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RMBS Trading Desk Strategy

Outlook for the RMBS Market in 2007


Sharad Chaudhary
212.847.5793
sharad.chaudhary@bankofamerica.com

December 27, 2006

 Review of 2006: Mortgages had a Great Year (p. 2)


Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 2125 ticks in 2006. Heavy net production of fixed-rate agency MBS and strong growth in MBS holdings of overseas investors and domestic money managers characterized supply and demand technicals in the mortgage market in 2006. The mortgage basis has also benefited enormously in 2006 from swap spread tightening, the decline in implied volatilities and very low realized volatilities. While relatively fast discount prepayment speeds and muted premium speeds were observed in 2006, sharp declines in HPA and the consequent mortgage credit issues started to attract the markets attention by the end of the year.

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Ohmsatya Ravi
212.847.5150
ohmsatya.p.ravi@bankofamerica.com

Qumber Hassan
212.933.3308
qumber.hassan@bankofamerica.com

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


We expect a range-bound rates market, slightly lower but still substantial net supply of agency fixed-rate MBS, heavy demand for MBS from overseas investors and domestic money managers, 2%-3% CPR slower discount prepayment speeds and mortgage credit to continue to make headlines in 2007. Bank portfolios of mortgages should record very modest growth, if any, in 2007.

Sunil Yadav
212.847.6817
sunil.s.yadav@bankofamerica.com

Ankur Mehta
212.933.2950
ankur.mehta@bankofamerica.com

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


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ChunNip Lee
212.583.8040
chunnip.lee@bankofamerica.com

Marat Rvachev
212.847.6632
marat.rvachev@bankofamerica.com

We see little upside from owning mortgages in the short-term for relative value players (pure OAS players). However, from a long-term perspective, we recommend an overweight on the mortgage basis to real money managers because of our expectations for a range-bound rates environment and strong demand technicals for MBS. We also recommend overweighting 30-yr 5.5s and 6.5s versus 5s and 6s, 15-yr MBS versus 30-yr MBS, and 15-yr 4.5s and 6s versus 5s and 5.5s.

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


Hybrids are attractively priced relative to the fixed rate sector with 5/1s offering more than 30 bps in OAS pickup relative to 15-yrs. However, based on our macro picture range bound interest rates, low realized volatility and lack of surge in implied volatilities much like this year, we expect hybrids to lag fixed-rate MBS in 2007. However, from a short term perspective, we recommend a tactical overweight on the hybrid basis due to favorable technicals caused by the inclusion of agency hybrids in the US aggregate Index and the seasonal low in ARMs issuance.

Vipul Jain
212.933.3309
vipul.p.jain@bankofamerica.com

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

RMBS Trading Desk Strategy

I. Review of 2006
Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 21-25 ticks in 2006 (at closes of 12/22/2006). The following themes dominated the MBS market sentiment in 2006: The mortgage basis had a great year. Heavy net production of fixed-rate agency MBS Strong growth in MBS holdings of overseas investors and domestic money managers Continued declines in implied volatilities and very low realized volatilities Relatively fast discount prepayment speeds (but slower than the discount speeds in 2005) and muted premium speeds Sharp slowdown in home price appreciation and higher delinquencies on new origination mortgage pools relative to older cohorts Higher servicing spreads being retained by servicers on their books Strong outperformance of 30-yr MBS versus 15-yrs and hybrid ARMs as investors rushed to sell convexity which helped the 30-yr sector more than others Positive net production of GNMAs and the dramatic cheapening of GN/FN swaps

Net supply of agency fixed-rate MBS was very high.

One of the biggest surprises associated with the mortgage market in 2006 was the strong supply of agency fixed-rate passthroughs. We estimate that net supply of fixed-rate agency MBS (gross issuance less pay-downs) totaled $254 billion in 2006 versus $110 billion in 2005 and a negative $27 billion in 2004. This net supply is substantially higher than what the market expected at the beginning of the year. We believe that the heavy net production is due to a combination of heavy cash-out refinancings in conjunction with the lower incentive for borrowers to choose an ARM versus a fixed-rate product in the flat yield curve environment that prevailed in 2006 (we will discuss this topic in more detail in the following section). While the heavy net supply of fixed-rate agency MBS in 2006 was a big surprise, what was even more interesting was the strong performance of the mortgage basis in 2006 despite this trend and very low net purchases of MBS by domestic banks. It turned out that the heavy net supply of agency MBS was comfortably absorbed by overseas investors and domestic money managers. As we have repeatedly commented before, historically net overseas investor purchases of agency debt and MBS have shown a strong correlation with the level of U.S. trade deficit and this strong relationship continued in 2006 as well. Domestic money managers provided a firm bid for MBS this year because interest rates backed up away from the range where mortgage refinancings could be of some concern and, in an environment of very tight spreads on AA and A rated corporate bonds, money managers viewed mortgages as an attractive alternative to corporate bonds. In addition, mortgages served as the vehicle of choice for money managers wanting to express a view on the direction of implied and realized volatilities. The mortgage basis also benefited enormously in 2006 from the sharp decline in implied volatilities and very low realized volatilities. In fact, we attribute more than 60% of the outperformance of mortgage basis versus swaps this year to declines in implied volatilities.

Overseas investors and domestic money managers provided a firm bid for MBS.

More than 60% of the mortgage outperformance versus swaps is due to declines in volatilities.

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As long-term rates continued to stay in a narrow range and the marginal buyer of MBS is not a Gamma and Vega hedger, demand for volatility has plummeted which helped mortgages outperform Treasuries and swaps. On the prepayment front, the prepayment experience during 2006 resembled that in 2005, i.e. relatively fast discount speeds and muted premium speeds. Mortgage pools that were 100 bps in-the-money prepaid at roughly 33% CPR (a far cry from 60%-70% CPR observed during 2002-2003) and pools that were 50 bps out-of-the-money prepaid at 10% CPR. The primary reason for continued robustness in discount speeds, despite the housing slowdown in 2006, is the fact that these pools had already seen fairly solid equity growth from the previous year. On the other hand, slower speeds of deep in-the-money pools can be attributed to weaker borrower characteristics with higher spreads at origination (SATO) for these pools. On the hybrid ARMs side, the markets fear of extremely fast tail speeds on hybrids waned over the course of the year as prepayments around the first reset proved to be a lot more docile than the markets initial expectations. An interesting trend observed in hybrid speeds in 2006 is the presence of a second spike in prepayment speeds at the second reset. On the mortgage credit front, newly originated pools recorded higher percentages of delinquencies relative to older cohorts (after adjusting for age). Another interesting trend in the MBS market was that the spread between the GWAC and the net coupon of fixed-rate agency mortgage pools increasing substantially over the past several months. For instance, new production 30-yr FNMA 6s pools have a GWAC of 6.67% versus 6.48% 1-yr ago. Similarly, new production 30-year FNMA 5.5s pools have a GWAC of 6.25% versus 5.96% 1-yr ago. On average, the spread between the aggregate GWAC and the net coupon of new production 30-yr mortgage pools was close to 47-48 bps in 2003 and 2004 versus 56 bps over the past year. We believe that originators/servicers are retaining more interest cash flows on their balance sheets as the MBS market came out of a significant Refi wave and the media-effect subsided. In addition, originators/servicers may be taking advantage of FAS 156 which allowed mark-to-market accounting treatment for servicing rights. This uptick in GWACs has some valuation implications as discussed in the following sections. 30-yr mortgages outperformed 15-yrs and hybrid ARMs by more than 20 ticks on a duration and curve adjusted basis in 2006. This was largely because 30-yrs benefited more than 15-yrs and hybrid ARMs from low realized volatilities and sharp declines in implied volatilities observed in 2006. In addition, the current marginal buyers of MBS, i.e., overseas investors and domestic money managers, preferred 30-yr due to the higher nominal spread they offer over Treasuries. It is worth pointing out that 30-yrs outperformed 15-yrs by a wide margin in a year where the net supply of 30-yr MBS totaled $310 billion while the outstanding balance of 15-yr MBS dwindled by more than $55 billion. Finally, GN/FN coupon swaps lost more than 1-point since their peak levels. Positive net supply in GNMAs coupled with the increased comfort level of overseas investors with the MBS backed by the GSEs caused this sharp cheapening of GNMAs versus conventional MBS in 2006. This has created an interesting opportunity in that the government guarantee on premium GN II pools was being offered for free at the beginning of December. Although GN/FN swaps have rebounded by 5-6 ticks over the past few days, premium GN II/FN swaps still seem to offer government guarantee for only a modest pay-up.

Relatively fast discount speeds and muted premium speeds characterized prepayments in 2006.

Servicers are retaining more interest cash flows on their balance sheets.

30-yrs outperformed 15-yrs and hybrid ARMs.

GN/FN swaps have cheapened by more than 1-point from their peak levels.

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II. Macro Themes Relevant for the RMBS Market in 2007


Looking ahead to 2007, we believe that the following issues will have a significant impact on the relative performance of mortgages versus other fixed income sectors: Outlook for Interest Rates and Volatilities: Remarkably range bound long-term interest rates and the consequent low realized volatilities and sharp declines in implied volatilities helped the MBS sector put in a strong performance versus Treasuries and swaps in 2006. Mortgage Supply Technicals: Despite all the talk about the housing market slow-down, the net supply of fixed-rate agency MBS was very strong in 2006. Overseas Investors: Overseas investor demand for MBS stayed very strong in 2006 and made a significant contribution to the outperformance of the mortgage basis. Domestic Money Managers: Cross-over buying of MBS by domestic money managers has been at very high levels since the 4Q05. Domestic Banks: Excluding the impact of Golden Wests acquisition, deposits on the books of large banks have grown by only 1.5% in 2006 versus an annual growth rate of 7%-8% during 2002-2005. Agency Portfolio Issues: The 2004-2005 trend of the GSEs substituting agency mortgages with subprime MBS appeared to subside in 2006. Convexity Hedging Related Issues: The last time convexity flows had dominated MBS pricing was in October/November 2005. Discount and Premium Prepayments: For the range-bound rates scenario we are projecting for 2007, OTM and ATM speeds of recent originations are the main area of concern due to continued softness in the housing market. Housing Slowdown and Mortgage Defaults: New origination pools are showing significantly higher 90+ day delinquencies than the older cohorts. As heavy volumes of ARMs (prime and subprime) come up for resets in 2007, the impact of housing slowdown on potential mortgage delinquencies becomes an important issue.

We will now take a detailed look at each one of these issues. Interest Rates and Volatilities Our baseline forecast of interest rates for year-end 2007 is as follows: 10-yr Treasury yield at 4.95%, 2-yr Treasury yield at 5.05% and a Fed funds rate of 5.0%. We expect a single 25 bps ease in the Fed funds rate in 2007. Realized volatility is likely to stay very low and implied volatilities are unlikely to spike up substantially from current multi-year lows. 10-yr swap spreads are likely to tighten by 8-9 bps and 2-yr swap spreads are likely to tighten by 4-5 bps in 2007.

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Over the past three years, long-term interest rates have remained in a very narrow range. In fact, the 10-yr CMT yield had been within a 155 bps range (3.70%-5.25%) over the past 3 years versus the 241 bps (2001-2003) and the 263 bps (1998-2000) ranges that prevailed over similar time spans in the past (Figure 1). This range-bound rates environment coupled with the fact that interest rates have moved away from the levels where another mortgage refinancing wave could be of some concern have made mortgages the asset class of choice for domestic money managers since the 4Q05.1 Figure 1: Range of 10-yr CMT Yields in Each Year Long-term interest rates were in a very narrow range over the past 3 years.
Max Min Range (bp) 2000 6.79 5.02 177 2001 5.54 4.22 132 2002 5.44 3.61 183 2003 4.61 3.13 148 2004 4.89 3.70 119 2005 4.66 3.89 77 2006 5.25 4.34 91

Source: Banc of America Securities

Looking ahead to 2007, we believe that the expected and realized ranges of interest rates over the year will have a significant impact on mortgage performance versus other asset classes. These factors are more important for the MBS market now than before because of the shift in the marginal buyer base for MBS. When the GSEs were marginal buyers of MBS, mortgage valuations in terms of OASs (with respect to the agency curve) were more important than realized and implied volatilities of interest rates because the GSEs would actively hedge volatility exposure in their portfolios. Similarly, these factors were less important when banks were marginal buyers because their funding costs were very low relative to mortgage yields to begin with. At the moment, domestic money managers are an important segment of marginal buyers of MBS (along with overseas investors) and the cross-over demand from domestic money managers has been a significant contributor to the recent strong performance of mortgages. The magnitude of this cross-over buying in 2007 clearly depends on the expected range of interest rates and the perceived prepayment risk within this range. Single Fed Ease, 10-yr Tsy at 4.95% and Tighter Swap Spreads by Year-end 2007 We expect long-term interest rates to remain range-bound and the 10-yr Treasury yield to reach 4.95% by the end of 2007. We also expect only a single 25 bps cut in Fed funds rate and also that the shape of the curve will remain nearly unchanged between now and the end of the year (with the risk skewed towards a slightly steeper curve). Our estimates are based on the expectation that the economic growth will be slightly above 2% in the first half of the year but will be solidly above 3% in the second half. At the same time, core inflation should stay above the Feds comfort zone of 1%-2% for most part of 2007 because the unemployment rate is below the generally accepted level of NAIRU. In this scenario, any easing by the Fed should be limited to a modest insurance cut in the first half of the year and our view differs from markets expectations for a 4.72% funds rate by the end of 2007 (or two to three 25 bps easings in 2007). The biggest risk to our rates view comes from the

We expect only a single 25 bps Fed easing in 2007.

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

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possibility of a deepening housing slump. If the housing slump turned out to be much longer and deeper than what we are projecting, reduced consumer spending could weaken the economy further and may warrant further Fed easings. Such a scenario is likely to be associated with curve steepening and lower long-term interest rates but we do not assign a high probability to this eventuality in 2007. On the swap spreads front, our interest rate strategists expect the 10-yr swap spread to tighten to 40 bps (8-9 bps tightening from last weeks levels) and the 2s/10s swap spread curve to flatten in 2007.2 Because mortgage spread movements tend to follow swap spreads rather closely for instance, a substantial portion of the mortgage outperformance versus Treasuries over the past 2 months can be attributed to swap spread tightening we expect mortgages to outperform Treasuries in 2007 due to swap spread tightening alone.

Mortgages should benefit from the 8-9 bps tightening of 10-yr swap spreads we are forecasting

Realized Volatility Should Remain Very Low The negative convexity of mortgages implies that they will outperform positively convex assets like Treasuries and non-callable agency and corporate bonds when realized volatility is low. MBS investments have benefited a lot over the past 3 years as realized volatility has declined sharply (Figure 2). Figure 2: 90-Day Realized Volatility of the 10-yr Swap Rate
165 90-day Realized Vol (bp) 145 125 105 85 65 45 May-02 May-03 May-04 May-05 May-06 Jan-02 Jan-03 Jan-04 Jan-05 Sep-02 Sep-03 Sep-04 Sep-05 Jan-06 Sep-06

Source: Banc of America Securities

10-yr Treasury yields should remain in the 4.35%-5.15% range and realized volatility should be very low in 2007.

As our base line economic forecast above indicates, we expect interest rates to remain range-bound in 2007 and the 10-yr Treasury to end the year only 35 bps above its current level. We do not expect the 10-yr Treasury to rally below 4.35% as long as the Fed funds rate is at or above 5% and there are no hints of the Fed embarking on an easing cycle. Similarly, the 10-yr Treasury is unlikely to backup above 5.15% as the overseas demand for the U.S. assets remains strong and is likely to increase further at higher yield levels which should keep a lid on how far rates could backup. This projected narrow range of long-term interest rates in 2007 should make mortgages very attractive for money managers. An interesting point about realized volatility is worth making here. In general, MBS market

See Global Rates Focus report dated December 14, 2006

RMBS Trading Desk Strategy

participants track realized volatility using daily interest rate fluctuations and treat it as a proxy for the cost of hedging negative convexity embedded in mortgages. We believe that it is not the correct way to track realized volatility in the current environment and here is why. In Figure 3, we show 60-day realized volatilities of the 10-year swap rate over a four month time period. The 10-year swap rate moved in the range of 5.83% and 5.28% (a 55 basis points range) over the two month period ending on September 1, 2006 (Period#1) while it moved in the range of 5.09% and 5.36% (a 27 bps range) over the two month period ending on November 1, 2006 (Period#2). Correspondingly, the 60-day realized volatility based on daily changes of 10-yr swap rates over Period#1 was 48 bps while the same number for Period#2 was 64 bps. The 60-day realized volatility was higher in Period#2 because interest rates fluctuated wildly during this period although the net effect of their up and down movements kept rates in a narrow range over this two-month period. On the other hand, daily rate fluctuations were lower in Period#1 but interest rates steadily declined over this period. A similar situation prevailed during the first half of 2006 also. Now, the interesting question is when was the realized volatility higher Period#1 or Period#2 as far as MBS investments are concerned? Figure 3: Recent History of 10-yr Swap Rate and its Realized Volatility
6.0 5.8 5.6 60 5.4 5.2 5.0 07/03/06 08/01/06 08/29/06 09/27/06 10/26/06 50 80

10-yr Swap Rate (%)

10-yr Swap Rate

60-day Realized Vol

70

40

Source: Banc of America Securities

Historically, measures of realized volatility based on daily interest rate changes have been followed in the MBS market because convexity hedging activity from GSEs was supposed to track this measure more closely. This argument certainly makes sense when active convexity hedgers like the GSEs, dealer desks and hedge funds are marginal buyers in the MBS market, but this is not the case at the moment. Overseas investors and domestic money managers are dominant players in the mortgage market now and these two groups of investors typically buy mortgages to earn the additional carry offered by them in a range-bound environment (i.e., they dont actively hedge negative convexity). In this scenario, as far as the MBS market is concerned, we think that the range in which interest rates move over few weeks or months is a better indicator of realized volatility than the measures based on daily rate fluctuations. From this perspective, realized volatility should remain very low in 2007 and continue to propel demand for mortgage assets.

60-day Realized Vol (bp)

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Implied volatilities are near their 8-yr lows but all the factors that resulted in lower volatilities are still in place.

Implied Volatilities are Unlikely to Bounce Back from Their Multi-year Lows Implied volatilities have steadily declined over the past three years which accounts for more than 60% of the mortgage outperformance versus swaps over this period (Figure 4). At the moment, implied volatilities are near their 8 year lows but most of the factors that have led to this decline over the past three years are still in place. First, although the negative convexity of the mortgage universe is very high, marginal buyers of MBS are not convexity hedgers. Second, as long-term interest rates have moved in a very narrow range over the past three years and the market still expects long-term rates to remain rangebound, there is very little demand for hedging interest rate exposure of fixed-income portfolios. Third, there is less motivation for buying interest rate protection in a flat yield curve environment and because of this, implied and realized volatilities tend to be lower when the curve is flat. Given that these factors are still in place, we do not expect implied volatilities to jump up substantially from their multi-year lows any time soon. Figure 4: History of the Implied Volatility of 3yr*7yr Swaption
150
Implied Volatility (bps)

135 120 105 90 75 60


May-98 May-99 May-00 May-01 May-02 May-03 May-04 May-05 May-06

Source: Banc of America Securities

The biggest risk to our views on implied and realized volatilities comes from the possibility of economic conditions deviating substantially from our base line forecast. For instance, if the weakness in the housing market deepens and forces the Fed to embark on a vigorous rate cutting path next year, uncertainty in the market would increase and the curve will steepen, both of which are likely to cause implied and realized volatilities to spike up. Mortgage Supply Technicals We see mortgage debt growing by 7% in 2007 after averaging 13.8% in 2005 and 8.9% in 2006. We project the net supply of agency fixed-rate MBS to total $220 billion in 2007 versus $254 billion in 2006 and $110 billion in 2005. The supply of affordability products is likely to decline following the inter-agency guidance issued a few months ago and also because of well-advertised credit problems in the mortgage market.

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Should we expect fixed-rate agency MBS supply to remain as strong as it was in 2006?

One of the biggest surprises associated with the mortgage market in 2006 was the strong supply of agency fixed-rate MBS. We estimate that the net issuance of agency fixed-rate MBS3 totaled $254 billion in 2006, an increase of over $140 billion from 2005 levels. Thus, one of the core questions for next year will be whether we should expect fixed-rate supply to remain as strong as it has been in the past. Unfortunately, it is quite difficult to forecast this number with any degree of certainty. As we will discuss in detail later, the dramatic increase in agency fixed-rate MBS issuance was due to a number of factors including a decline in the ARM share of mortgages, a large volume of resetting ARMs, an unprecedented level of cash-out refinancing activity, and an improvement in the GSEs share of the mortgage market. To build our forecast, lets begin with an examination of the fundamental forces that result in the growth of outstanding home mortgage debt. In general, the net supply of mortgages is driven by four forces: Household Growth. An increase in the number of households because of population growth; Increases in Homeownership Rates. An increase in the number of people owning a house versus renting; Home Price Increases. An increase in the value of homes so that for the same LTV, you require a larger mortgage; and Increase in LTV Ratios. An increase in borrower leverage. For example, a cashout refinance results in the net creation of mortgage debt since the new mortgage is larger than the old one.

The amount of equity cashed out by prime conventional mortgage holders soared to $296 billion in 2006.

Figures compiled by the Federal Reserve show that the net supply of all home mortgages4 has averaged between $800 billion to $1 trillion dollars per year since 2003 (Figure 5). Over this period, the annualized growth rate of home mortgage debt has ranged from 8% to 14%. By far, the most important contributors to these growth numbers have been the increase in home prices in conjunction with increases in LTV ratios accomplished through cash-out refinancings. The importance of cash-out refinancing in terms of creating new mortgage debt is summarized in Figure 6. Notice the remarkable strength of the numbers in 2006: despite mortgages rates being 50 bps higher on average and the annualized rate of home price appreciation falling from 13.4% in 2005 to 5.7% in 2006, the amount of equity cashed out by refinancing prime conventional mortgage holders soared from $262 billion to $296 billion. Thus, a substantial amount of net supply in the past few years has resulted from cash-out refinancings. In fact, the Freddie Mac numbers graphed in Figure 6 understate the net supply created by cash-out refis since the estimates do not include the equity extracted through second mortgages or cash-out volume in the subprime sector.

3 4

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

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


1200

1000 Annual Net Supply ($bb)

800

600

400

200

0 2001 2002 2003 2004 2005 2006 (E) 2007 (F)

E denotes an estimate and F a forecast. Source: Actuals: Federal Reserve Board. 2006 Estimate & 2007 Forecast: Banc of America. Securities

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


350 300 Cash-out Volume ($ billions) 250 200 150 100 50 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 (E) (F) (F)

Source: Freddie Mac. E denotes an Estimate and F a forecast. Cash-out volume of equity cashed-out through refinancing prime, first-lien conventional mortgages.

Given the discussion above, an integral part of the forecast is coming up with estimates for home price growth and cash-out refinance volume in 2007. Our forecast is built along the following assumptions: Home Price appreciation: After averaging 13.4% in 2005 and 5.7% in 2006, we believe home price growth will further moderate to about 3% per year in 2007. Cash-out Equity volume: Freddie Macs estimates have cash-out volume dropping by more than $100 billion in 2007. While we do think that we will see cash-out volume moderating, we think the magnitude of the drop projected by Freddie Mac is too punitive.

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

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amount of equity withdrawn by homeowners, we see mortgage debt growing by 7% in 2006 after averaging 13.8% in 2005 and 8.9% in 2006. A growth rate of 7% on an estimated outstanding home mortgage debt balance of $10.2 trillion (as of the end of 2006) in home mortgage debt should result in net issuance of $715 billion in 2007, down 15% from 2006 levels. In terms of agency fixed-rate MBS issuance, we think that overall net supply numbers in this sector will not decline by as much as the overall universe. First, there are signs that the agency share of the mortgage market has been improving over the last couple of years after falling sharply in 2004. The housing GSEs were distracted from their regular order of business over 2003 and 2004 because of their accounting issues. In fact, as Figure 7 shows, there was negative net issuance of agency fixed-rate MBS in 2004. While some of this was due to the increase in the popularity of ARMs as affordability issues began to show up in the mortgage market, many conforming balance agency-eligible loans were siphoned off into the non-agency alt-A sector over this period. The rebound in agency fixed-rate MBS supply over the past two years can be at least partly attributed to the progress made by Fannie Mae and Freddie Mac on their accounting and financials. We expect this trend to continue in the next year. Another factor that will help fixed-rate supply is the flat FRM-ARM slope which we expect to persist into next year. A more moderate home price environment and a small FRM-ARM term premium will steer more purchase borrowers towards a fixed-rate mortgage. Similarly, a large volume of resetting ARM borrowers in 2007 should also gravitate towards fixed-rate mortgages for the same reason. Obviously, the same factors should lead towards ARM supply decreasing in 2007. The trends and forecasts detailed above are collected in Figure 7. Figure 7: Trends and Forecasts for the Housing and Mortgage Markets
Home Price Appreciation (%) ARM Share of Applications (%) Growth in Home Mortgage Debt (%) Net Issuance of Home Mortgages ($bb) Net Issuance of Agency Fixed-rate MBS ($bb) Net Issuance of Agency ARM MBS ($bb) 2003 7.8 19 14.3 801 227 79 2004 11.9 32 14.1 1055 -27 81 2005 13.4 31 13.8 1135 110 53 2006 (E) 2007 (F) 5.7 3 28 24 8.9 835 254 42 7 715 220 36

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

E denotes an Estimate and F denotes a Forecast. Sources: OFHEO, MBA, Federal Reserve Board, Banc of America Securities. All estimates and forecasts by Banc of America Securities.

Overseas Investors We estimate that overseas investors have been net buyers of $288 billion agency debt and MBS in 2006. Based on our forecast for a slightly lower trade deficit and a weaker dollar versus other currencies, we expect combined net overseas investor purchases of agency debt and MBS to decline slightly in 2007. Most of the negative impact from potential FX diversification by overseas central banks on their MBS holdings should be offset by their willingness to rotate funds out of Treasuries into agency debt and MBS. We estimate that the net purchases of agency MBS by overseas investors in 2007 will be $150-$170 billion which is slightly higher than their net purchases in 2006.

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Despite the heavy net supply of agency fixed-rate MBS, the mortgage basis did extremely well versus Treasuries in 2006 and overseas investors played a big role in this strong performance. Using the latest TIC data, we estimate that overseas investors were net buyers of $288 billion agency debt and MBS in 2006. Considering that we are expecting another strong year for agency fixed-rate MBS supply, the participation of overseas investors is crucial for the MBS market in 2007. Figure 8 shows the actual annual net purchases of agency debt and MBS by overseas investors and our model fit of the data.5 Our model indicates that overseas investors have been investing 35-40 cents of every dollar of the US trade deficit in agency debt and MBS over the past few years. Based on our forecast for a slightly lower trade deficit and weaker dollar versus other currencies, we expect combined net overseas investor purchases of agency debt and MBS in 2007 to decline slightly from 2006. As far as the agency debt and MBS markets are concerned, most of the negative impact from potential FX diversification by overseas central banks should be offset by their willingness to rotate funds out of Treasuries into agency debt and MBS. In the base case scenario, overseas investors are likely to buy about $260-$280 billion agency debt and MBS in 2007. Figure 8: Net Overseas Investor Purchases of Long-term Agency Debt and MBS
320 280 Net Purchases ($BB) 240 200 160 120 80 40 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Actual purchases for 2006 are estimated by extrapolating the first 10 months of data. Source: Banc of America Securities
Actual Purchases Model Purchases

Net overseas investor purchases of agency debt and MBS should decline slightly in 2007.

MBS holdings of overseas investors as a percentage of their combined agency debt and MBS portfolios have been gradually increasing.

An interesting trend worth noting is that the fraction of overseas investor purchases of agency MBS in their total purchases of agency debt and MBS has been rising over the past 3 years. For instance, the fraction of agency MBS in total agency debt and MBS holdings of overseas investors rose from 25% in 2003 to 33% in 2005 (the latest year for which the data are available). We ascribe this trend to the following three factors: a) Reducing issuance level of agency debt; b) Increasing comfort level of Asian investors with prepayment risk; and, c) the range-bound rates environment that made additional carry offered by mortgages over agency debt very attractive.

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

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


2003 149 437 25.4% 2004 176 447 28.3% 2005 264 527 33.4%

Agency MBS ($bb) Agency Debt ($bb) Fraction of MBS (%)


Data as of June of each year Source: Treasury, Federal Reserve

We estimate that overseas investors will be net buyers of $150-$170 billion agency MBS in 2007.

Because the combined net overseas investor purchases of agency debt and MBS are likely to remain close to this years level (albeit slightly lower) and we expect the fraction of overseas investor purchases of agency MBS in this total to continue to rise, we expect overseas investors to provide a strong bid for MBS in 2007. We estimate that the net purchases of agency MBS by overseas investors will be $150-$170 billion next year. Domestic Money Managers We expect domestic money managers to continue to provide a strong bid for MBS in 2007. The range-bound rates environment coupled with mortgage rates staying above levels where refinancings could be an issue should make MBS the asset class of choice for domestic money managers. Our credit strategists are slightly bearish on corporate spreads which means that MBS could continue to benefit from a strong cross-over bid. Money managers are also using MBS investments for selling volatility and their bid is likely to remain strong unless expectations for a spike in implied volatilities build up.

Since 4Q05, domestic money managers have been playing an important role in determining the performance of the mortgage basis. Based on desk flows, we estimate that money managers were net buyers of more than $100 billion MBS since mortgage spreads widened a lot in Oct/Nov of 2005. Their purchases were second only to those of overseas investors over the past several months. Based on our expectations of a range-bound rates environment coupled with mortgage rates staying above the levels where refinancings could be an issue, MBS should remain the asset class of choice for domestic money managers. From the valuations perspective, on our OAS models, 30-yr current coupon LOASs have stayed in a range of -17 bps and +2 bps over the past 2-yrs. At the present LOAS level of 15 bps, current coupon mortgage valuations are at the rich end of the recent range. However, demand for MBS from domestic money managers is likely to be a function of expectations for interest rates and volatilities. In Figure 10, we show the expected outperformance of MBS investments versus equal dv01 swaps in different interest rate scenarios by the end of 2007 (assuming mortgage LOASs remain unchanged). We can see that 30-yr current coupon passthroughs outperform swaps even if interest rates move towards either the upper or lower ends of our projected range for 2007. Note also that this outperformance doesnt even account for a few basis points of likely additional gains from roll specialness.

Mortgages are rich in LOAS terms, but they should easily outperform swaps if interest rates remain within our projected range.

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RMBS Trading Desk Strategy

Figure 10: Excess Returns on MBS over Equal dv01 Swaps with Different Parallel Shifts of Interest Rates by the end of 2007 (Dollars / $100 Face Value)
TBA FNCL 5 FNCL 5.5 -1.00% (0.49) (0.48) -0.75% 0.05 0.13 -0.50% 0.38 0.55 -0.25% 0.55 0.77 0.00% 0.56 0.79 0.25% 0.44 0.63 0.50% 0.23 0.32 0.75% (0.06) (0.11) 1.00% (0.40) (0.63)

Source: Banc of America Securities

Another factor in favor of mortgages is that mortgage spreads still look attractive relative to spreads on corporate bonds and our credit strategists are slightly bearish on corporate spreads.6 In Figure 11, we show Treasury Z-spreads (ZVOAS) of 30-year current coupon MBS and the Z-spreads of AA & A rated corporate bond index. Figure 11: Treasury ZVOAS of 30-yr CC MBS vs. AA & A Corporate Debt
140 120 Tsy Z-Spreads (bp) 100 80 60 40 Jul-04 Jul-05 May-05 May-06 Jan-05 Jan-06 Jul-06 May-04 Nov-04 Nov-05 Nov-06 Jan-04 Mar-04 Mar-05 Mar-06 Sep-04 Sep-05 Sep-06

Mortgages look somewhat attractive versus corporates.

Tsy Z-spread of CC MBS

Tsy Z-spread of AA&A Corporate Debt

Source: Banc of America Securities

Notice that mortgage spreads were very wide relative to spreads on corporate bonds back in Nov05 Dec05. Money managers took advantage of these wider spreads by buying several billion MBS ($35-$45 billion by our estimates) and, as the spread differential compressed, there was some profit taking in late April and early May. At the beginning of the 2H06, we commented that mortgage valuations were very cheap relative to corporate bonds and that money managers are likely to provide strong cross-over bid for MBS. We were certainly not disappointed as domestic money managers were heavy buyers of MBS over the past 3-4 months which is partly responsible for the strong performance of MBS. It is possible that money managers may take short-term profits on their mortgage overweight if relative spreads between MBS and corporate bonds tighten another 4-5 bps, but from a long-term perspective we expect them to provide a strong bid for MBS if the 10-yr Treasury yield stays in our baseline forecasted range of 4.35%-5.15%.

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

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RMBS Trading Desk Strategy

Bank Purchases of Mortgages Changes in large bank holdings of MBS and their deposits have been heavily skewed by the acquisition of GoldenWest by Wachovia in 2006. Excluding the impact of Golden Wests acquisition, deposits on the books of large banks have grown by only 1.5% in 2006 versus an average annual growth of 7%-8% during 2002-2005. Although the spread between mortgage yields and average funding costs of banks is about 2.0% at the moment, what is relevant for estimating the growth of bank portfolios is the marginal cost of their funds. At a time when the growth in C&I loans can accommodate most of their deposit growth, the marginal cost of funding for banks to buy MBS is much higher than their average cost of funds. Considering our macro-theme that rates will remain range-bound next year, we do not expect banks to actively shed mortgages in 2007, but we expect only a very modest growth in bank holdings of MBS and whole loans.

Large bank holdings of MBS have declined by $62 billion since peaking in late August.

Recent data on changes in bank holdings of mortgages are heavily skewed by the acquisition of Golden West by Wachovia. After correcting for this, large bank holdings of MBS grew by $27 billion while their whole loan holdings rose by $40 billion in 2006. Bank holdings of mortgages grew very rapidly until August, but have stalled since then. In fact, large bank holdings of MBS declined by nearly $62 billion from their peak reached in late August (after adjusting for Golden West numbers). We attribute this drop to the following three factors: First, deposits on the books of large domestic banks are not growing (Figure 12). Historically bank holdings of MBS have a strong correlation with excess deposits (deposits less C&I loans). Banks have added $67 billion of mortgages and $46 billion C&I loans thus far in 2006 although deposit base rose by only $36 billion.7 Over the past 6 years, (Deposits - C&I - Mortgage Purchases) has never been less than zero. Second, although the spread between mortgage yields and the average funding costs of banks is a respectable 2.0% at the moment, what is relevant for estimating the growth of bank portfolios is the spread between the marginal cost of their funds and the current coupon mortgage yield. At a time when the growth in C&I loans can accommodate most of the deposit growth, the marginal cost of funding for banks to buy MBS is much higher than their average cost of funds. We believe that there is very little spread between current coupon mortgage yields and the marginal cost of funds for banks to buy MBS at the moment. Thus, from a carry perspective, banks should have very little incentive for growing their MBS portfolios. Third, at current dollar prices, we estimate that a substantial portion of MBS purchases by banks in 2006 (which total $125-$135 billion based on the YTD net purchases and estimated pay-downs) are in-the-money at the moment. Therefore, banks could shed mortgages if the current situation with deposits and C&I loans persists without having to worry about recognizing losses in their income statements. This is unlike the situation in June/July 2006 when unrealized losses on their books were very high at $24 billion.

The deposit base of large banks is not growing.

There is very little spread between mortgage yields and the marginal cost of funds for banks.

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

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RMBS Trading Desk Strategy

We project a very modest growth in bank holdings of MBS and whole loans in 2007.

In summary, we believe that deposit growth of large domestic banks will remain sluggish in 2007 and given the current situation with the C&I loan growth, banks are unlikely to grow their MBS portfolios in 2007. At the same time, we do not expect banks to actively sell mortgages because of the prevailing view of a range-bound rates environment. However, banks may selectively let their portfolios shrink from pay-downs if the deposit growth doesnt keep pace with the C&I loans. Figure 12: Large Bank Holdings of Mortgages, C&I Loans and Deposit Growth
Large Banks Net Mortgage Purchases MBS Whole Loans Total Net Mortgages C&I Loan Growth Deposit Growth As Reported 65 148 213 49 104 2006 Excl. Golden West 27 40 67 46 36 2005 35 73 107 45 157 2004 97 12 108 2 226 2003 36 45 82 -41 128 2002 44 102 146 -58 118 2001 84 -14 69 -72 101

All numbers are in billion dollars Source: Banc of America Securities

Agency Portfolio Issues Mortgage holdings of the GSEs have declined slightly in 2006 (by $12-$14 billion). Considering the current regulatory environment, we expect agency portfolio sizes to remain unchanged in 2007. The trend of the GSEs substituting agency mortgages with subprime mortgages that prevailed in 2004-2005 seems to have subsided in 2006. We expect the GSEs to be net buyers of agency mortgages in 2007 (although their overall portfolio size is likely to remain unchanged) following the recent directive from the OFHEO about non-traditional mortgages. 30-yr mortgages need to be 5-10 bps cheaper relative to agency debt for the GSEs to actively buy them as a substitute for subprime mortgages. In the short-term, we expect the GSE purchases to be concentrated in hybrid ARMs as a relative value play.

Agency portfolio size should remain unchanged in 2007.

Earlier this year, we commented that the agency portfolio caps, based on GAAP numbers, have introduced a new dynamic into the MBS market and estimated that Fannie Mae and Freddie Mac together have to sell $8-$9 billion MBS for a 25 bps rally in rates. Subsequent changes in the GSE portfolios have supported our assertion to some extent. However, going forward the cap should be much less of an issue assuming our expectations of longterm rates not rallying by more than 25 bps from their current levels in 2007 are justified. In the base case, we expect the size of the agency portfolios to remain unchanged next year. However, the previous two year (2004-2005) trend of the GSEs substituting agency mortgages by non-agency mortgages (primarily, subprime mortgages) seems to have subsided in 2006. As shown in Figure 13, the GSEs bought about $170 billion subprime MBS per year during 2004-2005 but the recent changes in the non-agency mortgage holdings of the GSEs indicate that the substitution of agency MBS by subprime MBS has stopped. In fact, we expect the GSEs to substitute a portion of their subprime holdings with agency MBS in 2007 because of the recent directive from the OFHEO about non-

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RMBS Trading Desk Strategy

We expect GSEs to be net buyers of $25-$35 billion of agency mortgages in 2007.

traditional mortgages. It is likely that the GSEs will direct a portion of pay-downs on subprime MBS into agency mortgages. Based on our estimates that the GSEs own about $250 billion subprime MBS and that prepayment speeds on these products are in the 40%50% CPR range, it is not unreasonable to think that the GSEs will be net buyers of $25-$35 billion of agency mortgages in 2007. Figure 13: Annual Purchases of Subprime MBS by the GSEs
Year Subprime Purchases

2005 169

2004 176

2003 81

2002 38

All numbers are in billion dollars Source: OFHEO, Banc of America Securities

CC MBS may have to widen 510 bps for the GSEs to buy fixed-rate MBS.

From the valuations side, we show the history of the OAS of the 30-yr current coupon MBS relative to the agency curve in Figure 14. Mortgage spreads are near the tighter end of the past 1.5-yr range relative to agency debentures. Thus the GSEs are unlikely to buy 30-yr mortgages at current valuations but mortgage spreads need to widen by no more than 5-10 bps for them to buy mortgages if they decide to move out of subprime mortgages in to prime products. In the short-term, we expect the GSE purchases to be concentrated in hybrid ARMs because of their cheap valuations in OAS terms. Figure 14: Agency OAS (proxy) of 30-yr Current Coupon MBS
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A gency OAS (bp)

10

-10

-20 1/3/2005 3/2/2005 4/28/2005 6/27/2005 8/23/2005 10/20/2005 12/19/2005 2/16/2006 4/17/2006 6/13/2006 8/9/2006 12/4/2006 10/05/06

Source: Banc of America Securities

Convexity Hedging Issues The last time convexity flows dominated MBS pricing was in October/November 2005. Since then, convexity related flows have been very limited (although not non-existent). In our base case interest rate scenario, convexity hedging shouldnt be an issue for the market in 2007.

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

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RMBS Trading Desk Strategy

(Figure 15). In fact, servicer portfolios are only 15-20 bps away from the point of maximum negative convexity and their portfolios extend or shorten by about $30 billion 10-yr Treasury equivalents for a 25 bps change in rates. We also believe that servicers are still somewhat under hedged for a rally in rates and we could see substantial convexity related flows if the 10-yr Treasury rallies through 4.40%. On the other hand, convexity related flows should be very limited if rates backup 25 bps. Interest rates need to rally 6070 bps for convexity hedging activity to become important. In our view, convexity hedging activity will have a heavy impact on rates, volatility and MBS markets only if another refinancing wave is initiated. Based on the current GWAC distributions, interest rates need to rally 60-70 bps from current levels for this to happen. Figure 15: Negative Convexity of the Agency Fixed-Rate MBS Universe
$ billion 10-yr Tsy equivalents 230 200 170 140 110 80 50 -100 -75 -50 -25 0 25 50 75 100 Interest Rate Shift from the Base Case (bp)
Source: Banc of America Securities
6/20/2006 12/22/2006

Outlook for Prepayment Speeds in 2007 For the range bound rate scenario during 2007, the out-of-the money and at-themoney speeds of recent originations are of chief concern due to continued softness in the housing market. We estimate that discount speeds for 2006 originations could be slower by up to 2%-3% after the initial ramp up period as compared to the discount speeds during 2006 for 12-24 WALA FNCL pools. Even though we are not expecting mortgage rates to rally 50 bps from the current levels, nevertheless, if such a scenario were to materialize, prepayment speeds of 100 bps in-the-money (FNCL 6s) pools will be significantly higher than what were observed during 2006. We expect prepayment speeds to be closer to 45% CPR as opposed to 33% CPR seen during 2006.

Relatively fast discount speeds and muted premium speeds characterized prepayment speeds in 2006.

Review of Prepayment Speeds in 2006 Before we go into the rationale for our expectations let us first review the prepayment behavior during 2006. We compare speeds for 12-24 WALA FNCL pools over the past 5 years for various incentives in Figure 16. Overall, the prepayment experience during 2006 resembled the 2005 experience i.e. relatively fast discount speeds and muted premium speeds. Pools that were 100 bps in the money prepaid at roughly 33% CPR (a far cry from 60%-70% CPR during 2002-2003) and pools that were 50 bps out of the money prepaid at 10% CPR.

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RMBS Trading Desk Strategy

Figure 16: FNCL Prepay Response Curves Over the Past 5 years (12-24 WALA)
80 70 60 CPR (%) 50 40 30 20 10 0 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 Incentive (bps) 2002 2003 2004 2005 2006

Source: Fannie Mae, Banc of America Securities

Recent slower speeds for ITM pools can be attributed to a weaker borrower profile.

The recent slower speeds for in-the-money pools can be attributed to weaker borrower characteristics with higher Spread At the Time of Origination (SATO). The sharp differences in the borrower characteristics of in-the-money mortgage pools relative to prior years can be clearly seen in Figures 17. It shows that 12-24 WALA pools with 100 bps of incentive during 2006 had average FICO score of 655 and OLTV of 82%, suggesting that borrowers in theses pools belonged to the lower end of the credit spectrum. In contrast, FICO score ranged between 700-720 and OLTV was closer to 75% for 100 bps in-themoney pools during the earlier periods (a mainstream prime borrower).

Figure 17: FICO Scores and OLTV for FNCL Pools by Incentive Over the past 5 years (12-24 WALA)
800 780 760 740 OLTV (%) 720 FICO 700 680 660 640 620 600 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 Incentive (bps) 2003 2004 2005 2006 2003 60 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 Incentive (bps) 2004 2005 2006 85 80 75 70 65 90

Source: Fannie Mae, Banc of America Securities

Additional factors that determine premium speeds only dampened in 2006. For example, the12-24 WALA pools that were in-the-money during 2006 had roughly 14% lower loan sizes (see Figure 18) and at the macro level the media effect was virtually non-existent in 2006.

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RMBS Trading Desk Strategy

Figure 18: ACLS for FNCL Pools by Incentive Over the Past 5 years (12-24 WALA)
220 200 180 ACLS (000s)

Lower loan sizes, higher LTVs also dampened premium speeds.

160 140 120 100 80 60 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 Incentive (bps) 2002 2003 2004 2005 2006

Source: Fannie Mae, Banc of America Securities

Figure 19 compares the recent history of prepayment speeds for 50 bps out-of-the money pools with $150K-$200K average loan sizes. For out-of-the money pools, average prepayment speed in 2006 was slightly lower (< 1% CPR) than in 2005 but it was still fairly robust (2%-3% CPR faster) as compared to the historical discount speeds. Figure 19: Average Prepayment Speeds for 50 bps Out-of-the Money FNCL Pools Over the Past 5 years (12-24 WALA, $150K-$200K average loan size)
14 12 10 CPR (%) 8 6 4 2 0 2002 2003 2004 Year 2005 2006

Source: Fannie Mae, Banc of America Securities

The primary reason for continued robustness in discount speeds of 12-24 WALA pools, despite the housing slowdown during 2006, is the fact that they had already seen fairly solid equity growth from the previous year as can be seen in Figure 20. The cumulative Equity Growth Since Origination (EGSO) was close to 18% for 50 bps out of the money pools. Even though it was lower than the 25% cumulative EGSO for the 12-24 WALA pools during 2005, it was still much higher than other years. This equity growth kept the cash-out activity at an elevated level even for discount collateral. The quarterly refinance

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RMBS Trading Desk Strategy

The robust discount speeds are due to the solid equity growth these pools have experienced.

statistics released by Freddie Mac provides credence to this hypothesis as it indicates that cash-out activity during 2006 was at an all time high on an absolute dollar amount basis and the cash-out borrowers were willing to pay slightly higher mortgage rates (2%, 8%, 12% higher during Q1, Q2, Q3 of 2006, respectively) to tap home equity. Figure 20: Average Cumulative EGSO for 12-24 WALA FNCL Pools
30.0 25.0 Cumulative EGSO (%) 20.0 15.0 10.0 5.0 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 Incentive (bps)
2002
2003
2004
2005
2006

Source: Fannie Mae, Banc of America Securities

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

Outlook for Prepayment Speeds in 2007 Looking ahead to 2007, for the range bound rate scenario we are projecting, the OTM and ATM speeds of recent originations are of chief concern due to continued softness in the housing market. Our estimates indicate that discount speeds for 2006 originations could be slower by up to 2%-3% CPR after the initial ramp up period as compared to discount speeds during 2006 for 12-24 WALA FNCL pools. Our estimate of the potential drop in speeds for recent originations is based on three different computations. First, we use discount speeds in 2002, as shown in Figure 19, to gauge the potential decline in discount speeds. The 12-24 WALA pools during 2002 had a cumulative EGSO of approximately 10%, which is actually higher than our baseline forecast of a flat housing market in real terms. During 2002, speeds were approximately 2% CPR slower as compared to the speeds in 2006. Another estimate can be obtained by grouping 12-24 WALA pools from 2006 by annualized EGSO. The results are shown in Figure 21. This analysis also indicates that ramped up speeds can drop by 2%-3% CPR if the HPA is within 5%. Finally, we can look at the prepayment speeds of states with low home price appreciation using the Fannie Mae state level data to estimate prepayment speeds in low HPA environment. The 2006 prepayment data at the GEO level also indicates that speeds on 12-24 WALA pools can drop by 3% CPR in a low HPA environment.

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RMBS Trading Desk Strategy

Figure 21: Prepayment Speeds in 2006 for 12-24 FNCL Pools by Annualized EGSO
14 12 2006 Average 10 C PR (% ) 8 6 4 2 0 5 10 HPA (%) 15 20

Source: Fannie Mae, Banc of America Securities

Earlier OTM cohorts will not be affected to the same degree by the housing slowdown as they already have substantial built in equity. They would be impacted more in a scenario where home sales were to slow down further from the current levels and result in lower levels of baseline turnover speeds. At this point we are not anticipating such a scenario. Even though we dont expect mortgage rates to rally 50 bps from the current levels, nevertheless, if such a scenario were to materialize, prepayment speeds of pools that are 100 bps ITM (FNCL 6s) will be significantly higher than what were observed during 2006. Our expectation in such a scenario is that prepayment speeds could shoot up to 45% CPR for 100 bps ITM 30-yr fixed rate agency pools. The reasons for this expectation are two fold. First, the collateral characteristics of the pools with 100 bps of incentive will be much better as compared to the 12-24 WALA pools that had 100 bps of incentive in 2006 and consequently, will not face the same barriers to refinancing. The summary of collateral characteristics for FNCL 5.5s and 6s by various incentive buckets (assuming current mortgage rate of 6.1%) is presented in Figure 22. For a 50 bps rally, FNCL 6s with current incentive of 25 bps or 50 bps will have incentives of 75 bps and 100 bps, respectively, and correspond to main stream prime borrowers.

If interest rates rally 50 bps, 100 bps ITM pools could prepay substantially faster than what were observed in 2006 with similar incentive.

Figure 22: Collateral Characteristics of FNCL 5.5s and 6s by Incentive (Assuming 6.1 % Mortgage Rate)
Coupon Incentive Balance WAC WAM WALA ACLS FICO OLTV (%) %Refi %Owner Cumulative (bps) (Billion $) ('000s) Occupied EGSO (%) 5.5 -25 266 5.89 320 33 157 723 71 64 92 36 0 147 6.06 328 27 159 724 71 55 91 27 25 29 6.29 342 15 178 717 73 51 90 14 50 2 6.56 327 28 140 664 81 55 91 27 75 1 6.83 325 30 134 622 81 56 96 30 6 25 123 6.39 330 26 146 716 73 53 86 26 50 122 6.58 333 23 150 717 74 48 89 21 75 24 6.79 329 27 141 705 77 48 88 25 100 2 7.06 325 31 116 639 84 50 94 26 125 1 7.34 328 28 119 612 81 54 96 25

Source: Fannie Mae, Banc of America Securities

Additionally, in such a rally scenario almost 49% the FNCL universe will have at least 50 bps of incentive which will cause the media effect to be higher. In Figure 23, we look at

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RMBS Trading Desk Strategy

the distribution of the universe by incentive on the December factor date for the past 5 years. In the same graph we also plot how the universe will shift in case of a 50 bps rally. It can be clearly seen that even though refinanceability of the mortgage universe will be no where close to that in Dec2002, it will be much closer to Dec2003 and Dec2004 factor dates. In the periods following those factor dates media effect was modestly higher than the current levels. To estimate prepayment speeds of FNCL 6s with 100 bps of incentive in a 50 bps rally scenario, we use prepayment experience during 2004 (see Figure 16) as our guide, which indicates speeds are likely to be close to 45% CPR in such a scenario. Figure 23: Cumulative Distribution of the MBS Universe by Incentive
100 90 80 %of the Universe -1 25 12 5 17 5 22 5 27 5 32 5 25 -7 5 -2 5 75

70 60 50 40 30 20 10

Ince ntiv e (bps)

200212

200312

200412

200512

200612

200612 - 50bps rally

Source: Fannie Mae, Banc of America Securities

Outlook for Mortgage Credit in 2007 We believe that residential mortgage credit will continue to make negative headline news for a large part of 2007. The 2006 vintage of alt-A ARMs is the worst performing (90+ delinquencies) vintage from the past 4 years and early payment defaults for the alt-A sector have almost doubled during 2006 as compared to 2004. There are some preliminary signs that housing market may stabilize going forward as the new and existing home sales are leveling off. Having said this, we still think it is too early to expect a reversal in the downward trend of HPA during 2007. We expect the home prices to stay flat in real terms or increase by 2%-3% in nominal terms during 2007.

2006 vintage alt-A ARMs is the worst performing vintage from the past 4 years.

We believe that residential mortgage credit will continue to make negative headline news for a large part of 2007. Cracks have already started appearing in the credit performance as indicated by recent increase in delinquencies of various prime sub-sectors, particularly altA ARMs. What stands out is the significantly faster ramp up in delinquencies of recently originated alt-A ARM loans as compared to the earlier vintages, and rise in early payment defaults during 2006. In fact, the 2006 vintage of alt-A ARMs (excluding Option ARMs) is the worst performing (90+ delinquencies) vintage from the past 4 years and early payment defaults for the alt-A sector have almost doubled during 2006 as compared to 2004. Furthermore, the credit performance of alt-A ARM loans from California is close to the US

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RMBS Trading Desk Strategy

average for the 2006 vintage as opposed to outperformance for the earlier vintages8. The primary reason for worsening in credit is the slower housing market and weak underwriting as indicated by increased origination of leveraged loans without full documentation (Figure 24). Figure 24: Prime RMBS Collateral Characteristics.
Leverage AOLS % % %Full % with % %IO %IO ('000s) FICO Cashout Purchase Doc OLTV Seconds NegAm (ARM) (Fixed) 311 719 13 75 62 72 5 3 0 386 725 24 38 66 66 1 3 0 385 728 24 32 60 63 1 2 8 0 351 728 24 32 52 62 10 1 15 1 312 720 26 51 42 68 24 12 34 2 328 720 35 50 32 70 30 27 27 10 353 717 35 49 23 71 37 30 26 12 % Balance 40Yr (Billion $) 0 62 0 162 0 224 0 307 0 406 2 465 7 218

Year 2000 2001 2002 2003 2004 2005 2006

Source: LoanPerformance

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

At this point, HPA is continuing to slowdown and the inventory of unsold homes is at a very high level (7.4 month supply for existing homes according to NAR). However, there are some preliminary signs that housing market may stabilize going forward as new and existing home sales are leveling off. Furthermore, home builders have reacted promptly to the housing slump by lowering the construction of new homes which will further support the housing market. Having said this, we still think it is too early to expect a reversal to the downward trend in HPA during 2007. We expect home prices to stay flat in real terms or up by 2%-3% in nominal terms during 2007. This scenario does not provide any relief to borrowers who have leveraged themselves beyond their means in anticipation of a continued boom in the housing market. They may find it hard to refinance out of trouble because of no growth in home equity due to flat home prices and potentially tighter underwriting by lenders in response to worsening credit situation and/or tighter regulations. The situation in some of the MSAs that saw extraordinary HPA during 2004-2005 is worth keeping an eye on as a lot of these areas are experiencing negative HPA already and have higher concentrations of leveraged borrowers. For 2007, the major risks for the investors are the widening of mortgage credit spreads and higher default rates combined with higher loss severities. Careful analysis of the collateral characteristics will be of paramount importance while taking credit exposure. Given our bearish outlook on credit performance especially for the 2006 cohort, the question is how bad can it get? At the national level, the 2000 vintage that corresponded to loans from prior purchase environment stands out for poor performance in recent times. The cumulative defaults for alt-A fixed rate loans (alt-A ARMs were a much smaller portion of the alt-A universe in 2000) were close to 5.9% and cumulative losses were 69 bps. The reasons for poor performance were weaker underwriting standards during 2000 and weak economic climate post 9/11. However, the drop in interest rates after 9/11 did help a lot of borrowers to refinance out of trouble. Given the ramp up in delinquencies of the 2006 alt-A ARM cohort (excluding Option ARMs) and the weak outlook for the housing market, it is possible for defaults and losses to reach or exceed 2000 levels. Figure 25 compares the delinquency ramp of 2006 alt-A ARMs with the 2000 cohort of alt-A fixed rate mortgages. It clearly shows that the 2006 alt-A ARM cohort is currently

2006 alt-A ARM cohort is underperforming the 2000 alt-A fixed cohort.

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

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RMBS Trading Desk Strategy

underperforming the 2000 alt-A fixed cohort. Figure 25: 90+ Delinquencies for Recent alt-A ARM Cohorts versus 2000 alt-A Fixed
20

90+ Delinquency (%)

16 12 8 4 0 0 5 10 15 20 25 30 35 40 45 50

WALA (months)
2003 alt-A ARM 2006 alt-A ARM 2004 alt-A ARM 2000 alt-A Fixed 2005 alt-A ARM

Source: LoanPerformance

Summary of Major Themes Relevant for the RMBS Market in 2007 Interest rates are likely to remain range bound. Realized volatility will stay low and implied volatilities are unlikely to move higher from their multi-year lows. Swap spreads should tighten 4-9 bps from their current levels. Net supply of fixed-rate agency MBS is likely to decline from 2006 levels. However, the decline should be modest because of ARM-to-fixed refinancings, stabilization of the housing market and continued strong cash-out refinancings. Overseas investor purchases of MBS are likely to grow further due to the substitution of Treasuries and agency debt by MBS and our projection for only a marginal decline in trade deficit. We expect domestic money managers to continue to provide a strong bid for MBS in 2007. The range-bound rates environment coupled with mortgage rates staying above the levels where refinancings could be an issue should make MBS the asset class of choice for domestic money managers. Excluding the impact of Golden Wests acquisition, deposits on the books of large banks have grown by only 1.5% in 2006 versus the average annual growth of 7%8% during 2002-2005. Considering our macro-theme that rates will remain rangebound next year, we do not expect banks to actively shed mortgages in 2007, but we expect only a very modest growth in bank holdings of MBS and whole loans. The trend of the GSEs substituting agency mortgages by subprime mortgages that prevailed in 2004-2005 seems to have subsided in 2006. We expect the GSEs to be net buyers of agency mortgages in 2007 (although their overall portfolio size is likely to remain unchanged) due to the recent directive from the OFHEO about non-traditional mortgages. We estimate that discount speeds for 2006 originations could be slower by up to

25

RMBS Trading Desk Strategy

2%-3% after the initial ramp up period as compared to the discount speeds during 2006 for 12-24 WALA FNCL pools. On the other hand, if interest rates were to rally by 50 bps, prepayment speeds of 100 bps ITM pools will be significantly higher than what were observed during 2006. In this case, we expect prepayment speeds to be closer to 45% CPR as opposed to 33% CPR seen during 2006. We believe that residential mortgage credit will continue to make negative headline news for a large part of 2007. The 2006 vintage of alt-A ARMs is the worst performing (90+ delinquencies) vintage from the past 4 years and early payment defaults for the alt-A sector have almost doubled during 2006 as compared to 2004.

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RMBS Trading Desk Strategy

III. Agency Pass-through Market


Summary Trade Recommendations Long-term Overweight on the Mortgage Basis Overweight 30-yr 5.5s and 6.5s versus 5s and 6s Overweight 15-yr MBS versus 30-yr MBS with Volatility hedges Overweight 15-yr 4.5s and 6s versus 15-yr 5s and 5.5s Overweight 15-yr Golds versus 15-yr FNMAs Buy Fixed-rate IOs versus Jumbo basis Buy premium GN/FN swaps

Mortgage Valuations and Summary Recommendation on the Mortgage Basis On our models, 30-yr current coupon LOASs have stayed in the range of -17 bps and +2 bps over the past 2 yrs (Figure 26). At the present LOAS level of -15 bps, current coupon 30-yr valuations are at the very rich end of the past 2-yr range. In addition, mortgages have benefited enormously from faster discount and muted premium prepayment speeds in 2006, but as our outlook for prepayments discussed in the previous section suggests, the mortgage market is unlikely to benefit from these favorable prepayment trends in 2007. Thus we see little upside from owning mortgages in the short-term for relative value players (pure OAS players). However, from a long-term perspective, we recommend an overweight on the mortgage basis (with the end of 2007 end as the horizon period) to real money managers for the following reasons: We expect a range bound rates market with very low convexity losses which generally favors negatively convex products. Swap spreads are likely to tighten in 2007. Since the MBS basis tends to track swaps, we expect mortgages to outperform Treasuries in 2007. Overseas investors are likely to absorb 60%-70% of the net supply coming into the agency fixed-rate MBS market in 2007. Corporate bonds continue to look rich relative to MBS and the cross-over buying from domestic money managers will continue in 2007. Although banks are unlikely to grow their MBS holdings in 2007, we expect the GSEs to be better buyers of agency mortgages. Considering that the mortgage universe has very limited refinancing risk at current rate levels, the mortgage basis should trade somewhat tight.

As shown in Figure 10, 30-yr current coupon passthroughs outperform swaps even if interest rates move towards either the upper or lower ends of our projected range for 2007. Note that this outperformance doesnt even account for a few basis points of likely additional gains from roll specialness. Considering that our base case scenario is for the 10-yr Treasury yield to reach 4.95% by the end of 2007 which is only 35 bps away from current levels, mortgages as an asset class are likely to do well in 2007. For active convexity hedgers (like GSEs and hedge funds), we recommend a modest underweight on the mortgage basis versus swaps as mortgages are trading near their 2-yr

27

RMBS Trading Desk Strategy

tights in LOAS terms. In addition, mortgage spreads are also at 1.5-yr tights versus corporate bonds and agency debentures (although still cheap by historical standards) and this may cause some money managers to take profits on their mortgage overweight positions. The projected swap spread tightening is also less of an issue for this investor community. Figure 26: History of the LOAS of 30-yr Current Coupon MBS
5 0 LOAS (bp) -5 -10 -15 -20 Jul-05 May-05 May-06 Jul-06 Nov-05 Nov-06 Jan-05 Jan-06 Mar-05 Mar-06 Sep-05 Sep-06

Source: Banc of America Securities

30-yr Coupon Stack: Overweight 30-yr 5.5s and 6.5s versus 30-yr 5s and 6s There are three important issues that investors need to keep in mind while thinking of positioning on the 30-yr coupon stack in 2007: The upward creep of GWACs and loan sizes in the agency pass-through market Discount prepayment speeds in a slow HPA environment The prepayment behavior of 50-100 bps ITM pools in 2007 versus speeds in 2006

Upward Creep of GWAC and Loan Sizes in the Agency Pass-through Market9 Over the past several months, the spread between the GWAC and the net coupon of fixedrate agency mortgage pools has increased substantially. For instance, new production 30year FNMA 6s pools have a GWAC of 6.67% versus 6.48% 1-year ago. Similarly, new production 30-year FNMA 5.5s pools have a GWAC of 6.25% versus 5.96% 1-year ago. On average, the spread between the aggregate GWAC and the net coupon of new production 30-year mortgage pools was close to 47-48 bps in 2003 and 2004 versus the 56 bps spread over the past one year. We believe that originators/servicers retained more interest cash flows on their balance sheets as the MBS market came out of a significant Refi wave and the media-effect subsided. In addition, originators/servicers may be taking advantage of FAS 156 which allowed mark-to-market accounting treatment for servicing rights.10 Another collateral characteristic that has changed significantly over the past 1-year is the
9

10

We first wrote about this issue in our weekly report dated 10/27/2006. See our weekly report dated April 21, 2005 for details about FAS 156.

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RMBS Trading Desk Strategy

average loan size on MBS pools. At the moment, the average loan-size for new production 30-year 6s is $225K versus $170K one year ago. Similarly, newly issued 30-year FNMA 5.5s pools have an average loan size of $230K versus $200K one year ago. These higher average loan balances are largely due to the sharp spike in the conforming loan balance limit from $359,650 to $417,000 at the beginning of this year. The higher GWACs and loan sizes make the new production mortgage pools a lot more negatively convex than the same net coupon pools originated one year ago which has some significant implications for their valuations. For instance, the higher loan size coupled with higher GWAC makes the current FNCL 6s TBA pools worth about 5-6 bps (in OAS terms) less than the collateral produced a year ago. The impact of the higher GWAC and loan sizes are somewhat lower on FNCL 5.5s since it is a discount coupon. Considering the very narrow range in which spreads have traded over the past few months, differing assumptions about TBA collateral characteristics can make the difference between viewing coupon swap valuations as rich or cheap. Prepayment Response Curves As discussed in the previous section, discount speeds for 2006 originations could be slower by up to 2%-3% CPR after the initial ramp up period as compared to the discount speeds during 2006 for 12-24 WALA FNCL pools. Similarly, even though we are not expecting mortgage rates to rally 50 bps from the current levels, prepayment speeds of pools that are 100 bps ITM (FNCL 6s) will be significantly higher than what were observed during 2006. Our expectation in such a scenario is that prepayment speeds can shoot up to 45% CPR for 100 bps in the money 30-yr fixed rate agency pools. At current valuation levels, 30-yr 6s and 5s look rich across the coupon stack and we recommend underweighting them in favor of 30-yr 5.5s and 6.5s. We will track this trade using 30-yr 5.5s and 6s butterflies with duration and curve hedges. Overweight 15-yr Basis versus 30-yr Basis Buy Dw 4.5s/FN 5s and Dw 5.5s/FN 6s swaps. Dw 4.5s pick-up 6-8 bps LOAS versus FN 5s after adjusting for the recent faster than model estimated prepayment speeds on Dw 4.5s. Dw 5.5s/FN 6s swap is a good hedge versus our mortgage overweight position if rates rally more than our expectations.

The 15-yr sector looks cheap relative to 30-years and we recommend buying Dw 4.5s/FN 5s and Dw 5.5s/FN 6s coupon swaps with duration and curve hedges. It is interesting that 15-yr discount pools are prepaying faster and 30-yr discount pools are prepaying slower relative to the estimates of most Street prepayment models but the market currently appears not to be paying attention to this trend. At the moment, Dw 4.5s pick-up 6-8 bps LOAS versus FN 5s after adjusting for the recent faster than model estimated prepayment speeds on Dw 4.5s. We also recommend Dw 5.5s/FN 6s swap as a good hedge versus our mortgage overweight position if rates rally more than our expectations.

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RMBS Trading Desk Strategy

15-yr Coupon Stack: Buy 15-yr 4.5s and 6s versus 15-yr 5s and 5.5s On our models, 4.5s is the cheapest coupon across the liquid 15-yr coupon stack (4.5%6.0% coupons). It picks-up 6-10 bps of LOAS versus 15-yr 5s and 5.5s after adjusting for faster than model expected prepayment speeds on 15-yr discounts. On our models, 15-yr 5.5s look very rich and although 15-yr 5s do not look very rich they will lag as the TBA deliverable on this coupon shifts from the current 8-9 WALA to 2-3 WALA over the next couple of months. However, since overweighting 15-yr 4.5s versus 5s and 5.5s will be a negative carry trade, we recommend combining it with 15-yr 6s. 15-yr MBS Market: Overweight 15-yr Golds versus FNMAs The 15-yr Freddie Mac TBAs are trading 2.0-3.5 ticks behind equal coupon 15-yr FNMAs, whereas 15-yr Golds should be trading 4 ticks above 15-yr FNMAs when all the collateral characteristics are similar (the 4 tick price difference accounts for the value of 10-days of less delay in Gold cash flows). We looked at the recent prepayment history of 15-yr Gold and FNMA pools and they are almost identical for all cohorts. Furthermore, there are no issues with dollar rolls in any liquid 15-yr coupon (4.5-6.0) at the moment. The market seems to be penalizing Golds with the expectation that rolls on 15-yr Golds are more difficult to be squeezed relative to 15-yr FNMAs. We believe that 15-yr Golds are 6.0-7.5 ticks cheap versus 15-yr FNMAs and recommend overweighting Golds versus FNMAs in the 15-yr sector. Buy Agency Fixed-rate IOs vs. Jumbo AAA Basis Agency fixed-rate IOs (5.5s, 6s and 6.5s) are trading 17-19 ticks behind equal coupon agency TBAs whereas the Jumbo AAA basis is trading 22-24 ticks behind agencies. Investors can therefore buy mortgages with lower loan balances and the agency guarantee for a pay-up of only 4-6 ticks. GNMAs vs. Conventionals Neutral on GN/FN 5s and 5.5s Coupon Swaps Buy New Origination Premium GN I and GN II Pools versus FNMA TBAs

This note is a follow up on the trade recommendation issued on 12/01 to buy new origination GN II 6s versus FN 6s.11 Below we look at some important reasons behind the sharp drop in the prices of GN I/FN and GN II/FN swaps over the past few months and the attractiveness of premium GN II/FN swaps based on their current valuations. GN/FN swaps traded at very rich valuation levels late last year and in early 2006 because of the negative net supply of GNMAs and the strong demand for this product from overseas investors. The sharp rise in GN/FN swap valuations forced shorts in GNMAs to cover their positions and most relative value players exited the GNMA market by the beginning of 2006 as liquidity became an issue. Since then, GN/FN swaps have gradually weakened and were trading at close to their two-year wides in early December. Although GN/FN swaps have bounced off from their lows by 5-6 ticks, we think that premium GN
11

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

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RMBS Trading Desk Strategy

II/FN swaps are still offering the government guarantee for free. There are two important reasons behind the cheapening of the GNMA sector over the past few months. First, after dwindling rapidly for 2-3 years, the size of GNMA market started expanding this year. The net production of GNMAs has turned positive this year due to a combination of factors that include streamlining of the underwriting process by FHA, reduced down payment requirements on FHA mortgages and higher subprime mortgage rates. The spread between subprime and FHA mortgages tightened from 200-220 bps in 2000 to 80-100 bps in 2004. Since then, this spread has widened back to 170-200 bps. At current relative mortgage rate levels, borrowers are unlikely to treat subprime and FHA mortgages as substitutes for one another. Second, overseas investors are getting more comfortable with MBS backed by the GSEs and their purchases have been less concentrated than before in GNMAs. Consequently, the weak supply/demand technicals resulted in GN/FN swaps weakening a lot from their lofty valuation levels. In addition, there is some concern in the market that discount GNMAs could prepay substantially slower than conventional mortgages in a weak housing environment. Figure 27 shows the current valuations of 30-yr GNMA and FNMA pass-throughs. The numbers under Model in this figure show where GN I/FN and GN II/FN swaps should trade on an equal OAS basis accounting for only the differences in the TBA collateral characteristics and assuming that GNMAs and FNMAs will have identically the same prepayment characteristics. For instance, we account for the fact that 3WALA, 6.65% GWAC, $220K pools are likely to be delivered for FN 6s while new production pools with 6.55% GWAC and $150K loan size are likely to be delivered for GN II 6s. Our models indicate that GN II/FN 6s and 6.5s swaps were trading below their equal OAS value (as of 12/12/2006) which essentially means that the market has not priced in any value for the government guarantee of GN IIs. In fact, numbers in Figure 27 understate the relative value in GNMAs because of the better convexity profile of GNMAs as discussed below. Figure 27: Valuations of FNMAs, GN Is and GN IIs
FNCL 30-yr TBA Price 5.0s 97-19+ 5.5s 99-19+ 6.0s 101-04 6.5s 102-03+ OAS -14.4 -17.7 -21.2 -17.3 Equal OAS Price GNSF G2SF 97-27+ 97-24+ 99-31+ 99-27+ 101-19+ 101-20 102-16 102-21+ GN I/ FN Swap Model Actual 8 21 12 18+ 15+ 19 13+ 23 GN II/ FN Swap Model Actual 5 9 8 11+ 16 12+ 18 11+

All numbers were as of 12/12/2006. GN/FN swaps have gained 3-5 ticks since then. Source: Banc of America Securities

Figure 28 shows the prepayment S-curves for 30-yr GN I, GN II and FNMA pools for 2004 and 2005 cohorts. For the same refinance incentive, 2004 cohort GN I and GN II pools have been prepaying substantially faster than FNMA. However, the situation is clearly different with the 2005 cohort. As an example, for the 2005 cohort, 50 bps in-the-money GN II pools are prepaying at about 22% CPR versus 26.5% CPR on FNMA pools. One of the primary reasons behind the slower prepayment speeds of 2005 cohort GNMAs when in-the-money is a change in rules that the FHA made at the beginning of 2005. Following the new rules effective at the beginning of 2005, FHA borrowers refinancing into a conventional mortgage will not receive the pro-rated initial mortgage insurance premium they paid to FHA for mortgages originated after 2004, which is unlike the FHA mortgages

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RMBS Trading Desk Strategy

originated in prior years. In addition, FHA also reduced the pro-rated period from 5 years to 3 years, which means that FHA borrowers will receive less of the initial insurance payment even if they refinance into another FHA mortgage. Essentially, these rule changes reduced the refinancing incentive of 2005 FHA borrowers by about 25 bps relative to the refinancing incentive that would have existed otherwise. After considering the negative convexity differentials, we believe that premium GN/FN swaps are cheap. Thus we recommend buying GN Is and GN IIs premiums versus FNMAs. We are neutral on GN I/FN 5s and 5.5s swaps and will wait for a better entry point. Figure 28: Prepay Response Curves for 2004 and 2005 Cohorts (12-24 WALA)
2004 Cohort
50
50

2005 Cohort

40

FNCL

GNSF

G2SF

40

FNCL

GNSF

G2SF

CPR (%)

30
CPR (%)

30

20

20

10

10

0 -100 -75 -50 -25 0 Incentive (bps) 25 50 75 100

0 -100 -75 -50 -25 0 Incentive (bps) 25 50 75 100

Source: Banc of America Securities

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RMBS Trading Desk Strategy

IV. ARMs Market


A. Some Key Themes Relevant for the ARMs Market in 2007
Supply/Demand Outlook for ARMs We believe that issuance in both the agency and non-agency hybrid sectors will decrease by 15% in 2007. This will lead to a gross issuance of $120 billion in agency hybrids and $100 billion in non-agency Hybrids. Since Option ARMs are a preferred for cash-out refinancings and also constitute an obvious target of regulatory scrutiny, we expect to see a bigger decline in issuance in this product type as compared to hybrid ARMs. We estimate the gross issuance of Option ARMs in 2007 to be between $75-$80 billion. From the demand standpoint, we expect a strong bid for hybrids in the short term as index trackers readjust their portfolios ahead of agency ARM inclusion in the US Aggregate Index. We estimate the incremental demand for agency ARMs as a result of this development to be around $8-$16 billion.

Robust demand for non-traditional ARM products including IOs and Option ARMs kept the overall ARM issuance at a respectable level in 2006 despite a continuing flat / inverted yield curve environment. Total agency hybrid supply in 2006 was about $138 billion with IOs representing over 70% of the total issuance. Similarly, in non-agency space, we estimate the total hybrid ARM supply to be approximately $120 billion with IOs representing more than 85% of the total issuance.12 In addition, $117 billion was issued in Option ARMs primarily through the non-agency channels. As was the case in the recent past, ARM issuance in the coming months will be primarily driven by the slope of the curve and affordability. Even assuming a modest home price growth in 2007, we expect affordability to remain an issue and to continue to provide support to the issuance of more leveraged ARM products including IOs and Option ARMs. On the other hand, given our forecast of just one rate cut and a relatively strong economic environment, we expect the curve to maintain a flattening bias during 2007, which should keep a lid on the issuance levels. However, a significant decline in cash-out activity from 2006 levels will have an adverse effect on overall ARM issuance levels in general and Option ARM issuance levels in particular. Option ARMs have been extensively used by borrowers for cash-out refinancing. For 2006, we estimate that 50% of Option ARMs consisted of cash-out loans. Furthermore, a potential tightening in the underwriting standards should affect the issuance of leveraged products the most. Another risk to ARM issuance comes from the growing popularity of the fixed rate IO product (Figure 29). Fixed Rate IO mortgages entail less risk as compared to leveraged ARM alternatives and will continue to curtail ARM issuance if the current flat curve environment persists. Based on the above factors and the recent trends observed in ARM issuance, we believe
12

Non-Agency issuance figures are annualized numbers based on the first six months of data from LoanPerformance database.

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RMBS Trading Desk Strategy

that issuance in both the agency and non-agency hybrid sectors will decrease by 15% in 2007. This will lead to a gross issuance of $120 billion in agency hybrids and $100 billion in non-agency Hybrids. On the other hand, given that Option ARMs are a preferred mortgage type for cash-out refinancing and also an obvious target of regulatory scrutiny, we expect to see a bigger decline in issuance as compared to hybrid ARMs. We estimate gross issuance in Option ARMs to be between $75-80 billion in 2007. From a demand standpoint, we expect a strong bid for hybrids in the short term as index trackers readjust their portfolios ahead of agency ARM inclusion in the US Aggregate Index. We estimate the incremental demand for agency ARMs to be around $8-16 billion based on the total agency debt and MBS holdings of $633 billion for open-end mutual funds and money-market funds (Source: Federal Reserve). This represents approximately 30% of the net agency hybrid issuance expected in 2007. After this initial spike in demand, things should revert to normal as the incremental demand for ARMs from index funds for reinvestment of pay downs should be marginal. MTA-indexed Option ARMs floaters are also expected to enjoy healthy demand as likely rate cuts (at least one) make lagging indexes more desirable. Figure 29: Growth in Fixed Rate IO Issuance
40 35 30 Issuance ($ bn) 25 20 15 10 5 0 2003 2004 2005 2006

Non-Agency

Agency

Note: 2006 estimates are annualized numbers based on first 11 months and 6 months of issuance data for the Agency and the Non-Agency respectively. Source: Banc of America Securities

Prepayments Around Reset The markets fear of extremely fast tail speeds on hybrids waned over the course of the year as prepayments around the first reset proved to be a lot more docile than the initial expectations. An interesting observation about hybrid speeds around reset observed in 2006 is the occurrence of a second spike in prepayments speeds at the second reset. Based on the limited data available so far, we notice a clear difference in prepayment speeds between 5/1s with a 2% initial cap versus those with a 5% initial cap. We believe that cap related prepayment issues will come into limelight next year as the volume of 5/1 pools approaching reset begins to pickup.

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RMBS Trading Desk Strategy

The markets fear of extremely fast tail speeds on hybrids waned over the course of the year as prepayments around the first reset proved to be a lot more docile than the initial expectations. Hybrids that reached their first reset during 2006 were primarily agency 3/1s with a total volume of $9.5 billion. In comparison, only $4 billion prime non-agency 3/1s transited from fixed rate into the adjustable rate domain. The 2006 prepayment experience of Agency 3/1s is summarized in Figure 30. The first spike in data primarily relates to 2003 originations. The average origination WAC of these hybrids was approximately 4.20% and most of them were capped out as they reset. An interesting observation is the occurrence of a second spike in prepayment speeds at the second reset. Hybrids corresponding to the second spike belong to 2002 cohort with an average origination WAC of 5.30%. On their first reset, these hybrids did not cap out but paid down similarly as their 2003 cousins. This is somewhat surprising given that the 2002 hybrid borrowers had 40-50 bps higher refinancing incentives at the reset relative to the 2003 borrowers. A plausible explanation for the muted response of the 2002 cohort at the first reset is their relatively higher degree of burnout.13 At the second reset, refinancing incentive for 2002 borrowers was high enough (115 bps on average relative to 30yr fixed rate) to extract a second spike in prepayments. The second spike was even stronger than the first; however, like the first, it was also very short lived. Figure 30: Prepay Speeds of Seasoned Agency 3/1s Around Reset (As of 01/06 11/06)
80 70 60 50 40 30 20 10 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 WALA (months)

Source: Banc of America Securities

Non-agency 3/1s also exhibited a similar prepayment profile as their agency counterparts; albeit with stronger spikes at the first reset (Figure 31). While Jumbo 3/1s that reset in 2006 had comparable initial WACs with that of corresponding agency 3/1s, the stronger spike at reset resulted from their higher average loan size ($400K vs. $160K). However, in the case of alt A 3/1s, the faster speeds at reset resulted from a combination of higher average loan size ($300K) and 100 bps higher GWAC (relative to both agency and non-agency jumbos). In 5/1 space, the volume of ARMs that have reached reset over the last one year or so has been relatively small. Based on the limited data available so far, we notice a clear difference in prepayment speeds between 5/1s with a 2% initial cap versus those with a 5% initial cap (Figure 32). 5/1s with a higher initial cap appear to approach reset at 7%-8% CPR faster
Based on the outstanding pools, we estimate that the factors at first reset for 2002 and 2003 originations were 14% and 25% respectively. Note that this method overstates the true factor at reset since it does not include pools which completely pay down before the reset.
13

CPR (%)

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RMBS Trading Desk Strategy

speed even though the 2% cap was also out-of-the-money (origination WACs of 5/1 hybrids corresponding to both of these cap levels were approximately 6.2% and they experienced a moderate shock of approximately 75 bps at the reset). However, prepayment speed differences converge in the post reset period. This prepayment trend suggests that the perceived risk of a higher cap alone is enough for borrowers to pay down at a faster rate as their loans approach reset. We believe that cap related prepayment issues will come into limelight next year as the volume of 5/1 pools approaching reset will begin to pickup. We expect a total of $10 billion and $40 billion of agency and prime non-agency 5/1s to reset in 2007 and 2008 respectively. Figure 31: Prepayment Speeds of Seasoned Agency vs. Non-Agency 3/1s around Reset (Based on 2006 Factor Dates)
100 90 80 70 CPR (%) 60 50 40 30 20 10 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 WALA (months)
Jumbo
Agency
Alt A

Source: Banc of America Securities, LoanPerformance

Figure 32: Prepay Speeds of Seasoned Agency 5/1s Around Reset (07/05 -09/06)
90 80 70 60 CPR (%) 50 40 30 20 10 55 56 57 58 59 60 61 62 63 64 65 1,600 1,400 1,200 1,000 800 600 400 200 Current Balance ($MM)

2% Cap - Bal

5% Cap - Bal

2% Cap - CPR

5% Cap - CPR

Source: Banc of America Securities

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RMBS Trading Desk Strategy

Looking ahead into 2007, based on the current outstanding balances, approximately $19 billion agency 3/1s with an average WAC of 4.55% will reset in 2007.14 Interpolating from the 2006 experience (Figure 33), if the rate environment remained unchanged, peak speeds at the first reset should be around 65% CPR. As for the hybrids reaching the second reset, we expect the peak speeds to reach 75%-80% CPR, since these borrowers will have even higher refinancing incentive than the corresponding 2002 borrowers and will have burnt out to a lesser extent. However, if the curve steepened, prepay speeds may decline moderately. In non-agency space, based on the current outstanding balances approximately $24 billion 3/1s will reset in 2007. This includes $7.4 billion Jumbo 3/1s with an average WAC of 4.46% and $16.5 billion Alt A 3/1s with an average WAC of 5.35%. We expect the prepayment experience in 2007 to be similar to that in 2006 for both Jumbo and alt-A sectors if the rate environment remained unchanged. In a moderate steepening scenario, prepayment speeds will decline moderately as in the case of agency hybrids. Finally, we believe that prepayment speeds on moderately to highly seasoned hybrids will not be affected by the continuing slow down in the housing market in 2007. Outstanding hybrids in this category have already built enough equity and will not slow down even if the softening in the housing market continued. For instance, 24-35 WALA agency 3/1s that will reset next year have experienced an EGSO of 23%-35% as of the latest factor date. This is similar to the EGSO of 28%-33% on 24-35 WALA agency 3/1s pools that reset in 2006 as of Dec 2005. Figure 33: Prepay Speeds of Agency 3/1s Around Reset by Issue WAC (01/06-11/06)
80 70 60 CPR (%)

50 40

30 20 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 WALA (months) Issue WAC 3.5%-4.0% Issue WAC 4%-4.5% Issue Wac 4.5%-5%

Source: Banc of America Securities

Impact of Curve Steepening on ARM Prepayments Although we do not expect the curve to steepen in our baseline forecast of rates in 2007, with 55 bps of easing by the end of 2007 already factored into Fed Funds futures (as of 12/19/06), the prospect of how a potential curve steepening could impact prepayment speeds on ARMs is of some concern to the market. To some extent, wider spread levels on premium hybrids are reflecting market concerns on prepayment speeds should such a scenario materialize. In addition, some market participants are concerned about a spike in option
14

Assuming no pay downs between now and the reset.

37

RMBS Trading Desk Strategy

ARM prepayments in a steep yield curve environment. We take a look at empirical evidence to estimate the potential impact of a curve steepening on prepayments in both of these sectors. Hybrid ARM Prepayments To understand the effect of curve slope on hybrid ARM prepayments we analyze historical prepayment data for 12-24 WALA 5/1s originated since 2000 after controlling for loan size. In our analysis, we consider four scenarios corresponding to steep and flat curve situations in both high and low HPA environments (Figure 34). The value of curve slope and cumulative equity growth since origination (EGSO) corresponding to each data point is provided in Figure 35. Further, to control for changes in the media effect over time, we only consider prepayment data corresponding to low media effect environments. Figure 34: Prepayment S-Curves for Agency 5/1s under Steep/Flat Curve
60 50 40 CPR (%) 30 20 10 0 -125 -100 -75 -50 -25 Incentive (bps) Steep Curve / High HPA Steep Curve / Low HPA Flat Curve / High HPA Flat Curve / Low HPA 0 25 50 75

Source: Banc of America Securities

The results generally indicate that prepayments on hybrids tend to be somewhat faster across all incentives in steeper curve environments regardless of the strength of the housing market. However, the results are more obvious in the low HPA setting. From a theoretical standpoint a steeper curve affects prepayments in the following manner. First, it results in increased ARM-to-ARM refinancing activity as borrowers roll down the yield curve. These refinancings also affect discount (relative to current mortgage rate on same hybrid product) speeds since the rates of shorter reset products are lower and offer positive incentives to ARM borrowers. However, at the same time, a steeper curve also means that fixed rate products (which are priced off the longer end of the curve) become relatively more expensive for the ARM borrowers, and reduces the impetus for ARM-toFRM refinancings. Thus, the above results imply that the increase in ARM-to-ARM refinancing activity in a steeper curve environment overwhelms the corresponding decrease in the ARM-to-FRM refinancings. In addition, a steeper curve also means that forward rates are higher and hence, prepayments will slow down along the forward path. This effect does not show up in the prepayment Scurve, but affects valuations. For estimating the effect of a potential curve steepening on prepayments in 2007, we focus

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RMBS Trading Desk Strategy

on the steep/flat curve scenarios in the low HPA environment (shown by dotted lines in Figure 5).15 The difference in slopes between the steep/flat curve scenarios averages approximately 160 bps. This difference in the curve slopes corresponds to a difference of about 3%-4% CPR across the entire incentive range in the two scenarios. For 2007, we consider curve steepening of 50-75 bps as the extreme case and if the curve steepened by this magnitude, we expect speeds to modestly increase by 1%-2% CPR on 5/1 hybrids. However, as explained earlier, the actual impact on hybrid valuations would be even smaller than what should correspond to this increase due to higher forward rates in a steeper curve. Figure 35: Slope and EGSO Data corresponding to Agency 5/1 Prepayment S-curves
HPA Curve High Steep High Steep High Steep High Steep High Steep High Steep High Steep High Steep High Steep High Flat High Flat High Flat High Flat High Flat High Flat High Flat High Flat High Flat Low Steep Low Steep Low Steep Low Steep Low Steep Low Steep Low Steep Low Steep Low Steep Low Flat Low Flat Low Flat Low Flat Low Flat Low Flat Low Flat Low Flat * 10yr - 2yr Slope Incentive -125 -100 -75 -50 -25 0 25 50 75 -125 -100 -75 -50 -25 0 25 50 75 -125 -100 -75 -50 -25 0 25 50 75 -125 -100 -75 -50 -25 0 25 50 CPR 26.1 24.4 25.6 26.5 29.1 32.1 38.2 40.5 48.2 17.7 18.3 20.4 22.8 26.5 31.5 35.5 43.7 45.2 14.3 14.6 16.4 15.7 18.4 20.7 22.9 29.4 34.1 12.2 11.4 11.8 13.2 15.0 15.6 19.2 23.2 Bal ($MM) 4,596 15,781 27,722 42,268 45,697 36,159 20,481 9,950 3,968 23,188 58,217 72,487 64,957 43,870 25,283 12,824 4,176 1,090 1,243 3,361 5,332 7,660 6,924 4,855 3,022 1,395 556 4,487 10,800 13,060 10,803 7,120 4,064 1,868 500 Slope* (bps) 154 163 163 168 176 184 195 216 234 9 12 16 19 24 27 34 41 44 154 165 165 172 179 186 200 222 240 11 13 14 19 23 25 34 46 Cum EGSO (%) 31 31 32 32 32 31 32 29 28 34 31 31 30 30 28 26 25 25 6 6 6 6 6 6 6 5 5 7 6 6 6 7 6 6 6

Source: Banc of America Securities

Option ARM Prepayments Historically, Option ARMs have not shown much sensitivity to the slope of the curve. The seasoning ramps of option ARMs originated since 2002 and grouped by prepayment penalty term are shown in Figure 36. The data does not show that the speeds were relatively fast during 2002/04 when the average curve slope was about 200 bps. On the contrary, more recent originations are exhibiting steeper seasoning ramps.16

Note that both the low HPA and low media effect assumed in plotting these S-curves are consistent with our view on these variables in 2007. We believe that more recently a higher percentage of borrowers are using no prepay penalty loans for bridge financing, which is resulting in faster prepayment speeds. Similarly, prepayment speeds on loans with 3yr prepayment penalty terms are seasoning faster due to change in the penalty characteristics representing a shift from a 3-2-1 penalty structure to a fixed penalty.
16

15

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RMBS Trading Desk Strategy

Figure 36: Non-agency Option ARM Prepayment Speeds by Origination Year


No Prepay Penalty MTA Option ARMs
2002 70 60 50
CPR (%)

2003

2004

2005

2006 250 200


Slope (bps)

150 100

40 30 20 10 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 WALA (months)
2002 2004
2005 2006
Avg 10yr/2yr Slope

50 0 -50

1yr Prepay Penalty MTA Option ARMs


2002 70 60 50
CPR (%)

2003

2004

2005

2006 250 200


Slope (bps)

150 100

40 30 20 10 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 WALA (months) 2002 2004 2005 2006 Avg 10yr/2yr Slope 50 0 -50

3yr Prepay Penalty MTA Option ARMs


2002 45 40 35 30
CPR (%)

2003

2004

2005

2006 250 200


Slope (bps)

150 100 50 0 -50 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 WALA (months) 2002 2004 2005 2006 Avg 10yr/2yr Slope

25 20 15 10 5 0

Source: Banc of America Securities, LoanPerformance

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RMBS Trading Desk Strategy

Hence, from a historical standpoint, we do not find any evidence which suggests that prepayments could increase substantially if the curve got steeper going forward. However, it is also important to note that MTA ARMs were not a mainstream product back in 2002/03 and as a result might not have received enough lender attention. Two mitigating factors that should keep a check on MTA prepayment speeds are 1) low HPA in 2006/07 MTA prepayment speeds have been particularly sensitive to the HPA environment, 2) Restricted availability of non-traditional (leveraged) mortgage products as a result of potential tightening in the underwriting standards as a response to worsening credit situation and/or increased regulatory pressure.

B. Key Trades in the ARM Sector for 2007


We summarize our key relative value trade ideas in the hybrid ARM market below. 1. Overweight Agency Hybrids vs. Fixed Rate (Short Term) Hybrids are attractively priced relative to the fixed rate sector with 5/1s offering more than 30 bps in OAS pickup relative to 15-yrs. However, based on the macro picture a range bound 10yr rate; low realized volatility; and lack of surge in implied volatilities much like this year, we expect hybrids to lag the fixed rate basis in 2007. But from a short term perspective, we recommend a tactical overweight on the hybrid basis due to favorable technicals caused by inclusion of agency hybrids in the US aggregate Index and the seasonal low in ARMs issuance. All else being equal, as housing seasonals kick in, we expect a 15%-20% drop in agency hybrid issuance over the next 3-4 months from the recent average issuance level of $12 billion. Figure 37 shows the historical relationship between lagged MBA purchase index and agency ARM issuance corresponding to purchase loans only. In the winter months, the index typically drops by about 35%. Given the flat yield curve, the average percentage of purchase loans in the agency ARM issuance has been relatively high at about 58% in 2006. Hence, barring an increase in refinancing activity, total ARMs issuance can easily drop by 15%-20% over the next few months. Note that the seasonal low in the ARMs issuance will coincide with the timing of their inclusion in the US Aggregate Index. This concurrence of squeeze in supply and increase in demand will create very favorable technicals for ARMs in the short term.

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RMBS Trading Desk Strategy

Figure 37: Volume of Purchase Loans in the Monthly Agency Hybrid ARM Issuance
11 10 9 Issuance ($bn) 8 400 7 350 6 5 4 Jul-03 Jul-04 Jul-05 Jan-03 Jan-04 Jan-05 Oct-03 Oct-04 Oct-05 Jan-06 Apr-03 Apr-04 Apr-05 Apr-06 Jul-06 300 250 200 600 550 500 450 MBA Purchase Index

ARM Issuance (Purchase)

Lagged MBA Purchase Index

Source: Banc of America Securities, Bloomberg

2. Overweight Agency Hybrids vs. Non-Agency Hybrids Based on the current valuation levels, non-agency hybrids appear tight relative to their agency counterparts on our models from a historical perspective (Figure 38). Although we perceive non-agency hybrids to be a suitable alternative to agency hybrids for the index trade, we think that it is likely that agency hybrids will enjoy stronger demand unless the non-agency basis widens substantially to offer more incentive. At the current valuations, we prefer agency hybrids. Figure 38: Relative LOAS of Par-priced Non-agency vs. Agency Hybrids
20 Non-Agency OAS (to Call) - Agency OAS (bps)

15

10

-5 4/3/06

5/1/06

5/29/06 6/26/06 7/24/06 8/21/06 9/18/06 10/16/06 11/13/06 12/11/06 3/1 NonAgy PickUp 5/1 NonAgy PickUp

Source: Banc of America Securities

3. Wait for Better Entry Point to Buy Seasoned Hybrids The limited availability of par and discount coupons due to falling rates over the past three months has caused seasoned hybrids to tighten substantially relative to new origination. Spreads on moderately seasoned lower coupon 5/1s have been affected the most. Another factor that appears to have helped seasoned pools is the inclusion of agency hybrids in the

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RMBS Trading Desk Strategy

Lehman Agg Index. Historically, moderately seasoned 5/1s have traded at an OAS pickup of 10-15 bps relative to new origination; however, the recent grab for discount coupons has made them trade through new originations. We recommend investors wait for a better entry point to buy seasoned 5/1 pools. Owing to a heavy supply of seasoned 5/1s in December, dealer inventories are quite heavy in this product. Apart from moderately seasoned 5/1s, we believe that highly seasoned hybrids (less than 12 MTR) continue to offer value. Hybrids in this category trade anywhere between 30-45 OAS in our models. With tail speeds getting lot more predictable, we continue to maintain our overweight in this sector. 4. Add MTA Option ARM Exposure In the current economic environment, we like adding MTA exposure for two reasons. First, while it is not our baseline forecast, if the Fed cuts rates as much as what the futures market is pricing in, the MTA / LIBOR basis could tighten (along the forward curve, the MTA/LIBOR 1M basis is expected to tighten by 32 bps by the end of 2007). Second, we expect a substantial slow down in MTA Option ARM prepayment speeds primarily as a result of a weak housing market in 2007 (Figure 39). Furthermore, as discussed before, the restricted availability of non-traditional (leveraged) mortgage products as a result of potential tightening in the underwriting standards may also help in lowering refinancing rates on Option ARMs going forward. Tightening in underwriting standards will become more likely if the emerging credit deterioration trend seen in recent originations continues into 2007. Figure 39: Impact of HPA on Option ARM (3 Year Penalty) Prepayments
35 30 25 CPR (%) 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 W ALA (months)
Low HPA
High HPA

Source: Banc of America Securities, LoanPerformance

For expressing the MTA / LIBOR view with limited Option ARM prepayment exposure, we recommend par-priced MTA floaters. Figure 40 presents some representative parameters and relative value metrics for par-priced floaters backed by MTA collateral. The underlying collateral is comprised of loans with 3-yr hard prepay penalty term and prepayment projections are based on BOA Model (LT speed 29% CPR). Furthermore, there are no additional caps on the floaters other than those imposed by the underlying collateral

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RMBS Trading Desk Strategy

(typically between 9%-10%). MTA indexed floaters, despite a 24-day delay and an unfavorable day-count basis, offer higher OAS than LIBOR floaters with similar credit enhancement. For example, a AAA MTA floater with a 10% higher credit enhancement offers 8 bps additional OAS relative to a AAA Mezz LIBOR floater. Similarly, a AAA Mezz MTA floater for same credit enhancement offers 11 bps in OAS pickup relative to a AAA Lower Mezz LIBOR floater. To check the resilience of par-priced MTA floaters from a prepayment standpoint, we stress test the OASs of the above securities by applying 150% of BOA prepayment model (LT speed 37% CPR). As for the LIBOR floaters, due to the par-price, the OASs remain virtually unchanged under the faster prepayment scenario. However, in the case of MTA floaters, the OAS decreases by 5-6 bps under the faster prepay scenario. This is because the primary source of the relatively higher OAS of the MTA floaters is the projected tightening in the MTA / LIBOR basis along the forward paths. Therefore, faster prepayment speeds hurt an MTA floater to some extent by reducing the potential benefit from the MTA / LIBOR tightening. Nonetheless, MTA floaters continue to offer higher value than LIBOR floaters even when prepayment speeds increase to 150% of BOA Model. However, to express the above Option ARM prepayment view, we recommend new origination premium MTA floaters with 250 bps or higher net margins. These floaters offer 10-20 bps in OAS pickup relative to par-priced floaters in the base case. As the impact of low HPA on prepayments will begin to weigh in, premium MTA floaters are likely to outperform par-priced floaters substantially. Figure 40: Relative Value in Par-priced Floaters Backed by MTA Collateral
Rating AAA AAA Mezz AAA AAA Mezz AAA Lower Mezz Index MTA MTA LIBOR 1M LIBOR 1M LIBOR 1M Margin (bps) 75 85 18 24 28 Delay 24 24 0 0 0 Day-Count 30/360 30/360 30/360 Actual/360 Actual/360 OAS (bps) 32 39 18 24 28 Credit Enhancement 30% 10% 46% 20% 10%

Source: Banc of America Securities

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RMBS Trading Desk Strategy

IMPORTANT INFORMATION CONCERNING U.S. TRADING STRATEGISTS


Trading desk material is NOT a research report under U.S. law and is NOT a product of a fixed income research department of Banc of America Securities LLC, Bank of America, N.A. or any of their affiliates (collectively, BofA). Analysis and materials prepared by a trading desk are intended for Qualified Institutional Buyers under Rule 144A of the Securities Act of 1933 or equivalent sophisticated investors and market professionals only. Such analyses and materials are being provided to you without regard to your particular circumstances, and any decision to purchase or sell a security is made by you independently without reliance on us. Any analysis or material that is produced by a trading desk has been prepared by a member of the trading desk who supports underwriting, sales and trading activities. Trading desk material is provided for information purposes only and is not an offer or a solicitation for the purchase or sale of any financial instrument. Any decision to purchase or subscribe for securities in any offering must be based solely on existing public information on such security or the information in the prospectus or other offering document issued in connection with such offering, and not on this document. Although information has been obtained from and is based on sources believed to be reliable, we do not guarantee its accuracy, and it may be incomplete or condensed. All opinions, projections and estimates constitute the judgment of the person providing the information as of the date communicated by such person and are subject to change without notice. Prices also are subject to change without notice. With the exception of disclosure information regarding BofA, materials prepared by its trading desk analysts are based on publicly available information. Facts and ideas in trading desk materials have not been reviewed by and may not reflect information known to professionals in other business areas of BofA, including investment banking personnel. Neither BofA nor any officer or employee of BofA accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. To our U.K. clients: trading desk material has been produced by and for the primary benefit of a BofA trading desk. As such, we do not hold out any such research (as defined by U.K. law) as being impartial in relation to the activities of this trading desk.

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Investors should be aware that BofA engages or may engage in the following activities, which present conflicts of interest: The person distributing trading desk material may have previously provided any ideas and strategies discussed in it to BofAs traders, who may already have acted on them. BofA does and seeks to do business with the companies referred to in trading desk materials. BofA and its officers, directors, partners and employees, including persons involved in the preparation or issuance of this report (subject to company policy), may from time to time maintain a long or short position in, or purchase or sell a position in, hold or act as market-makers or advisors, brokers or commercial and/or investment bankers in relation to the products discussed in trading desk materials or in securities (or related securities, financial products, options, warrants, rights or derivatives), of companies mentioned in trading desk materials or be represented on the board of such companies. For securities or products recommended by a member of a trading desk in which BofA is not a market maker, BofA usually provides bids and offers and may act as principal in connection with transactions involving such securities or products. BofA may engage in these transactions in a manner that is inconsistent with or contrary to any recommendations made in trading desk material. Members of a trading desk are compensated based on, among other things, the profitability of BofAs underwriting, sales and trading activity in securities or products of the relevant asset class, its fixed income department and its overall profitability. The person who prepares trading desk material and his or her household members are not permitted to own the securities, products or financial instruments mentioned. BofA, through different trading desks or its fixed income research department, may have issued, and may in the future issue, other reports that are inconsistent with, and reach different conclusions from the information presented. Those reports reflect the different assumptions, views and analytical methods of the persons who prepared them and BofA is under no obligation to bring them to the attention of recipients of this communication. This report is distributed in the U.S. by Banc of America Securities LLC, member NYSE, NASD and SIPC. This report is distributed in Europe by Banc of America Securities Limited, a wholly owned subsidiary of Bank of America NA. It is a member of the London Stock Exchange and is authorized and regulated by the Financial Services Authority. 2006 Bank of America Corporation

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