S T R I C TL Y P R I V A T E AN D C O N F I D E N T I A L

JPMORGAN MBS PRIMER

MBS
JUNE 2006
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M B S

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JP M O R G AN

MBS
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

P RIM E R

Case Studies 99

ARMs 110
M B S
JP M O R G AN

CMOs 116

MBS Index 163 MBS 1

 Agency MBS market composition and issuance

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

Hybrid ARM 1/1 ARM

Hybrid ARM ($29.4 292
IO ($107.1 276
($229.5 217 211 231
billion) billion)
billion) 156
3% 1% 109 93
7%
Other Fixed
($157.2 -17
billion)
1998 1999 2000 2001 2002 2003 2004 2005 2006
5% Total = $__mm
Source: JPMorgan, FNMA, FHLMC, GNMA

15-year
O RI G I N AT I O N

Annual
Annual hybrid
hybrid ARM
ARM net
net issuance
issuance ($
($ billions)
billions)
($650 billion)
19%
30-year
74 79
($2.2
trillion) 49 52

65% 13
10
AN D

-13 -11
-31
O V E RVI E W

1998 1999 2000 2001 2002 2003 2004 2005 2006

Total = $3.4 trillion
Source: JPMorgan, FNMA, FHLMC, GNMA Source: JPMorgan, FNMA, FHLMC, GNMA
MAR K E T

MBS 2
 MBS in the U.S. fixed income market

Overview Fixed
Fixed income
income market
market composition
composition
Overview
„ Largest US fixed income asset class

„ Many products to choose from within the MBS Asset-

backed Municipal
market
8% 9%
„ Agency fixed-rates and ARMs Money
„ Non-agency fixed-rates and ARMs (Jumbos, Alt- Market U.S.
14%
As) Treasury
17%
„ Whole loans
„ CMOs and other structured MBS
Fed Agencies
„ Superior liquidity
O RI G I N AT I O N

10%
„ The TBA market adds unique liquidity to MBS

„ MBS market often used to express duration and

curve views (due to its liquidity and size) Mortgage
Corporate Related
„ Agency fixed-rate pass-throughs is 34% of the 19% 23%
AN D

Lehman U.S. Aggregate Index (a benchmark of the

U.S. investment grade debt).
O V E RVI E W

Total = $25.9 trillion

Source: The Bond Market Association, as of March 2006
MAR K E T

MBS 3
 The mortgage market has surged, thanks to a strong housing
market and cash-out refis
1-4
1-4 Family
Family Mortgage
Mortgage Debt
Debt Outstanding
Outstanding ($
($ billions)
billions) 8,978
8,683
8,079

7,120

6,317

5,614
5,133
O RI G I N AT I O N
AN D
O V E RVI E W

2000 2001 2002 2003 2004 2005 2006

Source: Bond Market Association, Federal Reserve Board

MAR K E T

MBS 4
 The MBS market links borrowers and investors

Agencies Mortgage Loans MBS Pass-through

Securitization

Mortgage
MBS Dealers
lenders
O RI G I N AT I O N

Borrowers MBS Investors

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

„ Loans with similar characteristics are pooled together; loans are securitized

„ The investor has undivided ownership interest (the investor is entitled to the pro-rata share of interest and
O V E RVI E W

principal payments of the underlying loans)

„ A “pass-through” is the basic MBS structure

„ It passes the monthly principal and interest payments, minus a servicing spread, from a pool of mortgages to
MAR K E T

investors

MBS 5
 Origination: The Menu of Mortgages Has Expanded
ƒ Origination: production of new loans in primary market

ƒ Products

– Fixed-rate mortgages (30-year / 20-year / 15-year)

– Adjustable rate mortgages (Hybrid ARMs: 3/1, 5/1, 7/1, 10/1)
– Interest-Only
– MTAs; Option ARMs
– Other
O RI G I N AT I O N

ƒ Balloon mortgages (5-year / 7-year)

ƒ Prepayment penalty mortgages

ƒ “Conforming” balance loans

AN D

ƒ “Non-conforming” loans (Private label, Non-agencies)

O V E RVI E W

ƒ Jumbos and Alt-As

MAR K E T

MBS 6
 Understanding Mortgage Collateral : Borrower Credit
& Housing Leverage

Borrower Credit and Information

„ FICO Score – Historical Credit Use and Management
— Avg FICO Score for Jumbo Mortgages : ~730
— Avg FICO Score for Alt-A Mortgages : ~700
— Avg FICO Score for Subprime Mortgages : ~600
— Non-Linear Relationship Between FICO and Propensity to Default

„ Documentation
— Full vs. Limited/Reduced/No Doc
O RI G I N AT I O N

„ Leverage (Debt to Income Ratios)

„ Reserves : Staying Power in the event of financial trouble
AN D
O V E RVI E W
MAR K E T

MBS 7
 Understanding Collateral cont…

Housing Leverage
„ Loan-to-Value Ratio
— House Value / Mortgage Amount

— Higher LTV Æ Less Equity Protection for the Mortgage Investor Æ Higher Risk

„ Occupancy
— Owner Occupied – Borrower Lives in the Property (Most Secure)
— Second Home – Borrower has personal ties to the property
— Investor – Business Decision on Economic Situation (Least Secure)
O RI G I N AT I O N

„ Property Type
— Single Family Property (Most Secure)
— Condos
— Multi-Family
AN D
O V E RVI E W
MAR K E T

MBS 8
 Conforming loan limits rose by 16%, reaching $417,000 in 2006

Conforming
Conforming Limits
Limits ($’000)
($’000)

450

Conforming loan
400 limit for 2006

350

300
O RI G I N AT I O N

250

200
AN D

150
O V E RVI E W

1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: FHFB, JPMorgan

MAR K E T

MBS 9
 Origination channels
ƒ $3.0 trillion origination volume in
2005 ƒ Top 5 mortgage banking companies
account for over 48% of all new
ƒ Retail (42%) - loan officer employed by
origination volume
mortgage banking company; mortgage loan
is closed in the name of the lender
1. Countrywide
ƒ Broker (34%) – mortgage loan broker 2. Wells Fargo
represents borrower to lending institution;
3. Washington Mutual
mortgage loan is closed in the name of the
4. Chase Home Finance
O RI G I N AT I O N

lender
5. CitiMortgage
ƒ Correspondent (24%) – independent Source: National Mortgage News, as of Q1 2006
mortgage banking company; mortgage loan
is closed in “ABC” Mortgages name and
sold to mortgage banker
AN D

ƒ Internet – mortgage loan originated and

O V E RVI E W

funded by mortgage banking company

through website
MAR K E T

MBS 10
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

MBS 11
 Major MBS investors

MBS
MBS Investor
Investor Breakdown MBS
Breakdown MBS Investors
Investors ($
($ billion)
billion)
YE 2004 Mid-2005 % Chg
Dealer Personal Investor Type All MSRs Non-Agency All MSRs Non-Agency % of MSRs since 2004
REITs Inventory Sector Fannie Mae/Freddie Mac $ 1,261 $ 267 $ 1,192 $ 363 26% -5%
2% 1% 6% FDIC Commercial Banks $ 876 $ 124 $ 913 $ 158 20% 4%
Life Insurance Cos. $ 465 N.A. $ 480 $ 150 10% 3%
Finance
Foreign Investors $ 280 $ 30 $ 400 $ 50 9% 43%
Companies
Agencies Mutual Funds $ 318 N.A. $ 325 N.A. 7% 2%
2% Personal Sector $ 270 N.A. $ 290 N.A. 6% 7%
29%
Pension Public Pension Funds $ 270 N.A. $ 275 N.A. 6% 2%
Funds All Thrifts $ 234 $ 7 $ 228 $ 6 5% -3%
9% Priv. Pension Funds $ 125 $ 13 $ 128 $ 15 3% 2%
FHLBanks $ 113 $ 71 $ 117 $ 71 3% 3%
REITs $ 95 $ 50 $ 105 $ 60 2% 11%
Mutual Funds
Finance Companies $ 85 N.A. $ 88 N.A. 2% 4%
7% MBS Dealer Inventory $ 41 $ 15 $ 55 $ 20 1% 34%
Federal Credit Unions $ 28 N.A. $ 29 N.A. 1% 2%
Subtotal: $ 4,462 $ 577 $ 4,625 $ 893
Foreign All Other Investors* $ 317 $ 474
Investors Total Outstanding $ 4,779 $ 1,076 $ 5,098 $ 1,289

9% Banks
Insurance 25% Source: Inside MBS & ABS
Companies
10%

Total = $4.6 trillion

Source: Inside MBS & ABS
DEMAN D

MBS 12
 Foreign demand has dominated the mortgage market
over the past several years

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

250
Foreign GSE Bank
200

150

100

50

-50

-100

-150
2001 2002 2003 2004 2005 2006

Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan

* Foreign purchase data: March ’06, GSE: April ’06, Bank: May ‘06
DEMAN D

MBS 13
 Trends in bank demand

„ Bank holdings are still growing, but at a slower pace.

„ Some signs that bank demand could slow:

„ MBS holdings as a percentage of deposits have increased

„ C&I loan growth has picked up

„ But, there are mitigating factors:

„ Deposit rates have remained sticky

„ Unrealized losses are significant

„ Mortgages remain one of the few sectors that offers the size and
liquidity that large banks need
DEMAN D

MBS 14
 Large banks have been drawn to the mortgage market

Top
Top3 3Bank
BankHoldings
Holdingsasas%%ofofTotal
TotalBanks’
Banks’

40%
38%
36%
34%
32%
30%
28%
26%
24%
22%
20%
Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06

Source: Federal Reserve, JPMorgan

„ Large banks have enjoyed the liquidity of the mortgage market for large trades,
and average trade size has increased significantly.

„ Diversification and movement away from credit risk have been themes, but could
DEMAN D

shift if mortgages remain tight.

MBS 15
 Top 10 banks ranked by MBS portfolios as of 1Q 2006

Bank Holding Company Total MBS Change Pass-through Change CMO Change
BANK OF AMERICA CORPORATION 212,273,791 15,121,205 206,670,221 15,808,550 5,603,570 -687,345
WACHOVIA CORPORATION 94,293,000 3,173,000 78,527,000 2,338,000 15,766,000 835,000
JPMORGAN CHASE & CO 41,644,000 18,775,000 40,354,000 18,633,000 1,290,000 142,000
WELLS FARGO & COMPANY 40,042,000 7,676,000 33,969,000 8,729,000 6,073,000 -1,053,000
US BANCORP 35,975,000 -1,547,000 22,928,000 -576,000 13,047,000 -971,000
CITIZENS FINANCIAL GROUP INC 31,828,058 1,087,257 11,429,339 176,681 20,398,719 910,576
BANK OF NEW YORK COMPANY INC 22,671,000 189,000 2,908,000 -129,000 19,763,000 318,000
COMMERCE BANCORP INC 20,908,478 1,076,917 3,651,529 104,519 17,256,949 972,398
STATE STREET CORPORATION 20,252,615 581,874 6,324,590 -626,064 13,928,025 1,207,938
SUNTRUST BANKS INC 17,287,171 264,477 11,580,470 -159,294 5,706,701 423,771

·The top 10 banks account for over 58% of all bank MBS holdings.

Source: Federal Reserve, JPMorgan

DEMAN D

MBS 16
 Bank MBS holdings continue to grow

MBS
MBS Holdings
Holdings of
of Large
Large Banks
Banks ($
($ billions)
billions)

650

600

550

500

450

400

350

300

250

200
May-99 May-00 May-01 May-02 May-03 May-04 May-05 May-06

Source: Federal Reserve

DEMAN D

MBS 17
 Security purchases and C&I loan growth has typically been inversely
correlated

MBS
MBS and
and C&I
C&I Holdings
Holdings (Annual
(Annual changes
changes since
since 2000)
2000)

15%

10%
C&I Annual % Chg

5%

0%

-5%

-10%
R2 = 0.6155
-15%
-5% 0% 5% 10% 15% 20% 25% 30% 35%

MBS Annual % Chg

Source: Federal Reserve, JPMorgan

DEMAN D

MBS 18
 With many bank positions underwater,
it is unlikely that there will be large selling

150 20
Quarterly Changes in Security Holdings
Unrealized Gains/Losses 15
Changes in securities holdings ($bn)

100

Unrealized gains/losses ($bn)

10

5
50

0
(5)

(10)
(50)
Banks did not sell amid losses in 2000… (15)
… While most bank sales have occurred amid
gains
(100) (20)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
DEMAN D

MBS 19
 The GSEs

• Fannie Mae

• Freddie Mac

• Ginnie Mae

• FHLBs – the MPF and MPP programs

• GNMA pools are backed by FHA/VA loans which are government insured.
These pools have an explicit U.S. government guarantee and a zero risk-
capital weighting.

• FNMA and FHLMC pools are backed by conventional conforming loans, have an
implicit U.S. government guarantee, and a 20% risk-capital weighting. Single-
family loan limit is $359,650 in 2005.
DEMAN D

MBS 20
 Unique role of GSEs: issuer / investor

ƒ Mission is to facilitate secondary mortgage market in U.S. which provides

steady flow of low cost mortgage funds

ƒ Issue agency debt

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

ƒ Large portfolios (FN + FH hold over $1.4 trillion loans and MBS) demand active
hedging via swap and swaption markets
DEMAN D

MBS 21
 Agency portfolio growth has slowed

Retained
Retained Portfolio
Portfolio ($
($ billions)
billions)

1000
FNMA Portfolio FHLMC Portfolio

900

800

700

600

500

400

300
Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06

Source: FNMA, FHLMC, JPMorgan

DEMAN D

MBS 22
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S
JP M O R G AN

CMOs 116

MBS Index 163

MBS 23
 MBS Terminology

ƒ Pools are comprised of mortgage loans with similar rates and terms

ƒ WAC – weighted average coupon of all loans in pool (vs Coupon)

P R E P AY M E N T S

ƒ WAM – weighted average maturity of loans in pool

ƒ WALA – weighted average loan age

ƒ Original face – original principal amount of pool

T O
I N T R O

ƒ Current face – remaining principal balance of pool

A N D

ƒ Origination year – average origination year of loans in pool; age (WALA) is important in prepayment
assessment (“seasoning”)
C A S H F L O W S

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

M O R T G AG E

MBS 24
 Mortgage cash-flow characteristics

Homeowner's August After processing, security

payment due holders receive shares of
(in arrears) August payment
P R E P AY M E N T S

FHLMC FNMA
14th 24th

August 1st September 1st October 1st

T O

30 days in arrears 14 to 24 days processing

I N T R O

44 to 54 day delay
A N D
C A S H F L O W S
M O R T G AG E

MBS 25
 Mortgage cash-flow
„ Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year
fixed-rate loan

„ Using “MP” function on BBG…

P R E P AY M E N T S
T O
I N T R O
A N D
C A S H F L O W S
M O R T G AG E

Source: Bloomberg

MBS 26
 Mortgage cash-flows: without prepayments
P R E P AY M E N T S

Interest
T O
I N T R O
A N D

Principal
C A S H F L O W S
M O R T G AG E

Source: Bloomberg

MBS 27
 Mortgage cash-flows: with prepayments
P R E P AY M E N T S

Interest
T O
I N T R O

Pre-paid
A N D

Principal
C A S H F L O W S

Principal
M O R T G AG E

Source: Bloomberg

MBS 28
 Prepayments: source of MBS optionality

ƒ 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
P R E P AY M E N T S

ƒ Valuing this call option and the cash flow uncertainty it creates is the key to
understanding MBS

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

T O

cash flows
I N T R O

ƒ Prepayment (Call) Risk vs extension risk

A N D
C A S H F L O W S
M O R T G AG E

MBS 29
 Determinants of prepayments

ƒ Prepayments can be for economic / non-economic reasons

ƒ Interest rate incentive
P R E P AY M E N T S

ƒ Yield curve shape: refi down the curve

ƒ WALA: mobility increases over time

T O

ƒ Seasonality: Summer months have the fastest speeds owing to school

I N T R O

vacation
A N D

ƒ “Burnout”: Remaining borrowers in a pool may be credit constrained

C A S H F L O W S

ƒ Cash-out refinancing: Take built-up equity out of the home

M O R T G AG E

ƒ Default: Shows as a prepayment in agency pools

MBS 30
 Prepayment standards
ƒ CPR – Constant Prepayment Rate – annualized percentage of remaining
principal prepaid

ƒ 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;
P R E P AY M E N T S

prepayment assumptions for pricing stated as linear multiples of PSA

schedule

14
T O

200 PSA
12
I N T R O

10

8
CPR (%)
A N D

100 PSA
6
C A S H F L O W S

0
0 10 20 Age 30 40 50
M O R T G AG E

MBS 31
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S
JP M O R G AN

CMOs 116

MBS Index 163

MBS 32
 Many Different Types of Spreads
ƒ Basic: static yield spread over a single point on the curve
ƒ “I” : spread to Treasury
ƒ “N” : spread to swaps

ƒ Intermediate: zero volatility yield curve spread

ƒ “Z” : spread to Treasury curve
ƒ “E” : spread to Libor/swap curve
Libor ZSpread on JPMorgan’s analytic reports.
ƒ Advanced
ƒ OAS : option-adjusted spread
O AS

ƒ LIBOR OAS
AND

ƒ Treasury OAS
VALUATI O N

MBS 33
 Yield analysis in the MBS market

„ Static Spread (Yield Spread): standard measure of incremental return over a single
benchmark Treasury
Î Compares MBS to single point on the yield curve, usually to the interpolated point
closest to the Weighted Average Life of the MBS
Î But MBS does not return principal in one lump sum but over many periods. A better
assumption would include multiple data points on the yield curve. Z Spread takes this
another step further.

„ Z Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly
forward rates derived from the current yield curve
Î More accurate for securities that return principal over many periods as opposed to
bullets
Î Still a static measure since it assumes that interest rates and MBS cashflows remain
constant
O AS
AND
VALUATI O N

MBS 34
 Evaluating pass-throughs: yield / average life
O AS
AND
VALUATI O N

Source: Bloomberg

MBS 35
 Prepayments and OAS

„ Prepayment issues:
Î Reinvestment risk:
n When rates decline and speeds increase the investor has to reinvest an increased
amount of principal at lower rates
o When rates increase and speeds decline, the investor has less cashflow to reinvest at
higher rates
Î Discount bonds: when rates decline, the benefit of earlier return of principal at par may
mitigate reinvestment risk
Î Premium bonds: when rates increase, the benefit of a larger outstanding principal
balance and longer average life means higher and more interest payments which may
mitigate the reinvestment risk

„ OAS has been derived to account for the dispersion and uncertainty
associated with this return of principal from MBS
O AS
AND
VALUATI O N

MBS 36
 OAS Calculation

„ To incorporate prepayment volatility in the valuation of MBS, we can

calculate a theoretical price for a given OAS
1. Hundreds of hypothetical interest rate paths are simulated
2. On each interest rate path the prepayment model is used to predict prepayment speeds and thus,
MBS cashflows
3. For each path, the present value of the projected cashflows are calculated using a specified spread,
s, which is added to the forward rates
4. Value of MBS = Average value of PV(s) over all simulated interest rate paths
= AVGPV(s) where s is OAS

„ To find OAS given market price:

1. Start with an initial estimate for OAS
2. Calculate AGVPV(s) and keep adjusting until AVGPV(s) = market price

„ Drawback of OAS:
1. The spread earned by the investor depends on the actual path realized and can be drastically
different from the OAS
2. Wide differences in OASs are produced by different firms models due to different term structures,
volatility assumptions and prepayment projections
O AS

3. Doesn’t account for dollar roll financing

AND

4. Is a “black box” – difficult for investors to decompose OAS into its component parts.
VALUATI O N

MBS 37
 Pass-through risk measurement (duration)

ƒ Various measures of duration: % change in price for a 1% change in rates.

ƒ Modified duration is inappropriate for pass-throughs as it cannot

accommodate varying cash flows.

ƒ OAD is found by calculating constant OAS prices for parallel curve shifts.

ƒ Empirical duration uses actual observations regressed against a Treasury

benchmark. Directional/empiricals could be different against different
parts of the yield curve.

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

all.
O AS
AND
VALUATI O N

MBS 38
 Empirical durations

FN FN
FN 5.5
5.5 Empirical
Empirical Durations
Durations (using
(using 10-yr
10-yr Tsy;
Tsy; Dec.05
Dec.05 –– Jun.
Jun. 06)
FN 6
6 Empirical
Empirical Durations
Durations (using
(using 10-yr
10-yr Tsy;
Tsy; Dec.05
Dec.05 –– Jun.
Jun. 06)
06) 06)

FN 6 FN 5.5

y = -4.8009x + 0.0056
1.0 y = -3.3453x + 0.0015 1.0
R 2 = 0.8927
R 2 = 0.8266 0.5

% Px C hg
0.5
% Px C hg

0.0
0.0 -0.5
-0.5 -1.0
-0.15 -0.10 -0.05 0.00 0.05 0.10 -0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%) Yield Chg (%)

Source: JPMorgan Source: JPMorgan

O AS
AND
VALUATI O N

MBS 39
 Rates have little effect on OAS

FN FN
FN 5.5
5.5 OAS
OAS vs
vs rates
rates (using
(using 10-yr
10-yr Tsy;
Tsy; Dec.05
Dec.05 –– Jun.
Jun. 06)
FN 6
6 OAS
OAS vs
vs rates
rates (using
(using 10-yr
10-yr Tsy;
Tsy; Dec.05
Dec.05 –– Jun.
Jun. 06)
06) 06)

FN 6 FN 5.5
y = 6.455x - 0.0508
R 2 = 0.0713
4.0 y = -2.2723x - 0.0758 4.0

OAS Chg (bps)

OAS Chg (bps)

2.0 R 2 = 0.0079 2.0

0.0 0.0
-2.0 -2.0
-4.0 -4.0
-0.15 -0.10 -0.05 0.00 0.05 0.10 -0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%) Yield Chg (%)

Source: JPMorgan Source: JPMorgan

O AS
AND
VALUATI O N

MBS 40
 Pass-through risk measurement (convexity)

ƒ 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.
O AS
AND
VALUATI O N

MBS 41
 Negative convexity of mortgages

FN
FN 6
6 prices
prices ($)
($) vs
vs shift
shift in
in rates
rates (bps)
(bps)
105

100

95
FN 6 Px ($)

90

85
O AS

80
AND

-300 -225 -150 -75 0 75 150 225 300

Bps
Source: JPMorgan
VALUATI O N

MBS 42
 Mortgages have embedded options – valuation needs to
incorporate vol

ƒ Homeowners have the right to prepay at any time during the life of the mortgage

ƒ Consequently, an MBS investor is short many options to the homeowner:

Underlying
Short Long
Short 1m x 1y 1m x 10y
Option
Long 5m x 1y 5m x 10y

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

ƒ Higher vol should cause mortgages to cheapen

FN 30 Vega FN15 Vega

5.0 -0.21 4.5 -0.091
O AS

5.5 -0.26 5.0 -0.123

6.0 -0.27 5.5 -0.145
AND

6.5 -0.23 6.0 -0.111

VALUATI O N

Source: JPMorgan

MBS 43
 Mortgage efficiency of pricing in changes in implied vol
has been increasing

Correlation of 1-week change in current coupon ZV spread and 3x7 swaption premium, rolling
six-month window

1.0

0.8
0.6

0.4
0.2

0.0
(0.2)
O AS

(0.4)
AND

(0.6)
VALUATI O N

97 98 99 00 01 02 03 04 05 06
Source: JPMorgan

MBS 44
 Changes in mortgage market duration can impact the
rates markets

The rate of extension of the mortgage A sell-off could cause the curve to
market will slow in a sell-off steepen
Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in rates Change in 10-year equivalents for the mortgage market across the curve for a parallel +50 rate
shock

400 200
Change in 10-yr equivs ($bn)

200
150

10-year Equiv ($bn)

0

-200
100

-400 50
-600
0
-800
O AS

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

Rate change (bp) 2 5 Tenor 10 30
AND
VALUATI O N

MBS 45
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

MBS 46
 A closer look at turnover

„ Existing Home Sales (EHS)

„ Strong Lock-in

„ Seasonality and Calendar Effect

„ Cumulative Home Appreciation (CHPA)

„ Overall Shorter Baseline Ramp:

„ Interaction between EHS, CHPA, Lock-in and Aging Ramp successfully

R E P O R T S

captures periods of apparent shorter and longer ramps

„ In effect lower CHPA lengthens the ramp
„ Lock-in also lengthens the apparent ramp
AN D
AN AL Y SI S
P R EP AY M EN T S

MBS 47
 Home price appreciation and discount speeds have
been highly correlated…

„ 87% correlation between discount speeds and the housing strength now
„ … in the weaker housing environment of 2000, there was no correlation.

Discount Speeds by State (Last 12 mo.) versus HPI in 2005 14 Discount Speeds by State vs. HPI in 2000

14
13
13 AZ
12
12
CA
11
R E P O R T S

11

1-year CPR, %
VA FL 10
MD
1-year CPR, %

10 NJ AZ
MA 9
9
8 TX FL CA
8
WA MI
7
AN D

7 MI PA MA
TX PA 6 VA
6
NY
OH NJ
AN AL Y SI S

5
5 OH MD NY
4 4
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Home Price Appreciation,% Home Price Appreciation, %
P R EP AY M EN T S

Notes: Deep discount: 75bps or more out of the money; balance weighted average 12-month CPR observed in the past year

MBS 48
 Seasoning ramps under different HPA assumptions

1.0
0.9
0.8
Turnover Multiplier

0.7
0.6
0.5
0.4
0.3
R E P O R T S

0.2
0.1
0.0
1 11 21 31 41 51 61 71 81 91 101 111
AN D

WALA
AN AL Y SI S

0pct hpa 1pct hpa 4pct hpa 8pct hpa

P R EP AY M EN T S

Source: JPMorgan

MBS 49
 Turnover (cont’d)
Lock-in (disincentive to move)
„ Captures the relationship between
turnover and refinancing
“disincentive”
Lock-in (long WAM)
„ Strong Lock-in. However, home price 1
appreciation can strongly mitigate 0.9
lock-in
0.8

Multiplier
0.7
R E P O R T S

0.6

0.5
AN D

0.4
AN AL Y SI S

0.3
1 1.1 1.2 1.3 1.4 1.5 1.6

MtgRate/WAC
P R EP AY M EN T S

MBS 50
 Turnover (cont’d)

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

„ School schedules and weather conditions are

the main reasons for seasonal behavior 1.6

„ There is also a separate “day count” 1.4

adjustment to account for different collection
days in each month
1.2

1.0
R E P O R T S

0.8
AN D

0.6
AN AL Y SI S

0.4

0.2
P R EP AY M EN T S

0.0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

MBS 51
 Economics of refinancing

• CATO (curve at origination) – borrowers who take out a 30-year mortgage in a steep curve
environment are likely to exhibit slow turnover

• SATO (spread at origination) – high mortgage rates relative to prevailing rates at origination
indicate credit impairment. These borrowers are less likely to refinance

• Loan size – with similar fixed costs for refinancing, borrowers with larger loan sizes are more
likely to refi
R E P O R T S

• Home price appreciation – higher HPA allows borrowers to “cash-out refi”, or may allow some
AN D

borrowers to “cure” and obtain a better mortgage rate with A lower LTV
AN AL Y SI S

• Mortgage banking capacity – in large refi waves mortgage bankers may become inundated
with supply, causing mortgage spreads to widen
P R EP AY M EN T S

MBS 52
 The Refinancing Index

Seasonally-adjusted
Seasonally-adjusted refinancing
refinancing index
index

12,000

10,000

8,000

6,000
R E P O R T S

4,000
AN D

2,000
AN AL Y SI S

0
Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06
P R EP AY M EN T S

Source: MBAA

MBS 53
 P R EP AY M EN T S AN AL Y SI S AN D R E P O R T S

Burnout Multiplier
Burnout

Source: JPMorgan
0
0.2
0.4
0.6
0.8
1
1.2
10
30
50
70
90
11
0
13
0
15
0
17
0
19
0
21
0
23
0
25
0
27
0
29
0
31
0
Cum ulative Incentive (bps)

33
0
35
0
37
0
39
0
41
0
43
0
45
0
47
0
49
0
MBS
54
 Primary differences between GNMA and conventional
pools

Characteristic Conventional GNMA I GNMA II

Assumable No Yes
Pass-through rate 25 to 250bps below loan rate 50bps below 50 to 150bps below loan rate
Guarantee fee Negotiated (10 to 25bps) 6bps 6bps
Servicing fee 25bps minimum 44bps 44bps minimum
Mortgage insurance LTVs worse than 80% Mandatory Mandatory
Excess servicing Allowed Not allowed Allowed
Buy-ups/-downs Allowed Not allowed 10% buy-down allowed
Delay days 24 for FNMA, 14 for Golds 14 days 19 days
R E P O R T S

Prepayment reports Fifth business day Fifth business day Seventh business day

Revised GNMA II pooling guidelines came into effect July 1, 2003.

AN D
AN AL Y SI S
P R EP AY M EN T S

Source: JPMorgan, FNMA, FHLMC, GNMA

MBS 55
 GNMA prepayments

ƒRefinancing into conventionals

ƒServicer buy-out
R E P O R T S

ƒHigher delinquencies
AN D

ƒRolling 90-days delinquent with only one missing payment;

AN AL Y SI S

changed in 2003 to 90-days delinquent

P R EP AY M EN T S

MBS 56
 GNMA delinquencies

14
Conventional (Prime) VA FHA
12
Total Past Due (%)

10

8
R E P O R T S

4
AN D

2
Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05
AN AL Y SI S
P R EP AY M EN T S

Source: JPMorgan, MBA

MBS 57
 Prepayment reports: speeds by origination year
R E P O R T S
AN D
AN AL Y SI S
P R EP AY M EN T S

Source: JPMorgan

MBS 58
 Prepayment reports: speeds by WALA
R E P O R T S
AN D
AN AL Y SI S
P R EP AY M EN T S

Source: JPMorgan

MBS 59
 Prepayment reports: speeds by servicer
R E P O R T S
AN D
AN AL Y SI S
P R EP AY M EN T S

Source: JPMorgan

MBS 60
 P R EP AY M EN T S AN AL Y SI S AN D R E P O R T S

Source: JPMorgan
Prepayment expectations

MBS
61
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

MBS 62
 TBA pass-through market
ƒ TBA = “To Be Announced”. Essentially, a cheapest-to-deliver market (like a futures
contract). Most liquid market.
ƒ As with other delayed delivery transactions, a seller agrees to issue a TBA security at a future date.
However, in a TBA trade, the seller and the buyer do not identify the specific underlying mortgage pools,
simply certain pre-specified terms

ƒ TBAs are identified by agency, term, coupon, settle month, and traded on a dollar-price basis
ƒ “Cheapest-to-deliver” gives the seller a delivery option that the buyer is short

ƒ Standardized delivery dates (see Bloomberg TDAT).

ƒ Settles once a month like a futures contract

P O O L S

ƒ Delivering pools: seller must provide pool information by 3 p.m. 2 business days prior to
S P EC I F I E D

settlement (48-hour day).

ƒ Variance: the amount by which the face value at delivery can vary from the amount
AN D

specified at the time of the trade, expressed as a percentage of the initial face value
requested. The Bond Market Association suggests 0% variance on all TBA trades
M AR KE T
TB A

MBS 63
 TB A M AR KE T AN D S P EC I F I E D P O O L S

Bloomberg Generic TBA Tickers

MBS
64
 Dollar rolls

ƒ Dollar rolls are transactions where an institution sells mortgage

backed securities with a commitment to buy similar, but not identical,
mortgage backed securities on a future date at a lower price.

ƒ In the case of mortgage pass-throughs, “similar” securities refers to

securities with the same coupon, security type, and mortgage
collateral.
P O O L S

ƒ Dollar rolls offer an attractive means of borrowing at a low cost

S P EC I F I E D

primarily because they allow dealers to cover their short positions.

AN D

ƒ Dollar rolls offer dealers a convenient way to obtain promised

M AR KE T

mortgage securities, avoiding the higher costs of failing to deliver.

TB A

MBS 65
 TBA transactions: evaluating dollar rolls

ƒDrop

ƒCoupon

ƒPrepayments
P O O L S

ƒDelivery optionality
S P EC I F I E D

ƒRe-investment rate
AN D
M AR KE T
TB A

MBS 66
 TBA transactions: evaluating dollar rolls
P O O L S
S P EC I F I E D
AN D
M AR KE T

Source: Bloomberg
TB A

MBS 67
 Roll Specialness

12
Current Coupon roll specialness (tks)

10 30-yr CC
15-yr CC
8

4
P O O L S

0
S P EC I F I E D

-2

-4
AN D

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

M AR KE T

Source: JPMorgan
TB A

MBS 68
 Price spreads influence coupon production

TBA 6.0% TBA 6.5%

Mortgage note rate (a) 6.88 6.88
Less agency guaranty fee (b) 0.15 0.15
Retained servicing spread (c) 0.25 0.25
Remaining note rate (a-b-c) 6.48 6.48
Excess servicing (a-b-c-e) 0.48 0.00
Buydown of Guaranty Fee (%) 0.00 0.03
Cost to buydown guaranty fee (d) 0.00 0.12
P O O L S

Desired MBS coupon (e) 6.00 6.50

Market price of MBS (f) 98.05 100.13
Adjustment to TBA price for low WAC (g) 0.00 0.03
S P EC I F I E D

Price adjusted for cost of buydown (f+g-d) 98.05 100.04

Value of excess servicing (h) 2.09 0.00
Price adjusted for servicing value (f+g+h) 100.14 100.04
AN D
M AR KE T

Note: Prices are for illustration purposes only

Source: JPMorgan
TB A

MBS 69
 The many dimensions of specified pools

„ WALA

„ FICO

„ Low WAC

„ Low loan balance (LLB)

„ Geographic

„ Prepayment penalty

„ Relocation
P O O L S

„ Originator

„ High LTV
S P EC I F I E D
AN D
M AR KE T
TB A

MBS 70
 Specified pools make up roughly 80% of the mortgage
market

Spec
Spec pool
pool market
market composition
composition

New
Specified
4% New TBA
20%

Seasoned
P O O L S

(>30 WALA)
49% Moderate
(13-30
S P EC I F I E D

WALA)
27%
AN D

Total = $2.814 trillion

Source: JPMorgan
M AR KE T

Data is as of May 2006

TB A

MBS 71
 New issue specified pools report
P O O L S
S P EC I F I E D
AN D
M AR KE T

Source: JPMorgan
TB A

MBS 72
 Seasoned specified pools report
P O O L S
S P EC I F I E D
AN D
M AR KE T

Source: JPMorgan
TB A

MBS 73
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

MBS 74
 Relative value strategies and analysis

Trading
Trading Strategies Evaluation
Strategies Evaluation Approaches
Approaches
Mortgage - Swap basis OAS
Mortgage - Tsy basis Spread
Coupon swap Hedge-Adj Carry
15s / 30s Regressions
Ginnie / Fannie Deliverable
TBA / Seasoned Sponsorship
Agency / Non-agency
Pass-through / ARM
T RADIN G

CMO / Collateral
VALU E
RELATIV E

MBS 75
 Where to find JPMorgan MBS data

Factor Where to find it

Supply Net supply MRV charts, Dataquery
Gross supply MRV charts, Daily Packet, Dataquery
Demand Banks Federal Reserve Website
JPM quarterly bank report

Agencies Fannie, Freddie website

Dealers Bloomberg (PDPPMORT <index>)

Non-US investors TIC data

Prepayments by WALA, servicer, etc. JPM Monthly Prepay Appendix
MorganMarkets.com
OAS TBAs Current
Specifieds, strips, hybrids, etc Daily packet
Coupon swap history Daily packet
Hedge adjusted carry Daily packet (soon)
Volatility swaption premiums, bp vol Daily packet, Dataquery
T RADIN G

Regression Historical OAS by relative coupon JPM trading bloomberg

Coupon swaps, butterflies MBS Analyzer
MBS Index/performance Performance by coupon vs swaps and Treasuries Index Monitor
Dataquery
VALU E

Daily packet TBA Performance Report

Dataquery
Other Analytics/historical data Daily packet
MBS Analyzer
RELATIV E

MBS 76
 Mortgages have widened back to the widest levels since
the beginning of the year – but are they fundamentally
cheap?

30-year current coupon OAS (bps)

60

50

40

30

20

10

0
T RADIN G

(10)

(20)
VALU E

(30)
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
RELATIV E

Source: JPMorgan

MBS 77
 Declining long-dated vol has caused nominal spreads
and OAS to diverge

OAS vs. CC ZV spread (bps)

„ Current coupon OAS has been 0
OAS ZV spread
80

relatively stable, while nominal (5)

70

spreads have continued to tighten (10)

60
recently … (15)

(20) 50
Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

3YX10Y swaption premium (bps)

„ … Declining long-dated vol has 475
465

3Yx10Y Swaption Premium (bps)

been the driver
T RADIN G

455
445
435
425
415
VALU E

405
395
385
RELATIV E

375
Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

Source: JPMorgan
MBS 78
 Mortgage / Swap basis
T RADIN G
VALU E
RELATIV E

MBS 79
 30- and 15-year current coupon OAS
T RADIN G
VALU E
RELATIV E

MBS 80
 MBS Fixed-Rate Daily Analytics
COB June 9, 2006
T RADIN G
VALU E
RELATIV E

MBS 81
 Hedge-adjusted carry

„ We introduce a hedge-adjusted carry methodology which provides a short-

term (1- to 2-month) measure of performance using rather
straightforward calculations

„ Option-adjusted spreads serve as a long-term spread measure and assume

vega hedging, among other risk measures

„ It serves as a good complement to OAS valuations, capturing the return

for taking duration and convexity risks

„ Essentially, hedge-adjusted carry gives us the net carry of holding a TBA

T RADIN G

after hedging for duration and adjusting for convexity hedging costs
VALU E

„ Higher carry could suggest overweighting certain coupons. However, this

valuation ignores other risks like vega and mortgage Libor spread
RELATIV E

MBS 82
 Hedge-adjusted carry components

„ The valuation incorporates factors such as the roll, hedge ratios, durations,

convexities. Specifically, the main components of the analysis are:

„ Swap Hedge Ratios (using partial durations).

„ Duration Hedged Carry

„ Total Negative Convexity

„ Convexity Hedging Cost

T RADIN G
VALU E
RELATIV E

MBS 83
 Hedge-adjusted carry components
„ We hedge three partial durations on the swap curve (2-yr, 5-yr and 10-yr) with the cost being the
carry and rolldown on each of the swaps

„ To figure out the duration adjusted carry we simply calculate:

„ Duration Hedged Carry= TBA roll – ∑(cost of swap hedge)
„ Cost of swap hedge = hedge ratio * swap carry

„ In calculating total convexity cost, we incorporate swap convexity since we are long MBS and short
swaps (which are positively convex)
„ Total Convexity = MBS convexity – swap convexity

„ We can estimate the convexity cost using short-dated swaption implied vols (1-month x 10-year
swaptions) ⎡⎛ bp ⎞ 1⎤
⎟⎟ ∗ (22days ) ∧ ⎥ ∧ 2 ∗ 32
1
∗ C ⎢⎜⎜
2 ⎣⎝ day ⎠ 2⎦

TBA Passthroughs - 30 Year Conventionals TBA Passthroughs - 30 Year Conventionals

Roll Dur Hedged Roll Dur Hedged Cnv. Hedging Hedge Adj.
(32nds) Carry (32nds) Carry Cost Carry
T RADIN G

Sec Price .. (32nds) Sec Price .. (32nds) (32nds) (32nds)

FN 30 4.5 91-00 1.25 .. 0.1 FN 30 4.5 91-00 1.25 .. 0.1 -0.7 -0.6
FN 30 5.0 93-29 1.87 .. 0.8 FN 30 5.0 93-29 1.87 .. 0.8 -1.1 -0.4
FN 30 5.5 96-12 2.25 .. 1.2 FN 30 5.5 96-12 2.25 .. 1.2 -1.6 -0.4
FN 30 6.0 98-25+ 3.00 .. 2.1 FN 30 6.0 98-25+ 3.00 .. 2.1 -1.9 0.3
VALU E

FN 30 6.5 100-29 3.25 .. 2.6 FN 30 6.5 100-29 3.25 .. 2.6 -2.1 0.4
FN 30 7.0 102-14+ 2.00 .. 1.5 FN 30 7.0 102-14+ 2.00 .. 1.5 -2.1 -0.6
RELATIV E

Source: JPMorgan (as of June 1, 2006)

MBS 84
 Hedge Adjusted Carry Report
New York J.P. Morgan Securities Inc.
Jun 05, 2006 MBS Research
(1-212) 834-3121
MBS Research m organm arkets.jpm organ.com
MBS Hedge Adjusted Carry
TBA Passthroughs - 30 Year Conventionals Settle Dates Spot = [Jun-13-2006], 1M = [Jul-13-2006], 2M = [Aug-14-2006]
Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry
(32nds) Hedge Ratio / Sw ap (32nds) Total (32nds) (32nds)
Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m
FN 30 4.5 91-21 1.25 2.25 6.0 -5 0.21 0.32 0.49 0.3 0.6 -1.2 -0.8 -1.6 -0.4 -1.0
FN 30 5.0 94-16+ 1.87 3.37 5.5 -6 0.28 0.33 0.42 1.0 1.8 -1.9 -1.2 -2.5 -0.2 -0.6
FN 30 5.5 96-29+ 2.12 4.12 4.8 -7 0.37 0.32 0.34 1.3 2.7 -2.4 -1.6 -3.2 -0.3 -0.5
FN 30 6.0 99-07+ 3.00 6.00 3.8 -9 0.49 0.25 0.23 2.4 4.9 -2.8 -1.8 -3.7 0.6 1.2
FN 30 6.5 101-05+ 3.25 6.50 2.9 -1 0.51 0.20 0.15 2.7 5.7 -3.2 -2.0 -4.2 0.7 1.5
FN 30 7.0 102-19 2.00 4.00 1.9 0 0.51 0.11 0.07 1.7 3.5 -2.9 -1.9 -3.9 -0.2 -0.4

TBA Passthroughs - GNMA I 30 Years Settle Dates Spot = [Jun-19-2006], 1M = [Jul-18-2006], 2M = [Aug-17-2006]
Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry
(32nds) Hedge Ratio / Sw ap (32nds) Total (32nds) (32nds)
Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m
GN 30 4.5 92-29 2.00 4.00 5.4 -6 0.24 0.30 0.42 1.2 2.6 -1.2 -0.7 -1.5 0.5 1.1
GN 30 5.0 95-26+ 2.00 4.00 5.2 -23 0.29 0.32 0.40 1.2 2.6 -1.8 -1.1 -2.3 0.1 0.3
GN 30 5.5 97-31 2.50 5.00 4.8 -20 0.37 0.32 0.34 1.8 3.8 -2.4 -1.5 -3.1 0.3 0.7
GN 30 6.0 100-06+ 2.50 5.00 3.7 -20 0.47 0.26 0.22 1.9 4.0 -2.9 -1.8 -3.7 0.2 0.3
GN 30 6.5 102-03 3.00 6.00 2.3 -21 0.50 0.17 0.09 2.7 5.5 -2.7 -1.7 -3.5 1.0 2.0
GN 30 7.0 103-14 0.00 0.00 1.4 -31 0.52 0.09 0.01 -0.2 -0.3 -2.3 -1.4 -3.0 -1.6 -3.2

TBA Passthroughs - 15 Year Conventionals Settle Dates Spot = [Jun-21-2006], 1M = [Jul-20-2006], 2M = [Aug-21-2006]
T RADIN G

Roll Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry
(32nds) Hedge Ratio / Sw ap (32nds) Total (32nds) (32nds)
Sec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2m
FN 15 4.0 93-00 0.50 1.00 4.3 -1 0.30 0.35 0.25 -0.1 -0.1 -1.0 -0.6 -1.3 -0.7 -1.3
FN 15 4.5 95-06+ 0.75 1.25 4.3 -15 0.34 0.35 0.25 0.1 0.2 -1.3 -0.8 -1.7 -0.7 -1.5
FN 15 5.0 97-01 1.75 3.75 4.0 -15 0.40 0.33 0.22 1.1 2.7 -1.7 -1.1 -2.2 0.1 0.5
VALU E

FN 15 5.5 98-28+ 2.00 4.00 3.4 -14 0.48 0.28 0.17 1.5 3.1 -2.1 -1.3 -2.8 0.2 0.4
FN 15 6.0 100-26 3.50 6.50 3.0 -8 0.48 0.23 0.14 3.0 5.8 -2.1 -1.3 -2.7 1.7 3.0
FN 15 6.5 101-28 2.00 4.00 2.2 5 0.51 0.18 0.06 1.7 3.5 -1.8 -1.1 -2.3 0.6 1.2

Rolldow n and Carry of Sw aps betw een settles

RELATIV E

Sw ap 1m 2m Dur
2Y 0.29 0.36 1.89
5Y 0.82 1.46 4.38
10Y 1.25 2.32 7.68

MBS 85
 Performance vs. swaps and Treasuries
T RADIN G
VALU E
RELATIV E

COB June 9, 2006 MBS 86

T RADIN G
VALU E
RELATIV E MBS Issuance Report

MBS 87
 MBS coupon price spread
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 88
 MBS butterfly price spread
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 89
 Mortgage/swap basis vs Index
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 90
 Mortgage/Agency basis vs Index
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 91
 Longer-dated Vol vs Index
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 92
 Shorter-dated Vol vs Index
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 93
 30-year relative coupon OAS
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 94
 30-year relative coupon swaps
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 95
 15-year relative coupon OAS
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 96
 15-year relative coupon swaps
T RADIN G
VALU E
RELATIV E

Source: JPMorgan

MBS 97
 RELATIV E VALU E T RADIN G

Trust IO analytics

MBS
98
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

MBS 99
 Case Study #1: FNMA 6.5s – The Deliverable
The relationship between delivery size and
Over $400mm TBA 6.5 pools prepaid above paydown cost is non-linear; smaller trades
60CPR are far more exposed to adverse selection

Distribution of 1-mo speeds on 3-17 WALA FNMA 6.5s, Aggregate 1-month speeds on TBA 6.5s (3-17 WALA) for different
(April 2006) delivery size (based on Apr prepayments)

2500 100
90
2000 80
Balance, $mil

1mo CPR, %
1500 70
60
1000
50
500 40
30
0
20
60+ 50-60 40-50 30-40 20-30 10-20 0-10
CPR Range 0 1000 2000 3000 4000 5000 6000
Balance, $mil
S T UD I E S

•There are still a lot of fast pools available in TBA 6.5s

C AS E

M B S 100
 Case Study #1: FNMA 6.5s – Issuance and supply

•FN 6.5 supply should be robust

FNMA 30-year relative coupon issuance Issuance by coupon as a % of total FNMA 30

year issuance
17,000 50%
FN 30-yr Issuance ($MM)

R2 = 0.8045 R2 = 0.8793
14,000
40%

% of FN 30 Issuance
11,000 FN 6.5
Issuance Projection ($bn)
30%
8,000 Apr-06 3.8 20%
5,000 May-06 5.1
Jun-06 6.7 10%
2,000 Jul-06 8.9
0%
(1,000)
(1.00) (0.50) 0.00 0.50 1.00 1.50 2.00 (10)%
(1.00) (0.50) 0.00 0.50 1.00 1.50 2.00
Relative Coupon Relative coupon

Source: JPMorgan, FNMA Source: JPMorgan, FNMA

Note: Monthly issuance of FN 5s through 6.5s plotted as relative Note: Since September 2005
coupons vs CC, since September 2005

F N 6 .5
Issu a n ce P r o je ctio n ( $ b n )
S T UD I E S

Apr-06 3 .8
M ay -06 5 .1
Ju n - 0 6 6 .7
Ju l- 0 6 8 .9
C AS E

M B S 101
 Case Study #1: FNMA 6.5s – Fundamentals
Short WALA 6.5s have tight OAS and low SATO •FNMA 6.5s: New
OAS (left axis, bps) and SATO (right axis, bps) on issue pools have
FN 6.5s by WALA (in months)
worse loan
0 4 8 12 16 20 characteristics than
0 110
(2) 100 more seasoned
(4) 90 pools
(6) 80
(8) 70
(10) 60
(12) 50
(14) 40
OAS SATO
Source: JPMorgan, FNMA

FNMA 6.5s are fair fundamentally

LIBOR static spread of FNMA 6.5s by CPR, in bp
S T UD I E S

CPR
10 20 30 40 50
101—01 73 60 44 25 2
C AS E

M B S 102
 Case Study #2: DW 4.5s – Regressions

The Dwarf 5 / 4.5 is cheap historically Rich / cheap of the Dwarf 5 / 4.5 swap
Dwarf 5/4.5 swap (y-axis, in ticks) versus 15-year CC yield Residual of Dwarf 5 / 4.5 swap vs 15-year current coupon yield, in
(x-axis, %) ticks

70
10
8
65
6

60 4
2
55 0
-2
50 -4
-6
45 -8
5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 Feb06 Apr06 Jun06
S T UD I E S
C AS E

M B S 103
 Case Study #2: DW 4.5s – Fundamentals

Outstanding balance and 1-month CPR Outstanding balance and 1-month CPR
of Dwarf 4.5s by WALA of Dwarf 5s by WALA
12 20
14 35
1mo CPR 18

Cumulative Balance ($ B)
10 1-mo CPR
16 12 30

Cumulative Balance ($ B)
Cum bal
Cum Bal
1-mo CPR (%)

8 14
10 25

1-mo CPR (%)

12
6 10 8 20
8
4 6 15
6
4 4 10
2
2
2 5
0 0
1 3 5 7 9 11 13 15 17 19 21 23 0 0
WALA (mos) 1 3 5 7 9 11 13 15 17 19 21 23
WALA (mos)

Dwarf 5s are fundamentally cheaper than Dwarf 4.5s

.LIBOR static spread on Dwarf 4.5s and 5s by CPR

LIBOR Static Spread (bp)

S T UD I E S

Price 6 CPR 7 CPR 8 CPR 9 CPR 10 CPR

Dwarf 4.5s 95-08 -7 -3 1 6 10
Dwarf 5s 96-31 6 9 11 14 17
C AS E

M B S 104
 Case Study #3 (Seasoned pricing): Lower the dollar price, higher
the price spread between seasoned and new WALA pools

Payups by WALA vs. TBA Price

14

12 $96 $97 $98

10
Payup, 32nd

0
0 5 10 15 20 25 30 35
WALA
S T UD I E S

Pricing assumptions:
1. 24-month aging ramp
2. Peak speed of 9% CPR for $96 TBA
3. Peak speed of 10% CPR for $97 TBA
4. Peak speed of 11% CPR for $98 TBA
C AS E

M B S 105
 Case Study #3 (Seasoned pricing): Peak speeds versus the length
of the ramp
Payups by WALA vs. peak speed
„ The peak speed plays an
($97 TBA, 24-mo ramp)
insignificant role when
pricing seasoned pools 12.0 9CPR 10CPR 11CPR
10.0

Payup, 32nd
8.0

6.0
(Payup versus TBA assuming
4.0
constant LIBOR static spread)
2.0

Payups by WALA vs. aging ramp 0.0

0 5 10 15 20 25 30 35
($97 TBA price) WALA

34mo ramp 24mo ramp 14mo ramp

14
12 „ However, the length of seasoning
ramp is crucial
Payup, 32nd

10
8
6 „ A longer seasoning ramp leads to
S T UD I E S

4 higher payups for seasoning

2
0
0 5 10 15 20 25 30 35
C AS E

WALA
M B S 106
 Case Study #3: Aging ramp on moderate discount
collateral
„ Moderate discounts have two peaks: 14 months and 24 months
„ The 24 months peak is driven by
„ Tax-advantaged capital gains treatment of two-year old primary residences
„ Cash-out refinancing has been front-loaded

Aging curve: moderate discount, -25 to -75bps incentive

16

12
1mo CPR, %

4 2000~2001
2005~2006
S T UD I E S

0
0 5 10 15 20 25 30 35 40
Age
C AS E

Note: Average prepayment aging curves observed from 2000 to 2001 and from 2005 to March 2006

M B S 107
 Case Study #3: Specified Pools WALA- Actual versus
theoretical payup

„ Seasoned payups suggest that the market is priced to a 24 months ramp

„ Potential lengthening of the aging ramp should translate to higher payups for seasoned discounts

„ Relative value advantage in the’04 discounts versus the ’03s

FNMA 5: Actual vs. theoretical FNMA 5.5: Actual vs. theoretical

’05–’06 ramp (24-mo.) ’00–’01 ramp (34-mo.) 34-mo. ramp 24-mo. ramp 14-mo. ramp
18 16
16 14
14

Payup, 32nd
12
Payup, 32nd

12 10
10
8
8
6 6
4 4
2 2
0 0
5 10 15 20 25 30 35
S T UD I E S

0 5 10 15 20 25 30 35
WALA WALA
Note: As of: 5/3/2006; FNMA 5s are priced to 9% CPR terminal speed; FNMA 5.5s are priced to 10% CPR terminal speed
C AS E

M B S 108
 Case Study #4: Specified Pools LLB – Call/extension
protection
The trend points to faster LLB discount speeds similar to 1999-2000
Prepayment S-Curve differences (LLB (<$100k) minus generics ($>150k)),
in 1999-2000, 2004, 2005 and since fall 2005: 1mo CPR vs. Rate Incentive,bps.

1moCPR
2 1999~2000 2004
2005 2005 Oct~2006 Apr
1

-1

-2

-3 Incentive, bps
-125 -100 -75 -50 -25

Low loan balance discounts are priced at a small fraction of their combined call and extension value.

Payups and model valuations of MLB ($110k max) pools

Call
TBA M ark e t Prote ction 10% Fas te r Turnove r 20% Fas te r Turnove r
Coupon Price Payup Payup Ext. Prote ction Total Ext. Prote ction Total
S T UD I E S

FNCL 5 94-05 0.5 2 9 11 17 19

FNCL 5.5 96-22+ 1.5 3 6 9 11 14
FNCL 6 99-05 4 7 4 11 7 14
C AS E

M B S 109
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

M B S 110
 ARM share has remained close to half of total
applications

ARM
ARM share
share of
of total
total applications
applications by
by $
$ volume
volume (%)
(%)

60

50
ARM Share of Apps by $ Volume (%)

40

30

20

10

0
Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06
Source: MBA
ARM S

M B S 111
 Hybrids contributed to most of the growth of the non-agency
market

Year-end
Year-end outstandings
outstandings ($
($ billions)
billions)

800
Jumbo Fixed Jumbo ARM Alt-A Fixed Alt-A ARM
700

600

500

400

300

200

100

0
1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: JPMorgan, Loan Performance. 2006 data as of April.

ARM S

M B S 112
 Hybrid ARM Structure and Valuation
Structure
Structure
„ Typically 30-year terms
„ Fixed Rate Cash-Flows
„ 3, 5, 7,10 Year Fixed-Rate
„ Hybrid ARM Tails
„ Libor/CMT Floaters
„ Resets subject to Caps
(initial/periodic/life)
„ 2/2/6
„ 5/2/5
ARM S
Example
Example
ƒ 5/1 Hybrid ARM borrower with an initial
coupon rate of 4.5% and a 5/2/5 cap
structure pays 4.5% for 5 years
ƒ The highest the borrower’s rate can
reset after the 5 year fixed rate period
ends is (4.5%+5%), or 9.5%
ƒ The on-going periodic cap restricts the
borrower from resetting up more than
2% at each yearly reset
ƒ The life cap also protects the borrower
by ensuring that the coupon cannot
reset above 9.5% for the life of the loan
M B S 113
 Hybrid ARM Key Terminology

ƒRate caps (initial, periodic, and lifetime) offer protection from large interest rate
movements by providing a cap and a floor, limiting the amount the resetting contract
rate can increase or decrease on each adjustment date
ƒThe initial adjustment cap provides a cap and floor on the interest rate at the first
adjustment date
ƒPeriodic adjustment caps restrict upward and downward movements at each
subsequent reset date
ƒ Lifetime caps dictate the maximum interest rate of the mortgage loan at any given
time
ƒMTR (months to reset) is defined as the number of months until the Hybrid ARM resets
off its specified Index. In other words, the number of months until the fixed rate portion
of the bond ends
ƒOnce a Hybrid ARM loan reaches reset, the borrower’s new coupon is determined off a
specified index
ƒThe most popular indices are LIBOR and CMT
ƒThe gross margin is the spread added to the Index that determines the mortgage
holder’s new rate
ƒ The net margin is what is passed on to the investor. The net margin is the spread
added to the Index that determines the coupon the investor receives. Typically, unless
otherwise specified, LIBOR-indexed ARMs have approximately 175bps net margin, while
CMT-indexed bonds have approximately 225bps margin
ARM S

M B S 114
 How are Non-Agency MBS Valued and Traded
„ Non Agency MBS do not trade ‘in the screens’ thus valuation and pricing levels reflect this
uncertainty

„ Trading is Negotiated around structure, settlement and collateral composition

„ Relative Value and performance analytics help drive trading levels

„ Pricing Conventions
„ N-A Fixed Rates; Pass throughs relative to agency pass throughs
„ N-A ARMs : Swaps, Treasuries

„ Prepayment Analytics
„ OAS Methodology : Prepayment Modeling

„ Credit Analytics

„ Liquidity Premiums
ARM S

M B S 115
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

M B S 116
 FNMA Current Coupon Yield vs. UST 10 Year Yield

Current Coupon 10 yr

6.5

5.5

5
Yield

4.5

3.5

3
6/2/2003 12/1/2003 5/31/2004 11/29/2004 5/30/2005 11/28/2005 5/29/2006
C M O S

M B S 117
 Why Agency CMOs?
„ To broaden the investor base by customizing cash flows for investor needs while providing key
advantages over other instruments:
„ Excess Returns
„ Greater Liquidity
„ Virtually Zero Credit Risk

„ Can address the following specific needs of investors:

„ Enhanced Yields/Spreads
„ Targeted Average Life Profiles
„ Targeted Duration Profiles
„ Customize the risk/reward profiles for investor’s views on:
Î interest rates
Î yield curve shape
Î prepayments
Î volatility
C M O S

M B S 118
 CMOs as % of the Fixed Rate MBS Market

CMO Issuance % of Pass-Through

70 70

% of Fixed-Rate Pass-Through Issuance

60 60
CMO Issuance ($ Billions)

50 50

40 40

30 30

20 20

10 10

0 0
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05
C M O S

M B S 119
 CMO Principal Types
„ SEQ – Sequential

„ PAC – Planned Amortization Class

„ TAC – Targeted Amortization Class

„ AD or VADM- Accretion-Directed/Very Accurately Defined Maturity

„ FFIEC Bonds

„ SUP - Support or Companion

„ Z - Accrual bond
C M O S

M B S 120
 SEQs - Sequentials

„ Collateral principal payments are reallocated sequentially into a series of short, intermediate and long
maturity bonds

„ Sensitive to prepayments:
Î Prepayments faster than expected: SEQs shorten

Î Prepayments slower than expected: SEQs extend

„ The shorter average life sequentials (that pay before the longer SEQs within the structure) provide
prepayment protection for the longer average life SEQs

„ Shorter principal window than collateral

C M O S

M B S 121
 SEQ Yield Tables

Front SEQ

Last Cashflow (LCF) SEQ

C M O S

M B S 122
 PACs - Planned Amortization Class

„ Principal repaid according to a schedule within a specified range of prepayment assumptions called
PAC bands

„ Principal schedule provides protection from average life volatility and reinvestment risk associated
with prepayments

„ Principal schedules are maintained by redirecting cashflow uncertainty to Support bonds

„ Average Life is less volatile with speeds outside the bands because the supports continue to provide
stability

„ Corporate bond and agency bond surrogate

C M O S

M B S 123
 PAC Yield Tables and Cashflow Graph

Yield table

Cashflow Graph
C M O S

M B S 124
 TACs - Targeted Amortization Class

„ Structured to pay principal according to a schedule determined by one constant prepayment speed - a “one
sided” PAC

„ No protection against extension: TACs only have call protection because a TAC provides protection against
faster but not slower prepayments
Î Prepayments faster than TAC speed: Excess principal to supports

Î Prepayments slower than TAC speed: TAC and Support extend

„ Offer higher yield than PACs based on increased extension risk

„ More call protection than a SEQ

Yield Table
C M O S

M B S 125
 AD/VADMs - Accretion Directed / Very Accurately Defined Maturity

„ All cashflows are derived from the interest accretions of the Z bond

„ VADM tranches must mature prior to the start of the amortization on their corresponding Z because
when the Z becomes current pay the Z accretion is no longer available to amortize the VADMs

„ Very stable bond since cashflow is from interest accretion which is NOT affected by prepayments

„ VADMs do not extend even under a zero prepayment scenario

„ No whipsaw risk

„ Pay up for the extension protection results in lower yields and better convexity
C M O S

M B S 126
 VADM Yield Table and Cashflow Graph

VADM yield table in SEQ Z

structure

WAL Graph
C M O S

M B S 127
 FFIEC Bonds

„ Federal Financial Institutions Examination Council (FFIEC) derived guidelines to determine if MBS
investments are suitable for US depository institutions

„ Bonds that meet these guidelines have a wider audience, are more liquid, and trade at tighter spreads
than comparable non-FFIEC average life bonds

„ FFIEC test:
Test 1) WAL must be less than 10 years

Test 2) +300 shift Æ less than 4 years extension

-300 shift Æ less than 6 years contraction

Test 3) +300 shift Æ less than 17% price change

-300 shift Æ less than 17% price change
C M O S

M B S 128
 SUPs - Supports or Companions

„ Supports are cashflow shock absorbers for PACs

„ Faster prepayments - excess cash flow paid to supports providing call protection for PACs

„ Slower prepayments - any shortfall in cash flow is absorbed by supports which may not receive principal
until PAC schedule is met, providing extension protection for PACs

„ High average life and cashflow volatility

„ Higher yields compensate for volatility

C M O S

M B S 129
 Support Yield Table and Weighted Average Life

Sequentially Tranched
Support

Weighted Average Life Graph

C M O S

M B S 130
 Z bonds - Accrual Bonds

„ No interest until principal payment window starts

„ Interest due is added to outstanding principal of the bond = Z accretion

„ Z accretion accelerates the maturity of shorter tranches or more accurately defines the maturity of
others (VADMs)

„ Receive principal payments and interest once other bonds are retired

„ Addition of Z bond to a structure can improve the convexity of the other bonds by reducing extension
risk
C M O S

M B S 131
 Sequential Z Bond Yield Table & Cash Flow Graph

Yield Table

Cash Flow Graph

C M O S

M B S 132
 Support Z Bond Yield Table & Cash Flow Graph

Yield Table

Cash Flow Graph

C M O S

M B S 133
 Rocket Z Yield Table & Cash Flow Graph
„ Type of support Z that has a possibility of paying off very fast (“rocket”).

Yield Table

Weighted Average
Life Graph
C M O S

M B S 134
 CMO Interest Types
„ Floater

„ Inverse Floater

„ IO - Interest Only (Trust and Structured)

„ PO - Principal Only (Trust and Structured)

„ Inverse IO
C M O S

M B S 135
 Floaters

„ Coupons reset periodically, usually monthly, at a rate of an index, usually 1mLibor, plus a spread, know
as the margin

„ Created with an inverse or inverse IO such that the weighted-average coupon of the pair is always equal
to the underlying fixed-rate bond

„ Shorter and less negatively convex than underlying fixed rate

„ Offers protection against interest rate risk up to the cap

„ The cap adds some duration and negative convexity. Without a cap the duration would be negligible
and convexity neutral

„ Shorter durations= less price volatility than fixed-rate CMOs unless rates rise and the coupon reaches its
cap
C M O S

M B S 136
 Floater Yield Table & Coupon Graph

Yield Table

Coupon Graph
C M O S

M B S 137
 Support Floater Yield Table & Coupon Graph

Yield Table

Coupon Graph
C M O S

M B S 138
 Inverse Floaters
„ Pays down simultaneously with their corresponding floater

„ Coupon falls when the index rate rises and are typically levered positions in the underlying fixed
rate cash flow

„ High yields frequently compensate for the increased risks

„ Floored inverses: a “baby” inverse floater - coupon moves inversely but can never drop below a
designated fixed coupon

„ Provide a way to leverage MBS if you are bullish on the MBS sector

„ Provide a way to leverage views in one package if you disagree with

Î forward rate curve
Î FED expectations
Î prepayment forecasts
Î volatility views
C M O S

M B S 139
 Inverse Yield Table & Coupon Graph

Yield Table

Coupon Graph
C M O S

M B S 140
 Floored Inverse Yield Table & Coupon Graph

Yield Table

Coupon Graph
C M O S

M B S 141
 IO - Interest Only
„ Receive only interest cash flow from the notional amount of the underlying bond

„ Since IOs do not pay principal, cashflows exist only if principal remains outstanding

„ The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class

„ Benefit from slowing prepayments

Î Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments

„ Bearish security that usually have negative durations

„ Interest stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets

„ Interest stripped from CMOs are known as Structured IO and can be customized for investor needs on:
Î lockout
Î PAC bands
Î underlying collateral STIPs
C M O S

M B S 142
 IO Yield Tables

Structured PAC IO

Trust IO
C M O S

M B S 143
 PO - Principal Only
„ Stream of principal payments purchased at a discount

„ Hedge for prepayment risk since POs benefit from faster prepayments:
Î Principal is returned at par at a faster rate
Î Lower discount rates boost the price

„ The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class

„ Bullish security with large, positive duration and positive convexity

„ Super PO’s provide a more levered prepay bet

„ Principal stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets

„ Principal stripped from CMOs are known as Structured PO and can be customized for investor needs on:
Î lockout
Î PAC bands
Î underlying collateral STIPs
C M O S

M B S 144
 PO Yield Tables

Structured SUP PO

Trust PO
C M O S

M B S 145
 IO/PO Reports
„ Trust IO/PO reports from JPMorgan provide daily price data:
C M O S

M B S 146
 Inverse IO
„ Pays down simultaneously with their corresponding floater like an inverse except the Inverse IO does
not pay principal

„ Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate
cash flow

„ Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments

„ Provide a way to leverage views in one package if you disagree with

Î forward rate curve
Î FED expectations
Î prepayment forecasts
Î volatility views
C M O S

M B S 147
 Inverse IO Yield Table and Coupon Graph

Yield Table

Coupon Graph
C M O S

M B S 148
 Recent Innovations in CMO Market

„ AS/NAS – Accelerated Security/Non-accelerated Security

„ TTIB – Two Tiered Index Bonds

„ Super-Floater

„ Customized Floater: FHR 3069 CF

„ RELO – Relocation collateral deals

„ Pre-pay Linked Notes/Interest Accrual Notes (IANs)

„ Freddie Mac Reference Notes

C M O S

M B S 149
 AS and NAS - Accelerated and Non-Accelerated Securities

„ AS security receives principal payments more quickly than its respective collateral.

„ NAS Security receives principal more slowly than its respective collateral

„ NAS + AS = SEQ

„ The AS bond receives the “accelerated” principal payments that would have otherwise been allocated to
the NAS bonds

„ The NAS bond is locked out until the AS bond is paid off; then the NAS begins receiving its pro-rata
principal payments

„ NAS is better than a PAC = no whipsaw risk

C M O S

M B S 150
 AS and NAS Yield Tables

AS

NAS note the

average
life of 5.30
at 0 PSA
C M O S

M B S 151
 TTIB - Two Tiered Index Bond
„ A type of inverse floater that pays a fixed rate as long as 1m Libor stays below a certain threshold

„ Once 1m Libor crosses the threshold the coupon declines on a levered basis within a corridor of rates until it
reaches 0%

„ Essentially shorting an option that 1m Libor will not increase beyond a certain threshold

„ Compensating for shorting the option by getting a higher coupon.

Historical
Digital TTIBs: Once 1m Libor
1m Libor crosses the graph
threshold the coupon
declines immediately to 0%

Floored TTIB: Once

1m Libor crosses the threshold
the coupon declines
immediately to a fixed rate
floor
C M O S

M B S 152
 TTIB Yield Tables and Coupon Graphs
Digital TTIB yield table Digital TTIB coupon graph

1 bp Corridor TTIB yield table

1 bp Corridor TTIB coupon graph
C M O S

M B S 153
 TTIBs with additional features

„ TTIBs with lock-out: coupon rate is not conditional on 1m Libor for an initial period,
ensuring desirable rates over that period.

„ Initial reset date can be several years into bond’s lifetime.

Locked-out Digital TTIB yield table

Locked-out Digital TTIB coupon graph
C M O S

M B S 154
 TTIBs with additional features (cont.)

„ Floating-rate TTIBs: when 1m Libor is below a threshold, bond pays as a floater.

„ Floating-rate TTIBs with lock-out: bond maintains its initial coupon formula for an initial
period, regardless of 1m Libor.

Example: FHR 3140 CF

- Is a regular L + 165 bp bond
for first 7 years, before
converting into a regular
floating-rate TTIB.
C M O S

M B S 155
 Super-Floater
„ A type of floater that pays a fixed rate as long as 1m Libor stays above a certain threshold (usually greater
than current levels).

„ Essentially shorting an option that 1m Libor will remain below a certain threshold.

„ Compensated for shorting the option by receiving a VERY high coupon should 1m Libor go above the threshold.

„ Example: FHR 3111 HF (receives 66% coupon if 1m Libor > 6.5%)

Coupon Graph
C M O S

M B S 156
 Customized Floater: FHR 3069 CF
„ Classified on Bloomberg as “Complex” because the formula for calculating the payment is not the standard
Libor + discount margin
„ Unique structure
„ Payment Formula:
Î If Libor is less than 4.8%, bond pays Libor + 2.35%
Î If Libor is greater than 4.8% but less than 7.15%, bond pays 7.15%
Î If Libor is greater than 7.15%, bond pays 0%

Coupon Graph
C M O S

M B S 157
 RELO – CMO Backed by Relocation Mortgages
„ Relocation Mortgage: a mortgage made to a transferred employee to finance a home purchase at a new
job location

„ Mortgage usually requires an employer to contribute to mortgage funding

„ Mortgage typically originated by an agreement between the employer and the lender under a relocation
program administered by the employer or its agent

„ Prepayment speeds depends on typical prepayment behaviors and other RELO factors:
Î Whether the mortgages are made in connection with a permanent relocation of a corporate headquarters
Î The likelihood that borrowers will be relocated again
Î The frequency with which further relocations may occur

„ Historically this sector has fast prepay speeds

„ CMOs backed by RELO collateral usually trade at a deep discount

C M O S

M B S 158
 RELO Yield Table and Weighted Average Life Graph

Yield Table

Weighted Average Life graph

C M O S

M B S 159
 Prepay Linked Notes or Interest Accrual Notes (IANs)
„ Agency debt and MBS hybrid

„ Redemption schedule is based on a pre-selected reference pool

„ Like MBS (unlike agency debt) there is no explicit call date

„ Like agency debt (unlike MBS) there is a stated final maturity

„ Effective duration management tool for those who like MBS sector

Yield Table
Recently-priced deals
C M O S

M B S 160
 Freddie Reference Notes
„ A Pre-pay linked note that trades live on Trade Web; an automated broker

„ Availability by all dealers on Trade Web means

Î Better liquidity and
Î Better price transparency than pre-pay linked notes that do not trade live on Trade Web

„ Trades at slightly lower yields than other pre-pay linked notes due to the advantage of greater liquidity and
greater price transparency

Yield Table Trade Web Screen Offering:

C M O S

M B S 161
 Conclusion

„ As a premier investment bank, strives to be a leader in the CMO

market

„ The CMO team’s recent production is growing rapidly:

Î In April & May 2006, the #1 FNMA issuer!
Î The #3 overall conventional issuer (FNMA + FHLMC) over same period.
Î Over $5 billion in deal volume in those two months alone!

„ The CMO team can provide the following client needs:

Î Unique trade ideas through structuring capabilities
Î Relative value analysis
Î Marked-to-market valuations & portfolio analysis
Î Liquidity through market making

„ Let the CMO team help you maximize the total return of your portfolio!
C M O S

M B S 162
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

Case Studies 99
P RIM E R

ARMs 110
M B S

CMOs 116
JP M O R G AN

MBS Index 163

M B S 163
 JPMorgan MBS Index
„ The JPMorgan Mortgage Index (“the Index”) measures the performance of fixed-rate
agency-backed mortgage pass-through securities
• Included:
– Thirty-year and 15-year fixed-rate pass-through securities issued by FNMA, FHLMC,
and GNMA

• Excluded:
– ARMs
– Non-Agency (whole loan), Jumbo, and 10- or 20-year securities
– Balloons, GPMs, and TPMs
– FHLMC 75-day delay mortgages
– FNMA Mega, FHLMC Giant, and GNMA Platinum pools
I ND E X
MB S

M B S 164
 JPMorgan MBS Index
„ Due to paydowns and new pool issuance which are reported monthly, the mortgage
universe undergoes monthly transformations

„ JPMorgan re-balances the Index automatically to reflect the changing compositions

of the mortgage market. Once a month, on the last business day of the month, all
the pools represented in the Index are re-aggregated for use next month

„ At the end of each business day, JPMorgan trader marks are used to price all the
constituent securities in the Index
„ Traders mark benchmark issues (TBAs) and specified pools
„ Algorithm is used to price securities that are not actively traded
I ND E X
MB S

M B S 165
 Calculation of Index Returns
„ Daily total return of the Index is the market value weighted average of the daily returns of its
constituent securities

„ The daily total return of a security is defined as its daily change in market value over its previous
market value. The change in market value equals change in price plus change in accrued interest.
Interest is accrued daily at the net coupon rate based on 30/360 day-count convention. Using
formulas, the relationship is as follows:

„ The Index starts at 100 on January 1st, 2000. On every business day after market close, a daily
Index return is computed. A new index value is then calculated as the product of the previous
Index value and the daily Index return

„ This methodology assumes that the Index settles daily (on business days) and that returns are
reinvested into the Index on a daily basis. Using raw Index values, one can easily calculate the
periodic total return of the Index between any two business-days by dividing the ending Index
value by the starting Index value
I ND E X
MB S

M B S 166
 Total return swaps on the JPMorgan MBS Index
• Investors can receive (or pay) the total rate of return of the JPMorgan
Mortgage Index and pay (or receive) LIBOR – a specified spread

Investor

Index Return LIBOR - spread

JPMorganChase Bank

• Advantages of the TROR Index Swap:

– MBS returns competitive and less volatile than corporate debt
– Ease of execution
– Sector exposure with no security selection required
– No MBS delivery / allocation required
– Locked-in funding spread
– Finite investment term
– Paydowns automatically reinvested in Index
–
I ND E X

Pay or receive Index

MB S

M B S 167
 Mortgage Index returns
I ND E X

Source: Bloomberg
MB S

M B S 168
 Index Composition

Index
Index composition
composition in
in June
June 2006,
2006, par
par weighted
weighted (%)
(%) and
and month/month
month/month changes
changes in
in 10-year
10-year equivalents
equivalents ($bn)
($bn)
I ND E X

Source: JPMorgan
MB S

M B S 169
 Index Performance
Index
Index duration
duration and
and convexity
convexity profile,
profile, as
as of
of 5/31/06
5/31/06

Index
Index statistics,
statistics, May
May 31st,
31st, 2006
2006 Index
Index statistics,
statistics, May
May 31st,
31st, 2006
2006
I ND E X
MB S

M B S 170
 Index Performance
Index
Index returns
returns and
and excess
excess returns
returns by
by sector
sector and
and coupon
coupon (bps),
(bps), in
in May
May 2006
2006
I ND E X
MB S

M B S 171