Ratings

Consumer lending, however unorganized and sporadic, started during the 1991-1998 period. Since Russia's default in 1998, the economy has recovered, helped by strong oil export revenues. Monthly average consumer income increased to over $400 (€336.3) from $52 (€43.7) in 1998 (source: Federal Service of State Statistics, Bloomberg).

As the Russian economy improved, signs of greater consumer confidence and growing demand for consumer goods and services has led to a fast growing consumer-lending market. Effectively, since 2002, when personal lending amounted to RUR142 billion (€4.2 billion), the market has grown since 2004 by a 109% annual compound rate, to reach RUR1,096 billion (€32.2 billion) in the second quarter of 2005.

Still, it is an expanding market. Russian consumer borrowing remains untapped, with the debt representing 3.7% of GDP (as opposed to 19% in Poland or 49% in the Eurozone) at year-end 2005, based on data from the Central Bank of Russia (CBR).

Demand is seasonal but strong. RSB observed a 161% year-on-year retail sales growth by the end of 2005 compared with year-end 2004.

Regional and smaller banks have entered the consumer lending market.

RSB's main competitors on consumer POS lending market (in order of market share) are: Home Credit, Rosbank, Investsberbank, and Finansbank.

Standard & Poor's views the Russian consumer market as uncertain, as it is new and remains untested, especially if the economic growth slows down. Therefore, in its credit analysis of the portfolio, Standard & Poor's has reflected this concern by increasing the credit stresses at various rating levels compared with those in a more mature market (see "Collateral risk assessment").

• RSB has a strong position as provider of consumer loans in Russia.
• There will be a back-up servicing agreement in place at closing. The back-up servicer appointed at closing is VTB Retail Financial Services (unrated), the retail arm of Vneshtorgbank (JSC) (BBB/Stable/A-2).
• There is strong eligibility criteria to preserve the credit quality of the pool, as the loans will be seasoned (at least three months) and current at the date of the sale. The pool is geographically diversified, with no region accounting for more than 25% of the sold assets at any time. Also, the geographical coverage of the pool is in line with RSB's overall portfolio.
• The transaction benefits from high levels of excess spread (18% currently) given the high interest rate of the loans.
• There is an interest rate swap to convert the fixed rate of the loans into a rouble floating rate. There is a committed currency swap program.

• The short and untested track record of the Russian consumer loan market creates difficulties in quantifying risks.
• The payment chain involves many parties. This compounds the risk of potential payment delays (including exposure to originator, post office, clearing banks and backup servicer) and commingling risk.
• An imperfect swap mechanism protects against currency movements only up to a certain level, while the rouble volatility has historically been high.
• The Russian legal system remains weak and untested, subject to changes and on-going reforms.

• There is a strong level of subordination combined with substantial credit stress scenarios and liquidity lines providing a financial buffer to satisfactorily protect the class A-1 notes at the 'BBB' rating level.
• The sizing of the liquidity facility mitigates the risk of payment disruption. Amortization and notification triggers provide in turn some protection against a moratorium of RSB. The class A-2 notes will bear losses linked to the commingling upon the administration or moratorium of the originator, providing enhancement to the class A-1 and B notes.
• Standard & Poor's modeling and assessment of the currency and associated volatility risk are commensurate with the ratings.
• The securitization structures are new and therefore untested in Russian courts. Legal and tax analysis mitigates partially the risk.

The issuer is formed under the laws of Luxemburg. It has no employees.

The issuer has three independent directors, and its activities are restricted to purchasing the assets, issuing the notes, and carrying activities related to the transaction.

The legal system in Russia, particularly as it relates to commercial transactions, is in a relatively early stage of development and securitization structures have not yet been tested in Russian courts. In addition, in this transaction the laws of other jurisdictions are likely to be involved in adjudicating the issues that may arise in the transaction. These other jurisdictions include Luxembourg, as the jurisdiction of the issuer, and England, as the jurisdiction of the governing laws of the contracts, including the sale agreement.

Final ratings therefore will be subject to receipt of comfort on the legal and tax aspects of the transaction. This comfort will be expected to address corporate, security, true sale, insolvency and tax matters under all the relevant laws- namely, Russian, English, German and the laws of Luxembourg. This will be expected to include an analysis of sale arrangements that supports a conclusion that the assets purchased by the issuer are effectively isolated from RSB's insolvency risk.

We will also expect to receive comfort that payments to the issuer are free from withholding; that no VAT is payable by the issuer — or if it is, that it will be funded.

We understand that the transaction requires the consent of the anti-monopoly authorities and a relevant application will be made in due course. The anti-monopoly consent when given is valid for one year only and, therefore, the issuer will need to apply for it each year during the life of the transaction. If the consent is not provided or is delayed then there is a risk that purchases made without the consent would be invalid. This risk is mitigated by stopping the purchase of further assets, starting an amortization of the notes.

The provisional pool follows concentrations similar to that of RSB's portfolio (see table 1).

Table 1 Geographical Distribution
Region	% of total outstanding balance of loans
Ekaterinburg	11.57
Irkutsk	3.25
Kazan	8.23
Khabarovsk	0.32
Moscow	15.71
N.Novgorod	6.26
Novosibirsk	10.31
Omsk	8.81
Rostov	9.43
S.Peterburg	7.50
Samara	7.12
Volgograd	5.10
Voronezh	6.40

The regional concentration is in line with RSB's overall portfolio geographic exposure.

The assets to be purchased on the relevant asset dates will meet the eligibility criteria, the main aspects of which are the following:

• The loan must have been duly executed by the originator and constitute a legal, valid, binding, and enforceable obligation of the originator.
• The loan must be governed by and subject to Russian law.
• The loan must not contain any restriction on assignment of the benefit of the receivables arising thereunder.
• The minimum seasoning must equal three months.
• The loan must be no fewer than two and no more than nine loan payment dates outstanding.
• The loan must be current at the sale date, and not have been in arrears for more than two consecutive months prior.
• The monthly installments must be of an equal amount.
• No contractual variation is permitted.
• The loan must not be a credit card agreement or an auto loan agreement.
• Loans to purchase mobile phones will not exceed 25% of the outstanding balance of the pool.
• Concentrations of receivables in Moscow must not exceed 25% of the pool.
• The obligor must not be in default under its payment obligations of other products with the originator, and must never have incurred more than two consecutive missed payments in respect of these products.

Standard & Poor's has assessed the credit quality of the pool using the European consumer finance criteria, published on March 2000. However, Standard & Poor's has used more conservative multiples to reflect several aspects:

• The Russian consumer lending market remains untested and its evolution is uncertain.
• There is a lack of performance data or comparables in the market, and no indication of how the collateral might perform in different regions. As the market grows, more regions of different economic conditions may alter the expected performance.
• There is a high proportion of civil servants as obligors of the transaction, when historical macro economic data shows that some groups of civil servants can be subject to potential severe delays in the payment of their wages. In the current portfolio, 60% of the customers are civil servants, and 45% belong to sectors prone to such delays.

Equally, in its credit analysis Standard & Poor's has assessed conservatively the base default case, from which the relevant rating's default scenario will be derived. For this purpose, the originator has provided five years of monthly historical static data.

Standard & Poor's has also taken into account the poorer performance of certain assets (mobile phones), and the heavy reliance on the credit scoring adjustments by RSB for newer geographic expansion.

Standard & Poor's has not given credit to recoveries because:

• The collection of debt may become uncertain in a more strenuous economic environment;
• The transaction is amortizing quickly; and
• There are uncertain recovery procedures if RSB ceases to be the servicer.

The loans bear a fixed interest with a weighted average yield of 24% at closing. The yield of the loans will determine continually the amount of credit enhancement required. At each purchase date, if the yield of the assets is lower than 18%, the issuer is entitled to draw further amounts under the subordinated loan. These drawings are nonetheless uncommitted, and therefore Standard & Poor's has not given the drawings any credit.

If RSB fails to advance the funds, as subordinated loan provider, no further assets will be purchased. This is likely to trigger an amortization event.

Cash collections in Russia are transferred through a chain of institutions before reaching the servicer's account (see chart 2). According to RSB, collections are evenly spread throughout the calendar month.

At the onset of the loan, all customers receive a letter laying out their monthly payment amounts, and their current account bank details.

When the loan is underwritten, the servicer opens two accounts: a loan account and a current account. Funds will be received on the current account and debited to the loan account usually on the payment date.

With these letters, the customers either use the Russian Post Office (unrated; PO) or partner banks (mostly unrated) to make their monthly installments.

Currently, 70% of collections are paid through the PO. RSB, and the back-up servicer VTB Retail Financial Services, has a contract with the PO, under which customers pay 1% fee for the service. Customers pay cash at the local post office, which manually collates the information. The local post office then sends the information to a regional center, which electronically files the information, and transmits it to a central post office.

Subsequently, a payment will be made from the post office clearing house — Svyazbank (unrated) that sends payments in five daily batches — to the RSB account held at the CBR.

Payments can take up to 10 days to reach RSB's account. The exposure to Svyazbank is one day.

The remaining 30% are principally collected through: ATM or payments over the counter at RSB (25%), and its partner banks (5%) (including, but not limited to, Bank of Khanty-Mansyisk (B+/Stable/B); Promsvyazbank JSCB (B/Stable/C); Vneshtorgbank (Chelyzbinsk branch); Moscomprivatbank; Bank of St Petersburg; Basheconombank; Tatecobank; Tatagroprombank; Bank Vozrozhdeniye; and Tatfondbank).

The commission fee is 1% payable by the borrower to the corresponding bank. Payment may take up to one day with corresponding banks and the same day for RSB.

Once the moneys have reached RSB, the collections will remain in RSB's accounts until the due payment dates. Historically, the collections standing at the customers' current accounts at RSB have amounted up to 9.5% of loans. On the payment dates, the moneys will be transferred by direct debit to the account of the issuer held at RSB and at the end of the day, the amounts will be swept to the issuer's rouble account held at HVB.

On settlement dates under the swap agreements and on interest payment dates, some rouble funds will be converted and transferred to the euro accounts.

If certain events occur, the collection arrangements will be changed (see "Notification events and commingling risk"). The obligors will be notified by letter, and new pay slips issued so that the obligors will pay the new account in the name of the issuer at VTB Retail Financial Services.

The PO plays two roles in the transaction. Firstly, it delivers installment letters to the obligors and sends notification letters, if RSB becomes insolvent. Secondly, despite the growth of partner banks, the PO will remain a major paying agent, through which the obligors pay their installments.

It is Standard & Poor's view that in a 'BBB' scenario, the PO will continue performing its postal services, including cash transfers, given its universal postal service provider status and its politically strategic importance in delivering pension payments. However, Standard & Poor's does not view the PO's creditworthiness as commensurate with the highest rating on the notes and therefore has stressed potential payment delays (see "Description" and "Support").

The PO is a quasi-government entity, with a special legal status of a "unitary enterprise". However, its insolvency is subject to the ordinary regime, and there are no additional protections by law that may isolate, such cash transfers.

Therefore, there is the risk that if the PO defaults, an external administrator would be assigned. This administrator can freeze cash in transit and may integrate these amounts as part of the PO bankruptcy estate. This cash is a liability of the PO, which, despite the administration, is still responsible for payments to its obligors. RSB would be an unsecured creditor and would rank junior for the moneys to be paid.

Standard & Poor's views that a 'BBB' scenario is consistent with a delay of three months in these payments, arguing that the flows in transit will be frozen and then recovered by the issuer rather than being lost.

The Russian post office was created in 2003, accounting for more than 300,000 employees in 2005. It consolidated former federal institutions responsible for providing postal services in Russian regions. The PO provides a wide range of services and has a relatively diversified revenue structure.

The PO profile is positively affected by the government support due to the Russian post position as the universal postal service provider in Russia, and an important tool for pension payments together with its special legal status. PO belongs to a category of entities that, while autonomous in their operations, are largely public policy-based institutions. (For more information on Standard & Poor's rating methodology with respect to postal operators, see the commentary article titled "International Postal Entities: Influence of Government Support on Ratings" detailed under "Related Articles").

It is also supported by the post's diversified revenue structure and low debt, and its strong position in traditional postal services and its servicing of rural areas. However, the PO's low profitability, salaries, and investment pressures, growing competition in most profitable sectors, and low financial transparency restrict its credit profile. Direct federal support is low (see "Support").

The PO, as the national postal operator, has a strong position country-wide, except for a very few regions. In some territories and services the post may be considered a monopoly, especially in rural areas and small towns, where it is usually the single provider of traditional postal services and pension transfers. The environment in some sectors is quite competitive, however. Approximately 100 companies have obtained licenses for providing postal services, although competition is mainly limited to large cities and most profitable sectors. The Republic of Tatarstan (B/Positive/--; foreign currency) has, for example, a regional post office, which has concluded agreements with PO, including payment transfers.

State oversight comes from the Federal Ministry of Communications. In practice, it is very unlikely that the PO would go bankrupt, especially without federal government's approval. The state is obliged by legislation to support provision of postal services, although no details are provided.

In the past, different federal institutions — the government being the PO's biggest client — had substantial payables to the Russian postal service. This seems to have been resolved during 2005, although this demonstrates the relative weakness and lack of timeliness of federal support.

Although the Russian postal service has a special status of a state unitary enterprise, and currently may be treated as a quasi-government entity, this position does not result in any significant subsidies, however (RUR540 million for postal communications in 2005's federal budget).

The obligors will be notified upon the following notification events:

• The delivery of an enforcement notice;
• The insolvency of the originator;
• A servicer event (i.e.: the servicer failing to pay, or breaches of other obligations or warranties under the servicing agreement; it becoming unlawful for the servicer to perform its obligations; the servicer being prevented or severely hindered from complying with its obligations as a result of a force majeure event; or, any insolvency event occurring in relation to the servicer);
• A requirement of law;
• The long-term corporate credit rating on the originator being withdrawn or lowered below 'B-' by Standard & Poor's; or
• A breach of certain liquidity or capital ratios being reported to the central bank, reported on a monthly basis to the trustee and Standard & Poor's.

If the originator fails to notify the obligors then the trustee will authorize the notification notices to be delivered to the obligors by authorizing the asset data custodian to provide access to the information to the relevant standby servicer.

Notification of two million obligors across the Federation may take up to two weeks in the farthest regions, and 10 days on average. Up to 25% of the assets are located in Moscow and St Petersburg and, therefore, notification takes only three days.

For the CBR to intervene and put a credit entity into administration, certain liquidity and regulatory capital ratios must be breached. However, for moratorium to be imposed (which can be concomitant to administration by the CBR) the following must legally happen:

• Financial obligations (commercial debt, wages, tax) must not be paid for more than seven days due to the shortage or absence of funds on correspondent accounts.
• Executive bodies of the bank must be temporarily suspended.

As such, Standard & Poor's views that the lowering of RSB's current rating 'B+' directly to moratorium 'R', is possible in a 'BBB' scenario. This is because the ratings on the notes address only the timely payment of debt obligations, and not other financial obligations (e.g., wages or pension payments), which may rank junior to commercial debt.

Hence, Standard & Poor's considers that the notification trigger may anticipate the administration and moratorium of RSB by less than a week, and not by the maximum 14 days required for a full notification of all obligors. This means that funds will be trapped in RSB's insolvency while the notification is carried out.

Legally, notification can still be carried out despite a moratorium imposed on RSB.

Standard & Poor's has assumed that after the issuance of the notification letters, for the next seven days, whilst the moratorium has been imposed, funds will be received and commingled at RSB.

In the meantime, notification letters will be sent out and subsequently 10% of the obligors will not pay in the issuer's account held at the back-up servicer — VTB Retail Financial Services — due to, for example, lost letters or use of the first postal slip. Standard & Poor's has assumed that at least another 10% of obligors will take longer to pay their next installment (addressed in the liquidity facility requirements).

Standard & Poor's has also taken into account potential prepayments that may be received and early payments (on average 7.0% and for the purpose of the calculation 8.0%). Therefore, Standard & Poor's has evaluated that the commingled amounts are expected to reach 12.5% of the consumer loan pool. This amount is expected to be lost during the moratorium/administration of the RSB. This will be the amount of the class A-2 notes at closing (see "Redemption of the notes")

There will be five accounts to be opened in the name of the issuer. The first account is the issuer rouble account, with RSB as collection account in which the obligors will pay their monthly installments.

The issuer will have three accounts held at HVB (a rouble account, a euro account, and an euro escrow account). These accounts are subject to the downgrade language, whereby, if HVB is downgraded below 'A-3', then it must substitute itself with a suitably rated entity, or obtain a guarantor. Payments will be made through HVB's representative in Russia, International Moscow Bank (BB/Positive/B). The backup servicer will hold the fifth account.

The collection account has no secured pledge with the issuer. Money received into the collection account is transferred daily to the rouble account held with HVB. The euro liquidity principal will be kept on the euro-denominated account.

Finally, amounts that should have amortized the class A-2 notes will be credited to the issuer's escrow account, from which payments to the class A-2 notes may be done (see "Redemption of the notes").

The transaction will benefit from three sources of liquidity:

• A senior euro liquidity facility;
• A euro liquidity principal amount (euro cash reserve); and
• A rouble liquidity principal amount (rouble cash reserve).

A euro liquidity facility will be entered into at closing between the issuer and HVB. The liquidity facility has been sized to 8.5% of the notes to cover liquidity needs due to the hedging program and other disruptions of payments due to:

• Risk of delays in cash transfers within the post office;
• Invalidation of direct debit between the accounts at the servicer (untested with the CBR if the assignee is the issuer); and
• Delays in payments post notification or other disruptions of the payment chain, for example obligors notified taking more time to make the first payment.

If the short-term rating on the liquidity provider is lowered below 'A-2', then the provider must find a suitably rated replacement, or the line will be fully drawn on the euro account. Further liquidity will be provided in the transaction under the form of liquidity principal.

Part of this liquidity will be financed at closing by 3.35% of the euro notes proceeds (euro liquidity principal). This euro liquidity amount will increase up to 7% of the notes in case an amortization event has occurred.

The currency hedging is a series of rolling spot-forward swaps (see "Currency swap agreement"). A rouble liquidity amount will be calculated daily to ensure that there is sufficient funds on the day of calculation to settle all the maturing forward swaps, after nettings off the spot trades.

During the revolving period, there will be a liquidity and a borrowing base test in place. If the transaction does not meet its borrowing base requirements, the issuer may draw under the subordinated loan facility. If this fails, purchase of additional assets will stop and then the notes will start redeeming according to the relevant priority of payments (see "Redemption of the notes").

The assets bear a fixed interest rate and the notes carry a floating interest. Consequently, the issuer will enter in an interest swap agreement, whereby the issuer will pay a fixed rate in return for a Russian rouble floating rate. The notional of the swap will be 100% of the scheduled amortization of the assets.

The transaction will enter in a rolling program of spot-forward currency hedge.

At closing, the proceeds of the notes will be converted at the spot rate into roubles to purchase the consumer loan pool. At the same time, the cash manager will enter into 10 forward currency swaps, each swap for a notional of one-tenth of the outstanding balance of the notes plus one-tenth of the interest and expenses for that interest period.

The forwards will mature during the first month after closing, on three-day intervals. To settle the maturing forward, the issuer will enter in a new spot trade (to convert euros into roubles) and enter into a new forward trade for one month. The net balance of the maturing forward and spot trades is equivalent to one tenth of the monthly interest and expenses.

This swap program exposes the issuer to liquidity stresses due not only to an appreciation trend but also to the volatility of the currency. As the new forward rates are set and the spot transactions executed, shortfalls may arise. If during the day of the settlement of the forward there has been even a moderate appreciation of the currency, the spot rate used will deliver fewer roubles than expected under the forward to purchase euros (rates were set 30 days prior).

These shortfalls must be compensated by collections, liquidity provided by the euro and the rouble liquidity principal amount (see "Liquidity arrangements"), the liquidity facility, and ultimately an uncommitted drawing under the subordinated loan. These shortfalls may weaken the credit enhancement available to support the notes.

If the liquidity resources are not sufficient, this may trigger an amortization event.

The currency hedge provider will be HVB. If HVB is downgraded below 'BBB', it must find another counterparty rated at least 'BBB', or find a suitably rated guarantor.

The structure allows the servicer to monitor the swap currency quotations and eventually replace the swap counterparty. During this process the counterparty will continue to perform its obligations under the swap. As a result a new suitably rated counterparty may be appointed, upon rating confirmation. The new hedge counterparty(ies) may be affiliates of the servicer so long as a Western European or U.S. entity, rated at least 'BBB', provides an unconditional guarantee on the amounts to be paid. The guarantees must be compliant with Standard & Poor's criteria.

This transaction is not constrained by Standard & Poor's ratings' transfer and convertibility (T&C) assessment for Russia-based non-sovereign issuers associated with the risk of the Russian government or the CBR restricting access to foreign exchange needed for debt service.

At 'BBB+', the transfer and convertibility assessment is one notch above the long-term foreign currency sovereign credit rating on Russia and one notch above the highest rating on the notes. The T&C assessment reflects Standard & Poor's view that the probability of the sovereign restricting access to foreign exchange needed for non-sovereign debt service is slightly less than the probability of the sovereign defaulting on its foreign currency obligations. The distinction is based on the outward orientation of Russia's economy (current account receipts amount to 37% of GDP) and the fairly unrestrictive nature of Russia's foreign exchange regime (for further information see "Ratings Associated With Risk Of Foreign Exchange Controls Raised in 27 Countries" detailed in "Related Articles").

In accordance with the security deed, the issuer will grant security to the secured creditors and noteholders. This security will take the form of a first-fixed charge over the receivables, the issuer's accounts, and a floating charge. There will also be an absolute assignment of the receivables and transaction documents.

The revolving period, during which additional assets will be purchased, will end no later than March 2009.

Assets may be put on offer two business days before the sale date. These assets must satisfy the eligibility criteria. If on an interest payment date there is available issuer principal, then the cash manager may allocate a portion of principal received to redeem the notes, subject to retained principal.

Up to 15% of the outstanding balance of the notes may be retained as cash for future purchases; these retained principal amounts cannot be reinvested.

The price of the assets to be purchase will not be lower than the outstanding balance of the loans and the accrued interest at the sale date.

If the liquidity principal level and asset purchased are at the required level, the notes will not amortize until the earlier of the call date or amortization event notice date. If not, principal available will be used to redeem the notes according to the priority of payments during the revolving period.

A stop purchase will occur in the case of a non-renewal of the antimonopoly approval (see "Legal and tax analysis" section).

The notes will redeem in full on the call date in March 2009. If the notes are not called, an amortization event will occur, and notes will redeem according to the amortizing priority of payments.

An amortization event occurs if:

• The borrowing base test is not met and liabilities exceed assets;
• The three-month rolling average net spread is lower than 3%. Net spread is the difference between the yield of assets that are up to 60 days in arrears and the sum of the fixed rate under the swap plus the ratio of defaults that have been debited to the principal deficiency ledger divided by the outstanding non-defaulted balance of the loans multiplied by 12. In effect, at closing this trigger does not allow more than 1.25% monthly defaults;
• The originator becomes insolvent;
• The originator is downgraded below 'B';
• A sovereign event occurs (e.g., the originator being seized by a governmental body);
• The sovereign is downgraded below 'BBB-';
• Any unlawfulness is committed by the transaction parties;
• Non-payment occurs;
• The obligations or warranties are breached;
• The originator cross-defaults;
• There is a failure to call the notes; and
• A disruption event occurs (e.g., the contract is terminated, an absence of market quotations, or a force majeure event or act of state).

If an amortization event is called, the priority of payments will be simplified, by combining interest and principal. Furthermore, the notes will redeem at a faster pace, as all available cash will be used to pay:

• Fees, taxes, and expenses;
• Liquidity facility costs and principal, all amounts due in respect of the foreign exchange swaps and in respect of the interest rate swaps (other than termination amounts);
• The class A-1 and A-2 notes interest amounts;
• Interest on the class B notes (if no mezzanine trigger event occurs) and the termination payments of the swap (but only if the issuer is the defaulting party);
• A top-up of the liquidity principal amount;
• The class A-1 notes payment and escrow account payment (pro rata to the class A-1 and A-2 at closing); and subsequent release amounts from the escrow account to class A-1 and class B notes in case of commingling loss. The class A-2 notes may be redeemed if the class A-1 and B notes are fully redeemed or if the release amount formula, dependent on the decrease of the asset collections, is greater than zero. Once the class A-2 notes have reached 10% of their original size, then the issuer escrow account will not be further used;
• The class B notes' interest payments if a mezzanine trigger event occurs;
• The class B notes' principal redemption (other than amounts released under the escrow account);
• The class A-2 notes' redemption;
• The junior standby servicer fee;
• The hedging termination payments;
• The subordination interest payment;
• The expenses advance repayment (advanced under the subordinated loan);
• Outstanding subordinated loan advances payments; and
• Excess spread to the subordinated loan.

The class A-2 notes will protect against an amount (equivalent to the class A-2 note amount) being trapped in the accounts (commingling) during the administration, moratorium or insolvency of the originator. If commingling arises, the class A-2 notes will bear the risk.

Moneys that will be used to redeem these notes will be deposited in the escrow account of the originator at a pro rata rate between the class A-1 and A-2 notes before the amortization event. Deposited moneys will be redistributed to the class A-1 and B noteholders, up to an amount not exceeding the outstanding class A-2 notes.

Once the class A-1 and B notes have received these amounts, moneys will still be deposited in the escrow account until amounts may be released according to the release amount formula. This formula tracks the decrease in collections, compared with the collections before the amortization event (but not due to commingling).

As collections start decreasing, the class A-2 notes may redeem.

To assess the risk associated with the appreciation and volatility of the rouble against the euro in the swap agreement (see "Hedging"), Standard & Poor's has used a methodology combining an economic forecast and a statistical approach to determine currency fluctuations in a reasonable 'BBB' scenario. The pure statistical approach used in structured finance transactions in higher rated sovereigns (like in Western Europe) was deemed not sufficient to predict the currency movements in more volatile environments encountered in developing countries, such as Russia.

In addition, with the ratings in this transaction not exceeding The Russian Federation's foreign currency rating, the transaction is not aimed to survive a default of the sovereign. Nonetheless, recent historical data for Russia has been greatly affected by the default of the sovereign in 1998.

At the same time, historical data over 1999-2005 are a too-short track record to assess the volatility of the Russian rouble. Therefore, Standard & Poor's has used volatility of the rouble from 1995 until 2005, excluding the year of sovereign default (1998).

Standard & Poor's has assumed that the CBR will continue to pursue its dual objectives of bringing down the consumer price inflation rate while seeking to prevent what it considers excessive real rouble appreciation by purchasing foreign exchange, which has led to a rapid rise in foreign exchange reserves to around $200 billion as of February 2006. In the short-term (2006-2008), tight controls of administered prices (such as housing and utility prices), controlled increases in domestic petrol prices, and the progressive liberalization of food imports are assumed to be kept in place, contributing to further declines of about one percentage point per year of the inflation rate from its current (January 2006) level of 10.7%. Yet, those projections imply that the CBR misses its inflation target of 3% by 2008. Standard & Poor's baseline scenario has inflation declining much more moderately between 2009 and 2011 to reach 5.3% at the end of the forecast period.

Standard & Poor's assumed that the CBR would allow a stronger nominal depreciation of the rouble under the pressure of Russia's exporting sector. Inflation, as a result, goes down less rapidly, especially in the first three years of the forecast period, and reaches 6% at the end of 2011.

Chart 3 shows the inflation projections under the three scenarios.

Standard & Poor's has assumed that the CBR would adopt a tougher stance on inflation, letting its currency appreciate in real terms by 5% per year against the dollar. In that case, inflation goes down to 5.0% by 2008 and 3.7% at the end of 2011.

These three scenarios, together with the volatility, have been used in a statistical model. The result of the above analysis is the creation of patterns for the currency scenarios varying according to the ratings of the transaction. The patterns reproduce at various degrees volatility and consequently exchange rates that would occur on different dates, in particular every three days. Standard & Poor's has tested the transaction in a cash flow model. Interest rate stresses, defaults, delinquency stresses, and default patterns were factored into the analysis.

• The government's growing net external creditor position is expected to strengthen further in 2006 to 2008.
• The government has a strong ability to service its debt over the medium-term, despite high and possibly growing political uncertainties.
• There are strong liquidity ratios, despite a significant increase in private sector external borrowing.

• The political, legal, and economic institutions of Russia remain weak.
• A powerful and unreformed bureaucracy creates a serious barrier to the effective implementation of reform.
• The economy is vulnerable to shocks given its high dependence upon the natural resources sector.

The ratings on The Russian Federation reflect the government's improving financial strength, the result of recent extraordinary high oil prices and a successful debt-management strategy. Significant policy and institutional risk that continue to be key constraints on the ratings are likely to increase in advance of the 2008 presidential elections, but do not materially affect the government's ability to pay its low and declining debt over the medium term.

Russia's fiscal and external balance sheets strengthened well beyond expectations in 2005. Despite political pressure, prudent management of the Stabilization Fund (SF) resulted in the accumulation of funds at a much faster rate than expected, creating a relatively vast safeguard for the coming years. Total servicing of the general government debt (estimated at $119 billion, or 15% of GDP, at year-end 2005) equaled $28.9 billion in 2005 (including the $15 billion repaid to Paris Club), and is scheduled at lower than $10 billion for the period 2006 to 2008. This debt burden is tiny compared with an estimated $52 billion in assets in the SF at year-end 2005. The speed of further accumulation depends, among other factors, on planned further Paris Club debt repayment in 2006 and 2007.

The government's net external creditor position has strengthened radically; reflecting prepayment of Paris Club debt combined with a continuing large accumulation of international reserves and ever-rising current account receipts (CARs). Net general government assets to CAR increased to 31% at year-end 2005 from 9% at year-end 2004. The trend will continue in 2006-2008, helped by high average Ural oil prices expected to average $42 per barrel in 2006-2008.

A record 7.5% budget surplus masks significant fiscal easing that took place during the year. Russia's macroeconomic stability has weakened as massive inflows of funds from high oil prices make inflation increasingly difficult to control, and as the CBR tries to protect competitiveness. GDP grew at an estimated 6% in 2005 and is projected to grow by a respectable 5.0% to 5.5% in the period 2006 to 2008, despite the slowdown in the oil and gas sector and as a reflection of continuing high oil prices. The economy's ability to grow rapidly over the longer term hinges on increasing investment, improving productivity, diversifying the economy, and improving the business environment.

Unpredictable policy enforcement and regulatory actions depress domestic and foreign direct investment (FDI), which is needed to support growth and economic efficiency. Progress in restructuring natural monopolies is slow, the administrative burden and perceived corruption are high, an independent judiciary is lacking, and other obstacles to doing business in Russia that heighten country risk have increased as Kremlin decisions are increasingly driven by competing vested interests. Policy uncertainty and the slowdown in the structural reform are likely to further intensify in the run-up to the 2008 presidential elections.

The stable outlook balances current strong fiscal and external liquidity positions against uncertainties in the country's political environment in the context of the upcoming election cycle. Russia's long-term creditworthiness hinges on the transition to a more pluralistic, decentralized, and accountable government. Over the long-term, this trend would engender greater confidence in its institutions and lead to a more coherent policy approach. Increased transparency in decision-making and a more independent judiciary would strengthen the current political environment and enhance the administration's ability to tackle structural reform. This progress would significantly improve both the foundation of Russia's political economy and country risk.

Standard & Poor's does not expect these developments over the short- to medium term. Nevertheless, continued vigilance on public spending (particularly through the course of an upcoming electoral cycle), and a lasting commitment to enhancing SF's role as the buffer against the periods of lower oil prices, would improve the foundation of public finances and the sovereign's credit standing despite lack of progress in Russia's political economy. Conversely, significant fiscal easing and/or deterioration in the country's political environment in the context of the upcoming election cycle could impede any further improvement in Russia's credit standing.