S T R I C TL Y
P R I V A T E
AN D
C O N F I D E N T I A L
JUNE 2006
JPMORGAN MBS PRIMER
MBS
Analyst Certification The strategist(s) denoted by an asterisk (“*”) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed. This research contains the views, opinions and recommendations of research strategists with JPMorgan US Fixed Income Strategy. Research strategists routinely consult with JPMSI trading desk personnel in formulating views, opinions and recommendations in preparing this research. Trading desks may trade or may have traded as principal on the basis of the research strategist(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMSI trading desks which may conflict with your interests. In addition, research strategists receive compensation based, in part, on the quality of their analysis, firm revenues, trading revenues, and competitive factors.
JP M O R G AN
M B S
P RIM E R
Copyright 2006 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited is registered as an investment advisers with the Securities & Futures Commission in Hong Kong and itsCE numbers is AAJ321 Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (“MAS”). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer. This material is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. JPMorgan and its affiliates may have positions (long or short), effect transactions or make markets in securities or financial instruments mentioned herein (or options with respect thereto), or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers mentioned herein. The information contained herein is as of the date and time referenced above and JPMorgan does not undertake any obligation to update such information. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Transactions involving securities and financial instruments mentioned herein (including futures and options) may not be appropriate for all investors. Clients should contact their salespersons at, and execute transactions through, a JPMorgan entity qualified in their home jurisdiction unless governing law permits otherwise J.P. Morgan Securities Inc. is a member of NASD, NYSE and SIPC In the UK and other EEA countries, this material is not available for distribution to persons regarded as private customers (or equivalent) in their home jurisdiction.
MBS
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
MBS
1
Agency MBS market composition and issuance Securitized Securitized agency agency market market composition composition Hybrid ARM ($229.5 billion) 7%
Hybrid ARM IO ($107.1 billion) 3%
Annual Annual fixed-rate fixed-rate net net issuance issuance ($ ($ billions) billions)
1/1 ARM ($29.4
217
billion)
292
276
211
156
1%
231 109
93
2005
2006
Other Fixed ($157.2
-17
billion)
1998
5%
1999
2000
2001 2002 2003 Total = $__mm
2004
15-year
Annual Annual hybrid hybrid ARM ARM net net issuance issuance ($ ($ billions) billions)
($650 billion) 19%
30-year 74
($2.2 65%
O V E RVI E W MAR K E T
Source: JPMorgan, FNMA, FHLMC, GNMA
52 13
10
-31
Total = $3.4 trillion
79
49
trillion)
AN D
O RI G I N AT I O N
Source: JPMorgan, FNMA, FHLMC, GNMA
1998
-11
-13 1999
2000
2001
2002
2003
2004
2005
2006
Source: JPMorgan, FNMA, FHLMC, GNMA
MBS
2
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
Asset-
market
backed
Municipal
8%
9%
Agency fixed-rates and ARMs
Money
Non-agency fixed-rates and ARMs (Jumbos, Alt-
Market
U.S.
14%
Treasury
As)
17%
Whole loans
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
CMOs and other structured MBS Superior liquidity The TBA market adds unique liquidity to MBS
Fed Agencies 10%
MBS market often used to express duration and
curve views (due to its liquidity and size) Agency fixed-rate pass-throughs is 34% of the
Mortgage Corporate
Related
19%
23%
Lehman U.S. Aggregate Index (a benchmark of the U.S. investment grade debt). Total = $25.9 trillion Source: The Bond Market Association, as of March 2006
MBS
3
The mortgage market has surged, thanks to a strong housing market and cash-out refis 1-4 1-4 Family Family Mortgage Mortgage Debt Debt Outstanding Outstanding ($ ($ billions) billions)
8,683
8,978
8,079 7,120 6,317 5,614
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
5,133
2000
2001
2002
2003
2004
2005
2006
Source: Bond Market Association, Federal Reserve Board
MBS
4
The MBS market links borrowers and investors Agencies
MBS Pass-through
Mortgage Loans
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
Securitization
Mortgage lenders
MBS Dealers
Borrowers
MBS Investors
The issuer of the pass-through obtains the mortgages either by purchasing or originating the loans Loans with similar characteristics are pooled together; loans are securitized The investor has undivided ownership interest (the investor is entitled to the pro-rata share of interest and
principal payments of the underlying loans) A “pass-through” is the basic MBS structure It passes the monthly principal and interest payments, minus a servicing spread, from a pool of mortgages to
investors
MBS
5
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
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
– MTAs; Option ARMs – Other
Balloon mortgages (5-year / 7-year) Prepayment penalty mortgages
“Conforming” balance loans “Non-conforming” loans (Private label, Non-agencies) Jumbos and Alt-As
MBS
6
Understanding Mortgage Collateral : Borrower Credit & Housing Leverage Borrower Credit and Information FICO Score – Historical Credit Use and Management
— — — —
Avg FICO Score for Jumbo Mortgages : ~730 Avg FICO Score for Alt-A Mortgages : ~700 Avg FICO Score for Subprime Mortgages : ~600 Non-Linear Relationship Between FICO and Propensity to Default
— Full vs. Limited/Reduced/No Doc Leverage (Debt to Income Ratios) Reserves : Staying Power in the event of financial trouble
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
Documentation
MBS
7
Understanding Collateral cont… Housing Leverage Loan-to-Value Ratio
— House Value / Mortgage Amount — Higher LTV Æ Less Equity Protection for the Mortgage Investor Æ Higher Risk
— 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
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
Occupancy
MBS
8
Conforming loan limits rose by 16%, reaching $417,000 in 2006 Conforming Conforming Limits Limits ($’000) ($’000) 450
Conforming loan limit for 2006
400
350
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
300
250
200
150 1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: FHFB, JPMorgan
MBS
9
Origination channels
$3.0 trillion origination volume in 2005 Retail (42%) - loan officer employed by mortgage banking company; mortgage loan is closed in the name of the lender
MAR K E T
O V E RVI E W
AN D
O RI G I N AT I O N
Broker (34%) – mortgage loan broker represents borrower to lending institution; mortgage loan is closed in the name of the lender
Correspondent (24%) – independent
Top 5 mortgage banking companies account for over 48% of all new origination volume 1. Countrywide 2. Wells Fargo 3. Washington Mutual 4. Chase Home Finance 5. CitiMortgage Source: National Mortgage News, as of Q1 2006
mortgage banking company; mortgage loan is closed in “ABC” Mortgages name and sold to mortgage banker
Internet – mortgage loan originated and funded by mortgage banking company through website
MBS
10
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163 MBS
11
Major MBS investors MBS MBS Investor Investor Breakdown Breakdown
MBS MBS Investors Investors ($ ($ billion) billion)
Dealer
Personal
REITs
Inventory
Sector
2%
1%
6%
Investor Type Fannie Mae/Freddie Mac FDIC Commercial Banks Life Insurance Cos.
Finance Companies
Agencies
2% Pension
29%
Funds 9% Mutual Funds 7%
MBS Dealer Inventory Federal Credit Unions Subtotal: All Other Investors* Total Outstanding
Foreign Investors 9%
Foreign Investors Mutual Funds Personal Sector Public Pension Funds All Thrifts Priv. Pension Funds FHLBanks REITs Finance Companies
Insurance Companies
YE 2004 Mid-2005 % Chg All MSRs Non-Agency All MSRs Non-Agency % of MSRs since 2004 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
1,261 876 465 280 318 270 270 234 125 113 95 85 41 28 4,462 317 4,779
$ $
$
267 124 N.A. 30 N.A. N.A. N.A. 7 13 71 50 N.A. 15 N.A. 577
$
1,076
$
$ $ $ $ $
$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $
1,192 913 480 400 325 290 275 228 128 117 105 88 55 29 4,625 474 5,098
$ $ $ $
$
363 158 150 50 N.A. N.A. N.A. 6 15 71 60 N.A. 20 N.A. 893
$
1,289
$ $ $ $ $
26% 20% 10% 9% 7% 6% 6% 5% 3% 3% 2% 2% 1% 1%
-5% 4% 3% 43% 2% 7% 2% -3% 2% 3% 11% 4% 34% 2%
Banks 25%
Source: Inside MBS & ABS
10%
Total = $4.6 trillion
DEMAN D
Source: Inside MBS & ABS
MBS
12
Foreign demand has dominated the mortgage market over the past several years Net Net Purchases Purchases ($ ($ billions, billions, annual) annual) 250
Foreign
GSE
Bank
200 150 100 50 0 -50 -100 -150 2001
2002
2003
2004
2005
2006
DEMAN D
Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan * Foreign purchase data: March ’06, GSE: April ’06, Bank: May ‘06
MBS
13
Trends in bank demand
Bank holdings are still growing, but at a slower pace. Some signs that bank demand could slow: MBS holdings as a percentage of deposits have increased C&I loan growth has picked up But, there are mitigating factors: Deposit rates have remained sticky Unrealized losses are significant Mortgages remain one of the few sectors that offers the size and
DEMAN D
liquidity that large banks need
MBS
14
Large banks have been drawn to the mortgage market Top Top3 3Bank BankHoldings Holdingsasas%%ofofTotal TotalBanks’ Banks’ 40% 38% 36% 34% 32% 30% 28% 26% 24% 22% 20% Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Source: Federal Reserve, JPMorgan
Large banks have enjoyed the liquidity of the mortgage market for large trades,
DEMAN D
and average trade size has increased significantly. Diversification and movement away from credit risk have been themes, but could
shift if mortgages remain tight. MBS
15
Top 10 banks ranked by MBS portfolios as of 1Q 2006 Bank Holding Company
Total MBS
BANK OF AMERICA CORPORATION
212,273,791 15,121,205
Change 3,173,000
Pass-through
Change
206,670,221 15,808,550 78,527,000
CMO
Change
5,603,570
-687,345
2,338,000
15,766,000
835,000
1,290,000
142,000
WACHOVIA CORPORATION
94,293,000
JPMORGAN CHASE & CO
41,644,000 18,775,000
40,354,000 18,633,000
WELLS FARGO & COMPANY
40,042,000
7,676,000
33,969,000
8,729,000
6,073,000
-1,053,000
US BANCORP
35,975,000
-1,547,000
22,928,000
-576,000
13,047,000
-971,000
CITIZENS FINANCIAL GROUP INC
31,828,058
1,087,257
11,429,339
176,681
20,398,719
910,576
BANK OF NEW YORK COMPANY INC
22,671,000
189,000
2,908,000
-129,000
19,763,000
318,000
COMMERCE BANCORP INC
20,908,478
1,076,917
3,651,529
104,519
17,256,949
972,398
STATE STREET CORPORATION
20,252,615
581,874
6,324,590
-626,064
13,928,025
1,207,938
SUNTRUST BANKS INC
17,287,171
264,477
11,580,470
-159,294
5,706,701
423,771
DEMAN D
·The top 10 banks account for over 58% of all bank MBS holdings.
Source: Federal Reserve, JPMorgan
MBS
16
Bank MBS holdings continue to grow MBS MBS Holdings Holdings of of Large Large Banks Banks ($ ($ billions) billions) 650 600 550 500 450 400 350 300 250 200 May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
DEMAN D
Source: Federal Reserve
MBS
17
Security purchases and C&I loan growth has typically been inversely correlated MBS MBS and and C&I C&I Holdings Holdings (Annual (Annual changes changes since since 2000) 2000)
15%
C&I Annual % Chg
10% 5% 0% -5% -10% R2 = 0.6155 -15% -5%
0%
5%
10%
15%
20%
25%
30%
35%
MBS Annual % Chg
DEMAN D
Source: Federal Reserve, JPMorgan
MBS
18
With many bank positions underwater, it is unlikely that there will be large selling
Unrealized Gains/Losses
15
100 10 5
50
0 0
(5) (10)
(50) (15)
Banks did not sell amid losses in 2000…
(100) 1997
DEMAN D
20
Quarterly Changes in Security Holdings
Unrealized gains/losses ($bn)
Changes in securities holdings ($bn)
150
… While most bank sales have occurred amid gains
(20) 1998
1999
2000
2001
2002
2003
2004
2005
2006
MBS
19
The GSEs • Fannie Mae • Freddie Mac • Ginnie Mae • FHLBs – the MPF and MPP programs • GNMA pools are backed by FHA/VA loans which are government insured. These pools have an explicit U.S. government guarantee and a zero riskcapital weighting.
• FNMA and FHLMC pools are backed by conventional conforming loans, have an
DEMAN D
implicit U.S. government guarantee, and a 20% risk-capital weighting. Singlefamily loan limit is $359,650 in 2005. MBS
20
Unique role of GSEs: issuer / investor Mission is to facilitate secondary mortgage market in U.S. which provides steady flow of low cost mortgage funds
Issue agency debt Hold MBS, CMOs, and loans as well as ABS, CMBS, and mortgage-related spread products
Large portfolios (FN + FH hold over $1.4 trillion loans and MBS) demand active
DEMAN D
hedging via swap and swaption markets
MBS
21
Agency portfolio growth has slowed Retained Retained Portfolio Portfolio ($ ($ billions) billions) 1000
FNMA Portfolio
FHLMC Portfolio
900 800 700 600 500 400 300 Apr-01
Oct-01
Apr-02
Oct-02
Apr-03
Oct-03
Apr-04
Oct-04
Apr-05
Oct-05
Apr-06
DEMAN D
Source: FNMA, FHLMC, JPMorgan
MBS
22
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163 MBS
23
MBS Terminology Pools are comprised of mortgage loans with similar rates and terms
WAM – weighted average maturity of loans in pool WALA – weighted average loan age
Current face – remaining principal balance of pool Origination year – average origination year of loans in pool; age (WALA) is important in prepayment
M O R T G AG E
C A S H F L O W S
I N T R O
Original face – original principal amount of pool
A N D
T O
P R E P AY M E N T S
WAC – weighted average coupon of all loans in pool (vs Coupon)
assessment (“seasoning”)
CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid
MBS
24
Mortgage cash-flow characteristics
After processing, security holders receive shares of August payment
FHLMC 14th
August 1st 30 days in arrears
September 1st 14 to 24 days processing
FNMA 24th
October 1st
44 to 54 day delay
M O R T G AG E
C A S H F L O W S
A N D
I N T R O
T O
P R E P AY M E N T S
Homeowner's August payment due (in arrears)
MBS
25
Mortgage cash-flow Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year
fixed-rate loan
M O R T G AG E
C A S H F L O W S
A N D
I N T R O
T O
P R E P AY M E N T S
Using “MP” function on BBG…
Source: Bloomberg
MBS
26
P R E P AY M E N T S
Mortgage cash-flows: without prepayments
A N D
I N T R O
T O
Interest
M O R T G AG E
C A S H F L O W S
Principal
Source: Bloomberg
MBS
27
Interest
I N T R O
T O
P R E P AY M E N T S
Mortgage cash-flows: with prepayments
M O R T G AG E
C A S H F L O W S
A N D
Pre-paid Principal Principal
Source: Bloomberg
MBS
28
Prepayments: source of MBS optionality Borrowers have the right to prepay at any time without penalty – in effect
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 Prepayment (Call) Risk vs extension risk
M O R T G AG E
C A S H F L O W S
A N D
I N T R O
T O
P R E P AY M E N T S
“calling” their loans away from investors; prepayments may be partial or complete
MBS
29
Determinants of prepayments Prepayments can be for economic / non-economic reasons
M O R T G AG E
C A S H F L O W S
A N D
I N T R O
T O
P R E P AY M E N T S
Interest rate incentive Yield curve shape: refi down the curve WALA: mobility increases over time Seasonality: Summer months have the fastest speeds owing to school vacation
“Burnout”: Remaining borrowers in a pool may be credit constrained Cash-out refinancing: Take built-up equity out of the home Default: Shows as a prepayment in agency pools MBS
30
Prepayment standards CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid
14 12
M O R T G AG E
200 PSA
10 CPR (%)
C A S H F L O W S
A N D
T O
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
I N T R O
P R E P AY M E N T S
PSA – prepayment vector expressed as a series of CPRs; begins at .2% in the
8
100 PSA
6 4 2 0 0
10
20
Age
30
40
50
MBS
31
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
MBS
32
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 JPMorgan’s analytic reports.
Advanced
VALUATI O N
AND
O AS
OAS : option-adjusted spread LIBOR OAS Treasury OAS
MBS
33
Yield analysis in the MBS market
Static Spread (Yield Spread): standard measure of incremental return over a single benchmark Treasury Î Compares MBS to single point on the yield curve, usually to the interpolated point
closest to the Weighted Average Life of the MBS Î But MBS does not return principal in one lump sum but over many periods. A better
assumption would include multiple data points on the yield curve. Z Spread takes this another step further.
Z Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly forward rates derived from the current yield curve Î More accurate for securities that return principal over many periods as opposed to
bullets Î Still a static measure since it assumes that interest rates and MBS cashflows remain
VALUATI O N
AND
O AS
constant
MBS
34
VALUATI O N
AND
O AS
Evaluating pass-throughs: yield / average life
Source: Bloomberg
MBS
35
Prepayments and OAS Prepayment issues: Î Reinvestment risk: n When rates decline and speeds increase the investor has to reinvest an increased amount of principal at lower rates o When rates increase and speeds decline, the investor has less cashflow to reinvest at higher rates Î Discount bonds: when rates decline, the benefit of earlier return of principal at par may
mitigate reinvestment risk Î Premium bonds: when rates increase, the benefit of a larger outstanding principal
balance and longer average life means higher and more interest payments which may mitigate the reinvestment risk
OAS has been derived to account for the dispersion and uncertainty
VALUATI O N
AND
O AS
associated with this return of principal from MBS
MBS
36
OAS Calculation
To incorporate prepayment volatility in the valuation of MBS, we can calculate a theoretical price for a given OAS 1. 2. 3. 4.
To find OAS given market price: 1. 2.
O AS
2.
AND
Start with an initial estimate for OAS Calculate AGVPV(s) and keep adjusting until AVGPV(s) = market price
Drawback of OAS: 1.
VALUATI O N
Hundreds of hypothetical interest rate paths are simulated On each interest rate path the prepayment model is used to predict prepayment speeds and thus, MBS cashflows For each path, the present value of the projected cashflows are calculated using a specified spread, s, which is added to the forward rates Value of MBS = Average value of PV(s) over all simulated interest rate paths = AVGPV(s) where s is OAS
3. 4.
The spread earned by the investor depends on the actual path realized and can be drastically different from the OAS Wide differences in OASs are produced by different firms models due to different term structures, volatility assumptions and prepayment projections Doesn’t account for dollar roll financing Is a “black box” – difficult for investors to decompose OAS into its component parts.
MBS
37
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.
all.
VALUATI O N
AND
O AS
None of these measures is perfect. We tend to use a combination of them
MBS
38
Empirical durations
FN FN 5.5 5.5 Empirical Empirical Durations Durations (using (using 10-yr 10-yr Tsy; Tsy; Dec.05 Dec.05 –– Jun. Jun. 06) 06)
FN FN 6 6 Empirical Empirical Durations Durations (using (using 10-yr 10-yr Tsy; Tsy; Dec.05 Dec.05 –– Jun. Jun. 06) 06)
FN 5.5
1.0
y = -3.3453x + 0.0015
1.0
0.5
R 2 = 0.8266
0.5
% Px C hg
% Px C hg
FN 6
0.0
R 2 = 0.8927
0.0 -0.5 -1.0
-0.5 -0.15
-0.10
-0.05
0.00
0.05
0.10
-0.15
-0.05
0.00
0.05
0.10
Source: JPMorgan
VALUATI O N
AND
Source: JPMorgan
-0.10
Yield Chg (%)
Yield Chg (%)
O AS
y = -4.8009x + 0.0056
MBS
39
Rates have little effect on OAS
FN FN 5.5 5.5 OAS OAS vs vs rates rates (using (using 10-yr 10-yr Tsy; Tsy; Dec.05 Dec.05 –– Jun. Jun. 06) 06)
FN FN 6 6 OAS OAS vs vs rates rates (using (using 10-yr 10-yr Tsy; Tsy; Dec.05 Dec.05 –– Jun. Jun. 06) 06)
FN 5.5
4.0
y = -2.2723x - 0.0758
2.0
R 2 = 0.0079
0.0 -2.0 -4.0 -0.15
-0.10
-0.05
R 2 = 0.0713
0.00
0.05
0.10
2.0 0.0 -2.0 -4.0 -0.15
-0.05
0.00
0.05
0.10
Source: JPMorgan
VALUATI O N
AND
O AS
-0.10
Yield Chg (%)
Yield Chg (%)
Source: JPMorgan
y = 6.455x - 0.0508
4.0
OAS Chg (bps)
OAS Chg (bps)
FN 6
MBS
40
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
VALUATI O N
AND
O AS
negative convexity.
MBS
41
Negative convexity of mortgages
FN FN 6 6 prices prices ($) ($) vs vs shift shift in in rates rates (bps) (bps) 105
FN 6 Px ($)
100
95
90
80
VALUATI O N
AND
O AS
85
-300
-225
-150
-75
0
Bps
75
150
225
300
Source: JPMorgan
MBS
42
Mortgages have embedded options – valuation needs to incorporate vol 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:
Option
Short Long
Underlying Short Long 1m x 1y 1m x 10y 5m x 1y 5m x 10y
Term structure models are calibrated to the entire vol surface in swaptions
VALUATI O N
AND
O AS
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
6.5
-0.23
6.0
-0.111
Source: JPMorgan
MBS
43
Mortgage efficiency of pricing in changes in implied vol has been increasing Correlation of 1-week change in current coupon ZV spread and 3x7 swaption premium, rolling six-month window
1.0 0.8 0.6 0.4 0.2 0.0
VALUATI O N
AND
O AS
(0.2) (0.4) (0.6) 97
98
99
00
01
02
03
04
05
06
Source: JPMorgan
MBS
44
Changes in mortgage market duration can impact the rates markets
The rate of extension of the mortgage market will slow in a sell-off
A sell-off could cause the curve to steepen Change in 10-year equivalents for the mortgage market across the curve for a parallel +50 rate shock
Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in rates
VALUATI O N
AND
O AS
200
200
10-year Equiv ($bn)
Change in 10-yr equivs ($bn)
400
0 -200 -400 -600 -800 -100
150 100 50 0
-75
-50
-25
0
25
Rate change (bp)
50
75
100
-50 2
5
Tenor
10
30
MBS
45
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163 MBS
46
Existing Home Sales (EHS)
Strong Lock-in
Seasonality and Calendar Effect
Cumulative Home Appreciation (CHPA)
Overall Shorter Baseline Ramp:
Interaction between EHS, CHPA, Lock-in and Aging Ramp successfully captures periods of apparent shorter and longer ramps
In effect lower CHPA lengthens the ramp
Lock-in also lengthens the apparent ramp
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
A closer look at turnover
MBS
47
Home price appreciation and discount speeds have been highly correlated… 87% correlation between discount speeds and the housing strength now … in the weaker housing environment of 2000, there was no correlation.
Discount Speeds by State (Last 12 mo.) versus HPI in 2005 14
13 AZ
13
VA 10
NJ
1-year CPR, %
1-year CPR, %
R E P O R T S AN D
11
11
FL
MD
MA
9 8
10 AZ
9 TX
8
WA
7
MI
7
TX 6
AN AL Y SI S
12
CA
12
P R EP AY M EN T S
Discount Speeds by State vs. HPI in 2000
14
PA
PA
CA
MI
MA
VA
6
NY
FL
NJ
OH
5
5
MD
OH
NY
4
4 0
5
10
15
20
25
30
35
40
0
5
Home Price Appreciation,%
10
15
20
25
30
35
40
Home Price Appreciation, %
Notes: Deep discount: 75bps or more out of the money; balance weighted average 12-month CPR observed in the past year
MBS
48
11
21
31
41
51
61
71
81
91
101 111
Turnover Multiplier
WALA
AN AL Y SI S P R EP AY M EN T S
1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1
AN D
R E P O R T S
Seasoning ramps under different HPA assumptions
0pct hpa
1pct hpa
4pct hpa
8pct hpa
Source: JPMorgan
MBS
49
Turnover (cont’d) Lock-in (disincentive to move)
Captures the relationship between turnover and refinancing “disincentive”
Lock-in (long WAM) 1
Strong Lock-in. However, home price appreciation can strongly mitigate lock-in
0.9
P R EP AY M EN T S
AN AL Y SI S
AN D
Multiplier
R E P O R T S
0.8 0.7 0.6 0.5 0.4 0.3 1
1.1
1.2
1.3
1.4
1.5
1.6
MtgRate/WAC
MBS
50
Turnover (cont’d) Seasonality: Patterns tend to be impacted by weather and school schedules
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
School schedules and weather conditions are the main reasons for seasonal behavior There is also a separate “day count” adjustment to account for different collection days in each month
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0 Jan Feb Mar Apr May Jun
Jul Aug Sep Oct Nov Dec
MBS
51
Economics of refinancing • CATO (curve at origination) – borrowers who take out a 30-year mortgage in a steep curve environment are likely to exhibit slow turnover
• SATO (spread at origination) – high mortgage rates relative to prevailing rates at origination indicate credit impairment. These borrowers are less likely to refinance
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
• Loan size – with similar fixed costs for refinancing, borrowers with larger loan sizes are more likely to refi
• Home price appreciation – higher HPA allows borrowers to “cash-out refi”, or may allow some borrowers to “cure” and obtain a better mortgage rate with A lower LTV
• Mortgage banking capacity – in large refi waves mortgage bankers may become inundated with supply, causing mortgage spreads to widen
MBS
52
The Refinancing Index Seasonally-adjusted Seasonally-adjusted refinancing refinancing index index 12,000
10,000
8,000
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
6,000
4,000
2,000
0 Jun-00
Dec-00
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
Source: MBAA
MBS
53
P R EP AY M EN T S
AN AL Y SI S
90 11 0 13 0 15 0 17 0 19 0 21 0 23 0 25 0 27 0 29 0 31 0 33 0 35 0 37 0 39 0 41 0 43 0 45 0 47 0 49 0
50 70
10 30
AN D
Burnout Multiplier
R E P O R T S
Burnout
1.2
1
0.8
0.6
0.4
0.2
0
Cum ulative Incentive (bps)
Source: JPMorgan
MBS
54
Characteristic
Conventional
GNMA I
GNMA II
Assumable Pass-through rate Guarantee fee Servicing fee Mortgage insurance Excess servicing Buy-ups/-downs Delay days Prepayment reports
No 25 to 250bps below loan rate Negotiated (10 to 25bps) 25bps minimum LTVs worse than 80% Allowed Allowed 24 for FNMA, 14 for Golds Fifth business day
Yes 50bps below 6bps 44bps Mandatory Not allowed Not allowed 14 days Fifth business day
50 to 150bps below loan rate 6bps 44bps minimum Mandatory Allowed 10% buy-down allowed 19 days Seventh business day
Revised GNMA II pooling guidelines came into effect July 1, 2003.
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Primary differences between GNMA and conventional pools
Source: JPMorgan, FNMA, FHLMC, GNMA
MBS
55
GNMA prepayments
Refinancing into conventionals
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Servicer buy-out Higher delinquencies Rolling 90-days delinquent with only one missing payment; changed in 2003 to 90-days delinquent
MBS
56
GNMA delinquencies
14 Conventional (Prime)
VA
FHA
P R EP AY M EN T S
AN AL Y SI S
AN D
Total Past Due (%)
R E P O R T S
12 10 8 6 4 2 Dec-95
Dec-97
Dec-99
Dec-01
Dec-03
Dec-05
Source: JPMorgan, MBA
MBS
57
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Prepayment reports: speeds by origination year
Source: JPMorgan
MBS
58
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Prepayment reports: speeds by WALA
Source: JPMorgan
MBS
59
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Prepayment reports: speeds by servicer
Source: JPMorgan
MBS
60
P R EP AY M EN T S
AN AL Y SI S
AN D
R E P O R T S
Prepayment expectations
Source: JPMorgan
MBS
61
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163 MBS
62
TBA pass-through market TBA = “To Be Announced”. Essentially, a cheapest-to-deliver market (like a futures contract). Most liquid market. As with other delayed delivery transactions, a seller agrees to issue a TBA security at a future date. However, in a TBA trade, the seller and the buyer do not identify the specific underlying mortgage pools, simply certain pre-specified terms
TBAs are identified by agency, term, coupon, settle month, and traded on a dollar-price basis “Cheapest-to-deliver” gives the seller a delivery option that the buyer is short
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
Standardized delivery dates (see Bloomberg TDAT). Settles once a month like a futures contract Delivering pools: seller must provide pool information by 3 p.m. 2 business days prior to settlement (48-hour day).
Variance: the amount by which the face value at delivery can vary from the amount specified at the time of the trade, expressed as a percentage of the initial face value requested. The Bond Market Association suggests 0% variance on all TBA trades
MBS
63
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
Bloomberg Generic TBA Tickers
MBS
64
Dollar rolls
Dollar rolls are transactions where an institution sells mortgage backed securities with a commitment to buy similar, but not identical, mortgage backed securities on a future date at a lower price.
In the case of mortgage pass-throughs, “similar” securities refers to
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
securities with the same coupon, security type, and mortgage collateral.
Dollar rolls offer an attractive means of borrowing at a low cost primarily because they allow dealers to cover their short positions.
Dollar rolls offer dealers a convenient way to obtain promised mortgage securities, avoiding the higher costs of failing to deliver. MBS
65
TBA transactions: evaluating dollar rolls
Drop Coupon
Delivery optionality Re-investment rate
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
Prepayments
MBS
66
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
TBA transactions: evaluating dollar rolls
Source: Bloomberg
MBS
67
Roll Specialness
TB A
M AR KE T
AN D
Current Coupon roll specialness (tks)
S P EC I F I E D
P O O L S
12 10
30-yr CC 15-yr CC
8 6 4 2 0 -2 -4 Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Source: JPMorgan
MBS
68
Mortgage note rate (a) Less agency guaranty fee (b) Retained servicing spread (c) Remaining note rate (a-b-c) Excess servicing (a-b-c-e) Buydown of Guaranty Fee (%) Cost to buydown guaranty fee (d) Desired MBS coupon (e) Market price of MBS (f) Adjustment to TBA price for low WAC (g) Price adjusted for cost of buydown (f+g-d) Value of excess servicing (h) Price adjusted for servicing value (f+g+h)
TBA 6.0% 6.88 0.15 0.25 6.48 0.48 0.00 0.00 6.00 98.05 0.00 98.05 2.09 100.14
TBA 6.5% 6.88 0.15 0.25 6.48 0.00 0.03 0.12 6.50 100.13 0.03 100.04 0.00 100.04
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
Price spreads influence coupon production
Note: Prices are for illustration purposes only Source: JPMorgan MBS
69
WALA
FICO
Low WAC
Low loan balance (LLB)
Geographic
Prepayment penalty
Relocation
Originator
High LTV
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
The many dimensions of specified pools
MBS
70
Specified pools make up roughly 80% of the mortgage market Spec Spec pool pool market market composition composition
New Specified 4%
New TBA
Seasoned (>30 WALA) Moderate
49%
(13-30
S P EC I F I E D
P O O L S
20%
WALA)
TB A
M AR KE T
AN D
27%
Total = $2.814 trillion Source: JPMorgan Data is as of May 2006
MBS
71
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
New issue specified pools report
Source: JPMorgan
MBS
72
TB A
M AR KE T
AN D
S P EC I F I E D
P O O L S
Seasoned specified pools report
Source: JPMorgan
MBS
73
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
MBS
74
Relative value strategies and analysis
Trading Trading Strategies Strategies
Evaluation Evaluation Approaches Approaches
Mortgage - Swap basis
OAS
Mortgage - Tsy basis
Spread
Coupon swap
Hedge-Adj Carry
15s / 30s
Regressions
Ginnie / Fannie
Deliverable
TBA / Seasoned
Sponsorship
Agency / Non-agency CMO / Collateral
RELATIV E
VALU E
T RADIN G
Pass-through / ARM
MBS
75
Where to find JPMorgan MBS data Factor Supply Demand
Net supply
Where to find it MRV charts, Dataquery
Gross supply
MRV charts, Daily Packet, Dataquery
Banks
Federal Reserve Website JPM quarterly bank report
Prepayments
Agencies
Fannie, Freddie website
Dealers
Bloomberg (PDPPMORT )
Non-US investors by WALA, servicer, etc.
TIC data JPM Monthly Prepay Appendix MorganMarkets.com
OAS
TBAs
Current
Specifieds, strips, hybrids, etc
Daily packet
RELATIV E
VALU E
T RADIN G
Coupon swap history Hedge adjusted carry
Daily packet Daily packet (soon)
Volatility
swaption premiums, bp vol
Daily packet, Dataquery
Regression
Historical OAS by relative coupon
JPM trading bloomberg
Coupon swaps, butterflies
MBS Analyzer
MBS Index/performance
Performance by coupon vs swaps and Treasuries
Index Monitor Dataquery Daily packet TBA Performance Report Dataquery
Other Analytics/historical data
Daily packet MBS Analyzer
MBS
76
Mortgages have widened back to the widest levels since the beginning of the year – but are they fundamentally cheap? 30-year current coupon OAS (bps) 60 50 40 30 20 10
RELATIV E
VALU E
T RADIN G
0 (10) (20) (30) 1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Source: JPMorgan
MBS
77
Declining long-dated vol has caused nominal spreads and OAS to diverge OAS vs. CC ZV spread (bps) Current coupon OAS has been
relatively stable, while nominal spreads have continued to tighten recently …
0
80 OAS
ZV spread
(5)
70
(10) 60
(15)
50
(20) Dec-05
Jan-06
Feb-06
Mar-06
Apr-06
May-06
Jun-06
3YX10Y swaption premium (bps) been the driver
475 3Yx10Y Swaption Premium (bps)
RELATIV E
VALU E
T RADIN G
… Declining long-dated vol has
465 455 445 435 425 415 405 395 385 375 Dec-05
Jan-06
Source: JPMorgan
Feb-06
Mar-06
Apr-06
May-06
Jun-06 MBS
78
RELATIV E
VALU E
T RADIN G
Mortgage / Swap basis
MBS
79
RELATIV E
VALU E
T RADIN G
30- and 15-year current coupon OAS
MBS
80
MBS Fixed-Rate Daily Analytics
RELATIV E
VALU E
T RADIN G
COB June 9, 2006
MBS
81
Hedge-adjusted carry
We introduce a hedge-adjusted carry methodology which provides a short-
term (1- to 2-month) measure of performance using rather straightforward calculations Option-adjusted spreads serve as a long-term spread measure and assume
vega hedging, among other risk measures It serves as a good complement to OAS valuations, capturing the return
T RADIN G
Higher carry could suggest overweighting certain coupons. However, this
RELATIV E
Essentially, hedge-adjusted carry gives us the net carry of holding a TBA
VALU E
for taking duration and convexity risks
after hedging for duration and adjusting for convexity hedging costs
valuation ignores other risks like vega and mortgage Libor spread
MBS
82
Hedge-adjusted carry components The valuation incorporates factors such as the roll, hedge ratios, durations,
convexities. Specifically, the main components of the analysis are:
Swap Hedge Ratios (using partial durations). Duration Hedged Carry Total Negative Convexity
RELATIV E
VALU E
T RADIN G
Convexity Hedging Cost
MBS
83
Hedge-adjusted carry components We hedge three partial durations on the swap curve (2-yr, 5-yr and 10-yr) with the cost being the
carry and rolldown on each of the swaps To figure out the duration adjusted carry we simply calculate: Duration Hedged Carry= TBA roll – ∑(cost of swap hedge) Cost of swap hedge = hedge ratio * swap carry In calculating total convexity cost, we incorporate swap convexity since we are long MBS and short
swaps (which are positively convex) Total Convexity = MBS convexity – swap convexity We can estimate the convexity cost using short-dated swaption implied vols (1-month x 10-year
swaptions)
⎡⎛ bp ⎞ 1 1⎤ ⎟⎟ ∗ (22days ) ∧ ⎥ ∧ 2 ∗ 32 ∗ C ⎢⎜⎜ 2 2⎦ ⎣⎝ day ⎠
RELATIV E
VALU E
T RADIN G
TBA Passthroughs - 30 Year Conventionals Roll (32nds) Sec FN 30 4.5 FN 30 5.0 FN 30 5.5 FN 30 6.0 FN 30 6.5 FN 30 7.0
Price 91-00 93-29 96-12 98-25+ 100-29 102-14+
1.25 1.87 2.25 3.00 3.25 2.00
TBA Passthroughs - 30 Year Conventionals Roll (32nds)
Dur Hedged Carry .. .. .. .. .. .. ..
(32nds) 0.1 0.8 1.2 2.1 2.6 1.5
Sec FN 30 4.5 FN 30 5.0 FN 30 5.5 FN 30 6.0 FN 30 6.5 FN 30 7.0
Price 91-00 93-29 96-12 98-25+ 100-29 102-14+
1.25 1.87 2.25 3.00 3.25 2.00
.. .. .. .. .. .. ..
Dur Hedged Cnv. Hedging Hedge Adj. Carry Cost Carry (32nds) (32nds) (32nds) 0.1 -0.7 -0.6 0.8 -1.1 -0.4 1.2 -1.6 -0.4 2.1 -1.9 0.3 2.6 -2.1 0.4 1.5 -2.1 -0.6
Source: JPMorgan (as of June 1, 2006)
MBS
84
Hedge Adjusted Carry Report New York Jun 05, 2006
J.P. Morgan Securities Inc. MBS Research (1-212) 834-3121
MBS Research
m organm arkets.jpm organ.com
MBS Hedge Adjusted Carry Settle Dates Spot = [Jun-13-2006], 1M = [Jul-13-2006], 2M = [Aug-14-2006]
TBA Passthroughs - 30 Year Conventionals Roll (32nds) Sec FN 30 4.5 FN 30 5.0 FN 30 5.5 FN 30 6.0 FN 30 6.5 FN 30 7.0
Price 91-21 94-16+ 96-29+ 99-07+ 101-05+ 102-19
1m 1.25 1.87 2.12 3.00 3.25 2.00
2m 2.25 3.37 4.12 6.00 6.50 4.00
Hedge Ratio / Sw ap OAD 6.0 5.5 4.8 3.8 2.9 1.9
OAS -5 -6 -7 -9 -1 0
2Y 0.21 0.28 0.37 0.49 0.51 0.51
RELATIV E
VALU E
T RADIN G
Sec GN 30 4.5 GN 30 5.0 GN 30 5.5 GN 30 6.0 GN 30 6.5 GN 30 7.0
Price 92-29 95-26+ 97-31 100-06+ 102-03 103-14
OAD 5.4 5.2 4.8 3.7 2.3 1.4
Hedge OAS 2Y -6 0.24 -23 0.29 -20 0.37 -20 0.47 -21 0.50 -31 0.52
Sec FN 15 4.0 FN 15 4.5 FN 15 5.0 FN 15 5.5 FN 15 6.0 FN 15 6.5
Price 93-00 95-06+ 97-01 98-28+ 100-26 101-28
1m 0.3 1.0 1.3 2.4 2.7 1.7
2m 0.6 1.8 2.7 4.9 5.7 3.5
Cnvx -1.2 -1.9 -2.4 -2.8 -3.2 -2.9
1m -0.8 -1.2 -1.6 -1.8 -2.0 -1.9
2m -1.6 -2.5 -3.2 -3.7 -4.2 -3.9
1m -0.4 -0.2 -0.3 0.6 0.7 -0.2
2m -1.0 -0.6 -0.5 1.2 1.5 -0.4
OAD 4.3 4.3 4.0 3.4 3.0 2.2
Ratio / Sw ap 5Y 10Y 0.30 0.42 0.32 0.40 0.32 0.34 0.26 0.22 0.17 0.09 0.09 0.01
Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) (32nds) (32nds) Total 1m 2m Cnvx 1m 2m 1m 2m 1.2 2.6 -1.2 -0.7 -1.5 0.5 1.1 1.2 2.6 -1.8 -1.1 -2.3 0.1 0.3 1.8 3.8 -2.4 -1.5 -3.1 0.3 0.7 1.9 4.0 -2.9 -1.8 -3.7 0.2 0.3 2.7 5.5 -2.7 -1.7 -3.5 1.0 2.0 -0.2 -0.3 -2.3 -1.4 -3.0 -1.6 -3.2
Settle Dates Spot = [Jun-21-2006], 1M = [Jul-20-2006], 2M = [Aug-21-2006]
TBA Passthroughs - 15 Year Conventionals Roll (32nds) 1m 2m 0.50 1.00 0.75 1.25 1.75 3.75 2.00 4.00 3.50 6.50 2.00 4.00
10Y 0.49 0.42 0.34 0.23 0.15 0.07
Settle Dates Spot = [Jun-19-2006], 1M = [Jul-18-2006], 2M = [Aug-17-2006]
TBA Passthroughs - GNMA I 30 Years Roll (32nds) 1m 2m 2.00 4.00 2.00 4.00 2.50 5.00 2.50 5.00 3.00 6.00 0.00 0.00
5Y 0.32 0.33 0.32 0.25 0.20 0.11
Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) (32nds) (32nds) Total
Hedge OAS 2Y -1 0.30 -15 0.34 -15 0.40 -14 0.48 -8 0.48 5 0.51
Ratio / Sw ap 5Y 10Y 0.35 0.25 0.35 0.25 0.33 0.22 0.28 0.17 0.23 0.14 0.18 0.06
Dur Hedged Carry Cnv. Hedging Cost Hedge Adj. Carry (32nds) (32nds) (32nds) Total 1m 2m Cnvx 1m 2m 1m 2m -0.1 -0.1 -1.0 -0.6 -1.3 -0.7 -1.3 0.1 0.2 -1.3 -0.8 -1.7 -0.7 -1.5 1.1 2.7 -1.7 -1.1 -2.2 0.1 0.5 1.5 3.1 -2.1 -1.3 -2.8 0.2 0.4 3.0 5.8 -2.1 -1.3 -2.7 1.7 3.0 1.7 3.5 -1.8 -1.1 -2.3 0.6 1.2
Rolldow n and Carry of Sw aps betw een settles Sw ap 1m 2m Dur 2Y 0.29 0.36 1.89 5Y 0.82 1.46 4.38 10Y 1.25 2.32 7.68
MBS
85
RELATIV E
VALU E
T RADIN G
Performance vs. swaps and Treasuries
COB June 9, 2006
MBS
86
RELATIV E
VALU E
T RADIN G
MBS Issuance Report
MBS
87
RELATIV E
VALU E
T RADIN G
MBS coupon price spread
Source: JPMorgan MBS
88
RELATIV E
VALU E
T RADIN G
MBS butterfly price spread
Source: JPMorgan MBS
89
RELATIV E
VALU E
T RADIN G
Mortgage/swap basis vs Index
Source: JPMorgan
MBS
90
RELATIV E
VALU E
T RADIN G
Mortgage/Agency basis vs Index
Source: JPMorgan
MBS
91
RELATIV E
VALU E
T RADIN G
Longer-dated Vol vs Index
Source: JPMorgan
MBS
92
RELATIV E
VALU E
T RADIN G
Shorter-dated Vol vs Index
Source: JPMorgan
MBS
93
RELATIV E
VALU E
T RADIN G
30-year relative coupon OAS
Source: JPMorgan
MBS
94
RELATIV E
VALU E
T RADIN G
30-year relative coupon swaps
Source: JPMorgan
MBS
95
RELATIV E
VALU E
T RADIN G
15-year relative coupon OAS
Source: JPMorgan
MBS
96
RELATIV E
VALU E
T RADIN G
15-year relative coupon swaps
Source: JPMorgan
MBS
97
RELATIV E
VALU E
T RADIN G
Trust IO analytics
MBS
98
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
MBS
99
Case Study #1: FNMA 6.5s – The Deliverable Over $400mm TBA 6.5 pools prepaid above
The relationship between delivery size and paydown cost is non-linear; smaller trades
60CPR
are far more exposed to adverse selection Aggregate 1-month speeds on TBA 6.5s (3-17 WALA) for different delivery size (based on Apr prepayments)
Distribution of 1-mo speeds on 3-17 WALA FNMA 6.5s, (April 2006)
100 90 80
2500
1mo CPR, %
Balance, $mil
2000 1500 1000 500 0 60+
50-60
40-50
30-40
20-30
C AS E
S T UD I E S
CPR Range
10-20
0-10
70 60 50 40 30 20 0
1000
2000
3000 4000 Balance, $mil
5000
6000
•There are still a lot of fast pools available in TBA 6.5s
M B S 100
Case Study #1: FNMA 6.5s – Issuance and supply •FN 6.5 supply should be robust
Issuance by coupon as a % of total FNMA 30
FNMA 30-year relative coupon issuance
year issuance 14,000 11,000 8,000 5,000 2,000
50%
R2 = 0.8045
Apr-06 May-06 Jun-06 Jul-06
% of FN 30 Issuance
FN 30-yr Issuance ($MM)
17,000
FN 6.5 Issuance Projection ($bn) 3.8 5.1 6.7 8.9
R2 = 0.8793
40% 30% 20% 10% 0%
(1,000) (1.00)
(0.50)
0.00
0.50
1.00
1.50
2.00
(10)% (1.00)
(0.50)
Relative Coupon
C AS E
S T UD I E S
Source: JPMorgan, FNMA Note: Monthly issuance of FN 5s through 6.5s plotted as relative coupons vs CC, since September 2005
Apr-06 M ay -06 Ju n - 0 6 Ju l- 0 6
0.00
0.50 1.00 Relative coupon
1.50
2.00
Source: JPMorgan, FNMA Note: Since September 2005
F N 6 .5 Issu a n ce P r o je ctio n ( $ b n ) 3 .8 5 .1 6 .7 8 .9 M B S 101
Case Study #1: FNMA 6.5s – Fundamentals Short WALA 6.5s have tight OAS and low SATO OAS (left axis, bps) and SATO (right axis, bps) on FN 6.5s by WALA (in months) 0
4
8
12
16
20
•FNMA 6.5s: New issue pools have worse loan characteristics than
0
110
(2)
100
more seasoned
(4)
90
pools
(6)
80
(8)
70
(10)
60
(12)
50
(14)
40 OAS
SATO
Source: JPMorgan, FNMA
C AS E
S T UD I E S
FNMA 6.5s are fair fundamentally LIBOR static spread of FNMA 6.5s by CPR, in bp
101—01
10 73
20 60
CPR 30 44
40 25
50 2 M B S 102
Case Study #2: DW 4.5s – Regressions Rich / cheap of the Dwarf 5 / 4.5 swap
The Dwarf 5 / 4.5 is cheap historically
Residual of Dwarf 5 / 4.5 swap vs 15-year current coupon yield, in ticks
Dwarf 5/4.5 swap (y-axis, in ticks) versus 15-year CC yield (x-axis, %) 70
10 8
65
6
60
4
55
0
2 -2
50
-4 -6
45
-8
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
Feb06
Apr06
Jun06
C AS E
S T UD I E S
5.1
M B S 103
Case Study #2: DW 4.5s – Fundamentals Outstanding balance and 1-month CPR
Outstanding balance and 1-month CPR
of Dwarf 4.5s by WALA
of Dwarf 5s by WALA
10 1-mo CPR (%)
Cum bal
8 6 4 2 0 1
3
5
7
9 11 13 15 17 19 21 23 WALA (mos)
14
35 1-mo CPR
12
Cum Bal
10
30 25
8
20
6
15
4
10
2
5
0
0 1
3
5
7
Cumulative Balance ($ B)
1mo CPR
1-mo CPR (%)
20 18 16 14 12 10 8 6 4 2 0
Cumulative Balance ($ B)
12
9 11 13 15 17 19 21 23 WALA (mos)
C AS E
S T UD I E S
Dwarf 5s are fundamentally cheaper than Dwarf 4.5s .LIBOR static spread on Dwarf 4.5s and 5s by CPR
Dwarf 4.5s Dwarf 5s
Price 95-08 96-31
6 CPR -7 6
LIBOR Static Spread (bp) 7 CPR 8 CPR 9 CPR -3 1 6 9 11 14
10 CPR 10 17
M B S 104
Case Study #3 (Seasoned pricing): Lower the dollar price, higher the price spread between seasoned and new WALA pools
Payups by WALA vs. TBA Price 14 $96
Payup, 32nd
12
$97
$98
10 8 6 4 2 0
C AS E
S T UD I E S
0
5
10
15
20
25
30
35
WALA Pricing assumptions: 1. 24-month aging ramp 2. Peak speed of 9% CPR for $96 TBA 3. Peak speed of 10% CPR for $97 TBA 4. Peak speed of 11% CPR for $98 TBA
M B S 105
Case Study #3 (Seasoned pricing): Peak speeds versus the length of the ramp Payups by WALA vs. peak speed ($97 TBA, 24-mo ramp)
The peak speed plays an
insignificant role when pricing seasoned pools
12.0
9CPR
10CPR
11CPR
15 20 WALA
25
Payup, 32nd
10.0
(Payup versus TBA assuming constant LIBOR static spread)
8.0 6.0 4.0 2.0
Payups by WALA vs. aging ramp ($97 TBA price) 34mo ramp
24mo ramp
0.0 0
Payup, 32nd
30
35
However, the length of seasoning
12
ramp is crucial
10
S T UD I E S
10
14mo ramp
14
C AS E
5
8
A longer seasoning ramp leads to
6
higher payups for seasoning
4 2 0
0
5
10
15 20 WALA
25
30
35 M B S 106
Case Study #3: Aging ramp on moderate discount collateral
Moderate discounts have two peaks: 14 months and 24 months
The 24 months peak is driven by
Tax-advantaged capital gains treatment of two-year old primary residences
Cash-out refinancing has been front-loaded
Aging curve: moderate discount, -25 to -75bps incentive 16
1mo CPR, %
12
8
2000~2001
4
C AS E
S T UD I E S
2005~2006 0 0
5
10
15
20
25
30
35
40
Age Note: Average prepayment aging curves observed from 2000 to 2001 and from 2005 to March 2006
M B S 107
Case Study #3: Specified Pools WALA- Actual versus theoretical payup Seasoned payups suggest that the market is priced to a 24 months ramp Potential lengthening of the aging ramp should translate to higher payups for seasoned discounts Relative value advantage in the’04 discounts versus the ’03s
FNMA 5: Actual vs. theoretical ’05–’06 ramp (24-mo.)
FNMA 5.5: Actual vs. theoretical
’00–’01 ramp (34-mo.)
14-mo. ramp
Payup, 32nd
Payup, 32nd S T UD I E S
24-mo. ramp
16 14 12 10 8 6 4 2 0
18 16 14 12 10 8 6 4 2 0
C AS E
34-mo. ramp
5
10
15
20 WALA
25
30
35
0
5
10
15 20 WALA
25
30
35
Note: As of: 5/3/2006; FNMA 5s are priced to 9% CPR terminal speed; FNMA 5.5s are priced to 10% CPR terminal speed
M B S 108
Case Study #4: Specified Pools LLB – Call/extension protection The trend points to faster LLB discount speeds similar to 1999-2000 Prepayment S-Curve differences (LLB (<$100k) minus generics ($>150k)), in 1999-2000, 2004, 2005 and since fall 2005: 1mo CPR vs. Rate Incentive,bps. 1moCPR 2
2004 2005 Oct~2006 Apr
1999~2000 2005
1 0 -1 -2 -3 -125
Incentive, bps -100
-75
-50
-25
Low loan balance discounts are priced at a small fraction of their combined call and extension value.
C AS E
S T UD I E S
Payups and model valuations of MLB ($110k max) pools Call Prote ction 10% Fas te r Turnove r 20% Fas te r Turnove r Payup Ext. Prote ction Total Ext. Prote ction Total
Coupon
TBA Price
M ark e t Payup
FNCL 5
94-05
0.5
2
9
11
17
19
FNCL 5.5
96-22+
1.5
3
6
9
11
14
FNCL 6
99-05
4
7
4
11
7
14 M B S 109
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
M B S 110
ARM share has remained close to half of total applications ARM ARM share share of of total total applications applications by by $ $ volume volume (%) (%)
60
ARM Share of Apps by $ Volume (%)
50
40
30
20
10
0 Jun-97
Jun-98
Jun-99
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
ARM S
Source: MBA
M B S 111
Hybrids contributed to most of the growth of the non-agency market Year-end Year-end outstandings outstandings ($ ($ billions) billions) 800 Jumbo Fixed
Jumbo ARM
Alt-A Fixed
Alt-A ARM
700 600 500 400 300 200 100 0 1998
1999
2000
2001
2002
2003
2004
2005
2006
ARM S
Source: JPMorgan, Loan Performance. 2006 data as of April.
M B S 112
Hybrid ARM Structure and Valuation Example Example
Structure Structure
Typically 30-year terms
Fixed Rate Cash-Flows
ARM S
5/1 Hybrid ARM borrower with an initial coupon rate of 4.5% and a 5/2/5 cap structure pays 4.5% for 5 years
The highest the borrower’s rate can reset after the 5 year fixed rate period ends is (4.5%+5%), or 9.5%
The on-going periodic cap restricts the borrower from resetting up more than 2% at each yearly reset
The life cap also protects the borrower by ensuring that the coupon cannot reset above 9.5% for the life of the loan
Hybrid ARM Tails
3, 5, 7,10 Year Fixed-Rate
Libor/CMT Floaters
Resets subject to Caps (initial/periodic/life)
2/2/6
5/2/5
M B S 113
Hybrid ARM Key Terminology
Rate
caps (initial, periodic, and lifetime) offer protection from large interest rate movements by providing a cap and a floor, limiting the amount the resetting contract rate can increase or decrease on each adjustment date The initial adjustment cap provides a cap and floor on the interest rate at the first adjustment date Periodic adjustment caps restrict upward and downward movements at each subsequent reset date Lifetime caps dictate the maximum interest rate of the mortgage loan at any given time
MTR (months to reset) is defined as the number of months until the Hybrid ARM resets
off its specified Index. In other words, the number of months until the fixed rate portion of the bond ends
Once a Hybrid ARM loan reaches reset, the borrower’s new coupon is determined off a specified index
The most popular indices are LIBOR and CMT The gross margin is the spread added to the Index that determines the mortgage holder’s new rate
ARM S
The net margin is what is passed on to the investor. The net margin is the spread added to the Index that determines the coupon the investor receives. Typically, unless otherwise specified, LIBOR-indexed ARMs have approximately 175bps net margin, while CMT-indexed bonds have approximately 225bps margin
M B S 114
How are Non-Agency MBS Valued and Traded
Non Agency MBS do not trade ‘in the screens’ thus valuation and pricing levels reflect this uncertainty
Trading is Negotiated around structure, settlement and collateral composition
Relative Value and performance analytics help drive trading levels
Pricing Conventions N-A Fixed Rates; Pass throughs relative to agency pass throughs N-A ARMs : Swaps, Treasuries
Prepayment Analytics
ARM S
OAS Methodology : Prepayment Modeling
Credit Analytics
Liquidity Premiums
M B S 115
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
M B S 116
FNMA Current Coupon Yield vs. UST 10 Year Yield
Current Coupon
10 yr
6.5
6
5.5
Yield
5
4.5
4
3.5
3
C M O S
6/2/2003
12/1/2003
5/31/2004
11/29/2004
5/30/2005
11/28/2005
5/29/2006
M B S 117
Why Agency CMOs?
To broaden the investor base by customizing cash flows for investor needs while providing key advantages over other instruments:
Excess Returns
Greater Liquidity
Virtually Zero Credit Risk
Can address the following specific needs of investors:
Enhanced Yields/Spreads
Targeted Average Life Profiles
Targeted Duration Profiles
Customize the risk/reward profiles for investor’s views on:
C M O S
Î Î Î Î
interest rates yield curve shape prepayments volatility
M B S 118
CMOs as % of the Fixed Rate MBS Market
70
70
60
60
50
50
40
40
30
30
20
20
10
10
0
0 Jan-01
C M O S
% of Pass-Through
Jan-02
Jan-03
Jan-04
% of Fixed-Rate Pass-Through Issuance
CMO Issuance ($ Billions)
CMO Issuance
Jan-05
M B S 119
C M O S
CMO Principal Types
SEQ – Sequential
PAC – Planned Amortization Class
TAC – Targeted Amortization Class
AD or VADM- Accretion-Directed/Very Accurately Defined Maturity
FFIEC Bonds
SUP - Support or Companion
Z - Accrual bond
M B S 120
C M O S
SEQs - Sequentials
Collateral principal payments are reallocated sequentially into a series of short, intermediate and long maturity bonds
Sensitive to prepayments: Î
Prepayments faster than expected: SEQs shorten
Î
Prepayments slower than expected: SEQs extend
The shorter average life sequentials (that pay before the longer SEQs within the structure) provide prepayment protection for the longer average life SEQs
Shorter principal window than collateral
M B S 121
SEQ Yield Tables
Front SEQ
C M O S
Last Cashflow (LCF) SEQ
M B S 122
C M O S
PACs - Planned Amortization Class
Principal repaid according to a schedule within a specified range of prepayment assumptions called PAC bands
Principal schedule provides protection from average life volatility and reinvestment risk associated with prepayments
Principal schedules are maintained by redirecting cashflow uncertainty to Support bonds
Average Life is less volatile with speeds outside the bands because the supports continue to provide stability
Corporate bond and agency bond surrogate
M B S 123
PAC Yield Tables and Cashflow Graph
Yield table
C M O S
Cashflow Graph
M B S 124
TACs - Targeted Amortization Class
Structured to pay principal according to a schedule determined by one constant prepayment speed - a “one sided” PAC
No protection against extension: TACs only have call protection because a TAC provides protection against faster but not slower prepayments Î
Prepayments faster than TAC speed: Excess principal to supports
Î
Prepayments slower than TAC speed: TAC and Support extend
Offer higher yield than PACs based on increased extension risk
More call protection than a SEQ
C M O S
Yield Table
M B S 125
C M O S
AD/VADMs - Accretion Directed / Very Accurately Defined Maturity
All cashflows are derived from the interest accretions of the Z bond
VADM tranches must mature prior to the start of the amortization on their corresponding Z because when the Z becomes current pay the Z accretion is no longer available to amortize the VADMs
Very stable bond since cashflow is from interest accretion which is NOT affected by prepayments
VADMs do not extend even under a zero prepayment scenario
No whipsaw risk
Pay up for the extension protection results in lower yields and better convexity
M B S 126
VADM Yield Table and Cashflow Graph
VADM yield table in SEQ Z structure
C M O S
WAL Graph
M B S 127
FFIEC Bonds
Federal Financial Institutions Examination Council (FFIEC) derived guidelines to determine if MBS investments are suitable for US depository institutions
Bonds that meet these guidelines have a wider audience, are more liquid, and trade at tighter spreads than comparable non-FFIEC average life bonds
FFIEC test:
Test 1) WAL must be less than 10 years Test 2) +300 shift Æ less than 4 years extension -300 shift Æ less than 6 years contraction Test 3) +300 shift Æ less than 17% price change
C M O S
-300 shift Æ less than 17% price change
M B S 128
C M O S
SUPs - Supports or Companions
Supports are cashflow shock absorbers for PACs
Faster prepayments - excess cash flow paid to supports providing call protection for PACs
Slower prepayments - any shortfall in cash flow is absorbed by supports which may not receive principal until PAC schedule is met, providing extension protection for PACs
High average life and cashflow volatility
Higher yields compensate for volatility
M B S 129
Support Yield Table and Weighted Average Life
Sequentially Tranched Support
C M O S
Weighted Average Life Graph
M B S 130
C M O S
Z bonds - Accrual Bonds
No interest until principal payment window starts
Interest due is added to outstanding principal of the bond = Z accretion
Z accretion accelerates the maturity of shorter tranches or more accurately defines the maturity of others (VADMs)
Receive principal payments and interest once other bonds are retired
Addition of Z bond to a structure can improve the convexity of the other bonds by reducing extension risk
M B S 131
Sequential Z Bond Yield Table & Cash Flow Graph
Yield Table
C M O S
Cash Flow Graph
M B S 132
Support Z Bond Yield Table & Cash Flow Graph
Yield Table
C M O S
Cash Flow Graph
M B S 133
Rocket Z Yield Table & Cash Flow Graph
Type of support Z that has a possibility of paying off very fast (“rocket”).
Yield Table
Weighted Average
C M O S
Life Graph
M B S 134
C M O S
CMO Interest Types
Floater
Inverse Floater
IO - Interest Only (Trust and Structured)
PO - Principal Only (Trust and Structured)
Inverse IO
M B S 135
C M O S
Floaters
Coupons reset periodically, usually monthly, at a rate of an index, usually 1mLibor, plus a spread, know as the margin
Created with an inverse or inverse IO such that the weighted-average coupon of the pair is always equal to the underlying fixed-rate bond
Shorter and less negatively convex than underlying fixed rate
Offers protection against interest rate risk up to the cap
The cap adds some duration and negative convexity. Without a cap the duration would be negligible and convexity neutral
Shorter durations= less price volatility than fixed-rate CMOs unless rates rise and the coupon reaches its cap
M B S 136
Floater Yield Table & Coupon Graph
Yield Table
C M O S
Coupon Graph
M B S 137
Support Floater Yield Table & Coupon Graph
Yield Table
C M O S
Coupon Graph
M B S 138
Inverse Floaters
Pays down simultaneously with their corresponding floater
Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow
High yields frequently compensate for the increased risks
Floored inverses: a “baby” inverse floater - coupon moves inversely but can never drop below a designated fixed coupon
Provide a way to leverage MBS if you are bullish on the MBS sector
Provide a way to leverage views in one package if you disagree with Î forward rate curve Î FED expectations Î prepayment forecasts
C M O S
Î volatility views
M B S 139
Inverse Yield Table & Coupon Graph
Yield Table
C M O S
Coupon Graph
M B S 140
Floored Inverse Yield Table & Coupon Graph
Yield Table
C M O S
Coupon Graph
M B S 141
IO - Interest Only
Receive only interest cash flow from the notional amount of the underlying bond
Since IOs do not pay principal, cashflows exist only if principal remains outstanding
The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class
Benefit from slowing prepayments
C M O S
Î
Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments
Bearish security that usually have negative durations
Interest stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets
Interest stripped from CMOs are known as Structured IO and can be customized for investor needs on: Î
lockout
Î
PAC bands
Î
underlying collateral STIPs
M B S 142
IO Yield Tables
Structured PAC IO
C M O S
Trust IO
M B S 143
C M O S
PO - Principal Only
Stream of principal payments purchased at a discount
Hedge for prepayment risk since POs benefit from faster prepayments: Î
Principal is returned at par at a faster rate
Î
Lower discount rates boost the price
The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class
Bullish security with large, positive duration and positive convexity
Super PO’s provide a more levered prepay bet
Principal stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets
Principal stripped from CMOs are known as Structured PO and can be customized for investor needs on: Î
lockout
Î
PAC bands
Î
underlying collateral STIPs
M B S 144
PO Yield Tables
Structured SUP PO
C M O S
Trust PO
M B S 145
IO/PO Reports
C M O S
Trust IO/PO reports from JPMorgan provide daily price data:
M B S 146
Inverse IO
Pays down simultaneously with their corresponding floater like an inverse except the Inverse IO does not pay principal
Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow
Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments
Provide a way to leverage views in one package if you disagree with Î forward rate curve Î FED expectations Î prepayment forecasts
C M O S
Î volatility views
M B S 147
Inverse IO Yield Table and Coupon Graph
Yield Table
C M O S
Coupon Graph
M B S 148
C M O S
Recent Innovations in CMO Market
AS/NAS – Accelerated Security/Non-accelerated Security
TTIB – Two Tiered Index Bonds
Super-Floater
Customized Floater: FHR 3069 CF
RELO – Relocation collateral deals
Pre-pay Linked Notes/Interest Accrual Notes (IANs)
Freddie Mac Reference Notes
M B S 149
C M O S
AS and NAS - Accelerated and Non-Accelerated Securities
AS security receives principal payments more quickly than its respective collateral.
NAS Security receives principal more slowly than its respective collateral
NAS + AS = SEQ
The AS bond receives the “accelerated” principal payments that would have otherwise been allocated to the NAS bonds
The NAS bond is locked out until the AS bond is paid off; then the NAS begins receiving its pro-rata principal payments
NAS is better than a PAC = no whipsaw risk
M B S 150
AS and NAS Yield Tables
AS
C M O S
NAS
note the average life of 5.30 at 0 PSA
M B S 151
TTIB - Two Tiered Index Bond
A type of inverse floater that pays a fixed rate as long as 1m Libor stays below a certain threshold
Once 1m Libor crosses the threshold the coupon declines on a levered basis within a corridor of rates until it reaches 0%
Essentially shorting an option that 1m Libor will not increase beyond a certain threshold
Compensating for shorting the option by getting a higher coupon.
Digital TTIBs: Once 1m Libor crosses the threshold the coupon declines immediately to 0%
Historical 1m Libor graph
C M O S
Floored TTIB: Once 1m Libor crosses the threshold the coupon declines immediately to a fixed rate floor
M B S 152
TTIB Yield Tables and Coupon Graphs Digital TTIB yield table
C M O S
1 bp Corridor TTIB yield table
Digital TTIB coupon graph
1 bp Corridor TTIB coupon graph
M B S 153
TTIBs with additional features
TTIBs with lock-out: coupon rate is not conditional on 1m Libor for an initial period, ensuring desirable rates over that period.
Initial reset date can be several years into bond’s lifetime.
C M O S
Locked-out Digital TTIB yield table
Locked-out Digital TTIB coupon graph
M B S 154
TTIBs with additional features (cont.)
Floating-rate TTIBs: when 1m Libor is below a threshold, bond pays as a floater.
Floating-rate TTIBs with lock-out: bond maintains its initial coupon formula for an initial period, regardless of 1m Libor.
Example: FHR 3140 CF
C M O S
- Is a regular L + 165 bp bond for first 7 years, before converting into a regular floating-rate TTIB.
M B S 155
Super-Floater
A type of floater that pays a fixed rate as long as 1m Libor stays above a certain threshold (usually greater than current levels).
Essentially shorting an option that 1m Libor will remain below a certain threshold.
Compensated for shorting the option by receiving a VERY high coupon should 1m Libor go above the threshold.
Example: FHR 3111 HF (receives 66% coupon if 1m Libor > 6.5%)
C M O S
Coupon Graph
M B S 156
Customized Floater: FHR 3069 CF
Classified on Bloomberg as “Complex” because the formula for calculating the payment is not the standard Libor + discount margin
Unique structure
Payment Formula: Î If Libor is less than 4.8%, bond pays Libor + 2.35% Î If Libor is greater than 4.8% but less than 7.15%, bond pays 7.15% Î If Libor is greater than 7.15%, bond pays 0%
C M O S
Coupon Graph
M B S 157
C M O S
RELO – CMO Backed by Relocation Mortgages
Relocation Mortgage: a mortgage made to a transferred employee to finance a home purchase at a new job location
Mortgage usually requires an employer to contribute to mortgage funding
Mortgage typically originated by an agreement between the employer and the lender under a relocation program administered by the employer or its agent
Prepayment speeds depends on typical prepayment behaviors and other RELO factors: Î
Whether the mortgages are made in connection with a permanent relocation of a corporate headquarters
Î
The likelihood that borrowers will be relocated again
Î
The frequency with which further relocations may occur
Historically this sector has fast prepay speeds
CMOs backed by RELO collateral usually trade at a deep discount
M B S 158
RELO Yield Table and Weighted Average Life Graph
Yield Table
C M O S
Weighted Average Life graph
M B S 159
Prepay Linked Notes or Interest Accrual Notes (IANs)
Agency debt and MBS hybrid
Redemption schedule is based on a pre-selected reference pool
Like MBS (unlike agency debt) there is no explicit call date
Like agency debt (unlike MBS) there is a stated final maturity
Effective duration management tool for those who like MBS sector
C M O S
Recently-priced deals
Yield Table
M B S 160
Freddie Reference Notes
A Pre-pay linked note that trades live on Trade Web; an automated broker
Availability by all dealers on Trade Web means Î Î
Better liquidity and Better price transparency than pre-pay linked notes that do not trade live on Trade Web
Trades at slightly lower yields than other pre-pay linked notes due to the advantage of greater liquidity and greater price transparency
C M O S
Yield Table
Trade Web Screen Offering:
M B S 161
Conclusion
As a premier investment bank, market
The CMO team’s recent production is growing rapidly:
C M O S
strives to be a leader in the CMO
Î
In April & May 2006, the #1 FNMA issuer!
Î
The #3 overall conventional issuer (FNMA + FHLMC) over same period.
Î
Over $5 billion in deal volume in those two months alone!
The CMO team can provide the following client needs: Î
Unique trade ideas through structuring capabilities
Î
Relative value analysis
Î
Marked-to-market valuations & portfolio analysis
Î
Liquidity through market making
Let the
CMO team help you maximize the total return of your portfolio!
M B S 162
1
Demand
11
Mortgage Cashflows and Intro to Prepayments
23
Valuation and OAS
32
Prepayments Analysis and Reports
46
TBA Market and Specified Pools
62
Relative Value Trading
74
Case Studies
99
ARMs
110
CMOs
116
MBS Index
163
JP M O R G AN
M B S
P RIM E R
Market Overview and Origination
M B S 163
JPMorgan MBS Index The JPMorgan Mortgage Index (“the Index”) measures the performance of fixed-rate
agency-backed mortgage pass-through securities
• Included: – Thirty-year and 15-year fixed-rate pass-through securities issued by FNMA, FHLMC, and GNMA
• Excluded: – ARMs – Non-Agency (whole loan), Jumbo, and 10- or 20-year securities – Balloons, GPMs, and TPMs – FHLMC 75-day delay mortgages
MB S
I ND E X
– FNMA Mega, FHLMC Giant, and GNMA Platinum pools
M B S 164
JPMorgan MBS Index Due to paydowns and new pool issuance which are reported monthly, the mortgage
universe undergoes monthly transformations JPMorgan re-balances the Index automatically to reflect the changing compositions
of the mortgage market. Once a month, on the last business day of the month, all the pools represented in the Index are re-aggregated for use next month At the end of each business day, JPMorgan trader marks are used to price all the
constituent securities in the Index Traders mark benchmark issues (TBAs) and specified pools
MB S
I ND E X
Algorithm is used to price securities that are not actively traded
M B S 165
Calculation of Index Returns Daily total return of the Index is the market value weighted average of the daily returns of its
constituent securities The daily total return of a security is defined as its daily change in market value over its previous
market value. The change in market value equals change in price plus change in accrued interest. Interest is accrued daily at the net coupon rate based on 30/360 day-count convention. Using formulas, the relationship is as follows:
The Index starts at 100 on January 1st, 2000. On every business day after market close, a daily Index return is computed. A new index value is then calculated as the product of the previous Index value and the daily Index return
MB S
I ND E X
This methodology assumes that the Index settles daily (on business days) and that returns are
reinvested into the Index on a daily basis. Using raw Index values, one can easily calculate the periodic total return of the Index between any two business-days by dividing the ending Index value by the starting Index value
M B S 166
Total return swaps on the JPMorgan MBS Index
• Investors can receive (or pay) the total rate of return of the JPMorgan Mortgage Index and pay (or receive) LIBOR – a specified spread Investor
Index Return
LIBOR - spread
JPMorganChase Bank
MB S
I ND E X
• Advantages of the TROR Index Swap: – – – – – – – –
MBS returns competitive and less volatile than corporate debt Ease of execution Sector exposure with no security selection required No MBS delivery / allocation required Locked-in funding spread Finite investment term Paydowns automatically reinvested in Index Pay or receive Index
M B S 167
MB S
I ND E X
Mortgage Index returns
Source: Bloomberg
M B S 168
Index Composition
MB S
I ND E X
Index Index composition composition in in June June 2006, 2006, par par weighted weighted (%) (%) and and month/month month/month changes changes in in 10-year 10-year equivalents equivalents ($bn) ($bn)
Source: JPMorgan
M B S 169
Index Performance Index Index duration duration and and convexity convexity profile, profile, as as of of 5/31/06 5/31/06
Index Index statistics, statistics, May May 31st, 31st, 2006 2006
MB S
I ND E X
Index Index statistics, statistics, May May 31st, 31st, 2006 2006
M B S 170
Index Performance
MB S
I ND E X
Index Index returns returns and and excess excess returns returns by by sector sector and and coupon coupon (bps), (bps), in in May May 2006 2006
M B S 171
