRI entities have proven experience in underwriting the risks for this type of asset, as evidenced by strong performance in generating asset resolutions ahead of schedule and above expected proceeds. The performance of golf courses, however, has been less strong. Golf courses often involve shared liens, ground leases, and complicated employee and membership issues, which in addition to negotiations with operators, make predicting the ultimate outcome of the restructuring process very difficult. Nonetheless, MSRI entities have sufficient experience to survey all of the risks involved in servicing loans related to this asset type. Moreover, recent transactions have demonstrated that golf courses are becoming more liquid than was previously the case. Combined with MSRI entities' conservative underwriting for those asset types, Standard & Poor's believes that the risks pertaining to entertainment-related properties and golf courses are adequately assessed in this transaction.

Geographic diversity.
The assets are well-diversified geographically throughout Japan. Although about 47% of the allocated purchase price consists of assets located in the Kanto region, including Tokyo and its surrounding areas, 15% is located in the Kansai region, including Osaka, Kyoto, and surrounding areas, and the remainder of the portfolio is located throughout Japan. Standard & Poor's took a positive view of the portfolio's concentration in Tokyo. The center of business activity in Japan, Tokyo benefits from stability and liquidity in the real estate and financing markets. Compared with previous ICRJ transactions, however, this transaction contains a higher concentration of properties located outside Kanto and Kansai, where there is less liquidity in real estate markets. This risk was incorporated to some extent into MSRI entities' conservative underwriting for those assets, and is reflected in the generally lower purchase price paid for such assets.

Refinanced assets.
Asset portfolios refinanced from previous MSRI-related securitizations comprise 52.9% of the total allocated purchase price in this transaction. The refinanced asset portfolios carry a unique risk profile, owing to the heightened possibility of adverse selection. This is because the most marketable assets were liquidated in earlier securitizations, resulting in a higher concentration of less-liquid assets in the remaining portfolio included in this transaction.

MSRI entities periodically update their projected resolution values, thus decreasing the possibility that the timing or proceeds of refinanced asset resolutions will fail to meet expectations. Nonetheless, Standard & Poor's took additional steps in assessing the risks associated with the refinanced portion of the securitized pool. For mortgage loans and fee assets, excluding the assets purchased by RP Properties and DP Properties, Standard & Poor's not only re-underwrote all of the refinanced 10 assets in the top 30, but also performed individual asset underwriting for additional samples of larger refinanced assets in the remaining pool. As a result, Standard & Poor's found that the updated resolution values underwritten by MSRI entities are even more precise than those of newly acquired assets, primarily because refinanced assets, with an average servicing history of more than 1.5 years, tend to be further along in the resolution process.

RP Properties and DP Properties.
The fee assets owned by RP Properties and DP Properties, which comprise 16.6% of the total allocated purchase price, are almost all directly owned multifamily and single-room residential condominium units refinanced from previous securitizations. Residential properties of this type are generally highly liquid, and require the least amount of time to resolve since RP Properties and DP Properties have direct control over the assets. As a result, refinanced portfolios containing this type of residential asset carry greater risk of adverse selection, and thus might not perform as well as similar assets liquidated through previous securitizations. However, because the properties are homogeneous, and because they are concentrated in buildings for which recent sales prices for similar units are available, Standard & Poor's was able to assess the realistic resolution values for these assets.

Credit Evaluation
Historical performance.
Standard & Poor's credit analysis of this transaction is largely based on the strong experience and historical performance of MSRI entities in managing liquidating transactions backed by nonperforming loans and fee assets in Japan. Overall MSRI and its related entities together are among the largest investors in Japanese nonperforming loans, having purchased about 39 pools for an aggregate face value of about ¥1.8 trillion through their various single-purpose companies. Standard & Poor's assessment of the track record of MSRI entities in the resolution of nonperforming loan portfolios in Japan is based on detailed data, including data from portfolios unrelated to the first two ICRJ transactions. Of the 1,051 mortgage loan assets related to the two previous ICRJ deals, 396 assets, or 38%, have been resolved. On average, the resolution prices for these 396 assets were 131% over MSRI entities' underwritten value, and the resolution timing was on average 12 months ahead of the scheduled plan. Standard & Poor's received detailed information on the asset resolutions, and identified trends in performance based on property type, asset size, and resolution procedures.

This strong performance can largely be credited to the sound due diligence, underwriting, and collateral liquidation strategies of MSRI entities. When purchasing real estate-related loans, mortgages, or fee assets, the MSRI entities conducted in-depth due diligence, which included site visits and consultation with real estate professionals. The asset valuation derived from the MSRI entities' due diligence was then discounted to net out other expenses, including court and other legal fees, brokerage fees, and other costs related to the sale of each asset. The remaining projected proceeds, or underwriting value, are then further discounted by factoring in the time needed to realize proceeds from the resolution of the asset. The expected timeframe for foreclosure sales is generally two to three years, while the timeframe for discounted payoffs is determined on a case-by-case basis.

In addition to the basic discount of projected proceeds, further discounts are used to account for deflation of Japanese real estate value, as well as general auction or borrower negotiation costs. Furthermore, risks unique to Japanese real estate, such as complicated liens and ownership, organized crime, favorable tenancy laws, security deposit liabilities, and senior liens, are appropriately considered and discounted from the valuation. These plans factor all elements of Japanese judicial and voluntary workout practices and risks unique to Japanese real estate. The plans reflect the MSRI entities' underwritten cash flow based on the expected timing and proceeds from the ultimate sale of the assets. Furthermore, all management costs, taxes, sales costs, and any other transaction-related expenses are netted out from the net cash flow and value projections.

In this transaction, Lombard Special Servicing Co. KK, a licensed entity under Japan's Servicer Law, acts as the special servicer and is advised by Kearny Global Investors K.K., an MSRI subsidiary. These entities and their employees, including their Japanese counsel, have formulated detailed business plans for the resolution of all assets in this transaction. In formulating a plan for each loan, numerous types of workout or exit strategies are available to the asset managers. The strategies range from foreclosure and sale, to negotiation of a discounted payout with the defaulted borrower. While liquidation plans vary based on each asset's particular circumstances, foreclosure action is generally pursued immediately to gain leverage over the obligor. Standard & Poor's is satisfied that the servicing entities comply with applicable laws, including the use of Japanese counsel under the Practicing Attorney's Law. Asset managers are motivated by compensation structures that reward rapid dispositions at prices that equal or exceed predetermined target prices. Standard & Poor's has reviewed and assessed these compensation structures, and is satisfied that they provide a high level of motivation for the asset managers in line with the interests of noteholders.

Due diligence.
As part of its due diligence, Standard & Poor's reviewed and analyzed the resolution strategies, including those for the largest assets and representative samples of smaller assets. In addition, Standard & Poor's due diligence included visits to various properties in several parts of Japan, during which 18 of the largest 30 assets and a sample of 10 additional large assets were seen. As part of these visits, Standard & Poor's conducted on-site interviews with the individual asset managers responsible for formulating the business plans. The interviews were designed to examine the asset managers' understanding of the specific asset and the submarket in which it was located, to test the assumptions in the exit strategy for that asset, and assess whether the forecast timeframe for resolution of the asset was reasonable.

Acquisition cost.
As is normally the case in NPL-backed transactions, all of the underlying assets in ICRJ-III were purchased in bulk and at deep discount to book value. The overall acquisition cost of the securitized portfolio is 77% of MSRI entities' underwriting value. However, the acquisition cost for newly acquired assets is higher, at 87% of MSRI entities' underwritten value, reflecting increased competition in the market and the generally higher quality of assets.

Portfolio analysis and debt sizing.

Mortgage loans and fee assets excluding RP Properties and DP Properties.
Standard & Poor's assessed the MSRI entities' underwriting methodology by reviewing all of the largest loans or properties and sampling some of the smaller ones. The analytical process consisted of the following:

• Site visits to 25 properties, representing 37% of the total allocated purchase price;
  
• Revaluing the assets;
  
• Examination of individual resolution plans;
  
• In-depth interviews with on-site asset managers regarding the status of resolution strategies;
  
• Analysis of property-level historical performance data and any other property-related information where applicable; and
  
• Independent interviews with various real estate professionals.

Because 30 assets make up about 49% of the portfolio's allocated purchase price the portfolio is skewed toward larger assets. However, there is a large number of small assets in this transaction. Excluding RP Properties and DP Properties, 241 of the 481 properties, or 50%, have purchase prices of ¥5 million or less, and 380 properties, or 79% have purchase prices of ¥50 million or less. As a result, Standard & Poor's randomly selected a set of smaller assets for analysis, which in some cases included site visits. Smaller assets tend to have higher recovery potential and faster recovery timing as evidenced by historical performance.

Top 30 assets.
Standard & Poor's re-underwrote the resolution value and timing for the 30 largest assets in the portfolio, and arrived at a base-case value for the assets equal to 95.3% of the MSRI entities' underwritten value. Below is a summary of the top assets within this group.

Resort hotel.

• A Japanese-style hotel located at the city center of a resort destination south of Tokyo, which comprises 4% of Standard & Poor's underwritten portfolio value.
  
• The hotel operation has been improved to some extent as a result of a workout with the borrower.
  
• Refinanced from ICRJ One, the loans have been serviced long enough to be resolved in the near term.
  

Weekly-leased apartments.

• Six apartments that comprise 9% of Standard & Poor's total portfolio value
  
• Refinanced from ICRJ One, the assets are already fee-owned as REO, and produce a significant amount of cash flow income, over ¥400 million per year, which ultimately will be used to pay down the rated notes.
  
• As an owner of the assets, MSRI entities have recently invested in refurbishment costs.
  

Office building in Tokyo.

• An eight-story class B office building built in 1989 that comprises about 4% of Standard & Poor's underwritten portfolio value. This is the largest fee owned single asset in the portfolio.
  
• Conveniently located, with a current occupancy rate of 100%.
  
• Standard & Poor's has made no adjustment to the value given the conservative underwriting by MSRI entities.
  

Pachinko parlor in Kanagawa Prefecture.

• The largest asset among the newly acquired mortgage loans, accounting for about 3% of Standard & Poor's underwritten portfolio value.
  
• This asset consists of a three-story amusement facility—including pachinko parlor, video game center, bowling alley, and food court—a parking lot, and an employee dormitory across the street from the amusement center.
  
• The properties are located along a major roadway and near a highway exit.
  
• Recently resolved at higher-than-estimated resolution value.
  

Social buildings outside Kanto and Kansai.

• Four social buildings representing about 6% of Standard & Poor's underwritten portfolio value.
  
• Given the complex tenant agreements, Standard & Poor's stressed the resolution timing for these properties from MSRI entities' original underwritten value. For one asset located in Hokkaido Prefecture, Standard & Poor's allowed for a more stressful vacancy ratio than is underwritten.
  

Smaller asset analysis.
For smaller assets in the pool and those assets that were not individually underwritten, Standard & Poor's adjusted the MSRI entities' underwriting value and timing, taking into account characteristics of the securitized portfolio, general market trends, and the track record of the MSRI entities. Standard & Poor's divided the remaining portfolio into the following three groups:

• Assets with an allocated purchase price between ¥100 million and ¥274 million, which comprise 27% of the portfolio's allocated purchase price;
  
• Assets with an allocated purchase price between ¥50 million and ¥100 million, which comprise 8% of the portfolio's allocated purchase price; and
  
• Assets with an allocated purchase price below ¥50 million, which comprise 10% of the portfolio's allocated purchase price.
  

¥100 million-¥274 million assets.
An analysis of MSRI entities' performance in Japan shows an average recovery of 119% of original underwritten value from resolutions involving assets of this type, and completion of the resolutions nine months ahead of schedule. However, a comparison of average resolution proceeds and timing for assets of this type in ICRJ-One (137% of underwritten value, nine months ahead of schedule) and ICRJ-II (104% of underwritten value, nine months ahead of schedule), reveals that performance has declined. The performance data included a variety of asset types, among which residential, office, and retail properties were the major components. However, because these results were based on an insufficient sample size and because assets that exceed ¥100 million generally have limited liquidity compared with lower value assets, Standard & Poor's re-underwrote a sample of 10 assets in this category, and arrived at a value that was 95% of MSRI entities' underwritten value. No adjustments were made for resolution timing.

¥50 million-¥100 million assets.
On average, MSRI entities have recovered 105% of original underwritten value and have completed resolutions for assets of this type about seven months ahead of schedule. For ICRJ-One, on average these assets were resolved at 104% of underwritten value, while for ICRJ-II the average resolution was 106% of underwritten value, with both transactions recording resolution timing seven months ahead of schedule. Since these results were based on a statistically significant sample, Standard & Poor's made minor adjustments to this category. Standard & Poor's underwrote these assets at 97.5% of MSRI entities' underwritten value and made no adjustments for resolution timing.

Assets under ¥50 million.
On average, MSRI entities have recovered 167% of original underwritten value for assets of this type and have completed resolutions approximately 13 months ahead of schedule. These results are consistent with Standard & Poor's experience across various types of performing as well as nonperforming transactions, due to the higher liquidity and larger number of buyers in this price range. In light of these strengths, and the track record of a sufficient sample of assets, Standard & Poor's made no adjustments for timing and underwrote these assets at 115% of MSRI entities' underwritten value.

Sale proceeds and timing adjustments.
In analyzing the transaction, Standard & Poor's adjusted the expected timing and proceeds from asset resolutions using base-case scenarios for the cash flow and value of individual assets, taking into account economic and real estate market conditions. Starting from this base-case collateral value, various stresses were implemented consistent with the respective rating levels.

Standard & Poor's took a hybrid approach in making adjustments to the proposed underwriting value and resolution timing of individual properties. For the top 30 assets, Standard & Poor's re-underwrote the value and resolution timing of each property. For smaller assets, Standard & Poor's stressed the MSRI entities' underwriting value and timing, taking into account the securitized portfolio's characteristics, general market trends, and the track record of the MSRI entities. Conversely, for assets already resolved after the cutoff date of Nov. 30, 2000, Standard & Poor's underwritten value was adjusted to the actual resolution value. Given the strong resolution results of the portfolio, this generally resulted in an upward adjustment in portfolio value.

During the review, Standard & Poor's adjusted downward several asset values that were deemed to be underwritten aggressively, although the number of these assets was small. As a result, the net valuation of the portfolio, excluding RP Properties and DP Properties, based on Standard & Poor's analysis was 1.3% lower than the MSRI value. In assigning ratings to the transaction, Standard & Poor's used its own valuation of the portfolio.

RP Properties and DP Properties portfolios.
The properties purchased by RP Properties and DP Properties are almost all studio or multifamily apartments refinanced from previous transactions. Moreover, all of the properties are owned as individual condominium units, as opposed to being purchased as whole buildings. Because of these unique characteristics, Standard & Poor's analysis of the RP Properties and DP Properties assets differed from the approach used for the rest of the securitized pool. By examining these assets' historical data and other market information, Standard & Poor's found that the performance for these assets was directly correlated to property type and geographical location. Based on original underwriting, studio units have performed worse than multifamily units, and Kansai-based assets have performed worse than Kanto assets. As a result, Standard & Poor's stressed its underwriting of RP Properties- and DP Properties-related assets depending on unit type and location.

Summary of adjustments and stress levels.
Using the above adjustments, Standard & Poor's determined a base-case portfolio value of ¥41.63 billion, or 95.4% of the MSRI entities' underwritten value of ¥43.61 billion.

Starting from this base-case scenario and collateral value, various stresses were implemented in line with the respective rating categories. It was assumed that all properties would suffer a market value decline ranging from 55% for the 'AAA' stress scenario; 40% for 'AA', 30% for 'A', and 25% for 'BBB'. This transaction relies heavily on the MSRI entities' ability to implement a resolution strategy within a given timeframe. In light of MSRI's performance with ICRJ One and ICRJ-II, Standard & Poor's was comfortable with a 55% market value stress at the 'AAA' level. In addition, assets already resolved and now collateralized with cash were considered to be consistent with an 'AAA' scenario, and thus were not stressed at any rating categories.

Standard & Poor's also performed various stress analyses to sensitize the projected cash flow to delays in timing of resolutions as well as declines in proceeds. The results of these tests were used to determine the amount of liquidity that would be required to ensure timely interest payments on the notes.

Structural and Legal Issues

Chart 1 International Credit Recovery-Japan III Ltd. Transaction Structure

Transaction structure.
ICRJ-III, the issuer of the rated notes, is a single purpose entity incorporated in the Cayman Islands as a limited-liability company. The articles of association include a provision that requires ICRJ-III to secure bankruptcy-remote status through various legal agreements between the company, its common shareholder, and the trustee under the ICRJ-III indenture.

The ¥31.5 billion of notes issued by ICRJ-III are secured by a ¥31.5 billion ICRJ Gamma bond, which is the obligation of ICRJ Gamma as well as funds in the note reserve account and the collection accounts at closing. The ICRJ Gamma bond in turn is secured by loans to each of the MSRI entities, various reserve accounts, and the ordinary shares of ICRJ Gamma. The loans are an obligation of the MSRI entities and will be secured by the mortgage loan assets, fee assets, inter-company loan collateral, and the rights of the MSRI entities under various transaction agreements, operating expense accounts, and security deposit accounts. The loans will be cross-defaulted and cross-collateralized.

The ICRJ Gamma collateral is secured by the assignment of beneficial interests ("joto tanpo") on the mortgage loan and fee assets of each of the MSRI entities, any other debtors that may be established, rights under purchase and sales agreements, the servicing contracts, interest rate cap agreements, and various deposit and reserve accounts.

Perfection.
The perfection of the security interests in nonperforming loan transactions is especially difficult to achieve. Notices of assignment must be sent to the delinquent debtors, but timing of the delivery of the notices may be disruptive to ongoing discussions on asset resolutions with these parties. In addition, the assignment of mortgages requires a registration by the new owner in the land and building registries.

ICRJ Gamma will perfect its security in the mortgages by assignment of the mortgages loans via a registration under the Perfection Law ("saiken joto tokurei-ho"). In an event of default, ICRJ Gamma can perfect its assignment in the mortgages by issuing a notice and the registration certificate to the original delinquent debtors. In addition, ICRJ Gamma will be provided with a power of attorney to register its rights in the assets, if it is necessary to enforce its security rights in a court proceeding. Standard & Poor's believes that this lack of immediate perfection is mitigated by the bankruptcy remoteness of the MSRI entities, whose sole business will be limited to liquidating the assets.

A review of the legal due diligence provided by the arranger's attorneys identified several assets where the transfer of mortgages or notification to the original borrowers may result in an imperfect assignment. However, after detailed legal review of all the identified loans, Standard & Poor's believes that the possible negative results stemming from identified legal issues are limited.

Borrower structure.
ICRJ Gamma is incorporated in the Cayman Islands as a limited-liability company and is a single-purpose entity. The articles of association include a provision that requires ICRJ Gamma to secure the approval of the ICRJ Gamma shareholder prior to taking any significant action (including bankruptcy filing). The ICRJ Gamma shareholder will enter into an agreement prohibiting the ICRJ Gamma shareholder from giving such approval without the prior consent of the trustee under the ICRJ-III indenture.

Bankruptcy-remoteness.
As is typical of structured finance transactions, bankruptcy remoteness and isolation of the securitized assets from those of the sponsor are key factors of the analysis. The MSRI entities will operate under Japan's Commercial Code either as "tokumei-kumiai-shusshi" (TK entity; a limited partnership type arrangement) based in the Cayman Islands, or as a "yugen gaisha" established in Japan. All of the MSRI entities are single-purpose entities. Standard & Poor's saw particular importance in the MSRI entities achieving bankruptcy-remote status. To do this, the MSRI entities took steps to achieve bankruptcy remoteness consistent with Standard & Poor's criteria. These included the issuance of special shares to independent parties and having the MSRI entities' corporate articles require 100% shareholder approval to file any bankruptcy proceedings for Cayman entities, having the portfolio debtor owners execute non-petition agreements not to file nor permit to be filed insolvency petition for yugen gaisha entities, and ensuring the bankruptcy-remote nature of Japan Realty Inc. and DPC Holdings Inc., the owner of these entities.

Cash waterfall.
On the closing date, the cash proceeds will be received from the sale of the notes, transaction fees will be deducted, and the remainder will be used by ICRJ-III to fund the initial deposits to the note reserve account and to pay the purchase price of the ICRJ Gamma Bond.

After closing, all cash proceeds from the collateral assets will be deposited directly into the operating expense reserve accounts of the MSRI entities. Because MSRI entities have high degrees of bankruptcy remoteness, there is limited commingling risk associated with them. Every month, cash from the MSRI entities will be swept into ICRJ Gamma's Japan branch account, then immediately to ICRJ Gamma's collection account.

However, the MSRI entities are entitled to keep a maximum of six months of estimated expenses in the operating expense reserve accounts to ensure sufficient cash to work out the collateral assets. In particular, there will be an immediate need for cash when the asset manager elects to credit bid on a particular asset. This poses some concern for Standard & Poor's because if there is a large amount of cash remaining in the transaction, there is a risk of delay on the repayment of the rated notes. This concern is partially mitigated by the transaction having an interest rate cap agreement to hedge interest rate risk and a liquidity reserve account to meet required interest payments.

On the same day as excess cash proceeds are deposited into the Japan collection account, the administrative agent will transfer the entire credit balance of the Japan collection account to the ICRJ Gamma collection account.

On the applicable payment date, the administrative agent will apply all amounts in the ICRJ Gamma collection account on the calculation date, to meet the debt service requirement of the loans in accordance with priority payments specified in the loan agreements, including the payment of distributions to TK investors, and to make payments on the ICRJ Gamma bond in accordance with priority of payments specified in the ICRJ Gamma indenture on the instruction of the trustee.

On the same day as ICRJ-III receives a payment on the ICRJ Gamma bond, the administration agent shall transfer the entire amount to the paying agent for application of all such amounts to the notes in accordance with the priority of payments specified in the ICRJ Gamma indenture.

Chart 2 International Credit Recovery-Japan III Ltd. Cash Flow Structure

Priority of payments.

ICRJ-III rated notes.
In the absence of an event of default, the priority of payments for the ICRJ-III rated notes will be as follows:

• Transaction fees;
  
• Note reserve account deficiency;
  
• Interest on class A;
  
• Interest on class B;
  
• Interest on class C;
  
• Interest on class D;
  
• Principal on class A, until paid in full;
  
• Principal on class B, until paid in full;
  
• Principal on class C, until paid in full;
  
• Principal on class D, until paid in full;
  
• Any remaining amounts due under the indenture; and
  
• ICRJ-III.

Should an event of default occur, the priority of payments will change to the following:

• Transaction fees;
  
• Interest on class A;
  
• Principal on class A, until paid in full;
  
• Interest on class B;
  
• Principal on class B, until paid in full;
  
• Interest on class C;
  
• Principal on class C, until paid in full;
  
• Interest on class D;
  
• Principal on class D, until paid in full;
  
• Any remaining amounts due under the indenture; and
  
• ICRJ-III.
  

ICRJ Gamma bond.
The priority of payments for the ICRJ Gamma bond will be as follows:

• Transaction fees;
  
• Interest on the ICRJ Gamma bond;
  
• Principal on the ICRJ Gamma bond until the bond is paid in full;
  
• Any remaining amounts due under the indenture; and
  
• ICRJ Gamma.
  

Loan level.
On the loan level, the payment waterfall will go as follows:

• Transaction fees;
  
• Any fees and expenses to a replacement servicer;
  
• Interest on loans;
  
• Principal on loans until the amortization target is met;
  
• Accrued and unpaid fees and expenses under the loan documents;
  
• Additional principal on loans (MSRI entities' option);
  
• Distribution to TK investors;
  
• Payment of remaining outstanding principal amount on loans; and
  
• Repayment of inter-company loans to the relevant MSRI entities.
  

Liquidity enhancement.
A note reserve account that will cover nine months of maximum interest payments on the rated notes and 12 months of estimated transaction fees under the ICRJ-III indenture has been established and will be funded at closing. This account will be maintained at the ICRJ-III level and is available to cover all interest shortfalls on all classes of the notes. This account is replenished from the payment waterfall to the extent needed.

Interest rate risk.
An interest rate cap agreement will be entered into between the asset-holding entities and a properly rated counterparty. The strike price on Japanese yen three-month LIBOR will be stepped up 2%, 3%, 4%, 6%, and 8% each year. In sensitizing the cash flow, Standard & Poor's assumed this maximum LIBOR rate plus applicable spreads for interest expense assumptions. Whenever the cap counterparty becomes ineligible due to a downgrade, the counterparty must be replaced or guaranteed by an appropriately rated party, or post sufficient collateral to retain ratings acceptable to Standard & Poor's.

Legal issues.
Final ratings will be assigned after the amount and complete terms of the notes are finalized, and a full analysis of the transaction, including a complete legal review, is completed. The assignment of final ratings will be subject to a satisfactory review of the final pool, cash flow modeling, and structural and legal issues, including a review of the transaction documents, and tax and legal opinions. Standard & Poor's has yet to complete a full legal and tax analysis of the transaction, and all outstanding structural and legal issues must be addressed prior to the assignment of final ratings.