JUNE 2006
JPMORGAN MBS PRIMER NTIAL E CONFID ND A PRIVATE Y L T STRIC MBS Analyst Certification The strategist(s) denoted by an asterisk (“*”) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.
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JP MBS Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74 R
E Case Studies 99 RIM P
S ARMs 110 B M AN
G CMOs 116 R O M
JP MBS Index 163 MBS 1 Agency MBS market composition and issuance
Securitized agency market composition Annual fixed-rate net issuance ($ billions)
Hybrid ARM 1/1 ARM Hybrid ARM 292 IO ($107.1 ($29.4 276 ($229.5 217 211 231 billion) billion) billion) 156 3% 1% 109 93 7% Other Fixed ($157.2 -17 billion) 1998 1999 2000 2001 2002 2003 2004 2005 2006 5% Total = $__mm Source: JPMorgan, FNMA, FHLMC, GNMA
15-year Annual hybrid ARM net issuance ($ billions) ($650 billion) Annual hybrid ARM net issuance ($ billions)
TION 19% 30-year 79 ($2.2 74
GINA 49 52
I trillion)
R 65%
O 10 13 D N
A -13 -11 -31 W E
I 1998 1999 2000 2001 2002 2003 2004 2005 2006
V Total = $3.4 trillion Source: JPMorgan, FNMA, FHLMC, GNMA Source: JPMorgan, FNMA, FHLMC, GNMA OVER RKET A
M MBS 2 MBS in the U.S. fixed income market
Fixed income market composition Overview Fixed income market composition Largest US fixed income asset class
Many products to choose from within the MBS Asset- market backed Municipal 8% 9% Agency fixed-rates and ARMs Money Non-agency fixed-rates and ARMs (Jumbos, Alt- Market U.S. As) 14% Treasury 17% Whole loans CMOs and other structured MBS
Fed Agencies Superior liquidity 10%
TION The TBA market adds unique liquidity to MBS
MBS market often used to express duration and GINA I Mortgage R curve views (due to its liquidity and size)
O Corporate Related
D Agency fixed-rate pass-throughs is 34% of the 19% 23% N
A Lehman U.S. Aggregate Index (a benchmark of the
W U.S. investment grade debt). E I
V Total = $25.9 trillion Source: The Bond Market Association, as of March 2006 OVER RKET A
M MBS 3 The mortgage market has surged, thanks to a strong housing market and cash-out refis
1-4 Family Mortgage Debt Outstanding ($ billions) 1-4 Family Mortgage Debt Outstanding ($ billions) 8, 978 8, 683 8, 079
7, 120
6, 317 5, 614 5, 133 TION GINA I R O D N A W E I
V 2000 2001 2002 200 3 2004 2005 2006
Source: Bond Market Association, Federal Reserve Board OVER RKET A
M MBS 4 The MBS market links borrowers and investors
Agencies Mortgage Loans MBS Pass-through Securitization
Mortgage MBS Dealers lenders
TION Borrowers MBS Investors GINA I R O The issuer of the pass-through obtains the mortgages either by purchasing or originating the loans D
N Loans with similar characteristics are pooled together; loans are securitized A
W The investor has undivided ownership interest (the investor is entitled to the pro-rata share of interest and E
I principal payments of the underlying loans) V A “pass-through” is the basic MBS structure
OVER It passes the monthly principal and interest payments, minus a servicing spread, from a pool of mortgages to investors RKET A
M MBS 5 Origination: The Menu of Mortgages Has Expanded
Origination: production of new loans in primary market
Products
– Fixed-rate mortgages (30-year / 20-year / 15-year) – Adjustable rate mortgages (Hybrid ARMs: 3/1, 5/1, 7/1, 10/1) – Interest-Only – MTAs; Option ARMs – Other TION Balloon mortgages (5-year / 7-year) Prepayment penalty mortgages GINA I
R “Conforming” balance loans O D N A “Non-conforming” loans (Private label, Non-agencies) W E I
V Jumbos and Alt-As OVER RKET A
M MBS 6 Understanding Mortgage Collateral : Borrower Credit & Housing Leverage
Borrower Credit and Information FICO Score – Historical Credit Use and Management — Avg FICO Score for Jumbo Mortgages : ~730 — Avg FICO Score for Alt-A Mortgages : ~700 — Avg FICO Score for Subprime Mortgages : ~600 — Non-Linear Relationship Between FICO and Propensity to Default
Documentation — Full vs. Limited/Reduced/No Doc
TION Leverage (Debt to Income Ratios) Reserves : Staying Power in the event of financial trouble GINA I R O D N A W E I V OVER RKET A
M MBS 7 Understanding Collateral cont…
Housing Leverage Loan-to-Value Ratio — House Value / Mortgage Amount
— Higher LTV Æ Less Equity Protection for the Mortgage Investor Æ Higher Risk
Occupancy — Owner Occupied – Borrower Lives in the Property (Most Secure) — Second Home – Borrower has personal ties to the property — Investor – Business Decision on Economic Situation (Least Secure) TION Property Type
GINA — Single Family Property (Most Secure) I R
O — Condos
D — Multi-Family N A W E I V OVER RKET A
M MBS 8 Conforming loan limits rose by 16%, reaching $417,000 in 2006
Conforming Limits ($’000)
450
Conforming loan 400 limit for 2006
350
300
TION 250 GINA I
R 200 O D N A 150 W E
I 1990 1992 1994 1996 1998 2000 2002 2004 2006 V Source: FHFB, JPMorgan OVER RKET A
M MBS 9 Origination channels
$3.0 trillion origination volume in
2005 Top 5 mortgage banking companies account for over 48% of all new Retail (42%) - loan officer employed by origination volume mortgage banking company; mortgage loan is closed in the name of the lender 1. Countrywide Broker (34%) – mortgage loan broker 2. Wells Fargo represents borrower to lending institution; 3. Washington Mutual mortgage loan is closed in the name of the 4. Chase Home Finance lender
TION 5. CitiMortgage
Correspondent (24%) – independent Source: National Mortgage News, as of Q1 2006 GINA
I mortgage banking company; mortgage loan R
O is closed in “ABC” Mortgages name and D
N sold to mortgage banker A
W Internet – mortgage loan originated and E I
V funded by mortgage banking company through website OVER RKET A
M MBS 10 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E ARMs 110 RIM P S B
M CMOs 116 AN G R MBS Index 163 O M
JP MBS 11 Major MBS investors
MBS Investor Breakdown MBS Investor Breakdown MBS Investors ($ billion) YE 2004 Mid-2005 % Chg Dealer Personal Investor Type All MSRs Non-Agency All MSRs Non-Agency % of MSRs since 2004 REITs Inventory Sector Fannie Mae/Freddie Mac $ 1, 261 $ 2 67 $ 1,192 $ 3 63 26% -5% 2% 1% 6% FDIC Commercial Banks $ 8 76 $ 124 $ 913 $ 158 20% 4% Life Insurance Cos. $ 46 5 N.A. $ 480 $ 150 10% 3% Finance Foreign Investors $ 2 80 $ 3 0 $ 400 $ 5 0 9% 43% Companies Agencies Mutual Funds $ 31 8 N.A. $ 325 N.A. 7% 2% 2% 29% Personal Sector $ 27 0 N.A. $ 290 N.A. 6% 7% Pension Public Pension Funds $ 27 0 N.A. $ 275 N.A. 6% 2% Funds All Thrifts $ 23 4 $ 7 $ 228 $ 6 5% -3% 9% Priv. Pension Funds $ 12 5 $ 1 3 $ 128 $ 1 5 3% 2% FHLBanks $ 11 3 $ 7 1 $ 117 $ 7 1 3% 3% REITs $ 95 $ 50 $ 105 $ 6 0 2% 11% Mutual Funds Finance Companies $ 85 N.A. $ 88 N.A. 2% 4% 7% MBS Dealer Inventory $ 4 1 $ 15 $ 55 $ 20 1% 34% Federal Credit Unions $ 2 8 N.A. $ 29 N.A. 1% 2% Subtotal: $ 4, 462 $ 5 77 $ 4,625 $ 8 93 Foreign All Other Investors* $ 31 7 $ 474 Investors Total Outstanding $ 4, 779 $ 1,076 $ 5,098 $ 1,289 9% Banks Insurance 25% Source: Inside MBS & ABS Companies 10%
Total = $4.6 trillion Source: Inside MBS & ABS D
DEMAN MBS 12 Foreign demand has dominated the mortgage market over the past several years
Net Purchases ($ billions, annual)
250 Foreign GSE Bank 200
150
100
50
0
-50
-100
-150 2001 2002 2003 2004 2005 2006
Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan * Foreign purchase data: March ’06, GSE: April ’06, Bank: May ‘06 D
DEMAN MBS 13 Trends in bank demand
Bank holdings are still growing, but at a slower pace.
Some signs that bank demand could slow:
MBS holdings as a percentage of deposits have increased
C&I loan growth has picked up
But, there are mitigating factors:
Deposit rates have remained sticky
Unrealized losses are significant
Mortgages remain one of the few sectors that offers the size and liquidity that large banks need D
DEMAN MBS 14 Large banks have been drawn to the mortgage market
TopTop 3 3Bank Bank Holdi Holdingsngs as as % %of of Total Total Banks’ Banks’
40% 38% 36% 34% 32% 30% 28% 26% 24% 22% 20% Mar -01 Sep-01 Mar -02 Sep-02 Mar -03 Sep-03 Mar -04 Sep-04 Mar -05 Sep-05 Mar -06
Source: Federal Reserve, JPMorgan Large banks have enjoyed the liquidity of the mortgage market for large trades, and average trade size has increased significantly.
D Diversification and movement away from credit risk have been themes, but could shift if mortgages remain tight.
DEMAN MBS 15 Top 10 banks ranked by MBS portfolios as of 1Q 2006
Bank Holding Company Total MBS Change Pass-through Change CMO Change BANK OF AMERICA CORPORATION 212,273,791 15,121,205 206,670,221 15,808,550 5,603,570 -687,345 WACHOVIA CORPORATION 94,293,000 3,173,000 78,527,000 2,338,000 15,766,000 835,000 JPMORGAN CHASE & CO 41,644,000 18,775,000 40,354,000 18,633,000 1,290,000 142,000 WELLS FARGO & COMPANY 40,042,000 7,676,000 33,969,000 8,729,000 6,073,000 -1,053,000 US BANCORP 35,975,000 -1,547,000 22,928,000 -576,000 13,047,000 -971,000 CITIZENS FINANCIAL GROUP INC 31,828,058 1,087,257 11,429,339 176,681 20,398,719 910,576 BANK OF NEW YORK COMPANY INC 22,671,000 189,000 2,908,000 -129,000 19,763,000 318,000 COMMERCE BANCORP INC 20,908,478 1,076,917 3,651,529 104,519 17,256,949 972,398 STATE STREET CORPORATION 20,252,615 581,874 6,324,590 -626,064 13,928,025 1,207,938 SUNTRUST BANKS INC 17,287,171 264,477 11,580,470 -159,294 5,706,701 423,771
·The top 10 banks account for over 58% of all bank MBS holdings.
Source: Federal Reserve, JPMorgan D
DEMAN MBS 16 Bank MBS holdings continue to grow
MBS Holdings of Large Banks ($ billions)
650
600
550
500
450
400
350
300
250
200 May-99 May-00 May-01 May-02 May-03 May-04 May-05 May-06
Source: Federal Reserve D
DEMAN MBS 17 Security purchases and C&I loan growth has typically been inversely correlated
MBS and C&I Holdings (Annual changes since 2000)
15%
10%
g 5% Ch % l a 0% u n n
A -5% C&I
-10% R2 = 0.6155 -15% -5% 0% 5% 10% 15% 20% 25% 30% 35%
MBS Annual % Chg
Source: Federal Reserve, JPMorgan D
DEMAN MBS 18 With many bank positions underwater, it is unlikely that there will be large selling
150 20 Quarterly Changes in Security Holdings Unrealized Gains/Losses 15 100 10 ngs ($bn) di 5
50 osses ($bn) es hol 0 ns/l
securiti 0 n (5)
(10) Unrealized gai (50) Changes i Banks did not sell amid losses in 2000… (15) … While most bank sales have occurred amid gains (100) (20) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 D
DEMAN MBS 19 The GSEs
•Fannie Mae
•Freddie Mac
•Ginnie Mae
•FHLBs – the MPF and MPP programs
•GNMA pools are backed by FHA/VA loans which are government insured. These pools have an explicit U.S. government guarantee and a zero risk- capital weighting.
•FNMA and FHLMC pools are backed by conventional conforming loans, have an implicit U.S. government guarantee, and a 20% risk-capital weighting. Single-
D family loan limit is $359,650 in 2005.
DEMAN MBS 20 Unique role of GSEs: issuer / investor
Mission is to facilitate secondary mortgage market in U.S. which provides steady flow of low cost mortgage funds
Issue agency debt
Hold MBS, CMOs, and loans as well as ABS, CMBS, and mortgage-related spread products
Large portfolios (FN + FH hold over $1.4 trillion loans and MBS) demand active hedging via swap and swaption markets D
DEMAN MBS 21 Agency portfolio growth has slowed
Retained Portfolio ($ billions)
1000 FNMA Portfolio FHLMC Portfolio
900
800
700
600
500
400
300 Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06
Source: FNMA, FHLMC, JPMorgan D
DEMAN MBS 22 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
R Case Studies 99 E RIM P ARMs 110 S B M
AN CMOs 116 G R O M MBS Index 163 JP MBS 23 MBS Terminology
Pools are comprised of mortgage loans with similar rates and terms
WAC – weighted average coupon of all loans in pool (vs Coupon)
WAM – weighted average maturity of loans in pool MENTS Y WALA – weighted average loan age EPA R P
O Original face – original principal amount of pool T O Current face – remaining principal balance of pool NTR I
Origination year – average origination year of loans in pool; age (WALA) is important in prepayment AND assessment (“seasoning”)
CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid CASHFLOWS E G
MORTGA MBS 24 Mortgage cash-flow characteristics
Homeowner's August After processing, security payment due holders receive shares of (in arrears) August payment MENTS
Y FHLMC FNMA 14th 24th EPA R P
O August 1st September 1st October 1st T 30 days in arrears 14 to 24 days processing O NTR I 44 to 54 day delay AND CASHFLOWS E G
MORTGA MBS 25 Mortgage cash-flow
Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year fixed-rate loan
Using “MP” function on BBG… MENTS Y EPA R P O T O NTR I AND CASHFLOWS E G
Source: Bloomberg
MORTGA MBS 26 Mortgage cash-flows: without prepayments MENTS Y EPA R P O T Interest O NTR I AND Principal CASHFLOWS E G
Source: Bloomberg
MORTGA MBS 27 Mortgage cash-flows: with prepayments MENTS Y EPA R
P Interest O T O NTR I Pre-paid AND Principal Principal CASHFLOWS E G
Source: Bloomberg
MORTGA MBS 28 Prepayments: source of MBS optionality
Borrowers have the right to prepay at any time without penalty – in effect “calling” their loans away from investors; prepayments may be partial or complete
Valuing this call option and the cash flow uncertainty it creates is the key to MENTS Y understanding MBS EPA R P Timing and rate of prepayments vary and produce non-level, less-predictable O T cash flows O
NTR Prepayment (Call) Risk vs extension risk I AND CASHFLOWS E G
MORTGA MBS 29 Determinants of prepayments
Prepayments can be for economic / non-economic reasons
Interest rate incentive
Yield curve shape: refi down the curve MENTS Y
EPA WALA: mobility increases over time R P O T
O Seasonality: Summer months have the fastest speeds owing to school vacation NTR I
AND “Burnout”: Remaining borrowers in a pool may be credit constrained
Cash-out refinancing: Take built-up equity out of the home CASHFLOWS E G Default: Shows as a prepayment in agency pools
MORTGA MBS 30 Prepayment standards CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid
PSA – prepayment vector expressed as a series of CPRs; begins at .2% in the first month, increases .2% per month, leveling out at 6.0% in month 30;
MENTS prepayment assumptions for pricing stated as linear multiples of PSA Y schedule EPA R P
O 14 T 200 PSA
O 12
NTR 10 I )
% 8
( 100 PSA R AND 6 CP 4
2
0 CASHFLOWS 0 1020304050
E Age G
MORTGA MBS 31 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74 R
E Case Studies 99 RIM P
S ARMs 110 B M
AN CMOs 116 G R O M
JP MBS Index 163 MBS 32 Many Different Types of Spreads Basic: static yield spread over a single point on the curve “I” : spread to Treasury “N” : spread to swaps
Intermediate: zero volatility yield curve spread “Z” : spread to Treasury curve “E” : spread to Libor/swap curve Libor ZSpread on JPMorgan’s analytic reports. Advanced OAS : option-adjusted spread S A
O LIBOR OAS ND A Treasury OAS N O
VALUATI MBS 33 Yield analysis in the MBS market
Static Spread (Yield Spread): standard measure of incremental return over a single benchmark Treasury Î Compares MBS to single point on the yield curve, usually to the interpolated point closest to the Weighted Average Life of the MBS Î But MBS does not return principal in one lump sum but over many periods. A better assumption would include multiple data points on the yield curve. Z Spread takes this another step further.
Z Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly forward rates derived from the current yield curve Î More accurate for securities that return principal over many periods as opposed to bullets Î Still a static measure since it assumes that interest rates and MBS cashflows remain constant S A O ND A N O
VALUATI MBS 34 Evaluating pass-throughs: yield / average life S A O ND A N O
Source: Bloomberg
VALUATI MBS 35 Prepayments and OAS
Prepayment issues: Î Reinvestment risk: n When rates decline and speeds increase the investor has to reinvest an increased amount of principal at lower rates o When rates increase and speeds decline, the investor has less cashflow to reinvest at higher rates Î Discount bonds: when rates decline, the benefit of earlier return of principal at par may mitigate reinvestment risk Î Premium bonds: when rates increase, the benefit of a larger outstanding principal balance and longer average life means higher and more interest payments which may mitigate the reinvestment risk
OAS has been derived to account for the dispersion and uncertainty associated with this return of principal from MBS S A O ND A N O
VALUATI MBS 36 OAS Calculation
To incorporate prepayment volatility in the valuation of MBS, we can calculate a theoretical price for a given OAS 1. Hundreds of hypothetical interest rate paths are simulated 2. On each interest rate path the prepayment model is used to predict prepayment speeds and thus, MBS cashflows 3. For each path, the present value of the projected cashflows are calculated using a specified spread, s, which is added to the forward rates 4. Value of MBS = Average value of PV(s) over all simulated interest rate paths = AVGPV(s) where s is OAS
To find OAS given market price: 1. Start with an initial estimate for OAS 2. Calculate AGVPV(s) and keep adjusting until AVGPV(s) = market price
Drawback of OAS: 1. The spread earned by the investor depends on the actual path realized and can be drastically different from the OAS 2. Wide differences in OASs are produced by different firms models due to different term structures, S volatility assumptions and prepayment projections A
O 3. Doesn’t account for dollar roll financing
ND 4. Is a “black box” – difficult for investors to decompose OAS into its component parts. A N O
VALUATI MBS 37 Pass-through risk measurement (duration)
Various measures of duration: % change in price for a 1% change in rates.
Modified duration is inappropriate for pass-throughs as it cannot accommodate varying cash flows.
OAD is found by calculating constant OAS prices for parallel curve shifts.
Empirical duration uses actual observations regressed against a Treasury benchmark. Directional/empiricals could be different against different parts of the yield curve.
None of these measures is perfect. We tend to use a combination of them all. S A O ND A N O
VALUATI MBS 38 Empirical durations
FN 5.5 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06) FN 6 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06) FN 5.5 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06)
FN 6 FN 5.5
y = -4.8009x + 0.0056 1.0 1.0 y = -3.3453x + 0.0015 R2 = 0.8927 2 g 0.5 g R = 0.8266 h h 0.5 C C
x 0.0 x 0.0
% P -0.5 % P -0.5 -1.0
-0.15 -0.10 -0.05 0.00 0.05 0.10 -0.15 -0.10 -0.05 0.00 0.05 0.10
Yield Chg (%) Yield Chg (%)
Source: JPMorgan S Source: JPMorgan A O ND A N O
VALUATI MBS 39 Rates have little effect on OAS
FN 5.5 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06) FN 6 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06) FN 5.5 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06)
FN 6 FN 5.5 y = 6.455x - 0.0508 R2 = 0.0713 4.0 4.0
y = -2.2723x - 0.0758 ) ) 2.0 R2 = 0.0079 2.0 hg (bps
hg (bps 0.0 0.0 C -2.0 -2.0 OAS OAS C -4.0 -4.0 -0.15 -0.10 -0.05 0.00 0.05 0.10 -0.15 -0.10 -0.05 0.00 0.05 0.10
Yield Chg (%) Yield Chg (%)
Source: JPMorgan Source: JPMorgan S A O ND A N O
VALUATI MBS 40 Pass-through risk measurement (convexity)
Convexity: the rate at which the duration of a security changes as interest rates change.
– Positive convexity implies that for small, equal and opposite changes in interest rates, the increase in price if rates go down will be more than the decrease in price if rates rise.
– Negative convexity implies that the increase in price if rates go down will be smaller than the decrease in price if rates rise.
– Bullet Treasuries have positive convexity. Pass-throughs typically have negative convexity. S A O ND A N O
VALUATI MBS 41 Negative convexity of mortgages
FN 6 prices ($) vs shift in rates (bps) 105
100
) 95 ($ x
FN 6 P 90
85 S A
O 80 -300 -225 -150 -75 0 75 150 225 300 ND
A Bps Source: JPMorgan N O
VALUATI MBS 42 Mortgages have embedded options – valuation needs to incorporate vol
Homeowners have the right to prepay at any time during the life of the mortgage
Consequently, an MBS investor is short many options to the homeowner:
Underlying Short Long Short 1m x 1y 1m x 10y Option Long 5m x 1y 5m x 10y
Term structure models are calibrated to the entire vol surface in swaptions
Higher vol should cause mortgages to cheapen
FN 30 Vega FN15 Vega
S 5.0 -0.21 4.5 -0.091 A
O 5.5 -0.26 5.0 -0.123 6.0 -0.27 5.5 -0.145 ND
A 6.5 -0.23 6.0 -0.111 N O
Source: JPMorgan
VALUATI MBS 43 Mortgage efficiency of pricing in changes in implied vol has been increasing
Correlation of 1-week change in current coupon ZV spread and 3x7 swaption premium, rolling six-month window
1.0
0.8 0.6
0.4 0.2
0.0 (0.2) S A
O (0.4) ND A (0.6) N O 97 98 99 00 01 02 03 04 05 06
Source: JPMorgan
VALUATI MBS 44 Changes in mortgage market duration can impact the rates markets
The rate of extension of the mortgage A sell-off could cause the curve to market will slow in a sell-off steepen
Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in rates Change in 10-year equivalents for the mortgage market across the curve for a parallel +50 rate shock
400 200 bn)
$ 200 150 vs ( 0 ($bn) equi 100 yr -200 quiv 10- n -400 50
-600 10-year E
hange i 0 C -800 S
A -100 -75 -50 -25 0 25 50 75 100 -50 O Rate change (bp) 2 5 Tenor 10 30 ND A N O
VALUATI MBS 45 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E RIM
P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163
JP MBS 46 A closer look at turnover
Existing Home Sales (EHS)
Strong Lock-in
Seasonality and Calendar Effect
Cumulative Home Appreciation (CHPA)
Overall Shorter Baseline Ramp:
Interaction between EHS, CHPA, Lock-in and Aging Ramp successfully captures periods of apparent shorter and longer ramps In effect lower CHPA lengthens the ramp REPORTS
D Lock-in also lengthens the apparent ramp N A S I S Y L NA A NTS ME Y A P E R
P MBS 47 Home price appreciation and discount speeds have been highly correlated…
87% correlation between discount speeds and the housing strength now … in the weaker housing environment of 2000, there was no correlation.
Discount Speeds by State (Last 12 mo.) versus HPI in 2005 14 Discount Speeds by State vs. HPI in 2000
14 13 13 AZ 12 CA 12 11 11 % 10 VA MD FL % 10 NJ AZ MA 9 9 8 TX FL
REPORTS CA 8 1-year CPR, WA MI D 7 1-year CPR, 7 MI N PA MA TX PA VA A NY 6 6 OH NJ S
I 5 5 OH MD
S NY
Y 4 4 L 0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
NA Home Price Appreciation,% Home Price Appreciation, % A
NTS Notes: Deep discount: 75bps or more out of the money; balance weighted average 12-month CPR observed in the past year ME Y A P E R
P MBS 48 Seasoning ramps under different HPA assumptions
1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3
Turnover Multiplier 0.2 0.1
REPORTS 0.0
D 1 112131415161718191101111 N A
S WALA I S
Y 0pct hpa 1pct hpa 4pct hpa 8pct hpa L NA A NTS ME Y A Source: JPMorgan P E R
P MBS 49 Turnover (cont’d) Lock-in (disincentive to move)
Captures the relationship between turnover and refinancing “disincentive” Lock-in (long WAM) 1 Strong Lock-in. However, home price appreciation can strongly mitigate 0.9 lock-in 0.8
0.7 iplier lt
u 0.6 M
REPORTS 0.5 D N
A 0.4 S I
S 0.3 Y
L 1 1.1 1.2 1.3 1.4 1.5 1.6 NA A MtgRate/WAC NTS ME Y A P E R
P MBS 50 Turnover (cont’d)
Seasonality: Patterns tend to be impacted by weather and school schedules
School schedules and weather conditions are the main reasons for seasonal behavior 1.6
There is also a separate “day count” 1.4 adjustment to account for different collection days in each month 1.2
1.0
0.8 REPORTS D
N 0.6 A S I
S 0.4 Y L NA
A 0.2
NTS 0.0
ME Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Y A P E R
P MBS 51 Economics of refinancing
• CATO (curve at origination) – borrowers who take out a 30-year mortgage in a steep curve environment are likely to exhibit slow turnover
• SATO (spread at origination) – high mortgage rates relative to prevailing rates at origination indicate credit impairment. These borrowers are less likely to refinance
• Loan size – with similar fixed costs for refinancing, borrowers with larger loan sizes are more likely to refi
REPORTS • Home price appreciation – higher HPA allows borrowers to “cash-out refi”, or may allow some D
N borrowers to “cure” and obtain a better mortgage rate with A lower LTV A S I S
Y • Mortgage banking capacity – in large refi waves mortgage bankers may become inundated L
NA with supply, causing mortgage spreads to widen A NTS ME Y A P E R
P MBS 52 The Refinancing Index
Seasonally-adjusted refinancing index
12,000
10,000
8,000
6,000
4,000 REPORTS D N
A 2,000 S I S Y L 0 NA
A Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06
Source: MBAA NTS ME Y A P E R
P MBS 53 Burnout
1.2
1
0.8
0.6
0.4 Burnout Multiplier 0.2
REPORTS 0 D
N 0 0 0 0 0 0
A 0 10 3 50 70 90 70 90 30 11 130 15 1 190 210 230 25 27 2 310 330 350 370 39 41 4 450 470 490 S I S
Y Cumulative Incentive (bps) L NA A NTS ME Y A Source: JPMorgan P E R
P MBS 54 Primary differences between GNMA and conventional pools
Characteristic Conventional GNMA I GNMA II
Assumable No Yes Pass-through rate 25 to 250bps below loan rate 50bps below 50 to 150bps below loan rate Guarantee fee Negotiated (10 to 25bps) 6bps 6bps Servicing fee 25bps minimum 44bps 44bps minimum Mortgage insurance LTVs worse than 80% Mandatory Mandatory Excess servicing Allowed Not allowed Allowed Buy-ups/-downs Allowed Not allowed 10% buy-down allowed Delay days 24 for FNMA, 14 for Golds 14 days 19 days Prepayment reports Fifth business day Fifth business day Seventh business day
Revised GNMA II pooling guidelines came into effect July 1, 2003. REPORTS D N A S I S Y L NA A NTS ME Y A Source: JPMorgan, FNMA, FHLMC, GNMA P E R
P MBS 55 GNMA prepayments
Refinancing into conventionals
Servicer buy-out
Higher delinquencies REPORTS D N A
S Rolling 90-days delinquent with only one missing payment; I S Y L changed in 2003 to 90-days delinquent NA A NTS ME Y A P E R
P MBS 56 GNMA delinquencies
14 Conventional (Prime) VA FHA 12
10 e (%) u
8
6 Total Past D
4 REPORTS D N
A 2
S Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 I S Y L NA A NTS ME Y A Source: JPMorgan, MBA P E R
P MBS 57 Prepayment reports: speeds by origination year REPORTS D N A S I S Y L NA A NTS ME Y A
P Source: JPMorgan E R
P MBS 58 Prepayment reports: speeds by WALA REPORTS D N A S I S Y L NA A NTS ME Y A P Source: JPMorgan E R
P MBS 59 Prepayment reports: speeds by servicer REPORTS D N A S I S Y L NA A NTS ME Y
A Source: JPMorgan P E R
P MBS 60 Prepayment expectations REPORTS D N A S I S Y L NA A NTS ME Y
A Source: JPMorgan P E R
P MBS 61 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E
RIM ARMs 110 P S B
M CMOs 116 AN G R
O MBS Index 163 M
JP MBS 62 TBA pass-through market
TBA = “To Be Announced”. Essentially, a cheapest-to-deliver market (like a futures contract). Most liquid market. As with other delayed delivery transactions, a seller agrees to issue a TBA security at a future date. However, in a TBA trade, the seller and the buyer do not identify the specific underlying mortgage pools, simply certain pre-specified terms
TBAs are identified by agency, term, coupon, settle month, and traded on a dollar-price basis “Cheapest-to-deliver” gives the seller a delivery option that the buyer is short
Standardized delivery dates (see Bloomberg TDAT).
Settles once a month like a futures contract S OOL
P Delivering pools: seller must provide pool information by 3 p.m. 2 business days prior to settlement (48-hour day). IFIED C
SPE Variance: the amount by which the face value at delivery can vary from the amount
ND specified at the time of the trade, expressed as a percentage of the initial face value A
T requested. The Bond Market Association suggests 0% variance on all TBA trades E K R A M A B
T MBS 63 Bloomberg Generic TBA Tickers S OOL P IFIED C SPE ND A T E K R A M A B
T MBS 64 Dollar rolls
Dollar rolls are transactions where an institution sells mortgage backed securities with a commitment to buy similar, but not identical, mortgage backed securities on a future date at a lower price.
In the case of mortgage pass-throughs, “similar” securities refers to securities with the same coupon, security type, and mortgage
S collateral. OOL P Dollar rolls offer an attractive means of borrowing at a low cost IFIED C primarily because they allow dealers to cover their short positions. SPE ND A Dollar rolls offer dealers a convenient way to obtain promised T E K
R mortgage securities, avoiding the higher costs of failing to deliver. A M A B
T MBS 65 TBA transactions: evaluating dollar rolls
Drop
Coupon
Prepayments S OOL P Delivery optionality IFIED C
SPE Re-investment rate ND A T E K R A M A B
T MBS 66 TBA transactions: evaluating dollar rolls S OOL P IFIED C SPE ND A T E K R A
M Source: Bloomberg A B
T MBS 67 Roll Specialness
12
10 30-yr CC 15-yr CC 8
6
ll specialness (tks) 4 ro n S 2 upo OOL P 0 IFIED
C -2 Current Co SPE -4 ND
A Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 T E K
R Source: JPMorgan A M A B
T MBS 68 Price spreads influence coupon production
TBA 6.0% TBA 6.5% Mortgage note rate (a) 6.88 6.88 Less agency guaranty fee (b) 0.15 0.15 Retained servicing spread (c) 0.25 0.25 Remaining note rate (a-b-c) 6.48 6.48 Excess servicing (a-b-c-e) 0.48 0.00 Buydown of Guaranty Fee (%) 0.00 0.03 Cost to buydown guaranty fee (d) 0.00 0.12
S Desired MBS coupon (e) 6.00 6.50
OOL Market price of MBS (f) 98.05 100.13 P Adjustment to TBA price for low WAC (g) 0.00 0.03 Price adjusted for cost of buydown (f+g-d) 98.05 100.04
IFIED Value of excess servicing (h) 2.09 0.00 C Price adjusted for servicing value (f+g+h) 100.14 100.04 SPE ND A T E K
R Note: Prices are for illustration purposes only A
M Source: JPMorgan A B
T MBS 69 The many dimensions of specified pools
WALA
FICO
Low WAC
Low loan balance (LLB)
Geographic
Prepayment penalty
Relocation
S Originator OOL
P High LTV IFIED C SPE ND A T E K R A M A B
T MBS 70 Specified pools make up roughly 80% of the mortgage market
Spec pool market composition
New Specified 4% New TBA 20%
S Seasoned (>30 WALA)
OOL 49% Moderate P (13-30 WALA) 27% IFIED C SPE
ND Total = $2.814 trillion A Source: JPMorgan T
E Data is as of May 2006 K R A M A B
T MBS 71 New issue specified pools report S OOL P IFIED C SPE ND A T E K R A M Source: JPMorgan A B
T MBS 72 Seasoned specified pools report S OOL P IFIED C SPE ND A T E K R A M Source: JPMorgan A B
T MBS 73 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E RIM
P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163
JP MBS 74 Relative value strategies and analysis
Trading Strategies Trading Strategies Evaluation Approaches Mortgage - Swap basis OAS Mortgage - Tsy basis Spread Coupon swap Hedge-Adj Carry 15s / 30s Regressions Ginnie / Fannie Deliverable TBA / Seasoned Sponsorship Agency / Non-agency Pass-through / ARM
G CMO / Collateral RADIN T E VALU E
RELATIV MBS 75 Where to find JPMorgan MBS data
Factor Where to find it Supply Net supply MRV charts, Dataquery Gross supply MRV charts, Daily Packet, Dataquery Demand Banks Federal Reserve W ebsite JPM quarterly bank report
Agencies Fannie, Freddie website
Dealers Bloomberg (PDPPMORT
Non-US investors TIC data Prepayments by WALA, servicer, etc. JPM Monthly Prepay Appendix MorganMarkets.com OAS TBAs Current Specifieds, strips, hybrids, etc Daily packet Coupon swap history Daily packet Hedge adjusted carry Daily packet (soon)
G Volatility swaption premiums, bp vol Daily packet, Dataquery Regression Historical OAS by relative coupon JPM trading bloomberg Coupon swaps, butterflies MBS Analyzer
RADIN MBS Index/performance Performance by coupon vs swaps and Treasuries Index Monitor T Dataquery E Daily packet TBA Performance Report Dataquery
VALU Other Analytics/historical data Daily packet
E MBS Analyzer
RELATIV MBS 76 Mortgages have widened back to the widest levels since the beginning of the year – but are they fundamentally cheap?
30-year current coupon OAS (bps)
60
50
40
30
20
10
0 G (10) RADIN
T (20) E (30)
VALU 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 E Source: JPMorgan
RELATIV MBS 77 Declining long-dated vol has caused nominal spreads and OAS to diverge
OAS vs. CC ZV spread (bps)
Current coupon OAS has been 0 80 OAS ZV spread (5) relatively stable, while nominal 70 spreads have continued to tighten (10) 60 recently … (15)
(20) 50 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06
3YX10Y swaption premium (bps) … Declining long-dated vol has 475 465 G
been the driver (bps) 455 m u
i 445 435 RADIN
T 425 on Prem i t E p 415 405 Swa Y 0 VALU
1 395 x Y E
3 385 375 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Source: JPMorgan RELATIV MBS 78 Mortgage / Swap basis G RADIN T E VALU E
RELATIV MBS 79 30- and 15-year current coupon OAS G RADIN T E VALU E
RELATIV MBS 80 MBS Fixed-Rate Daily Analytics
COB June 9, 2006 G RADIN T E VALU E
RELATIV MBS 81 Hedge-adjusted carry
We introduce a hedge-adjusted carry methodology which provides a short- term (1- to 2-month) measure of performance using rather straightforward calculations
Option-adjusted spreads serve as a long-term spread measure and assume vega hedging, among other risk measures
It serves as a good complement to OAS valuations, capturing the return for taking duration and convexity risks
G Essentially, hedge-adjusted carry gives us the net carry of holding a TBA after hedging for duration and adjusting for convexity hedging costs RADIN T E Higher carry could suggest overweighting certain coupons. However, this
VALU valuation ignores other risks like vega and mortgage Libor spread E
RELATIV MBS 82 Hedge-adjusted carry components
The valuation incorporates factors such as the roll, hedge ratios, durations,
convexities. Specifically, the main components of the analysis are:
Swap Hedge Ratios (using partial durations).
Duration Hedged Carry
Total Negative Convexity
Convexity Hedging Cost G RADIN T E VALU E
RELATIV MBS 83 Hedge-adjusted carry components
We hedge three partial durations on the swap curve (2-yr, 5-yr and 10-yr) with the cost being the carry and rolldown on each of the swaps
To figure out the duration adjusted carry we simply calculate: Duration Hedged Carry= TBA roll – ∑(cost of swap hedge) Cost of swap hedge = hedge ratio * swap carry
In calculating total convexity cost, we incorporate swap convexity since we are long MBS and short swaps (which are positively convex) Total Convexity = MBS convexity – swap convexity
We can estimate the convexity cost using short-dated swaption implied vols (1-month x 10-year swaptions) 1 ⎡⎛ bp ⎞ 1⎤ ∗C⎢⎜ ⎟ ∗ ()22days ∧ ⎥ ∧ 2 ∗32 2 ⎣⎝ day ⎠ 2⎦
TBA Passthroughs - 30 Year Conventionals TBA Passthroughs - 30 Year Conventionals Roll Dur He dge d Roll Dur He dge d Cnv. Hedging Hedge Adj. (32nds) Carry (32nds) Carry Cost Carry G Sec Price .. (32nds) Sec Price .. (32nds) (32nds) (32nds) FN 30 4.5 91-00 1.25 .. 0.1 FN 30 4.5 91-00 1.25 .. 0.1 -0.7 -0.6 FN 30 5.0 93-29 1.87 .. 0.8 FN 30 5.0 93-29 1.87 .. 0.8 -1.1 -0.4 RADIN FN 30 5.5 96-12 2.25 .. 1.2 FN 30 5.5 96-12 2.25 .. 1.2 -1.6 -0.4 T FN 30 6.0 98-25+ 3.00 .. 2.1 FN 30 6.0 98-25+ 3.00 .. 2.1 -1.9 0.3 E FN 30 6.5 100-29 3.25 .. 2.6 FN 30 6.5 100-29 3.25 .. 2.6 -2.1 0.4 FN 30 7.0 102-14+ 2.00 .. 1.5 FN 30 7.0 102-14+ 2.00 .. 1.5 -2.1 -0.6 VALU E Source: JPMorgan (as of June 1, 2006)
RELATIV MBS 84 Hedge Adjusted Carry Report
New York J.P. Morgan Securities Inc. Jun 05, 2006 MBS Research (1-212) 834-3121 MBS Research morganmarkets.jpmorgan.com MBS Hedge Adjusted Carry
TBA Passthroughs - 30 Year Conventionals Settle Dates Spot = [Jun-13-2006], 1M = [Jul-13-2006], 2M = [Aug-14-2006] Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) Hedge Ratio / Swap (32nds) Total (32nds) (32nds) Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m FN 30 4.5 91-21 1.25 2.25 6.0 -5 0.21 0.32 0.49 0.3 0.6 -1.2 -0.8 -1.6 -0.4 -1.0 FN 30 5.0 94-16+ 1.87 3.37 5.5 -6 0.28 0.33 0.42 1.0 1.8 -1.9 -1.2 -2.5 -0.2 -0.6 FN 30 5.5 96-29+ 2.12 4.12 4.8 -7 0.37 0.32 0.34 1.3 2.7 -2.4 -1.6 -3.2 -0.3 -0.5 FN 30 6.0 99-07+ 3.00 6.00 3.8 -9 0.49 0.25 0.23 2.4 4.9 -2.8 -1.8 -3.7 0.6 1.2 FN 30 6.5 101-05+ 3.25 6.50 2.9 -1 0.51 0.20 0.15 2.7 5.7 -3.2 -2.0 -4.2 0.7 1.5 FN 30 7.0 102-19 2.00 4.00 1.9 0 0.51 0.11 0.07 1.7 3.5 -2.9 -1.9 -3.9 -0.2 -0.4
TBA Passthroughs - GNMA I 30 Years Settle Dates Spot = [Jun-19-2006], 1M = [Jul-18-2006], 2M = [Aug-17-2006] Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) Hedge Ratio / Swap (32nds) Total (32nds) (32nds) Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m GN 30 4.5 92-29 2.00 4.00 5.4 -6 0.24 0.30 0.42 1.2 2.6 -1.2 -0.7 -1.5 0.5 1.1 GN 30 5.0 95-26+ 2.00 4.00 5.2 -23 0.29 0.32 0.40 1.2 2.6 -1.8 -1.1 -2.3 0.1 0.3 GN 30 5.5 97-31 2.50 5.00 4.8 -20 0.37 0.32 0.34 1.8 3.8 -2.4 -1.5 -3.1 0.3 0.7 GN 30 6.0 100-06+ 2.50 5.00 3.7 -20 0.47 0.26 0.22 1.9 4.0 -2.9 -1.8 -3.7 0.2 0.3 GN 30 6.5 102-03 3.00 6.00 2.3 -21 0.50 0.17 0.09 2.7 5.5 -2.7 -1.7 -3.5 1.0 2.0 GN 30 7.0 103-14 0.00 0.00 1.4 -31 0.52 0.09 0.01 -0.2 -0.3 -2.3 -1.4 -3.0 -1.6 -3.2
TBA Passthroughs - 15 Year Conventionals Settle Dates Spot = [Jun-21-2006], 1M = [Jul-20-2006], 2M = [Aug-21-2006] G Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) Hedge Ratio / Swap (32nds) Total (32nds) (32nds) Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m FN 15 4.0 93-00 0.50 1.00 4.3 -1 0.30 0.35 0.25 -0.1 -0.1 -1.0 -0.6 -1.3 -0.7 -1.3 RADIN
T FN 15 4.5 95-06+ 0.75 1.25 4.3 -15 0.34 0.35 0.25 0.1 0.2 -1.3 -0.8 -1.7 -0.7 -1.5 FN 15 5.0 97-01 1.75 3.75 4.0 -15 0.40 0.33 0.22 1.1 2.7 -1.7 -1.1 -2.2 0.1 0.5 E FN 15 5.5 98-28+ 2.00 4.00 3.4 -14 0.48 0.28 0.17 1.5 3.1 -2.1 -1.3 -2.8 0.2 0.4 FN 15 6.0 100-26 3.50 6.50 3.0 -8 0.48 0.23 0.14 3.0 5.8 -2.1 -1.3 -2.7 1.7 3.0 FN 15 6.5 101-28 2.00 4.00 2.2 5 0.51 0.18 0.06 1.7 3.5 -1.8 -1.1 -2.3 0.6 1.2 VALU
E Rolldown and Carry of Swaps between settles Sw ap 1m 2m Dur 2Y 0.29 0.36 1.89 5Y 0.82 1.46 4.38 10Y 1.25 2.32 7.68
RELATIV MBS 85 Performance vs. swaps and Treasuries G RADIN T E VALU E
RELATIV COB June 9, 2006 MBS 86 MBS Issuance Report G RADIN T E VALU E
RELATIV MBS 87 MBS coupon price spread G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 88 MBS butterfly price spread G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 89 Mortgage/swap basis vs Index G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 90 Mortgage/Agency basis vs Index G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 91 Longer-dated Vol vs Index G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 92 Shorter-dated Vol vs Index G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 93 30-year relative coupon OAS G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 94 30-year relative coupon swaps G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 95 15-year relative coupon OAS G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 96 15-year relative coupon swaps G RADIN T E VALU E
Source: JPMorgan
RELATIV MBS 97 Trust IO analytics G RADIN T E VALU E
RELATIV MBS 98 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E RIM
P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163
JP MBS 99 Case Study #1: FNMA 6.5s – The Deliverable The relationship between delivery size and Over $400mm TBA 6.5 pools prepaid above paydown cost is non-linear; smaller trades 60CPR are far more exposed to adverse selection
Distribution of 1-mo speeds on 3-17 WALA FNMA 6.5s, Aggregate 1-month speeds on TBA 6.5s (3-17 WALA) for different (April 2006) delivery size (based on Apr prepayments)
2500 100 90 2000 80 l i
% 70 ,
$m 1500 R ce, P 60 n
a 1000 l o C a 50 B 500 1m 40 30 0 20 60+ 50-60 40-50 30-40 20-30 10-20 0-10 CPR Range 0 1000 2000 3000 4000 5000 6000 Balance, $mil S E I
D •There are still a lot of fast pools available in TBA 6.5s STU SE
CA MBS 100 Case Study #1: FNMA 6.5s – Issuance and supply
•FN 6.5 supply should be robust
FNMA 30-year relative coupon issuance Issuance by coupon as a % of total FNMA 30 year issuance
17,000 50% ) R2 = 0.8045 2 M 14,000 R = 0.8793 M 40% ($
e 11,000 FN 6.5 c 30% n Issuance Projection ($bn) a u 8,000 Apr-06 3.8 s 20% 30 Issuance s
May-06 5. 1 N r I 5,000
-y Jun-06 6. 7 10% 0
3 2,000 Jul-06 8 .9 % of F
N 0% F (1,000) (1.00) (0.50) 0.00 0.50 1.00 1.50 2.00 (10)% (1.00) (0.50) 0.00 0.50 1.00 1.50 2.00 Relative Coupon Relative coupon
Source: JPMorgan, FNMA Source: JPMorgan, FNMA Note: Monthly issuance of FN 5s through 6.5s plotted as relative Note: Since September 2005 coupons vs CC, since September 2005 FN 6.5 Issuance Projection ($bn) S E
I Apr-06 3.8 D May-06 5.1
STU Jun-06 6.7
SE Jul-06 8.9
CA MBS 101 Case Study #1: FNMA 6.5s – Fundamentals
Short WALA 6.5s have tight OAS and low SATO •FNMA 6.5s: New OAS (left axis, bps) and SATO (right axis, bps) on issue pools have FN 6.5s by WALA (in months) worse loan
04812 16 20characteristics than 0 110 (2) 100 more seasoned (4) 90 pools (6) 80 (8) 70 (10) 60 (12) 50 (14) 40 OAS SATO Source: JPMorgan, FNMA
FNMA 6.5s are fair fundamentally LIBOR static spread of FNMA 6.5s by CPR, in bp S E I
D CPR 10 20 30 40 50 STU 101—01 73 60 44 25 2 SE
CA MBS 102 Case Study #2: DW 4.5s – Regressions
The Dwarf 5 / 4.5 is cheap historically Rich / cheap of the Dwarf 5 / 4.5 swap Dwarf 5/4.5 swap (y-axis, in ticks) versus 15-year CC yield Residual of Dwarf 5 / 4.5 swap vs 15-year current coupon yield, in (x-axis, %) ticks
70 10 8 65 6
60 4 2 55 0 -2 50 -4 -6 45 -8 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 Feb06 Apr06 Jun06 S E I D STU SE
CA MBS 103 Case Study #2: DW 4.5s – Fundamentals
Outstanding balance and 1-month CPR Outstanding balance and 1-month CPR of Dwarf 4.5s by WALA of Dwarf 5s by WALA
12 20 14 35 1mo CPR 18 1-mo CPR 10 16 12 30 B)
Cum bal ) $ 14 e ($ B) Cum Bal (
8 ) 10 25 e
12 c n a l 6 10 R (% 8 20 Balanc CPR (% e
8 Ba CP mo
o 6 15 ve - 4 lativ ti 1 6 u a l 1-m 4 m 4 10 2 u mu C 2 u
2 5 C 0 0 1 3 5 7 9 11131517192123 0 0 WALA (mos) 1 3 5 7 9 11131517192123 WALA (mos)
Dwarf 5s are fundamentally cheaper than Dwarf 4.5s .LIBOR static spread on Dwarf 4.5s and 5s by CPR
S LIBOR Static Spread (bp) E
I Price 6 CPR 7 CPR 8 CPR 9 CPR 10 CPR
D Dwarf 4.5s 95-08 -7 -3 1 6 10 Dwarf 5s 96-31 6 9 11 14 17 STU SE
CA MBS 104 Case Study #3 (Seasoned pricing): Lower the dollar price, higher the price spread between seasoned and new WALA pools
Payups by WALA vs. TBA Price
14
12 $96 $97 $98
10
8
6
Payup, 32nd 4
2
0 0 5 10 15 20 25 30 35
S WALA E
I Pricing assumptions: D 1. 24-month aging ramp 2. Peak speed of 9% CPR for $96 TBA 3. Peak speed of 10% CPR for $97 TBA STU 4. Peak speed of 11% CPR for $98 TBA SE
CA MBS 105 Case Study #3 (Seasoned pricing): Peak speeds versus the length of the ramp Payups by WALA vs. peak speed The peak speed plays an ($97 TBA, 24-mo ramp) insignificant role when pricing seasoned pools 12.0 9CPR 10CPR 11CPR 10.0 8.0 32nd 6.0 (Payup versus TBA assuming up, constant LIBOR static spread) Pay 4.0 2.0 0.0 Payups by WALA vs. aging ramp 0 5 10 15 20 25 30 35 ($97 TBA price) WALA
34mo ramp 24mo ramp 14mo ramp 14 12 However, the length of seasoning 10 ramp is crucial
32nd 8 p, u 6 A longer seasoning ramp leads to S Pay E I 4 higher payups for seasoning D 2
STU 0 0 5 10 15 20 25 30 35
SE WALA
CA MBS 106 Case Study #3: Aging ramp on moderate discount collateral
Moderate discounts have two peaks: 14 months and 24 months The 24 months peak is driven by Tax-advantaged capital gains treatment of two-year old primary residences Cash-out refinancing has been front-loaded
Aging curve: moderate discount, -25 to -75bps incentive
16
12
8 o CPR, % 1m 4 2000~2001 2005~2006 S
E 0 I
D 0 5 10 15 20 25 30 35 40 Age STU
Note: Average prepayment aging curves observed from 2000 to 2001 and from 2005 to March 2006 SE
CA MBS 107 Case Study #3: Specified Pools WALA- Actual versus theoretical payup
Seasoned payups suggest that the market is priced to a 24 months ramp
Potential lengthening of the aging ramp should translate to higher payups for seasoned discounts
Relative value advantage in the’04 discounts versus the ’03s
FNMA 5: Actual vs. theoretical FNMA 5.5: Actual vs. theoretical
’05–’06 ramp (24-mo.) ’00–’01 ramp (34-mo.) 34-mo. ramp 24-mo. ramp 14-mo. ramp 18 16 16 14 14 12 12 10 32nd 10 p, 8 u 8 6 Payup, 32nd
Pay 6 4 4 2 2 0 0 S 5 101520253035 0 5 10 15 20 25 30 35 E I WALA WALA D
Note: As of: 5/3/2006; FNMA 5s are priced to 9% CPR terminal speed; FNMA 5.5s are priced to 10% CPR terminal speed STU SE
CA MBS 108 Case Study #4: Specified Pools LLB – Call/extension protection
The trend points to faster LLB discount speeds similar to 1999-2000 Prepayment S-Curve differences (LLB (<$100k) minus generics ($>150k)), in 1999-2000, 2004, 2005 and since fall 2005: 1mo CPR vs. Rate Incentive,bps.
1moCPR 2 1999~2000 2004 2005 2005 Oct~2006 Apr 1
0
-1
-2
-3 Incentive, bps -125 -100 -75 -50 -25
Low loan balance discounts are priced at a small fraction of their combined call and extension value.
Payups and model valuations of MLB ($110k max) pools Call TBA Market Protection 10% Faster Turnover 20% Faster Turnover
S Coupon Price Payup Payup Ext. Protection Total Ext. Protection Total E I
D FNCL 5 94-05 0.5 2 9 11 17 19 FNCL 5.5 96-22+ 1.5 3 6 9 11 14 STU FNCL 6 99-05 4 7 4 11 7 14 SE
CA MBS 109 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E RIM
P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163
JP MBS 110 ARM share has remained close to half of total applications
ARM share of total applications by $ volume (%)
60
50 ) % ( e m u l 40 $ Vo y b s
p 30 Ap f o e
ar 20 h S M AR 10
0 Jun- 97 Jun- 98 Jun- 99 Jun- 00 Jun- 01 Jun- 02 Jun- 03 Jun- 04 Jun- 05 Jun- 06
Source: MBA S
ARM MBS 111 Hybrids contributed to most of the growth of the non-agency market
Year-end outstandings ($ billions)
800 Jumbo Fixed Jumbo ARM Alt-A Fixed Alt-A ARM 700
600
500
400
300
200
100
0 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: JPMorgan, Loan Performance. 2006 data as of April. S
ARM MBS 112 Hybrid ARM Structure and Valuation
Example Structure Example
Typically 30-year terms 5/1 Hybrid ARM borrower with an initial coupon rate of 4.5% and a 5/2/5 cap Fixed Rate Cash-Flows structure pays 4.5% for 5 years 3, 5, 7,10 Year Fixed-Rate The highest the borrower’s rate can reset after the 5 year fixed rate period ends is (4.5%+5%), or 9.5% Hybrid ARM Tails Libor/CMT Floaters The on-going periodic cap restricts the borrower from resetting up more than 2% at each yearly reset Resets subject to Caps The life cap also protects the borrower (initial/periodic/life) by ensuring that the coupon cannot 2/2/6 reset above 9.5% for the life of the loan 5/2/5 S
ARM MBS 113 Hybrid ARM Key Terminology
Rate caps (initial, periodic, and lifetime) offer protection from large interest rate movements by providing a cap and a floor, limiting the amount the resetting contract rate can increase or decrease on each adjustment date The initial adjustment cap provides a cap and floor on the interest rate at the first adjustment date Periodic adjustment caps restrict upward and downward movements at each subsequent reset date Lifetime caps dictate the maximum interest rate of the mortgage loan at any given time MTR (months to reset) is defined as the number of months until the Hybrid ARM resets off its specified Index. In other words, the number of months until the fixed rate portion of the bond ends Once a Hybrid ARM loan reaches reset, the borrower’s new coupon is determined off a specified index The most popular indices are LIBOR and CMT The gross margin is the spread added to the Index that determines the mortgage holder’s new rate The net margin is what is passed on to the investor. The net margin is the spread added to the Index that determines the coupon the investor receives. Typically, unless otherwise specified, LIBOR-indexed ARMs have approximately 175bps net margin, while CMT-indexed bonds have approximately 225bps margin S
ARM MBS 114 How are Non-Agency MBS Valued and Traded
Non Agency MBS do not trade ‘in the screens’ thus valuation and pricing levels reflect this uncertainty
Trading is Negotiated around structure, settlement and collateral composition
Relative Value and performance analytics help drive trading levels
Pricing Conventions N-A Fixed Rates; Pass throughs relative to agency pass throughs N-A ARMs : Swaps, Treasuries
Prepayment Analytics OAS Methodology : Prepayment Modeling
Credit Analytics
Liquidity Premiums S
ARM MBS 115 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
R Case Studies 99 E RIM P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163 JP MBS 116 FNMA Current Coupon Yield vs. UST 10 Year Yield
Current Coupon 10 yr
6.5
6
5.5
5 d l e Yi 4.5
4
3.5
3 6/2/2003 12/1/2003 5/31/2004 11/29/2004 5/30/2005 11/28/2005 5/29/2006
CMOS MBS 117 Why Agency CMOs?
To broaden the investor base by customizing cash flows for investor needs while providing key advantages over other instruments: Excess Returns Greater Liquidity Virtually Zero Credit Risk
Can address the following specific needs of investors: Enhanced Yields/Spreads Targeted Average Life Profiles Targeted Duration Profiles Customize the risk/reward profiles for investor’s views on: Î interest rates Î yield curve shape Î prepayments Î volatility
CMOS MBS 118 CMOs as % of the Fixed Rate MBS Market
CMO Issuance % of Pass-Through
70 70 e
60 60 c n a ssu I s) 50 50 n h o g u lli i ro B 40 40 h $ T ( e ss- c a n P a 30 30 e t a ssu R I - O d M 20 20 e C x i F f
10 10 o %
0 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05
CMOS MBS 119 CMO Principal Types
SEQ – Sequential
PAC – Planned Amortization Class
TAC – Targeted Amortization Class
AD or VADM- Accretion-Directed/Very Accurately Defined Maturity
FFIEC Bonds
SUP - Support or Companion
Z - Accrual bond
CMOS MBS 120 SEQs - Sequentials
Collateral principal payments are reallocated sequentially into a series of short, intermediate and long maturity bonds
Sensitive to prepayments:
Î Prepayments faster than expected: SEQs shorten
Î Prepayments slower than expected: SEQs extend
The shorter average life sequentials (that pay before the longer SEQs within the structure) provide prepayment protection for the longer average life SEQs
Shorter principal window than collateral
CMOS MBS 121 SEQ Yield Tables
Front SEQ
Last Cashflow (LCF) SEQ
CMOS MBS 122 PACs - Planned Amortization Class
Principal repaid according to a schedule within a specified range of prepayment assumptions called PAC bands
Principal schedule provides protection from average life volatility and reinvestment risk associated with prepayments
Principal schedules are maintained by redirecting cashflow uncertainty to Support bonds
Average Life is less volatile with speeds outside the bands because the supports continue to provide stability
Corporate bond and agency bond surrogate
CMOS MBS 123 PAC Yield Tables and Cashflow Graph
Yield table
Cashflow Graph
CMOS MBS 124 TACs - Targeted Amortization Class
Structured to pay principal according to a schedule determined by one constant prepayment speed - a “one sided” PAC
No protection against extension: TACs only have call protection because a TAC provides protection against faster but not slower prepayments
Î Prepayments faster than TAC speed: Excess principal to supports
Î Prepayments slower than TAC speed: TAC and Support extend
Offer higher yield than PACs based on increased extension risk
More call protection than a SEQ
Yield Table
CMOS MBS 125 AD/VADMs - Accretion Directed / Very Accurately Defined Maturity
All cashflows are derived from the interest accretions of the Z bond
VADM tranches must mature prior to the start of the amortization on their corresponding Z because when the Z becomes current pay the Z accretion is no longer available to amortize the VADMs
Very stable bond since cashflow is from interest accretion which is NOT affected by prepayments
VADMs do not extend even under a zero prepayment scenario
No whipsaw risk
Pay up for the extension protection results in lower yields and better convexity
CMOS MBS 126 VADM Yield Table and Cashflow Graph
VADM yield table in SEQ Z structure
WAL Graph
CMOS MBS 127 FFIEC Bonds
Federal Financial Institutions Examination Council (FFIEC) derived guidelines to determine if MBS investments are suitable for US depository institutions
Bonds that meet these guidelines have a wider audience, are more liquid, and trade at tighter spreads than comparable non-FFIEC average life bonds
FFIEC test:
Test 1) WAL must be less than 10 years
Test 2) +300 shift Æ less than 4 years extension -300 shift Æ less than 6 years contraction
Test 3) +300 shift Æ less than 17% price change -300 shift Æ less than 17% price change
CMOS MBS 128 SUPs - Supports or Companions
Supports are cashflow shock absorbers for PACs
Faster prepayments - excess cash flow paid to supports providing call protection for PACs
Slower prepayments - any shortfall in cash flow is absorbed by supports which may not receive principal until PAC schedule is met, providing extension protection for PACs
High average life and cashflow volatility
Higher yields compensate for volatility
CMOS MBS 129 Support Yield Table and Weighted Average Life
Sequentially Tranched Support
Weighted Average Life Graph
CMOS MBS 130 Z bonds - Accrual Bonds
No interest until principal payment window starts
Interest due is added to outstanding principal of the bond = Z accretion
Z accretion accelerates the maturity of shorter tranches or more accurately defines the maturity of others (VADMs)
Receive principal payments and interest once other bonds are retired
Addition of Z bond to a structure can improve the convexity of the other bonds by reducing extension risk
CMOS MBS 131 Sequential Z Bond Yield Table & Cash Flow Graph
Yield Table
Cash Flow Graph
CMOS MBS 132 Support Z Bond Yield Table & Cash Flow Graph
Yield Table
Cash Flow Graph
CMOS MBS 133 Rocket Z Yield Table & Cash Flow Graph
Type of support Z that has a possibility of paying off very fast (“rocket”).
Yield Table
Weighted Average Life Graph
CMOS MBS 134 CMO Interest Types
Floater
Inverse Floater
IO - Interest Only (Trust and Structured)
PO - Principal Only (Trust and Structured)
Inverse IO
CMOS MBS 135 Floaters
Coupons reset periodically, usually monthly, at a rate of an index, usually 1mLibor, plus a spread, know as the margin
Created with an inverse or inverse IO such that the weighted-average coupon of the pair is always equal to the underlying fixed-rate bond
Shorter and less negatively convex than underlying fixed rate
Offers protection against interest rate risk up to the cap
The cap adds some duration and negative convexity. Without a cap the duration would be negligible and convexity neutral
Shorter durations= less price volatility than fixed-rate CMOs unless rates rise and the coupon reaches its cap
CMOS MBS 136 Floater Yield Table & Coupon Graph
Yield Table
Coupon Graph
CMOS MBS 137 Support Floater Yield Table & Coupon Graph
Yield Table
Coupon Graph
CMOS MBS 138 Inverse Floaters
Pays down simultaneously with their corresponding floater
Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow
High yields frequently compensate for the increased risks
Floored inverses: a “baby” inverse floater - coupon moves inversely but can never drop below a designated fixed coupon
Provide a way to leverage MBS if you are bullish on the MBS sector
Provide a way to leverage views in one package if you disagree with Î forward rate curve Î FED expectations Î prepayment forecasts Î volatility views
CMOS MBS 139 Inverse Yield Table & Coupon Graph
Yield Table
Coupon Graph
CMOS MBS 140 Floored Inverse Yield Table & Coupon Graph
Yield Table
Coupon Graph
CMOS MBS 141 IO - Interest Only
Receive only interest cash flow from the notional amount of the underlying bond
Since IOs do not pay principal, cashflows exist only if principal remains outstanding
The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class
Benefit from slowing prepayments Î Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments
Bearish security that usually have negative durations
Interest stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets
Interest stripped from CMOs are known as Structured IO and can be customized for investor needs on: Î lockout Î PAC bands Î underlying collateral STIPs
CMOS MBS 142 IO Yield Tables
Structured PAC IO
Trust IO
CMOS MBS 143 PO - Principal Only
Stream of principal payments purchased at a discount
Hedge for prepayment risk since POs benefit from faster prepayments: Î Principal is returned at par at a faster rate Î Lower discount rates boost the price
The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class
Bullish security with large, positive duration and positive convexity
Super PO’s provide a more levered prepay bet
Principal stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets
Principal stripped from CMOs are known as Structured PO and can be customized for investor needs on: Î lockout Î PAC bands Î underlying collateral STIPs
CMOS MBS 144 PO Yield Tables
Structured SUP PO
Trust PO
CMOS MBS 145 IO/PO Reports
Trust IO/PO reports from JPMorgan provide daily price data:
CMOS MBS 146 Inverse IO
Pays down simultaneously with their corresponding floater like an inverse except the Inverse IO does not pay principal
Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow
Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments
Provide a way to leverage views in one package if you disagree with Î forward rate curve Î FED expectations Î prepayment forecasts Î volatility views
CMOS MBS 147 Inverse IO Yield Table and Coupon Graph
Yield Table
Coupon Graph
CMOS MBS 148 Recent Innovations in CMO Market
AS/NAS – Accelerated Security/Non-accelerated Security
TTIB – Two Tiered Index Bonds
Super-Floater
Customized Floater: FHR 3069 CF
RELO – Relocation collateral deals
Pre-pay Linked Notes/Interest Accrual Notes (IANs)
Freddie Mac Reference Notes
CMOS MBS 149 AS and NAS - Accelerated and Non-Accelerated Securities
AS security receives principal payments more quickly than its respective collateral.
NAS Security receives principal more slowly than its respective collateral
NAS + AS = SEQ
The AS bond receives the “accelerated” principal payments that would have otherwise been allocated to the NAS bonds
The NAS bond is locked out until the AS bond is paid off; then the NAS begins receiving its pro-rata principal payments
NAS is better than a PAC = no whipsaw risk
CMOS MBS 150 AS and NAS Yield Tables
AS
NAS note the average life of 5.30 at 0 PSA
CMOS MBS 151 TTIB - Two Tiered Index Bond
A type of inverse floater that pays a fixed rate as long as 1m Libor stays below a certain threshold
Once 1m Libor crosses the threshold the coupon declines on a levered basis within a corridor of rates until it reaches 0%
Essentially shorting an option that 1m Libor will not increase beyond a certain threshold
Compensating for shorting the option by getting a higher coupon.
Historical Digital TTIBs: Once 1m Libor 1m Libor crosses the graph threshold the coupon declines immediately to 0%
Floored TTIB: Once 1m Libor crosses the threshold the coupon declines immediately to a fixed rate floor
CMOS MBS 152 TTIB Yield Tables and Coupon Graphs
Digital TTIB yield table Digital TTIB coupon graph
1 bp Corridor TTIB yield table 1 bp Corridor TTIB coupon graph
CMOS MBS 153 TTIBs with additional features
TTIBs with lock-out: coupon rate is not conditional on 1m Libor for an initial period, ensuring desirable rates over that period.
Initial reset date can be several years into bond’s lifetime.
Locked-out Digital TTIB yield table Locked-out Digital TTIB coupon graph
CMOS MBS 154 TTIBs with additional features (cont.)
Floating-rate TTIBs: when 1m Libor is below a threshold, bond pays as a floater.
Floating-rate TTIBs with lock-out: bond maintains its initial coupon formula for an initial period, regardless of 1m Libor.
Example: FHR 3140 CF - Is a regular L + 165 bp bond for first 7 years, before converting into a regular floating-rate TTIB.
CMOS MBS 155 Super-Floater
A type of floater that pays a fixed rate as long as 1m Libor stays above a certain threshold (usually greater than current levels).
Essentially shorting an option that 1m Libor will remain below a certain threshold.
Compensated for shorting the option by receiving a VERY high coupon should 1m Libor go above the threshold.
Example: FHR 3111 HF (receives 66% coupon if 1m Libor > 6.5%)
Coupon Graph
CMOS MBS 156 Customized Floater: FHR 3069 CF
Classified on Bloomberg as “Complex” because the formula for calculating the payment is not the standard Libor + discount margin
Unique structure
Payment Formula: Î If Libor is less than 4.8%, bond pays Libor + 2.35% Î If Libor is greater than 4.8% but less than 7.15%, bond pays 7.15% Î If Libor is greater than 7.15%, bond pays 0%
Coupon Graph
CMOS MBS 157 RELO – CMO Backed by Relocation Mortgages
Relocation Mortgage: a mortgage made to a transferred employee to finance a home purchase at a new job location
Mortgage usually requires an employer to contribute to mortgage funding
Mortgage typically originated by an agreement between the employer and the lender under a relocation program administered by the employer or its agent
Prepayment speeds depends on typical prepayment behaviors and other RELO factors: Î Whether the mortgages are made in connection with a permanent relocation of a corporate headquarters Î The likelihood that borrowers will be relocated again Î The frequency with which further relocations may occur
Historically this sector has fast prepay speeds
CMOs backed by RELO collateral usually trade at a deep discount
CMOS MBS 158 RELO Yield Table and Weighted Average Life Graph
Yield Table
Weighted Average Life graph
CMOS MBS 159 Prepay Linked Notes or Interest Accrual Notes (IANs)
Agency debt and MBS hybrid
Redemption schedule is based on a pre-selected reference pool
Like MBS (unlike agency debt) there is no explicit call date
Like agency debt (unlike MBS) there is a stated final maturity
Effective duration management tool for those who like MBS sector
Yield Table Recently-priced deals
CMOS MBS 160 Freddie Reference Notes
A Pre-pay linked note that trades live on Trade Web; an automated broker
Availability by all dealers on Trade Web means Î Better liquidity and Î Better price transparency than pre-pay linked notes that do not trade live on Trade Web
Trades at slightly lower yields than other pre-pay linked notes due to the advantage of greater liquidity and greater price transparency
Yield Table Trade Web Screen Offering:
CMOS MBS 161 Conclusion
As a premier investment bank, strives to be a leader in the CMO market
The CMO team’s recent production is growing rapidly: Î In April & May 2006, the #1 FNMA issuer! Î The #3 overall conventional issuer (FNMA + FHLMC) over same period. Î Over $5 billion in deal volume in those two months alone!
The CMO team can provide the following client needs: Î Unique trade ideas through structuring capabilities Î Relative value analysis Î Marked-to-market valuations & portfolio analysis Î Liquidity through market making
Let the CMO team help you maximize the total return of your portfolio!
CMOS MBS 162 Market Overview and Origination 1
Demand 11
Mortgage Cashflows and Intro to Prepayments 23
Valuation and OAS 32
Prepayments Analysis and Reports 46
TBA Market and Specified Pools 62
Relative Value Trading 74
Case Studies 99 R E RIM
P ARMs 110 S B M CMOs 116 AN G R O
M MBS Index 163
JP MBS 163 JPMorgan MBS Index
The JPMorgan Mortgage Index (“the Index”) measures the performance of fixed-rate agency-backed mortgage pass-through securities • Included: – Thirty-year and 15-year fixed-rate pass-through securities issued by FNMA, FHLMC, and GNMA
• Excluded: – ARMs – Non-Agency (whole loan), Jumbo, and 10- or 20-year securities – Balloons, GPMs, and TPMs – FHLMC 75-day delay mortgages – FNMA Mega, FHLMC Giant, and GNMA Platinum pools X E ND I S
MB MBS 164 JPMorgan MBS Index
Due to paydowns and new pool issuance which are reported monthly, the mortgage universe undergoes monthly transformations
JPMorgan re-balances the Index automatically to reflect the changing compositions of the mortgage market. Once a month, on the last business day of the month, all the pools represented in the Index are re-aggregated for use next month
At the end of each business day, JPMorgan trader marks are used to price all the constituent securities in the Index Traders mark benchmark issues (TBAs) and specified pools Algorithm is used to price securities that are not actively traded X E ND I S
MB MBS 165 Calculation of Index Returns
Daily total return of the Index is the market value weighted average of the daily returns of its constituent securities
The daily total return of a security is defined as its daily change in market value over its previous market value. The change in market value equals change in price plus change in accrued interest. Interest is accrued daily at the net coupon rate based on 30/360 day-count convention. Using formulas, the relationship is as follows:
The Index starts at 100 on January 1st, 2000. On every business day after market close, a daily Index return is computed. A new index value is then calculated as the product of the previous Index value and the daily Index return
This methodology assumes that the Index settles daily (on business days) and that returns are reinvested into the Index on a daily basis. Using raw Index values, one can easily calculate the periodic total return of the Index between any two business-days by dividing the ending Index
X value by the starting Index value E ND I S
MB MBS 166 Total return swaps on the JPMorgan MBS Index •Investors can receive (or pay) the total rate of return of the JPMorgan Mortgage Index and pay (or receive) LIBOR – a specified spread
Investor
Index Return LIBOR - spread
JPMorganChase Bank
•Advantages of the TROR Index Swap: – MBS returns competitive and less volatile than corporate debt – Ease of execution – Sector exposure with no security selection required – No MBS delivery / allocation required – Locked-in funding spread – Finite investment term – Paydowns automatically reinvested in Index X
E – Pay or receive Index ND I S
MB MBS 167 Mortgage Index returns X E ND I Source: Bloomberg S
MB MBS 168 Index Composition
Index composition in June 2006, par weighted (%) and month/month changes in 10-year equivalents ($bn) X E ND I Source: JPMorgan S
MB MBS 169 Index Performance
Index duration and convexity profile, as of 5/31/06
Index statistics, May 31st, 2006 Index statistics, May 31st, 2006 X E ND I S
MB MBS 170 Index Performance
Index returns and excess returns by sector and coupon (bps), in May 2006 X E ND I S
MB MBS 171