nomura mbs research 9-16

MGM Mirage Credit Research | United States

Securitized Products Research | Americas

Nomura Securities International Inc.

See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures

Securitized Products Weekly

24 SEPTEM BER 2010

Agency MBS: Market Overview and Relative Value

During the past week, 30-year lower coupon agency MBS (4.0s and 4.5s) have lagged their Treasury hedges by 10-12 ticks and swap hedges by 7-9 ticks. 30-year and 15-year 3.5s passthroughs were the best performers across the respective coupon stacks. Although we are holding on to our tactical modest overweight on agency MBS versus Treasuries and swaps because of the current cheap valuations of agency MBS, we have little conviction on this trade as supply/demand technicals are negative for the agency MBS sector. We have initiated up-in-coupon trades across the 15-year and 30-year coupon stacks to take advantage of the recent sharp underperformance of the higher coupons.

Agency MBS: How Bad are the Bad Billions?

The fastest paying $20bn pools (excluding pools locked in CMOs and held by the Fed) are prepaying marginally faster than breakeven speeds implied by 30-year Fannie dollar rolls. Based on recent prepays on these worst to deliver pools and our expectations of a further increase in speeds over the next two months, we think that dollar rolls are still trading rich.

Agency MBS: Outlook for Domestic Bank Demand

Although the yield curve is steep and loan demand has been weak, which typically point to strong demand for agency MBS from domestic banks, we have been maintaining a bearish stance on the magnitude of likely demand for agency MBS from domestic bank portfolios since the beginning of 2010. As we have 7-8 months of data related to changes in bank holdings of agency MBS in 2010 and there is some clarity around required bank capital and liquidity ratios from Basel III, we are revisiting the issue of bank demand for agency MBS this week.

Mortgage Credit:

The non-agency mortgage market was fairly active in the past week, with about $3bn bonds trading off bid lists. Prices were firmer for Alt-A and Prime Fixed-rate bonds, and subprime seasoned mezz bonds.

Consumer ABS: Primer on Pooled Aircraft Securitization

We analyze the main drivers of performance for pre-9/11 pooled aircraft (―classic‖) securitizations. At current valuation, we find that the rebound in the transportation sector has been fully priced and deals have limited upside.

CMBS Market

Spreads remain firm as we head into quarter end, with Super Senior CMBS closing at 300bp over swaps. We take a closer look at the relationship between commercial real estate prices and loss severities. We also highlight two recent loan workouts and the effects of each on certain tranches in their respective deals.

Fixed Income Research

Contributing Research Strategists

Ohmsatya Ravi

+1 212 667 2338 [email protected]

Gaetan Ciampini


Dhivya Krishna


Ankur Mehta


Paul Nikodem


Lea Overby


Sean Xie, CFA

+1 212 667 9081 sean.xie @nomura.com

Table of Contents Page

Agency MBS: Overview 2

Agency MBS Prepays 7

Agency MBS: Bank Demand 10

Mortgage Credit 15

Consumer ABS 17

CMBS Market 29

Nomura | Structured Products Weekly 24 September 2010

2

Agency MBS: Market Overview and Relative Value

Recent Performance and Market flows

During the past week, 30-year lower coupon agency MBS (4.0s and 4.5s) have lagged their

Treasury hedges by 10-12 ticks and swap hedges by 7-9 ticks (Thursday – Thursday closes). 30-

year and 15-year 3.5s passthroughs were the best performers across the respective coupon

stacks. The strong variation in the performance of different coupon passthroughs over the week

could be gauged from the fact that the dollar prices of FN 5.0s-6.0s have declined by 2-4 ticks

over the week even as the dollar price of FN 3.5s increased by close to 1-point over the same

time period. Renewed concerns about the possibility of the Fed increasing the size of its Treasury

purchases and potential changes to the streamlined refinancing programs of the GSEs have

dominated overall market sentiment this week.

Last week, Trust IOs have continued to lag their current coupon TBA hedges by 20-24 ticks which

is in addition to the 1-2 point underperformance seen over the prior several weeks. Although a

major portion of this underperformance could be attributed to market pricing in the very high

callability of 2009 and 2010 vintage collateral, we believe that Trust 4.5% and 5% IOs are

attractively priced at current price levels. While we believe that long-term investors should start

initiating modest long positions in Trust IOs (or IOS) considering the current attractive valuations,

we want to emphasize again that the Trust IO market is suffering from the negative technicals

coming from heavy issuance of structured IOs and we are not sure when its effect will subside.

MBS Basis: Modest Overweight but not with Much Conviction....

Below we summarize some positive and negative technicals for the agency MBS basis at the

moment:

Positive Factors:

a) Agency MBS are trading at wide spreads versus Treasuries and swaps relative to the

spreads seen over the past several months.

b) Money managers are still significantly underweight on agency MBS which puts a cap on

how much MBS could widen from here.

c) There is very limited float available in the agency MBS market (although the float

situation is improving every single month).

d) Current low absolute levels of yields which means MBS could trade at tighter spreads

than historical averages.

Negative Factors:

a) Heavy net supply of agency MBS to private investors from paydowns on Fed and

Treasury holdings of MBS.

b) Dollar rolls have weakened recently which reduced carry attractiveness of mortgages.

c) Any activity from the Fed on initiating a new QE 2 over the next two Fed meetings is

likely to be unfavorable to MBS versus Treasuries.

d) High prepay uncertainty because of the possibility of streamlined refis.

e) Overseas investor demand for MBS is likely to disappoint the market: Recent sharp

decline in Fed's custody holdings is indicating at least a small decline in overseas

holdings of MBS in August and September (although the magnitude is highly uncertain).

f) Growth in bank holdings of agency MBS is uncertain: Recent growth in bank holdings of

agency MBS was primarily driven by MSR hedging. This flow should go away from now

onwards or could even reverse in a backup in rates. At the same time, Liquidity

constraints imposed by Basel III on banks should push banks to continue to use

Ohmsatya Ravi

+1 212 667 2338

[email protected]

Ankur Mehta


Dhivya Krishna

+1 212 667 2183

[email protected]


3

paydowns on their loan and securities holdings to reduce reliance on whole sale funding

rather than to buy new assets.

g) MBS investments are unlikely to benefit from a sharp decline in implied volatilities as

seasonal factors are such that implied volatility will have a bias to move higher between

now and the end of the year.

Figure 1 shows our estimates of the likely net supply/demand for agency MBS from September-

December of this year assuming that the 30-year mortgage rate remains below 4.50% (these are

average monthly supply/demand technicals and the demand numbers corresponding to different

market participants are net of paydowns).

Figure 1: Estimates of Monthly Supply/Demand Technicals for Agency MBS

Note: We believe that the risk to our estimates of net demand from banks, overseas investors and GSEs is to the downside.

Source: Nomura Securities International

Our strategy team initiated a tactical modest overweight on agency MBS on September 10th when

mortgages were lagging their Treasury and swap hedges by 4-6 ticks on the day. Although we are

holding onto this recommendation for now, we don’t expect mortgages to either significantly

outperform or underperform Treasuries and swaps from a long-term perspective. Agency MBS

look cheap in terms of both nominal and option-adjusted spreads, but the long-term

supply/demand technicals are somewhat negative for the mortgage basis because of the heavy

net supply of agency MBS to private investors. A sustained outperformance of agency MBS

probably requires domestic bank portfolios (instead of their servicing arms) to grow their MBS

holdings significantly which we doubt will materialize in the remainder of 2010. Thus, as

discussed in our last weekly report, our overweight on MBS is more of a short-term tactical trade

rather than a core view on the long-term direction of MBS spreads.

Relative Value in Agency Passthrough Market1

UIC in 30-year MBS: Long 30-year 5.5s/4.5s Swap (New Trade)

UIC in 15-year MBs: Long DW 5.0s/4.5s Swap (New Trade)

15-year MBS vs. 30-year MBS: Long DW 3.5s/FN 4.0s Swap (New Trade)

Take Profits on Short DW 4.0s Butterfly (Since 9/16/2010)

Figures 2 and 3 show the valuations of 30-year and 15-year coupon stacks on our models as of

yesterday’s closes (YieldBook models adjusted to reflect our expectations for prepayment speeds).

1 This subsection is a reprint of the short-note published earlier today.

Net Growth of Agency MBS market

Net supply (excl. GSE buyouts) $21bn

GSE buyout volume -$12bn

Net growth of agency MBS $9bn

Likely net demand for agency MBS

Federal Reserve + Tsy -$36bn

Domestic banks $7bn

Overseas investors $5bn

GSEs -$10bn

Others (Domestic Money Managers) $20bn

Excess Supply $23bn


4

Following the significant underperformance of the up-in-coupon trades over the past several weeks,

higher coupons are beginning to look attractive versus lower coupons in both 15-year and 30-year

markets. We recommend long 30-year FN 5.5s/4.5s swap (at a hedge ratio of 45%) and long 15-

year DW 5.0s/4.0s swap (at a hedge ratio of 50%) trades to take advantage of the current

cheapness of higher coupons. Obviously, there is some idiosyncratic risk in these trades in that

FN/FH could ease requirements for refinancing existing agency mortgages further which could hurt

higher coupons in the short-term. However, we believe that current valuations of higher coupons

are such that there is enough risk premium built in the dollar prices of higher coupons to buy FN

5.5s/4.5s and DW 5.0s/4.0s swaps. Our conviction on the up-in-coupon trade in 15-year MBS is

somewhat better than that in 30-year MBS market however. Both these coupon swaps are lagging

by 0.5 tick on the day today and we will track the performance of these swaps without curve

hedges starting from current levels.

We are also reinitiating the long DW 3.5s/FN 4.0s trade that we closed last week to take advantage

of the strong positive carry offered by this swap. At current dollar roll levels, DW 3.5s/FN 4.0s swap

is offering 2.75 ticks per month of positive carry and the swap still looks slightly cheap. We expect

the demand for DW 3.5s from money managers and domestic banks to remain strong and

recommend buying it for November settlement (to lock in Oct/Nov rolls).

Finally, our strategy team recommended shorting the DW 4.0s butterfly on September 16th when

this fly was bid at 21 ticks. As DW 3.5s have significantly outperformed across the 15-year coupon

stack, this fly had come down to 14/15 tick levels over the past one week. Although the strong

demand for DW 3.5s could drive this fly further down to 10-11 ticks, we recommend taking profits

on the short DW 4.0s fly trade now as fundamentally the fly looks close to fairly priced at the 14/15

tick level2.

Figure 2: Valuations of the 30-year Coupon Stack (as of September 23, 2010)

Source: YieldBook, Nomura Securities International

Figure 3: Valuations of the 15-year Coupon Stack (as of September 23, 2010)

Source: YieldBook, Nomura Securities International

VA Prepays Much Faster than FHA

Besides a couple of months in late 2009 and early 2010, when servicer related buyouts were fairly

high, VA prepay speeds have been noticeably faster than FHA. We show a snapshot of prepays

in August (September factor) on FHA and VA loans backing Ginnie Is in Figure 4. VA loans

prepaid anywhere between 2%CPR to 15%CPR faster than FHA loans. We attribute the faster

prepays on VA loans to their relatively relaxed streamline refinance program and lower

refinancing cost (Figure 5). The FHA UFMIP of 225bps versus the 50bp of VA guarantee fee

coupled with the fact that the VA’s IRRRL program (the VA Streamline refinancing program) does

not require any credit check and additional documentation is causing VA speeds to be higher

2 This subsection is a reprint of the short-note published on September 22

nd.

Security TBA Assumption (Oct) Yield Tsy ZV (bp) Swap ZV (bp) Tsy OAS (bp) LOAS (bp)

FNCL 4.0s 2 WALA, 4.55 GWAC, $300 K 3.24% 90 93 17 17

FNCL 4.5s 6 WALA, 4.95 GWAC, $290 K 2.94% 116 114 28 24

FNCL 5.0s 20 WALA, 5.45 GWAC, $280 K 2.50% 123 115 34 25

FNCL 5.5s 28 WALA, 6.05 GWAC, $240 K 2.22% 124 110 57 43

FNCL 6.0s 24 WALA, 6.53 GWAC, $220 K 2.04% 115 99 77 62

Security TBA Assumption (Oct) Yield Tsy ZV (bp) Swap ZV (bp) Tsy OAS (bp) LOAS (bp)

FNCI 3.5s 2 WALA, 4.05 GWAC, $230 K 2.67% 75 66 34 24

FNCI 4.0s 2 WALA, 4.50 GWAC, $260 K 2.49% 86 76 31 20

FNCI 4.5s 6 WALA, 5.10 GWAC, $220 K 2.20% 88 75 33 19

FNCI 5.0s 24 WALA, 5.55 GWAC, $200 K 2.09% 96 81 47 31

FNCI 5.5s 30 WALA, 6.05 GWAC, $180K 2.05% 94 78 51 34


5

across the coupon stack. We expect the difference between FHA and VA prepay speeds to

increase further as the new insurance premiums for FHA borrowers become effective in October

2010. Based on our estimates, we expect the change in FHA insurance premiums to add an

additional 36bps of disincentive for FHA borrowers3.

Figure 4: Comparison of FHA and VA prepay speeds for different coupons and vintages for August 2010

Source: Ginnie Mae, Nomura Securities International

Figure 5: Comparison of FHA and VA Streamline Refinance Programs

Source: FHA, VA, Ginnie, Nomura Securities International

3 ―Impact of a Change in Insurance Premiums‖ in Securitized Products Weekly August 20th 2010

0

5

10

15

20

25

30

35

40

45

50

2009 2010 2009 2010 2009 2008 2005 2009 2008 2007 2006 2005 2009 2008 2007 2006 2005 2008 2007 2006

4 4.5 5 5.5 6 6.5

CP

R (

%)

FHA VA

FHA Streamline Refinance VA Interest Rate Reduction Refinancing Loan (IRRRL)

SeasoningBorrower must have made at least 6 payments on the

FHA-insured mortgage being refinanced.None.

Payment History

Borrower has made all the prior three payments and

experienced only one 30-day late payment. For less than

12-month payment history all payments must be made

Borrowers who are 30-days or more delinquent can also

refinance through IRRRL if VA approves.

Reduction in Total

Mortgage Payment

New total mortgage payment (principal, interest, taxes

and insurances, homeowners’ association fees, ground

rents, special assessments and all subordinate liens) is 5

percent lower.

New payment is lower.

Appraisal Required if borrower rolls closing costs into the loan. Not required.

LTV LimitsCLTV limit of 125% is only applicable if a loan has

subordinate financingNone.

Credit Score Lender reports credit score to FHA if available.Required only if loan to be refinanced is delinquent or if

new monthly payment (PITI) increases more than 20%.

Income, Employment

and Asset

Documentation

Lender must verify and document borrowers income,

employment and assets.

Required only if loan to be refinanced is delinquent or if

new monthly payment (PITI) increases more than 20%

Costs

• Closing costs: Can be rolled into new loan amount only

with and appraisal.

• Upfront Mortgage Insurance Premium of 225bps

(UFMIP): Can be rolled into new loan amount.

• Monthly Annual Premium of 50bps.

• Closing costs: Can be rolled into new loan amount.

• VA Guarantee Fee of 50bps (UFMIP): Can be rolled into

new loan amount.

Discount Points Cannot be rolled into new loan.Can roll in upto 2% of discount points into new loan

amount.

http://www.nomura.com/research/getpub.aspx?pid=387915


6

August Freddie Transition Rates

Freddie released the 90-day and 120-day delinquency matrices along with their monthly volume

summary today. The 120-day delinquencies were marginally higher than expected (Figure 6)

because of higher 90-120 day roll rates in August (Figure 7). As per the latest release, 90-day

delinquencies at the end of August were lower than the prior month. As a result we expect the

120-day delinquencies for the end of September to be lower than August (Figure 6)4.

Figure 6: Projected and Actual End of August 120-day Delinquencies

Source: Freddie Mac, Nomura Securities International

Figure 7: Ratio of Freddie August and July 90-day delinquency and 90-120 roll rates


4 Note that the projected 120-day delinquencies for September will be eligible for repurchase in October.


7

Agency MBS: How Bad are the Bad Billions?

Summary

The fastest paying $20bn pools (excluding pools locked in CMOs and held by the Fed) are

prepaying marginally faster than breakeven speeds implied by 30-yr Fannie dollar rolls. Based on

recent prepays on these worse to deliver pools and our expectations of a further increase in

speeds over the next two months, we think that dollar rolls are still trading higher than fair value.

Dollar Rolls and Worst Billions

Dollar rolls across the coupon stack have collapsed over the last few cycles as a combination of

higher dollar prices and faster prepays resulted in prepay speeds on TBA deliverable collateral to

worsen significantly (partly because some real money investors that usually didn't dollar roll sold

passthroughs and delivered fast prepaying pools worsening the overall pool available to be

delivered towards TBA). Figure 1 shows breakeven speeds on Oct/Nov rolls assuming a funding

rate of 25bps.

Figure 1: Oct/Nov Rolls and Breakeven Speeds assuming 25bp Funding

Coupon Oct/Nov Roll

(ticks) b/e CPR assuming 25bps funding (%)

4.0s 9 0%CPR

4.5s 6.75 25%CPR

5.0s 3.125 43%CPR

5.5s 3.25 42%CPR

6.0s 3.75 40%CPR


Clearly, October prepay speeds (November factor) that are being priced into the Oct/Nov roll are

fairly high. To see how these implied speeds compare with prepays on some of the fastest paying

pools, we summarize collateral characteristics on the worse $20bn pools for each FNMA coupon in

the table below. We exclude pools locked up in CMOs and held by the Fed since they are very

unlikely to be delivered into TBA. To eliminate pools which had just a one month jump in prepays,

we sorted out fast paying pools based on 3-month CPRs.

Figure 2: Collateral Characteristics of Fastest Paying 30-yr FN $20bn Pools (Excl. Pools locked in CMOs and Fed held pools)

Coupon WAC WALA AOLS WAM FICO LTV 1-mo CPR (%) 3-mo CPR (%)

4.0s 4.60 17 242,682 338 766 65 7 5

4.5s 5.17 51 225,531 301 748 69 35 28

5.0s 5.61 38 239,923 315 745 72 48 39

5.5s 6.02 42 236,072 312 733 74 44 39

6.0s 6.53 41 224,823 314 719 77 43 42

6.5s 7.04 41 174,802 314 696 81 36 36

Source: Fannie Mae, Nomura Securities International

Based on the data presented in Figure 2, the $20bn fastest prepaying pools (excluding pools

locked up in CMOs and held by the Fed) prepaid at 35% CPR for FN 4.5s, 48% CPR for FN 5.0s,

44% CPR for FN 5.5s and 43% CPR for FN 6.0s. Interestingly enough, the WALA on the worst to

Ankur Mehta


Dhivya Krishna

+1 212 667 2183

[email protected]

Ohmsatya Ravi

+1 212 667 2338

[email protected]


8

deliver pools in FN 4.5s is 56 months, much higher than what we have been seeing through-the-

box. Similarly, the average WALAs on 5.0s-6.0s are also higher than the pools that are being

delivered through-the- box. Although it can be argued that these fast paying seasoned bonds

should be delivered into TBA, it is possible that they are in held to maturity portfolios of Banks or

Overseas Investors and are thus not delivered out. To adjust for this, we only consider pools with

WALA less than 48 months and re- calculate the worse $20bn pools across the coupon stack in

Figure 3 After putting the WALA restriction, the average WALA on the worst to deliver pools are

much closer to the through-the-box pools.

Figure 3: Collateral Characteristics of Fastest Paying 30-yr FN $20bn Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)


4.0s 4.58 13 245,936 342 768 65 6 5

4.5s 5.04 17 261,318 339 761 69 31 23

5.0s 5.62 26 236,877 329 747 72 47 38

5.5s 6.05 32 237,364 323 733 75 42 37

6.0s 6.54 34 226,668 322 719 78 40 39

6.5s 7.05 36 175,068 321 695 82 33 33

Source: Fannie Mae, Nomura Securities International

The 1-month CPRs on the worse to deliver pools considered above are much higher for 4.5s and

5.0s and more-or-less inline for 5.5s and 6.0s as compared to the implied breakeven CPRs on the

Oct/Nov roll. Apart from comparing prepays on this table to breakeven prepays on the roll,

investors need to consider the following important factors:

The 1-month CPRs in the table above correspond to August prepays (September

factors). We expect speeds to increase by around 15% in September (October factor)

and another 5% in October (November factor) with a majority of the increase occuring in

4.0s through 5.0s. Hence, prepays on worse to deliver pools are likely to be higher

corresponding to the Oct/Nov roll.

The deliverables have gradually deteriorated over time as dollar prices increased and

prepays jumped. Investors holding consistently fast paying seasoned bonds seem to be

gradually delivering these pools into TBA and this may lead to a further deterioration of

TBA deliverables (as shown above, prepays on the worse $20bn pools without WALA

restriction are faster).

We have considered the worse $20bn bonds for each coupon. As we move higher

across the coupon stack, liquidity decreases and the size of the trades goes down.

Arguably, one should consider a smaller float (for example, instead of the worse $20bn

pools, one should consider the worse $5bn or $10bn pools for FN 6s) for the worse to

deliver. This will result in worse collateral characteristics (and prepays) than the ones

outlined in the tables above.

We have not accounted for pools held by investors (like some overseas

investors/banks/insurance companies) who may choose not to roll the bonds that they

hold. This could improve the actual float that is delivered into TBA.

Overall, based on recent prepays on worse to deliver pools and our expectations of a further

increase in speeds over the next two months, we think that 30-year Fannie Mae dollar rolls are

still trading higher than fair value.


9

Worst Billions for Freddie and Ginnies

We summarize the collateral characteristics and prepays on the worse $20bn Freddie, GN I and

GN II pools (WALA<48) based on 3-month CPRs in Figure 4, 5 and 6 below.

Figure 4: Collateral Characteristics of Fastest Paying $20bn 30-yr FH Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)


4.0s 4.62 11 253,008 345 770 64 8 6

4.5s 5.03 15 254,867 341 763 68 32 22

5.0s 5.61 28 222,711 327 747 70 43 34

5.5s 6.04 29 216,214 326 738 74 42 37

6.0s 6.52 32 217,413 324 721 78 41 38

6.5s 7.02 34 175,920 321 700 82 29 29


Figure 5: Collateral Characteristics of Fastest Paying $20bn 30-yr GN I Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)


4.0s 4.50 11 182969 346 - 94 4 4

4.5s 5.00 17 221794 341 - 94 28 17

5.0s 5.50 18 184979 340 - 94 42 34

5.5s 6.00 27 72015 331 - 94 38 35

6.0s 6.50 28 69973 329 - 94 35 36

6.5s 7.00 29 102886 327 - 93 31 40


Figure 6: Collateral Characteristics of Fastest Paying $20bn 30-yr GN II Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)


4.0s 4.52 6 188040 352 - 95 3 4

4.5s 4.94 11 191159 347 - 95 10 7

5.0s 5.44 20 171536 338 - 94 27 21

5.5s 5.96 26 146827 331 - 94 32 29

6.0s 5.96 26 146827 331 - 94 32 29

6.5s 6.88 27 122734 329 - 94 32 37



10

Agency MBS: Outlook for Domestic Bank Demand

Since the beginning of 2010, large bank holdings of Treasuries and agency debentures have

increased by $87bn, while those of agency MBS have increased by $34bn (Figure 1). Most of the

rise in large bank holdings of agency MBS can be attributed to the $57bn increase seen in July and

August of this year and banks were actually net sellers of agency MBS in 1H’10. Several investors

have asked us if the recent rise in bank holdings of agency MBS represents a true pick-up in

demand for MBS from bank portfolios or will bank holdings of MBS revert back to the pattern seen

in 1H’10.

Although the yield curve is steep and loan demand has been weak, which typically point to strong

demand for agency MBS from domestic banks, we have been maintaining a bearish stance on the

magnitude of likely demand for agency MBS from domestic bank portfolios since the beginning of

20105. We opined that the overall demand for ―all securities‖ from domestic banks in 2010 will be

less than in 2009 as loan holdings of domestic banks are unlikely to decline by as much as they did

in 2009, FAS 166/167 brings additional assets onto bank balance sheets and there is lot of

uncertainty about regulatory issues surrounding bank capital ratios. In addition, even if bank

demand for "all securities" remains as high as in 2009, we thought that domestic banks will

continue to prefer other securities (predominantly Treasuries) over agency MBS unless current-

coupon MBS spreads widen meaningfully. As we have 7-8 months of data related to changes in

bank holdings of agency MBS in 2010 and there is some clarity around required bank capital and

liquidity ratios from Basel III, we are revisiting the issue of bank demand for agency MBS this week.

Figure 1: Changes in Large Bank Holdings of MBS, Treasuries, Loans and Deposits ($bn)

Note: Effect of consolidations due to new accounting regulations in 2010: Loans & Leases: $397bn; Other Securities = -$28.7bn

Source: Fed’s H.8 Report, Nomura Securities International (as of September 1, 2010)

Below we discuss some recent trends in bank demand for mortgages and present our assessment

of some important factors that are likely to drive bank holdings of agency MBS going forward.

Recent Trends in Bank Demand for Agency MBS

Figure 2 shows changes in the mortgage loan and MBS holdings of large domestic commercial

banks over the past few years. The top half shows numbers as reported in the Federal Reserve’s

H.8 report while the bottom half shows corresponding numbers after subtracting assets acquired by

large commercial banks from non-bank institutions through a corporate transaction. Although the

data as reported in the standard H.8 report (top half of Figure 2) is indicating that bank holdings of

all mortgages (MBS + closed end residential mortgage loans) have increased by $85-$90bn per

year over the past two years, it is obscuring some important trends about bank demand for

residential mortgage assets because of the acquisition related changes.

5 See our 2010 Outlook for the RMBS Market published in January 2010 for details.

Total Agency Treasuries & Other Loans &

Year Securities MBS Agency Debt Securities Leases Deposits

2001 82 65 -33 50 -6 122

2002 96 51 33 12 139 151

2003 64 33 9 22 190 152

2004 127 97 3 27 440 347

2005 21 4 -17 34 282 208

2006 107 71 -12 48 309 238

2007 54 -47 -5 105 456 285

2008 105 132 -7 -20 315 507

2009 222 60 95 66 -383 58

YTD 2010 57 34 87 -65 153 35

Ohmsatya Ravi

+1 212 667 2338

[email protected]

Ankur Mehta


Dhivya Krishna

+1 212 667 2183

[email protected]


11

Large domestic banks have acquired about $153bn and $124bn closed-end residential mortgage

loans from non-bank institutions in 2009 and 2008, respectively. They have also acquired $4.9bn

and $11bn agency MBS over the same two-year period. If we exclude acquisitions of mortgage

assets from non-bank institutions, domestic banks do not seem to have grown their exposure to

mortgage assets over the past two years (as shown in bottom half of Figure 2). The sharp growth

in bank holdings of agency MBS in 2008 came from simply reinvesting paydowns on their

unsecuritized mortgage loan holdings back in the agency MBS market. Similarly, the actual net

demand for mortgages provided by domestic banks in 2006 was a lot lower than is indicated by the

standard H.8 reports.

Figure 2: Annual Changes in Large Bank Holdings of Mortgages, C&I Loans and Deposits ($bn) Mort

Source: The Fed’s H.8 Report, Nomura Securities International (YTD 2010 numbers are as of September 1, 2010)

During 1H’10, bank holdings of agency MBS have declined even as their Treasury holdings have

increased meaningfully. However, this trend of weak demand for agency MBS had reversed since

the beginning of 2H’10 and large bank holdings of agency MBS rose by $57bn in July and August

alone. However, most likely, more than half of this growth came from rebalancing of servicer

duration hedges as servicers took delivery of MBS from their origination arm directly and, the

historical data presented in Figure 3, which shows changes in bank holdings of agency MBS over a

three month time period immediately preceding the peak of Refi index in several instances since

2001, seem to support this view6. Note that agency MBS holdings of banks increased significantly

every time there was a meaningful pickup in Refi activity (except in late 2007/early 2008, when

banks were actively selling agency MBS to raise cash).

Figure 3: Approximate changes in bank holdings of agency MBS ($bn)


6 We first discussed this issue in the short-note titled ―Bank Holdings of Agency MBS‖ published on August 3.

Not adjusted for acquisition of assets from nonbank institutions & accounting rule changes

Large Banks YTD 2010 2009 2008 2007 2006 2005 2004 2003 2002

Net Mortgage Purchases

Agency MBS 34 60 132 -47 71 4 64 33 51

Whole Loans -5 27 -44 125 178 64 47 59 65

Agency MBS + Whole Loans 29 87 87 78 250 68 112 92 115

C&I Loans -37 -160 46 122 65 61 16 -15 -25

Deposit Growth 35 58 507 306 238 208 195 152 151

All numbers are in billion dollars.

Adjusted for acquisition of assets from nonbank institutions & accounting rule changes

Large Banks YTD 2010 2009 2008 2007 2006 2005 2004 2003 2002

Net Mortgage Purchases

Agency MBS 34 55 121 -51 31 4 64 33 51

Whole Loans -26 -125 -168 120 47 64 47 59 65

Agency MBS + Whole Loans 7 -70 -47 70 78 68 112 92 115

C&I Loans -67 -166 27 110 61 61 16 -15 -25

Deposit Growth 35 -34 292 235 141 208 195 152 151

All numbers are in billion dollars.

Change in

No. Date Level MBS Holdings

1 11/9/2001 5,528 $34bn

2 10/4/2002 6,927 $40bn

3 3/14/2003 9,354 $27bn

4 5/30/2003 9,978 $55bn

5 3/19/2004 4,973 $65bn

6 1/25/2008 5,103 $4bn

7 1/9/2009 7,404 $57bn

Peak Refi Index


12

We believe that this growth in bank holdings of agency MBS at the onset of a Refi wave is because

of the duration rebalancing of their MSR books and the increase in bank holdings seen thus far in

2H’10 is not unusual. In fact, in prior instances, a meaningful portion of MSR books were with non-

bank financial institutions which have become part of commercial banks since then and the

convexity hedging related demand for agency MBS from banks should be higher now than before,

all else being equal. While it is difficult to estimate exactly what percentage of the recent growth in

bank holdings of agency MBS is because of convexity hedging related activity because of the

differences between the accounting treatment of TBAs at different firms, based on the flows seen

by the Street, we believe that a significant portion of recent growth in agency MBS holdings of

domestic banks had occurred because of convexity hedging related activity.

What Factors will Drive Bank Demand for MBS Going Forward?

Over the past several months, regulatory issues (capital and liquidity related issues) rather than the

availability of cash for investments seem to have been the driving force behind bank demand for

agency MBS. There are two important consequences of this trend in terms of the preference of

domestic banks for Treasuries over other securities classes and their eagerness to reduce

dependency on wholesale funding mechanism versus core deposits.

The first trend related to the preference of banks for Treasuries can be seen in Figure 4 which

shows bank holdings of Treasuries as a percentage of their total securities holdings have

increased noticeably over the past several months. Prior to 2009, most of the growth in securities

portfolios of domestic banks came from ―agency MBS‖ and ―other securities,‖ while their Treasury

holdings have actually declined (both in absolute and percentage terms). Although this trend had

reversed since the beginning of 2009, Treasury holdings by domestic banks is still somewhat lower

than what it was in the 1990s after adjusting for the size of their portfolios.

Figure 4: Different Security Types in Large Bank Portfolios of a % of Total Securities Holdings Mort

Source: The Fed’s H.8 Report, Nomura Securities International

Similarly, banks seem to be reducing leverage on their liabilities side by increasing the percentage

of assets funded by core deposits and reducing their dependence on wholesale funding (Figure 5).

Based on the FDIC data, the percentage of all bank assets funded by core deposits has declined

from 62.4% in 1992 to 42.5% in 2008 but this trend had reversed over the past two years as this

number rose to 49.8% by the end of 2009.

0.0%

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Agency MBS Treasuries & Agency Debt Other Securities


13

Figure 5: Percentage of All Bank Assets Funded by Core Deposits (%)

Note: 1H’10 data includes assets consolidated under new accounting regulations

Source: The Fed’s H.8 Report, Nomura Securities International

Looking ahead, we expect the regulatory issues rather than the combination of the availability of

cash, loan demand and the slope of the yield curve to continue drive bank demand for agency

MBS. Specifically, Basel III imposed a couple of capital and liquidity related issues that are likely to

play an important role in determining bank demand for MBS over the next several quarters as

discussed below.

Capital Related Issues

Although the market’s attention seems to have been focused mainly on the total Tier-1 capital

ratios imposed by Basel III, there is a limit on the contribution of mortgage servicing rights (MSRs)

to Tier-1 capital that could become an important factor for the mortgage market. As per the

guidelines issued by the Basel Committee on Banking Supervision, the value of mortgage servicing

rights (MSRs) needs to be capped at 10% of the bank’s Tier-1 equity capital. An earlier version of

the package issued by the Basel Committee on Banking Supervision would have required

deducting the entire value of MSRs from Tier-1 equity capital but the amendment released in July

only limits MSRs to 10% of the Tier-1 equity capital. However, this is still a lot more restrictive than

the current limit in the U.S. of 50% of MSRs in total common equity.

Right now, most domestic banks seem to be below the 10% cap imposed on the contribution of

MSRs to Tier-1 capital, but this is primarily because of the historically low mortgage rates which led

to very low valuations of MSRs. If mortgage rates backup 100-150bp from here, MSRs could easily

appreciate by 60%-80% from their current values (For example, Trust IOs are trading in the range

of $14-$15 at the moment while they are likely to trade in the range of $25-$30 if mortgage rates

backup 100-150bp from here) and several banks are likely to hit the 10% cap based on the data

presented in the 10-Qs published by different firms for 2Q’10. Essentially, this restriction makes

MSRs less attractive as an asset class for domestic banks. If the US regulators implement Basel III

guidelines without making any changes, we could see servicers more actively securitize MSRs

(through excess servicing IO deals) which should be a modest negative for bank/servicer demand

for agency MBS.

Liquidity Related Issues

The following two liquidity related constraints imposed by Basel III are also likely to play a

meaningful role in the preference of banks for agency MBS versus Treasuries and GNMA MBS

versus conventionals:

As per Basel III guidelines, the ―Liquidity Coverage Ratio,‖ defined as the ratio of the stock

of high-quality liquid assets to net cash outflows over a 30-day time period, should be

above 100%. Agency MBS count towards liquid assets (with a 15% haircut on FN/FH

30.0%

35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

1992 1994 1996 1998 2000 2002 2004 2006 2008 2009 2Q'10


14

MBS and 0% hair-cut on GNMA MBS and Treasuries) but FN/FH MBS fall under ―Level 2‖

of liquid assets which cannot be more than 40% total liquid assets as per current Basel III

guidelines. As of now, most of the ―Level I‖ liquid assets of banks are in cash and cash

equivalents (essentially excess reserves) and it is likely that they will consider the

scenario of excess reserves being pulled out of the system by the Fed in the future while

making their investment decisions. If they are worried about this scenario, banks will

prefer Treasuries and GNMA MBS over FN/FH MBS.

The ―Net Stable Funding Ratio,‖ defined as the ratio of the available amount of stable

funding to the required amount of stable funding, also should be above 100% as per

Basel III guidelines. This constraint is likely to lead banks to prefer MBS over mortgage

loans (because agency MBS need a lot lower lower percentage of stable funding than

mortgage loans) but it is also likely to lead banks to continue to use paydowns on their

loan books to delever on the liabilities side by reducing their exposure to wholesale

funding sources.

Summary Outlook for Bank Demand for Agency MBS

As discussed before, over the past several months, regulatory issues (capital and liquidity related

issues) rather than the availability of cash for investments have been driving bank demand for

agency MBS. Some of the liquidity related constraints imposed by Basel III on domestic banks

should be a positive factor for agency MBS versus mortgages and other loans, but it is also likely

that these constraints will limit the ability of the banks to grow their overall balance sheets. From

valuations side, agency MBS are looking quite attractively priced versus Treasuries and swaps in

terms of both nominal and option-adjusted spreads.

In our base case, we expect the net bank demand for agency MBS from domestic banks to be $6-

$8bn per month (net of paydown reinvestments) over the next several months unless mortgage

spreads widen meaningfully from here. However, we acknowledge that there is still lot of

uncertainty about how regulators will interpret Basel III guidelines in the US and its potential impact

on the preference of banks to buy agency MBS.


15

Mortgage Credit: Market Summary and HAMP update

Market Summary

Non-agency mortgages continued to trade at a torrid pace this week, with about $3 billion in bid

lists circulated around the market. Demand continues to be strong, with buyers outnumbering

sellers by a large margin. Market participants were broad based, with both buyers and sellers

coming from all types of accounts, including banks, money managers, insurance companies and

hedge funds. Prices were flat to slightly higher during the week.

In Alt-A and prime space, roughly $1 billion bonds changed hands. The focus continued to be on

clean fixed-rate passthrough products, with prices firming by approximately half a point during the

week. Elsewhere, in the Alt-A and prime space, prices were mostly flat on the week.

About $2.4 billion bonds were in for bid in the subprime and Option ARM markets. Trades in

seasoned Mezz bonds continued to dominate, with prices up by 1-2 points. Yields grinded tighter

as investors are re-evaluating their default expectations in light of the recent fall in current-to-30

day roll rates. Investment grade seasoned Mezz bonds are trading in the 5-7% yield range, while

levered bonds are trading in the low single digits. Supply came from bank prop desks and hedge

fund profit-taking as prices in this sector have risen 10+ points in the past few months. About 400

million bonds in the Option ARM market traded last week, with prices mostly unchanged.

News Update

On Tuesday, Housing Starts in August came in at 598,000, higher than the expected 550,000

units. However, the increase was buoyed by a 32% jump in multi-family and apartment

construction. Single family construction continues to be sluggish, highlighting the lack of

confidence in the housing recovery among the home builders.

The FHFA purchase only house price index for July was released on Wednesday. U.S home

prices dropped 3.3% in July from a year earlier, and fell 0.5% from June. At the same time FHFA

revised the May-to-June decline to 1.2% from the previous estimate of 0.3%. The month-over-

month drop in house prices is primary due to an increase in distressed home sales. The largest

drop occurred in the southeast which fell 1.6%, followed by a 1.5% drop in the states of Arizona

and Nevada. The report highlights the fact that distressed inventory will be an obstacle for home

price recovery going forward. Although the FHFA index only surveys houses with conforming

balance loan, it is highly correlated with more widely watched Case-Shiller index that is to be

release on September 28th.

After hitting all time low in July, existing home sales for the month of August rebounded slightly to

a 4.13 million seasonally adjusted annual rate. New home sale numbers released Friday morning

were lower than expected, at a seasonally adjusted rate of 288,000. Both indices are at the

second lowest level in history, highlighting the lack of demand for housing after the expiration of

home-buyer tax credit in June.

HAMP report update

The August HAMP report was updated on September 22nd and showed that a total of 33,342

permanent modifications have begun since July, compared to 36,695 last month. The number has

continued to decline over the past few months as servicers struggle to verify borrowers’ income, a

requirement to convert a trial modification to a permanent one. At the same time, reported trial

modifications were 26,628, largely unchanged from the previous month. We do not expect the

speed of trial and permanent modifications to pick up significantly from here

This month, the HAMP report added a quarterly compliance review section. This report revealed

that, for loans sampled from large servicers, fewer than 5% were evaluated incorrectly. For these

loans, servicers are required to forestall foreclosure sales and re-evaluate homeowners under

Paul Nikodem


Sean Xie, CFA

+1 212 667 9081 sean.xie @nomura.com


16

HAMP guidelines. The two servicers with the highest percentage of compliance review issues

were Wells Fargo and JP Morgan Chase. As the Treasury Department is serious about ensuring

the servicers adhere to the HAMP program guidelines, a foreclosure forestall and other actions

could potentially elongate the already extended liquidation timeline.


17

Consumer ABS

Discover to acquire SLC’s private student loan business

On Friday, the Student Loan Corporation announced that Discover Financial Services had agreed

to purchase SLC’s private student loan business and $4.2bn of private student loans. At the same

time, Sallie Mae will acquire $28bn of federal loans from SLC while Citibank will purchase FFELP

and private loans totaling $8.7bn. SLC is 80% owned by Citibank and the sale of its assets is part

of Citibank’s plan of shedding non-core businesses.

We view the acquisition by Discover as positive for future private student loan issuance

and neutral to slightly positive for the existing SLCLT ABS transactions.

SLC’s existing FFELP transaction should start trading on top of the Sallie Mae shelf as

they will benefit from the same servicer.

As of June 30, SLC owned $28.5bn of FFELP loans and $9.8bn of private student loans. The

acquisition continues Discover’s foray in the private student loan business after exiting the FFELP

business. Discover has grown its private student loan business quickly and as of May 31, it

owned $819mn of private student loans up from $580mn in 2009. With the FFELP program

ending on June 30, Discover announced it would sell it Federal student loans to Department of

Education before October 15, 2010.

Effectively, Discover is acquiring the residual interest in the following three ABS transaction:

SLCLT 2006-A, SLCLT 2010-A and SLCLT 2010-B along with the private student loan origination

business. The TALF-eligible SLCLT 2009-AA is not included in the transaction along with any non

securitized private student loans.

Loans in the three ABS transactions are a mix of privately insured and uninsured loans. Between

2003 and 2007, SLC was insuring losses on its private student loan portfolio with United Guaranty

(subsidiary of AIG) and Royal & Sun Alliance (its US operation was subsequently acquired by

Arrowpoint Capital). According to Discover’s filing, 70% of the loans are covered by insurance and

65% are in repayment. The average FICO is 724 with 74% of cosigners. Discover is purchasing

the loans with an estimated book value of $4.2bn at 8.5% discount leading to an acquisition price

slightly under par according to our estimates.

Discover’s commitment to the private student market is a clear positive. We believe the

acquisition is positive for future ABS origination: Discover could rely on securitization in the future

as they grow their private student loan business. SLC will continue to service SLCLT loans. In the

short run, servicing could deteriorate slightly as the platforms are combined but in the long run

Discover’s experience as a collection oriented servicer is likely to lift SLCLT credit performance.

Gaetan Ciampini



18

Value in the “Classic” Pooled Aircraft Securitization

Recent Market Activity

Throughout 2008 and 2009 the recession affected both passenger and air freight traffic. Looking

at international traffic, Revenue Passenger Kilometers (RPK) dropped 11.1% between March

2008 and March 2009 and in January 2009, freight traffic (measure by Freight Ton Kilometers)

had decreased by 23.2% year-on-year.

Demand has bounced back in 2010 along with the global economy. According to the International

Air Transport Association (IATA), July 2010 global passenger traffic was up 9.2% year-on-year

and 3% higher than the pre-crisis levels of early 2008. Similarly, cargo traffic was up 22.7% year-

on-year and 4% higher than pre-crisis levels.

As traffic has rebounded, aircraft financing has followed with a number a transactions:

In late May, AWAS priced a $530mn six-year term loan at L+575bp. The loan was

secured by a portfolio of 30 aircraft at a 64% LTV (loan to value).

In July, Aircastle announced the pricing of $300mn 9.75% senior unsecured notes.

In August, ILFC priced $3.9bn of senior secured notes with a four-year note at 6.50%,

six-year notes at 6.75% and eight-year at 7.125%.The notes were secured by a pool of

122 aircraft. ILFC further priced $500mn of second-lien notes at 8.875%.

In addition, airlines were able to tap the EETC (Enhanced Equipment Trust Certificates) and

senior secured debt market: United Airlines priced a transaction backed by US-Japan routes and

gates and Delta issued a $450mn EETC transaction, refinancing its 2000-1 EETC transaction and

adding two recently delivered B777-200. In July, Air Canada issued $600mn of a senior-secured

notes (B2/B+), along with $500mn of subordinated debt, and in early August, Continental offered

$800mn of five-year senior-secured notes backed by a mix of collateral (route, gates and

Continental’s equity interest in its Micronesia based subsidiaries).

In the pooled aircraft securitization space, we distinguish between the ―classic‖ transaction issued

before 9/11 and ―next generation‖ transactions issued after 9/11.The moniker refers to the type of

B737 present in the pool and the overall age of the airplanes. Boeing 737 Classic is the name

given to the 300/400/500 series after the 600/700/800/900 ―next generation‖ series were

introduced. Classic production ended in 2000, while deliveries of the more fuel-efficient ―next

generation‖ aircraft started in December 1997.


19

―Next generation‖ deals are reaching their expected repayment date and sponsors will need to

refinance to avoid losing residual cash flows. Prices have rallied 8 to 10 points and reflect the

increasing probability of refinancing.

Pre 9/11 ―classic‖ deals have appreciated 8 to 12 points also suggesting even higher returns

given those bonds’ lower dollar prices. Classic transactions have gone through two airline industry

recessions and have experienced large price declines and, those transactions are more difficult to

value. Structures are usually distressed with subordinates not receiving any cash flows. Deal

portfolios are composed of older airplanes with more volatile values and reduced lease rates.

Higher maintenance costs and expenses can reduce overall payments to the structures.

Furthermore, the servicer’s ability to keep airplanes flying becomes paramount as repossession

and storage reduce lease revenues.

In this write up, we provide an introduction to aircraft financing and describe the main drivers of

performance for pre-9/11 pooled aircraft securitization. We describe how the securitization

structures have fared through the last two industry downturns. We review the collateral

characteristics of the current plane portfolio and take a simple approach to analyze risk across

different deals. Finally, we attempt to model the entire lease cycle, taking into account aircraft

value, lease expiration, sale timing, maintenance expenses and the costs associated with planes

on ground.

Our model offers interesting relative value recommendations within the ―classic‖ pooled aircraft

market: LIFT benefits from younger aircraft and lower price-adjusted LTV. By contrast, PALS

1999-1A and its re-packaged version PJETS 2007-1A are severely distressed.

At current valuation, we find that the rebound in the transportation sector has been fully priced

and deals have limited upside. Clearly, the reach for yield has been a strong technical support for

―classic‖ pooled aircraft ABS, but in the long run we believe the sector’s rich valuations will fall.

Current state of aircraft securitization

As aircraft technology has evolved since the early DC-3 and B-247, so has aircraft financing. The

emergence of asset-based lending in the late 1980s has increased the diversity of funding

sources for airlines and leasing companies. Historically, aircraft financing has relied on a

combination of bank loans, credit export agencies and manufacturer. However, starting in the

early 1990s, aircraft-backed securities have made a growing share of the funding. The two main

forms of asset-backed securities are EETC (Enhanced Equipment Trust Certificates) and pooled

aircraft securitizations.

EETC is corporate debt secured by a set of aircraft as collateral. EETCs permit airlines to access

lower costs of financing to fund purchases of aircraft. In contrast with pooled aircraft ABS, EETCs

rely on the credit and cash flows of a single corporate issuer and EETC investors are exposed to

the credit quality of the airline and the collateral value. EETCs benefit from structural

enhancements to reduce the risk of default and impairment.

Liquidity facility: a highly rated financial institution that covers missed interest

payments up to 18 months.

Over-collateralization: Typical EETC deals have 2 to 4 tranches; the most senior

tranche has the first claim on collateral and benefits from low loan-to-value. The A class is rated 6 to 8 notches higher than the unsecured airline credit.

Protection under Bankruptcy Code (§1110): investors get rapid access to the

collateral following bankruptcy filing (60 days) if the airline does not resume debt servicing.


20

EETC structures were tested during the last round of airline bankruptcies (2001-03). The most

senior tranche performed well, as either the obligation was confirmed in reorganization, or terms

were renegotiated resulting in full recovery value, or aircraft repossession led to full recovery.

Pooled aircraft securitizations rely on the cash flows generated by a pool of aircraft. The servicer

actively manages the aircraft portfolios to maximize the number of aircraft on lease. Similar to

other transportation sectors such as container leasing, securitization is used by operating

lessors to diversify their funding and free up balance sheets. Securitization also allows the

sponsor to match its funding to the useful life of its aircraft fleet. The operating lease market is

fairly concentrated with GECAS and ILFC managing nearly 39%.

Across pooled aircraft securitizations, we differentiate the pre 9/11 ―classic‖ transactions from the

more recent ―next generation‖ deal-like GNFL, ACST or BBAIR. Following the terrorist attacks of

9/11, air travel, both domestic and international, has dropped significantly. The number of

airplanes on the ground increased sharply and there was a wave of airline bankruptcies, which

sent lease rates down 25% to 60%. This industry-wide recession forced issuers to re-assess the

structures and collateral used for pooled aircraft transactions.

Collateral: ―next generation‖ deals are composed of newer aircraft types such as the

B737NG family and the A320 family. Base value and lease rates have held up better

through the recession than older aircraft, as those aircraft tend to have lower storage

percentages, broader user base and healthy order books.


21

Monoline insurance: the majority of ―next generation‖ deals benefit from a monoline

wrap. Securities are structured as soft bullet (typically with an underlying rating of single

A) and all the cash flows are used to pay down the senior bonds past the expected

repayment date. Given most monolines current ratings, next-gen ABS ratings do not

give any benefit to the wrap.

Structural enhancement: post 9/11 transactions have introduced enhancements that

protect senior bond holders and avoid interest leakage to subordinate holders such as

DSCR tests (ACST, GNFL), senior debt/equity structures and full turbo mechanisms

(AERLS).

Collateral valuation is driven by industry changes

Understanding airplane valuation necessitates analyzing supply and demand dynamics in the

industry. The demand for an airplane is a function of the cost of exploitation for different airlines.

This cost is shaped by competing factors: airplane characteristics, regional and global traffic

growth, existing models in the fleet, as well as fuel prices. The life cycle of a given aircraft model

plays an important role in setting the level of supply. In the first years of production, supply comes

exclusively from new aircraft, but as initial leases expire, older aircraft come back on the market.

At the end of the life cycle, the percentage of airplanes in storage or kept on the ground for spare

parts increases, putting a cap on lease rates and valuation. Technological changes such as

winglets and fly by wire have affected those supply-demand dynamics as new technology

increases the obsolescence of older models.


22

The recent downturn was similar to the recession that followed the 9/11 terrorist attacks in the

sense that it forced the retirement of a large number of obsolete models nearing the end of their

useful lives. For example, Japan Airline’s bankruptcy put further pressure on classic aircraft

values as it announced the retirement of 103 aircraft (MD-90, B747-400 and A300-600).

Depreciation of older planes accelerated during the downturn and we do not expect

them to recover meaningfully. We expect sales and storage of MD80s, and older

generation B737 classics to continue.

Least efficient planes are put in storage. Figure 9 shows that aircraft storage increased

significantly in the last two years. The recent drop in storage has been driven by aircraft

consignment rather than aircraft coming back on lease.

Lease rates have dropped more for classic aircraft than for ―next generation‖ aircraft.

According to Ascend Worldwide, market lease rates for 1992 B737-300 decreased 40%-

45% in the last two years, while same vintage A320s decreased to 25%-30%. For

classic planes at the end of their useful life, the economic value is realized by the

operator rather than the lessor.

As more airlines filed for bankruptcy during the recession, the deals incurred higher

expenses due to higher repossession costs and aircraft on ground.


23

Structures in “classic” aircraft securitization are distressed

Classic aircraft securitizations have gone through two industry downturns and underlying

securities are paying slower than scheduled. Lease payments have been less than their predicted

values due to a distressed lease market and longer re-marketing periods. As a consequence,

structures have not de-levered and currently only senior securities are expected to receive

principal payment. Valuations have also been affected by the higher level of expenses.

Maintenance expenses, repossession costs, storage costs (due to longer re-marketing periods)

and lessee bankruptcies have remained high and we expect these costs to represent a higher

fraction of total collections in the future.

Additionally, bonds that had been scheduled as soft bullets have failed to refinance which

significantly extended their average lives. Figure 11 and Figure 12 compare the expected and

actual bond balance for EAST 2000-A. The expected refinancing rate for class A-1 was August 15,

2003, but it failed to receive principal until September 2007.

Additionally, a number of trusts have hedged the basis risk between their floating-rate liabilities

and fixed-rate assets by entering swap agreements or purchasing interest rate caps. Given the

current low interest rate environment, these swaps are out of the money and represent a drag on

revenue. As some of these swaps expire, we expect the trusts to enter new hedges at lower rates,

which should benefit the senior bonds.

Two transactions, EAST and AFT, had entered interest rate hedges with Lehman Brothers

Special Financing (LBSF). As the hedges were out of the money, LBSF requested payment

equivalent to the market value of the swap and the indenture trustee segregated respectively

$12.2mn for AFT and $16.3mn for EAST in a separate account. In February 2010, a settlement

between the EAST trustee and LBSF led to a release of the account and a $8.1mn principal

payment to EAST 2000-A A1 and A2. A similar settlement between AFT and LBSF would be

positive for the AFT seniors.


24

Subordinated bonds are not receiving interest or principal payment after issuers exhausted

reserve funds to make interest payments. In most transactions, the senior liquidity reserve

amount is standing at its required level. One exception is PALS 1999-1A, which exhausted its

liquidity reserve; if a class A interest shortfall occurs, the senior notes will be accelerated.

Given the depressed lease rates and low aircraft valuations, a number of provisions in the

indenture have prevented issuers from maximizing cash flows to senior bond holders through

aircraft sales. In December 2009, AERCO successfully amended the indenture to permit aircraft

sales without a minimum sale price, relax concentration limits and lower the minimum liquidity

reserve amount. EAST bondholders agreed to similar amendments to its indenture in August. In

general, indentures for different trusts have different provisions, but we view positively any

amendment that increases the operational flexibility of the issuer.

Aircraft portfolios are older and less fuel efficient

In Figure 14, we show a high level collateral profile of different classic securitizations. With the

exception of LIFT 1A and AFT 1999-1A, the aircraft are very seasoned and close to the end of

their expected useful lifes (25 years for passenger planes and approximately 35 years for

freighters). At that point in the lifecycle of the portfolio, most of the value will be released through

sales rather than lease revenue. That being said, keeping planes flying is extremely important as

plane repossessions and storage costs can represent a significant cash drain for the trust.


25

The value of wide-body and narrow-body aircraft varies markedly due to wide-body vulnerability to

lease-rate volatility (Figure 15). Long-range wide-bodies tend to exhibit large swings in lease rates

depending on economic conditions. During the 2001 downturn, A330-200 lease rates dropped

32%, while narrow-bodies such as the ―next generation‖ B737-700 only decreased 10%.

Classic pooled aircraft ABS tend to be heavily weighted towards older narrow-body aircraft. Most

of those aircraft (B737-300, MD-80) are out of production and are therefore unlikely to witness a

recovery in lease rates or value. Typically, we observe a one-time drop in value during a downturn

across aircraft types; afterwards, values and lease rates recover more or less strongly depending

on age (older aircraft do not recover as much) and aircraft lifecycle.

Early in the lifecycle of a given aircraft type, market values and lease rates tend to

bounce back quickly after a recession due to growing order books.

In general, mature models benefit from a diversified lessee base in developed markets

and while lease rates drop in a downturn, they tend to recover (albeit at a lower level).

At the end of its lifecycle, a model has been replaced by more fuel efficient and

technologically advanced series. The lessee base is concentrated in developing

countries (usually with a higher bankruptcy rate) and supply depends mainly on storage

and part-outs. External shocks usually increase the pace of storage, keeping lease rates

and valuations low.


26

Quantifying collateral risk in pooled aircraft transactions

While pooled aircraft securitizations rely on base value to determine bond amortization schedules,

we believe that market value is more appropriate when analyzing classic securitizations.

Base value is the appraiser’s opinion of the underlying value of an aircraft in an open,

unrestricted, stable market environment with a reasonable balance of supply and

demand.

Market value is the appraiser’s opinion of the most likely trading price that may be

generated for an aircraft under the market circumstances at the time.

We argue that market LTV and more precisely price-adjusted LTV7 capture more accurately the

risk profile of classic transactions. For each classic transaction, a majority of aircraft are coming

off lease in the next three years. Since aircraft are close to the end of their expected usable life,

the lessor has extracted most of the rent revenue, and the best way to unlock the remaining

economic value in the transaction is through collateral sale. Moreover, costs from aircraft on the

ground (AOG) and repossession-related expenses represent a clear strain on the balance sheet

of the issuer. Most issuers have already started selling their oldest and most obsolete planes

(B727-200, B737-200, DC-9, and DC-10) and we expect the trend to continue. As a result, classic

aircraft ABS transactions are exposed to market value risk rather than base value risk.

7Price-adjusted LTV is computed by dividing the current market value of the securities (the current balance of

the securities weighted by their market price) and the market value of the aircraft portfolio. 8 We assume that the three planes currently leased to Mexicana are returned to the lessor.


27

In Figure 17, we computed three different LTV measures for the senior tranche: base LTV and

market LTV rely on base value and market value respectively, while price-adjusted market LTV

further takes into account the current price at which the senior bonds are trading. The recent rally

in price combined with the lower market value has moved price-adjusted LTV from the mid 80s to

the high 90s.

At a high level, priced-adjusted LTV summarizes collateral leverage in a simple measure and

allows investors to rank order risk across transactions. Under this framework, LIFT 1A and PALS

1999-1A are the least levered transactions with a price-adjusted LTV of 93%. That being said, we

think investors should not rely exclusively on a single measure as it fails to capture the

idiosyncrasies of each structure. For example, PALS 1999-1A (or its repackaged version PJETS

2007-1A) has a number of delinquent accounts and a large percentage of planes on the ground (8

out of 22). Moreover one of the aircraft is on lease with Mexicana, which recently filed for

bankruptcy.

Modeling classic aircraft securitization

While a simple measure such as price-adjusted LTV is a good first step towards analyzing classic

aircraft ABS, it simply assumes that planes are sold immediately at their market value and does

not take into account the fact that airplanes are income-generating assets. We think a better way

to analyze classic aircraft ABS is to model revenue and expenses on a plane-by-plane basis. By

running individual airplane cash flows through the deal waterfall, investors can properly stress the

transaction based on their assumptions on expenses, leases revenue and sale price.

Clearly, developing a full model for classic aircraft ABS, along with the correct set of assumptions

is not an easy task: servicers do not always publish lease expiration schedules or individual lease

payments in monthly reports and information on hedges through swaps and cap is usually limited.

At a high level, our model takes into account the following to analyze classic ABS securities:

We use lease termination dates from the issuer quarterly report or Ascend Worldwide

database.

We estimate lease payments using the Ascend Worldwide database based on lease

commencement. Only a few issuers such as PALS 1999-1A or EAST 2000-A offer

leases at the aircraft level.

We make assumptions for time on the ground and associated expenses (repossessions

and storage costs).

We project future base and market values for each aircraft based on aircraft age and

model.

We apply a fixed lease rate factor to our projected aircraft market values to derive future

lease rates.

Aircraft are sold at the end of the expected usable life with a 15% discount to market

value to account for the fact that most aircraft types will be out of production at the sale

date.

We use information from the deal annual reports to estimate interest rate swap and cap

schedules.

Finally, we run cash flows associated with each aircraft through the deal waterfall under

the Libor forwards path.

Relative value

In Figure 18, we present bond yields under our base case and two scenarios: stress and

optimistic. In the stress scenarios, we further decrease lease revenue by 20% and sale value by

an extra 15%, as well as increase the re-marketing time and repossession expenses for aircraft

on the ground. In the optimistic scenario, we increase lease revenue by 20%, sale value by 15%

and shorten the re-marketing period. We note that model results are highly sensitive to


28

assumptions. In particular, higher expenses can markedly reduce yields since they are taken out

at the top of the waterfall.

Yields on classic ABS have decreased from the low to mid teens at the beginning of the year to

the high single-digits currently. At $87 LIFT 1-A A3 offers a 10.6%, the highest among classic

aircraft securities. As a senior amortizer, the A3 class receives a majority of the cash flows

(compared with the A1 and A2 tranches) and reaches a 0% yield by November 2012. At a lower

price point, AFT 1999-1A A1 offers a 9.8% yield, while PALS 1999-1A is the least attractive

security. Our model shows that PALS 1999-1A could hit an event of default owing to a class A

interest shortfall as early as June 2011. The acceleration of the A class is obviously a positive for

the trust as it prevents cash flow leaking to pay interest on the subordinates, but the age and

lessee composition of PALS 1999-1A portfolio remains a significant drag, in our view.

The rally in the pooled aircraft ABS sector (Figure 1) has compressed yields from the mid teens to

the high single-digits. While the sector still looks attractive compared with the rest of the

transportation sector and versus the broader high yield sector, we believe that the rebound in the

airline sector has been priced in and valuations look full. Clearly, the reach for yield has been a

strong technical support for ―classic‖ pooled aircraft ABS, but in the long run we believe the

sector’s rich valuations will fall.


29

CMBS

Market Overview

CMBS super senior spreads remained unchanged on the week, and bid list activity began to

subside as we head into quarter end. Super senior 2007 vintage spreads ended the week at

300bp over swaps. Bid lists this week were more heavily weighted towards the super senior

space. However, we continue to see interest in higher quality AM and AJ bonds. Spreads on AM

bonds continue to improve with better performing 2006 and 2007 AM bonds now trading in the

mid to high 300s over swaps. We expect the CMBS market to continue to perform well going into

year-end as buyers seek yield. We recommend remaining near the top of the capital structure in

wider last cash flow super seniors, later-vintage AMs and higher quality AJs.

Collateral Update: Moody’s/REAL Commercial Property Price Indices and Loss Severities On September 20

th, Moody’s Investor Service reported that their All Property Type Aggregate

Index dropped 3.1% in July and has declined 4.0% since the beginning of the year1. The index is

now 43.2% below the peak in October 2007 and is only 0.9% above the recession low that

occurred in October 2009. Moody’s expects prices to remain volatile over the near term and

forming a bottom as the economy recovers.

Universe As property prices have dropped considerably over the past three years, we have seen an

increase in CMBS loss severities as well. Below we show the six-month rolling average loss

severity for conduit CMBS loans securitized since 2000. While commercial real estate prices

began to drop in early 2008, CMBS recovery rates started to fall approximately a year later.

Through December 2008, loss severities generally averaged around 25%, while in 2009 average

severities reached the high-30% range.

Lea Overby

+1 212 667 9479

[email protected]


30

Universe With property prices stabilizing along with the broader economy, we expect CMBS loss severities

to peak near 45%. However, the range of loss severities is likely to remain very wide. This month,

the Macon and Burlington Mall loan in WBCMT 2005-C20 finally sold, resulting in a 97% loss

severity and a $127 million loss to the Trust. In contrast, the 90+ delinquent 1775 Broadway loan

in WBCMT 2006-C20 was purchased out of the Trust, resulting in no loss for investors.

The data set used to calculate the CPPI remains sparse, with 119 repeat sales included in the

latest calculation. Moody’s CPPI Index references property transaction data rather than appraisals,

and it incorporates all sales over $2.5 million. Over the last five months, repeat sales have

averaged 124 per month. While this is a substantial increase from the 52 transactions used to

calculate the CPPI in May 2009, it remains well below the 300 – 400 eligible monthly transactions

in 2007.

We expect the number of transactions contributing to the CPPI to increase as lending conditions

improve. Already, we are beginning to see a rise in CMBS liquidations as special servicers are

more able to dispose of troubled loans and properties. There were only 100 stressed dispositions

during the first six months of 2009, while the number has increased to over 100 per month over

the last quarter. Similarly, the disposed balance has risen sharply, with over a billion in resolutions

for each the two prior months.

Universe

0%

10%

20%

30%

40%

50%

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%


31

A Tale of Two Loans: Pay downs, extensions, and short WAL super senior classes

The performance of certain CMBS tranches often hinges on the cash flows from only a single loan

within the pool. This month, the CMBS market saw both an early prepay and an extension that

altered the expected principal cash flows for several super senior tranches. The five- and seven-

year tranches in WBCMT 2006-C23 were shortened considerably when the 1775 Broadway loan

in paid in full, while the five- and seven-year tranches in MSC 2007-HQ12 extended when the

Columbia Center loan received a modification. Both results highlight the current instability within

the commercial real estate market and the effects that loan workouts may have on CMBS tranche

performance.

1775 Broadway

An office building located near Columbus Circle in Manhattan serves as collateral for this $250

million ten-year loan. At origination, the property was appraised at $350 million and was 95%

occupied, with Newsweek taking 33% of the available space. Several firms vacated in 2008, and

Newsweek left in May 2009, causing the occupancy to fall to only 25%. The sponsor, Joseph

Moinian of The Moinian Group, began an extensive renovation to rebrand the property in late

2008. His plans were estimated to cost almost $100 million and included replacing the brick

facade with a glass curtain, redesigning the entrance, upgrading the elevators and office suites,

and renaming the property to ―3 Columbus Circle‖.

In January 2010, with the renovation nearing completion, the borrower informed the servicer that

he would no longer be able to cover the debt service shortfall. In spite of the renovation, he was

unable to fill the vacant space, and the building is currently only 23% occupied. According to the

special servicer comments, Mr. Moinian and CWCapital, the special servicer, began negotiating a

loan workout. A new appraisal valued the building at $202 million, increasing the LTV to 124%.

Because of the strength of the submarket and the borrower’s commitment to the property, we

believed that a modification involving forbearance and a hope note were the likely outcome.

However, in the August remittance report, the special servicer commented that they were

discussing a loan payoff with the borrower. On September 8th, the Wall Street Journal reported

that Stephen Ross’s firm, Related Cos., and Deutsche Bank AG had purchased the mortgage

from the Trust2, paying the loan in full. The article states that Related might demolish the property

and build a new tower for Nordstrom. The New York Post reports that Moinian has turned to SL

Green Realty Trust to lend him the funds to pay off the mortgage3 that is now in the hands of

Stephen Ross.

As a result of this early pay down, tranches A2 and A3 paid in full, and A-PB was curtailed by $57

million. Prior to this pay down, the five year A-2 tranche had been scheduled to pay in full in

February 2011, while the A-3 had been scheduled to pay in full between November 2012 and

January 2013. In general, amortizing balance classes such as this A-PB tranche are designed to

pay down over several years according to a predetermined schedule. However, this $190 million

tranche in this deal is now the current pay class with a weighted average life less than year.

Columbia Center

A trophy office tower located in downtown Seattle serves as collateral for two five-year A notes

totalling $380 million and accounting for 20.2% of the current balance of MSC 2007-HQ12. The

property also serves as collateral for a $100 million B-Note held outside the Trust. Built in 1985,

the building was purchased by Beacon Capital Partners in 2007. The loan was underwritten using

pro forma financials, with underwritten NOI 36% higher than the most recent annualized figure.

The first full-year Trust DSCR was reported at 1.04x, showing that the building produced barely

enough income to cover the debt service on the A-Notes.

This deal also contains a $161 million pari passu portion of the five-year $2.9 billion Beacon

Seattle & DC Portfolio loan. Collateral for this larger loan consists of 20 office buildings, with eight

in the Seattle and Bellevue, WA, and it is also underperforming. Although the loan is current, the


32

sponsors have requested a modification. The special servicer reports that they are not willing to

continue covering leasing costs and debt service shortfalls.

The borrower stopped making payments on the Columbia Center loan in March 2010. With a

2009 DSCR of 0.74x and occupancy of only 77%, the property did not generate enough income to

cover the debt service. Additionally, the largest tenant, Amazon.com with 12% of the net rentable

square feet, announced their plan to vacate their space within the next year. PPR reports that the

second quarter 2010 vacancy rate in the Seattle CBD is nearly 20%, indicating that the borrower

will most likely not be able to lease the vacant space quickly.

The special servicer, LNR Partners, began discussions with Beacon Capital Partners for a loan

modification shortly after the default. The most recent appraisal, dated March 2010, valued the

property at only $330mm, down from $648 million at origination, causing the Trust LTV to

increase from 58.6% at origination to 115%. We believed that the modification might not

materialize for Columbia Center given the anticipated decline in financials upon Amazon.com’s

departure at lease maturity and the reluctance of Beacon Capital to further support similar

properties.

However, in the September remittance, the special servicer reported that both A notes have been

modified. Both were extended 36 months to May 2015 with two 1-year extension options. The

borrower has agreed to bring the $300 million A1 note current, while the $80 million A2 note will

defer interest until maturity, resulting in an ongoing $375,000 interest rate shortfall to the Trust.

The borrower will also fund a $30 million rollover reserve immediately and another $19.2 million

reserve in 2013. The $49.2 million in borrower reserves is senior to the A2 note. The modification

does not reduce the A1 note interest rate, however, and we calculate an in-place DSCR of only

0.95x, based on year-end 2009 net cash flow. While we cannot rule out the likelihood of default

after Amazon.com leaves, the loan will likely perform in the short term, as Beacon Capital has

agreed to fund a sizeable reserve.

At origination, 79% of the five-year bullet super senior tranche principal balance in this deal was

scheduled to be paid by the Columbia Center and Beacon Seattle & DC Portfolio loans. As a

result of the maturity extension on the Columbia Center loan, the expected final distribution date

for classes A-2, A-2FL, and A-2FX, and A3 in this deal also extended to May 2015. The weighted

average life of all four classes extended over a year. With a modification and loan extension also

likely for the Beacon Seattle & DC Portfolio loan, the expected principal cash flow for these four

tranches may extend further.

Conclusion

As these two examples demonstrate, the early pay down or extension of large loans within a

CMBS pool can drastically alter the cash flows and yields for certain short WAL super senior

tranches. With these tranches generally trading well above par, an unexpected early pay down

can damage returns, while an extension can be quite beneficial. In addition to monitoring these

holdings closely, we recommend that investors maintain a diversified portfolio when investing in

this type of CMBS class.

1 Nick Levidy, Andrea M. Daniels, Seth Anspach, Tiffany Putman, ―Moody’s/REAL Commercial Property Price

Indices, September 2010,‖ Moody’s Investors Service, 20 September 2010

2 Lingling Wei and Eliot Brown, ―Ross Raids Wobbly Tower,‖ Wall Street Journal, 8 September 2010

3 Lois Weiss, ―Moinian’s Columbus Circle,‖ New York Post, 13 September 2010


33

Disclosure Appendix A1

ANALYST CERTIFICATIONS

I, Ohmsatya Ravi, Ankur Mehta, Dhivya Krishna, Gaetan Ciampini, Lea Overby, Paul Nikodem and Sean Xie CFA, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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