outlook for the rmbs market in 2007

8/22/2019 Outlook for the RMBS Market in 2007

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RMBS Trading Desk Strategy

Outlook for the RMBS Market in 2007 December 27, 2

Sharad Chaudhary212.847.5793

[email protected]

RMBS Trading Desk StrategyOhmsatya Ravi212.847.5150

[email protected]

Qumber [email protected]

Sunil [email protected]

Ankur [email protected]

RMBS Trading Desk ModelingChunNip Lee212.583.8040

[email protected]

Marat Rvachev212.847.6632

[email protected]

Vipul Jain212.933.3309

[email protected]

Review of 2006: Mortgages had a Great Year (p. 2)Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 21

25 ticks in 2006. Heavy net production of fixed-rate agency MBS and strong

growth in MBS holdings of overseas investors and domestic money managers

characterized supply and demand technicals in the mortgage market in 2006. The

mortgage basis has also benefited enormously in 2006 from swap spread tightening

the decline in implied volatilities and very low realized volatilities. While relatively

fast discount prepayment speeds and muted premium speeds were observed in

2006, sharp declines in HPA and the consequent mortgage credit issues started to

attract the markets attention by the end of the year.

Major Themes Relevant for the RMBS Market in 2007 (p. 4)

We expect a range-bound rates market, slightly lower but still substantial net suppl

of agency fixed-rate MBS, heavy demand for MBS from overseas investors and

domestic money managers, 2%-3% CPR slower discount prepayment speeds and

mortgage credit to continue to make headlines in 2007. Bank portfolios of

mortgages should record very modest growth, if any, in 2007.

Agency Pass-throughs: Valuations and Recommended Positioning (p. 27)

We see little upside from owning mortgages in the short-term for relative value

players (pure OAS players). However, from a long-term perspective, we

recommend an overweight on the mortgage basis to real money managers because

of our expectations for a range-bound rates environment and strong demand

technicals for MBS. We also recommend overweighting 30-yr 5.5s and 6.5s versus

5s and 6s, 15-yr MBS versus 30-yr MBS, and 15-yr 4.5s and 6s versus 5s and 5.5s.

Hybrid ARMs: Valuations and Recommended Positioning (p. 33)

Hybrids are attractively priced relative to the fixed rate sector with 5/1s offering

more than 30 bps in OAS pickup relative to 15-yrs. However, based on our macro

picture range bound interest rates, low realized volatility and lack of surge in

implied volatilities much like this year, we expect hybrids to lag fixed-rate MBS

in 2007. However, from a short term perspective, we recommend a tactical

overweight on the hybrid basis due to favorable technicals caused by the inclusion

of agency hybrids in the US aggregate Index and the seasonal low in ARMs

issuance.

This document is NOT a research report under U.S. law and is NOT a product of a fixed income research department. This documhas been prepared for Qualified Institutional Buyers, sophisticated investors and market professionals only.To our U.K. clients: this communication has been produced by and for the primary benefit of a trading desk. As such, we do notout this piece of investment research (as defined by U.K. law) as being impartial in relation to the activities of this trading desk.Please see the important conflict disclosures that appear at the end of this report for information concerning the role of trading dstrategists.


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The mortgage basis had a greatyear.

Net supply of agency fixed-rateMBS was very high.

Overseas investors anddomestic money managersprovided a firm bid for MBS.

More than 60% of the mortgageoutperformance versus swaps isdue to declines in volatilities.

I. Review of 2006Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 21-25 tick

in 2006 (at closes of 12/22/2006). The following themes dominated the MBS market

sentiment in 2006:

Heavy net production of fixed-rate agency MBS

Strong growth in MBS holdings of overseas investors and domestic money

managers

Continued declines in implied volatilities and very low realized volatilities

Relatively fast discount prepayment speeds (but slower than the discount speeds

in 2005) and muted premium speeds

Sharp slowdown in home price appreciation and higher delinquencies on new

origination mortgage pools relative to older cohorts Higher servicing spreads being retained by servicers on their books

Strong outperformance of 30-yr MBS versus 15-yrs and hybrid ARMs as

investors rushed to sell convexity which helped the 30-yr sector more than others

Positive net production of GNMAs and the dramatic cheapening of GN/FN swaps

One of the biggest surprises associated with the mortgage market in 2006 was the strong

supply of agency fixed-rate passthroughs. We estimate that net supply of fixed-rate agency

MBS (gross issuance less pay-downs) totaled $254 billion in 2006 versus $110 billion in

2005 and a negative $27 billion in 2004. This net supply is substantially higher than what

the market expected at the beginning of the year. We believe that the heavy net production

is due to a combination of heavy cash-out refinancings in conjunction with the lower

incentive for borrowers to choose an ARM versus a fixed-rate product in the flat yield

curve environment that prevailed in 2006 (we will discuss this topic in more detail in the

following section).

While the heavy net supply of fixed-rate agency MBS in 2006 was a big surprise, what wa

even more interesting was the strong performance of the mortgage basis in 2006 despite

this trend and very low net purchases of MBS by domestic banks. It turned out that the

heavy net supply of agency MBS was comfortably absorbed by overseas investors and

domestic money managers. As we have repeatedly commented before, historically net

overseas investor purchases of agency debt and MBS have shown a strong correlation with

the level of U.S. trade deficit and this strong relationship continued in 2006 as well.

Domestic money managers provided a firm bid for MBS this year because interest rates

backed up away from the range where mortgage refinancings could be of some concern

and, in an environment of very tight spreads on AA and A rated corporate bonds, money

managers viewed mortgages as an attractive alternative to corporate bonds. In addition,

mortgages served as the vehicle of choice for money managers wanting to express a view

on the direction of implied and realized volatilities.

The mortgage basis also benefited enormously in 2006 from the sharp decline in implied

volatilities and very low realized volatilities. In fact, we attribute more than 60% of the

outperformance of mortgage basis versus swaps this year to declines in implied volatilities


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Relatively fast discount speedsand muted premium speedscharacterized prepayments in2006.

Servicers are retaining moreinterest cash flows on theirbalance sheets.

30-yrs outperformed 15-yrs andhybrid ARMs.

GN/FN swaps have cheapenedby more than 1-point from theirpeak levels.

As long-term rates continued to stay in a narrow range and the marginal buyer of MBS is

not a Gamma and Vega hedger, demand for volatility has plummeted which helped

mortgages outperform Treasuries and swaps.

On the prepayment front, the prepayment experience during 2006 resembled that in 2005,

i.e. relatively fast discount speeds and muted premium speeds. Mortgage pools that were

100 bps in-the-money prepaid at roughly 33% CPR (a far cry from 60%-70% CPR

observed during 2002-2003) and pools that were 50 bps out-of-the-money prepaid at 10%

CPR. The primary reason for continued robustness in discount speeds, despite the housing

slowdown in 2006, is the fact that these pools had already seen fairly solid equity growth

from the previous year. On the other hand, slower speeds of deep in-the-money pools can

be attributed to weaker borrower characteristics with higher spreads at origination (SATO)

for these pools. On the hybrid ARMs side, the markets fear of extremely fast tail speeds o

hybrids waned over the course of the year as prepayments around the first reset proved to

be a lot more docile than the markets initial expectations. An interesting trend observed in

hybrid speeds in 2006 is the presence of a second spike in prepayment speeds at the second

reset. On the mortgage credit front, newly originated pools recorded higher percentages of

delinquencies relative to older cohorts (after adjusting for age).

Another interesting trend in the MBS market was that the spread between the GWAC and

the net coupon of fixed-rate agency mortgage pools increasing substantially over the past

several months. For instance, new production 30-yr FNMA 6s pools have a GWAC of

6.67% versus 6.48% 1-yr ago. Similarly, new production 30-year FNMA 5.5s pools have a

GWAC of 6.25% versus 5.96% 1-yr ago. On average, the spread between the aggregate

GWAC and the net coupon of new production 30-yr mortgage pools was close to 47-48 bp

in 2003 and 2004 versus 56 bps over the past year. We believe that originators/servicers ar

retaining more interest cash flows on their balance sheets as the MBS market came out of

significant Refi wave and the media-effect subsided. In addition, originators/servicers may

be taking advantage of FAS 156 which allowed mark-to-market accounting treatment for

servicing rights. This uptick in GWACs has some valuation implications as discussed in th

following sections.

30-yr mortgages outperformed 15-yrs and hybrid ARMs by more than 20 ticks on a

duration and curve adjusted basis in 2006. This was largely because 30-yrs benefited more

than 15-yrs and hybrid ARMs from low realized volatilities and sharp declines in implied

volatilities observed in 2006. In addition, the current marginal buyers of MBS, i.e.,

overseas investors and domestic money managers, preferred 30-yr due to the higher

nominal spread they offer over Treasuries. It is worth pointing out that 30-yrs outperforme

15-yrs by a wide margin in a year where the net supply of 30-yr MBS totaled $310 billion

while the outstanding balance of 15-yr MBS dwindled by more than $55 billion.

Finally, GN/FN coupon swaps lost more than 1-point since their peak levels. Positive net

supply in GNMAs coupled with the increased comfort level of overseas investors with the

MBS backed by the GSEs caused this sharp cheapening of GNMAs versus conventional

MBS in 2006. This has created an interesting opportunity in that the government guarantee

on premium GN II pools was being offered for free at the beginning of December.

Although GN/FN swaps have rebounded by 5-6 ticks over the past few days, premium GN

II/FN swaps still seem to offer government guarantee for only a modest pay-up.


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II. Macro Themes Relevant for the RMBS Market in 2007Looking ahead to 2007, we believe that the following issues will have a significant impact

on the relative performance of mortgages versus other fixed income sectors:

Outlook for Interest Rates and Volatilities: Remarkably range bound long-term

interest rates and the consequent low realized volatilities and sharp declines in

implied volatilities helped the MBS sector put in a strong performance versus

Treasuries and swaps in 2006.

Mortgage Supply Technicals: Despite all the talk about the housing market

slow-down, the net supply of fixed-rate agency MBS was very strong in 2006.

Overseas Investors: Overseas investor demand for MBS stayed very strong in

2006 and made a significant contribution to the outperformance of the mortgage

basis.

Domestic Money Managers: Cross-over buying of MBS by domestic money

managers has been at very high levels since the 4Q05.

Domestic Banks: Excluding the impact of Golden Wests acquisition, deposits o

the books of large banks have grown by only 1.5% in 2006 versus an annual

growth rate of 7%-8% during 2002-2005.

Agency Portfolio Issues:The 2004-2005 trend of the GSEs substituting agency

mortgages with subprime MBS appeared to subside in 2006.

Convexity Hedging Related Issues:The last time convexity flows had

dominated MBS pricing was in October/November 2005.

Discount and Premium Prepayments: For the range-bound rates scenario we a

projecting for 2007, OTM and ATM speeds of recent originations are the main ar

of concern due to continued softness in the housing market.

Housing Slowdown and Mortgage Defaults: New origination pools are showing

significantly higher 90+ day delinquencies than the older cohorts. As heavy

volumes of ARMs (prime and subprime) come up for resets in 2007, the impact o

housing slowdown on potential mortgage delinquencies becomes an important

issue.

We will now take a detailed look at each one of these issues.

Interest Rates and Volatilities Our baseline forecast of interest rates for year-end 2007 is as follows: 10-yr

Treasury yield at 4.95%, 2-yr Treasury yield at 5.05% and a Fed funds rate of

5.0%. We expect a single 25 bps ease in the Fed funds rate in 2007.

Realized volatility is likely to stay very low and implied volatilities are unlikely to

spike up substantially from current multi-year lows.

10-yr swap spreads are likely to tighten by 8-9 bps and 2-yr swap spreads are

likely to tighten by 4-5 bps in 2007.


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Long-term interest rates were ina very narrow range over thepast 3 years.

We expect only a single 25 bpsFed easing in 2007.

Over the past three years, long-term interest rates have remained in a very narrow range. In

fact, the 10-yr CMT yield had been within a 155 bps range (3.70%-5.25%) over the past 3

years versus the 241 bps (2001-2003) and the 263 bps (1998-2000) ranges that prevailed

over similar time spans in the past (Figure 1). This range-bound rates environment coupledwith the fact that interest rates have moved away from the levels where another mortgage

refinancing wave could be of some concern have made mortgages the asset class of choice

for domestic money managers since the 4Q05.1

Figure 1: Range of 10-yr CMT Yields in Each Year

2000 2001 2002 2003 2004 2005 2006

Max 6.79 5.54 5.44 4.61 4.89 4.66 5.25

Min 5.02 4.22 3.61 3.13 3.70 3.89 4.34

Range (bp) 177 132 183 148 119 77 91

Source: Banc of America Securities

Looking ahead to 2007, we believe that the expected and realized ranges of interest rates

over the year will have a significant impact on mortgage performance versus other asset

classes. These factors are more important for the MBS market now than before because of

the shift in the marginal buyer base for MBS. When the GSEs were marginal buyers of

MBS, mortgage valuations in terms of OASs (with respect to the agency curve) were more

important than realized and implied volatilities of interest rates because the GSEs would

actively hedge volatility exposure in their portfolios. Similarly, these factors were less

important when banks were marginal buyers because their funding costs were very lowrelative to mortgage yields to begin with. At the moment, domestic money managers are an

important segment of marginal buyers of MBS (along with overseas investors) and the

cross-over demand from domestic money managers has been a significant contributor to

the recent strong performance of mortgages. The magnitude of this cross-over buying in

2007 clearly depends on the expected range of interest rates and the perceived prepayment

risk within this range.

Single Fed Ease, 10-yr Tsy at 4.95% and Tighter Swap Spreads by Year-end 2007

We expect long-term interest rates to remain range-bound and the 10-yr Treasury yield to

reach 4.95% by the end of 2007. We also expect only a single 25 bps cut in Fed funds rate

and also that the shape of the curve will remain nearly unchanged between now and the enof the year (with the risk skewed towards a slightly steeper curve). Our estimates are based

on the expectation that the economic growth will be slightly above 2% in the first half of

the year but will be solidly above 3% in the second half. At the same time, core inflation

should stay above the Feds comfort zone of 1%-2% for most part of 2007 because the

unemployment rate is below the generally accepted level of NAIRU. In this scenario, any

easing by the Fed should be limited to a modest insurance cut in the first half of the year

and our view differs from markets expectations for a 4.72% funds rate by the end of 2007

(or two to three 25 bps easings in 2007). The biggest risk to our rates view comes from the

1 We discuss the relative performance of mortgages versus swaps with different interest rate shifts in the following section.


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Mortgages should benefit fromthe 8-9 bps tightening of 10-yrswap spreads we are forecasting

possibility of a deepening housing slump. If the housing slump turned out to be much

longer and deeper than what we are projecting, reduced consumer spending could weaken

the economy further and may warrant further Fed easings. Such a scenario is likely to be

associated with curve steepening and lower long-term interest rates but we do not assign a

high probability to this eventuality in 2007.

On the swap spreads front, our interest rate strategists expect the 10-yr swap spread to

tighten to 40 bps (8-9 bps tightening from last weeks levels) and the 2s/10s swap spread

curve to flatten in 2007.2 Because mortgage spread movements tend to follow swap spread

rather closely for instance, a substantial portion of the mortgage outperformance versus

Treasuries over the past 2 months can be attributed to swap spread tightening we expect

mortgages to outperform Treasuries in 2007 due to swap spread tightening alone.

Realized Volatility Should Remain Very Low

The negative convexity of mortgages implies that they will outperform positively convex

assets like Treasuries and non-callable agency and corporate bonds when realized volatilityis low. MBS investments have benefited a lot over the past 3 years as realized volatility ha

declined sharply (Figure 2).

Figure 2: 90-Day Realized Volatility of the 10-yr Swap Rate

45

65

85

105

125

145

165

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

90-dayR

ealizedVol(bp


10-yr Treasury yields shouldremain in the 4.35%-5.15%range and realized volatilityshould be very low in 2007.

As our base line economic forecast above indicates, we expect interest rates to remain

range-bound in 2007 and the 10-yr Treasury to end the year only 35 bps above its current

level. We do not expect the 10-yr Treasury to rally below 4.35% as long as the Fed fundsrate is at or above 5% and there are no hints of the Fed embarking on an easing cycle.

Similarly, the 10-yr Treasury is unlikely to backup above 5.15% as the overseas demand

for the U.S. assets remains strong and is likely to increase further at higher yield levels

which should keep a lid on how far rates could backup. This projected narrow range of

long-term interest rates in 2007 should make mortgages very attractive for money

managers.

An interesting point about realized volatility is worth making here. In general, MBS marke

2 See Global Rates Focus report dated December 14, 2006


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participants track realized volatility using daily interest rate fluctuations and treat it as a

proxy for the cost of hedging negative convexity embedded in mortgages. We believe that

it is not the correct way to track realized volatility in the current environment and here is

why. In Figure 3, we show 60-day realized volatilities of the 10-year swap rate over a four

month time period. The 10-year swap rate moved in the range of 5.83% and 5.28% (a 55basis points range) over the two month period ending on September 1, 2006 (Period#1)

while it moved in the range of 5.09% and 5.36% (a 27 bps range) over the two month

period ending on November 1, 2006 (Period#2). Correspondingly, the 60-day realized

volatility based on daily changes of 10-yr swap rates over Period#1 was 48 bps while the

same number for Period#2 was 64 bps. The 60-day realized volatility was higher in

Period#2 because interest rates fluctuated wildly during this period although the net effect

of their up and down movements kept rates in a narrow range over this two-month period.

On the other hand, daily rate fluctuations were lower in Period#1 but interest rates steadily

declined over this period. A similar situation prevailed during the first half of 2006 also.

Now, the interesting question is when was the realized volatility higher Period#1 or

Period#2 as far as MBS investments are concerned?

Figure 3: Recent History of 10-yr Swap Rate and its Realized Volatility

5.0

5.2

5.4

5.6

5.8

6.0

07/03/06

08/01/06

08/29/06

09/27/06

10/26/06

10-yrSwapRate(%)

40

50

60

70

80

60-dayRealizedVol(bp

10-yr Swap Rate 60-day Realized Vol


Historically, measures of realized volatility based on daily interest rate changes have been

followed in the MBS market because convexity hedging activity from GSEs was supposed

to track this measure more closely. This argument certainly makes sense when active

convexity hedgers like the GSEs, dealer desks and hedge funds are marginal buyers in theMBS market, but this is not the case at the moment. Overseas investors and domestic

money managers are dominant players in the mortgage market now and these two groups

of investors typically buy mortgages to earn the additional carry offered by them in a

range-bound environment (i.e., they dont actively hedge negative convexity). In this

scenario, as far as the MBS market is concerned, we think that the range in which interest

rates move over few weeks or months is a better indicator of realized volatility than the

measures based on daily rate fluctuations. From this perspective, realized volatility should

remain very low in 2007 and continue to propel demand for mortgage assets.


8/45


Implied volatilities are neartheir 8-yr lows but all thefactors that resulted in lowervolatilities are still in place.

Implied Volatilities are Unlikely to Bounce Back from Their Multi-year Lows

Implied volatilities have steadily declined over the past three years which accounts for

more than 60% of the mortgage outperformance versus swaps over this period (Figure 4).

At the moment, implied volatilities are near their 8 year lows but most of the factors that

have led to this decline over the past three years are still in place. First, although thenegative convexity of the mortgage universe is very high, marginal buyers of MBS are no

convexity hedgers. Second, as long-term interest rates have moved in a very narrow range

over the past three years and the market still expects long-term rates to remain range-

bound, there is very little demand for hedging interest rate exposure of fixed-income

portfolios. Third, there is less motivation for buying interest rate protection in a flat yield

curve environment and because of this, implied and realized volatilities tend to be lower

when the curve is flat. Given that these factors are still in place, we do not expect implied

volatilities to jump up substantially from their multi-year lows any time soon.

Figure 4: History of the Implied Volatility of 3yr*7yr Swaption

60

75

90

105

120

135

150

May-98

May-99

May-00

May-01

May-02

May-03

May-04

May-05

May-06

ImpliedVolatility(bps


The biggest risk to our views on implied and realized volatilities comes from the

possibility of economic conditions deviating substantially from our base line forecast. For

instance, if the weakness in the housing market deepens and forces the Fed to embark on a

vigorous rate cutting path next year, uncertainty in the market would increase and the

curve will steepen, both of which are likely to cause implied and realized volatilities to

spike up.

Mortgage Sup ply Technicals We see mortgage debt growing by 7% in 2007 after averaging 13.8% in 2005 and

8.9% in 2006.

We project the net supply of agency fixed-rate MBS to total $220 billion in 2007

versus $254 billion in 2006 and $110 billion in 2005.

The supply of affordability products is likely to decline following the inter-agenc

guidance issued a few months ago and also because of well-advertised credit

problems in the mortgage market.


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Should we expect fixed-rateagency MBS supply to remainas strong as it was in 2006?

The amount of equity cashedout by prime conventionalmortgage holders soared to$296 billion in 2006.

One of the biggest surprises associated with the mortgage market in 2006 was the strong

supply of agency fixed-rate MBS. We estimate that the net issuance of agency fixed-rate

MBS3 totaled $254 billion in 2006, an increase of over $140 billion from 2005 levels.

Thus, one of the core questions for next year will be whether we should expect fixed-rate

supply to remain as strong as it has been in the past. Unfortunately, it is quite difficult to

forecast this number with any degree of certainty. As we will discuss in detail later, the

dramatic increase in agency fixed-rate MBS issuance was due to a number of factors

including a decline in the ARM share of mortgages, a large volume of resetting ARMs, an

unprecedented level of cash-out refinancing activity, and an improvement in the GSEs

share of the mortgage market.

To build our forecast, lets begin with an examination of the fundamental forces that result

in the growth of outstanding home mortgage debt. In general, the net supply of mortgages

is driven by four forces:

Household Growth. An increase in the number of households because of

population growth;

Increases in Homeownership Rates. An increase in the number of people

owning a house versus renting;

Home Price Increases. An increase in the value of homes so that for the same

LTV, you require a larger mortgage; and

Increase in LTV Ratios. An increase in borrower leverage. For example, a cash-

out refinance results in the net creation of mortgage debt since the new mortgage

is larger than the old one.

Figures compiled by the Federal Reserve show that the net supply of all home mortgages4

has averaged between $800 billion to $1 trillion dollars per year since 2003 (Figure 5).

Over this period, the annualized growth rate of home mortgage debt has ranged from 8%

to 14%. By far, the most important contributors to these growth numbers have been the

increase in home prices in conjunction with increases in LTV ratios accomplished through

cash-out refinancings. The importance of cash-out refinancing in terms of creating new

mortgage debt is summarized in Figure 6. Notice the remarkable strength of the numbers

in 2006: despite mortgages rates being 50 bps higher on average and the annualized rate of

home price appreciation falling from 13.4% in 2005 to 5.7% in 2006, the amount of equity

cashed out by refinancing prime conventional mortgage holders soared from $262 billion

to $296 billion. Thus, a substantial amount of net supply in the past few years has resultedfrom cash-out refinancings. In fact, the Freddie Mac numbers graphed in Figure 6

understate the net supply created by cash-out refis since the estimates do not include the

equity extracted through second mortgages or cash-out volume in the subprime sector.

3 Including 15-years, 20-years, 30-years and 10-20 IOs.4 Mortgages on 1-4 family properties.


10/45


Figure 5: Historical Trends in the Net Supply of Residential Mortgage Debt

0

200

400

600

800

1000

1200

2001 2002 2003 2004 2005 2006 (E) 2007 (F)

AnnualNetSupply($bb)

E denotes an estimate and F a forecast.

Source: Actuals: Federal Reserve Board. 2006 Estimate & 2007 Forecast: Banc of America. Securities

Figure 6: Trends in Annual Cash-out Volume for Prime Conventional Loans

0

50

100

150

200

250

300

350

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

(E)

2006

(F)

2007

(F)

Cash-outVolume($billions)

Source: Freddie Mac. E denotes an Estimate and F a forecast.

Cash-out volume of equity cashed-out through refinancing prime, first-lien conventional mortgages.

Given the discussion above, an integral part of the forecast is coming up with estimates for

home price growth and cash-out refinance volume in 2007. Our forecast is built along the

following assumptions:

Home Price appreciation: After averaging 13.4% in 2005 and 5.7% in 2006, we

believe home price growth will further moderate to about 3% per year in 2007.

Cash-out Equity volume: Freddie Macs estimates have cash-out volume

dropping by more than $100 billion in 2007. While we do think that we will see

cash-out volume moderating, we think the magnitude of the drop projected by

Freddie Mac is too punitive.

Thus, given an environment of modest growth in home prices and a diminution in the


11/45


We project the net issuance ofagency fixed-rate MBS in 2007to total $220 billion.

amount of equity withdrawn by homeowners, we see mortgage debt growing by 7% in

2006 after averaging 13.8% in 2005 and 8.9% in 2006. A growth rate of 7% on an

estimated outstanding home mortgage debt balance of $10.2 trillion (as of the end of

2006) in home mortgage debt should result in net issuance of $715 billion in 2007, down

15% from 2006 levels.

In terms of agency fixed-rate MBS issuance, we think that overall net supply numbers in

this sector will not decline by as much as the overall universe. First, there are signs that

the agency share of the mortgage market has been improving over the last couple of years

after falling sharply in 2004. The housing GSEs were distracted from their regular order of

business over 2003 and 2004 because of their accounting issues. In fact, as Figure 7

shows, there was negative net issuance of agency fixed-rate MBS in 2004. While some of

this was due to the increase in the popularity of ARMs as affordability issues began to

show up in the mortgage market, many conforming balance agency-eligible loans were

siphoned off into the non-agency alt-A sector over this period. The rebound in agency

fixed-rate MBS supply over the past two years can be at least partly attributed to the

progress made by Fannie Mae and Freddie Mac on their accounting and financials. We

expect this trend to continue in the next year. Another factor that will help fixed-rate

supply is the flat FRM-ARM slope which we expect to persist into next year. A more

moderate home price environment and a small FRM-ARM term premium will steer more

purchase borrowers towards a fixed-rate mortgage. Similarly, a large volume of resetting

ARM borrowers in 2007 should also gravitate towards fixed-rate mortgages for the same

reason. Obviously, the same factors should lead towards ARM supply decreasing in 2007.

The trends and forecasts detailed above are collected in Figure 7.

Figure 7: Trends and Forecasts for the Housing and Mortgage Markets

2003 2004 2005 2006 (E) 2007 (F)

Home Price Appreciation (%) 7.8 11.9 13.4 5.7 3ARM Share of Applications (%) 19 32 31 28 24

Growth in Home Mortgage Debt (%) 14.3 14.1 13.8 8.9 7

Net Issuance of Home Mortgages ($bb) 801 1055 1135 835 715

Net Issuance of Agency Fixed-rate MBS ($bb) 227 -27 110 254 220

Net Issuance of Agency ARM MBS ($bb) 79 81 53 42 36

E denotes an Estimate and F denotes a Forecast.

Sources: OFHEO, MBA, Federal Reserve Board, Banc of America Securities. All estimates and forecasts by

Banc of America Securities.

Overseas Investors We estimate that overseas investors have been net buyers of $288 billion agency

debt and MBS in 2006. Based on our forecast for a slightly lower trade deficit and

a weaker dollar versus other currencies, we expect combined net overseas

investor purchases of agency debt and MBS to decline slightly in 2007.

Most of the negative impact from potential FX diversification by overseas central

banks on their MBS holdings should be offset by their willingness to rotate funds

out of Treasuries into agency debt and MBS.

We estimate that the net purchases of agency MBS by overseas investors in 2007

will be $150-$170 billion which is slightly higher than their net purchases in 2006


12/45


Net overseas investor purchasesof agency debt and MBS shoulddecline slightly in 2007.

MBS holdings of overseasinvestors as a percentage oftheir combined agency debt andMBS portfolios have beengradually increasing.

Despite the heavy net supply of agency fixed-rate MBS, the mortgage basis did extremely

well versus Treasuries in 2006 and overseas investors played a big role in this strong

performance. Using the latest TIC data, we estimate that overseas investors were net buyer

of $288 billion agency debt and MBS in 2006. Considering that we are expecting another

strong year for agency fixed-rate MBS supply, the participation of overseas investors is

crucial for the MBS market in 2007.

Figure 8 shows the actual annual net purchases of agency debt and MBS by oversea

investors and our model fit of the data.5 Our model indicates that overseas investors hav

been investing 35-40 cents of every dollar of the US trade deficit in agency debt and MB

over the past few years. Based on our forecast for a slightly lower trade deficit and weake

dollar versus other currencies, we expect combined net overseas investor purchases o

agency debt and MBS in 2007 to decline slightly from 2006. As far as the agency debt an

MBS markets are concerned, most of the negative impact from potential FX diversificatio

by overseas central banks should be offset by their willingness to rotate funds out oTreasuries into agency debt and MBS. In the base case scenario, overseas investors ar

likely to buy about $260-$280 billion agency debt and MBS in 2007.

Figure 8: Net Overseas Investor Purchases of Long-term Agency Debt and MBS

0

40

80

120

160

200

240

280

320

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

NetPurc

hases($BB)

Actual Purchases Model Purchases

Actual purchases for 2006 are estimated by extrapolating the first 10 months of data.Source: Banc of America Securities

An interesting trend worth noting is that the fraction of overseas investor purchases oagency MBS in their total purchases of agency debt and MBS has been rising over the pas

3 years. For instance, the fraction of agency MBS in total agency debt and MBS holding

of overseas investors rose from 25% in 2003 to 33% in 2005 (the latest year for which th

data are available). We ascribe this trend to the following three factors: a) Reducin

issuance level of agency debt; b) Increasing comfort level of Asian investors wit

prepayment risk; and, c) the range-bound rates environment that made additional carr

offered by mortgages over agency debt very attractive.

5 2006 numbers have been extrapolated based on the data from January to October.


13/45


Figure 9: Overseas Holdings of Long-term Agency Debt and Agency MBS

2003 2004 2005Agency MBS ($bb) 149 176 264

Agency Debt ($bb) 437 447 527

Fraction of MBS (%) 25.4% 28.3% 33.4%

Data as of June of each yearSource: Treasury, Federal Reserve

We estimate that overseasinvestors will be net buyers of$150-$170 billion agency MBSin 2007.

Mortgages are rich in LOASterms, but they should easilyoutperform swaps if interestrates remain within ourprojected range.

Because the combined net overseas investor purchases of agency debt and MBS are likel

to remain close to this years level (albeit slightly lower) and we expect the fraction o

overseas investor purchases of agency MBS in this total to continue to rise, we expec

overseas investors to provide a strong bid for MBS in 2007. We estimate that the ne

purchases of agency MBS by overseas investors will be $150-$170 billion next year.

Domestic Money Managers We expect domestic money managers to continue to provide a strong bid for MB

in 2007. The range-bound rates environment coupled with mortgage rates staying

above levels where refinancings could be an issue should make MBS the asset

class of choice for domestic money managers.

Our credit strategists are slightly bearish on corporate spreads which means that

MBS could continue to benefit from a strong cross-over bid. Money managers are

also using MBS investments for selling volatility and their bid is likely to remain

strong unless expectations for a spike in implied volatilities build up.

Since 4Q05, domestic money managers have been playing an important role in

determining the performance of the mortgage basis. Based on desk flows, we estimate that

money managers were net buyers of more than $100 billion MBS since mortgage spreads

widened a lot in Oct/Nov of 2005. Their purchases were second only to those of overseas

investors over the past several months. Based on our expectations of a range-bound rates

environment coupled with mortgage rates staying above the levels where refinancings

could be an issue, MBS should remain the asset class of choice for domestic money

managers.

From the valuations perspective, on our OAS models, 30-yr current coupon LOASs have

stayed in a range of -17 bps and +2 bps over the past 2-yrs. At the present LOAS level of 15 bps, current coupon mortgage valuations are at the rich end of the recent range.

However, demand for MBS from domestic money managers is likely to be a function of

expectations for interest rates and volatilities. In Figure 10, we show the expected

outperformance of MBS investments versus equal dv01 swaps in different interest rate

scenarios by the end of 2007 (assuming mortgage LOASs remain unchanged). We can see

that 30-yr current coupon passthroughs outperform swaps even if interest rates move

towards either the upper or lower ends of our projected range for 2007. Note also that this

outperformance doesnt even account for a few basis points of likely additional gains from

roll specialness.


14/45


Mortgages look somewhatattractive versus corporates.

Figure 10: Excess Returns on MBS over Equal dv01 Swaps with Different Parallel

Shifts of Interest Rates by the end of 2007 (Dollars / $100 Face Value)

TBA -1.00% -0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00%

FNCL 5 (0.49) 0.05 0.38 0.55 0.56 0.44 0.23 (0.06) (0.40)

FNCL 5.5 (0.48) 0.13 0.55 0.77 0.79 0.63 0.32 (0.11) (0.63)


Another factor in favor of mortgages is that mortgage spreads still look attractive relative t

spreads on corporate bonds and our credit strategists are slightly bearish on corporate

spreads.6 In Figure 11, we show Treasury Z-spreads (ZVOAS) of 30-year current coupon

MBS and the Z-spreads of AA & A rated corporate bond index.

Figure 11: Treasury ZVOAS of 30-yr CC MBS vs. AA & A Corporate Debt

40

60

80

100

120

140

Jan-04

Mar-04

May-04

Jul-04

Sep-04

Nov-04

Jan-05

Mar-05

May-05

Jul-05

Sep-05

Nov-05

Jan-06

Mar-06

May-06

Jul-06

Sep-06

Nov-06

TsyZ-Spreads(bp)

Tsy Z-spread of CC MBS Tsy Z-spread of AA&A Corporate Debt


Notice that mortgage spreads were very wide relative to spreads on corporate bonds back i

Nov05 Dec05. Money managers took advantage of these wider spreads by buying

several billion MBS ($35-$45 billion by our estimates) and, as the spread differential

compressed, there was some profit taking in late April and early May. At the beginning of

the 2H06, we commented that mortgage valuations were very cheap relative to corporate

bonds and that money managers are likely to provide strong cross-over bid for MBS. We

were certainly not disappointed as domestic money managers were heavy buyers of MBS

over the past 3-4 months which is partly responsible for the strong performance of MBS. I

is possible that money managers may take short-term profits on their mortgage overweight

if relative spreads between MBS and corporate bonds tighten another 4-5 bps, but from a

long-term perspective we expect them to provide a strong bid for MBS if the 10-yr

Treasury yield stays in our baseline forecasted range of 4.35%-5.15%.

6 Please see the Credit Market Strategist report dated December 15 for more details.


15/45


Large bank holdings of MBShave declined by $62 billionsince peaking in late August.

The deposit base of large banksis not growing.

There is very little spreadbetween mortgage yields andthe marginal cost of funds forbanks.

Bank Purchases of Mortgages Changes in large bank holdings of MBS and their deposits have been heavily

skewed by the acquisition of GoldenWest by Wachovia in 2006. Excluding the

impact of Golden Wests acquisition, deposits on the books of large banks have

grown by only 1.5% in 2006 versus an average annual growth of 7%-8% during

2002-2005.

Although the spread between mortgage yields and average funding costs of banks

is about 2.0% at the moment, what is relevant for estimating the growth of bank

portfolios is the marginal cost of their funds. At a time when the growth in C&I

loans can accommodate most of their deposit growth, the marginal cost of fundin

for banks to buy MBS is much higher than their average cost of funds.

Considering our macro-theme that rates will remain range-bound next year, we do

not expect banks to actively shed mortgages in 2007, but we expect only a very

modest growth in bank holdings of MBS and whole loans.

Recent data on changes in bank holdings of mortgages are heavily skewed by the

acquisition of Golden West by Wachovia. After correcting for this, large bank holdings of

MBS grew by $27 billion while their whole loan holdings rose by $40 billion in 2006.

Bank holdings of mortgages grew very rapidly until August, but have stalled since then. In

fact, large bank holdings of MBS declined by nearly $62 billion from their peak reached in

late August (after adjusting for Golden West numbers). We attribute this drop to the

following three factors:

First, deposits on the books of large domestic banks are not growing (Figure 12).

Historically bank holdings of MBS have a strong correlation with excess deposits(deposits less C&I loans). Banks have added $67 billion of mortgages and $46 billion

C&I loans thus far in 2006 although deposit base rose by only $36 billion.7 Over the past 6

years, (Deposits - C&I - Mortgage Purchases) has never been less than zero.

Second, although the spread between mortgage yields and the average funding costs of

banks is a respectable 2.0% at the moment, what is relevant for estimating the growth of

bank portfolios is the spread between the marginal cost of their funds and the current

coupon mortgage yield. At a time when the growth in C&I loans can accommodate most o

the deposit growth, the marginal cost of funding for banks to buy MBS is much higher tha

their average cost of funds. We believe that there is very little spread between current

coupon mortgage yields and the marginal cost of funds for banks to buy MBS at the

moment. Thus, from a carry perspective, banks should have very little incentive for

growing their MBS portfolios.

Third, at current dollar prices, we estimate that a substantial portion of MBS purchases by

banks in 2006 (which total $125-$135 billion based on the YTD net purchases and

estimated pay-downs) are in-the-money at the moment. Therefore, banks could shed

mortgages if the current situation with deposits and C&I loans persists without having to

worry about recognizing losses in their income statements. This is unlike the situation in

June/July 2006 when unrealized losses on their books were very high at $24 billion.

7 Please note that the deposit growth numbers in the table include growth from Golden West acquisition and give a misleading picture.


16/45


We project a very modestgrowth in bank holdings ofMBS and whole loans in 2007.

Agency portfolio size should

remain unchanged in 2007.

In summary, we believe that deposit growth of large domestic banks will remain sluggish

in 2007 and given the current situation with the C&I loan growth, banks are unlikely to

grow their MBS portfolios in 2007. At the same time, we do not expect banks to actively

sell mortgages because of the prevailing view of a range-bound rates environment.

However, banks may selectively let their portfolios shrink from pay-downs if the deposit

growth doesnt keep pace with the C&I loans.

Figure 12: Large Bank Holdings of Mortgages, C&I Loans and Deposit Growth

Large Banks As Reported Excl. Golden West 2005 2004 2003 2002 2001

Net Mortgage Purchases

MBS 65 27 35 97 36 44 84

Whole Loans 148 40 73 12 45 102 -14

Total Net Mortgages 213 67 107 108 82 146 69

C&I Loan Growth 49 46 45 2 -41 -58 -72

Deposit Growth 104 36 157 226 128 118 101

2006

All numbers are in billion dollarsSource: Banc of America Securities

Agency Portfolio Issues Mortgage holdings of the GSEs have declined slightly in 2006 (by $12-$14

billion). Considering the current regulatory environment, we expect agency

portfolio sizes to remain unchanged in 2007.

The trend of the GSEs substituting agency mortgages with subprime mortgages

that prevailed in 2004-2005 seems to have subsided in 2006. We expect the GSEs

to be net buyers of agency mortgages in 2007 (although their overall portfolio siz

is likely to remain unchanged) following the recent directive from the OFHEO

about non-traditional mortgages.

30-yr mortgages need to be 5-10 bps cheaper relative to agency debt for the GSEs

to actively buy them as a substitute for subprime mortgages. In the short-term, we

expect the GSE purchases to be concentrated in hybrid ARMs as a relative value

play.

Earlier this year, we commented that the agency portfolio caps, based on GAAP numbers,

have introduced a new dynamic into the MBS market and estimated that Fannie Mae and

Freddie Mac together have to sell $8-$9 billion MBS for a 25 bps rally in rates. Subsequen

changes in the GSE portfolios have supported our assertion to some extent. However,

going forward the cap should be much less of an issue assuming our expectations of long-term rates not rallying by more than 25 bps from their current levels in 2007 are justified.

In the base case, we expect the size of the agency portfolios to remain unchanged next yea

However, the previous two year (2004-2005) trend of the GSEs substituting agency

mortgages by non-agency mortgages (primarily, subprime mortgages) seems to have

subsided in 2006. As shown in Figure 13, the GSEs bought about $170 billion subprime

MBS per year during 2004-2005 but the recent changes in the non-agency mortgage

holdings of the GSEs indicate that the substitution of agency MBS by subprime MBS has

stopped. In fact, we expect the GSEs to substitute a portion of their subprime holdings with

agency MBS in 2007 because of the recent directive from the OFHEO about non-


17/45


We expect GSEs to be netbuyers of $25-$35 billion ofagency mortgages in 2007.

CC MBS may have to widen 5-10 bps for the GSEs to buyfixed-rate MBS.

traditional mortgages. It is likely that the GSEs will direct a portion of pay-downs on

subprime MBS into agency mortgages. Based on our estimates that the GSEs own about

$250 billion subprime MBS and that prepayment speeds on these products are in the 40%-

50% CPR range, it is not unreasonable to think that the GSEs will be net buyers of $25-$3

billion of agency mortgages in 2007.

Figure 13: Annual Purchases of Subprime MBS by the GSEs

Year 2005 2004 2003 2002

Subprime Purchases 169 176 81 38

All numbers are in billion dollars

Source: OFHEO, Banc of America Securities

From the valuations side, we show the history of the OAS of the 30-yr current couponMBS relative to the agency curve in Figure 14. Mortgage spreads are near the tighter end

of the past 1.5-yr range relative to agency debentures. Thus the GSEs are unlikely to buy

30-yr mortgages at current valuations but mortgage spreads need to widen by no more than

5-10 bps for them to buy mortgages if they decide to move out of subprime mortgages in t

prime products. In the short-term, we expect the GSE purchases to be concentrated in

hybrid ARMs because of their cheap valuations in OAS terms.

Figure 14: Agency OAS (proxy) of 30-yr Current Coupon MBS

-20

-10

0

10

20

1/3/2005

3/2/2005

4/28/2005

6/27/2005

8/23/2005

10/20/2005

12/19/2005

2/16/2006

4/17/2006

6/13/2006

8/9/2006

10/05/06

12/4/2006

AgencyOAS(bp


Convexity Hedging Issues The last time convexity flows dominated MBS pricing was in October/November

2005. Since then, convexity related flows have been very limited (although not

non-existent). In our base case interest rate scenario, convexity hedging shouldnt

be an issue for the market in 2007.

The negative convexity of mortgage market has worsened a lot over the past 5-6 months


18/45


Interest rates need to rally 60-70 bps for convexity hedgingactivity to become important.

Relatively fast discount speedsand muted premium speedscharacterized prepaymentspeeds in 2006.

(Figure 15). In fact, servicer portfolios are only 15-20 bps away from the point of

maximum negative convexity and their portfolios extend or shorten by about $30 billion

10-yr Treasury equivalents for a 25 bps change in rates. We also believe that servicers are

still somewhat under hedged for a rally in rates and we could see substantial convexity

related flows if the 10-yr Treasury rallies through 4.40%. On the other hand, convexityrelated flows should be very limited if rates backup 25 bps.

In our view, convexity hedging activity will have a heavy impact on rates, volatility and

MBS markets only if another refinancing wave is initiated. Based on the current GWAC

distributions, interest rates need to rally 60-70 bps from current levels for this to happen.

Figure 15: Negative Convexity of the Agency Fixed-Rate MBS Universe

50

80

110

140

170

200

230

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

Interest Rate Shift from the Base Case (bp)

$billion10-yrTsye

quivalents

6/20/2006 12/22/2006


Outlook for Prepayment Speeds in 2007 For the range bound rate scenario during 2007, the out-of-the money and at-th

money speeds of recent originations are of chief concern due to continued softne

in the housing market.

We estimate that discount speeds for 2006 originations could be slower by up

2%-3% after the initial ramp up period as compared to the discount speeds durin

2006 for 12-24 WALA FNCL pools.

Even though we are not expecting mortgage rates to rally 50 bps from the curre

levels, nevertheless, if such a scenario were to materialize, prepayment speeds

100 bps in-the-money (FNCL 6s) pools will be significantly higher than what we

observed during 2006. We expect prepayment speeds to be closer to 45% CPR

opposed to 33% CPR seen during 2006.

Review of Prepayment Speeds in 2006Before we go into the rationale for our expectations let us first review the prepayme

behavior during 2006. We compare speeds for 12-24 WALA FNCL pools over the pas

years for various incentives in Figure 16. Overall, the prepayment experience during 20

resembled the 2005 experience i.e. relatively fast discount speeds and muted premiu

speeds. Pools that were 100 bps in the money prepaid at roughly 33% CPR (a far cry fro

60%-70% CPR during 2002-2003) and pools that were 50 bps out of the money prepaid

10% CPR.


19/45


Recent slower speeds for ITMpools can be attributed to aweaker borrower profile.

Figure 16: FNCL Prepay Response Curves Over the Past 5 years (12-24 WALA)

0

10

20

30

40

50

60

70

80

-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

CPR(%)

2002 2003 2004 2005 2006

Source: Fannie Mae, Banc of America Securities

The recent slower speeds for in-the-money pools can be attributed to weaker borrower

characteristics with higher Spread At the Time of Origination (SATO). The sharp

differences in the borrower characteristics of in-the-money mortgage pools relative to prio

years can be clearly seen in Figures 17. It shows that 12-24 WALA pools with 100 bps of

incentive during 2006 had average FICO score of 655 and OLTV of 82%, suggesting that

borrowers in theses pools belonged to the lower end of the credit spectrum. In contrast,

FICO score ranged between 700-720 and OLTV was closer to 75% for 100 bps in-the-

money pools during the earlier periods (a mainstream prime borrower).

Figure 17: FICO Scores and OLTV for FNCL Pools by Incentive Over the past 5 years (12-24 WALA)

60

65

70

75

80

85

90

-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

OLTV(%)

2003 2004 2005 2006

600

620

640

660

680

700

720

740

760

780

800

-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

FICO

2003 2004 2005 2006


Additional factors that determine premium speeds only dampened in 2006. For example,

the12-24 WALA pools that were in-the-money during 2006 had roughly 14% lower loan

sizes (see Figure 18) and at the macro level the media effect was virtually non-existent in

2006.


20/45


Lower loan sizes, higher LTVsalso dampened premiumspeeds.

Figure 18: ACLS for FNCL Pools by Incentive Over the Past 5 years (12-24 WALA)

60

80

100

120

140

160

180

200

220

-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

ACLS(000s)

2002 2003 2004 2005 2006


Figure 19 compares the recent history of prepayment speeds for 50 bps out-of-the mone

pools with $150K-$200K average loan sizes. For out-of-the money pools, averag

prepayment speed in 2006 was slightly lower (< 1% CPR) than in 2005 but it was sti

fairly robust (2%-3% CPR faster) as compared to the historical discount speeds.

Figure 19: Average Prepayment Speeds for 50 bps Out-of-the Money FNCL Pools

Over the Past 5 years (12-24 WALA, $150K-$200K average loan size)

0

2

4

6

8

10

12

14

2002 2003 2004 2005 2006

Year

CPR(%


The primary reason for continued robustness in discount speeds of 12-24 WALA pool

despite the housing slowdown during 2006, is the fact that they had already seen fairl

solid equity growth from the previous year as can be seen in Figure 20. The cumulativ

Equity Growth Since Origination (EGSO) was close to 18% for 50 bps out of the mone

pools. Even though it was lower than the 25% cumulative EGSO for the 12-24 WAL

pools during 2005, it was still much higher than other years. This equity growth kept th

cash-out activity at an elevated level even for discount collateral. The quarterly refinanc


21/45


The robust discount speeds aredue to the solid equity growththese pools have experienced.

Discount speeds for 2006originations could be 2%-3%CPR slower.

statistics released by Freddie Mac provides credence to this hypothesis as it indicates th

cash-out activity during 2006 was at an all time high on an absolute dollar amount bas

and the cash-out borrowers were willing to pay slightly higher mortgage rates (2%, 8%

12% higher during Q1, Q2, Q3 of 2006, respectively) to tap home equity.

Figure 20: Average Cumulative EGSO for 12-24 WALA FNCL Pools

-

5.0

10.0

15.0

20.0

25.0

30.0

-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

CumulativeEGSO(%)

2002 2003 2004 2005 2006


Outlook for Prepayment Speeds in 2007Looking ahead to 2007, for the range bound rate scenario we are projecting, the OTM an

ATM speeds of recent originations are of chief concern due to continued softness in th

housing market. Our estimates indicate that discount speeds for 2006 originations could b

slower by up to 2%-3% CPR after the initial ramp up period as compared to discoun

speeds during 2006 for 12-24 WALA FNCL pools. Our estimate of the potential drop

speeds for recent originations is based on three different computations. First, we us

discount speeds in 2002, as shown in Figure 19, to gauge the potential decline in discou

speeds. The 12-24 WALA pools during 2002 had a cumulative EGSO of approximatel

10%, which is actually higher than our baseline forecast of a flat housing market in re

terms. During 2002, speeds were approximately 2% CPR slower as compared to the speed

in 2006.

Another estimate can be obtained by grouping 12-24 WALA pools from 2006 b

annualized EGSO. The results are shown in Figure 21. This analysis also indicates tha

ramped up speeds can drop by 2%-3% CPR if the HPA is within 5%. Finally, we can loo

at the prepayment speeds of states with low home price appreciation using the Fannie Mastate level data to estimate prepayment speeds in low HPA environment. The 200

prepayment data at the GEO level also indicates that speeds on 12-24 WALA pools ca

drop by 3% CPR in a low HPA environment.


22/45


If interest rates rally 50 bps,100 bps ITM pools couldprepay substantially faster than

what were observed in 2006with similar incentive.

Figure 21: Prepayment Speeds in 2006 for 12-24 FNCL Pools by Annualized EGSO

0

2

4

6

8

10

12

14

5 10 15 20

HPA (%)

CPR(%


Earlier OTM cohorts will not be affected to the same degree by the housing slowdown a

they already have substantial built in equity. They would be impacted more in a scenari

where home sales were to slow down further from the current levels and result in low

levels of baseline turnover speeds. At this point we are not anticipating such a scenario.

Even though we dont expect mortgage rates to rally 50 bps from the current levels,

nevertheless, if such a scenario were to materialize, prepayment speeds of pools that are

100 bps ITM (FNCL 6s) will be significantly higher than what were observed during 2006

Our expectation in such a scenario is that prepayment speeds could shoot up to 45% CPR

for 100 bps ITM 30-yr fixed rate agency pools. The reasons for this expectation are two

fold. First, the collateral characteristics of the pools with 100 bps of incentive will be mucbetter as compared to the 12-24 WALA pools that had 100 bps of incentive in 2006 and

consequently, will not face the same barriers to refinancing. The summary of collateral

characteristics for FNCL 5.5s and 6s by various incentive buckets (assuming current

mortgage rate of 6.1%) is presented in Figure 22. For a 50 bps rally, FNCL 6s with curren

incentive of 25 bps or 50 bps will have incentives of 75 bps and 100 bps, respectively, and

correspond to main stream prime borrowers.

Figure 22: Collateral Characteristics of FNCL 5.5s and 6s by Incentive (Assuming 6.1 % Mortgage Rate)

Coupon Incentive Balance WAC WAM WALA ACLS FICO OLTV (%) %Refi %Owner Cumulative(bps) (Billion $) ('000s) Occupied EGSO (%)

5.5 -25 266 5.89 320 33 157 723 71 64 92 360 147 6.06 328 27 159 724 71 55 91 27

25 29 6.29 342 15 178 717 73 51 90 14

50 2 6.56 327 28 140 664 81 55 91 27

75 1 6.83 325 30 134 622 81 56 96 30

6 25 123 6.39 330 26 146 716 73 53 86 2650 122 6.58 333 23 150 717 74 48 89 2175 24 6.79 329 27 141 705 77 48 88 25

100 2 7.06 325 31 116 639 84 50 94 26

125 1 7.34 328 28 119 612 81 54 96 25


Additionally, in such a rally scenario almost 49% the FNCL universe will have at least 50

bps of incentive which will cause the media effect to be higher. In Figure 23, we look a

2006 Average


23/45


2006 vintage alt-A ARMs is theworst performing vintage fromthe past 4 years.

the distribution of the universe by incentive on the December factor date for the past 5

years. In the same graph we also plot how the universe will shift in case of a 50 bps rally

It can be clearly seen that even though refinanceability of the mortgage universe will be no

where close to that in Dec2002, it will be much closer to Dec2003 and Dec2004 factor

dates. In the periods following those factor dates media effect was modestly higher thanthe current levels. To estimate prepayment speeds of FNCL 6s with 100 bps of incentive

in a 50 bps rally scenario, we use prepayment experience during 2004 (see Figure 16) as

our guide, which indicates speeds are likely to be close to 45% CPR in such a scenario.

Figure 23: Cumulative Distribution of the MBS Universe by Incentive

-

10

20

30

40

50

60

70

80

90

100

-125 -7

5-25 25 75 12

5175

225

275

325

Incentive (bps)

%ofthe

Universe

200212 200312 200412

200512 200612 200612 - 50bps rally


Outlook for Mortgage Credit in 2007 We believe that residential mortgage credit will continue to make negative headli

news for a large part of 2007. The 2006 vintage of alt-A ARMs is the wo

performing (90+ delinquencies) vintage from the past 4 years and early payme

defaults for the alt-A sector have almost doubled during 2006 as compared to 200

There are some preliminary signs that housing market may stabilize going forwa

as the new and existing home sales are leveling off. Having said this, we still thin

it is too early to expect a reversal in the downward trend of HPA during 2007. W

expect the home prices to stay flat in real terms or increase by 2%-3% in nomin

terms during 2007.

We believe that residential mortgage credit will continue to make negative headline newsfor a large part of 2007. Cracks have already started appearing in the credit performance as

indicated by recent increase in delinquencies of various prime sub-sectors, particularly alt-

A ARMs. What stands out is the significantly faster ramp up in delinquencies of recently

originated alt-A ARM loans as compared to the earlier vintages, and rise in early payment

defaults during 2006. In fact, the 2006 vintage of alt-A ARMs (excluding Option ARMs) i

the worst performing (90+ delinquencies) vintage from the past 4 years and early payment

defaults for the alt-A sector have almost doubled during 2006 as compared to 2004.

Furthermore, the credit performance of alt-A ARM loans from California is close to the U


24/45


average for the 2006 vintage as opposed to outperformance for the earlier vintages8. The

primary reason for worsening in credit is the slower housing market and weak underwritin

as indicated by increased origination of leveraged loans without full documentation (Figur

24).

Figure 24: Prime RMBS Collateral Characteristics.

AOLS % % %Full % with % %IO %IO % BalanceYear ('000s) FICO Cashout Purchase Doc OLTV Seconds NegAm (ARM) (Fixed) 40Yr (Billion $)

2000 311 719 13 75 62 72 - 5 3 0 0 622001 386 725 24 38 66 66 - 1 3 0 0 162

2002 385 728 24 32 60 63 1 2 8 0 0 2242003 351 728 24 32 52 62 10 1 15 1 0 3072004 312 720 26 51 42 68 24 12 34 2 0 406

2005 328 720 35 50 32 70 30 27 27 10 2 4652006 353 717 35 49 23 71 37 30 26 12 7 218

Leverage

Source: LoanPerformance

We expect home prices to stayflat in real terms or up 2%-3%in nominal terms.

2006 alt-A ARM cohort isunderperforming the 2000 alt-Afixed cohort.

At this point, HPA is continuing to slowdown and the inventory of unsold homes is at avery high level (7.4 month supply for existing homes according to NAR). However, there

are some preliminary signs that housing market may stabilize going forward as new and

existing home sales are leveling off. Furthermore, home builders have reacted promptly to

the housing slump by lowering the construction of new homes which will further support

the housing market. Having said this, we still think it is too early to expect a reversal to the

downward trend in HPA during 2007. We expect home prices to stay flat in real terms or

up by 2%-3% in nominal terms during 2007. This scenario does not provide any relief to

borrowers who have leveraged themselves beyond their means in anticipation of a

continued boom in the housing market. They may find it hard to refinance out of trouble

because of no growth in home equity due to flat home prices and potentially tighter

underwriting by lenders in response to worsening credit situation and/or tighter regulations

The situation in some of the MSAs that saw extraordinary HPA during 2004-2005 is worth

keeping an eye on as a lot of these areas are experiencing negative HPA already and have

higher concentrations of leveraged borrowers. For 2007, the major risks for the investors

are the widening of mortgage credit spreads and higher default rates combined with higher

loss severities. Careful analysis of the collateral characteristics will be of paramount

importance while taking credit exposure.

Given our bearish outlook on credit performance especially for the 2006 cohort, the

question is how bad can it get? At the national level, the 2000 vintage that corresponded to

loans from prior purchase environment stands out for poor performance in recent times.

The cumulative defaults for alt-A fixed rate loans (alt-A ARMs were a much smaller

portion of the alt-A universe in 2000) were close to 5.9% and cumulative losses were 69

bps. The reasons for poor performance were weaker underwriting standards during 2000

and weak economic climate post 9/11. However, the drop in interest rates after 9/11 did

help a lot of borrowers to refinance out of trouble. Given the ramp up in delinquencies of

the 2006 alt-A ARM cohort (excluding Option ARMs) and the weak outlook for the

housing market, it is possible for defaults and losses to reach or exceed 2000 levels. Figure

25 compares the delinquency ramp of 2006 alt-A ARMs with the 2000 cohort of alt-A

fixed rate mortgages. It clearly shows that the 2006 alt-A ARM cohort is currently

8Please have a look at our RMBS Trading Desk Strategy report from Dec 8, 2006 for a comprehensive review of recent credit performance.


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underperforming the 2000 alt-A fixed cohort.

Figure 25: 90+ Delinquencies for Recent alt-A ARM Cohorts versus 2000 alt-A

Fixed

0

4

8

12

16

20

0 5 10 15 20 25 30 35 40 45 50

WALA (months)

90+Delinquency(%)

2003 alt-A ARM 2004 alt-A ARM 2005 alt-A ARM

2006 alt-A ARM 2000 alt-A Fixed

Source: LoanPerformance

Summary of Major Themes Relevant for the RMBS Market in 2007 Interest rates are likely to remain range bound. Realized volatility will stay low

and implied volatilities are unlikely to move higher from their multi-year lows.

Swap spreads should tighten 4-9 bps from their current levels.

Net supply of fixed-rate agency MBS is likely to decline from 2006 levels.

However, the decline should be modest because of ARM-to-fixed refinancings,

stabilization of the housing market and continued strong cash-out refinancings.

Overseas investor purchases of MBS are likely to grow further due to the

substitution of Treasuries and agency debt by MBS and our projection for only a

marginal decline in trade deficit.

We expect domestic money managers to continue to provide a strong bid for MB

in 2007. The range-bound rates environment coupled with mortgage rates staying

above the levels where refinancings could be an issue should make MBS the asse

class of choice for domestic money managers.

Excluding the impact of Golden Wests acquisition, deposits on the books of larg

banks have grown by only 1.5% in 2006 versus the average annual growth of 7%

8% during 2002-2005. Considering our macro-theme that rates will remain range

bound next year, we do not expect banks to actively shed mortgages in 2007, but

we expect only a very modest growth in bank holdings of MBS and whole loans.

The trend of the GSEs substituting agency mortgages by subprime mortgages tha

prevailed in 2004-2005 seems to have subsided in 2006. We expect the GSEs to

be net buyers of agency mortgages in 2007 (although their overall portfolio size i

likely to remain unchanged) due to the recent directive from the OFHEO about

non-traditional mortgages.

We estimate that discount speeds for 2006 originations could be slower by up


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2%-3% after the initial ramp up period as compared to the discount speeds durin

2006 for 12-24 WALA FNCL pools. On the other hand, if interest rates were

rally by 50 bps, prepayment speeds of 100 bps ITM pools will be significant

higher than what were observed during 2006. In this case, we expect prepayme

speeds to be closer to 45% CPR as opposed to 33% CPR seen during 2006.

We believe that residential mortgage credit will continue to make negative headli

news for a large part of 2007. The 2006 vintage of alt-A ARMs is the wo

performing (90+ delinquencies) vintage from the past 4 years and early payme

defaults for the alt-A sector have almost doubled during 2006 as compared to 200


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III. Agency Pass-through MarketSummary Trade Recommendations

Long-term Overweight on the Mortgage Basis

Overweight 30-yr 5.5s and 6.5s versus 5s and 6s

Overweight 15-yr MBS versus 30-yr MBS with Volatility hedges

Overweight 15-yr 4.5s and 6s versus 15-yr 5s and 5.5s

Overweight 15-yr Golds versus 15-yr FNMAs

Buy Fixed-rate IOs versus Jumbo basis

Buy premium GN/FN swaps

Mortgage Valuations and Summary Recommendation on the Mortgage BasisOn our models, 30-yr current coupon LOASs have stayed in the range of -17 bps and +2

bps over the past 2 yrs (Figure 26). At the present LOAS level of -15 bps, current coupon

30-yr valuations are at the very rich end of the past 2-yr range. In addition, mortgages

have benefited enormously from faster discount and muted premium prepayment speeds in

2006, but as our outlook for prepayments discussed in the previous section suggests, the

mortgage market is unlikely to benefit from these favorable prepayment trends in 2007.

Thus we see little upside from owning mortgages in the short-term for relative value

players (pure OAS players). However, from a long-term perspective, we recommend an

overweight on the mortgage basis (with the end of 2007 end as the horizon period) to real

money managers for the following reasons:

We expect a range bound rates market with very low convexity losses which

generally favors negatively convex products.

Swap spreads are likely to tighten in 2007. Since the MBS basis tends to track

swaps, we expect mortgages to outperform Treasuries in 2007.

Overseas investors are likely to absorb 60%-70% of the net supply coming into

the agency fixed-rate MBS market in 2007.

Corporate bonds continue to look rich relative to MBS and the cross-over buying

from domestic money managers will continue in 2007.

Although banks are unlikely to grow their MBS holdings in 2007, we expect the

GSEs to be better buyers of agency mortgages.

Considering that the mortgage universe has very limited refinancing risk at

current rate levels, the mortgage basis should trade somewhat tight.

As shown in Figure 10, 30-yr current coupon passthroughs outperform swaps even if

interest rates move towards either the upper or lower ends of our projected range for 2007

Note that this outperformance doesnt even account for a few basis points of likely

additional gains from roll specialness. Considering that our base case scenario is for the

10-yr Treasury yield to reach 4.95% by the end of 2007 which is only 35 bps away from

current levels, mortgages as an asset class are likely to do well in 2007.

For active convexity hedgers (like GSEs and hedge funds), we recommend a modest

underweight on the mortgage basis versus swaps as mortgages are trading near their 2-yr


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tights in LOAS terms. In addition, mortgage spreads are also at 1.5-yr tights versus

corporate bonds and agency debentures (although still cheap by historical standards) and

this may cause some money managers to take profits on their mortgage overweight

positions. The projected swap spread tightening is also less of an issue for this investor

community.

Figure 26: History of the LOAS of 30-yr Current Coupon MBS

-20

-15

-10

-5

0

5

Jan-05

Mar-05

May-05

Jul-05

Sep-05

Nov-05

Jan-06

Mar-06

May-06

Jul-06

Sep-06

Nov-06

LOAS(bp


30-yr Coupon Stack: Overweight 30-yr 5.5s and 6.5s versus 30-yr 5s and 6sThere are three important issues that investors need to keep in mind while thinking of

positioning on the 30-yr coupon stack in 2007:

The upward creep of GWACs and loan sizes in the agency pass-through market

Discount prepayment speeds in a slow HPA environment

The prepayment behavior of 50-100 bps ITM pools in 2007 versus speeds in 2006

Upward Creep of GWAC and Loan Sizes in the Agency Pass-through Market9

Over the past several months, the spread between the GWAC and the net coupon of fixed-

rate agency mortgage pools has increased substantially. For instance, new production 30-

year FNMA 6s pools have a GWAC of 6.67% versus 6.48% 1-year ago. Similarly, new

production 30-year FNMA 5.5s pools have a GWAC of 6.25% versus 5.96% 1-year ago.

On average, the spread between the aggregate GWAC and the net coupon of new

production 30-year mortgage pools was close to 47-48 bps in 2003 and 2004 versus the 56

bps spread over the past one year. We believe that originators/servicers retained more

interest cash flows on their balance sheets as the MBS market came out of a significant

Refi wave and the media-effect subsided. In addition, originators/servicers may be taking

advantage of FAS 156 which allowed mark-to-market accounting treatment for servicing

rights.10

Another collateral characteristic that has changed significantly over the past 1-year is the

9 We first wrote about this issue in our weekly report dated 10/27/2006.10 See our weekly report dated April 21, 2005 for details about FAS 156.


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average loan size on MBS pools. At the moment, the average loan-size for new production

30-year 6s is $225K versus $170K one year ago. Similarly, newly issued 30-year FNMA

5.5s pools have an average loan size of $230K versus $200K one year ago. These higher

average loan balances are largely due to the sharp spike in the conforming loan balance

limit from $359,650 to $417,000 at the beginning of this year.

The higher GWACs and loan sizes make the new production mortgage pools a lot more

negatively convex than the same net coupon pools originated one year ago which has some

significant implications for their valuations. For instance, the higher loan size coupled with

higher GWAC makes the current FNCL 6s TBA pools worth about 5-6 bps (in OAS terms

less than the collateral produced a year ago. The impact of the higher GWAC and loan

sizes are somewhat lower on FNCL 5.5s since it is a discount coupon. Considering the ver

narrow range in which spreads have traded over the past few months, differing assumption

about TBA collateral characteristics can make the difference between viewing coupon

swap valuations as rich or cheap.

Prepayment Response Curves

As discussed in the previous section, discount speeds for 2006 originations could be slowe

by up to 2%-3% CPR after the initial ramp up period as compared to the discount speeds

during 2006 for 12-24 WALA FNCL pools. Similarly, even though we are not expecting

mortgage rates to rally 50 bps from the current levels, prepayment speeds of pools that are

100 bps ITM (FNCL 6s) will be significantly higher than what were observed during 2006

Our expectation in such a scenario is that prepayment speeds can shoot up to 45% CPR for

100 bps in the money 30-yr fixed rate agency pools.

At current valuation levels, 30-yr 6s and 5s look rich across the coupon stack and we

recommend underweighting them in favor of 30-yr 5.5s and 6.5s. We will track this trade

using 30-yr 5.5s and 6s butterflies with duration and curve hedges.

Overweight 15-yr Basis versus 30-yr Basis Buy Dw 4.5s/FN 5s and Dw 5.5s/FN 6s swaps.

Dw 4.5s pick-up 6-8 bps LOAS versus FN 5s after adjusting for the recent faster

than model estimated prepayment speeds on Dw 4.5s.

Dw 5.5s/FN 6s swap is a good hedge versus our mortgage overweight position if

rates rally more than our expectations.

The 15-yr sector looks cheap relative to 30-years and we recommend buying Dw 4.5s/FN

5s and Dw 5.5s/FN 6s coupon swaps with duration and curve hedges. It is interesting that15-yr discount pools are prepaying faster and 30-yr discount pools are prepaying slower

relative to the estimates of most Street prepayment models but the market currently

appears not to be paying attention to this trend. At the moment, Dw 4.5s pick-up 6-8 bps

LOAS versus FN 5s after adjusting for the recent faster than model estimated prepayment

speeds on Dw 4.5s. We also recommend Dw 5.5s/FN 6s swap as a good hedge versus our

mortgage overweight position if rates rally more than our expectations.


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15-yr Coupon Stack: Buy 15-yr 4.5s and 6s versus 15-yr 5s and 5.5sOn our models, 4.5s is the cheapest coupon across the liquid 15-yr coupon stack (4.5%-

6.0% coupons). It picks-up 6-10 bps of LOAS versus 15-yr 5s and 5.5s after adjusting for

faster than model expected prepayment speeds on 15-yr discounts. On our models, 15-yr

5.5s look very rich and although 15-yr 5s do not look very rich they will lag as the TBA

deliverable on this coupon shifts from the current 8-9 WALA to 2-3 WALA over the next

couple of months. However, since overweighting 15-yr 4.5s versus 5s and 5.5s will be a

negative carry trade, we recommend combining it with 15-yr 6s.

15-yr MBS Market: Overweight 15-yr Golds versus FNMAsThe 15-yr Freddie Mac TBAs are trading 2.0-3.5 ticks behind equal coupon 15-yr

FNMAs, whereas 15-yr Golds should be trading 4 ticks above 15-yr FNMAs when all the

collateral characteristics are similar (the 4 tick price difference accounts for the value of

10-days of less delay in Gold cash flows). We looked at the recent prepayment history of

15-yr Gold and FNMA pools and they are almost identical for all cohorts. Furthermore,there are no issues with dollar rolls in any liquid 15-yr coupon (4.5-6.0) at the moment.

The market seems to be penalizing Golds with the expectation that rolls on 15-yr Golds

are more difficult to be squeezed relative to 15-yr FNMAs. We believe that 15-yr Golds

are 6.0-7.5 ticks cheap versus 15-yr FNMAs and recommend overweighting Golds versus

FNMAs in the 15-yr sector.

Buy Agency Fixed-rate IOs vs. Jumbo AAA BasisAgency fixed-rate IOs (5.5s, 6s and 6.5s) are trading 17-19 ticks behind equal coupon

agency TBAs whereas the Jumbo AAA basis is trading 22-24 ticks behind agencies.

Investors can therefore buy mortgages with lower loan balances and the agency guaranteefor a pay-up of only 4-6 ticks.

GNMAs vs. Conventionals Neutral on GN/FN 5s and 5.5s Coupon Swaps

Buy New Origination Premium GN I and GN II Pools versus FNMA TBAs

This note is a follow up on the trade recommendation issued on 12/01 to buy new

origination GN II 6s versus FN 6s.11 Below we look at some important reasons behind the

sharp drop in the prices of GN I/FN and GN II/FN swaps over the past few months and the

attractiveness of premium GN II/FN swaps based on their current valuations.

GN/FN swaps traded at very rich valuation levels late last year and in early 2006 because

of the negative net supply of GNMAs and the strong demand for this product from

overseas investors. The sharp rise in GN/FN swap valuations forced shorts in GNMAs to

cover their positions and most relative value players exited the GNMA market by the

beginning of 2006 as liquidity became an issue. Since then, GN/FN swaps have gradually

weakened and were trading at close to their two-year wides in early December. Although

GN/FN swaps have bounced off from their lows by 5-6 ticks, we think that premium GN

11 Please see the weekly report dated 12/01/06 for more details.


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II/FN swaps are still offering the government guarantee for free.

There are two important reasons behind the cheapening of the GNMA sector over the past

few months. First, after dwindling rapidly for 2-3 years, the size of GNMA market started

expanding this year. The net production of GNMAs has turned positive this year due to a

combination of factors that include streamlining of the underwriting process by FHA,

reduced down payment requirements on FHA mortgages and higher subprime mortgage

rates. The spread between subprime and FHA mortgages tightened from 200-220 bps in

2000 to 80-100 bps in 2004. Since then, this spread has widened back to 170

outlook for the rmbs market in 2007

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