(Bank of America) Outlook For The RMBS Market in 2007

RMBS Trading Desk Strategy
Outlook for the RMBS Market in 2007 December 27, 2006
Sharad Chaudhary Review of 2006: Mortgages had a Great Year (p. 2)

212.847.5793
sharad.chaudhary@bankofamerica.com
Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 21-
25 ticks in 2006. Heavy net production of fixed-rate agency MBS and strong
growth in MBS holdings of overseas investors and domestic money managers
RMBS Trading Desk Strategy characterized supply and demand technicals in the mortgage market in 2006. The
Ohmsatya Ravi mortgage basis has also benefited enormously in 2006 from swap spread tightening,
212.847.5150 the decline in implied volatilities and very low realized volatilities. While relatively
ohmsatya.p.ravi@bankofamerica.com
fast discount prepayment speeds and muted premium speeds were observed in
Qumber Hassan 2006, sharp declines in HPA and the consequent mortgage credit issues started to
212.933.3308 attract the market’s attention by the end of the year.
qumber.hassan@bankofamerica.com
Major Themes Relevant for the RMBS Market in 2007 (p. 4)
Sunil Yadav We expect a range-bound rates market, slightly lower but still substantial net supply
212.847.6817
sunil.s.yadav@bankofamerica.com of agency fixed-rate MBS, heavy demand for MBS from overseas investors and
domestic money managers, 2%-3% CPR slower discount prepayment speeds and
Ankur Mehta mortgage credit to continue to make headlines in 2007. Bank portfolios of
212.933.2950
mortgages should record very modest growth, if any, in 2007.
ankur.mehta@bankofamerica.com
Agency Pass-throughs: Valuations and Recommended Positioning (p. 27)

RMBS Trading Desk Modeling 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
ChunNip Lee
212.583.8040 recommend an overweight on the mortgage basis to real money managers because
chunnip.lee@bankofamerica.com 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
Marat Rvachev 5s and 6s, 15-yr MBS versus 30-yr MBS, and 15-yr 4.5s and 6s versus 5s and 5.5s.
212.847.6632
marat.rvachev@bankofamerica.com Hybrid ARMs: Valuations and Recommended Positioning (p. 33)
Vipul Jain Hybrids are attractively priced relative to the fixed rate sector with 5/1s offering
212.933.3309 more than 30 bps in OAS pickup relative to 15-yrs. However, based on our macro
vipul.p.jain@bankofamerica.com
picture – range bound interest rates, low realized volatility and lack of surge in
implied volatilities – much like this year, we expect hybrids to lag fixed-rate MBS
in 2007. However, from a short term perspective, we recommend a tactical
overweight on the hybrid basis due to favorable technicals caused by the inclusion
of agency hybrids in the US aggregate Index and the seasonal low in ARMs
issuance.
This document is NOT a research report under U.S. law and is NOT a product of a fixed income research department. This 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.
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:
• Heavy net production of fixed-rate agency MBS

• Strong growth in MBS holdings of overseas investors and domestic money
managers
The mortgage basis had a great • Continued declines in implied volatilities and very low realized volatilities
year. • Relatively fast discount prepayment speeds (but slower than the discount speeds
in 2005) and muted premium speeds
• Sharp slowdown in home price appreciation and higher delinquencies on new
origination mortgage pools relative to older cohorts
• Higher servicing spreads being retained by servicers on their books
• Strong outperformance of 30-yr MBS versus 15-yrs and hybrid ARMs as
investors rushed to sell convexity which helped the 30-yr sector more than others
• Positive net production of GNMAs and the dramatic cheapening of GN/FN swaps
One of the biggest surprises associated with the mortgage market in 2006 was the strong
supply of agency fixed-rate passthroughs. We estimate that net supply of fixed-rate agency
MBS (gross issuance less pay-downs) totaled $254 billion in 2006 versus $110 billion in
Net supply of agency fixed-rate 2005 and a negative $27 billion in 2004. This net supply is substantially higher than what
MBS was very high. 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
Overseas investors and
domestic money managers domestic money managers. As we have repeatedly commented before, historically net
provided a firm bid for MBS. 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.
More than 60% of the mortgage The mortgage basis also benefited enormously in 2006 from the sharp decline in implied
outperformance versus swaps is volatilities and very low realized volatilities. In fact, we attribute more than 60% of the
due to declines in volatilities. outperformance of mortgage basis versus swaps this year to declines in implied volatilities.
2
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
Relatively fast discount speeds slowdown in 2006, is the fact that these pools had already seen fairly solid equity growth
and muted premium speeds from the previous year. On the other hand, slower speeds of deep in-the-money pools can
characterized prepayments in
be attributed to weaker borrower characteristics with higher spreads at origination (SATO)
2006.
for these pools. On the hybrid ARMs side, the market’s 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 market’s 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
Servicers are retaining more GWAC of 6.25% versus 5.96% 1-yr ago. On average, the spread between the aggregate
interest cash flows on their
GWAC and the net coupon of new production 30-yr mortgage pools was close to 47-48 bps
balance sheets.
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
30-yrs outperformed 15-yrs and than 15-yrs and hybrid ARMs from low realized volatilities and sharp declines in implied
hybrid ARMs. 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
GN/FN swaps have cheapened supply in GNMAs coupled with the increased comfort level of overseas investors with the
by more than 1-point from their MBS backed by the GSEs caused this sharp cheapening of GNMAs versus conventional
peak levels. 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.
3
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 4Q’05.
• Domestic Banks: Excluding the impact of Golden West’s 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.
4
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 4Q’05.1
Figure 1: Range of 10-yr CMT Yields in Each Year
Long-term interest rates were in 2000 2001 2002 2003 2004 2005 2006
a very narrow range over the Max 6.79 5.54 5.44 4.61 4.89 4.66 5.25
past 3 years.
Min 5.02 4.22 3.61 3.13 3.70 3.89 4.34
Range (bp) 177 132 183 148 119 77 91
Source: Banc of America Securities
Looking ahead to 2007, we believe that the expected and realized ranges of interest rates
over the year will have a significant impact on mortgage performance versus other asset
classes. These factors are more important for the MBS market now than before because of
the shift in the marginal buyer base for MBS. When the GSEs were marginal buyers of
MBS, mortgage valuations in terms of OASs (with respect to the agency curve) were more
important than realized and implied volatilities of interest rates because the GSEs would
actively hedge volatility exposure in their portfolios. Similarly, these factors were less
important when banks were marginal buyers because their funding costs were very 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
We expect only a single 25 bps of the year (with the risk skewed towards a slightly steeper curve). Our estimates are based
Fed easing in 2007. 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 Fed’s 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 market’s expectations for a 4.72% funds rate by the end of 2007
(or two to three 25 bps easings in 2007). The biggest risk to our rates view comes from the
1
We discuss the relative performance of mortgages versus swaps with different interest rate shifts in the following section.
5
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 week’s levels) and the 2s/10s swap spread
Mortgages should benefit from
curve to flatten in 2007.2 Because mortgage spread movements tend to follow swap spreads
the 8-9 bps tightening of 10-yr
swap spreads we are forecasting rather closely – for instance, a substantial portion of the mortgage outperformance versus
Treasuries over the past 2 months can be attributed to swap spread tightening – we expect
mortgages to outperform Treasuries in 2007 due to swap spread tightening alone.
Realized Volatility Should Remain Very Low

The negative convexity of mortgages implies that they will outperform positively convex
assets like Treasuries and non-callable agency and corporate bonds when realized 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
Jan-02
May-02
Jan-03
May-03
Jan-04
May-04
Jan-05
May-05
Jan-06
May-06
Sep-02
Sep-03
Sep-04
Sep-05
Sep-06
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
10-yr Treasury yields should
level. We do not expect the 10-yr Treasury to rally below 4.35% as long as the Fed funds
remain in the 4.35%-5.15%
range and realized volatility rate is at or above 5% and there are no hints of the Fed embarking on an easing cycle.
should be very low in 2007. 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
2
See Global Rates Focus report dated December 14, 2006
6
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 80
60-day Realized Vol (bp)

5.8 10-yr Swap Rate 60-day Realized Vol
10-yr Swap Rate (%)
70
5.6
60
5.4
50
5.2
5.0 40
07/03/06
08/01/06
08/29/06
09/27/06
10/26/06
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 don’t 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.
7
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
Implied volatilities are near negative convexity of the mortgage universe is very high, marginal buyers of MBS are not
their 8-yr lows but all the convexity hedgers. Second, as long-term interest rates have moved in a very narrow range
factors that resulted in lower over the past three years and the market still expects long-term rates to remain range-
volatilities are still in place.
bound, there is very little demand for hedging interest rate exposure of fixed-income
portfolios. Third, there is less motivation for buying interest rate protection in a flat yield
curve environment and because of this, implied and realized volatilities tend to be lower
when the curve is flat. Given that these factors are still in place, we do not expect implied
volatilities to jump up substantially from their multi-year lows any time soon.
Figure 4: History of the Implied Volatility of 3yr*7yr Swaption
150
135
Implied Volatility (bps)
120
105
90
75
60
May-98
May-99
May-00
May-01
May-02
May-03
May-04
May-05
May-06
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.
8
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
Should we expect fixed-rate
forecast this number with any degree of certainty. As we will discuss in detail later, the
agency MBS supply to remain
as strong as it was in 2006? 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, let’s begin with an examination of the fundamental forces that result
in the growth of outstanding home mortgage debt. In general, the net supply of mortgages
is driven by four forces:
• Household Growth. An increase in the number of households because of

population growth;
• Increases in Homeownership Rates. An increase in the number of people

owning a house versus renting;
• Home Price Increases. An increase in the value of homes so that for the same
LTV, you require a larger mortgage; and
• Increase in LTV Ratios. An increase in borrower leverage. For example, a cash-

out refinance results in the net creation of mortgage debt since the new mortgage
is larger than the old one.
Figures compiled by the Federal Reserve show that the net supply of all home mortgages4
has averaged between $800 billion to $1 trillion dollars per year since 2003 (Figure 5).
Over this period, the annualized growth rate of home mortgage debt has ranged from 8%
to 14%. By far, the most important contributors to these growth numbers have been the
The amount of equity cashed increase in home prices in conjunction with increases in LTV ratios accomplished through
out by prime conventional cash-out refinancings. The importance of cash-out refinancing in terms of creating new
mortgage holders soared to mortgage debt is summarized in Figure 6. Notice the remarkable strength of the numbers
$296 billion in 2006. 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
Including 15-years, 20-years, 30-years and 10-20 IOs.
4
Mortgages on 1-4 family properties.
9
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 Mac’s 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
10
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
We project the net issuance of
shows, there was negative net issuance of agency fixed-rate MBS in 2004. While some of
agency fixed-rate MBS in 2007
to total $220 billion. this was due to the increase in the popularity of ARMs as affordability issues began to
show up in the mortgage market, many conforming balance agency-eligible loans were
siphoned off into the non-agency alt-A sector over this period. The rebound in agency
fixed-rate MBS supply over the past two years can be at least partly attributed to the
progress made by Fannie Mae and Freddie Mac on their accounting and financials. We
expect this trend to continue in the next year. Another factor that will help fixed-rate
supply is the flat FRM-ARM slope which we expect to persist into next year. A more
moderate home price environment and a small FRM-ARM term premium will steer more
purchase borrowers towards a fixed-rate mortgage. Similarly, a large volume of resetting
ARM borrowers in 2007 should also gravitate towards fixed-rate mortgages for the same
reason. Obviously, the same factors should lead towards ARM supply decreasing in 2007.
The trends and forecasts detailed above are collected in Figure 7.
Figure 7: Trends and Forecasts for the Housing and Mortgage Markets
2003 2004 2005 2006 (E) 2007 (F)
Home Price Appreciation (%) 7.8 11.9 13.4 5.7 3
ARM Share of Applications (%) 19 32 31 28 24
Growth in Home Mortgage Debt (%) 14.3 14.1 13.8 8.9 7

Net Issuance of Home Mortgages ($bb) 801 1055 1135 835 715
Net Issuance of Agency Fixed-rate MBS ($bb) 227 -27 110 254 220
Net Issuance of Agency ARM MBS ($bb) 79 81 53 42 36
E denotes an Estimate and F denotes a Forecast.

Sources: OFHEO, MBA, Federal Reserve Board, Banc of America Securities. All estimates and forecasts by
Banc of America Securities.
Overseas Investors
• We estimate that overseas investors have been net buyers of $288 billion agency
debt and MBS in 2006. Based on our forecast for a slightly lower trade deficit and
a weaker dollar versus other currencies, we expect combined net overseas
investor purchases of agency debt and MBS to decline slightly in 2007.
• Most of the negative impact from potential FX diversification by overseas central

banks on their MBS holdings should be offset by their willingness to rotate funds
out of Treasuries into agency debt and MBS.
• We estimate that the net purchases of agency MBS by overseas investors in 2007
will be $150-$170 billion which is slightly higher than their net purchases in 2006.
11
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
Net overseas investor purchases over the past few years. Based on our forecast for a slightly lower trade deficit and weaker
of agency debt and MBS should dollar versus other currencies, we expect combined net overseas investor purchases of
decline slightly in 2007. 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-$280 billion agency debt and MBS in 2007.
Figure 8: Net Overseas Investor Purchases of Long-term Agency Debt and MBS
320
280
240
Net Purchases ($BB)
Actual Purchases Model Purchases
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.
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
MBS holdings of overseas
investors as a percentage of 3 years. For instance, the fraction of agency MBS in total agency debt and MBS holdings
their combined agency debt and of overseas investors rose from 25% in 2003 to 33% in 2005 (the latest year for which the
MBS portfolios have been data are available). We ascribe this trend to the following three factors: a) Reducing
gradually increasing. 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.
5
2006 numbers have been extrapolated based on the data from January to October.
12
Figure 9: Overseas Holdings of Long-term Agency Debt and Agency MBS
2003 2004 2005

Agency MBS ($bb) 149 176 264
Agency Debt ($bb) 437 447 527
Fraction of MBS (%) 25.4% 28.3% 33.4%
Data as of June of each year

Source: Treasury, Federal Reserve
Because the combined net overseas investor purchases of agency debt and MBS are likely
We estimate that overseas to remain close to this year’s level (albeit slightly lower) and we expect the fraction of
investors will be net buyers of overseas investor purchases of agency MBS in this total to continue to rise, we expect
$150-$170 billion agency MBS overseas investors to provide a strong bid for MBS in 2007. We estimate that the net
in 2007.
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 4Q’05, 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
Mortgages are rich in LOAS
terms, but they should easily expectations for interest rates and volatilities. In Figure 10, we show the expected
outperform swaps if interest outperformance of MBS investments versus equal dv01 swaps in different interest rate
rates remain within our scenarios by the end of 2007 (assuming mortgage LOASs remain unchanged). We can see
projected range. 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 doesn’t even account for a few basis points of likely additional gains from
roll specialness.
13
Figure 10: Excess Returns on MBS over Equal dv01 Swaps with Different Parallel
Shifts of Interest Rates by the end of 2007 (Dollars / $100 Face Value)
TBA -1.00% -0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00%
FNCL 5 (0.49) 0.05 0.38 0.55 0.56 0.44 0.23 (0.06) (0.40)
FNCL 5.5 (0.48) 0.13 0.55 0.77 0.79 0.63 0.32 (0.11) (0.63)
Another factor in favor of mortgages is that mortgage spreads still look attractive relative 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
Mortgages look somewhat

attractive versus corporates. 80
60
40
Jul-04
Jul-05
Jul-06
Jan-04
May-04
Nov-04
Jan-05
May-05
Nov-05
Jan-06
May-06
Nov-06
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Tsy Z-spread of CC MBS Tsy Z-spread of AA&A Corporate Debt
Notice that mortgage spreads were very wide relative to spreads on corporate bonds back in
Nov’05 – Dec’05. 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 2H’06, 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%.
6
Please see the Credit Market Strategist report dated December 15 for more details.
14
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 West’s 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.
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
Large bank holdings of MBS MBS grew by $27 billion while their whole loan holdings rose by $40 billion in 2006.
have declined by $62 billion Bank holdings of mortgages grew very rapidly until August, but have stalled since then. In
since peaking in late August. 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
The deposit base of large banks
is not growing. (“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
There is very little spread
the deposit growth, the marginal cost of funding for banks to buy MBS is much higher than
between mortgage yields and
the marginal cost of funds for their average cost of funds. We believe that there is very little spread between current
banks. coupon mortgage yields and the marginal cost of funds for banks to buy MBS at the
moment. Thus, from a carry perspective, banks should have very little incentive for
growing their MBS portfolios.
Third, at current dollar prices, we estimate that a substantial portion of MBS purchases by
banks in 2006 (which total $125-$135 billion based on the YTD net purchases and
estimated pay-downs) are in-the-money at the moment. Therefore, banks could shed
mortgages if the current situation with deposits and C&I loans persists without having to
worry about recognizing losses in their income statements. This is unlike the situation in
June/July 2006 when unrealized losses on their books were very high at $24 billion.
7
Please note that the deposit growth numbers in the table include growth from Golden West acquisition and give a misleading picture.
15
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
We project a very modest
grow their MBS portfolios in 2007. At the same time, we do not expect banks to actively
growth in bank holdings of
MBS and whole loans in 2007. 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 doesn’t keep pace with the C&I loans.
Figure 12: Large Bank Holdings of Mortgages, C&I Loans and Deposit Growth
2006
Large Banks As Reported Excl. Golden West 2005 2004 2003 2002 2001
Net Mortgage Purchases
MBS 65 27 35 97 36 44 84
Whole Loans 148 40 73 12 45 102 -14
Total Net Mortgages 213 67 107 108 82 146 69
C&I Loan Growth 49 46 45 2 -41 -58 -72
Deposit Growth 104 36 157 226 128 118 101
All numbers are in billion dollars

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.
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
Agency portfolio size should changes in the GSE portfolios have supported our assertion to some extent. However,
remain unchanged in 2007. going forward the cap should be much less of an issue assuming our expectations of long-
term rates not rallying by more than 25 bps from their current levels in 2007 are justified.
In the base case, we expect the size of the agency portfolios to remain unchanged next 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-
16
traditional mortgages. It is likely that the GSEs will direct a portion of pay-downs on
We expect GSEs to be net subprime MBS into agency mortgages. Based on our estimates that the GSEs own about
buyers of $25-$35 billion of $250 billion subprime MBS and that prepayment speeds on these products are in the 40%-
agency mortgages in 2007. 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 2005 2004 2003 2002
Subprime Purchases 169 176 81 38
All numbers are in billion dollars

Source: OFHEO, Banc of America Securities
From the valuations side, we show the history of the OAS of the 30-yr current 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
CC MBS may have to widen 5-
10 bps for the GSEs to buy 30-yr mortgages at current valuations but mortgage spreads need to widen by no more than
fixed-rate MBS. 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

20
10
A gency OAS (bp)
-10
-20
1/3/2005
3/2/2005
4/28/2005
6/27/2005
8/23/2005
10/20/2005
12/19/2005
2/16/2006
4/17/2006
6/13/2006
8/9/2006
10/05/06
12/4/2006
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 shouldn’t
be an issue for the market in 2007.
The negative convexity of mortgage market has worsened a lot over the past 5-6 months
17
(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.
In our view, convexity hedging activity will have a heavy impact on rates, volatility and
Interest rates need to rally 60-
70 bps for convexity hedging MBS markets only if another refinancing wave is initiated. Based on the current GWAC
activity to become important. 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

230
$ billion 10-yr Tsy equivalents
200
170
140
110
6/20/2006 12/22/2006
80
50
-100 -75 -50 -25 0 25 50 75 100
Interest Rate Shift from the Base Case (bp)
Outlook for Prepayment Speeds in 2007

• For the range bound rate scenario during 2007, the out-of-the money and at-the-
money 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.
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
Relatively fast discount speeds years for various incentives in Figure 16. Overall, the prepayment experience during 2006
and muted premium speeds
resembled the 2005 experience i.e. relatively fast discount speeds and muted premium
characterized prepayment
speeds in 2006. 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.
18
Figure 16: FNCL Prepay Response Curves Over the Past 5 years (12-24 WALA)
80
70
60
50
CPR (%)
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
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
Recent slower speeds for ITM
pools can be attributed to a years can be clearly seen in Figures 17. It shows that 12-24 WALA pools with 100 bps of
weaker borrower profile. incentive during 2006 had average FICO score of 655 and OLTV of 82%, suggesting that
borrowers in theses pools belonged to the lower end of the credit spectrum. In contrast,
FICO score ranged between 700-720 and OLTV was closer to 75% for 100 bps in-the-
money pools during the earlier periods (a mainstream prime borrower).
Figure 17: FICO Scores and OLTV for FNCL Pools by Incentive Over the past 5 years (12-24 WALA)
800 90
780
760 85
740
80
720
OLTV (%)
FICO
700 75
680
70
660
640
65
620
600 60
-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 -150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200
Incentive (bps) Incentive (bps)
2003 2004 2005 2006 2003 2004 2005 2006
Additional factors that determine premium speeds only dampened in 2006. For example,
the12-24 WALA pools that were in-the-money during 2006 had roughly 14% lower loan
sizes (see Figure 18) and at the macro level the media effect was virtually non-existent in
2006.
19
Figure 18: ACLS for FNCL Pools by Incentive Over the Past 5 years (12-24 WALA)
220
200
180
Lower loan sizes, higher LTVs
ACLS (000s)
160
also dampened premium 140
speeds.
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
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
8
CPR (%)
0
2002 2003 2004 2005 2006
Year
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
20
statistics released by Freddie Mac provides credence to this hypothesis as it indicates that
The robust discount speeds are cash-out activity during 2006 was at an all time high on an absolute dollar amount basis
due to the solid equity growth and the cash-out borrowers were willing to pay slightly higher mortgage rates (2%, 8%,
these pools have experienced. 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
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
Discount speeds for 2006 speeds during 2006 for 12-24 WALA FNCL pools. Our estimate of the potential drop in
originations could be 2%-3% speeds for recent originations is based on three different computations. First, we use
CPR slower.
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.
21
Figure 21: Prepayment Speeds in 2006 for 12-24 FNCL Pools by Annualized EGSO
14
12
2006 Average
10
CPR (%)
6
0
5 10 15 20
HPA (%)
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 don’t 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.
If interest rates rally 50 bps, Our expectation in such a scenario is that prepayment speeds could shoot up to 45% CPR
100 bps ITM pools could for 100 bps ITM 30-yr fixed rate agency pools. The reasons for this expectation are two
prepay substantially faster than
what were observed in 2006 fold. First, the collateral characteristics of the pools with 100 bps of incentive will be much
with similar incentive. 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.
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
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
22
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 Dec’2002, it will be much closer to Dec’2003 and Dec’2004 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
70
60
50
40
30
20
10
-
25
5
25
75
5
12
17
22
27
32
-7
-2
-1
Ince ntiv e (bps)
200212 200312 200412

200512 200612 200612 - 50bps rally
Outlook for Mortgage Credit in 2007

• We believe that residential mortgage credit will continue to make negative 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.
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 alt-
A ARMs. What stands out is the significantly faster ramp up in delinquencies of recently
2006 vintage alt-A ARMs is the originated alt-A ARM loans as compared to the earlier vintages, and rise in early payment
worst performing vintage from defaults during 2006. In fact, the 2006 vintage of alt-A ARMs (excluding Option ARMs) is
the past 4 years.
the worst performing (90+ delinquencies) vintage from the past 4 years and early payment
Furthermore, the credit performance of alt-A ARM loans from California is close to the US
23
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 % Balance
Year ('000s) FICO Cashout Purchase Doc OLTV Seconds NegAm (ARM) (Fixed) 40Yr (Billion $)
2000 311 719 13 75 62 72 - 5 3 0 0 62
2001 386 725 24 38 66 66 - 1 3 0 0 162
2002 385 728 24 32 60 63 1 2 8 0 0 224
2003 351 728 24 32 52 62 10 1 15 1 0 307
2004 312 720 26 51 42 68 24 12 34 2 0 406
2005 328 720 35 50 32 70 30 27 27 10 2 465
2006 353 717 35 49 23 71 37 30 26 12 7 218
Source: LoanPerformance
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
We expect home prices to stay existing home sales are leveling off. Furthermore, home builders have reacted promptly to
flat in real terms or up 2%-3% the housing slump by lowering the construction of new homes which will further support
in nominal terms. 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
2006 alt-A ARM cohort is
portion of the alt-A universe in 2000) were close to 5.9% and cumulative losses were 69
underperforming the 2000 alt-A
fixed cohort. 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
8
Please have a look at our RMBS Trading Desk Strategy report from Dec 8, 2006 for a comprehensive review of recent credit performance.
24
underperforming the 2000 alt-A fixed cohort.
Figure 25: 90+ Delinquencies for Recent alt-A ARM Cohorts versus 2000 alt-A
Fixed
20
16
90+ Delinquency (%)

12
0
0 5 10 15 20 25 30 35 40 45 50
WALA (months)
2003 alt-A ARM 2004 alt-A ARM 2005 alt-A ARM

2006 alt-A ARM 2000 alt-A Fixed
Source: LoanPerformance
Summary of Major Themes Relevant for the RMBS Market in 2007

• Interest rates are likely to remain range bound. Realized volatility will stay low
and implied volatilities are unlikely to move higher from their multi-year lows.
Swap spreads should tighten 4-9 bps from their current levels.
• Net supply of fixed-rate agency MBS is likely to decline from 2006 levels.
However, the decline should be modest because of ARM-to-fixed refinancings,
stabilization of the housing market and continued strong cash-out refinancings.
• Overseas investor purchases of MBS are likely to grow further due to the
substitution of Treasuries and agency debt by MBS and our projection for only a
marginal decline in trade deficit.
• We expect domestic money managers to continue to provide a strong bid for 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 West’s 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 range-
bound next year, we do not expect banks to actively shed mortgages in 2007, but
we expect only a very modest growth in bank holdings of MBS and whole loans.
• The trend of the GSEs substituting agency mortgages by subprime mortgages 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
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
26
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 doesn’t 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
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
0
LOAS (bp)
-5
-10
-15
-20
Jul-05
Jul-06
Jan-05
May-05
Nov-05
Jan-06
May-06
Nov-06
Mar-05
Mar-06
Sep-05
Sep-06
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 fixed-
rate agency mortgage pools has increased substantially. For instance, new production 30-
year FNMA 6s pools have a GWAC of 6.67% versus 6.48% 1-year ago. Similarly, new
production 30-year FNMA 5.5s pools have a GWAC of 6.25% versus 5.96% 1-year ago.
On average, the spread between the aggregate GWAC and the net coupon of new
production 30-year mortgage pools was close to 47-48 bps in 2003 and 2004 versus the 56
bps spread over the past one year. We believe that originators/servicers retained more
interest cash flows on their balance sheets as the MBS market came out of a significant
Refi wave and the media-effect subsided. In addition, originators/servicers may be taking
advantage of FAS 156 which allowed mark-to-market accounting treatment for servicing
rights.10
Another collateral characteristic that has changed significantly over the past 1-year is the
9
We first wrote about this issue in our weekly report dated 10/27/2006.
10
See our weekly report dated April 21, 2005 for details about FAS 156.
28
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.
29
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.
30
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 Equal OAS Price GN I/ FN Swap GN II/ FN Swap
30-yr TBA Price OAS GNSF G2SF Model Actual Model Actual
5.0s 97-19+ -14.4 97-27+ 97-24+ 8 21 5 9
5.5s 99-19+ -17.7 99-31+ 99-27+ 12 18+ 8 11+
6.0s 101-04 -21.2 101-19+ 101-20 15+ 19 16 12+
6.5s 102-03+ -17.3 102-16 102-21+ 13+ 23 18 11+
All numbers were as of 12/12/2006. GN/FN swaps have gained 3-5 ticks since then.
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
31
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 2005 Cohort
50
40
FNCL GNSF G2SF 40
FNCL GNSF G2SF
30
CPR (%)
30
CPR (%)
20
20
10
10
0
0
-100 -75 -50 -25 0 25 50 75 100
-100 -75 -50 -25 0 25 50 75 100
Incentive (bps)
Incentive (bps)
32
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.
33
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
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.
Prepayments Around Reset

• The market’s 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.
34
The market’s 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
CPR (%)
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)
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
13
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.
35
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 $40 billion of agency and prime non-agency 5/1s to reset in
2007 and 2008 respectively.
Figure 31: Prepayment Speeds of Seasoned Agency vs. Non-Agency 3/1s around Reset
(Based on 2006 Factor Dates)
100
90
80
70
CPR (%)
60
50
40
30
20
10
30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52
WALA (months)
Jumbo Agency Alt A
Source: Banc of America Securities, LoanPerformance
Figure 32: Prepay Speeds of Seasoned Agency 5/1s Around Reset (07/05 -09/06)
90 1,600
80 1,400
70 1,200
Current Balance ($MM)
60 1,000
CPR (%)
50 800
40 600
30 400
20 200
10 -
55 56 57 58 59 60 61 62 63 64 65
2% Cap - Bal 5% Cap - Bal 2% Cap - CPR 5% Cap - CPR
36
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%
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
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 0 25 50 75
Incentive (bps)
Steep Curve / High HPA Flat Curve / High HPA

Steep Curve / Low HPA Flat Curve / Low HPA
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-to-
FRM 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 S-
curve, but affects valuations.
For estimating the effect of a potential curve steepening on prepayments in 2007, we focus
38
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
Bal Slope* Cum EGSO
HPA Curve Incentive CPR ($MM) (bps) (%)
High Steep -125 26.1 4,596 154 31
High Steep -100 24.4 15,781 163 31
High Steep -75 25.6 27,722 163 32
High Steep -50 26.5 42,268 168 32
High Steep -25 29.1 45,697 176 32
High Steep 0 32.1 36,159 184 31
High Steep 25 38.2 20,481 195 32
High Steep 50 40.5 9,950 216 29
High Steep 75 48.2 3,968 234 28
High Flat -125 17.7 23,188 9 34
High Flat -100 18.3 58,217 12 31
High Flat -75 20.4 72,487 16 31
High Flat -50 22.8 64,957 19 30
High Flat -25 26.5 43,870 24 30
High Flat 0 31.5 25,283 27 28
High Flat 25 35.5 12,824 34 26
High Flat 50 43.7 4,176 41 25
High Flat 75 45.2 1,090 44 25
Low Steep -125 14.3 1,243 154 6
Low Steep -100 14.6 3,361 165 6
Low Steep -75 16.4 5,332 165 6
Low Steep -50 15.7 7,660 172 6
Low Steep -25 18.4 6,924 179 6
Low Steep 0 20.7 4,855 186 6
Low Steep 25 22.9 3,022 200 6
Low Steep 50 29.4 1,395 222 5
Low Steep 75 34.1 556 240 5
Low Flat -125 12.2 4,487 11 7
Low Flat -100 11.4 10,800 13 6
Low Flat -75 11.8 13,060 14 6
Low Flat -50 13.2 10,803 19 6
Low Flat -25 15.0 7,120 23 7
Low Flat 0 15.6 4,064 25 6
Low Flat 25 19.2 1,868 34 6
Low Flat 50 23.2 500 46 6
* 10yr - 2yr Slope
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
15
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.
16
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.
39
Figure 36: Non-agency Option ARM Prepayment Speeds by Origination Year
No Prepay Penalty MTA Option ARMs
2002 2003 2004 2005 2006

70 250
60 200
50
150
Slope (bps)
CPR (%)
40
100
30
50
20
10 0
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
1yr Prepay Penalty MTA Option ARMs
2002 2003 2004 2005 2006

70 250
60 200
50
150
Slope (bps)
CPR (%)
40
100
30
50
20
10 0
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
3yr Prepay Penalty MTA Option ARMs
2002 2003 2004 2005 2006

45 250
40
200
35
30 150
Slope (bps)
CPR (%)
25
100
20
15 50
10
0
5
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
40
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.
41
Figure 37: Volume of Purchase Loans in the Monthly Agency Hybrid ARM Issuance
11 600
10 550
500
9
MBA Purchase Index

Issuance ($bn)
450
8
400
7
350
6
300
5 250
4 Jan-03 200
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Apr-03
Oct-03
Apr-04
Oct-04
Apr-05
Oct-05
Apr-06
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
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
42
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
20
CPR (%)
15
10
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
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
43
(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
Margin OAS Credit

Rating Index (bps) Delay Day-Count (bps) Enhancement
AAA MTA 75 24 30/360 32 30%
AAA Mezz MTA 85 24 30/360 39 10%
AAA LIBOR 1M 18 0 30/360 18 46%
AAA Mezz LIBOR 1M 24 0 Actual/360 24 20%
AAA Lower Mezz LIBOR 1M 28 0 Actual/360 28 10%
44
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45

(Bank of America) Outlook For The RMBS Market in 2007

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(Bank of America) Outlook For The RMBS Market in 2007

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RMBS Trading Desk Strategy

Outlook for the RMBS Market in 2007 December 27, 2006

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

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

• Heavy net production of fixed-rate agency MBS

II. Macro Themes Relevant for the RMBS Market in 2007

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

• Domestic Banks: Excluding the impact of Golden West’s acquisition, deposits on

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

Interest Rates and Volatilities

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

Range (bp) 177 132 183 148 119 77 91

Source: Banc of America Securities

Realized Volatility Should Remain Very Low

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

Source: Banc of America Securities

60-day Realized Vol (bp)

Source: Banc of America Securities

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

Mortgage Supply Technicals

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

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

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

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

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

Annual Net Supply ($bb)

E denotes an estimate and F a forecast.

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

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

• Cash-out Equity volume: Freddie Mac’s estimates have cash-out volume

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

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

E denotes an Estimate and F denotes a Forecast.

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

Actual Purchases Model Purchases

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

2003 2004 2005

Agency Debt ($bb) 437 447 527

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

Data as of June of each year

Domestic Money Managers

Source: Banc of America Securities

Mortgages look somewhat

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

Source: Banc of America Securities

Bank Purchases of Mortgages

Deposit Growth 104 36 157 226 128 118 101

All numbers are in billion dollars

Agency Portfolio Issues

Figure 13: Annual Purchases of Subprime MBS by the GSEs

Year 2005 2004 2003 2002

Subprime Purchases 169 176 81 38

All numbers are in billion dollars

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

Source: Banc of America Securities

Convexity Hedging Issues

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

Source: Banc of America Securities

Outlook for Prepayment Speeds in 2007

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

Review of Prepayment Speeds in 2006

2002 2003 2004 2005 2006

Source: Fannie Mae, Banc of America Securities

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

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