Jpm - Mbs Primer

I N T R O D U C T I O N T O M B S

September 2009

J P M O R G A N M B S P R I M E R

MBS StrategyMatt JozoffAC

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Analyst CertificationThe 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.

This research contains the views, opinions and recommendations of research strategists with JPMorgan US Fixed Income Strategy. Research strategists routinely consult with JPMSI trading desk personnel in formulating views, opinions and recommendations in preparing this research. Trading desks may trade or may have traded as principal on the basis of the research strategist(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMSI trading desks which may conflict with your interests. In addition, research strategists receive compensation based, in part, on the quality of their analysis, firm revenues, trading revenues, and competitive factors.

Copyright 2008 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a memberof FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited is registered as an investment advisers with the Securities & Futures Commission in Hong Kong and itsCE numbers is AAJ321 Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (“MAS”). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer.

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I N T R O D U C T I O N T O M B S 1

Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

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OverviewOverview

MBS in the U.S. fixed income market

Largest US fixed income asset class

Many products to choose from within the MBS market

Agency fixed-rates and ARMsNon-agency fixed-rates and ARMs (Jumbos, Alt-As)Whole loansCMOs and other structured MBS

Superior liquidityThe TBA market adds unique liquidity to MBS

MBS market often used to express duration and curve views (due to its liquidity and size)

Agency fixed-rate pass-throughs is 34% of the U.S. Aggregate Index (a benchmark of the U.S. investment grade debt).

Municipal8%

Mortgage Related

26%

Fed Agencies10%

Money Market11%

Asset-backed8%

Corporate19%

U.S. Treasury18%

Source: Securities Industry and Financial Markets Association (4Q 2008)

Fixed income market compositionFixed income market composition

Total = $30.8 trillion

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30-year ($3.93 trillion)

76%

Other Fixed ($297.9 billion)

6%

Hybrid ARM IO ($175 billion)

4%

1/1 ARM ($14.2 billion)

<1%

Hybrid ARM ($157 billion)

3%

15-year ($582 billion)11%

Source: JPMorgan, FNMA, FHLMC, GNMAAs of December 2009



Securitized agency market compositionSecuritized agency market composition Annual fixed-rate net issuance ($ billions)Annual fixed-rate net issuance ($ billions)

Annual ARM net issuance ($ billions)Annual ARM net issuance ($ billions)


Total = $__mm

Agency MBS market composition and issuance

158

296210

255

-26

99

273

514415

514

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

9

-12

4773 80

5129

17

-65

-8

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

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The mortgage market surged, thanks to a strong housing market and cash-out refis

5,2055,738

6,463

7,183

9,384

10,445

11,164 11,031

8,273

11,158

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Federal Reserve Board* As of 1Q2009

1-4 Family Mortgage Debt Outstanding ($ billions)1-4 Family Mortgage Debt Outstanding ($ billions)

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Yield History of the FNMA 30yr CC and the 5/10 yr On-the-run UST BlendYield History of the FNMA 30yr CC and the 5/10 yr On-the-run UST Blend

Why do investors buy mortgages? Yield pickup over Treasuries, with little credit risk in Agency space

Source: JPMorgan

5

2009

2

1

2001

4

8

1997

7

6

9

2005

3

Current Coupon Pass-through YieldAverage of 5 and 10 yr UST Yields

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Securitization and the money flow of pass-throughs

AgenciesMortgage Lenders

Servicer

Loans

Agency Backed Securites

Home Owner Payment Agencies

Servicing Fee Guarantee Fee

Insurance Pool

Investors

Defaults

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The MBS market links borrowers and investors

Agencies

Mortgage Lenders MBS Dealers

Borrowers MBS Investors

A “pass-through” is the basic MBS structure

The issuer of the pass-through obtains the mortgages either by purchasing or originating the loans

Loans with similar characteristics are pooled together and then securitized

Investors are entitled to a pro-rata share of monthly principal and interest payments of the underlying loans, minus a servicing spread and guarantee fee

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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

– OthersBalloon mortgages (5-year / 7-year)Prepayment penalty mortgages

“Conforming” balance loans: agency eligible loans need to meet certain collateral criteria

“Non-conforming” loans (Private label or Non-agencies)

Jumbos and Alt-As

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Understanding Mortgage Collateral : Borrower Credit & Housing Leverage

Borrower Credit and InformationFICO 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 DocLeverage (Debt to Income Ratios)Reserves : Staying Power in the event of financial trouble

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Understanding Collateral cont…

Housing LeverageLoan-to-Value Ratio– Mortgage Amount / House Value

– Higher LTV Less Equity Protection for the Mortgage Investor 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)

Property Type– Single Family Property (Most Secure)– Condos– Multi-Family

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Demand 11






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Source: Inside MBS & ABS

MBS Investor BreakdownMBS Investor Breakdown


Major MBS investors

Fannie Mae/Freddie

Mac16%

Commercial Banks16%

Foreign Investors

14%

Pension Funds

7%

Other Investors*

8% Mutual Funds15%

Remaining Investors

12%Public

Pension Funds

4%Priv. Pension Funds

4%

State/Local government

4%

MBS Investors ($ billion)MBS Investors ($ billion)

Source: Inside MBS & ABS

All MBS Non-Agency All MBS Non-Agency Change Market ShareFannie Mae/Freddie Mac 1,040 346 1,113 295 7% 16%Commercial Banks 971 260 1,089 210 12% 16%Mutual Funds 655 995 185 52% 15%Foreign Investors 1,220 550 920 320 -25% 14%Other Investors* 700 565 200 -19% 8%Life Insurance Cos. 360 475 240 32% 7%State/Local government 285 280 20 -2% 4%Priv. Pension Funds 225 268 75 19% 4%Public Pension Funds 235 245 52 4% 4%Savings Institutions 265 123 212 68 -20% 3%Securities Brokers & Dealers 260 171 26 -34% 3%FHLBanks 127 82 160 75 26% 2%Property/Casualty Insurers 145 145 60 0% 2%US Treasury/NY Fed 72 - 1%Credit Unions 63 46 3 -27% 1%REITs 85 85 39 7 -54% 1%

Total Outstanding 6,636 2,117 6,793 1,835 2%

2007 2008

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Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan* As of YE 2008.

Net Purchases ($ billions, annual)Net Purchases ($ billions, annual)

Foreign demand had dominated the mortgage market during the boom

-150

-100

-50

0

50

100

150

200

250

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Net

Pur

chas

es ($

bill

ions

, ann

ual)

Foreign GSE Bank

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*As of Sep 9, 2009

Source: JPMorgan, Federal Reserve

Federal Reserve Purchases of Agency MBSFederal Reserve Purchases of Agency MBS

Now, the Fed and Treasury have stepped in to support the market…

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$836.45

0100200300400500600700800900

Jan Feb Mar Apr May Jun Jul Aug Sep

$ (B

illio

ns)

Cumulativ e PurchasesAgency 30y r Breakdow n

0%

10%

20%

30%

40%

50%

60%

3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5

% of Outstanding% of YTD Issuance% of Fed Purchases


• Fannie Mae and Freddie Mac

• Conforming loan limits are now the higher of $417,000 or 125% of median home price, with a cap of $729,750.

• 20% risk capital weighting, regulators considering 10% weighting

• Ginnie Mae

• Explicitly government guaranteed

• Zero risk weighting

• Federal Home Loan Banks (FHLBs)

• No securitization program like the other agencies

• Represent a funding mechanism for commercial banks in the US to tap capital markets

• Have portfolios of loans that they hold, similar to Fannie and Freddie

The GSEs

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Unique role of Fannie and Freddie: issuer / investor

Fannie Mae was created in 1938 to make mortgages available to low-income families. In 1968, Fannie was converted to a

shareholder-owned corporation, and in 1970, Freddie Mac was created to compete with Fannie and expand the secondary market

in mortgages.

Mission is to facilitate secondary mortgage market in U.S. which provides steady flow of low cost mortgage funds

2 major functions:

Guarantee loans against credit losses (charge a guarantee fee)

Buy loans and securities and issue agency debt

Hold MBS, CMOs, and loans as well as ABS, CMBS, and mortgage-related spread products

Large portfolios (FN + FH hold over $1.5 trillion in loans and MBS)

Placed in a conservatorship with support from the US Treasury in September 2008

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Agency Portfolio Growth, 2000-2009

Source: FNMA, FHLMC, JPMorgan

As of July 2009

Agency Retained PortfoliosAgency Retained Portfolios

0

200

400

600

800

1,000

00 01 02 03 04 05 06 07 08 09

$ Billi

ons

Fannie Mae Freddie Mac

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Top 20 banks ranked by MBS portfolios as of 2Q2009

Bank MBS and 1-4 family whole loan holdings: Top 20 banks ranked by total assets, as of 2Q09 and changes since 1Q09, $mmBank MBS and 1-4 family whole loan holdings: Top 20 banks ranked by total assets, as of 2Q09 and changes since 1Q09, $mm

Source: JPMorgan, Federal Reserve

Bank MBS Chg* Whole Loans Chg Total Chg1 JPMorgan Chase & Co. 243,519 5,367 286,079 (9,078) 529,598 (3,711) 2 Bank of America Corporation 232,838 (1,588) 444,443 (6,856) 677,282 (8,444) 3 Wells Fargo & Company 147,234 24,969 386,463 (3,348) 533,697 21,621 4 Citigroup Inc. 103,881 3,941 209,501 (5,542) 313,382 (1,601) 5 Goldman Sachs Group, Inc. 58,242 327 565 6 58,807 333 6 MetLife, Inc. 44,834 2,157 5,724 1,129 50,558 3,286 7 Bank of New York Mellon Corporation 37,346 4,919 5,535 248 42,881 5,167 8 PNC Financial Services Group, Inc. 34,125 (802) 60,278 (428) 94,403 (1,231) 9 Taunus Corporation 32,717 (1,863) 2,738 177 35,455 (1,686)

10 U.S. Bancorp 30,015 (285) 57,026 2,284 87,041 1,999 11 Capital One Financial Corporation 29,687 1,272 18,337 (1,227) 48,025 46 12 BB&T Corporation 27,220 12,098 33,207 (305) 60,427 11,793 13 Morgan Stanley 26,198 11,062 115 96 26,313 11,158 14 Citizens Financial Group, Inc. 26,165 (487) 46,422 (2,527) 72,587 (3,013) 15 Barclays Group US Inc. 25,329 (20,706) 3,376 (1,688) 28,705 (22,394) 16 Regions Financial Corporation 17,147 390 29,128 (627) 46,275 (237) 17 State Street Corporation 15,470 (3,126) - - 15,470 (3,126) 18 SunTrust Banks, Inc. 14,894 52 54,360 1,094 69,254 1,146 19 HSBC North America Holdings Inc. 13,820 (5,470) 88,051 (5,398) 101,871 (10,868) 20 TD Banknorth Inc. 11,196 (130) 15,138 748 26,334 617

Top 20 1,171,877 32,097 1,746,486 (31,242) 2,918,363 855

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Demand 11




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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

WALA – weighted average loan age

Original face – original principal amount of pool

Current face – remaining principal balance of pool

Origination year – average origination year of loans in pool; age (WALA) is important in prepayment assessment (“seasoning”)

CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid

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Mortgage cash-flow characteristics

FHLMC FNMA14th 24th

August 1st September 1st October 1st30 days in arrears 14 to 24 days processing

44 to 54 day delay

Homeowner's August payment due (in arrears)

After processing, security holders receive shares of

August payment

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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…

Source: Bloomberg

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Source: Bloomberg

Interest

Principal

Mortgage cash-flows: without prepayments

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Source: Bloomberg

Interest

Pre-paid Principal

Principal

Mortgage cash-flows: with prepayments

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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 understanding MBS

Timing and rate of prepayments vary and produce non-level, less-predictable cash flows

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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; prepayment assumptions for pricing stated as linear multiples of PSA schedule

0

2

4

6

8

10

12

14

0 10 20 30 40 50Age

CPR

(%)

200 PSA

100 PSA

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Demand 11




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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 curveLibor ZSpread on JPMorgan’s analytic reports.

Advanced

OAS : option-adjusted spread

LIBOR OAS

Treasury OAS

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Yield analysis in the MBS market

Static Spread (Yield Spread): standard measure of incremental return over a single benchmark TreasuryCompares MBS to single point on the yield curve, usually to the interpolated point closest to the Weighted Average Life of the MBSBut 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.

ZV Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly forward rates derived from the current yield curve

More accurate for securities that return principal over many periods as opposed to bulletsStill a static measure since it assumes that interest rates and MBS cashflows remain constant

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Source: Bloomberg

Evaluating pass-throughs: yield / average life

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Prepayments and OAS

Prepayment issues:Reinvestment risk:

When rates decline and speeds increase the investor has to reinvest an increased amount of principal at lower ratesWhen rates increase and speeds decline, the investor has less cashflow to reinvest at higher rates

Discount bonds: when rates decline, the benefit of earlier return of principal at par may mitigate reinvestment riskPremium 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

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OAS Calculation

To incorporate prepayment volatility in the valuation of MBS, we can calculate a theoretical price for a given OAS1. Hundreds of hypothetical interest rate paths are simulated2. On each interest rate path the prepayment model is used to predict prepayment speeds and thus, MBS cashflows3. For each path, the present value of the projected cashflows are calculated using a specified spread, s, which is added to

the forward rates4. 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 OAS2. 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 OAS2. Wide differences in OASs are produced by different firms models due to different term structures, volatility assumptions

and prepayment projections3. Doesn’t account for dollar roll financing4. Is a “black box” – difficult for investors to decompose OAS into its component parts.

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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.

Duration is typically expressed as a % of the 10-year Treasury duration:

For instance, a par-priced mortgage with a duration of 3 years, compared to a 10-yr Tsy duration of 7.5 yrs: 3/7.5 = 40% of a 10-yr

None of these measures is perfect. We tend to use a combination of them all.

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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.

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Negative convexity of mortgages

FN 5.5 prices ($) vs shift in rates (bps), as of September 2009FN 5.5 prices ($) vs shift in rates (bps), as of September 2009

Source: JPMorgan

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108

-200 -150 -100 -50 0 50 100 150 200 250 300Bps

FNCL

5.5 P

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A real-world example: Hedging a position of FNMA 6s

Buy $100m FNMA 30 6.0

Hedging PossibilitiesHedge duration with $54m 10Y Treasuries (OAD=4.12 Treas Dur=7.64). This provides protection against parallel yield curve shifts.

Hedge duration with 2Y, 5Y, 10Y, and 30Y Treasuries. This protects against any yield curve movements.

Convexity hedge with $19m ATM 3Mx10Y swaption straddle.

4.17Total0.0414.090.5930Y0.227.641.6710Y0.274.371.175Y0.391.890.742Y

Hedge Ratio

Treasury Duration

Pass-through Partial

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Scenario Analysis with Duration Hedging

What happens if the yield curve shifts in parallel?

Duration Hedged Change

-1.50

-1.20

-0.90

-0.60

-0.30

0.00

0.30

-150 -100 -50 0 50 100 150

Spread Change (bps)

Pric

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10 Year Hedge 2, 5, 10, 30 Year Hedge

The portfolio incurs convexity costs for large yield movements

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Duration and Convexity Hedging

Note that multiple options are needed to completely hedge the convexity of the mortgage prepayment option.

Convexity Hedged Change

-1.50

-1.20

-0.90

-0.60

-0.30

0.00

0.30

-150 -100 -50 0 50 100 150

Spread Change (bps)

Pric

e Ch

ange

10 Year Hedge 2, 5, 10, 30 Year Hedge

With a static position in options, one can nearly eliminate the convexity cost.

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Changes in mortgage market duration can impact the rates markets

-800

-600

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0

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400

-100 -75 -50 -25 0 25 50 75 100

Rate change (bp)

Cha

nge

in 1

0-yr

equ

ivs

($bn

)

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

The rate of extension of the mortgage market will slow in a sell-off A sell-off could cause the curve to steepen

-50

0

50

100

150

200

2 5 10 30Tenor

10-ye

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quiv

($bn

)

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Mortgages have embedded options – Investors need to hedge changes in vol as well….

Term structure models are calibrated to the entire vol surface in swaptions

Higher vol should cause mortgages to cheapen

FN 30 Vega FN15 Vega5.0 -0.21 4.5 -0.0915.5 -0.26 5.0 -0.1236.0 -0.27 5.5 -0.1456.5 -0.23 6.0 -0.111

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:

Short LongShort 1m x 1y 1m x 10yLong 5m x 1y 5m x 10y

Underly ing

Option

Source: JPMorgan

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Where to find mortgage risk measures: Front page of the JPMorgan mortgage daily packet

Source: JPMorgan Pricing and Analytics Package, May 12, 2009

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Tracking valuations historically: Current coupon OAS


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Demand 11




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The Prepayment S-Curve

0

10

20

30

40

50

60

70

-250 -200 -150 -100 -50 0 50 100 150 200 250

Refi Incentive (bp)

CPR

(%)

Turnover

Burnout: Refi response slows once deep in-the-

money

Refi: How quickly speeds increase as incentive increases

Elbow: The amount of incentive to get borrowers to begin refinancing

(to overcome fixed costs)

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A closer look at prepayments: The major components

Rate refinancingLargest component of prepaymentsBorrowers take advantage of lower interest rates to refinanceA steep curve can cause borrowers to refi into shorter mortgages (ARMs)

TurnoverPrepayment occurs when borrower moves from one home to anotherAs loans age (or “season”) they show higher turnover speedsSeasonality is an important driver of turnover, as most families move during the summer (when kids are out of school)

Cash-out refinancingBorrowers with accumulated equity can refinance and take out a larger mortgageCash can be used for home improvement, paying off bills, or other debt consolidationThis effect is driven primarily by home price appreciation (HPA)

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No love for the coasts...Home prices converging on Nebraska?

Incr

ease

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oym

ent

Source: Case-Shiller home prices mid-2006 to 1Q09, OFHEO, Bureau of Labor Statistics Unemployment Rate 06Q2-09Q1

<-11.7% -11.7 - 5.6% >5.6%

Housing DeclineTexas: Limits on cash-out refis prevented bubble

Hardest hit

Employment weak but housing stable

> 4.4%

4.4%—2.4%

<2.4%

Northeast: surging unemployment to take its toll

Unemployment pressures home prices, esp. on the coasts

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Seasonality in prepayments, especially turnover

School schedules and weather conditions are the main reasons for seasonal behavior

There is also a separate “day count” adjustment to account for different collection days in each month

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Seasonality: Patterns tend to be impacted by weather and school schedules

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Housing prices and turnover matter a lot for a discount mortgage …

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Prepayment reports: speeds by origination year

Source: JPMorgan, FNMA (April 2009)

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Prepayment reports: speeds by WALA

Source: JPMorgan, FNMA (April 2009)

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Demand 11




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How does the TBA market work?

The TBA mortgage market has been incredibly successfulLiquidity that is at least as good as in the Treasury marketEstimated $X billion trades daily as TBA on average

What is TBA?Buyer agrees to buy a coupon and program (e.g. 30-year 6s), butSeller can decide what collateral to deliver (WAC, WAM, WALA, loan size, etc.)Allows very large trades to occur (>$10 billion at times)TBA trades settle on 1 day per month (a.k.a. PSA settle)

The problem? The seller is long the delivery option, so the buyer will always get the “worst to deliver”

Highest loan sizeWorst servicersAdverse WALA

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Collateral Performance VariesTBA = Cheapest to Deliver

Prepayments of FNMA 30-year 6.5% coupons in March 2007, grouped by age and loan size

Realized return on MBS investments depends on collateral performance

Efficient allocation by dealers and investors and pooling by originators ensure that “cheapest”pools are delivered into the TBA market

Source: JPMorgan, Fannie Mae

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1-month CPR, %

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p

TBA 6.5 is negative carry at 30CPR

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0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12

< $100k $100~150k $150~200k $200~250k $250k +

CP

R, %

Performance of TBA delivery pools

Carry of $102 TBA FNMA 6.5s versus 1-month CPR, bp

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Why consider specified pools?

Avoid the uncertainty of TBA delivery

Pick up value in specific loan characteristics

Improve convexity relative to TBAs

Match the mortgage index composition

Anticipate demand from specific buyers

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Demand for Specified Pools Comes from Many Sources

CMO

CMO execution is often driven by model valuation

Dealers arbitrage between collateral intrinsic value and demand from different investor types

Collateral selection is important when buying structured securities, particularly for structures with leverage

Money Managers

Indexed investors need exposure to specified pools as seasoned pools comprise 80% of the outstanding agency MBS universe

Total return investors aim to reduce convexity hedging costs

FNMA and FHLMC

Portfolio risk management and hedging are model dependant, thus improvements in portfolio convexity reduce hedging cost

Hedge Funds

Buy/sell specified pools versus TBA to take advantage of relative value opportunities

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Specified Pools Offer a Superior Prepayment Profile

Prepayment speed versus economic rate incentive

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-200 -150 -100 -50 0 50 100 150 200Rate Incentive, bps

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nth C

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GenericSpecified Pool

Discount Premium

Choosing the right pool attributes can lead to slower speeds as a premium (Call Protection) and faster speeds as a discount (Extension Protection)Choosing the right pool attributes can lead to slower speeds as a premium (Call Protection) and faster speeds as a discount (Extension Protection)

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Attribute Name Definition Purpose

WAC Low WAC Lower than average gross WAC Call Protection Lower the WAC, slower the speeds

WALA Seasoned Premium Loan age > 24 months and older than TBA

Call protection Burnout: after the most reactive borrowers leave the pool, the remaining borrowers are less likely to prepay

Seasoned Discount Loan age > 12 months and older than TBA

Extension protection

Loan Size LLB / $85k Max Maximum loan size < $85k Call protection Lower the loan size, slower the speeds

MLB/ $110k Max Max loan size < $110k

HLB / $150k Max Max loan size < $150k

$175k Max Max loan size < $175k

Geography Texas All loans originated in Texas Call Protection

New York All loan originated in NY Call Protection

LTV High LTV 90% LTV or higher Call Protection

FICO Low FICO Credit Score < 620 Call Protection Credit impaired borrowers have fewer refinancing options

Occupancy NOO – Non Owner Occupied

100% Investor property or 2nd Home

Call protection

Types of specified PoolsTypes of specified Pools

Specified Pools Come In Many Flavors

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Source: JPMorgan MBS Pricing and Analytics Package, May 12, 2009

Specified Pools: Quoted as price payups vs TBAs

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Valuing loan balance and geographic pools

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Loan Attribute: WALA (Loan Age)Prepayment Convexity Improves With the Passage of Time

WALA (weighted average loan age) measures time elapsed in months from when borrowers took out the loan

Seasoned Premiums: slower prepayments

Seasoned collateral that has been “in-the-money” for an extended period of time is considered to have “burnout”

Pools will start to slow-down as the most negatively convex, or the most reactive, borrowers prepay out of the pool

The surviving borrower population is less reactive to rates and can have more desirable attributes such as lower loan balances

Seasoned Discounts: faster prepayments

Home tenure is how long a borrower has been in the current home

Longer the home tenure, more likely a borrower will move, leading to faster speeds

Monetize equity gains in their homes and curtail their loan

Built-in equity enables faster turnover speeds via increased mobility (“trade-up”), greater cash-out activity, and flexibility to refinance to different product types

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One month CPR versus Rate Incentive, in 2005~2006

Loan Attribute: WALA (Loan Age)Prepayment convexity improves with the passage of time

Source: JPMorgan, Fannie Mae

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Rate Incentive, bp

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0~12 mo12~24 mo24~36 mo> 36 mo

Burnout: seasoned premiums slow down.

Seasoned discounts prepay faster than new issues

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Seasoned Discounts:Fundamental value increases as dollar prices decline

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$93 TBA$96 TBA$98 TBA

Fair value payups by WALA for discount TBAs at different price levels, assuming constant libor static Z

spread to TBA.

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Loan Balance S-Curves

Loan Monthly Months Size Savings to BE

65,000$ 34$ 59100,000$ 52$ 38130,000$ 68$ 29300,000$ 158$ 13

*assumes $2,000 Closing Costs

Borrowers with lower loan balances have less incentive to refinance – the fixed costs of refinancing represent a larger percentage of their monthly savings

Monthly Breakevens Refinancing from a 7% to 6% Rate

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"TBA" GenericHLB (150k MAX)MLB (110k Max)LLB (85k Max)

Loan Attribute: Loan SizeThe Lower the Loan size, the Slower the Speeds

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Loan Attribute: GeographyIt is not just HPA

Regional prepayment differences are due to

Housing market

Demographics & economy

Taxes and fees

New York’s mortgage recording tax is >2% in the metro area and >1% in the rest of the state

Other states with mortgage tax: Alabama, Florida, Georgia, Maryland, Minnesota, Oklahoma, Tennessee, Virginia

Other factors

Cashout refinancing restrictions in Texas

Borrowers can only cash-out refi once per year

Cash-outs can only go to 80 LTV max

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Evaluation ApproachesEvaluation Approaches

Relative value strategies and analysis

Sponsorship

Deliverable

Regressions

Hedge-Adj Carry

Spread

OAS

CMO / Collateral

Pass-through / ARM

Agency / Non-agency

TBA / Seasoned

Ginnie / Fannie

15s / 30s

Coupon swap

Mortgage - Tsy basis

Mortgage - Swap basis

Trading StrategiesTrading Strategies

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I N T R O D U C T I O N T O M B S 66TB

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Jpm - Mbs Primer

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