J U N E 2 0 0 6
H Y B R I D P R I M E R
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John Sim* (212) 834-3124
M B S
Analyst CertificationThe strategist(s) denoted by an asterisk (“*”) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.
This research contains the views, opinions and recommendations of research strategists with JPMorgan US Fixed Income Strategy. Research strategists routinely consult with JPMSI trading desk personnel in formulating views, opinions and recommendations in preparing this research. Trading desks may trade or may have traded as principal on the basis of the research strategist(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMSI trading desks which may conflict with your interests. In addition, research strategists receive compensation based, in part, on the quality of their analysis, firm revenues, trading revenues, and competitive factors.
Copyright 2006 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a memberof FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited is registered as an investment advisers with the Securities & Futures Commission in Hong Kong and itsCE numbers is AAJ321 Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (“MAS”). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer.
This material is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. JPMorgan and its affiliates may have positions (long or short), effect transactions or make markets in securities or financial instruments mentioned herein (or options with respect thereto), or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers mentioned herein. The information contained herein is as of the date and time referenced above and JPMorgan does not undertake any obligation to update such information. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Transactions involving securities and financial instruments mentioned herein (including futures and options) may not be appropriate for all investors. Clients should contact their salespersons at, and execute transactions through, a JPMorgan entity qualified in their home jurisdiction unless governing law permits otherwise J.P. Morgan Securities Inc. is a member of NASD, NYSE and SIPC In the UK and other EEA countries, this material is not available for distribution to persons regarded as private customers (or equivalent) in their home jurisdiction.
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Agenda
Page
M B S
Overall Market Size and Issuance 1
Terminology, Basic Structure and Valuation 15
Prepayments 25
Structure 40
Credit Performance 46
Recent Trends and Relative Value 54
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The mortgage market 5 years ago …
M B S
2001 Current amount outstanding (by product type)2001 Current amount outstanding (by product type)
Agency Fixed
88%
MTA ARM
0%Non-Agency Fixed
10%
Non-Agency ARM
0%
Agency ARM
2%
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Source: Source: FNMA, FHLMC, GNMA, Loan Performance, JPMorgan
2
…and now
M B S
2006 Current amount outstanding (by product type)2006 Current amount outstanding (by product type)
Agency Fixed
73%
Non-Agency Fixed
7%
Non-Agency ARM
8%
MTA ARM
3%
Agency ARM
9%
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Source: Source: FNMA, FHLMC, GNMA, Loan Performance, JPMorgan
3
Agency hybrids represent 45% of all ARMs
M B S
Alt-A Hybrid 21%
Prime Hybrid 25%
Option ARM 9%
Agency Hybrid 45%
72% IO
23% IO52% IO
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Agency ARM Issuance…
M B S
Agency ARM Issuance ($ bln)Agency ARM Issuance ($ bln)
-
20
40
60
80
100
120
140
160
180
2000 2001 2002 2003 2004 2005 2006
3/1 5/1 7/1 10/1
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Source: JPMorgan
5
Prime ARM Issuance…
M B S
0
20
40
60
80
100
120
140
2000 2001 2002 2003 2004 2005 2006
Non-Conf IO ARM Non-Conf Reg ARM Conf IO ARM Conf Reg ARM
Non-Agency Prime ARM Issuance ($ bln)Non-Agency Prime ARM Issuance ($ bln)
Source: Loan Performance, JPMorgan
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Alt-A ARM Issuance…
M B S
0
20
40
60
80
100
120
2000 2001 2002 2003 2004 2005 2006
Non-Conf IO ARM Non-Conf Reg ARM Conf IO ARM Conf Reg ARM
Non-Agency Alt-A ARM Issuance ($ bln)Non-Agency Alt-A ARM Issuance ($ bln)
Source: Loan Performance, JPMorgan
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Gross issuance in the agency ARM market has been dominated by IO loans
M B S
0%
20%
40%
60%
80%
100%
ARM ARM IO Fixed IO
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
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ARMs are a purchase driven affordability product more than a refinancing vehicle
M B S
0
10
20
30
40
50
60
Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
AR
M S
hare
%($
volu
me)
-
10
20
30
40
50
60
70
80
90
100
Purc
hase
Sha
re %
($vo
lum
e)
ARM share Purchase Share
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Source: JPMorgan, MBA
9
This is why the ARM share of applications has remained high despite a flat/inverted yield curve
M B S
ARM share ($volume) versus the slope of the swap curveARM share ($volume) versus the slope of the swap curve
0
10
20
30
40
50
60
Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
AR
M S
hare
%($
volu
me)
-50
0
50
100
150
200
250
300
350
2s/1
0s s
wap
s
ARM Share ($ volume) 2s/10s swaps
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Source: MBA, JPMorgan
10
A flatter mortgage yield curve…
M B S
4.0
4.5
5.0
5.5
6.0
6.5
1 2 3 4 5
Prim
ary
Rat
es (%
)
Feb. 2006Feb. 2005Feb. 2004
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Source: JPMorgan, FHLMC, HSH
11
Alternative product evolution
M B S
The evolution of products
(2003) (2004) (2005) (2006)
Fixed 30yr -> hybrid ARM -> hybrid IO -> option ARM -> Fixed 30yr IO
Targeted borrowing base (Income and Credit paving the path)
Prime conforming -> Prime Jumbo -> Alt-A Jumbo -> Alt-A Conforming
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A very different landscape (more choices and greater stratification)
M B S
Market share by product type (Prime Conforming) --- Total size $40 billionMarket share by product type (Prime Conforming) --- Total size $40 billion
0%
20%
40%
60%
80%
100%
Jan-9
4Ja
n-95
Jan-9
6Ja
n-97
Jan-9
8Ja
n-99
Jan-0
0Ja
n-01
Jan-0
2Ja
n-03
Jan-0
4Ja
n-05
Conf Fixed 30Y Bal Conf Fixed 15Y Bal Conf Fixed IO Bal Conf MTA ARM BalConf 1/1 ARM Bal Conf 1/1 ARM IO Bal Conf 3/1 ARM Bal Conf 3/1 ARM IO BalConf 5/1 ARM Bal Conf 5/1 ARM IO Bal Conf 7/1 ARM Bal Conf 7/1 ARM IO BalConf 10/1 ARM Bal Conf 10/1 ARM IO Bal
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Source: Loan Performance, JPMorgan
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The trend has been slower in the Jumbo market…
M B S
Market share by product type (Prime Jumbo) – Total size $330 billionMarket share by product type (Prime Jumbo) – Total size $330 billion
0%
20%
40%
60%
80%
100%
Jan-9
4Ja
n-95
Jan-9
6Ja
n-97
Jan-9
8Ja
n-99
Jan-0
0Ja
n-01
Jan-0
2Ja
n-03
Jan-0
4Ja
n-05
Non-Conf Fixed 30Y Bal Non-Conf Fixed 15Y Bal Non-Conf Fixed IO BalNon-Conf MTA ARM Bal Non-Conf 1/1 ARM Bal Non-Conf 1/1 ARM IO BalNon-Conf 3/1 ARM Bal Non-Conf 3/1 ARM IO Bal Non-Conf 5/1 ARM BalNon-Conf 5/1 ARM IO Bal Non-Conf 7/1 ARM Bal Non-Conf 7/1 ARM IO BalNon-Conf 10/1 ARM Bal Non-Conf 10/1 ARM IO Bal
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Source: Loan Performance, JPMorgan
14
Agenda
Page
M B S
Overall Market Size and Issuance 1
Prepayments
Terminology, Basic Structure and Valuation 15
25
Structure 40
Credit Performance 46
Recent Trends and Relative Value 54
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Hybrid Structure and Valuation
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StructureStructure
Fixed Rate Cash-flows
3, 5,7,10 Year Fixed
Defined payment windows
Floating rate Cash-flow (Tail)
LIBOR/CMT Floaters with large Margins, Subject to Caps
LIB+175bps, CMT+225bps
Full Amortization
Interest Only
Terms: 3, 5, 7, 10 year
Interest Only term and fixed rate term do not have to match.
e.g. A 5/1 hybrid with a 10-year IO term.
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Key Terminology
M B S
Source: JPMorgan
Rate caps (initial, periodic, and lifetime) offer protection from large interest rate movements by providing a cap and a floor, limiting the amount the resetting contract rate can increase or decrease on each adjustment date.
Initial adjustment caps provide a cap and floor on the interest rate at the first adjustment date.
Periodic adjustment caps restrict upward and downward movements at each subsequent resetdate.
Lifetime caps dictate the maximum interest rate of the mortgage loan at any given time.
Typical cap structures:
3/1: 2/2/6 2% Initial cap, 2% Periodic cap, 6% life cap
5/1: 2/2/6 and 5/2/5
7/1: 5/2/5
10/1: 5/2/5
For example, a 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. The highest the borrower’s rate can reset after the 5 year fixed rate period ends is (4.5%+5%), or 9.5%. In addition the on-going periodic cap restricts the borrower from resetting up more than 2% at each yearly reset. The life cap also protects the borrower by ensuring that the coupon cannot reset about 9.5% for the life of the loan.
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Key Terminology
M B S
Source: JPMorgan
Once a Hybrid ARM loan reaches reset, the borrower’s new coupon is determined off a specified index. The most popular indices are LIBOR and CMT.
The gross margin is the spread added to the Index that determines the mortgage holder’s new rate.
The net margin is what is passed on to the investor. The net margin is the spread added to the Index that determines the coupon the investor receives. Typically, unless otherwise specified, LIBOR-indexed ARMs have approximately 175bps net margin, while CMT-indexed bonds have approximately 225bps margin.
MTR (months to reset) is defined as the number of months until the Hybrid ARM resets off its specified Index. In other words, the number of months until the fixed rate portion of the bond ends.
Each agency has established a payment delay that gives it time to process monthly payments received from mortgage servicers and distribute them to the appropriate investors. Payment delays are as follows:
Stated Actual
•Fannie Mae: 24 54
•Freddie Mac: 44 74
•Ginnie Mae II: 19 49
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Bloomberg Description Screen (page 2)
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Source: JPMorgan
19
Pricing versus Relative Value
M B S
Pricing conventions
Agency hybrids are priced using a constant prepayment assumption of 15CPB.
The spread convention is Z-spread to U.S. Treasuries.
Non-agency hybrids are priced using a constant prepayment assumption of 25CPB
The spread convention is N-spread to Swaps.
Relative Value methods
–Static spread analysis under constant or vectored prepayment assumptions.
–OAS analysis using a hybrid prepayment model and arbitrage free interest rate framework.
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Using Z-Spread to Price FNMA 5/1 Hybrid ARM(BC35 SCREEN)
M B S
Source: JPMorgan
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Static spread analysisFH 1B2935 MTGE YT SPREAD <GO>
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A relative value framework
M B S
Assume a prepayment rate for the fixed rate period of the pool
Assume par price redemption at first reset
Add in tail value by:
Assuming a tail price
Present value the tail price
Convert to a spread using spread duration
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A concrete example: More transparent than OAS, but less rigorous
M B S
FN 5/1 5% (5.5% WAC, 12 WALA)Price = $98-00 15CPB 20CPB 25CPBYield 5.377 5.445 5.52AvgLife 2.8 2.54 2.3Spread Dur 2.52 2.29 2.07Spread N -4 4 12
Tail SpreadTail price $102-00 34 29 25
$101-16 25 22 19$101-00 17 15 12
(Tail price - 100) * Factor at Reset * Discount Factor / Spread Duration
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Agenda
Page
M B S
Overall Market Size and Issuance 1
Terminology, Basic Structure and Valuation 15
Structure
Prepayments 25
40
Credit Performance 46
Recent Trends and Relative Value 54
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Prepayment fundamentals
M B S
Hybrid borrowers have a shorter horizon and therefore prepay faster
than traditional 30-year and 15-year fixed-rate paper.
Hybrids also have shorter seasoning ramps than fixed-rates.
Short resets prepay faster and season quicker than longer resets.
Prepayments near reset accelerate (usually 6 months prior)
Regardless of the reset the ending factors for current coupon hybrids
converge to a similar level.
Loan attributes, such as loan balance and geography offer a convexity
advantage during the fixed-rate period of the hybrid, but do not
necessarily lead to higher factors at reset.
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Prime vs Alt A prepayments
M B S
Prime Jumbo (720 FICO or above)
(Observed in 2005, 12–24 WALA)
Alt-A conforming (680-720 FICO)
1-m
o %
CP
R
30-year 15-year 3/1 5/1 7/130-year 15-year 3/15/1 7/1 10/1
Incentive (bps)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
Incentive (bps)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
1-m
o %
CP
R
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Prime vs Alt A 3/1 prepayments
M B S
Alt-A conforming (680-720 FICO)Prime Jumbo (720 FICO or above)
Incentive (bps)
0
10
20
30
40
50
60
70
(100) (75) (50) (25) 0 25 50 75 100
1-m
o %
CP
R
3/1 IO 3/1 3/1 IO 3/1
(Observed in 2005, 12—24 WALA)
Incentive (bps)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
1-m
o %
CP
R
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Prime vs Alt A 5/1 prepayments
M B S
Prime Jumbo (720 FICO or above) Alt-A conforming (680-720 FICO)
(Observed in 2005, 12—24 WALA)
5/1 IO 5/1
1-m
o %
CP
R
Incentive (bps)(100) (75) (50) (25) 0 25 50 75 100
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
5/1 IO 5/1
1-m
o %
CP
R
Incentive (bps)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
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Prime vs Alt A 7/1 prepayments
M B S
Prime Jumbo (720 FICO or above) Alt-A conforming (680-720 FICO)
(Observed in 2005, 12—24 WALA)
7/1 IO 7/1
1-m
o %
CP
R
Incentive (bps)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
7/1 IO 7/1
1-m
o %
CP
R
Incentive (bps)(100) (75) (50) (25) 0 25 50 75 100
0
10
20
30
40
50
60
70
80
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Prime vs Alt A 10/1 prepayments
M B S
Alt-A conforming (680-720 FICO)Prime Jumbo (720 FICO or above)
(Observed in 2005, 12—24 WALA)
10/1 IO 10/1 10/1 IO 10/1
Incentive (bps)
1-m
o %
CP
R0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100Incentive (bps)
1-m
o %
CP
R
(100) (75) (50) (25) 0 25 50 75 100
0
10
20
30
40
50
60
70
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Empirical seasoning ramps
M B S
Q1 2006 discount seasoning ramps (Incentive < -25bps)
0
1 0
2 0
3 0
4 0
5 0
6 0
7 0
0 6 1 2 1 8 2 4 3 0 3 6 4 2W AL A
3M %
CPR
3 /1 5 /1
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A piecewise 5/1 discount prepayment profile
M B S
Q1 2006 discount seasoning ramps (Incentive < -25bps)
0
1 0
2 0
3 0
4 0
5 0
6 0
7 0
0 6 1 2 1 8 2 4 3 0 3 6 4 2 4 8 5 4 6 0 6 6 7 2
W A L A
3-m
o %
CPR
5 /1 3 /1
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With only 19% of the MBS market refinanceable, the focus has shifted to extension….
M B S
0%
5%
10%
15%
20%
25%
-250 -200 -150 -100 -50 0 50 100 150 200 250
Incentive (bps)
%R
efin
ance
able
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... hybrids have been the natural alternative
M B S
Agency hybrids (12-24 WALA) in 2001-present.Agency hybrids (12-24 WALA) in 2001-present.
0
5
10
15
20
25
30
35
40
45
-100 -75 -50 -25 0 25
Incentive (bps)
1-m
o %
CPR
3/1 5/1 7/1 10/1 30-yr 15-yr
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Source: MBA, JPMorgan
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Better convexity due to loan size does not necessarily translate into more tail preservation
M B S
Agency hybrid 5/1 (6-12 WALA) in 2005.Agency hybrid 5/1 (6-12 WALA) in 2005.
2003 originations
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Jan-04 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05
Fact
or
FN 5/1 NYFN 5/1 (AOLS < $150k)FN 5/1Jumbo 5/1 IOJumbo 5/1
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Source: MBA, JPMorgan
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Large prepayment differences between geographic regions
M B S
Agency hybrid 5/1 (6-12 WALA) in 2005.Agency hybrid 5/1 (6-12 WALA) in 2005.
0
10
20
30
40
50
60
-75 -50 -25 0 25 50 75 100 125 150
Incentive (bps)
1-m
o %
CPR
CA NY FL
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Source: MBA, JPMorgan
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Geographics also offer the most potential for tail preservation
M B S
Agency hybrid 5/1 (6-12 WALA) in 2005.Agency hybrid 5/1 (6-12 WALA) in 2005.
2002 originations
0.00.10.20.30.40.50.60.70.80.91.0
Jan-03 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05
Fact
or
FN 3/1FN 3/1 NYJumbo 3/1
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Source: MBA, JPMorgan
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Agenda
Page
M B S
Overall Market Size and Issuance 1
Terminology, Basic Structure and Valuation 15
Prepayments 25
Credit Performance
Structure 40
46
Recent Trends and Relative Value 54
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The Credit Spectrum
M B S
FICO range 750 700 650 600 550
Loan
designation
Securitization
structure
Prime Jumbo
Alternative A—Alternative B
SubPrime
Senior / Sub
OC / Residual
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Typical Structure – SR/Sub Credit Enhancement
M B S
Subordination – create AAA rated securities with little credit risk a portion of the collateral is set aside to absorb losses before the rest of the collateral
Subordinates are further tranched into 6 classes rated AA through NR. AAA are rated by at least 2rating agencies, subordinates can be double- or single-agency rated
Rating agencies - Standard & Poors, Moody’s, Fitch, Dominion
Credit Support – amount of collateral available to absorb losses.AAA credit support (credit enhancement) levels are approximately 3-4% of the principal for Jumbo-A and 4-7% for Alt-A structured as sr/sub. Shifting-Interest Structure - redirects prepayments disproportionately from the subordinated class to the senior class according to a specified schedule The rationale is to have enough protection outstanding for future losses – if defaults and losses are low and prepayments are fast the effective credit enhancement will increase over time (de-levering) Shifting-interest structure is subject to credit (delinquency and cumulative loss) testsSeniors receive their pro-rata share of scheduled and prepay principal + a portion of the subordinate’s share of prepayments (100% for 5 years, 70/60/40/20% per year, and pro-rata after 10 years), effectively accelerating and shortening senior class average livesARM subordinates are typically locked out of prepays for a longer term (7 or 10 years); however, they shift to pro rata payers with the seniors once credit enhancement doubles
Sr/Sub Credit Enhancement is typical on standard FICO (700-720) where par or slight premium senior classes will be created. Higher coupon / lower FICO collateral often goes OC.
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Sr/Sub Subordination Example
M B S
AA
BBB-
Class Size(% of collateral)
AAA
AA
A
BBB
BB
B
NR
94.00 %
2.50 %
1.25 %
0.75 %
0.60 %
0.40 %
0.50 %
Investment Grade
Subordinates
Non-Investment
Grade Subordinates
Mortgage
Pool
6.00 %
3.50 %
2.25%
1.50 %
0.90 %
0.00 %
Credit Support (% of collateral)
0.40 %
Seniors
ST
RU
CT
UR
E
Source: JP Morgan Securities Inc.
43
Recent Alternative ALT-A Structure – Over-Collateralization
M B S
Subordination – like Sr/Sub credit enhancement, AAA senior classes are carved out with subordinate classes below them. The difference is that the non-investment grade subordinates are lumped into a single class of equity referred to as over-collateralization. Added enhancement is achieved through the use of excess spread, which is generated from the difference between the interest received on the collateral, and the interest payable to the debt
Subordinates are typically tranched down to the lowest investment-grade rating (BBB- S&P/Fitch; Baa3 Moody’s), often with notched-rating classes (ex. AA+, AA, AA-, etc.)
Credit Support – amount of collateral available to absorb losses.AAA credit enhancement levels are generally great than 7% of the principal balance and can go as high as 9%. Anything higher than that would be indicative of ALT-B or SubprimeLocked-Out Subordinates – subordinates (and equity OC) do not receive any principal for at least three years. De-levers the seniors faster than typical Sr/Sub credit enhanced dealStep-Down – after three years, principal can be released to the subordinates (and equity OC) to maintain double the original credit enhancement level to each respective rating level. Effectively turns deal at that point into a full pro rata principal pay structure.Step-Down Test – the Step-Down is subject to credit (delinquency and cumulative loss) tests that are generally more stringent than that associated with Sr/Sub credit enhanced deals
Excess Spread – difference between mortgage interest received and debt interest payableCreated by structuring coupons (floaters or fixed) at a rate less than the mortgage net rate.Available to (1) first, maintain credit enhancement targets by paying interest as principal, (2) second, to cover any basis risk shortfall on floaters, and (3) to cover credit losses.
ST
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CT
UR
E
44
Over-Collateralization ALT-A Subordination Example
M B S
AA
BBB-
Class Size(% of collateral)
AAA
AA
A
BBB
BB-
OC
92.00 %
2.50 %
2.00 %
1.35 %
0.50 %
1.65 %
Investment Grade
Subordinates
Equity Residual
Mortgage
Pool
8.00 %
5.50 %
3.50 %
2.15 %
1.65 %
Credit Support (% of collateral)
0.00 %
Seniors
ST
RU
CT
UR
E
Source: JP Morgan Securities Inc.
45
Agenda
Page
M B S
Overall Market Size and Issuance 1
Terminology, Basic Structure and Valuation 15
Prepayments 25
Structure 40
Recent Trends and Relative Value
Credit Performance 46
54
HY
BR
ID
PR
IM
ER
46
Credit Performance
M B S
Prime hybrid collateral typically has credit scores above Prime fixed-rate collateral.
Credit performance of hybrid IO collateral has been better than amortizing and fixed-rate collateral.
Increased option ARM origination has removed some of the marginal levered borrowers from traditional hybrid IO.
Less than $5 billion hybrids are resetting this year.
The concerns usually surround credit performance near reset.N
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47
Hybrid IOs have had solid credit performance.
M B S
60+ day delinquencies (2002 vintage)60+ day delinquencies (2002 vintage)
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
Jan-02 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04
% C
urre
nt B
alan
ce (6
0D+
delin
q)
Jumbo Alt-A 30-yr Jumbo Alt-A 5/1 Jumbo Alt-A 5/1 IO
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However, slower growth regions tell a slightly different story
M B S
Credit performance by region for Jumbo 5/1 hybrid and hybrid IO (90+ day delinquencies; 2003 vintage)Credit performance by region for Jumbo 5/1 hybrid and hybrid IO (90+ day delinquencies; 2003 vintage)
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05% 9
0+ d
ay d
elin
quen
cies
of c
urre
nt b
alan
ce
North CentralNortheastSouthWest
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05% 9
0+ d
ay d
elin
quen
cies
of c
urre
nt b
alan
ce
North CentralNortheastSouthWest
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49
M B S
Payment shock to an ARM IO borrower at reset
ARM 8% 9% 10% ARM IO 8% 9% 10%
Original pmt/month ($) 3,221 2,500
Amt amortized after 60 mos ($) 550,050 600,000
Pmt/month at reset ($) 4,245 4,616 4,998 4,631 5,035 5,452
% increase in mortgage pmt 32% 43% 55% 85% 102% 118%
Mtg rate at reset Mtg rate at reset
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Assuming an original loan size of $600,000 and a WAC of 5%.
Source: JPMorgan
50
Resets on the horizon
M B S
Non-agency ARMs ($ billions)Non-agency ARMs ($ billions)Agency ARMs ($ billions)Agency ARMs ($ billions)
0
1
2
3
4
5
6
7
Mar-06
May-06
Jul-0
6Sep
-06Nov
-06Ja
n-07
Mar-07
May-07
Jul-0
7Sep
-07
Bill
ion
($)
First reset Subsequent resets
0
1
2
3
4
5
6
7
Mar-06
May-06
Jul-0
6Sep
-06Nov
-06Ja
n-07
Mar-07
May-07
Jul-0
7Sep
-07
Bill
ion
($)
First reset
OR
MA
NC
EC
RE
DI
TP
ER
F
April 2006 current balancesApril 2006 current balances
51
Affordable lending growth: hybrid IO -> option ARMs.
M B S
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05
AR
M IO
Pur
chas
e Sh
are
in C
A
ARM IO share
ARM IO and MTA share
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Defaults are well within the subordination levels near reset.
M B S
Cumulative Default RampCumulative Default Ramp
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
0 4 8 12 16 20 24 28 32 36 40 44 48
WALA
Cum
. Def
aults
(%)
Prime 5/1Alt-A 5/1
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Agenda
Page
M B S
Overall Market Size and Issuance 1
Terminology, Basic Structure and Valuation 15
Prepayments 25
Structure 40
Credit Performance 46
Recent Trends and Relative Value 54
HY
BR
ID
PR
IM
ER
54
Factors near reset have been rising, but post reset factors have not changed
M B S
Factor at resetFactor at reset
0
5
10
15
20
25
30
35
40
Jan-04 Jun-04 Dec-04 Jun-05 Dec-05
Fact
or a
t res
et
30–36 WALA36–42 WALA42–48 WALA
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
55
Post reset speeds have increased while pre-reset speeds have slowed
M B S
3-month CPR (%)3-month CPR (%)
0
10
20
30
40
50
60
70
80
90
Jan-04 Jun-04 Dec-04 Jun-05 Dec-05
3-m
o C
PR
(%)
30–36 WALA36–42 WALA42–48 WALA
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
56
Borrowers have been resetting to higher rates
M B S
FN 3/1s 36-42 WALAFN 3/1s 36-42 WALA
3.03.54.04.55.05.56.06.57.07.58.0
Rat
e (%
)
Jan-04 Jun-04 Dec-04 Jun-05 Dec-05
Pre Reset WACPost Reset WAC30-yr primary rates
RE
CE
NT
TR
EN
DS
AN
DR
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AT
IV
EV
AL
UE
57
Relative value in longer resets (7/1s and 10/1s)
M B S
Comparing 7/1s versus 10/1s versus 15-year paper
OAS is a viable relative value measure in longer resets
Theoretical non-agency/agency hybrid basis
RE
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UE
58
Agency 7/1s have lagged the tightening in 10/1s
M B S
Current coupon (nearest coupon below par)Current coupon (nearest coupon below par)
0
20
40
60
80
100
120
140
Jan-05 Apr-05 Jun-05 Sep-05 Dec-05 Mar-06
Z/U
ST
@ 1
5CP
B (b
ps)
CC 7/1 (Z/UST 15CPB)CC 10/1 (Z/UST 15CPB)
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
59
Agency 7/1s relative to Dwarfs are also on the wide end of the range
M B S
Current coupon (nearest coupon below par)Current coupon (nearest coupon below par)
CC 7/
1 -CC
15yr
(Pric
e Spr
ead %
)
(0.8)(0.6)
(0.4)(0.2)
0.00.2
0.40.6
0.81.0
Jun-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
60
OAS further corroborates the relative cheapness
M B S
Current coupon OAS for FNMA and Jumbo A securities (We prefer Agency 7/1s and Non-agency 10/1s)Current coupon OAS for FNMA and Jumbo A securities (We prefer Agency 7/1s and Non-agency 10/1s)
Months to roll
0
2
4
6
8
10
12
14
48 60 72 84 96 108 120
OA
S
FNMA Jumbo A
(6)
(4)
(2)
0
2
4
6
8
48 60 72 84 96 108 120
Months to roll
OA
S (t
o ba
lloon
)
FNMA Jumbo A
RE
CE
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TR
EN
DS
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AT
IV
EV
AL
UE
61
Jumbo 10/1 basis
M B S
Current coupon price spreads between agency and non-agency 10/1sCurrent coupon price spreads between agency and non-agency 10/1s
0
2
4
6
8
10
12
14
16
18
20
05/05 06/05 07/05 08/05 09/05 10/05 11/05 12/05 01/06 02/06 03/06
Non
-age
ncy
10/1
bas
is (3
2nds
)
RE
CE
NT
TR
EN
DS
AN
DR
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AT
IV
EV
AL
UE
62
The ratio between premium conforming 10/1s and Jumbo 10/1s in 2004 and 2005 has been roughly 65%
M B S
Observations: 2004—2005 (12—24 WALA)Observations: 2004—2005 (12—24 WALA)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100Incentive (bps)
3-m
onth
%C
PR
Jumbo 10/1Conforming 10/1
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
63
Excluding California suggests a smaller ratio
M B S
Observations: 2004—2005 (12—24 WALA)Observations: 2004—2005 (12—24 WALA)
0
10
20
30
40
50
60
(100) (75) (50) (25) 0 25 50 75 100
Incentive (bps)
3-m
onth
%C
PR
Jumbo 10/1Conforming 10/1
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
64
Theoretical value of the 10/1 basis
M B S
Value of AAA Jumbo vs. agency hybrid 10/1 (in 32nds)Value of AAA Jumbo vs. agency hybrid 10/1 (in 32nds)
Convexity Servicing Loan size CA Liquidity Total
+3 (5) (3) (1) (6)
(to balloon) +2 (4) (2) (1) (5)
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
65
The value of seasoning
M B S
Should 3-year seasoned 10/1s trade through new issue 7/1s?
What about 2-year seasoned 7/1s versus new issue 5/1s?
Stability of cashflow (new issue short resets versus seasoned longer resets)
The theoretical value of seasoning is very conservative
JPMorgan’s prepayment model suggests that longer reset seasoned hybrids should trade through new issue, despite fundamental differences in baseline turnover
RE
CE
NT
TR
EN
DS
AN
DR
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AT
IV
EV
AL
UE
66
Seasoning: Market versus Model Implied
M B S
Comparing 5.25% 10/1 pricing curve versus new issue shorter resets with the same couponComparing 5.25% 10/1 pricing curve versus new issue shorter resets with the same coupon
Market pricingModel impliedModel implied (to Balloon)
97.0
97.5
98.0
98.5
99.0
99.5
100.0
100.5
101.0
101.5
102.0
0 12 24 36 48 60 72 84 96 108 120Months to Roll
Pric
e (%
)
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
67
Model discount seasoning ramps
M B S
0
5
10
15
20
25
30
0 2 4 6 8 10 12 14 16 18 20 22 24
WALA
1-m
o %
CP
R
3/1 5/1 7/1 10/1
RE
CE
NT
TR
EN
DS
AN
DR
EL
AT
IV
EV
AL
UE
68
Seasoning ramps
M B S
Q1 2006 (25bps or more out-of-the-money)Q1 2006 (25bps or more out-of-the-money)
0
10
20
30
40
50
60
70
0 6 12 18 24 30 36 42WALA
3M %
CP
R
3/1 5/1 7/1 10/1
TT
RE
ND
SA
ND
RE
LA
TI
VE
VA
LU
ER
EC
EN
69
A piecewise empirical seasoning ramp for 5/1s
M B S
0
10
20
30
40
50
60
70
0 6 12 18 24 30 36 42 48 54 60 66 72WALA
3-m
o %
CPR
5/1 3/1
TT
RE
ND
SA
ND
RE
LA
TI
VE
VA
LU
ER
EC
EN
70