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March 25, 2011

Structured Products Research


Chris van Heerden, CFA chris.vanheerden@wellsfargo.com (704) 715-8321
Landon Frerich landon.frerich@wellsfargo.com (704) 715-8376

The Agency CMBS Primer


Executive Summary
Agency CMBS is taking on new significance as new issue nonagency deals have returned largely in the form of deals with lopsided property type and borrower concentrations. Agency CMBS describes multifamily mortgage-backed securities (MBS) that are guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Aside from providing diversification away from the heavy retail concentration in nonagency deals, a further benefit of agency CMBS has been the lower spread volatility. The spread performance for agency deals diverged dramatically from conduit transactions during the credit crisis. In general, agency CMBS bonds are characterized by sound collateral performance, stable cash flow profiles based on loan-level prepayment protection, guaranteed interest and principal payments, lower spread volatility compared with nonagency CMBS, and higher yields versus agency debentures and other comparable investments. There are numerous ways to participate in the agency CMBS market. Securities range, from the guaranteed single-property pass-through Fannie Mae DUS structure to BBB-rated Freddie Mac K certificates with features including structured credit support, the use of a master and special servicer and a controlling class. The securities in the agency market are publicly issued in contrast to the nonagency CMBS primary market, which is currently dominated by 144A private placements. Contents An Introduction to Agency CMBS ......... 2 Freddie Mac KCertificates ............ 3 Fannie Mae DUS MBS ............... 7 Ginnie Mae Project Loans ................... 17

Please see the disclosure appendix of this publication for certification and disclosure information
This report is available on wellsfargo.com/research and on Bloomberg WFSP

The Agency CMBS Primer March 25, 2011

WELLS FARGO SECURITIES, LLC STRUCTURED PRODUCTS RESEARCH

An Introduction to Agency CMBS


Agency CMBS is taking on new significance with CMBS investors because new issue nonagency CMBS has returned largely through deals that are lopsided in property type and borrower concentrations. Non-agency conduit CMBS deals issued after 2008 have been lacking in multifamily collateral. In fact, multifamily loans made up only 1% of the collateral for multi-borrower CMBS deals in 2009 and 2010, compared with a 46% retail component on average. Agency CMBS describes multifamily MBS that are guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. This primer provides a detailed analysis of Freddie-Mac K certificates, the Fannie Mae DUS program, and Ginnie Mae project loans. Aside from providing diversification away from the heavy retail concentration in recent non-agency CMBS, a further benefit of agency CMBS is the lower spread volatility. The spread performance for agency deals diverged dramatically from conduit transactions during the credit crisis. Spreads on Fannie Mae DUS paper, for example, widened 215 bps during the course of 2008 to peak at 275 bps to swaps in November 2008. Over the same period, 2007 vintage 10-year 30% subordination superseniors widened 1,450 bps to a peak of 1,535 bps to swaps. The long-term outlook for Fannie Mae and Freddie Mac continues to evolve. There is agreement that large lending portfolios, shareholder earnings growth and a government backstop cannot continue to coexist as it has in the past. Within this debate, government support for affordable rental housing has received less criticism. In fact, the goal of affordable home ownership has been replaced by a broader mandate to provide affordable housing. The delinquency rate for both Fannie Mae and Freddie Mac multifamily loans remain below 1%. For multifamily securitizations, we believe the most significant outcome from GSE reform is already evident, namely the rundown of the GSE portfolios and a reliance on private investors to absorb the supply. As a result, borrowing costs may increase over time. Exhibit 1: Share of Multifamily MBS Volume by Agency
2009 2010

Freddie Mac 11% Fannie Mae 55%

Fannie Mae 35%

Freddie Mac 28%

Ginnie Mae 34%

Ginnie Mae 37%

Note: Fannie Mae only includes 10/9.5 mortgage loans, Ginnie Mae only inlcludes GNR Remic transactions and Freddie Mac only includes K-Certificates. Source: Wells Fargo Securities, LLC, Fannie Mae and Intex Solutions, Inc.

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Freddie Mac-K-Certificates
Introduction
Since 2009, Freddie Mac has been using the Structured Pass-Through Certificates (K Certificates) program to securitize multifamily mortgages. These transactions largely resemble conventional CMBS deals by featuring time-tranched cash flows, structured credit enhancement and the use of master servicer, special servicer and directing certificate holder roles. Senior bonds receive a guaranty of timely payment of interest and payment of principal at loan maturity guaranty provided by Freddie Mac. The program is growing; eight K deals priced in 2009 and 2010, and 10 may be brought to market in 2011. The K Certificates program has proven to be versatile, as evidenced by the funding of a single-asset deal in 2010 and a transaction backed entirely by seven-year mortgages in 2011. Finally, the dearth of publicly registered CMBS deals over the past two years may steer investors that have a constrained 144A mandate to consider K Certificates. Exhibit 2: Summary of K Certificate Deals
Deal COMM 2009-K3 FREMF 2009-K4 FREMF 2010-K5 FREMF 2010-K6 FREMF 2010-K7 FREMF 2010-K8 FREMF 2010-K9 FREMF 2010-KSCT FREMF 2011-K10 FREMF 2011-K701 Total:
1

Orig. Pricing Bal. ($mm) Date 984.8 6/5/09 994.6 10/7/09 1,024.3 1/26/10 1,081.1 3/24/10 1,012.4 6/11/10 1,010.9 9/16/10 1,089.0 11/17/10 476.0 2/25/10 1,009.5 1/12/11 1,877.6 2/11/11 10,560.4 Average:

WAC 5.85 5.56 5.68 5.55 5.63 5.54 5.26 5.77 4.89 4.58 5.43

Loans 62 46 70 68 83 72 70 1 76 44 59.20

WA LTV 68.77 69.16 67.68 70.04 70.06 69.24 70.55 68.70 70.59 69.21 69.40

DSCR 1.67 1.35 1.56 1.39 1.36 1.35 1.39 1.25 1.54 1.47 1.43

Largest Top 3 Loan % Loan % 5.71 4.41 14.19 6.71 11.35 2.83 7.35 4.44 10.31 2.85 12.03 3.73 7.20 6.88 100.00 0.00 11.36 3.52 23.76 5.34 20.33 4.07

Partial IO % 64.10 39.15 40.37 38.55 27.29 35.61 30.66 0.00 43.74 53.95 37.34

Full IO % 2.78 0.00 18.28 3.66 1.35 3.75 14.41 0.00 6.74 10.03 6.10

Yield Maint.1 22% 0% 2% 2% 6% 4% 5% 100% 6% 0.16

Defeasance 78% 100% 98% 98% 94% 97% 95% 0% 94% 0.84

Includes loans that require a static prepayment premium charge. Source: Bloomberg, LP. and deal documents.

Collateral Characteristics
Freddie Mac K Certificate loans are originated directly through the Freddie Mac Capital Markets Execution (CME) program. All Freddie Mac loans are underwritten in house by Freddie Mac employees. This provides meaningful continuity in loan quality and loan risk assessment. In-house underwriting is unique to the Freddie Mac program as Fannie Mae and Ginne Mae utilize designated third-party underwriters that adhere to specific guidelines. Freddie Mac underwriting criteria balance flexibility to the borrower against standardization for efficient securitization. To this end, leverage and coverage terms are keyed to the loan term, amortization schedule and loan type (e.g., acquisition or cash-out refinance). Prepayment protection most commonly takes the form of a two-year lockout period with defeasance thereafter.

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Exhibit 3: Freddie Mac CME Product Overview


Product Summary Financing Eligible for Securitization Multifamily fixed-rate mortgages, purpose-built student housing, seniors housing, conventional structured finance pools, cooperative housing, Section 8 HAP, and Targeted Affordable Housing cash mortgages. Borrowing Entity - If the loan is $5 million or more, the borrower must be a Single Purpose Entity (SPE): See Section 33 of the Security Instrument for basic SPE requirements. - If the loan is less than $5 million, the borrower may be a SPE with some additional restrictions: Limited partnerships, General partnerships (no individuals may be general partners), Limited liability companies, Corporations, Real Estate Investment Trusts (must be a corporation, not a trust). - If the borrower is structured as a Tenancy In Common (TIC), each Tenant in Common must be an SPE Loan Size $5 to $100 million (Loans as low as $3.5 million will be considered in certain strong markets) Loan Terms 5-30 years Maximum Amortization 30 years Amortization Calculations Actual/360 standard; 30/360 available Lockout Period 2 years Prepayment Provisions - Yield maintenance until securitized followed by 2-year lockout; defeasance thereafter. No penalty for final 90 days. - If loan is not securitized within first year, then yield maintenance applies for the life of the loan - Yield maintenance is available for securitized loans for an additional cost Tax & Insurance Escrow Required Replacement Reserve Deposit Required Recourse Requirements Non-recourse except for carve outs Supplemental Loan Availability Yes, subject to requirements specified in the CME Security Instrument
Source: Freddie Mac.

Exhibit 4: Minimum DSCR and Maximum LTV (Fixed-Rate CME Mortgage)


Fixed-Rate Mortgage Amortizing Partial Interest-Only Acquisition and No Cash-Out Refinance 80% / 1.25x 80% / 1.25x > 7 Year Term < 7 Year Term 70% / 1.30x Same as IO Supplemental Loan or Cash-Out Refinance 75% / 1.30x 75% / 1.30x > 7 Year Term < 7 Year Term 65% / 1.35x Same as IO Interest-Only 65% / 1.30x 60% / 1.35x 65% / 1.35x 60% / 1.40x

Note: The DSCR for Partial Interest-Only and Interest-Only period uses an amortizing payment. Source: Freddie Mac.

K Certificate Transaction Structure


Freddie Mac K Certificate deals largely resemble conventional CMBS deals. Transactions are structured with an A1 amortizing front-pay bond and an A2 balloon bond. Timely interest payments and principal payments at loan maturity are guaranteed by the agency to the senior classes. These transactions issued after FHMS K006 generally also include an unguaranteed credit bond with 7.5% credit support. Similar to traditional CMBS, interest and principal flows through the capital structure in sequential order starting at the top, while losses flow in reverse order starting at the bottom. However, the interest distributions among the A1 and A2 tranches are made on a pro rata basis. Principal distributions are made sequentially for all classes. However, should losses reach the A1 and A2 classes, these collapse to a pro rata principal priority. The senior classes benefit from the Freddie Mac guaranty in addition to the loss protection provided by the subordinated tranches. The guaranty provided by Freddie Mac 4

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covers 1) timely payment of interest, 2) to each class as entitled, the payment of principal at the maturity date of each mortgage, 3) the reimbursement of realized losses or allocated expenses and 4) the ultimate payment of interest. Freddie Mac receives a monthly fee for its guarantee, which varies according to the collateral composition and structure of each transaction. For the K-006 transaction, the guarantee fee was 14 bps on the outstanding principal balance. For the preceding transactions, the guarantee fee was 34 bps. Freddie Mac K certificate deals are structured with IO classes, which have typically been retained by Freddie Mac. Because the timely payment of principal upon loan maturity is guaranteed, the return profiles of these IO classes differ from those of nonagency CMBS IO tranches. For non-agency CMBS deals, the IO classes would receive additional cash flow if loan maturities extend. One notable difference between non-agency CMBS and K Certificates is the controlling Class B-pieces in the K-series transactions are paid principal only. In our view, this structure offers the special servicer a clean incentive to pursue a speedy loan resolution to the highest achievable recovery. Similar to traditional CMBS, performing loans are serviced by the master servicer, which may delegate responsibilities to a sub-servicer. Non-performing loans are transferred to a special servicer that is compensated through a running special serving fee of 25 bps and a workout or liquidation fee of 1%. Exhibit 5: FEMF 2011-K10 Snapshot
Class A1 A2 X1 X3 X2 B C R Orig. Bal. ($mm) 313.8 695.7 1,009.5 87.4 1,165.4 68.5 87.4 0.0 Tranche % of Deal Bal. 27% 60% ---6% 8% -Coupon OWAL 3.32 5.48 4.33 9.58 0.42 8.00 4.60 9.51 0.20 8.50 4.60 9.71 0.00 9.76 0.00 0.00 Fitch Rating AAA AAA AAA NR NR ANR NR Credit Support 13.4% 13.4% ---7.5% 0.0% --

Source: Freddie Mac.

Relative Value
Freddie Mac K Certificates offer investors access to publicly issued securities with stable cash flows and sound collateral performance. Furthermore, the exposure to multifamily collateral is a diversifier in CMBS portfolios as new issue deals of 20102011 have not included multifamily collateral. Cash flows are stabilized through 1) prepayment penalties, 2) loan diversity and 3) the resolution of defaulted loans within the trust. Prepayment penalties most often take the form of defeasance. The sponsor and geographic diversity of loans within the pool diffuses investor exposure to idiosyncratic loan prepayment risk. Finally, defaulted loans are resolved within the trust, rather than bought out as in the case of Fannie Mae DUS. These factors combine to create a stable cash flow stream. Compared to DUS, K-series transactions are differentiated in terms of default-driven prepayment risk.

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First, unlike Fannie Mae DUS securities, defaulted loans are not bought out of the pool. The resolution of loans within the trust, complemented with insured timely interest and principal at mortgage maturity during the workout period, may dampen some of the default-driven prepayment sensitivity compared with DUS. Second, because prepayments are not interest-rate driven, a more diversified collateral pool should diffuse the prepayment exposure. Within each deal, the presence of an amortizing first-pay class would also alleviate cash flow variability to the second-pay senior. Exhibit 6: Relative Value Matrix for Agency CMBS
Product Agency CMBS 5 Yr* Agency CMBS 10 Yr* FNMA Dus 10/9.5 2005 AAA 10 Yr CMBS 2010 AAA 5Yr CMBS Agency Unsecured Debt - FHLMC 10 Yr Spread to Swaps (bps) 58 64 82 130 115 6.8

*Agency CMBS includes both Freddie Mac K-Series and Fannie Mae remics. As of 3/24/11 Source: Wells Fargo Securities, LLC

Conclusion
We expect the Freddie Mac K Certificates program to continue to expand. These securities provide access to multifamily collateral, which has been largely absent from 2010 and 2011 vintage nonagency CMBS deals. Moreover, Freddie Mac deals are issued publicly and benefit from structured credit support, the use of a master and special servicer and a controlling classfeatures that CMBS investors are well familiarized with. The delinquency rate of Freddie Macs multifamily portfolio at 26 bps as of Q4 2010 is clearly differentiated from nonagency CMBS, which had an overall delinquency rate of 9.5% as of Q4 2010.

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Fannie Mae DUS Mortgage-Backed Securities


Introduction
Fannie Mae Delegated Underwriting and Servicing (DUS) mortgage-backed securities (MBS) have been issued since 1994 to fund multifamily loans. The DUS program allows approved lenders to underwrite, close and service loans that meet set eligibility guidelines. Approximatley $65 billion of DUS MBS have been issued. Fannie Mae DUS issuance remains active, pricing remains favorable to historical levels and Fannie Mae provides backing to term and balloon defaults. As an investment vehicle, DUS MBS characteristics include the following:

DUS lenders enter into loss sharing agreements with Fannie Mae. In most cases, the loss sharing is a pari passu arrangement, in which the lender bears one-third of the losses and Fannie Mae the remaining two-thirds. A triple-A rating based on the timely interest and principal guaranty from Fannie Mae, qualifying for a 20% risk-based capital requirement for banks. A stable cash flow profile because of call protection and a guaranteed final maturity.1 Consistent liquidity, reflecting a number of active market makers. Bid/offer spreads range from 5 bps10 bps for the two primary bonds in the market (seven-year final maturity/6.5-year yield maintenance and 10-year final maturity/9.5-year yield maintenance). Low spread volatility compared with AAA CMBS. DUS MBS swap spreads had a standard deviation of 57 bps in 2008 compared with 234 bps for 10-year AAArated supersenior CMBS. Higher yields than Fannie Mae debentures and other comparable investments.

Fannie Mae DUS MBS are backed by multifamily mortgages. Fannie Mae delegates the underwriting and servicing to lenders that have been qualified based on criteria that cover capital, liquidity and business infrastructure. These lenders underwrite, close and sell loans in accordance with Fannie Mae credit and underwriting criteria. Fannie Mae created its DUS program in 1988. The primary purpose was to accelerate Fannie Maes origination process and increase its participation in the multifamily housing market. Before the DUS program, lenders had to go through the more time-consuming process of having Fannie Mae underwrite and approve loans. In August 1994, Fannie Mae began securitizing and issuing DUS MBS. Since then, the program has grown steadily, with $64.9 billion issued as of December 2010. DUS issuance surged in 1996, averaging $328 million per month, and rose again in 1998 when average monthly issuance hit $576 million. In 2001, issuance doubled again to nearly $1 billion per month as rates hit record lows following the recession and 9/11 attacks. Similar to other fixed-income products, issuance tends to increase when rates fall. In addition to the effect of low rates, the issuance in 20092010 has benefited from Fannie Maes shift from portfolio lender to liquidity provider.

1 Call protection has consisted primarily of yield maintenance agreements and, increasingly in recent years, of defeasance with Fannie Mae debentures. Prepayment lockouts and fees have also been used.

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Exhibit 7: Fannie Mae Multifamily MBS Yearly Origination (10/9.5 loans)

12.0 10.0 8.0 ($billion) 6.0 4.0 2.0 0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010
Note Annual Issuance of 10/9.5 multifamily mortgage loans backing MBS. Source: Fannie Mae.

DUS Mortgages and Properties


DUS securities largely consist of fixed-rate mortgages with balloon maturities of five-, seven-, 10-, 15- and 18-year terms. DUS MBS are often backed by a single loan. The two primary Fannie Mae DUS MBS are 10/9.5 and 7/6.5 bonds. The former bonds have a 10year final balloon maturity and 9.5 years of prepayment protection; the latter have a seven-year final balloon maturity and 6.5 years of prepayment protection. Other mortgage types, although less common, are fully amortizing loans with 20-, 25-, or 30year terms. In addition, DUS MBS are on occasion backed by adjustable-rate mortgages and second liens. Adjustable-rate mortgages generally have maturities of five, seven or 10 years. Loan sizes range from $1 million to $50 million. DUS loans are underwritten on a nonrecourse basis and are generally assumable. DUS-eligible properties include income-producing multifamily rental and cooperative buildings with at least five units. Generally, occupancy rates must be a minimum of 90%. The buildings must already exist, be recently completed or need modest rehabilitation.

The Fannie Mae Guarantee and Credit Risk


Fannie Mae guarantees the timely payment of principal and interest of DUS MBS. This guarantee is identical to Fannie Maes guarantee on Fannie Mae residential MBS. As such, Fannie Mae DUS MBS qualify for a 20% bank risk-based capital weighting. In the event of a default, Fannie Mae would continue to pass through scheduled principal and interest. Fannie Mae, however, may also repurchase a loan out of a pool at par if it is delinquent for several consecutive months. In the event of repurchase or foreclosure, Fannie Mae pays the outstanding balance to investors, regardless of the amount recovered from the borrower. Fannie Mae also guarantees the final principal payment on the balloon date, addressing the risk of extension.

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Underwriting
The credit quality of the underlying mortgages is high, in our view. The historical delinquencies of Fannie Maes entire DUS loan portfolio have been consistently below those of nonagency conduit commercial mortgages (Exhibit 8). According to Fannie Mae, serious delinquencies as of Q4 2010 stood at 71 bps for multifamily loans in its portfolio and loans underlying MBS, compared with 60+ day delinquencies of 14.22% for multifamily properties in non-agency CMBS deals. Differentiated collateral performance can be attributed to stringent underwriting. Conduit CMBS lending has in the past been subject to underwriting drift, reflecting an intensely competitive lending environment. In contrast, DUS loans are underwritten to a static grid. Fannie Maes loss sharing arrangement with lenders further differentiates DUS underwriting. The most common loss sharing arrangement requires that the lender bear a third of the losses from the loans it underwrites on a pari passu basis with Fannie Mae. However, the loss sharing arrangements vary between transactions. Exhibit 8: Fannie Mae Multifamily 60+ Day Delinquency Rate
16% 14% 12% 10% 8% 6% 4% 2% 0% 6/97 6/98 6/99 6/00 6/01 6/02 6/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10

CMBS Fixed-Rate Conduit

Fannie Mae Multifamily

Note: Fannie Mae Multifamily deliinquencies include owned and securitized loans. Source: FannieMae, Intex Solutions, Inc., and Trepp LLC.

The quality of Fannie Mae DUS loans is due, in part, to the admission qualifications to become a DUS lender, according to Fannie Mae. Under the DUS program, Fannie Mae licenses DUS lenders that originate and sell multifamily mortgage loans. To participate, the lender must meet criteria that cover capital and liquidity levels, subject to periodic review.

The Agency CMBS Primer March 25, 2011 Exhibit 9: DUS Program Lenders
Alliant Capital Finance, LLC AmeriSphere Multifamily Finance, LLC Arbor Commercial Funding, LLC Beech Street Capital, LLC Berkadia Commercial Mortgage LLC CBRE Multifamily Capital, Inc Centerline Mortgage Capital, Inc. Citibank, N.A. CWCapital LLC Deutsche Bank Berkshire Mortgage, Inc (DB Mortgage Services, LLC) Dougherty Mortgage, LLC Grandbridge Real Estate Capital, LLC
Source: Fannie Mae.

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Greystone Servicing Corporation, Inc. HomeStreet Capital Corporation HSBC Bank USA, N.A. JP Morgan Chase Bank, N.A. KeyCorp Real Estate Capital Markets, Inc M&T Realty Capital Corporation Oak Grove Commercial Mortgage, LLC Pillar Multifamily, LLC PNC Multifamily Mortgage, LLC Prudential Multifamily Mortgage, Inc. Red Mortgage Capital, LLC Walker & Dunlop, LLC Wells Fargo Bank, N.A.

DUS mortgage loan interest rates are set based on a three-tiered credit grid. Each tier varies according to the debt service coverage and loan-to-value (LTV) ratio of the property. The criteria for standard conventional multifamily loans are shown in Exhibit 10. Alternative loan types (e.g., student housing or manufactured housing) are subject to stricter standards. The majority of DUS MBS are backed by Tier 2 and Tier 3 loans. The higher the tier, the lower the guaranty fee paid to Fannie Mae. DUS loans are generally nonrecourse to the borrower and assumable. However, because Fannie Mae DUS are priced and traded at a zero prepayment speed and Fannie Mae guarantees final maturities, the assumption feature has no impact on DUS MBS convexity. There is a 1% assumption fee, which is not shared with the investor. Exhibit 10: FNMA DUS Underwriting Minimum Maximum DSCR LTV Ratio Tier 2 1.25 80% Tier 3 1.35 65% Tier 4 1.55 55%
Source: Fannie Mae.

Prepayment Protection
As in the CMBS market, the risk of an economically induced prepayment is greatly mitigated, if not eliminated, by prepayment protection. Prepayment protections may vary, but usually include yield maintenance or defeasance. The most prevalent form of DUS prepayment protection has been yield maintenance. DUS ARM pools, on the other hand, use a percentage-of-balance method. Defeasance is one of the best types of prepayment protection available. With defeasance, the borrower must replace the principal and interest cash flows of the DUS MBS with those of Fannie Mae agency debentures, if the loan is refinanced. Thus, from the investors perspective, there is no change to the principal and interest cash flows received. In addition, because the possibility of a property default-induced prepayment has been 10

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eliminated, the DUS MBS spreads should not widen if the market rallies and the price of the DUS rises above par. As with yield maintenance, the borrower may refinance the loan during the last 90 days before maturity without defeasing or paying a premium. Defeasance prepayment protection occurs on fixed-rate loans with maturities less than or equal to 10.5 years. Yield maintenance agreements allow for a full loan prepayment at a premium. A pro rata portion of this premium is shared with the investor. Voluntary partial prepayments are prohibited at all times. For prepayments occurring between the end of the yieldmaintenance period and 90 days prior to maturity, a 1% premium is due but is not shared with the investor. Fannie Mae has the right, but is not required, to waive the 1% premium. There is no prepayment premium charged during the 90 days prior to loan maturity. In addition to having low call or early prepayment risk, Fannie Mae DUS MBS, unlike CMBS, have final maturities that are guaranteed by Fannie Mae, thereby mitigating extension risk. In the CMBS market, modifications have become more prevalent as borrowers sometimes negotiate with special servicers for maturity extensions or lower rates. Default-induced prepayments pose a material performance risk for DUS MBS that trade at premium prices. Since 2002, Fannie Mae has repurchased 100 10/9.5 loans, triggering prepayments without yield maintenance. Of those repurchases, 74 occurred in 2009 2010. The early payment of principal may occur in the event of default, casualty or a breach of lender representation and warranties. In these cases, no prepayment penalty is assessed, because the prepayment is not at the discretion of the borrower. This risk contributes to DUS MBS spreads widening at higher dollar prices.

How They Trade


Fannie Mae DUS MBS tend to trade primarily, and are generally compared, against agency debentures and swaps. Exhibit 11 compares the credit, maturity, liquidity, callability and other features of DUS MBS with Fannie Mae debentures. The two products differ in terms of liquidity and the risk of default-induced prepayments. Over the past 12 months, DUS MBS has traded an average 66 bps wide of Fannie Mae debentures. Exhibit 11: Fannie Mae DUS MBS versus Fannie Mae Debentures
10/9.5 FNMA DUS TBA Fannie Mae 10-Year Final 30-Year Schedule 9.5-Year Yield Maintenance 5 bps10 bps Good Default Induced Prepayment 85 bps/Swaps 10-Year FNMA Debenture Fannie Mae 10-Year Final None 10-Year Noncall 0.5 bp1.0 bp Excellent None 8 bps/Swaps

Credit Maturity Amortization Callability Bid/Ask Liquidity Call Risk Offer Spread

As of March 24, 2011. Source: Wells Fargo Securities, LLC.

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Exhibit 12: DUS 10/9.5 versus Fannie Mae Debentures


250

200 Basis Points

150

100

50

0 4/05 8/05 4/06 8/06 4/07 8/07 4/08 8/08 4/09 8/09 4/10 12/04 12/05 12/06 12/07 12/08 12/09 8/10 12/10

Source: Bloomberg LP and Wells Fargo Securities, LLC.

Exhibit 13: DUS 10/9.5 versus Fannie Mae Debentures (Past Five Years)
Date Maximum Minimum Average Standard Deviation Current 12/11/2008 3/25/2010 Spread (bps) 216 21 71 39 77

3/24/2011

Source: Wells Fargo Securities, LLC.

As mentioned above, default-induced prepayment presents a material risk to price premiums for DUS bonds. Because most Fannie Mae DUS MBS are backed by one property and because Fannie Mae does not compensate the investor for involuntary defaults, a default on the underlying loan would constitute a prepayment at par. As such, DUS MBS prices tend to compress (i.e., spreads tend to widen) as interest rates decline. Fannie Mae DUS MBS also trade against 10-year swaps. Over the past 12 months, DUS MBS spreads have traded at an average spread of 83 bps to swaps. Prior to mid-2007, DUS MBS traded at an average of around 14 bps spread to swaps.

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Exhibit 14: DUS 10/9.5 versus Swaps


300 250 200 150 100 50 0 2/05 6/05 2/06 6/06 2/07 6/07 2/08 6/08 2/09 6/09 2/10 6/10 10/05 10/06 10/07 10/08 10/09 10/10 2/11

Exhibit 15: DUS 10/9.5 versus Swaps (Past Five Years)


Date Maximum Minimum Average Standard Deviation Current 12/11/2008 12/4/2006 Spread (bps) 275 10 75 59 85

Basis Points

Source: Bloomberg LP and Wells Fargo Securities, LLC.

3/24/2011

Source: Wells Fargo Securities, LLC.

DUS MBS also trade in relation to CMBS, although this relationship weakened in 2008. CMBS spreads spiked to 1,535 bps over swaps in November 2008, and DUS MBS reached their wides of 275 bps to swaps in the same month. Lower spread volatility for DUS MBS, in our view, is attributable to a static underwriting framework that did not experience the underwriting drift of recent-vintage CMBS, in addition to Fannie Maes guarantee of timely interest and principal and a guaranteed final maturity.

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Exhibit 16: DUS 10/9.5 versus Super Senior 10-Year AAA CMBS
0 -200 -400 Basis Points -600 -800 -1000 -1200 -1400 12/06 12/07 12/08 12/09 12/10 3/07 6/07 9/07 3/08 6/08 9/08 3/09 6/09 9/09 3/10 6/10 9/10

Source: Bloomberg LP and Wells Fargo Securities, LLC.

Exhibit 17: DUS 10/9.5 versus Super Senior 10-Year AAA CMBS (Past Five Years)
Date Maximum Minimum Average Standard Deviation Current 2/19/2007 1/9/2009 Spread (bps) -59 -1,298 -262 256 -103

3/24/2011

Source: Wells Fargo Securities, LLC.

Mega Pools
Mega pools and REMICs combine single loan DUS pass-through securities or other mega transactions. The result is a diversified collateral pool, greater transaction size, and, in the case of REMICs, the ability to structure a range of average lives. Multiple fixed-rate DUS pools with coupons within a 100-bp range may be pooled to create a Mega. Investors sometimes prefer Megas because the pools are diversified (DUS MBS pools are usually backed by one property) and large (size being attractive for liquidity and the large investment requirements of some investors).

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CRA Investment Treatment


Some DUS MBS qualify as Community Reinvestment Act (CRA) investments. These DUS MBS are backed by loans used to finance properties with low-income occupancy requirements. The rents for these properties are typically subsidized by the government to keep them affordable. The schedule of loan information (Schedule A) discloses whether the property or properties backing a DUS MBS qualify as affordable housing. Schedule A can be found on Bloomberg within the DES page.

Multifamily Assured Schedule Payment Trusts


Multifamily Assured Schedule Payments Trusts (MASTs) are multiple-class, callprotected (by defeasance) securities backed by DUS MBS. MASTs restructure principal and interest payments cash flows into three classes: a bullet tranche maturing in about 10 years that receives only monthly interest payments during the term and then principal at maturity; a five-year tranche that receives monthly payments of interest and scheduled amortized principal; and a third interest-only tranche that, unlike most IO tranches, has a predetermined cash flow. Fannie Mae guarantees the payment of scheduled principal and interest through maturity, regardless of what happens to the underlying loans, including condemnation, casualty or default.

Fannie Mae DUS ARMs


Fannie Mae DUS MBS backed by adjustable-rate mortgages, although not common, exist. Coupons and payments reset over either one- or three-month LIBOR every one or three months. DUS ARMs have five-, seven- or 10-year terms, with lifetime caps and floors available at 2%6% above or below the underwritten interest rate. Interim caps and floors allow coupons to adjust by plus or minus 100 bps.

ERISA Eligibility
Fannie Mae DUS MBS certificates are ERISA eligible, according to the Fannie Mae MBS Prospectus. Investors should refer to the prospectus and consult with ERISA professionals for further details.

Who Buys Fannie Mae DUS MBS?


A wide variety of investors have purchased Fannie Mae DUS MBS including corporate bond buyers, agency debenture buyers, insurance companies, pension funds, state funds, money mangers, and banks. Non-U.S. investors who purchase Fannie Mae/FHLMC debentures should also consider Fannie Mae DUS MBS as an attractive way to pick up spread for liquidity. As some DUS bonds can help investors satisfy regulators Community Reinvestment Act (CRA) investment requirements, they can offer an additional advantage to banks. Because of their prepayment stability, they can be swapped into attractive synthetic LIBOR floaters. In addition, because they are backed 100% by multifamily mortgages, we believe they should be attractive to Federal Home Loan Banks.

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Conservatorship
Fannie Mae was placed in conservatorship and brought under the supervision of the Federal Housing Finance Agency (FHFA) on Sept. 6, 2008. The conservator assumed all powers of the boards, management and shareholders. A $200 billion Senior Preferred Stock Facility provided by the U.S. Treasury effectively provides an explicit guarantee of Fannie Maes and Freddie Macs debt by ensuring that the GSEs maintain positive net worth, according to the FHFA. Under the agreement, the Treasury owns 79.9% of the common stock of each enterprise.

Further Information
Bloomberg. Original loan and property information at the pool level as well as current WAC, WAM and balance data are available on Bloomberg for all DUS MBS and Megas backed by DUS MBS. Analytics are also available for most DUS fixed-rate pools along with delinquency information. Internet. Go to www.efanniemae.com then click on Multifamily Securities for information, ranging from current loan and property information (including delinquencies and debt service coverage), schedules of loan information (for pools closed after Sept. 1, 2001), product descriptions and current prospectus supplement narrative templates.

Conclusion
The shift in Fannie Maes mandate in 2009 ushered in a transitional period for the DUS market that must now adjust to a dramatic increase in issuance. The 15-fold increase in supply from $661 million in 2008 to $9.65 billion in 2009 resulted in DUS spreads drifting wider from 2009 to 2010 even as pricing on most other spread products tightened. The supply technical may offer investors an attractive spread for a risk profile that has included sub-1% serious delinquencies through the credit crisis and the added benefit of a Fannie Mae guaranty.

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Ginnie Mae Project Loans


Introduction
Agency CMBS describes those securities that are issues or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Within this group, Ginnie Mae stands apart because it is wholly owned by the U.S. government. Ginnie Mae is further differentiated because it does not act as a portfolio lender; instead, the agency acts only as a guarantor of federally insured or federally guaranteed loans. These differences in Ginnie Maes business model mean greater reliance on issuers in the program. These private institutions must provide the capital to repurchase loans for modifications and make principal and interest payments for delinquent loans. Ginnie Mae project loans often finance Section 8 rental housing, Low Income Housing Tax Credit (LIHTC) projects, or Medicaid assisted nursing homes. Project loans are backed by one or more mortgages. Each mortgage, in turn, is insured by the Federal Housing Administration (FHA) and administered by the Department of Housing and Urban Development (HUD). Ginnie Mae guarantees the timely payment of principal and interest on the securities. During fiscal 2010, $12.3 billion of multifamily projects were insured by the FHA and funded by Ginnie Mae securities. In FY 2010, the Multifamily Program portfolio increased by $7.9 billion, from $41.8 billion to $49.7 billion, marking 16 years of consecutive growth in Ginnie Maes multifamily housing program. Since 1971, Ginnie Mae has guaranteed $123.2 billion in multifamily MBS, helping to finance affordable and community-stabilizing multifamily housing developments across the nation.

The Path to a GNMA Multifamily Deal


The creation of a Government National Mortgage Association (GNMA, Ginnie Mae) multifamily project loan deal involves essentially three steps: 1) the Federal Housing Administration guaranty, 2) the GNMA guaranty and 3) the creation of the GNMA deal. Exhibit 18: The Path to a GNMA Multifamily Deal
Borrower Borrower Borrower Source: Wells Fargo Securities, LLC. FHA Approved Lender FHA Guaranty GNMA Guaranty Dealer GNMA Multifamily Deal

Step 1: Federal Housing Administration (FHA) Guaranty The first step for any GNMA multifamily deal begins with the Federal Housing Administration (FHA).2 The FHA provides mortgage insurance for multifamily and single-family loans originated by FHA-approved lenders. FHA-approved lenders can be, but are not limited to, commercial banks, insurance companies, mortgage banks, savings
2

The FHA was created in 1934 by the Federal Housing Act with the goal of making it easier for lower- and middle-income families to finance homes.

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and loan institutions, pension funds and trust companies. This primer focuses on nonsingle-family mortgages that can be for the construction, rehabilitation, purchase and refinancing of multifamily and healthcare facilities and make up what is often referred to as the Project Loan market. Since 1970, the FHA has insured $158.5 billion (36,680 loans) of multifamily loans. A public or private entity can receive financing from an FHA-approved lender as long as the project falls under one of the FHA programs also known as sections in the Fair Housing Act, which are discussed in more detail later in the report. If the loan qualifies for one of the FHA programs, it is given an FHA guaranty. In return, the FHA receives a monthly premium from the lender. The FHA guaranty means that the ultimate payment of principal and interest on the loan is backed by the full faith and credit of the U.S. government. The FHA, however, does not guarantee the timeliness of principal and interest payments. In addition, in the event of a default, the FHA charges a 1% assignment fee and only begins accruing interest after the first month of missed payment. This results in a 99% repayment of principal and one month of lost interest. Step 2: GNMA Guaranty GNMA3 provides a second level guaranty for an FHA-insured loan. Essentially, GNMA makes up for the inadequacies of the FHA project loans by guaranteeing both the timeliness of principal and interest payments and by taking care of the 1% assignment fee in the event of a default. For the guaranty, GNMA charges a 13-bp fee. Since 1971, GNMA has insured $123.2 billion of FHA project loans. Early on in the program, GNMA provided a guaranty on only a small fraction of FHA-insured loans, whereas today GNMA insures more than 90% of FHA-insured loans. Step 3: A Deal Is Born The final phase of a GNMA Multifamily REMIC deal involves three partiesan FHAapproved lender, a dealer (investment bank) and the investors. Once an FHA project loan is insured with a GNMA guaranty, a dealer may purchase the loan and place it with an existing pool of GNMA-insured loans. When a dealer has enough loans, typically around 4080, the dealer structures a deal to be sold to investors. Although the majority of GNMA-insured loans are pooled and placed in REMIC structures, some are left as single loans and sold off individually to investors. The first GNMA multifamily deal to be launched under the GNR shelf name was in 2001 (GNR 2001-12).4 From 2001 through February 2011, there have been 195 deals with a total original balance of $59.5 billion, of which $44.5 billion is currently outstanding. Issuance in 2010 was $11.1 billon, up from $6.0 billion in 2009 and $3.8 billion in 2008 (Exhibit 19).

The FHA became part of the U.S. Department of Housing and Urban Development (HUD) in 1965. In 1968, Congress created GNMA as a government-owned corporation within HUD with the intent of making a more liquid secondary market for mortgages. 4 Prior to the GNR 2001-12 deal, GNMA-insured loans were securitized and placed in a number of Fannie Mae REMIC Trust deals, the first of which was Fannie Mae Grantor Trust 1995-T5. Since 2000, however, only a handful of GNMA multifamily loans have been in Fannie Mae deals, the last of which was Fannie Mae Multifamily REMIC Trust 2005-M1.

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Exhibit 19: GNR REMIC Multifamily Issuance


12 10
Issuance ($Bil)
11.1

8 6 4 2 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
2.2 4.5 6.6 6.6 5.5 4.9 3.8 2.4

6.0

6.0

*2011 data is through February. Source: Wells Fargo Securities, LLC and Intex Solutions, Inc.

Underlying Collateral (Loan Characteristics)


GNMA loans have fixed rates and accrue interest on a 30/360 day basis. The loans are monthly level pay and generally have 3540 year fully amortizing schedules. The loans always have a minimum spread difference of 25 bps between the interest rate on the mortgage and the interest rate on the security. The 25 bps consists of 13 bps GNMA charges as a guaranty fee and 12 bps kept by the issuer as a servicing fee. The spread between the mortgage rate and the rate on the security cannot exceed 50 bps without written approval from GNMA. Most GNMA loans have some form of call protection, typically a lockout period followed by penalty points for the remainder of the term of the loan. Until 2005, the predominant structure was five years of lockout followed by five years of penalty points (we use a shorthand notation of 5_5) 5, accounting for nearly 60% of all GNMA loans securitized from 20012004 (Exhibit 20). Since 2005, however, the more common protection has been two years of lockout and eight years of penalty points (2_8), accounting for 52% of the loans securitized from 2005-2010. One year of lockout followed by nine years of penalty points has also been common in recent years.

The penalty points typically decline 1% each year, thus, a 5_5 is five years of lockout followed by penalty points of 5%, 4%, 3%, 2% and 1% for years six through 10, respectively. There are many variations (e.g., a loan in the GNR 2006-30 deal has two years of lockout followed by penalty points of 8% for three years and then 5%, 4%, 3%, 2% and 1% for the remaining years).

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Exhibit 20: Call Protection in GNMA Deals by Vintage (Based on Balance)


2001 2002 2003 2004 2005 % of % of % of % of % of LO/PP Total LO/PP Total LO/PP Total LO/PP Total LO/PP Total 5_5 55.5% 5_5 55.7% 5_5 67.5% 5_5 47.6% 2_8 35.8% 10_0 16.2% 10_0 15.7% 4_5 7.7% 3_7 15.8% 5_5 18.4% 4_5 9.0% 4_5 11.9% 10_0 4.9% 4_5 8.6% 3_7 16.7% 9_0 7.3% 9_0 6.1% 9_0 4.5% 1_9 4.6% 1_9 7.3% 5_0 3.2% 5_0 2.3% 3_7 1.8% 2_8 3.6% 4_5 6.4% 3_5 2.3% 3_5 1.8% 3_5 1.7% 3_5 2.8% 3_5 1.9% 8_0 1.2% 0_5 0.8% 5_0 1.5% 10_0 2.3% 0_10 1.1% 7_0 1.0% 2_5 0.7% 3_3 1.3% 3_3 2.2% 1_8 1.1% 5_3 0.9% 7_0 0.7% 0_3 1.1% 9_0 2.1% 9_0 1.0% 3_3 0.7% 8_0 0.7% 0_5 1.1% 5_0 1.6% 10_0 1.0% Other 2.7% Other 3.5% Other 6.8% Other 8.8% Other 9.4% 2006 2007 2008 2009 2010 % of % of % of % of % of LO/PP Total LO/PP Total LO/PP Total LO/PP Total LO/PP Total 2_8 42.7% 1_9 48.7% 2_8 34.4% 2_8 53.1% 2_8 75.9% 1_9 23.0% 2_8 23.1% 1_9 27.8% 3_7 19.7% 1_9 7.5% 5_5 7.1% 5_5 5.2% 3_7 6.2% 1_9 8.0% 3_7 6.3% 4_5 4.6% 1_8 4.9% 0_9 5.2% 0_9 5.5% 0_9 2.0% 3_7 3.3% 2_7 2.9% 1_8 4.8% 1_8 3.2% 2_3 1.8% 1_8 3.0% 0_9 2.1% 4_5 3.2% 2_7 2.0% 5_5 0.7% 10_0 2.3% 4_5 1.6% 5_5 2.6% 0_8 1.3% 1_8 0.7% 9_0 1.6% 0_8 1.4% 0_8 2.0% 2_0 1.1% 0_3 0.5% 2_7 1.6% 3_7 1.1% 2_7 1.5% 5_5 1.0% 1_3 0.4% 0_9 1.1% 0_3 0.9% 1_4 1.1% 0_7 1.0% 2_7 0.4% Other 9.5% Other 8.2% Other 11.2% Other 4.2% Other 3.6%
Note: LO / PP stands for lockout and penalty points and are given in terms of years. Source: Wells Fargo Securities, LLC and Intex Solutions, Inc.

Project Loans and Construction Loan Certificates GNMA loans can be classified as project loans certificates (PLCs) or construction loan certificates (CLCs). Many loans begin as construction loans, and as a project is completed or rehabilitated, a borrower obtains longer-term financing in the form of a PLC. PLCs and CLCs can be further broken up into more detailed categories; the descriptions of these can be found in Exhibit 21. GNMA loans are also categorized by the FHA program under which they are insured. We take a closer look at those programs in the following section.

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Exhibit 21: Descriptions of Project Loans and Construction Loan Certificates


Project Loan Certificates PL A pool consisting of a single, level payment FHA-insured project loan that has a first scheduled payment date no more than 24 months before the issue date of the securities and has not been modified subsequent to FHA's final endorsement. A pool consisting of a single, non-level payment FHA-insured or Rural Development, RD-guaranteed project loan that has a first scheduled payment date no more than 24 months before the issue date of the securities and has not been modified subsequent to FHA's final endorsement. A pool consisting of a single project loan with a first scheduled payment date more than 24 months before the issue date of the securities or a loan that has been modified subsequent to final endorsement. A pool consisting of one or more project loans, each of which is secured by a lien on a small project as determined by FHA or an RD-Section 538 guaranteed loan that has been used for the revitalization of the Section 515 loan portfolio, each of which has a first scheduled payment date no more than 24 months before the issue date of the securities and none of which has been modified subsequent to final endorsement, or issuance of the RD permanent loan guarantee. A pool consisting of one or more project loans, each of which is secured by a lien on a Mark-to-Market project as determined by FHA and the Office of Affordable Housing Preservation (OAHP) and each of which has a first scheduled payment date no more than 24 months before the issue date of the securities. Construction Loan Certificates CL A pool consisting of a single construction loan; the interest rate payable on the securities backed by a CL pool will also be the interest rate payable, upon conversion of the construction loan securities, on the resulting project loan securities. A pool consisting of a single construction loan; the interest rate payable on the securities backed by a CS pool will differ from the interest rate payable, upon conversion of the construction loan securities, on the resulting project loan securities.

PN

LM

LS

RX

CS

Source: Wells Fargo Securities, LLC and GNMA.

FHA Program Types GNMA loans qualify for certain FHA programs when underwritten. A majority of the loans, 80%, fall into one of five groups. A breakdown of the FHA sections within the GNMA multifamily deals based on original loan balance is shown in Exhibit 22. Notice that some loans can qualify for more than one FHA program. A considerable amount of loans, for example, fall under both 232 and 223(f). We provide a brief description of the most common FHA programs below.

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Exhibit 22: FHA Programs in GNMA Multifamily Deals (20012010)


232 6% 207/223(f) 7% Other 12% 221(d)4 27%

223(a)7 14% 232/223(f) 16% Source: Wells Fargo Securities, LLC and GNMA.

223(f) 18%

Sections 221(d)4 and 221(d)3 provide insurance for the construction and rehabilitation of multifamily housing for low- and moderate-income families that have lost their homes due to urban renewal, government actions or disaster. Section 221(d)3 applies to nonprofit borrowers, whereas Section 221(d)4 applies to profit-seeking borrowers. Section 223(a)7 allows the FHA to refinance loans that are currently insured under any section, resulting in the prepayment of the existing mortgage. The refinanced loan cannot be greater than the original loan amount and is allowed a term equal to the unexpired duration of the previous loan plus 12 years. Section 223(f) provides insurance for loans originated for the purpose of purchasing or refinancing multifamily complexes, hospitals and nursing homes that are not in need of major rehabilitation. The goal of the program is to allow refinancing to lower the debt service or to purchase existing properties to maintain a sufficient amount of affordable housing. Section 232 provides insurance on construction loans for new or rehabilitated nursing homes, intermediate care facilities, board and care homes, and assisted-living facilities for the elderly. Section 207 provides insurance for FHA-approved lender loans for the construction or rehabilitation of multifamily properties and manufactured home parks. Section 220 provides insurance for loans collateralized by multifamily properties that are in federally aided urban renewal areas or areas experiencing redevelopment. The purpose of Section 220 is to promote quality housing in areas where revitalization is planned. Section 213 provides insurance for loans backed by cooperative housing and allows nonprofit cooperative ownership housing corporations to develop the projects. Section 241 provides insurance to finance property improvements that should enable the property to remain competitive, to extend its useful life and to replace dated equipment without having to refinance.

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How Are the Deals Structured?


GNMA multifamily deals are REMIC sequential pay structures with an interest-only (IO) class. The typical GNMA multifamily deal has six classesA, B, C, D, Z and an IO with approximate weighted average lives of three, five, eight, 12 and 20 years. The A tranche is typically a fixed-rate class, and tranches B, C and D are typically weighted average coupon classes. The Z tranche is an accrual class in which interest is accrued and added to the principal balance, while the previous classes, A through D, are outstanding. In the case where prepayment penalties are collected, proceeds are distributed to the IO class. For GNMA deals, the trustee can terminate the trust once the current principal balance is less than 1% of the original principal balance. An example of a GNMA Remic dealGNR 2010-74, which closed in June 2010is shown in Exhibit 23. Exhibit 23: Example of a GNMA Multifamily Remic Deal (GNR 2010-74)
GNMA-Insured Loans
Ginnie Mae Pool # 734787 Property Name: North Lamar Apartments FHA Program: 223(f) Location: Austin, TX Original Bal: $14.9 million Closing Date: 3/1/10 Stated Maturity: 3/15/45 Lockout Period: 23 Months Mortgage Rate: 4.93% Certificate Rate: 4.68% Ginnie Mae Pool # 719618 Property Name: University Village FHA Program: 223(a)(7) Location: Minneapolis, MN Original Bal: $10.9 million Closing Date: 10/1/09 Stated Maturity: 11/15/44 Lockout Period: 19 Months Mortgage Rate: 4.60% Certificate Rate: 4.35% GNR 2010-74 Original Balance: $298.2 million Closing Date: 6/30/2010

A Tranche - WAL: 2.5 Coupon: 2.63% Original Balance: $150 million B Tranche - WAL: 6.1 Coupon: 3.81% Original Balance: $73 million C Tranche - WAL: 8.9 Coupon: 4.24% Original Balance: $24 million D Tranche - WAL: 12.8 Coupon: 4.62% Original Balance: $45 million Z Tranche - WAL: 21.5 Coupon: 4.87% Original Balance: $6.2 million IO Tranche - WAL: 6.1 Coupon: 1.47% Collateral 40 GNMA-Insured Mortgage Loans

38 Additional Loans

Note: Information is as of the time of issuance. Source: Wells Fargo Securities, LLC, GNMA and Intex Solutions, Inc.

Most deals have 4080 loans, although there have been outliers with as few as four loans and as many as 156 loans backing a deal. Deal sizes are normally in the range of $250 million$350 million, with the average, since 2001, at $302.6 million (Exhibit 24). The average deal size in 2010 was $315.9 million compared to $260.5 million in 2009.

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Exhibit 24: Average Deal Size for GNMA Multifamily Remic Deals
500 450 400 Avg. Deal Size ($Mil.) 350 300 250 200 150 100 50 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 318.2 315.3 284.5 273.7 313.6 248.3 260.5 437.2 Avg. Deal Size - $302.6 million

373.3 315.9

Source: Wells Fargo Securities, LLC , and Intex Solutions, Inc.

Trading GNMA Multifamily Bonds


When evaluating GNMA multifamily bonds, the most important considerations are the assumptions used when these deals are priced. The standard assumption used by the industry is the pricing speed of 15% CPJ. This assumes that no voluntary prepayments occur during lockout, but loans then prepay at a 15% CPR the first year lockout ends through the life of the deal. The second part of the 15% CPJ is the assumption that defaults (involuntary prepayments) follow the timing of the project loan default curve (PLD)6, which is shown in Exhibit 25. Exhibit 25: The Project Loan Default (PLD) Curve
Loan Age (months) 0-12 13-24 25-36 37-48 49-60 61-72 73-84 85-96 97-108 109-168 169-240 241-maturity Default Rate 1.30% 2.47% Default Rate 2.51% 2.20% 2.13% 1.46% 1.26% 0.80% 0.57% 0.50% 0.25% 0.00%
0.0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 3.0% 2.5% 2.0% 1.5% 1.0% 0.5%

Year

Source: Wells Fargo Securities, LLC and GNMA.

While not specifically documented anywhere, the Project Loan Default (PLD) curve is believed to have been developed by Donaldson, Lufkin & Jenrette in 2000 or 2001 and was based on historical default data.

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The PLD curve assumes that involuntary prepayments begin immediately, starting at 1.30% in year one and then ramp up to 2.51% in year three before steadily declining to 0.25% for years 15 through 20. The sequential pay classes (usually A, B, C and D) are priced to the swaps curve while the accrual class (usually Z) is priced to the U.S. Treasury curve (specifically the 30-year bond).

What Are the Risks?


As the principal and interest for these securities are guaranteed, the main concern for an investor is cash flow volatility and the linked reinvestment risk. As the deals are priced at a speed (15% CPJ), there is the risk that the loans will actually pay off at slower or faster speeds. A GNMA loan can prepay in one of the following two ways: as a voluntary prepayment or a default. A voluntary prepayment occurs when a borrower willingly prepays the loan after lockout and incurs penalty points to retire the mortgage. A voluntary prepayment is usually motivated by a) a rise in property values, in which case the borrower may want to sell or b) lower interest rates such that the borrower is motivated to refinance the loan. A prepayment, resulting from a default, occurs when a property is struggling financially and can no longer maintain the debt service. Under a default, the lockout period or prepayment penalties no longer apply. When a GNMA loan defaults, one of the following three things occur: a typical default, an override or a modification. In a typical default situation, the loan is given to the FHA, which then liquidates the property. When a loan goes through an override, the FHA works with the borrower to refinance a lower rate of interest. In the case of a modification, the borrower works with the issuer/servicer and the terms of the loan are modified to provide some relief to the borrower. In all three cases, the loans are paid off and the impact to the bondholder is a prepayment. The FHA has the ability to override lockouts and prepayment provisions if it is deemed to be in the best interest of the federal government to do so. Investors should be aware that while prepayment penalties are passed through to the IO class, GNMA does not guarantee the payment of penalties by the borrower. The holders of the IO only receive the proceeds if they are received by the trustee. A final consideration for investors is the lack of readily available information regarding the collateral in GNMA deals. In most cases, financial statements and appraisals for the properties are unavailable. Also default, delinquency and prepayment information is limited and difficult to access.

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Voluntary Prepayment and Default Analysis of GNMA Multifamily Loans


As discussed earlier, the main concern for investors is the amount of prepayments both voluntary and involuntary (defaults) within GNMA multifamily deals. In this section, we show the volatility when prepayment speeds are adjusted to slower and faster levels. We also review actual voluntary prepayments and defaults within GNMA remic deals. Speed It Up, Slow It Down In Exhibit 26, we show changes in weighted average life (WAL) for the tranches in the GNR 2010-74 transaction when the voluntary prepayment rate is adjusted faster and slower. The PLD curve is also applied to each of the scenarios. When the CPR rate is slowed to 5% from the standard 15%, the WALs for Classes B and C extend 6.4 and 9.2 years, respectively. When the CPR rate is increased to 25% the WALs for Classes B and C shorten by 1.8 and 2.9 years, respectively. Exhibit 26: Voluntary Prepayments Speeds and the Effect on WAL Class 0% CPR 5% CPR 15% CPR 25% CPR 40% CPR A 9.4 4.3 2.5 1.9 1.5 B 24.1 12.5 6.1 4.3 3.1 C 28.8 18.1 8.9 6.0 4.1 D 31.7 23.6 12.8 8.6 5.9 Z 35.7 31.7 21.5 14.9 10.0 IO 19.7 11.8 6.1 4.2 3.0
Source: Wells Fargo Securities, LLC and GNR 2010-74 offering circular.

Voluntary Prepayments and Defaults Actual Performance For our prepayment and default analysis, we used loan data provided by GNMA and HUD. Voluntary prepayments for GNMA loans experienced a substantial spike in 2010. We found 452 voluntary prepayments in 2010 with an original loan balance totaling $2.6 billion. In comparison, we found 203 instances of voluntary prepayments in 2009 with a total original loan balance of $1.2 billion. The bulk of the voluntary prepayments in 2010 came from the 2003, 2004 and 2005 vintages. The majority of voluntary prepays were loans that originally had five years of lockout. We are, however, also starting to see loans from the more recent vintages with only a few years of lockout starting to prepay. Unlike voluntary prepayments, which spiked in 2010, defaults in GNMA remic deals remain low. We found only 34 defaults in 2010 with a total loan balance of $230 million. Historically, the GNMA transactions have experienced very few defaults. The 2002, 2003 and 2004 vintages have accounted for the majority of GNMA loan defaults. The most common program types in terms of defaults have been 221(d)4, 223(f), 223(a)7 and 232.

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Exhibit 27: Prepayments and Defaults in GNMA Remic Deals (Loan Count)
500 450 400 350 Loan Count 300 250 200 150 100 50 0
22 85 41 14 133 104 42 43 37 53 36 34 41 34 220 227 203 452

Defaults Voluntary Prepayments

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Wells Fargo Securities, LLC, GNMA and HUD.

Exhibit 28: Prepayments and Defaults in GNMA Remic Deals (Loan Balance)
3,000 2,750 2,500 Loan Balance ($Mil) 2,250 2,000 1,750 1,500 1,250 1,000 750 500 250 0
481 326 275 197 74 5 6 55 34 632 170 144 206 275 230 849 1,232 1,185 1,185 2,619

Defaults Voluntary Prepayments

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Wells Fargo Securities, LLC, GNMA and HUD.

Conclusion
Ginnie Mae project loan transactions provide another option for investors in the agency CMBS space. GNMA multifamily remic issuance topped $11 billion in 2010 and is on pace for another year of sizable issuance. As the principal and interest for these securities are guaranteed by the U.S. government, the main risk for investors is the timing of cash flows due to prepayments, both voluntary and involuntary (defaults). Defaults have remained low in GNMA remic transactions, but voluntary prepayments saw a significant spike in 2010. Investors need to be mindful of the shift in call protection to shorter lockout periods and the potential for faster prepayments.

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DISCLOSURE APPENDIX Additional information is available on request. This report was prepared by Wells Fargo Securities, LLC. About Wells Fargo Securities, LLC Wells Fargo Securities, LLC is a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of the New York Stock Exchange, the Financial Industry Regulatory Authority and the Securities Investor Protection Corp. Important Information for Non-U.S. Recipients EEA The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For certain non-U.S. institutional reader (including readers in the EEA), this report is distributed by Wells Fargo Securities International Limited (WFSIL). For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 (the Act), the content of this report has been approved by WFSIL a regulated person under the Act. 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Diane Schumaker-Krieg, Managing Director, Global Head of Research & Economics diane.schumaker@wellsfargo.com (704) 715-8437 (212) 214-5070

Structured Products Research


Marielle Jan de Beur, Managing Director Glenn M. Schultz, CFA, Managing Director John McElravey, CFA, Director David Preston, CFA, Director Chris van Heerden, CFA, Director Lad Duncan, Vice President Mark Fontanilla, Vice President Landon Frerich, Vice President Randy Ahlgren, Associate Zachary L. Bolster, Associate Bee Sim Koh, Associate Head of Structured Products Research CMBS and Real Estate Research Head of Residential Mortgage Research Head of Consumer ABS Research CDO and Commercial ABS Research CMBS and Real Estate Research CMBS and Real Estate Research Residential Mortgage Research CMBS and Real Estate Research Residential Mortgage Research ABS and CDO Research Residential Mortgage Research marielle.jandebeur@wellsfargo.com (212) 214-8047 (704) 715-8425 glenn.schultz@wellsfargo.com john.mcelravey@wellsfargo.com david.preston@wellsfargo.com chris.vanheerden@wellsfargo.com lad.duncan@wellsfargo.com mark.fontanilla@wellsfargo.com landon.frerich@wellsfargo.com randy.ahlgren@wellsfargo.com zachary.bolster@wellsfargo.com beesim.koh@wellsfargo.com (704) 383-4758 (704) 715-7615 (704) 715-7383 (704) 715-8321 (704) 715-7423 (704) 383-1936 (704) 715-8376 (704) 715-8889 (704) 715-8382 (704) 715-0536

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