JPMORGAN MBS PRIMER

MBS Strategy
Matt JozoffAC
212-834-3121
May 2009
STRICTLY PRIVATE AND CONFIDENTIAL

INTRODUCTION TO MBS
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JPMORGAN MBS PRIMER

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INTRODUCTION TO MBS
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 1
 MBS in the U.S. fixed income market

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

Many products to choose from within the MBS

market Asset-backed Municipal
8% 8%
Agency fixed-rates and ARMs
Money Market
Non-agency fixed-rates and ARMs (Jumbos, Alt- 11%
U.S. Treasury
As) 18%
Whole loans
CMOs and other structured MBS Fed Agencies
10%
Superior liquidity
The TBA market adds unique liquidity to MBS

MBS market often used to express duration and

curve views (due to its liquidity and size) Corporate
MARKET OVERVIEW AND ORIGINATION

19% Mortgage
Related
Agency fixed-rate pass-throughs is 34% of the 26%
U.S. Aggregate Index (a benchmark of the U.S.
investment grade debt).
Total = $30.8 trillion
Source: Securities Industry and Financial Markets Association (4Q 2008)

INTRODUCTION TO MBS 2
 Agency MBS market composition and issuance

Securitized
Securitized agency
agency market
market composition
composition Annual
Annual fixed-rate
fixed-rate net
net issuance
issuance ($
($ billions)
billions)
Hybrid ARM
Hybrid ARM
IO ($199 514 514
($156 billion) 1/1 ARM
billion)
3% ($14.2 billion)
4%
<1% 296 273
Other Fixed 255
210
($297.9 158
billion) 99 81
6%

-26
2000 2001 2002 2003Total
2004= $__mm
2005 2006 2007 2008 2009*
15-year ($545
Source: JPMorgan, FNMA, FHLMC, GNMA
billion) * As of April 2009
12%
Annual
Annual ARM
ARM net
net issuance
issuance ($
($ billions)
billions)

80
73
51
MARKET OVERVIEW AND ORIGINATION

30-year 47
($3.53 trillion) 29
75% 17
9

-12 -8
-28
Total = $4.71 trillion 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
Source: JPMorgan, FNMA, FHLMC, GNMA Source: JPMorgan, FNMA, FHLMC, GNMA
As of Sep 2008 * As of April 2009

INTRODUCTION TO MBS 3
 The mortgage market surged, thanks to a strong housing market and cash-out refis

1-4
1-4 Family
Family Mortgage
Mortgage Debt
Debt Outstanding
Outstanding ($
($ billions)
billions)

11,158 11,164

10,452

9,379

8,273

7,183

6,463

5,738
5,205
MARKET OVERVIEW AND ORIGINATION

2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Federal Reserve Board

* As of 3Q2008

INTRODUCTION TO MBS 4
 Why do investors buy mortgages? Yield pickup over Treasuries, with little credit
risk in Agency space
Yield
Yield History
History of
of the
the FNMA
FNMA 30yr
30yr CC
CC and
and the
the 10
10 yr
yr On-the-run
On-the-run UST
UST

Current Coupon Pass-through 10 yr UST

6.5

5.5

5
Yield

4.5

3.5
MARKET OVERVIEW AND ORIGINATION

2.5

2
Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09

Source: JPMorgan

INTRODUCTION TO MBS 5
 Securitization and the money flow of pass-throughs

Loans
Mortgage
Agencies
Lenders
Agency Backed Securites

Home Owner Payment Servicer Agencies Investors

MARKET OVERVIEW AND ORIGINATION

Defaults

Servicing Fee Guarantee Fee

Insurance Pool

INTRODUCTION TO MBS 6
 The MBS market links borrowers and investors

Agencies

Mortgage
MBS Dealers
Lenders

Borrowers MBS Investors

MARKET OVERVIEW AND ORIGINATION

A pass-through is the basic MBS structure

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

Loans with similar characteristics are pooled together and then securitized

Investors are entitled to a pro-rata share of monthly principal and interest payments of the underlying loans,
minus a servicing spread and guarantee fee

INTRODUCTION TO MBS 7
 Origination: The Menu of Mortgages Has Expanded
Origination: production of new loans in primary market

Products

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

Adjustable rate mortgages (Hybrid ARMs: 3/1, 5/1, 7/1, 10/1)
Interest-Only
MTAs; Option ARMs
Others
Balloon mortgages (5-year / 7-year)
Prepayment penalty mortgages

Conforming balance loans: agency eligible loans need to meet certain collateral criteria

Non-conforming loans (Private label or Non-agencies)

MARKET OVERVIEW AND ORIGINATION

Jumbos and Alt-As

INTRODUCTION TO MBS 8
 Understanding Mortgage Collateral : Borrower Credit & Housing Leverage

Borrower Credit and Information

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

Documentation
Full vs. Limited/Reduced/No Doc
Leverage (Debt to Income Ratios)
Reserves : Staying Power in the event of financial trouble
MARKET OVERVIEW AND ORIGINATION

INTRODUCTION TO MBS 9
 Understanding Collateral cont

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

Higher LTV Less Equity Protection for the Mortgage Investor Higher Risk

Occupancy
Owner Occupied Borrower Lives in the Property (Most Secure)
Second Home Borrower has personal ties to the property
Investor Business Decision on Economic Situation (Least Secure)

Property Type
Single Family Property (Most Secure)
Condos
Multi-Family
MARKET OVERVIEW AND ORIGINATION

INTRODUCTION TO MBS 10
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 11
 Major MBS investors

MBS MBS
MBS Investors
Investors ($
($ billion)
MBS Investor
Investor Breakdown
Breakdown billion)
2007 2008
All MBS Non-Agency All MBS Non-Agency Change Market Share
Fannie Mae/Freddie Mac 1,040 346 1,113 295 7% 16%
Remaining Commercial Banks 971 260 1,089 210 12% 16%
Investors Fannie Mutual Funds 655 995 185 52% 15%
Public
12% Mae/Freddie Foreign Investors 1,220 550 920 320 -25% 14%
Pension
Funds Mac Other Investors* 700 565 200 -19% 8%
16% Life Insurance Cos. 360 475 240 32% 7%
Priv. Pension 4% State/Local government 285 280 20 -2% 4%
Funds Priv. Pension Funds 225 268 75 19% 4%
4% Public Pension Funds 235 245 52 4% 4%
Savings Institutions 265 123 212 68 -20% 3%
Securities Brokers & Dealers 260 171 26 -34% 3%
State/Local Commercial
FHLBanks 127 82 160 75 26% 2%
government Banks
Property/Casualty Insurers 145 145 60 0% 2%
4% 16% US Treasury/NY Fed 72 - 1%
Credit Unions 63 46 3 -27% 1%
REITs 85 85 39 7 -54% 1%
Pension
Funds Total Outstanding 6,636 2,117 6,793 1,835 2%
7%

Other
Investors* Source: Inside MBS & ABS
8% Mutual Funds
Foreign 15%
Investors
14%

Total = $6.79 trillion

Source: Inside MBS & ABS
DEMAND

INTRODUCTION TO MBS 12
 Foreign demand had dominated the mortgage market during the boom

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

250
Foreign GSE Bank
200
Net Purchases ($ billions, annual)

150

100

50

-50

-100

-150
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan
* As of YE 2008.
DEMAND

INTRODUCTION TO MBS 13
 Now, the Fed and Treasury have stepped in to support the market

Cumulative
Cumulative Federal
Federal Reserve
Reserve Purchases
Purchases of
of Agency
Agency MBS
MBS

Cum Purchases
500,000

450,000

400,000

350,000

300,000
$mm

250,000

200,000

150,000

100,000

50,000

0
1/7 1/21 2/4 2/18 3/4 3/18 4/1 4/15 4/29
DEMAND

Source: JPMorgan, Federal Reserve

INTRODUCTION TO MBS 14
 The GSEs
Fannie Mae and Freddie Mac

Conforming loan limits are now the higher of $417,000 or 125% of median home price, with a cap of $729,750.

20% risk capital weighting, regulators considering 10% weighting

Ginnie Mae

Explicitly government guaranteed

Zero risk weighting

Federal Home Loan Banks (FHLBs)

No securitization program like the other agencies

Represent a funding mechanism for commercial banks in the US to tap capital markets

Have portfolios of loans that they hold, similar to Fannie and Freddie
DEMAND

INTRODUCTION TO MBS 15
 Unique role of Fannie and Freddie: issuer / investor
Placed in a conservatorship with support from the US Treasury in September 2008

Mission is to facilitate secondary mortgage market in U.S. which provides steady flow of low cost mortgage funds

2 major functions:

Guarantee loans against credit losses (charge a guarantee fee)

Buy loans and securities and issue agency debt

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

Large portfolios (FN + FH hold over $1.5 trillion in loans and MBS)
DEMAND

INTRODUCTION TO MBS 16
 Agency Portfolio Growth, 1994-2008

Agency
Agency Retained
Retained Portfolios
Portfolios

1,000
900
800
700
600
$ Billions

500
400
300
200
Fannie Mae Freddie Mac
100
0
00 01 02 03 04 05 06 07 08 09

Source: FNMA, FHLMC, JPMorgan

As of March 2009
DEMAND

INTRODUCTION TO MBS 17
 Top 20 banks ranked by MBS portfolios as of year end 2008
Bank
Bank MBS
MBS and
and 1-4
1-4 family
family whole
whole loan
loan holdings:
holdings: Top
Top 20
20 banks
banks ranked
ranked by
by total
total assets,
assets, as
as of
of 4Q08
4Q08 and
and changes
changes
since
since 3Q08,
3Q08, $mm
$mm

Bank MBS Chg % Chg Pass-through Chg % Chg CMO Chg % Chg
1 BANK OF AMERICA CORPORATION 231,771 13,894 6% 196,188 16,109 9% 35,583 (2,215) -6%
2 JPMORGAN CHASE & CO 131,127 23,415 22% 108,192 16,250 18% 22,935 7,165 45%
3 WELLS FARGO & COMPANY 106,497 (42,824) -29% 64,374 (37,262) -37% 42,123 (5,562) -12%
4 CITIGROUP INC 63,313 6,672 12% 23,199 5,431 31% 40,114 1,241 3%
5 PNC FINANCIAL SERVICES GROUP INC 42,240 4,898 13% 20,129 5,441 37% 22,111 (543) -2%
6 BANK OF NEW YORK MELLON CORPORATION 36,869 (1,837) -5% 5,377 355 7% 31,492 (2,192) -7%
7 US BANCORP 31,271 (104) 0% 16,155 (464) -3% 15,116 360 2%
8 BB&T CORPORATION 28,690 12,207 74% 20,292 12,240 152% 8,398 (33) 0%
9 CITIZENS FINANCIAL GROUP INC 26,868 (872) -3% 10,359 (510) -5% 16,509 (363) -2%
10 CAPITAL ONE FINANCIAL CORPORATION 25,765 3,660 17% 14,016 1,930 16% 11,749 1,730 17%
11 STATE STREET CORPORATION 23,401 (1,214) -5% 7,133 (232) -3% 16,268 (982) -6%
12 SUNTRUST BANKS INC 15,022 5,192 53% 13,998 5,212 59% 1,024 (19) -2%
13 REGIONS FINANCIAL CORPORATION 14,606 1,526 12% 9,331 1,692 22% 5,274 (166) -3%
14 TD BANKNORTH INC 13,456 888 7% 3,107 1,083 54% 10,349 (195) -2%
15 FIFTH THIRD BANCORP 8,621 (1,247) -13% 4,956 (1,493) -23% 3,664 246 7%
16 BBVA USA BANCSHARES INC 7,974 (131) -2% 4,590 144 3% 3,383 (274) -7%
17 KEYCORP 7,885 5 0% 1,504 (7) 0% 6,380 12 0%
18 COMERICA INCORPORATED 7,624 (299) -4% 6,146 (215) -3% 1,479 (84) -5%
19 M&T BANK CORPORATION 7,090 (291) -4% 2,998 (97) -3% 4,093 (194) -5%
20 BOK FINANCIAL CORPORATION 6,481 395 6% 1,779 (394) -18% 4,702 789 20%
Top 20 836,572 23,933 3% 533,824 25,213 5% 302,747 (1,280) 0%
Next 30 68,404 3,567 6% 35,305 2,909 9% 33,099 657 2%

Source: JPMorgan, Federal Reserve

DEMAND

INTRODUCTION TO MBS 18
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 19
 MBS Terminology

Pools are comprised of mortgage loans with similar rates and terms

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

WAM weighted average maturity of loans in pool

WALA weighted average loan age

Original face original principal amount of pool

Current face remaining principal balance of pool

MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

Origination year average origination year of loans in pool; age (WALA) is important in prepayment assessment (seasoning)

CPR Constant Prepayment Rate annualized percentage of remaining principal prepaid

INTRODUCTION TO MBS 20
 Mortgage cash-flow characteristics

Homeowner's August After processing, security

payment due holders receive shares of
(in arrears) August payment

FHLMC FNMA
14th 24th
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

August 1st September 1st October 1st

30 days in arrears 14 to 24 days processing

44 to 54 day delay

INTRODUCTION TO MBS 21
 Mortgage cash-flow

Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year
fixed-rate loan

Using MP function on BBG

MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

Source: Bloomberg

INTRODUCTION TO MBS 22
 Mortgage cash-flows: without prepayments
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

Interest

Principal

Source: Bloomberg

INTRODUCTION TO MBS 23
 Mortgage cash-flows: with prepayments

Interest
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

Pre-paid
Principal
Principal

Source: Bloomberg

INTRODUCTION TO MBS 24
 Prepayments: source of MBS optionality

Borrowers have the right to prepay at any time without penalty in effect calling their loans away from investors; prepayments
may be partial or complete

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

Timing and rate of prepayments vary and produce non-level, less-predictable cash flows
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

INTRODUCTION TO MBS 25
 Prepayment standards
CPR Constant Prepayment Rate annualized percentage of remaining principal prepaid

PSA prepayment vector expressed as a series of CPRs; begins at .2% in the first month,
increases .2% per month, leveling out at 6.0% in month 30; prepayment assumptions for
pricing stated as linear multiples of PSA schedule
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS

14
200 PSA
12

10

8
CPR (%)

100 PSA
6

0
0 10 20 Age 30 40 50

INTRODUCTION TO MBS 26
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 27
 Many Different Types of Spreads
Basic: static yield spread over a single point on the curve
I : spread to Treasury
N : spread to swaps

Intermediate: zero volatility yield curve spread

Z : spread to Treasury curve
E : spread to Libor/swap curve
Libor ZSpread on JPMorgans analytic reports.
Advanced
OAS : option-adjusted spread
LIBOR OAS
Treasury OAS
VALUATION AND OAS

INTRODUCTION TO MBS 28
 Yield analysis in the MBS market

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

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

INTRODUCTION TO MBS 29
 Evaluating pass-throughs: yield / average life
VALUATION AND OAS

Source: Bloomberg

INTRODUCTION TO MBS 30
 Prepayments and OAS

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

OAS has been derived to account for the dispersion and uncertainty
associated with this return of principal from MBS
VALUATION AND OAS

INTRODUCTION TO MBS 31
 OAS Calculation

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

To find OAS given market price:

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

Drawback of OAS:
1. The spread earned by the investor depends on the actual path realized and can be drastically different from the OAS
2. Wide differences in OASs are produced by different firms models due to different term structures, volatility assumptions
and prepayment projections
3. Doesnt account for dollar roll financing
4. Is a black box difficult for investors to decompose OAS into its component parts.
VALUATION AND OAS

INTRODUCTION TO MBS 32
 Pass-through risk measurement (duration)

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

Modified duration is inappropriate for pass-throughs as it cannot accommodate varying

cash flows.

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

Empirical duration uses actual observations regressed against a Treasury benchmark.

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

Duration is typically expressed as a % of the 10-year Treasury duration:

For instance, a par-priced mortgage with a duration of 3 years, compared to a 10-yr

Tsy duration of 7.5 yrs: 3/7.5 = 40% of a 10-yr

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

VALUATION AND OAS

INTRODUCTION TO MBS 33
 Pass-through risk measurement (convexity)

Convexity: the rate at which the duration of a security changes as interest rates change.

Positive convexity implies that for small, equal and opposite changes in interest rates,
the increase in price if rates go down will be more than the decrease in price if rates
rise.

Negative convexity implies that the increase in price if rates go down will be smaller
than the decrease in price if rates rise.

Bullet Treasuries have positive convexity. Pass-throughs typically have negative

convexity.
VALUATION AND OAS

INTRODUCTION TO MBS 34
 Negative convexity of mortgages

FN
FN 6
6 prices
prices ($)
($) vs
vs shift
shift in
in rates
rates (bps),
(bps), as
as of
of July
July 2007
2007

104

102

100

98
FN 6 Px ($)

96

94

92

90

88

86
-300 -200 -100 0 100 200 300
Bps
VALUATION AND OAS

Source: JPMorgan

INTRODUCTION TO MBS 35
 A real-world example: Hedging a position of FNMA 6s

Buy $100m FNMA 30 6.0

Hedging Possibilities
Hedge duration with $54m 10Y Treasuries (OAD=4.12 Treas Dur=7.64). This provides protection against parallel yield curve
shifts.

Hedge duration with 2Y, 5Y, 10Y, and 30Y Treasuries. This protects against any yield curve movements.

Convexity hedge with $19m ATM 3Mx10Y swaption straddle.

Pass-through Treasury Hedge

Partial Duration Ratio
2Y 0.74 1.89 0.39
5Y 1.17 4.37 0.27
10Y 1.67 7.64 0.22
30Y 0.59 14.09 0.04
Total 4.17
VALUATION AND OAS

INTRODUCTION TO MBS 36
 Scenario Analysis with Duration Hedging

What happens if the yield curve shifts in parallel?

Duration Hedged Change

0.30

0.00
Price Change

-0.30

-0.60

-0.90

-1.20

-1.50
-150 -100 -50 0 50 100 150

Spread Change (bps)

10 Year Hedge 2, 5, 10, 30 Year Hedge

VALUATION AND OAS

The portfolio incurs convexity costs for large yield movements

INTRODUCTION TO MBS 37
 Duration and Convexity Hedging

With a static position in options, one can nearly eliminate the convexity cost.

Convexity Hedged Change

0.30

0.00

-0.30
Price Change

-0.60

-0.90

-1.20

-1.50
-150 -100 -50 0 50 100 150

Spread Change (bps)

10 Year Hedge 2, 5, 10, 30 Year Hedge

VALUATION AND OAS

Note that multiple options are needed to completely hedge the convexity of the mortgage prepayment
option.

INTRODUCTION TO MBS 38
 Changes in mortgage market duration can impact the rates markets

The rate of extension of the mortgage market will slow in a sell-off A sell-off could cause the curve to steepen

Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in Change in 10-year equivalents for the mortgage market across the curve for a parallel +50
rates rate shock

400
Change in 10-yr equivs ($bn)

200
200

0 150

10-year Equiv ($bn)

-200
100
-400
50
-600

-800 0
-100 -75 -50 -25 0 25 50 75 100
Rate change (bp) -50
VALUATION AND OAS

2 5 Tenor 10 30

INTRODUCTION TO MBS 39
 Mortgages have embedded options Investors need to hedge changes in vol as
well.

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

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

Underly ing
S hort Long
S hort 1m x 1y 1m x 10y
O ption
Long 5m x 1y 5m x 10y

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

Higher vol should cause mortgages to cheapen

FN 30 Vega FN15 Vega

5. 0 -0. 21 4. 5 -0. 091
5. 5 -0. 26 5. 0 -0. 123
6. 0 -0. 27 5. 5 -0. 145
VALUATION AND OAS

6. 5 -0. 23 6. 0 -0. 111

Source: JPMorgan

INTRODUCTION TO MBS 40
 Where to find mortgage risk measures:
Front page of the JPMorgan mortgage daily packet
VALUATION AND OAS

Source: JPMorgan Pricing and Analytics Package, May 12, 2009

INTRODUCTION TO MBS 41
 Tracking valuations historically: Current coupon OAS
VALUATION AND OAS

Source: JPMorgan Pricing and Analytics Package, May 12, 2009

INTRODUCTION TO MBS 42
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 43
 The Prepayment S-Curve

70

60

50 Burnout: Refi response

slows once deep in-the-
money
40
CPR (%)

30 Refi: How quickly

speeds increase as
incentive increases
20
PREPAYMENT ANALYSIS AND REPORTS

10 Elbow: The amount of incentive to

get borrowers to begin refinancing
Turnover (to overcome fixed costs)
0
-250 -200 -150 -100 -50 0 50 100 150 200 250

Refi Incentive (bp)

INTRODUCTION TO MBS 44
 A closer look at prepayments: The major components

Rate refinancing
Largest component of prepayments
Borrowers take advantage of lower interest rates to refinance
A steep curve can cause borrowers to refi into shorter mortgages (ARMs)

Turnover
Prepayment occurs when borrower moves from one home to another
As loans age (or season) they show higher turnover speeds
Seasonality is an important driver of turnover, as most families move during
the summer (when kids are out of school)

Cash-out refinancing
PREPAYMENT ANALYSIS AND REPORTS

Borrowers with accumulated equity can refinance and take out a larger
mortgage
Cash can be used for home improvement, paying off bills, or other debt
consolidation
This effect is driven primarily by home price appreciation (HPA)

INTRODUCTION TO MBS 45
 Unemployment vs. HPA

Employment weak but

housing still strong

Northeast: weak housing

but better employment so
far
PREPAYMENT ANALYSIS AND REPORTS

Texas: Bucking
the trend
Housing Decline

Hardest hit
<-8% -8 to 7% >7%

Unemployment
>1.9%

Increase in
0.6
1.9%

<0.6%

Source: Case-Shiller home prices mid-2006 to mid-2008, OFHEO, Bureau of Labor Statistics

INTRODUCTION TO MBS 46
 Seasonality in prepayments, especially turnover

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

School schedules and weather conditions are the main

reasons for seasonal behavior 1.6
There is also a separate day count adjustment to account
for different collection days in each month 1.4

1.2

1.0

0.8
PREPAYMENT ANALYSIS AND REPORTS

0.6

0.4

0.2

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

INTRODUCTION TO MBS 47
 Housing prices and turnover matter a lot for a discount mortgage
PREPAYMENT ANALYSIS AND REPORTS

INTRODUCTION TO MBS 48
 Prepayment reports: speeds by origination year
PREPAYMENT ANALYSIS AND REPORTS

Source: JPMorgan, FNMA (April 2009)

INTRODUCTION TO MBS 49
 Prepayment reports: speeds by WALA
PREPAYMENT ANALYSIS AND REPORTS

Source: JPMorgan, FNMA (April 2009)

INTRODUCTION TO MBS 50
 Market Overview and Origination 1

Demand 11

Mortgage Cashflows and Intro to Prepayments 19

Valuation and OAS 27

Prepayment Analysis and Reports 43

TBA Market and Specified Pools 51

JPMORGAN MBS PRIMER

INTRODUCTION TO MBS 51
 How does the TBA market work?

The TBA mortgage market has been incredibly successful

Liquidity that is at least as good as in the Treasury market
Estimated $X billion trades daily as TBA on average

What is TBA?
Buyer agrees to buy a coupon and program (e.g. 30-year 6s), but
Seller can decide what collateral to deliver (WAC, WAM, WALA, loan
size, etc.)
Allows very large trades to occur (>$10 billion at times)
TBA trades settle on 1 day per month (a.k.a. PSA settle)

The problem? The seller is long the delivery option, so the buyer will
TBA MARKET AND SPECIFIED POOLS

always get the worst to deliver

Highest loan size
Worst servicers
Adverse WALA

INTRODUCTION TO MBS 52
 Collateral Performance Varies
TBA = Cheapest to Deliver

Realized return on MBS investments depends on collateral performance

Efficient allocation by dealers and investors and pooling by originators ensure that cheapest
pools are delivered into the TBA market

Prepayments of FNMA 30-year 6.5% coupons in Carry of $102 TBA FNMA 6.5s versus 1-month CPR,
March 2007, grouped by age and loan size bp

35
Performance of TBA delivery pools 8
30 6.8
7

25 6 5.7

1-month Funded Carry, bp

5 4.6 TBA 6.5 is negative
20
CPR, %

carry at 30CPR
4 3.5
15
3
2.3
10 2
TBA MARKET AND SPECIFIED POOLS

1.0
5 1

0
0
0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 -1 -0.5
0 5 10 15 20 25 30
< $100k $100~150k $150~200k $200~250k $250k +
1-month CPR, %

Source: JPMorgan, Fannie Mae

INTRODUCTION TO MBS 53
 Why consider specified pools?

Avoid the uncertainty of TBA delivery

Pick up value in specific loan characteristics

Improve convexity relative to TBAs

Match the mortgage index composition

Anticipate demand from specific buyers

TBA MARKET AND SPECIFIED POOLS

INTRODUCTION TO MBS 54
 Demand for Specified Pools Comes from Many Sources

CMO

CMO execution is often driven by model valuation

Dealers arbitrage between collateral intrinsic value and demand from different investor types

Collateral selection is important when buying structured securities, particularly for structures
with leverage

Money Managers

Indexed investors need exposure to specified pools as seasoned pools comprise 80% of the
outstanding agency MBS universe

Total return investors aim to reduce convexity hedging costs

FNMA and FHLMC

TBA MARKET AND SPECIFIED POOLS

Portfolio risk management and hedging are model dependant, thus improvements in portfolio
convexity reduce hedging cost

Hedge Funds

Buy/sell specified pools versus TBA to take advantage of relative value opportunities

INTRODUCTION TO MBS 55
 Specified Pools Offer a Superior Prepayment Profile

Choosing
Choosing the
the right
right pool
pool attributes
attributes can
can lead
lead to
to slower
slower speeds
speeds as
as a
a premium
premium (Call
(Call Protection)
Protection) and
and faster
faster speeds
speeds as
as a
a
discount (Extension Protection)
discount (Extension Protection)

Prepayment speed versus economic rate incentive

60

50 Discount Premium
40
1-month CPR

30

20
TBA MARKET AND SPECIFIED POOLS

Generic
10 Specified Pool

0
-200 -150 -100 -50 0 50 100 150 200
Rate Incentive, bps

INTRODUCTION TO MBS 56
 Specified Pools Come In Many Flavors

Types
Types of
of specified
specified Pools
Pools
Attribute Name Definition Purpose
WAC Low WAC Lower than average gross WAC Call Protection
Lower the WAC, slower the speeds
WALA Seasoned Premium Loan age > 24 months and older Call protection
than TBA Burnout: after the most reactive borrowers leave the pool,
the remaining borrowers are less likely to prepay
Seasoned Discount Loan age > 12 months and older Extension protection
than TBA

Loan Size LLB / $85k Max Maximum loan size < $85k Call protection
Lower the loan size, slower the speeds
MLB/ $110k Max Max loan size < $110k
HLB / $150k Max Max loan size < $150k
$175k Max Max loan size < $175k
Geography Texas All loans originated in Texas Call Protection
New York All loan originated in NY Call Protection
TBA MARKET AND SPECIFIED POOLS

LTV High LTV 90% LTV or higher Call Protection

FICO Low FICO Credit Score < 620 Call Protection

Credit impaired borrowers have fewer refinancing options
Occupancy NOO Non Owner 100% Investor property or 2nd Call protection
Occupied Home

INTRODUCTION TO MBS 57
 Specified Pools: Quoted as price payups vs TBAs
TBA MARKET AND SPECIFIED POOLS

Source: JPMorgan MBS Pricing and Analytics Package, May 12, 2009

INTRODUCTION TO MBS 58
 Valuing loan balance and geographic pools
TBA MARKET AND SPECIFIED POOLS

Source: JPMorgan Pricing and Analytics Package, May 12, 2009

INTRODUCTION TO MBS 59
 Loan Attribute: WALA (Loan Age)
Prepayment Convexity Improves With the Passage of Time
WALA (weighted average loan age) measures time elapsed in months from when
borrowers took out the loan

Seasoned Premiums: slower prepayments

Seasoned collateral that has been in-the-money for an extended period of time is
considered to have burnout

Pools will start to slow-down as the most negatively convex, or the most reactive,
borrowers prepay out of the pool

The surviving borrower population is less reactive to rates and can have more desirable
attributes such as lower loan balances

Seasoned Discounts: faster prepayments

TBA MARKET AND SPECIFIED POOLS

Home tenure is how long a borrower has been in the current home

Longer the home tenure, more likely a borrower will move, leading to faster speeds

Monetize equity gains in their homes and curtail their loan

Built-in equity enables faster turnover speeds via increased mobility (trade-up), greater
cash-out activity, and flexibility to refinance to different product types

INTRODUCTION TO MBS 60
 Loan Attribute: WALA (Loan Age)
Prepayment convexity improves with the passage of time

One month CPR versus Rate Incentive, in 2005~2006

0~12 mo
50
12~24 mo
24~36 mo
40 > 36 mo
1mo CPR, %

30 Seasoned discounts
prepay faster than new
issues
20
Burnout: seasoned
TBA MARKET AND SPECIFIED POOLS

premiums slow down.

10

0
-200 -150 -100 -50 0 50 100 150 200
Rate Incentive, bp

Source: JPMorgan, Fannie Mae

INTRODUCTION TO MBS 61
 Seasoned Discounts:
Fundamental value increases as dollar prices decline

Fair value payups by WALA for discount TBAs at different price levels, assuming constant libor static Z

spread to TBA.

$93 TBA
30
$96 TBA
25 $98 TBA

20

15

10
TBA MARKET AND SPECIFIED POOLS

0
0 10 20 30 40 50

INTRODUCTION TO MBS 62
 Loan Attribute: Loan Size
The Lower the Loan size, the Slower the Speeds

Borrowers with lower loan balances have less incentive to refinance the fixed costs
of refinancing represent a larger percentage of their monthly savings

Loan Balance S-Curves

Monthly Breakevens Refinancing from a
7% to 6% Rate 50
"TBA" Generic
45 HLB (150k MAX)
Loan Monthly Months MLB (110k Max)
40
Size Savings to BE LLB (85k Max)
35
1-month CPR
$ 65,000 $ 34 59
$ 100,000 $ 52 38 30
$ 130,000 $ 68 29
TBA MARKET AND SPECIFIED POOLS

25
$ 300,000 $ 158 13
20
*assumes $2,000 Closing Costs
15

10
0 20 40 60 80 100 120 140
Rate Incentive, bps

INTRODUCTION TO MBS 63
 Loan Attribute: Geography
It is not just HPA

Regional prepayment differences are due to

Housing market

Demographics & economy

Taxes and fees

New Yorks mortgage recording tax is >2% in the metro area and >1%
in the rest of the state

Other states with mortgage tax: Alabama, Florida, Georgia, Maryland,

Minnesota, Oklahoma, Tennessee, Virginia

Other factors
TBA MARKET AND SPECIFIED POOLS

Cashout refinancing restrictions in Texas

Borrowers can only cash-out refi once per year

Cash-outs can only go to 80 LTV max

INTRODUCTION TO MBS 64
 Relative value strategies and analysis

Trading
Trading Strategies
Strategies

Mortgage - Swap basis Evaluation

Evaluation Approaches
Approaches
Mortgage - Tsy basis OAS
Coupon swap Spread
15s / 30s Hedge-Adj Carry
Ginnie / Fannie Regressions
TBA / Seasoned Deliverable
Agency / Non-agency Sponsorship
Pass-through / ARM
TBA MARKET AND SPECIFIED POOLS

CMO / Collateral

INTRODUCTION TO MBS 65
 TBA MARKET AND SPECIFIED POOLS

INTRODUCTION TO MBS
66