JPM - Mbs Primer

JPMORGAN MBS PRIMER
MBS Strategy Matt JozoffAC 212-834-3121

September 2009
STRICTLY PRIVATE AND CONFIDENTIAL
INTRODUCTION TO MBS
Analyst Certification The strategist(s) denoted by an asterisk (*) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed. This research contains the views, opinions and recommendations of research strategists with JPMorgan US Fixed Income Strategy. Research strategists routinely consult with JPMSI trading desk personnel in formulating views, opinions and recommendations in preparing this research. Trading desks may trade or may have traded as principal on the basis of the research strategist(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMSI trading desks which may conflict with your interests. In addition, research strategists receive compensation based, in part, on the quality of their analysis, firm revenues, trading revenues, and competitive factors. Copyright 2008 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a member of FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited is registered as an investment advisers with the Securities & Futures Commission in Hong Kong and itsCE numbers is AAJ321 Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer. This material is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. JPMorgan and its affiliates may have positions (long or short), effect transactions or make markets in securities or financial instruments mentioned herein (or options with respect thereto), or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers mentioned herein. The information contained herein is as of the date and time referenced above and JPMorgan does not undertake any obligation to update such information. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Transactions involving securities and financial instruments mentioned herein (including futures and options) may not be appropriate for all investors. Clients should contact their salespersons at, and execute transactions through, a JPMorgan entity qualified in their home jurisdiction unless governing law permits otherwise J.P. Morgan Securities Inc. is a member of NASD, NYSE and SIPC In the UK and other EEA countries, this material is not available for distribution to persons regarded as private customers (or equivalent) in their home jurisdiction.
JPMORGAN MBS PRIMER
INTRODUCTION TO MBS
Market Overview and Origination
Demand
11
Mortgage Cashflows and Intro to Prepayments
19
Valuation and OAS
27
Prepayment Analysis and Reports
43
TBA Market and Specified Pools
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JPMORGAN MBS PRIMER
INTRODUCTION TO MBS
MBS in the U.S. fixed income market

Overview Overview Fixed income market composition Fixed income market composition
Largest US fixed income asset class Many products to choose from within the MBS market Agency fixed-rates and ARMs Non-agency fixed-rates and ARMs (Jumbos, AltAs) Whole loans CMOs and other structured MBS Superior liquidity The TBA market adds unique liquidity to MBS
MARKET OVERVIEW AND ORIGINATION
Asset-backed 8% Money Market 11%
Municipal 8%
U.S. Treasury 18%
Fed Agencies 10%
MBS market often used to express duration and curve views (due to its liquidity and size) Agency fixed-rate pass-throughs is 34% of the U.S. Aggregate Index (a benchmark of the U.S. investment grade debt).
Corporate 19%
Mortgage Related 26%
Total = $30.8 trillion

Source: Securities Industry and Financial Markets Association (4Q 2008)
INTRODUCTION TO MBS
Agency MBS market composition and issuance

Securitized agency market composition Securitized agency market composition
Hybrid ARM ($157 billion) 3% Other Fixed ($297.9 billion) 6% Hybrid ARM IO ($175 1/1 ARM billion) ($14.2 billion) 4% <1%
Annual fixed-rate net issuance ($ billions) Annual fixed-rate net issuance ($ billions)
514 296 158 210 273 99 514 415 255
-26
15-year ($582 billion) 11%
2000
2001
2002
2003Total = $__mm 2006 2004 2005
2007
2008
2009
Source: JPMorgan, FNMA, FHLMC, GNMA As of December 2009
Annual ARM net issuance ($ billions) Annual ARM net issuance ($ billions)
73
80 51 29 17 -8 -65
47
30-year ($3.93 trillion) 76%
9 -12

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
INTRODUCTION TO MBS
The mortgage market surged, thanks to a strong housing market and cash-out refis
1-4 Family Mortgage Debt Outstanding ($ billions) 1-4 Family Mortgage Debt Outstanding ($ billions)
11,158 11,164 11,031 10,445 9,384 8,273 7,183 6,463 5,738 5,205
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: Federal Reserve Board * As of 1Q2009
INTRODUCTION TO MBS
Why do investors buy mortgages? Yield pickup over Treasuries, with little credit risk in Agency space
Yield History of the FNMA 30yr CC and the 5/10 yr On-the-run UST Blend Yield History of the FNMA 30yr CC and the 5/10 yr On-the-run UST Blend
9 8 7 6 5 4
Current Coupon Pass-through Yield Average of 5 and 10 yr UST Yields
3 2 1 1997 2001 2005 2009
Source: JPMorgan
INTRODUCTION TO MBS
Securitization and the money flow of pass-throughs
Mortgage Lenders
Loans
Agencies
Agency Backed Securites
Home Owner
Payment
Servicer
Agencies
Investors
Defaults Servicing Fee Guarantee Fee
Insurance Pool
INTRODUCTION TO MBS
The MBS market links borrowers and investors

Agencies
Mortgage Lenders
MBS Dealers
Borrowers
MBS Investors
A pass-through is the basic MBS structure The issuer of the pass-through obtains the mortgages either by purchasing or originating the loans Loans with similar characteristics are pooled together and then securitized Investors are entitled to a pro-rata share of monthly principal and interest payments of the underlying loans, minus a servicing spread and guarantee fee
INTRODUCTION TO MBS
Origination: The Menu of Mortgages Has Expanded

Origination: production of new loans in primary market Products
Fixed-rate mortgages (30-year / 20-year / 15-year) Adjustable rate mortgages (Hybrid ARMs: 3/1, 5/1, 7/1, 10/1) Interest-Only MTAs; Option ARMs Others
Balloon mortgages (5-year / 7-year) Prepayment penalty mortgages Conforming balance loans: agency eligible loans need to meet certain collateral criteria Non-conforming loans (Private label or Non-agencies)
Jumbos and Alt-As
INTRODUCTION TO MBS
Understanding Mortgage Collateral : Borrower Credit & Housing Leverage
Borrower Credit and Information FICO Score Historical Credit Use and Management Avg FICO Score for Jumbo Mortgages : ~730 Avg FICO Score for Alt-A Mortgages : ~700 Avg FICO Score for Subprime Mortgages : ~600 Non-Linear Relationship Between FICO and Propensity to Default Documentation Full vs. Limited/Reduced/No Doc Leverage (Debt to Income Ratios) Reserves : Staying Power in the event of financial trouble
INTRODUCTION TO MBS
Understanding Collateral cont

Housing Leverage Loan-to-Value Ratio Mortgage Amount / House Value Higher LTV Less Equity Protection for the Mortgage Investor Higher Risk
Occupancy Owner Occupied Borrower Lives in the Property (Most Secure) Second Home Borrower has personal ties to the property Investor Business Decision on Economic Situation (Least Secure) Property Type Single Family Property (Most Secure) Condos Multi-Family
INTRODUCTION TO MBS
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Demand
11
19
Valuation and OAS
27
43
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JPMORGAN MBS PRIMER
INTRODUCTION TO MBS
11
Major MBS investors

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

Source: Inside MBS & ABS
DEMAND
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Foreign demand had dominated the mortgage market during the boom
Net Purchases ($ billions, annual) Net Purchases ($ billions, annual)
250 200 150 100 50 0 -50 Foreign GSE Bank
Net Purchases ($ billions, annual)
-100 -150 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan * As of YE 2008.
DEMAND
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Now, the Fed and Treasury have stepped in to support the market
Federal Reserve Purchases of Agency MBS Federal Reserve Purchases of Agency MBS
Cumulativ e Purchases 900 800 700 600 500 400 300 200 100 0 $836.45
60% 50% 40% 30% 20% 10% 0% Agency 30y r Breakdow n % of Outstanding % of YTD Issuance % of Fed Purchases
$ (Billions)
Jan Feb Mar Apr May Jun Jul Aug Sep
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
*As of Sep 9, 2009

DEMAND
Source: JPMorgan, Federal Reserve
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The GSEs
Fannie Mae and Freddie Mac Conforming loan limits are now the higher of $417,000 or 125% of median home price, with a cap of $729,750. 20% risk capital weighting, regulators considering 10% weighting Ginnie Mae Explicitly government guaranteed Zero risk weighting Federal Home Loan Banks (FHLBs) No securitization program like the other agencies Represent a funding mechanism for commercial banks in the US to tap capital markets Have portfolios of loans that they hold, similar to Fannie and Freddie
DEMAND
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Unique role of Fannie and Freddie: issuer / investor

Fannie Mae was created in 1938 to make mortgages available to low-income families. In 1968, Fannie was converted to a shareholder-owned corporation, and in 1970, Freddie Mac was created to compete with Fannie and expand the secondary market in mortgages. Mission is to facilitate secondary mortgage market in U.S. which provides steady flow of low cost mortgage funds 2 major functions: Guarantee loans against credit losses (charge a guarantee fee) Buy loans and securities and issue agency debt Hold MBS, CMOs, and loans as well as ABS, CMBS, and mortgage-related spread products Large portfolios (FN + FH hold over $1.5 trillion in loans and MBS) Placed in a conservatorship with support from the US Treasury in September 2008
DEMAND
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Agency Portfolio Growth, 2000-2009

Agency Retained Portfolios Agency Retained Portfolios
1,000 800 $ Billions 600 400 200 0 00 01 02 03 04 05 06 07 08 09 Fannie Mae Freddie Mac
Source: FNMA, FHLMC, JPMorgan As of July 2009

DEMAND
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Top 20 banks ranked by MBS portfolios as of 2Q2009

Bank MBS and 1-4 family whole loan holdings: Top 20 banks ranked by total assets, as of 2Q09 and changes Bank MBS and 1-4 family whole loan holdings: Top 20 banks ranked by total assets, as of 2Q09 and changes since 1Q09, $mm since 1Q09, $mm
Bank MBS JPMorgan Chase & Co. 243,519 Bank of America Corporation 232,838 Wells Fargo & Company 147,234 Citigroup Inc. 103,881 Goldman Sachs Group, Inc. 58,242 MetLife, Inc. 44,834 Bank of New York Mellon Corporation 37,346 PNC Financial Services Group, Inc. 34,125 Taunus Corporation 32,717 U.S. Bancorp 30,015 Capital One Financial Corporation 29,687 BB&T Corporation 27,220 Morgan Stanley 26,198 Citizens Financial Group, Inc. 26,165 Barclays Group US Inc. 25,329 Regions Financial Corporation 17,147 State Street Corporation 15,470 SunTrust Banks, Inc. 14,894 HSBC North America Holdings Inc. 13,820 TD Banknorth Inc. 11,196 Top 20 1,171,877 Chg* Whole Loans Chg Total 5,367 286,079 (9,078) 529,598 (1,588) 444,443 (6,856) 677,282 24,969 386,463 (3,348) 533,697 3,941 209,501 (5,542) 313,382 327 565 6 58,807 2,157 5,724 1,129 50,558 4,919 5,535 248 42,881 (802) 60,278 (428) 94,403 (1,863) 2,738 177 35,455 (285) 57,026 2,284 87,041 1,272 18,337 (1,227) 48,025 12,098 33,207 (305) 60,427 11,062 115 96 26,313 (487) 46,422 (2,527) 72,587 (20,706) 3,376 (1,688) 28,705 390 29,128 (627) 46,275 (3,126) 15,470 52 54,360 1,094 69,254 (5,470) 88,051 (5,398) 101,871 (130) 15,138 748 26,334 32,097 1,746,486 (31,242) 2,918,363 Chg (3,711) (8,444) 21,621 (1,601) 333 3,286 5,167 (1,231) (1,686) 1,999 46 11,793 11,158 (3,013) (22,394) (237) (3,126) 1,146 (10,868) 617 855
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Source: JPMorgan, Federal Reserve

DEMAND
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Demand
11
19
Valuation and OAS
27
43
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JPMORGAN MBS PRIMER
INTRODUCTION TO MBS
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MBS Terminology
Pools are comprised of mortgage loans with similar rates and terms WAC weighted average coupon of all loans in pool (vs Coupon) WAM weighted average maturity of loans in pool WALA weighted average loan age Original face original principal amount of pool
MORTGAGE CASHFLOWS AND INTRO TO PREPAYMENTS
Current face remaining principal balance of pool Origination year average origination year of loans in pool; age (WALA) is important in prepayment assessment (seasoning) CPR Constant Prepayment Rate annualized percentage of remaining principal prepaid
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Mortgage cash-flow characteristics
Homeowner's August payment due (in arrears)
After processing, security holders receive shares of August payment
FHLMC 14th
FNMA 24th
August 1st 30 days in arrears
September 1st 14 to 24 days processing
October 1st
44 to 54 day delay
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Mortgage cash-flow
Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year fixed-rate loan Using MP function on BBG
Source: Bloomberg
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Mortgage cash-flows: without prepayments
Interest
Principal
Source: Bloomberg
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Mortgage cash-flows: with prepayments
Interest
Pre-paid Principal Principal
Source: Bloomberg
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Prepayments: source of MBS optionality

Borrowers have the right to prepay at any time without penalty in effect calling their loans away from investors; prepayments may be partial or complete Valuing this call option and the cash flow uncertainty it creates is the key to understanding MBS Timing and rate of prepayments vary and produce non-level, less-predictable cash flows
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Prepayment standards
CPR Constant Prepayment Rate annualized percentage of remaining principal prepaid PSA prepayment vector expressed as a series of CPRs; begins at .2% in the first month, increases .2% per month, leveling out at 6.0% in month 30; prepayment assumptions for pricing stated as linear multiples of PSA schedule
14
200 PSA
12 10 CPR (% ) 8 6 4 2 0 0 10 20 Age 30 40 50
100 PSA
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Demand
11
19
Valuation and OAS
27
43
51
JPMORGAN MBS PRIMER
INTRODUCTION TO MBS
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Many Different Types of Spreads

Basic: static yield spread over a single point on the curve I : spread to Treasury N : spread to swaps Intermediate: zero volatility yield curve spread Z : spread to Treasury curve E : spread to Libor/swap curve Libor ZSpread on JPMorgans analytic reports. Advanced OAS : option-adjusted spread LIBOR OAS Treasury OAS
VALUATION AND OAS
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Yield analysis in the MBS market

Static Spread (Yield Spread): standard measure of incremental return over a single benchmark Treasury Compares MBS to single point on the yield curve, usually to the interpolated point closest to the Weighted Average Life of the MBS But MBS does not return principal in one lump sum but over many periods. A better assumption would include multiple data points on the yield curve. Z Spread takes this another step further.
ZV Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly forward rates derived from the current yield curve More accurate for securities that return principal over many periods as opposed to bullets Still a static measure since it assumes that interest rates and MBS cashflows remain constant
VALUATION AND OAS
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Evaluating pass-throughs: yield / average life
VALUATION AND OAS
Source: Bloomberg
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Prepayments and OAS Prepayment issues: Reinvestment risk:

When rates decline and speeds increase the investor has to reinvest an increased amount of principal at lower rates When rates increase and speeds decline, the investor has less cashflow to reinvest at higher rates Discount bonds: when rates decline, the benefit of earlier return of principal at par may mitigate reinvestment risk Premium bonds: when rates increase, the benefit of a larger outstanding principal balance and longer average life means higher and more interest payments which may mitigate the reinvestment risk
OAS has been derived to account for the dispersion and uncertainty associated with this return of principal from MBS
VALUATION AND OAS
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31
OAS Calculation
To incorporate prepayment volatility in the valuation of MBS, we can calculate a theoretical price for a given OAS
1. 2. 3. 4.
Hundreds of hypothetical interest rate paths are simulated On each interest rate path the prepayment model is used to predict prepayment speeds and thus, MBS cashflows For each path, the present value of the projected cashflows are calculated using a specified spread, s, which is added to the forward rates Value of MBS = Average value of PV(s) over all simulated interest rate paths = AVGPV(s) where s is OAS
To find OAS given market price:

1. 2.
Start with an initial estimate for OAS Calculate AGVPV(s) and keep adjusting until AVGPV(s) = market price
Drawback of OAS:
1. 2. 3. 4.
The spread earned by the investor depends on the actual path realized and can be drastically different from the OAS Wide differences in OASs are produced by different firms models due to different term structures, volatility assumptions and prepayment projections Doesnt account for dollar roll financing Is a black box difficult for investors to decompose OAS into its component parts.
VALUATION AND OAS
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Pass-through risk measurement (duration)

Various measures of duration: % change in price for a 1% change in rates. Modified duration is inappropriate for pass-throughs as it cannot accommodate varying cash flows. OAD is found by calculating constant OAS prices for parallel curve shifts. Empirical duration uses actual observations regressed against a Treasury benchmark. Directional/empiricals could be different against different parts of the yield curve. Duration is typically expressed as a % of the 10-year Treasury duration: For instance, a par-priced mortgage with a duration of 3 years, compared to a 10-yr Tsy duration of 7.5 yrs: 3/7.5 = 40% of a 10-yr None of these measures is perfect. We tend to use a combination of them all.
VALUATION AND OAS
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Pass-through risk measurement (convexity)

Convexity: the rate at which the duration of a security changes as interest rates change.
Positive convexity implies that for small, equal and opposite changes in interest rates,
the increase in price if rates go down will be more than the decrease in price if rates rise.
Negative convexity implies that the increase in price if rates go down will be smaller
than the decrease in price if rates rise.
Bullet Treasuries have positive convexity. Pass-throughs typically have negative

convexity.
VALUATION AND OAS
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Negative convexity of mortgages

FN 5.5 prices ($) vs shift in rates (bps), as of September 2009 FN 5.5 prices ($) vs shift in rates (bps), as of September 2009
108 106 104 102 FNCL 5.5 Price 100 98 96 94 92 90 88 -200

VALUATION AND OAS
-150
-100
-50
50 Bps
100
150
200
250
300
Source: JPMorgan
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A real-world example: Hedging a position of FNMA 6s

Buy $100m FNMA 30 6.0 Hedging Possibilities Hedge duration with $54m 10Y Treasuries (OAD=4.12 Treas Dur=7.64). This provides protection against parallel yield curve shifts. Hedge duration with 2Y, 5Y, 10Y, and 30Y Treasuries. This protects against any yield curve movements.
Convexity hedge with $19m ATM 3Mx10Y swaption straddle.
2Y 5Y 10Y 30Y Total

VALUATION AND OAS
Pass-through Partial 0.74 1.17 1.67 0.59 4.17
Treasury Duration 1.89 4.37 7.64 14.09
Hedge Ratio 0.39 0.27 0.22 0.04
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Scenario Analysis with Duration Hedging

What happens if the yield curve shifts in parallel?
Duration Hedged Change

0.30 0.00
Price Change
-0.30 -0.60 -0.90 -1.20 -1.50 -150
-100
-50
50
100
150
Spread Change (bps)

10 Year Hedge
VALUATION AND OAS
2, 5, 10, 30 Year Hedge
The portfolio incurs convexity costs for large yield movements
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Duration and Convexity Hedging

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

0.30 0.00 Price Change -0.30 -0.60 -0.90 -1.20 -1.50 -150
-100
-50
50
100
150
Spread Change (bps)

10 Year Hedge
VALUATION AND OAS
2, 5, 10, 30 Year Hedge
Note that multiple options are needed to completely hedge the convexity of the mortgage prepayment option.
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Changes in mortgage market duration can impact the rates markets
The rate of extension of the mortgage market will slow in a sell-off

Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in rates
A sell-off could cause the curve to steepen

Change in 10-year equivalents for the mortgage market across the curve for a parallel +50 rate shock
400 Change in 10-yr equivs ($bn) 200 0 -200 -400 -600 -800 -100
200 150 100 50 0

-75 -50 -25 0 25 50 75 100 Rate change (bp)
10-year Equiv ($bn)
VALUATION AND OAS
-50 2 5 Tenor 10 30
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Mortgages have embedded options Investors need to hedge changes in vol as well.
Homeowners have the right to prepay at any time during the life of the mortgage Consequently, an MBS investor is short many options to the homeowner:
O ption
S hort Long
Underly ing S hort Long 1m x 1y 1m x 10y 5m x 1y 5m x 10y
Term structure models are calibrated to the entire vol surface in swaptions Higher vol should cause mortgages to cheapen
FN 30 5. 0 5. 5
VALUATION AND OAS
Vega -0. 21 -0. 26 -0. 27 -0. 23
FN15 4. 5 5. 0 5. 5 6. 0
Vega -0. 091 -0. 123 -0. 145 -0. 111
6. 0 6. 5
Source: JPMorgan
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Where to find mortgage risk measures: Front page of the JPMorgan mortgage daily packet
VALUATION AND OAS
Source: JPMorgan Pricing and Analytics Package, May 12, 2009
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Tracking valuations historically: Current coupon OAS
VALUATION AND OAS
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Demand
11
19
Valuation and OAS
27
43
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JPMORGAN MBS PRIMER
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The Prepayment S-Curve

70
60 Burnout: Refi response slows once deep in-themoney
50
CPR (%)
40
30
20
PREPAYMENT ANALYSIS AND REPORTS
Refi: How quickly speeds increase as incentive increases
10 Turnover -250 -200 -150 -100 -50
0 0
Elbow: The amount of incentive to get borrowers to begin refinancing (to overcome fixed costs) 50 100 150 200 250
Refi Incentive (bp)
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A closer look at prepayments: The major components

Rate refinancing Largest component of prepayments Borrowers take advantage of lower interest rates to refinance A steep curve can cause borrowers to refi into shorter mortgages (ARMs) Turnover Prepayment occurs when borrower moves from one home to another As loans age (or season) they show higher turnover speeds Seasonality is an important driver of turnover, as most families move during the summer (when kids are out of school) Cash-out refinancing
Borrowers with accumulated equity can refinance and take out a larger mortgage Cash can be used for home improvement, paying off bills, or other debt consolidation This effect is driven primarily by home price appreciation (HPA)
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No love for the coasts... Home prices converging on Nebraska?

Unemployment pressures home prices, esp. on the coasts
Employment weak but housing stable
Northeast: surging unemployment to take its toll
Texas: Limits on cash-out refis prevented bubble Increase in Unemployment Hardest hit
Housing Decline
<-11.7% > 4.4% 4.4% 2.4% <2.4% -11.7 - 5.6% >5.6%
Source: Case-Shiller home prices mid-2006 to 1Q09, OFHEO, Bureau of Labor Statistics Unemployment Rate 06Q2-09Q1
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Seasonality in prepayments, especially turnover

Seasonality: Patterns tend to be impacted by weather and school schedules
School schedules and weather conditions are the main reasons for seasonal behavior There is also a separate day count adjustment to account for different collection days in each month
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0 Jan Feb Mar Apr May Jun
Jul Aug Sep Oct Nov Dec
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Housing prices and turnover matter a lot for a discount mortgage
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Prepayment reports: speeds by origination year
Source: JPMorgan, FNMA (April 2009)
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Prepayment reports: speeds by WALA
Source: JPMorgan, FNMA (April 2009)
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Demand
11
19
Valuation and OAS
27
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How does the TBA market work?
The TBA mortgage market has been incredibly successful Liquidity that is at least as good as in the Treasury market Estimated $X billion trades daily as TBA on average What is TBA? Buyer agrees to buy a coupon and program (e.g. 30-year 6s), but Seller can decide what collateral to deliver (WAC, WAM, WALA, loan size, etc.) Allows very large trades to occur (>$10 billion at times) TBA trades settle on 1 day per month (a.k.a. PSA settle)
TBA MARKET AND SPECIFIED POOLS
The problem? The seller is long the delivery option, so the buyer will always get the worst to deliver Highest loan size Worst servicers Adverse WALA
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Collateral Performance Varies TBA = Cheapest to Deliver

Realized return on MBS investments depends on collateral performance Efficient allocation by dealers and investors and pooling by originators ensure that cheapest pools are delivered into the TBA market
Prepayments of FNMA 30-year 6.5% coupons in March 2007, grouped by age and loan size
35 Performance of TBA delivery pools 30
Carry of $102 TBA FNMA 6.5s versus 1-month CPR, bp

8 7 1-month Funded Carry, bp 6 5 4 3 2 1 0 1.0 6.8 5.7 4.6 3.5 TBA 6.5 is negative carry at 30CPR
25 CPR, % 20 15 10
2.3
5 0 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 0-4 4-8 8-12 < $100k $100~150k $150~200k $200~250k $250k +
-1 0 5 10 15 1-month CPR, % 20 25
-0.5 30
Source: JPMorgan, Fannie Mae
INTRODUCTION TO MBS
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Why consider specified pools?
Avoid the uncertainty of TBA delivery Pick up value in specific loan characteristics Improve convexity relative to TBAs Match the mortgage index composition Anticipate demand from specific buyers
INTRODUCTION TO MBS
54
Demand for Specified Pools Comes from Many Sources

CMO CMO execution is often driven by model valuation Dealers arbitrage between collateral intrinsic value and demand from different investor types Collateral selection is important when buying structured securities, particularly for structures with leverage Money Managers Indexed investors need exposure to specified pools as seasoned pools comprise 80% of the outstanding agency MBS universe Total return investors aim to reduce convexity hedging costs FNMA and FHLMC
Portfolio risk management and hedging are model dependant, thus improvements in portfolio convexity reduce hedging cost Hedge Funds Buy/sell specified pools versus TBA to take advantage of relative value opportunities
INTRODUCTION TO MBS
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Specified Pools Offer a Superior Prepayment Profile

Choosing the right pool attributes can lead to slower speeds as a premium (Call Protection) and faster speeds as a Choosing the right pool attributes can lead to slower speeds as a premium (Call Protection) and faster speeds as a discount (Extension Protection) discount (Extension Protection)
Prepayment speed versus economic rate incentive

60 50 40 30 20 10 0 -200
Discount
Premium
1-month CPR
Generic Specified Pool
-150
-100
-50
0 Rate Incentive, bps
50
100
150
200
INTRODUCTION TO MBS
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Specified Pools Come In Many Flavors

Types of specified Pools Types of specified Pools
Attribute WAC WALA Name Low WAC Definition Lower than average gross WAC Purpose Call Protection Lower the WAC, slower the speeds Seasoned Premium Loan age > 24 months and older than TBA Seasoned Discount Loan age > 12 months and older than TBA Loan Size LLB / $85k Max MLB/ $110k Max HLB / $150k Max $175k Max Geography
Call protection Burnout: after the most reactive borrowers leave the pool, the remaining borrowers are less likely to prepay Extension protection Call protection Lower the loan size, slower the speeds
Maximum loan size < $85k Max loan size < $110k Max loan size < $150k Max loan size < $175k All loans originated in Texas All loan originated in NY 90% LTV or higher Credit Score < 620 100% Investor property or 2nd Home
Texas New York High LTV Low FICO NOO Non Owner Occupied
Call Protection Call Protection Call Protection Call Protection Credit impaired borrowers have fewer refinancing options Call protection
LTV FICO Occupancy
INTRODUCTION TO MBS
57
Specified Pools: Quoted as price payups vs TBAs
Source: JPMorgan MBS Pricing and Analytics Package, May 12, 2009
INTRODUCTION TO MBS
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Valuing loan balance and geographic pools
INTRODUCTION TO MBS
59
Loan Attribute: WALA (Loan Age) Prepayment Convexity Improves With the Passage of Time
WALA (weighted average loan age) measures time elapsed in months from when borrowers took out the loan Seasoned Premiums: slower prepayments Seasoned collateral that has been in-the-money for an extended period of time is considered to have burnout Pools will start to slow-down as the most negatively convex, or the most reactive, borrowers prepay out of the pool The surviving borrower population is less reactive to rates and can have more desirable attributes such as lower loan balances Seasoned Discounts: faster prepayments
Home tenure is how long a borrower has been in the current home Longer the home tenure, more likely a borrower will move, leading to faster speeds Monetize equity gains in their homes and curtail their loan Built-in equity enables faster turnover speeds via increased mobility (trade-up), greater cash-out activity, and flexibility to refinance to different product types
INTRODUCTION TO MBS
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Loan Attribute: WALA (Loan Age) Prepayment convexity improves with the passage of time
One month CPR versus Rate Incentive, in 2005~2006
50
0~12 mo 12~24 mo 24~36 mo > 36 mo Seasoned discounts prepay faster than new issues Burnout: seasoned premiums slow down.
40 1mo CPR, %
30
20
10
0 -200
-150
-100
-50
50
100
150
200
Rate Incentive, bp
Source: JPMorgan, Fannie Mae
INTRODUCTION TO MBS
61
Seasoned Discounts: Fundamental value increases as dollar prices decline
Fair value payups by WALA for discount TBAs at different price levels, assuming constant libor static Z spread to TBA.
30 25 20 15
$93 TBA $96 TBA $98 TBA
10 5 0 0 10 20 30 40 50
INTRODUCTION TO MBS
62
Loan Attribute: Loan Size The Lower the Loan size, the Slower the Speeds
Borrowers with lower loan balances have less incentive to refinance the fixed costs of refinancing represent a larger percentage of their monthly savings
Loan Balance S-Curves

Monthly Breakevens Refinancing from a 7% to 6% Rate
50 45 40 1-month CPR 35 30 25 20 15 10 0 20 40 60 80 Rate Incentive, bps 100 120 140
Loan Monthly Months Size Savings to BE $ 65,000 $ 34 59 $ 100,000 $ 52 38 $ 130,000 $ 68 29 $ 300,000 $ 158 13 *assumes $2,000 Closing Costs
"TBA" Generic HLB (150k MAX) MLB (110k Max) LLB (85k Max)
INTRODUCTION TO MBS
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Loan Attribute: Geography It is not just HPA

Regional prepayment differences are due to Housing market Demographics & economy Taxes and fees New Yorks mortgage recording tax is >2% in the metro area and >1% in the rest of the state Other states with mortgage tax: Alabama, Florida, Georgia, Maryland, Minnesota, Oklahoma, Tennessee, Virginia
Other factors Cashout refinancing restrictions in Texas Borrowers can only cash-out refi once per year Cash-outs can only go to 80 LTV max
INTRODUCTION TO MBS
64
Relative value strategies and analysis
Trading Strategies Trading Strategies
Mortgage - Swap basis Mortgage - Tsy basis Coupon swap 15s / 30s Ginnie / Fannie TBA / Seasoned Agency / Non-agency Pass-through / ARM
Evaluation Approaches Evaluation Approaches
OAS Spread Hedge-Adj Carry Regressions Deliverable Sponsorship
CMO / Collateral
INTRODUCTION TO MBS
65
INTRODUCTION TO MBS
66

JPM - Mbs Primer

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JPMORGAN MBS PRIMER

MBS Strategy Matt JozoffAC 212-834-3121

JPMORGAN MBS PRIMER

Market Overview and Origination

Mortgage Cashflows and Intro to Prepayments

Valuation and OAS

Prepayment Analysis and Reports

TBA Market and Specified Pools

JPMORGAN MBS PRIMER

MBS in the U.S. fixed income market

Asset-backed 8% Money Market 11%

U.S. Treasury 18%

Fed Agencies 10%

Mortgage Related 26%

Total = $30.8 trillion

Agency MBS market composition and issuance

2003Total = $__mm 2006 2004 2005

Source: JPMorgan, FNMA, FHLMC, GNMA As of December 2009

30-year ($3.93 trillion) 76%

Total = $5.16 trillion

Source: JPMorgan, FNMA, FHLMC, GNMA As of December 2009

MARKET OVERVIEW AND ORIGINATION

Source: Federal Reserve Board * As of 1Q2009

Current Coupon Pass-through Yield Average of 5 and 10 yr UST Yields

3 2 1 1997 2001 2005 2009

Securitization and the money flow of pass-throughs

Agency Backed Securites

Defaults Servicing Fee Guarantee Fee

The MBS market links borrowers and investors

MARKET OVERVIEW AND ORIGINATION

Origination: The Menu of Mortgages Has Expanded

MARKET OVERVIEW AND ORIGINATION

Understanding Mortgage Collateral : Borrower Credit & Housing Leverage

MARKET OVERVIEW AND ORIGINATION

Understanding Collateral cont

MARKET OVERVIEW AND ORIGINATION

Market Overview and Origination

Mortgage Cashflows and Intro to Prepayments

Valuation and OAS

Prepayment Analysis and Reports

TBA Market and Specified Pools

JPMORGAN MBS PRIMER

Major MBS investors

Public Pension Funds Priv. Pension 4% Funds 4% State/Local government 4%

Remaining Investors 12%

Fannie Mae/Freddie Mac 16%

Commercial Banks 16%

Pension Funds 7% Other Investors* 8% Foreign Investors 14%

Source: Inside MBS & ABS

Mutual Funds 15%

Total = $6.79 trillion

250 200 150 100 50 0 -50 Foreign GSE Bank

Net Purchases ($ billions, annual)

Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan * As of YE 2008.

Jan Feb Mar Apr May Jun Jul Aug Sep

*As of Sep 9, 2009

Source: JPMorgan, Federal Reserve

Unique role of Fannie and Freddie: issuer / investor

Agency Portfolio Growth, 2000-2009

Source: FNMA, FHLMC, JPMorgan As of July 2009

Top 20 banks ranked by MBS portfolios as of 2Q2009

Source: JPMorgan, Federal Reserve