Specified Pools

8/19/2019 Specified Pools

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U N I T E D S T A T E S Apri l 18, 2011(First pub lished on November 2, 2005)

M A

M A R K E T Q U A N T I T A T I V E

A N A L Y S I S

Mortgages

UNITED STATES

Robert Young(212) [email protected]

New York

Specified Pools: SuperiorPrepayment Profiles Offer

Added Value

This Commentary has been prepared by Markets Quantitative Analysis ("MQA"), which is part of Citigroup Global

Markets' sales and trading operations.


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D D D D Apri l 18, 2011(First pub lished on November 2, 2005)

M A

Specified Pools: SuperiorPrepayment Profiles Offer Added Value

TBA sellers have an incentive to deliver pools with poorprepayment characteristics: faster than average forpremium pools and slower than average for discountpools.

Owing to call protection or extension protection,

“ specified” pools are considered more valuable thanTBA pools. Specified pools are priced based on apremium, or pay-up, to the TBA price.

Originators that sell mortgages to the agencies, poolthem in a manner that maximizes the value of theresulting MBSs they receive in return for their loans.

Two common methods for determining the value of aspecified pool relative to TBA are carry-based valuationand OAS-based valuation. Each has advantages and

disadvantages.

This Commentary has been prepared by Markets Quantitative Analysis ("MQA"), which is part of Citigroup Global

Markets' sales and trading operations.


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November 2, 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value

Citigroup Global Markets4

Contents

I. TBA: Cheapest-to-Deliver 5

II. Specified Pool Creation: A “Waterfall” of Pooling 7

Loan Balance: The Once and Future King.............. .............. .............. ............. .............. .............. ...... 8

GEO: Location, Location, Location .............. ............. .............. .............. .............. ............. ............ .... 11

Investor Property Loans: A Nice Place to Visit ............. .............. ............. ............. .............. ............. . 13

Poor Credit: Usually Slower, Unless It’s Faster........... ............. .............. .............. ............. .............. .. 14

Loan Age: Good News for the Young and the Old ............ .............. ............. .............. .............. ......... 16

WAC: Show Me the Money............. ............. .............. ............. .............. ............. .............. ............ .... 18

Purchase Loans: Nothing to Write Home About............ .............. ............. ............. ............. .............. . 19

III. Specified Pool Value: Enhanced Returns Through Superior Convexity 21

Carry-Based Valuation............. ............. .............. ............. .............. ............. ............. .............. .......... 21

OAS-Based Valuation............ ............. .............. ............. .............. ............. .............. ............. ............ 22

Comparison of Carry and OAS Valuations........ .............. ............. .............. ............. .............. ............ 27

Scenario Analysis — What If Rates Move?........ .............. .............. ............. .............. .............. .......... 27

IV. Conclusion 29

Acknowledgements

We thank Brett Rose and Lakhbir Hayre for their helpful suggestions, Carsten Schwarting for

guidance on the structure of the specified pool market, and Buchi Ramagopal and Mikhail Teytel

for their insights. The authors would also like to thank Peg Pisani for editing the report and Adela

Carrazana for providing production editing.


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Citigroup Global Markets 5

I. TBA: Cheapest-to-Deliver

The creation of the to-be-announced (TBA) MBS added significant depth to the

mortgage market. By allowing forward contracts with standardized delivery, the

TBA mortgage added the liquidity necessary for the market to flourish. It also gave

the MBS seller the ability to choose which pools to deliver into the forward trade.TBA trading requires the specification of the agency, maturity term, product, and

coupon, in addition to the par amount, price, and settlement date. However, the

individual pool is not known at the time of the trade, so other pool attributes cannot

be identified.

As prepayment models evolved, market participants realized that certain attributes

were correlated with slower prepayment speeds while others indicated that a pool

had a higher propensity to prepay. Sellers became more discerning in their choice of

what to deliver into a TBA trade, keeping the pools that they deemed to have the

most attractive characteristics. TBA sellers have an incentive to deliver pools with

poor prepayment characteristics: faster than average for premium pools and slower

than average for discount pools. Examples of this adverse selection process in theTBA MBS market are known as “worst-to-deliver” or “cheapest-to-deliver.”

If sellers deliver pools that they believe have poor prepayment profiles into TBA

trades, what do they do when they want to sell pools with good prepayment profiles?

Sellers sell pools with good prepayment profiles on a “specified” basis. That is, they

sell the individual pool rather than a generic TBA. A specified pool has certain

attributes that predictive models assess as having a likelihood for prepayments that is

different than the overall aggregate average — slower for premium coupon pools or

faster for discount coupon pools. Figure 1 shows the outstanding balance for various

categories of specified attributes as of August 2005.

The table lists some of the well-known specified attributes and shows the outstandingbalance for ranges correlated with slower- or faster-than-average prepayment speeds.

While originators have grown more sophisticated in pooling their mortgage loans,

the amount of outstanding balance with characteristics suggesting a pool will have

prepayment speeds that differ significantly from the overall averages is, in general,

limited.


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Figure 1. Conventional 30-Year Outstanding Balance by Specified Attribute, Aug 05

Attribute Specified Value Definition Outstanding ($MM) Pct. Total

Loan Balance Low Loan Balance (LLB) Max Loan Size = 90 124,261 7

Very High LTV LTV > 90 31,901 2

Normal LTV LTV


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II. Specified Pool Creation:

A “Waterfall” of Pooling

Owing to call protection or extension protection, “specified” pools are considered

more valuable than TBA pools. With the TBA serving as a commoditized baseline

product, specified pools are priced based on a premium, or pay-up, to the TBA price.Originators that sell mortgages to the agencies, pool them in a manner that

maximizes the value of the resulting MBSs they receive in return for their loans.

The pooling decision hinges on the relative prices of individual security coupons at the

time of sale. Originators select the coupon and distribution channel that provides the

highest value, a process known as “best execution.” With regard to security attributes,

this process can be characterized as a waterfall, with value flowing downstream.1

The most basic determinant of prepayment speeds is the borrower’s incentive to

refinance. Intuitively, it seems obvious that a borrower with a note rate significantly

above the currently available mortgage rate has an economic incentive to refinance,

whereas a borrower with a note rate at or below current rates has no such incentive.Because the coupon of the security is one of the attributes known at trade time, the

buyer of a TBA has an idea of the expected range for prepayment speeds, at least in

the prevailing interest rate environment.2

The second most important security attribute is the age of the loans in the pool. The

weighted average loan age (WALA) identifies where a pool is in its life cycle.

Borrowers generally do not pay off their mortgages within a few months of obtaining

them for several reasons. First, turnover tends to be low, because people usually do not

move again quickly.3 Second, the number of rate refinancers is low, because it is

unlikely that rates would have decreased enough to justify another outlay of closing

costs. As pools age, their prepayment speeds tend to increase, and they eventuallyreach a plateau within about two years.

Most broker/dealers stratify their prepayment reports by coupon and year of

origination (vintage) for this reason. A quick glance at any prepayment report shows

that 2005 (i.e., current year) originations are paying, on average, slower than 2004 or

2003 originations for the same coupon. At the same time, 2001 and 2002 production

are prepaying at about the same rate as 2003 production.4

The gradual increasing of prepayment speeds in the early life of a pool is referred to

as “seasoning.” The seasoning ramp is well known to MBS investors, having been

institutionalized in the form of the PSA ramp. Figure 2 shows the standard PSA

1 We will cover the actual valuation techniques later, but for now we will simply state the hierarchy of relative value.

2 Simply put, higher coupons prepay faster than lower coupons. In other words, 6.00% pools, on average, prepay faster than 5.50%

pools which, in turn, prepay faster than 5.00% pools.

3 Also, the incidence of refinancing for noneconomic reasons soon after closing is similarly low.

4 Older vintages tend to exhibit slightly slower prepayment speeds as burnout begins to take effect. The composition of borrowers in a

pool changes as more rate-sensitive borrowers self-select out of pools (prepay), leaving less rate-sensitive borrowers to comprise agrowing percentage of the remaining pool balance.


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ramp, in which prepayment speeds increase linearly for 30 months before leveling

off at 6% CPR for the remainder of the mortgage term.5

Figure 2. Standard PSA Ramp

0%

1%

2%

3%

4%

5%

6%

7%

8%

0 6 12 18 24 30 36 42 48 54 60

Month

C P R

PSA Ramp

Source: Citigroup.

After coupon and age, many other attributes can be used to further refine estimates of

prepayment speeds. The market recognizes these attributes and is willing to pay a

premium to TBA for them based on the magnitude and consistency of their

differentials from the aggregate averages.

Originators also recognize the extra value that can be extracted by grouping certain

attributes and pooling their loans accordingly. They take the most valuable loans and

pool them together to capture the market’s pay-up for the specific attribute(s). Each

attribute is segregated in a particular order to maximize the total value of the

portfolio of loans to be sold. The next few sections cover some of these attributes.6

Loan Balance: The Once and Future King

The first groups of loans to be segregated into their own pools are loans with low

loan balances. Loan balance is considered one of the most important factors in

predicting prepayment speeds, particularly for in-the-money coupons. Low loan

balance pools have consistently prepaid slower than their higher balance counterparts

for in-the-money coupons. The differential has held consistently during periods of

high aggregate prepayments, such as the record refinance wave of 2003, as well as

periods when aggregate prepayment speeds have been considerably slower. Indeed,

after rate incentive and age, loan balance is the most reliable predictor of speeds.The basic premise is that for a lower loan balance, a given rate reduction results in a

smaller decrease in the borrower’s monthly payment. Therefore, measuring the rate

incentive using only the difference between the borrower’s note rate and the

5 Although the PSA ramp has limited usage in the current market environment, it was the standard expression for prepayment speeds

in the early development of the MBS market. In the current market environment, its main use is related to CMOs (PAC bands).6 Once all of the attributes that can be isolated to give additional value are segregated from an originator’s portfolio of loans, the

remainder is packaged into pools that are destined for the TBA market. As shown above, that constitutes the large majority of theagency mortgage universe.


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currently available mortgage rate only tells part of the story. Figure 3 shows a

borrower’s principal and interest (P&I) payment for a given rate for various loan

balances. The difference in payments represents the reduction available from

refinancing to a lower rate mortgage. For example, for a rate reduction from 7.0% to

6.0%, the monthly P&I payment decreases by $65 on a loan balance of $100,000 but

falls by $197 on a loan balance of $300,000.

Figure 3. P&I Payments Based on Note Rate and Loan Balance

Rate (%) $100,000 $200,000 $300,000

5.0 537 1,074 1,610

5.5 568 1,136 1,703

6.0 600 1,199 1,799

6.5 632 1,264 1,896

7.0 665 1,331 1,996

7.5 699 1,398 2,098

8.0 734 1,468 2,201

Source: Citigroup.

Specified loan balance pools are marketed according to their maximum loan balance;

that is the highest individual loan size in the pool.7

The generally established categoriesare for pools with a maximum loan size less than $85,000 (low loan balance, or

“LLB”), maximum loan size less than $110,000 (moderate loan balance, or “MLB”),

and maximum loan size less than $150,000 (high loan balance, or “HLB”).8

Originators first pool loans with balances less than $85,000 (LLB) separately. LLB

pools command the highest pay-ups in the world of specified pools. Of the remaining

loans, those with balances less than $110,000 (MLB) are pooled next, followed by

those with a balance less than $150,000 (HLB).

Figure 4 shows prepayment speeds for fully seasoned 2001 production during the

height of the refinance wave in 2003. The “S” curves from the refinance wave can

only be shown for premium coupon pools where the WAC is at least 50bp in themoney because, as was noted at the time, rates were the lowest they had been in four

decades and the yield curve was close to 300bp steep (ten-year minus two-year

rates). In short, there were no discounts. LLB pools provided tremendous protection

against prepayments, with speeds as much as 30% CPR or more slower than the

aggregate averages for individual cohorts.

7 Using the average loan size would convey more information about a pool. However, because originators are meticulous about how

they pool loans, most pools have a very narrow range of loan sizes.8 Some market participants use different nomenclature, referring to the first two categories as LLB1 and LLB2 and the third as MLB,

but the loan size thresholds are consistent for conventional pools. The loan balance thresholds for GNMA pools are $75,000 for LLB,$110,000 for MLB, and $150,000 for HLB.


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Figure 4. “S” Curves for 2001 Production During the Apr 03–Sep 03 Refinance Wave

0

10

20

30

40

50

60

70

80

0 50 100 150 200 250

Rate Incentive (bp)

C P R ( % )

LLB MLB Total

Sources: CPR and CDR Technologies.

While loan balance is significant for refinances it makes little difference for

turnover.9 When borrowers contemplate moving, they calculate their potential

monthly mortgage payment based on the home they are considering purchasing. Ifthe payment is too great, they are forced to purchase a less expensive home or

postpone moving. However, the decision to move is essentially independent of the

loan balance on the current mortgage.10 Figure 5 shows the “S” curves for fully

seasoned 2003 production in the first half of 2005, when rates were still low by

historical standards but higher than the generational lows of 2003, and the yield

curve was relatively flat.

Figure 5. “S” Curves for 2003 Production During the Current Year, Jan 05–Jul 05

0

5

10

15

20

25

30

35

40

45

50

-150 -100 -50 0 50 100 150 200

Rate Incentive (bp)

C P R ( % )

LLB

MLB

Total


9 Discount coupon speeds are mostly due to turnover and, hence, show little difference between size categories.

10 The current LTV does determine the amount of equity available for a down payment on a new house.


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Out-of-the-money speeds are virtually on top of each other, while in-the-money

speeds still show distinct differences based on loan size. There is no difference for

pools that are 50bp or more out-of-the-money, even though overall aggregate speeds

are at their long-term historical averages. The CPR differential between LLB pools

and higher balance pools, however, is still quite consistent for in-the-money pools.

CPR differentials for premium coupons on the cusp range from 5% to 10% CPR and

for higher premiums can be as much as 15%–20% CPR.

GEO: Location, Location, Location

Once all loans below the loan balance thresholds are removed, originators segregate

loans from states that have historically slow prepayments. Pools that have a high

concentration of loans from a particular state might command a pay-up (referred to

as “geo” pools) depending on whether the state prepays faster or slower than average

and the pool is in or out of the money.

New York is the best-known geo story because of a mortgage recording tax that

raises the effective mortgage rate available to the borrower by 1% (2% in New York

City). Prepayments tend to be slower in New York for in-the-money coupons. Texasis also consistently slower than the aggregate average because of restrictions on cash-

out refinances and higher-than-average closing costs.11

In some cases, higher-than-average loan sizes or strong home price appreciation may

mitigate the effects of geo trends. For example, Florida has a mortgage tax of 55bp.

This tax historically had slowed prepayments in Florida to below the national

average. However, Florida has experienced significant home price appreciation over

the past several years that appears to have offset the effect of the mortgage tax.

Figure 6 shows “S” curves for fully seasoned 2001 production for some historically

slow prepaying states during the 2003 refinance wave.

Figure 6. Slow State “S” Curves for FNMA 2001 Originations in the 2003 Refinance Wave

0

10

20

30

40

50

60

70

80

0 50 100 150 200 250Rate Incentive (bp)

C P R ( % )

New York Texas

Florida Puerto RicoNational Average


11 Puerto Rico pools are actually the most valuable, with prepayment speeds up to 70% slower than the aggregate averages, but the

small outstanding balance makes them hard to find and sparsely traded.


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The states mentioned above were prepaying consistently slower than the national

average for in-the-money pools. The rate incentive only goes down to zero because,

as mentioned, there were no discounts at the time. Figure 7 shows the “S” curves for

the same states for 2003 production in 2005. Note that Florida is now paying slightly

above the national average.

Figure 7. Slow State “S” Curves for FNMA 2003 Originations in 2005

0

10

20

30

40

50

60

70

-150 -100 -50 0 50 100 150 200 250Rate Incentive (bp)

C P R ( % )

New York

Texas

Florida

Puerto Rico

National Average


Collateral from faster-prepaying states — such as Illinois and Michigan, which have

low closing costs for refinancing — typically ends up as TBA collateral. However, a

discount coupon pool with a high concentration of loans from a state with fast

enough housing turnover speeds could warrant a modest pay-up. Figure 8 shows the

“S” curves for some historically faster-prepaying states in 2005.

Figure 8. Fast State “S” Curves for FNMA 2003 Originations in 2005

0

10

20

30

40

50

60

70

80

-150 -100 -50 0 50 100 150 200 250Rate Incentive (bp)

C P R ( % )

California

Massachusetts

Illinois

Michigan

National Average



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Investor Property Loans: A Nice Place to Visit

In the summer of 2003 the agencies began to release additional disclosure items for

pools including the original FICO, original LTV, loan purpose, occupancy status,

and property type. The implementation of the new disclosure generated a great deal

of anticipation, and initially, the attributes were used as a basis for specified pay-ups.

In the current environment, however, only pools with a very high percentage of

investor properties (close to 100%) command a pay-up.

Investor loans often face a greater hurdle to refinancing: (1) They are generally more

difficult to originate as investors tend to have more complex financial situations;

(2) they are generally full-documentation loans, which are slower to process and

approve; and (3) investors generally have less commitment to a mortgage transaction

than an owner-occupant. As a result, borrowers taking out a mortgage loan for an

investment property are generally charged higher rates.12

Although underwriting guidelines for non-owner-occupied collateral are stricter,

specified pool trading for investor properties typically involves above-average loan

size collateral, because low-loan-size investor loans have already been placed into

more valuable LLB pools. For a pool with 100% investor properties, the pay-up is

usually in the range between those for MLB and HLB pools. The basis for the pay-up

is the market perception that non-owner-occupied properties are harder to refinance

than owner-occupied properties.

Despite the above-average loan sizes, specified pools with a high percentage of

investor loans do appear to offer prepayment protection. Figure 9 shows the “S”

curves for second homes, investor properties, and owner-occupied properties for

pools with an average loan size greater than $150,000. It shows that investor

properties consistently prepay slower for in-the-money pools, while paying virtually

on top of owner-occupied properties for out-of-the-money pools.

Figure 9. “S” Curve by Occupancy Status (Average Loan Size > $150,000)

0

10

20

30

40

50

60

-100 -50 0 50 100 150 200 250

Rate Incentive (bp)

C P R ( % )

2nd Home Investor Owner


12 The agencies charge fees ranging from 1.5% to 2.5%, depending on the LTV.


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The seasoning ramps for the different occupancy status categories have the same

general slopes and are equivalent in length. Figure 10 shows the seasoning ramps for

second homes, investor properties, and owner-occupied properties for pools with an

average loan size greater than $150,000. The investor property ramp is higher than

the owner-occupied ramp, because for pools of the same age (the loans were

originated at the same time), investor property pools have average borrower note

rates that are about 35bp–45bp higher. In general, owner-occupied properties merit a

better rate than non-owner-occupied properties. As shown, however, for identicalrate incentives, investor properties prepay more slowly.

Figure 10. Seasoning Ramp by Occupancy Status (Average Loan Size > $150,000)

0

5

10

15

20

25

30

0 6 12 18 24 30

Months

C P R ( % )

2nd Home Investor Owner


Poor Credit: Usually Slower, Unless It’s Faster

Low FICO scores and high LTVs were thought to indicate slower prepayment speeds

because borrowers with impaired credit find it harder to refinance. Before 2003, the

market used the spread-at-origination (SATO) as a proxy for creditworthiness. It was

thought that borrowers with mortgage note rates significantly above the generally

available rate at the time of origination must have had impaired credit, otherwise

they would have gotten the prevailing rate for prime borrowers.

When the agencies began to release FICO and LTV data in June 2003, prepayment

speeds were as expected: Low-FICO and high LTV speeds were considerably slower

than their higher-FICO and lower-LTV counterparts, as well as the overall averages.

However, since that time, the credit story has turned upside down. Lower-FICO and

higher LTV pools have prepaid faster than their complements and the overall

aggregate averages.13

Part of the reason for this trend lies in home price appreciation, which has been

significant over the past several years. Original LTVs from just a few years ago have

been rendered obsolete. Borrowers with newly found equity in their homes may be

13 The phenomenon is consistent with GNMA prepayment speeds, which were slower than conventional speeds during the refinance

wave of 2003 but recently have been faster than conventional speeds.


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able to refinance into lower-rate mortgages than they qualified for before. Other

borrowers may be able to extract the equity to clear up lingering credit blemishes.

Aggressive solicitation by overstaffed originators has also contributed. With many

prime borrowers already in lower-rate mortgages, originators are willing to reach

down the credit spectrum to refinance less creditworthy borrowers. In the current

environment, those attributes do not command pay-ups on their own.

Market participants look for a combination of attributes that indicate true creditimpairment and may pay-up slightly for pools that they believe include borrowers

who have yet to cure their credit problems. To determine credit impairment, we use a

combination of attributes derived from FNMA’s Expanded Approval (EA) program.

The EA program reclassifies loans that were previously rated as “caution” in

FNMA’s Desktop Underwriter (DU) automated underwriting system into additional

levels of approval.14

Figure 11 shows 2001 production during the 2003 refinance wave. The EA “S”

curves are considerably below the overall aggregate average, demonstrating the

validity of the credit story at the time. Figure 12 shows 2003 production in 2005. In

this figure, the EA “S” curves are above the overall aggregate averages, althoughthey are considerably closer than in 2003.

Figure 11. Credit-Related “S” Curves in the 2003 Refinance Wave

0

10

20

30

40

50

60

70

80

-100 -50 0 50 100 150 200 250

Rate Incentive (bp)

C P R ( % )

EA-1

EA-2

EA-3

Total


14 These pools are not identifiable as such, but experience indicates that the average ranges of attributes for EA-1 are a FICO score of

600–650, an original LTV of 75%–90%, and a servicing spread of 50bp–60bp. EA-2 ranges are FICO scores of 590–620, LTVs of80%–95%, and a servicing spread of 60bp–100bp. EA-3 ranges are FICOs of 560–600, LTVs of 80%–95%, and a servicing spread of100bp–140bp.


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Figure 12. Credit Related “S” Curves in 2005

0

10

20

30

40

50

60

70

-100 -50 0 50 100 150 200 250

Rate Incentive (bp)

C P R ( % )

EA-1

EA-2

EA-3

Total


Loan Age: Good News for the Young and the Old

The next attribute to be segregated is loan age. Loan age has long been recognizedas a primary determinant of prepayment speeds. The original PSA ramp

institutionalized the fact that speeds on new pools tend to be slower than the overall

average and “ramp up” over time. Understanding speeds in terms of a ramp is simple

enough for turnover. Borrowers generally do not move within a few months of

buying a new home and taking out a new mortgage. As their tenures in their homes

increase over time, borrowers begin to move and payoff their mortgages.

Refinances do not require borrowers to move, but there are reasons for a ramp to

exist for in-the-money loans as well. The process of taking out a mortgage involves

costs, such as a new appraisal, title search, property recording fees, and the like.

Even if a borrower refinances into a so-called “no point” mortgage, in which noorigination points are charged for the mortgage, closing costs typically can run up to

several thousand dollars. As a result, borrowers may be reluctant to refinance if they

have refinanced very recently, even if rates have declined again.15

Pay-ups for loan age are generally small compared with loan balance pay-ups, but

can occur either in the beginning of the ramp or further along the ramp, depending on

whether the pool is in or out of the money. For in-the-money coupons, that means

low-WALA pools; for out-of-the money (discount) coupons, it means older, or fully

seasoned pools. Loan age can command a pay-up in its own right, but it is also used

in conjunction with other attributes. For example, LLB pools command a higher pay-

up if they are also low WALA, as opposed to being a year old.

Of course, loan age is a transient attribute. In other words, a low-WALA pool

remains low-WALA for only a few months. The market is paying up only for in-the-

money pools that are three months old or less. A fully seasoned discount can also

command a pay-up, because the expectation is that it will prepay faster than newer

15 Lenders also try to discourage refinances that occur soon after the previous refinance. For example, one major lender states in its

seller guide that an originator that sells it a loan that prepays within 90 days is held responsible for any losses resulting from lostservicing rights and a premium purchase price.


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pools with the same coupon. Very seasoned pools also have shorter legal final

maturities, which can decrease extension risk.16

Although the PSA ramp is fixed in length and magnitude, it is useful for

understanding the concept of the seasoning ramp. Modern attempts to model the

seasoning ramp account for the fact that it can vary over time, depending on

economic conditions and the interest rate environment. When the level of interest

rates is high, the ramp tends to be longer and have a gentler slope. As rates decline,the ramp becomes shorter and steeper, sometimes dramatically so.

Figure 13 shows the seasoning ramp for cuspy coupon pools for three different

periods. In this case, “cuspy” is defined as having a rate incentive between 0bp and

50bp. During a period of high rates in 2000, the ramp peaked at about 24 months or

so, whereas for the refinance wave of 2003 speeds reached their fully seasoned level

at about 12–15 months. In 2005, speeds also reached their fully seasoned level in

about 12–15 months and actually begin to taper off slightly after that.

Figure 13. Seasoning Ramp for Cuspy Coupons (0bp–50bp Rate Incentive)

0

10

20

30

40

50

60

0 6 12 18 24 30 Age (Months)

C P R ( % )

Apr 00–Sep 00

Apr 03–Sep 03

Jan 05–Jul 05


Seasoning ramps can have different lengths depending on the rate incentive, which is

also included in most prepayment models. Figure 14 shows seasoning ramps for five

different levels of rate incentive ranging from 100bp out of the money to 150bp in

the money. For positive rate incentives, the ramp is steeper and peaks sooner. This

illustrates the value of low-WALA pools for in-the-money pools. In addition, for out-

of-the-money pools the ramp becomes fully seasoned at about 24 months.

16 Very seasoned premium collateral can also be of value owing to favorable convexity characteristics (burnout, for example).


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Figure 14. Seasoning Ramp by Rate Incentive

0

5

10

15

2025

30

35

40

45

50

0 6 12 18 24 30 Age (Months)

C P R

( % )

-100bp to -50bp -50bp to 0bp 0bp to 50bp

50bp to 100bp 100bp to 150bp


WAC: Show Me the Money

As mentioned, the rate incentive is the most important determinant of prepaymentspeeds with the security coupon giving a general range of expectations for speeds.

The weighted-average coupon (WAC) is the weighted average of borrowers’ note

rates in a pool and determines the rate incentive. Clearly, higher-coupon pools will,

on balance, have higher WACs, and thus, a greater incentive to refinance as rates

decline. Within a given coupon, however, pools can have a wide range of WACs. For

example, a 5.5% pool can have a WAC that ranges anywhere from 5.75% to 6.50%

or higher. For slightly in-the-money coupons on the cusp of being refinanceable, the

difference in WAC can have a significant impact.17

The difference between the WAC and security coupon, known as the servicing

spread, can be anywhere from 25bp to 100bp or more. How can pools with the samesecurity coupon have such different WACs? Agency pooling requirements specify

that a loan note rate must be at least 25bp higher than the security coupon of the pool

into which it is placed, ensuring that each loan has at least 25bp of servicing spread

attached.18 However, for all practical purposes, there is no maximum WAC for a loan

to be in a pool. When an originator sells a loan to one of the agencies, it has a choice

as to the security coupon of the pool. For example, a loan with a note rate of 6.25%

can be placed into either a 6.00% pool or a 5.50% pool.

During the height of the refinance wave in 2003 and for while after, “low-WAC”

pools commanded pay-ups in their own right. In the current environment, lower

WACs are considered an enhancement to other specified attributes. In our LLB

example, a cuspy coupon LLB pool with a servicing spread of 25bp would commanda higher pay-up than a LLB pool with the same security coupon but a servicing

spread of 75bp.

17 From a modeling perspective, this corresponds to the steepest part of the “S” curve where convexity effects are greatest. Small

changes in the rate incentive have a large impact on prepayment speeds.

18 To qualify for TBA good delivery, 25bp is the minimum servicing spread.


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The additional pay-up is generally restricted to cuspy and slight premium coupons. A

higher-premium coupon has a considerable incentive to refinance regardless of the

servicing spread. Figure 15 shows the effect of different WACs for LLB 6.00% pools

from the beginning of 2003 through August of 2005. The LLB pools with smaller

servicing spreads, corresponding to lower WACs, consistently prepaid slower than

LLB pools with higher servicing spreads (higher WACs).19

Figure 15. FNMA LLB 6.00% Pools by Servicing Spread, Jan 03–Jul 05

0

10

20

30

40

50

60

70

80

Jan 03 Apr 03 Jul 03 Oct 03 Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05

C P R ( % )

LLB - Svcg Spread 25bp–50bp



Overall Aggregate Average


Purchase Loans: Nothing to Write Home About

When the agencies first began their additional disclosures in 2003, high percentages

of purchase money loans, as opposed to refinance loans, were thought to signal

slower prepayment speeds. The prevailing wisdom was that purchase money loans,

on average, would refinance more slowly than refinance loans, because the refinanceloans represented borrowers that had already shown themselves to be sensitive to

positive rate incentives and able to take advantage of them.

Purchase money loans, by contrast, comprised a mix of rate-sensitive borrowers with

borrowers who were not as rate sensitive. Based on relative percentages, pools with a

higher percentage of refinance loans should prepay faster. In addition, turnover could

be higher for refinance loans, because they were already seasoned in terms of the

borrower’s tenure in the home.

Thus far, however, the evidence does not support the initial hypothesis. Instead, there

appears to be little difference between the prepayment speeds of purchase money and

refinance loans. Market participants are aware of this and are not willing to pay upfor pools with higher percentages of purchase money loans. Figure 16 shows the “S”

curves for purchase money and refinance loans.

19 Even though the higher-servicing-spread LLB prepaid faster than the lower-servicing-spread LLB, they were still considerably

slower than the overall aggregate averages. For example, during the height of the refinance wave in 2003, overall aggregate 6.00%coupon speeds peaked above 70% CPR compared with the high-servicing-spread LLB speeds of less than 50% CPR.


20/31



Figure 16. “S” Curve by Loan Purpose

0

5

10

15

20

25

30

35

40

-100 -50 0 50 100 150 200 250 300

Rate Incentive (bp)

C

P R ( % )

Purchase Refinance


For out-of-the-money pools, refinance loans appear marginally faster than purchase

money loans, lending some credence to the notion that borrower tenure starts further

along the seasoning ramp for refinance loans. However, for in-the-money pools, thepurchase money and refinance curves are virtually on top of each other with

purchases marginally higher on super-premiums.

Figure 17 shows the seasoning ramps for purchase money and refinance loans. The

ramp for out-of-the-money refinances rises faster than the purchase money ramp,

further supporting the notion that borrower tenure is further along the seasoning

ramp for the refinance loans. For in-the-money pools, the ramps for purchase money

and refinance loans cross a couple of times before settling into a long-term pattern

with purchase money loans prepaying slightly faster than refinance loans after about

the first year or so.

Figure 17. Seasoning Ramp by Loan Purpose

0

5

10

15

20

25

30

35

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Age (Months)

C P R ( % )

Out-of-the-Money Purchase Out-of-the-Money Refinance

In-the-Money Purchase In-the-Money Refinance



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III. Specified Pool Value: Enhanced

Returns Through Superior Convexity

The notion that a specified pool, with superior prepayment characteristics, is worth

more than a generic TBA is simple enough to understand on a conceptual basis.

Borrowers have the option to prepay at any time without penalty (with the rareexception of prepayment penalty mortgages). The MBS investor, conversely, is

explicitly short a call option. The premium that the investor receives for “selling” the

call option is the discount, in the form of a lower price, that they get for buying an

MBS relative to an option-free bond with the same nominal coupon.20

Specified pools afford prepayment protection for premium coupons and, in the case

of fully seasoned paper, extension protection for discount coupons. For a premium

coupon specified pool, slower prepay speeds erode the desirable premium coupon

paid to the investor more slowly than TBA collateral. For a discount coupon

specified pool, faster speeds return par-priced principal to the investor more quickly

than TBA. But how much is the difference in prepayment speeds worth?Two common methods for determining the value of a specified pool relative to TBA

are carry-based valuation and OAS-based valuation. Each has advantages and

disadvantages. We cover both in the following sections.

Carry-Based Valuation

The traditional method of computing the carry advantage from owning a specified

pool, due to its superior prepayment behavior, is based on dollar roll analysis. The

Bloomberg Roll Analysis calculator compares the difference between holding a pool

and selling it into the roll. The three variables in the roll analysis are the break-even

finance rate, the drop (difference between the front-month and back-month prices),

and the prepayment speed.21

By using the market rate for the break-even financing rate and varying the

prepayment speed assumption, we can see how the drop changes. In other words, we

can determine the value of the prepayment speed differential between specified pools

and TBA by comparing the drops for the different prepayment speeds.

Figure 18 shows the difference in the drop and the incremental carry advantage for

various prepayment speeds for a FNMA 6% MBS (dollar price 102-04). For

example, a pool that pays at 30% CPR when the aggregate average is 40% CPR

would have a one-tick advantage in carry for that month. Figure 19 shows the

difference in the drop and the incremental carry advantage for various prepaymentspeeds for a FNMA 5% MBS (a discount coupon with a dollar price of 98-25).

20 Moreover, the investor is also implicitly short a put option. While borrowers cannot increase their loan balance at the existing note

rate when market rates rise, they can prepay slower than expected. In this case, investors would have to wait longer to receive some ofthe principal cash flow than they expected and they would be unable to invest it at the prevailing higher rates. In this sense, relative tothe cash flow that they expected based on their prepayment assumptions when they originally purchased the MBS, they have had aput exercised against them.

21 For an explanation of dollar rolls, see Dollar Rolls — In Practice and Theory, Citigroup, July 1, 2004.


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Figure 18. FNMA 6% Carry Advantage by CPR

One-Month CPR (%) Back-Month Price Drop Incremental Carry Advantage

10 102-01+ 05+ 00:6

20 102-02:2 04:6 00:7

30 102-03:1 03:7 01

40 102-04:1 02:7 01:2

50 102-05:3 01:5 01+

60 102-06:7 00:1 NA

NA Not applicable.

Source: Citigroup.

Figure 19. FNMA 5% Carry Advantage by CPR

One-Month CPR (%) Back-Month Price Drop Incremental Carry Advantage

5 98-20:7 04:1 NA

10 98-20:6 04:2 00:1

15 98-20+ 04+ 00:1

20 98-20:3 04:5 00:1

25 98-20:2 04:6 00:1

30 98-20 05 00:2

NA Not applicable.

Source: Citigroup.

The tables show that the carry advantage is larger when the overall rate of

prepayment is faster. For the premium coupon, the carry difference for a 10% CPR

change in prepayment speeds is 1½ ticks from 60% CPR down to 50% CPR and 1¼

ticks from 50% CPR down to 40% CPR.22 Furthermore, the carry advantage is

cumulative, so a specified pool that pays at 40% CPR when the overall aggregate

average is 60% CPR has a 2¾-tick carry advantage.

Finally, the carry advantage estimated from the roll is the advantage for one month.

Because the advantage is cumulative, each month that the specified pool prepays

slower than the TBA adds to the carry advantage. This makes it possible to estimate

the payback period for a market pay-up. For example, if a specified pool with a

6.00% coupon has a 12-tick pay-up and prepays at 30% CPR when the overallaggregate average is 40% CPR, the investor will earn the pay-up back in 12

months.23 After that, any advantage in prepayment speeds represents profit on the

trade for the investor, relative to purchasing a TBA.

OAS-Based Valuation

The other main method of valuation is OAS-based valuation. The most common

method for expressing the relative value of specified pools using OAS is to use a

constant OAS as a benchmark to calculate a theoretical price for the specified pool.

The OAS of the TBA is used as a proxy for the specified pool. The difference

22 The carry advantage is also greater for pools that are further from par. For example, if we look at a FNMA 6.50% pool (dollar price

103-08), the carry difference for a 10% CPR drop in prepayments from 50% CPR to 40% CPR is 1¾ ticks compared with the 1¼ticks for the 6.00% pool.

23 A 12-tick pay-up divided by 1 tick per month equals 12 months.


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between the theoretical price of the specified pool and the market price of the TBA is

the theoretical, or implied, pay-up. 24

Market pay-ups are typically not as high as theoretical (implied) pay-ups because of

various factors that we discuss below. Figure 20 shows attributes for a generic

FNMA 6.00% TBA pool including the OAS, calculated for a price of 102-04. Figure

21 shows the specified value for various attributes, the theoretical price, and implied

pay-up (using constant OAS). We used the generic TBA attribute values for allattributes except the specified attribute listed in the table. The table also shows the

weighted average life (WAL), one-year CPR, long-term CPR, the effective duration,

effective convexity, the option cost, and the Z-spread for each specified pool.25

Figure 20. Generic FNMA 6.00% TBA Attributes

Attribute Value

Coupon 6.00%

WAC 6.50%

WAM 343 Months

WALA 15 Months

Loan Balance $167,000

FICO 703

LTV 77%

Servicing Spread 50bp

Refinance Pct. 42%

Investor Pct. 13%

OAS (@102-04) -13bp

Source: Citigroup.

Figure 21. Theoretical Prices and Implied Pay-Ups for Individual Specified Attributes

Specified

Pool

Specified

Attribute

Specified

Value

Theoretical

Price

Implied

Pay-Up WAL

One-Year

CPR (%)

Long-Term

CPR (%)

Effective

Duration

Effective

Convexity

Option

Cost (bp)

Z-Spread

(bp)

TBA NA NA 102-04 NA 4.0 29.0 20.9 1.88 -2.78 98 85

LLB Avg. Loan Balance $65,000 103-11:2 39:2 4.9 21.7 17.2 2.59 -2.19 76 63

MLB Avg. Loan Balance $95,000 102-28:7 24:7 4.6 23.8 18.4 2.32 -2.42 84 71

HLB Avg. Loan Balance $125,000 102-15:5 11:5 4.3 25.7 19.4 2.07 -2.65 92 79Investor Inv. Property Pct. 100% 102-17:2 13:2 4.2 27.8 20.3 2.13 -2.44 88 75

Low FICO FICO 600 102-12:1 8:1 4.0 29.6 21.2 2.06 -2.48 90 77

High LTV LTV 90% 102-02 -2:0 3.9 28.0 21.8 1.91 -2.70 98 85

High SATO Servicing Spread 100bp 102-00 -4:0 3.2 35.7 26.5 1.91 2.57 90 77

Low WALA WALA 0 Mo. 102-04 0:0 4.2 16.4 20.1 2.31 -2.79 105 92

Fully Seasoneda WALA 24 Mo. 99-04:6 11:6 6.8 13.0 11.3 3.68 -1.94 73 60

Low WAC Servicing Spread 25bp 102-10:4 6:4 4.7 23.1 17.8 1.93 2.91 100 87

Purchase Purchase Loan Pct. 100% 102-04 0:0 4.0 29.0 20.9 1.88 2.78 98 85

New York State Pct. 100% 102-17:6 13:6 4.6 14.2 18.5 2.60 -2.61 101 88

a The fully seasoned pool is compared to a FNMA 5.00% TBA with a price of 98-25. NA Not applicable.

Note: New York is run assuming a $227,000 loan size and two-month WALA. See report on manifold MB707.

Source: Citigroup.

24 It is also possible to compare OASs. The TBA price plus the market pay-up is used as the price to calculate an OAS for the

specified pool. The investor can then directly compare the OAS of the TBA and OAS of the specified pool. The OAS of the specifiedpool (even with the market pay-up included in the price) is generally higher than the OAS of the TBA because of its superiorprepayment profile. The difference between the OAS of the specified pool and the OAS of the TBA is known as an “OAS pickup.”

25 Daily specified collateral valuation reports are available on FI Direct : Origination Year Report to Swaps on manifold MB712,

Stipulated Attributes Report on MB721, and Model Payups for State Specific Pools on MB707.


24/31



The most valuable specified pool is LLB, which has an implied pay-up of 39¼

ticks.26 LLB pools prepay considerably slower as the WAL extends to 4.9 years

(from the TBA value of 4.0 years) and the one-year CPR drops from 29.0% CPR to

21.7% CPR. The duration is about 0.7 year longer and the bond is less negatively

convex.

By comparison, the next most valuable pool is the MLB pool, which has an implied

pay-up of 24⅞

ticks. Its WAL extends to 4.6 years with the one-year CPR at 23.8%CPR. The other specified pools follow a similar pattern.

The implied pay-ups for high LTV and high SATO are negative, indicating that the

models value these pools at less than the TBA pool.27 The high-LTV and high-SATO

pools have weighted-average lives that are less than TBA, suggesting that they

prepay faster over the life of the pool. Of course, no one would sell a pool for less

than TBA; they would simply deliver the pool into a TBA trade.

The table shows low-WALA pools with no implied pay-up. Low-WALA pools

sometimes command a modest pay-up in the market only for pools with a WALA of

three or less. However, as noted, a low WALA can enhance the value of other

specified attributes. Figure 22 shows implied pay-ups for a few combinations ofspecified attributes.

Figure 22. Theoretical Prices and Implied Pay-Ups for Selected Combinations of Specified Attributes

Specified Pool Specified Attribute

Specified

Value

Theoretical

Price

Implied

Pay-Up WAL

One-Year

CPR (%)

Long-Term

CPR (%)

Effective

Duration

Effective

Convexity

Option

Cost (bp)

Z-Spread

(bp)

TBA NA NA 102-04 NA 4.0 29.0 20.9 1.88 -2.78 98 85


LLB w/Low WAC Avg. Loan Balance $65,000 103-20:6 48:6 5.5 18.3 14.9 2.71 -2.23 76 63


LLB w/Low WALA Avg. Loan Balance $65,000 103-19:3 47:3 5.5 10.2 15.2 3.17 -1.99 82 69

WALA 0 Mo.

LLB w/Low WAC & Low WALA Avg. Loan Balance $65,000 104-00:7 60:7 6.5 8.4 12.6 3.34 -1.96 80 67


WALA 0 Mo.

Credit Impaired FICO 600 101-31:6 -4:2 2.8 36.5 29.7 2.08 -2.10 83 70

LTV 90%


NA Not applicable.

Source: Citigroup.

The table shows that some combinations are worth more than the sum of the

individual attributes. For example, the LLB and low WALA combination has an

implied pay-up of 47⅜

ticks. Why is the total implied pay-up for the combination of

LLB and low WALA worth more than the sum of the individual pay-ups for LLB

and low WALA (39¼ + 0 = 39¼ ticks)? Part of the explanation is that Yield Book®

recognizes that the seasoning ramps for different loan sizes are different.

26 The theoretical prices and implied pay-ups are listed in trader notation. The units for the numbers before the dash are points, the

numbers after the dash are in ticks (32nds of a point), and the numbers after the colons are eighths of a tick.

27 From the model’s perspective, the TBA pool has the aggregate average for specific attributes (average loan balance, LTV, FICO,

etc.). As noted, however, credit-related stories that were valid during the refinance wave of 2003 have turned around since then, withlow-FICO and high-LTV pools prepaying faster than the overall aggregate averages.


25/31



Figure 23 shows the seasoning ramps by loan size category in 2005. The ramp for

LLB is below that for the overall aggregate average, graphically showing the

prepayment advantage. Further, the slope for LLB is gentler than the aggregate

average. The differential between the two ramps is increasing and peaks at about

10%–12% CPR CPR around 12–15 months before narrowing to a long-term

differential of about 5%–8% CPR. The difference in the seasoning ramp for LLB

adds extra value beyond what our prepayment model predicts based on the pure loan

balance effect alone. That extra value is recognized when we inform the model of thelower WALA as well.

28

Figure 23. Seasoning Ramps for In-the-Money Pools (0bp–100bp) by Loan Size Category

0

5

10

15

20

25

30

35

0 6 12 18 24 30 36

Age (Months)

C

P R ( % )

LLB MLB All


Using Yield Book affords a better understanding of the effects of interactions

between security attributes. Figure 24 shows the waterfall of specified attributes

layered on top of each other. Each subsequent line represents the addition of thatspecified attribute to the previous ones. For example, the second line shows the value

added by having a loan balance of $65,000 instead of the generic TBA average of

$167,000. The next line shows a pool with a loan balance of $65,000 that is also

100% investor properties. We listed specified attributes in the order of their

individual value from Figure 21, while removing inconsistent values.29

28 Simply put, a LLB pool with a WALA of less than 3 is worth more than a LLB with a WALA of 15.

29 For example, a pool cannot simultaneously have a low WAC (with a servicing spread of 25bp) and the high-servicing-spread

characteristic of credit-impaired pools (100bp).


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Figure 24. Theoretical Prices and Implied Pay-ups for a Waterfall of Specified Attributes

Specified

Pool

Specified

Attribute

Specified

Value

Theoretical

Price

Implied

Pay-Up WAL

One-Year

CPR (%)

Long-Term

CPR (%)

Effective

Duration

Effective

Convexity

Option

Cost (bp)

Z-Spread

(bp)

TBA NA NA 102-04 NA 4.0 29.0 20.9 1.88 -2.78 98 85


Investor Inv Property Pct. 100% 103-16:3 44:3 5.0 21.0 16.7 2.69 -2.08 74 61

Low FICO FICO 600 103-15:6 43:6 4.9 21.7 17.2 2.70 -2.02 73 60

Low WAC Servicing Spread 25bp 103-25:2 53:2 5.5 18.3 14.9 2.82 -2.06 73 60

Low WALA WALA 0 Mo. 104-02:3 62:3 6.4 11.4 12.8 3.23 -2.00 77 64

High LTV LTV 90% 104-07:2 67:2 6.5 12.0 12.4 3.23 -2.11 75 62

Best Combination Loan Size, Inv. Prop.Pct., Low WAC,Low WALA

NA 104-11 71:0 6.9 7.7 11.7 3.49 -1.84 76 63

NA Not applicable.

Source: Citigroup.

The last line shows the “best combination,” which is the combination of attributes

that provides the largest implied pay-up. The attributes are LLB and 100% investor

properties, combined with low WALA and low WAC (servicing spread). A low FICO

and/or high LTV actually make prepayments faster, reducing the implied pay-up.

If the implied pay-ups seem too high compared with current market pay-ups, that’s

because they are. In general, market pay-ups not are as high as theoretical pay-ups,because there is uncertainty regarding the recovery of the pay-up. Most importantly,

the prepayment model can be wrong. The difference in speeds predicted by the

model may not materialize.

Beyond model projection errors, market conditions can change to make the

differential in prepayment speeds less than expected or less relevant from a relative

value perspective. The recovery period for a specified pay-up can be many months,

potentially stretching into years. Over this time frame, rates can change, turning a

premium coupon pool into a discount coupon pool, at which point the prepayment

protection can cease to exist.

Also, the roll could become “special.” A roll is considered special when the drop is

trading above carry. In other words, an investor selling into a dollar roll would pay

less to repurchase the TBA in the back month than indicated by the current market

financing rate and the market’s consensus for prepayments. Rolls usually become

special because of technical factors, such as supply shortages or heightened demand

for collateral for CMOs. When rolls are special, the value of specified pools declines

because investors can earn additional carry via the roll. Moreover, because the back

month price is determined at the time of the roll, the carry is locked in.30

Because the theoretical prices given by the model are often different (usually higher)

compared with market pay-ups, effective durations can differ from observed market

durations. In particular, model LLB effective durations are often substantially longer

than durations implied by market price moves. Investors hedging specified poolssometimes pick a duration between that of the TBA and the duration given by a

model for the specified pool. For example, if the implied pay-up is 20 ticks and the

market pay-up is 10 ticks, an investor might use a duration that is midway between

30 Investors can earn additional carry via the roll when it is special. For example, if the drop is trading 2 ticks above carry, the

investor is paying 2 ticks less than breakeven for the repurchase in the back month (i.e., earning 2 ticks of additional carry). Theinvestor must then choose between guaranteed carry for as long as the roll remains special and the carry advantage from specifiedprepayment protection, which may last longer but is not guaranteed.


27/31



the model durations for the TBA and specified pool for hedging purposes.

Alternatively, an investor might use an “empirical” duration, estimating the duration

of the specified pool based on recent rate and price movements in the market.

Comparison of Carry and OAS Valuations

Which method of assessing the relative value advantage of specified pools is more

accurate? Carry-based relative values are easy to understand but assume that the

environment doesn’t change. Because OAS models average valuations over a

spectrum of interest rate paths, this method has the advantage of taking into account

changing rates, but it is also very model dependent. OAS valuations are only as

accurate as the prepayment model projections.

Further, an OAS model is in some ways a “black box” — it is not always obvious

where the value of the specified pool is coming from (in other words, it can be

difficult to know how much certain rate scenarios are contributing to the theoretical

price and implied pay-up without additional analysis). Neither method accounts for

the loss of liquidity when moving from TBA to a specified pool (and the potential

loss of advantageous roll opportunities). Figure 25 provides a summary comparisonof the carry-based and OAS-based valuation methods.

Figure 25. Comparison of Valuation Methods

Criteria Carry-Based OAS-Based

Pricing Assumption Constant pay-up/price TBA OAS

Prepayment Projection Requirements Need near-term prepayment projections. Need prepayment model.

Advantages Simple and intuitive — only need near-term prepayment projections and cancompute “breakeven” number ofmonths for earning back specified poolpay-up.

Accounts for changing rates viachanging prepayment modelprojections and logical from atheoretical perspective.

Disadvantages Assumes stable rates, so ignores how

specified pool advantage may beaffected by rate moves.

Dependent on having prepayment model

and OAS model, and not clear thatapplying the TBA OAS to the specifiedpool is correct.

Source: Citigroup.

Scenario Analysis — What If Rates Move?

Looking at multiple interest rate shift scenarios can be useful for both the carry-

based and OAS-based approaches. In the case of carry-based valuation, rate shift

scenarios provide an illustration of the impact of rate moves that is missing from the

traditional base case carry analysis. In the case of OAS-based valuation, rate shift

scenarios should reveal where the value of the specified pool comes from. As an

illustration of the use of scenario analysis, Figure 26 shows projected prices for LLBand TBA conventional 6.00% pools in a range of interest rate scenarios, along with

price differences. The differences can be thought of as theoretical specified pool pay-

ups to TBA.


28/31



Figure 26. LLB and TBA 6.00% Pools Constant OAS Immediate Rate Shift Scenario Projected Prices andDifferences, 13 Sep 05 Close

Scenario -300bp -200bp -100bp 0bp +100bp +200bp +300bp

FN 6.00% LLB 106-00 105-11 104-30 103-11 99-23 94-31 89-24

TBA 103-28 103-00 102-22 102-04 99-01 94-19 89-19

Difference 2-04 2-11 2-08 1-07 0-23 0-12 0-05

Source: Citigroup.

The scenario pay-ups are as one might expect. Because LLB provides protectionagainst refinancings, the relative value of LLB collateral generally increases as rates

decline and refinancings increase. In other words, the bulk of the value of LLB

comes from rate rally scenarios.31

However, although rallies tend to enhance the value of LLB, the LLB advantage

reaches a maximum in the -200bp scenario. In this scenario, TBA 6.00% pools are so

far in the money that further drops in rates have little impact on projected speeds.32 In

contrast, speeds of LLB 6.00% pools, which are at lower levels than TBA speeds, can

continue to increase as rates decline. (Figure 27 shows projected scenario speeds.) As

a result, the speed advantage of LLB 6.00% pools can be seen to decline as rates

decline from the -200bp to -300bp scenario, and the implied pay-up follows suit.

Figure 27. LLB and TBA 6.00% Pools Immediate Rate Shift Scenario Projected Long-Term Projected CPRs (%),13 Sep 05 Close

Scenario -300bp -200bp -100bp 0bp +100bp +200bp +300bp

FN 6.00% LLB 53.4 45.9 31.3 17.2 10.4 8.4 7.6

TBA 72.9 71.3 52.2 20.9 10.4 8.5 7.7

Difference -19.5 -25.4 -20.9 -3.7 0.0 -0.1 -0.1

Source: Citigroup.

31 It follows that an investor who believes rates will increase would tend to value LLB less than others who do not have a view on

rates or expect rates to fall.

32 At this point, speeds have essentially reached their maximum level. See Anatomy of Prepayments — The Citigroup Prepayment

Model, Citigroup, March 2004.


29/31



IV. Conclusion

Specified pool trading has long been an important sector of the mortgage market. In

the 1990s, seasoned collateral was actively traded. In recent years, loan size has

tended to dominate specified pool trading, but, as described in this paper, many other

collateral characteristics have been identified as providing added value to investors.There is good reason to believe future opportunities in specified pools will arise:

1 Interest in specified pools naturally grew after the agencies increased their pool

level disclosures in 2003. Freddie Mac recently announced that it would begin

providing loan level data for its newly issued pools in the near future. This more

detailed data may provide additional ways in which to identify value; for

example, non-third-party originations and condominiums might exhibit favorable

prepayment behavior.

2 In recent months, there have not been many dollar roll opportunities. Less value

in rolls translates into greater value in specified pools.

3 Changing market conditions, such as a weakening of the currently stronghousing market, may result in changes in the prepayment behavior of certain

specified categories, leading to investment opportunities. For example, high-

LTV and low-FICO collateral has been prepaying relatively fast as these less

affluent, highly-leveraged borrowers take advantage of strong home price

appreciation. However, if home appreciation weakens significantly, this

collateral will likely slow substantially, possibly creating opportunities in high-

LTV/low-FICO premium coupons.


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Disclaimer

This communication is issued by a member of the sales and trading department ofCitigroup Global Markets Inc. or one of its affiliates (collectively, “Citi”). Sales and tradingdepartment personnel are not research analysts, and the information in thiscommunication (“Communication”) is not intended to constitute “research” as that term isdefined by applicable regulations. Unless otherwise indicated, any reference to aresearch report or research recommendation is not intended to represent the wholereport and is not in itself considered a recommendation or research report. All views,opinions and estimates expressed in this Communication (i) may change without notice

and (ii) may differ from those views, opinions and estimates held or expressed by Citi orother Citi personnel.

This Communication is provided for information and discussion purposes only. Unlessotherwise indicated, it does not constitute an offer or solicitation to purchase or sell anyfinancial instruments or other products and is not intended as an official confirmation ofany transaction. Unless otherwise expressly indicated, this Communication does nottake into account the investment objectives or financial situation of any particular person.Recipients of this Communication should obtain advice based on their own individualcircumstances from their own tax, financial, legal and other advisors before making aninvestment decision, and only make such decisions on the basis of the investor's ownobjectives, experience and resources. The information contained in this Communication

is based on generally available information and, although obtained from sourcesbelieved by Citi to be reliable, its accuracy and completeness cannot be assured, andsuch information may be incomplete or condensed.

Citi often acts as an issuer of financial instruments and other products, acts as a marketmaker and trades as principal in many different financial instruments and other products,and can be expected to perform or seek to perform investment banking and otherservices for the issuer of such financial instruments or other products.

The author of this Communication may have discussed the information contained thereinwith others within or outside Citi and the author and/or such other Citi personnel mayhave already acted on the basis of this information (including by trading for Citi's

proprietary accounts or communicating the information contained herein to othercustomers of Citi). Citi, Citi's personnel (including those with whom the author may haveconsulted in the preparation of this communication), and other customers of Citi may belong or short the financial instruments or other products referred to in thisCommunication, may have acquired such positions at prices and market conditions thatare no longer available, and may have interests different from or adverse to yourinterests.


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Investments in financial instruments or other products carry significant risk, including thepossible loss of the principal amount invested. Financial instruments or other productsdenominated in a foreign currency are subject to exchange rate fluctuations, which mayhave an adverse effect on the price or value of an investment in such products. Noliability is accepted by Citi for any loss (whether direct, indirect or consequential) thatmay arise from any use of the information contained in or derived from this

Communication.

Past performance is not a guarantee or indication of future results. Any prices providedin this Communication (other than those that are identified as being historical) areindicative only and do not represent firm quotes as to either price or size. You shouldcontact your local representative directly if you are interested in buying or selling anyfinancial instrument or other product or pursuing any trading strategy that may bementioned in this Communication.

Although Citibank, N.A. (together with its subsidiaries and branches worldwide,"Citibank") is an affiliate of Citi, you should be aware that none of the financialinstruments or other products mentioned in this Communication (unless expressly stated

otherwise) are (i) insured by the Federal Deposit Insurance Corporation or any othergovernmental authority, or (ii) deposits or other obligations of, or guaranteed by, Citibankor any other insured depository institution.

IRS Circular 230 Disc losure: Citi and its employees are not in the business ofproviding, and do not provide, tax or legal advice to any taxpayer outside of Citi. Anystatements in this Communication to tax matters were not intended or written to be used,and cannot be used or relied upon, by any taxpayer for the purpose of avoiding taxpenalties. Any such taxpayer should seek advice based on the taxpayer’s particularcircumstances from an independent tax advisor.

© 2011 Citigroup Global Markets Inc. Member SIPC. All rights reserved. Citi and ArcDesign are trademarks and service marks of Citigroup Inc. or its affiliates and are usedand registered throughout the world.

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