June 12, 2006

Agency CMOs
Steven Abrahams (212) 272-2206 sabrahams@bear.com Scott Buchta (312) 580-4161 sbuchta@bear.com

Understanding CMO Toggle Floaters

Floating-rate investors, particularly those looking to generate excess returns over LIBOR, have been faced with falling spreads in most products. Increased demand, tighter credit spreads, a flatter yield curve and lower volatility have all contributed. The CMO market in turn has introduced toggle floaters, which allow investors to sell a leveraged cap in return for a coupon that floats at a relatively high margin over LIBOR. For portfolios comfortable that LIBOR will remain below the toggle floaters cap, the structure can be a good way to add spread income. Basic Characteristics of the Toggle Floater Most of todays outstanding toggle floaters have a coupon that floats at 1-month LIBOR plus a spread with a relatively high cap for five to seven years after settlement. After this initial period, the toggle feature applies. This feature allows the floater to pay its coupon until LIBOR hits a certain level or strike. At the strike, the coupon on a typical toggle floater drops to zero instead of remaining capped like a standard CMO floater. Some toggle floaters drop to a minimum or floor coupon instead of going all the way to zero. The buyer of a toggle floater has effectively sold a digital cap that toggles the floater coupon down to a lower fixed level. Due to the toggle, the LIBOR strike on the floater is typically much higher than that of a standard floater, and the spread over the floating index is much higher as well. The structure allows the investor to sell a more leveraged set of caps and consequently earn increased spread in the process. PRLM BS-773 TF is an example of a toggle floater with a floor coupon. This structure offers a coupon of 1-month LIBOR plus 60 bp as long as LIBOR remains below 7.40%. If LIBOR goes above the strike, the coupon goes to 4%. A version of this bond (PRLM BS-772 TF) that is structured without the 4% coupon floor would be priced at L+110 bp as long as LIBOR remains below 7.40%. Figure 1 shows the effective coupon on this toggle floater as interest rates change. A floater structured with a fixed cap off of the same underlying CMO class would have a coupon of roughly LIBOR + 45 bp with a 7.00% cap. A 3-year floater backed by home equity loans would offer roughly LIBOR + 17 bp (30/360) with an available funds cap. Table 1. Profile of a Toggle Floater
Security Coupon Structure Collateral LIBOR Strike Price Average Life Yield Duration Convexity Note: all market data as of 6/5/06. Source: Bear Stearns. PRLM BS-773 TF L +60 TAC FHLMC 6.5's 7.40% 100 9.20 5.85 2.45 -3.31

Table 2. Discount Margin Profile: Constant Price of Par

Prepay Avg. Life DM DM DM 123% PSA 15.8 60 60 -336 152% PSA 13.7 60 60 -336 217% PSA 9.2 60 60 -336 527% PSA 1.0 60 60 -336 746% PSA 0.5 60 60 -336

LIBOR 5.13 7.40 7.41

Figure 1. Yield Comparison of MBS Floaters Priced at Par

10.00 9.00 8.00 Yield 7.00 6.00 5.00 4.00 3.00 5.0 5.5 6.0 6.5 7.0 LIBOR 7.5 8.0 8.5 9.0 Toggle Floater CMO Floater HEL Floater

The research analysts who prepared this research report hereby certify that the views expressed in this research report accurately reflect the analysts personal views about the subject companies and their securities. The research analysts also certify that the analysts have not been, are not, and will not be receiving direct or indirect compensation for expressing the specific recommendation(s) or view(s) in this report.

Understanding CMO Toggle Floaters

Compared to a Corridor Floater An interesting comparison can be made between a toggle floater and some of the corridor floaters that are in the marketplace today. Both offer relatively high margins and caps, but for different reasons. The margin and cap on the toggle floater comes from the embedded sale of the digital cap. The margin and cap on a corridor floater comes from the combined sale of a low-strike cap and from a subtle form of prepayment risk. In a corridor floater, the investor is buying a security with a below market cap usually 5%-6%. The lowstrike cap gets raised, often to around 9%, through the purchase of an amortizing cap corridor. As long as prepayments stay above a pre-determined speed (usually 75% or 100% PPC) the full coupon of the security is realized up to the level of the cap corridor. If prepayments fall below the amortization schedule and LIBOR rises above the initial stated cap, however, the realized DM of the bond falls. That happens when the outstanding amount of the low-capped floater exceeds the outstanding amount of the cap corridor. The excess low-capped floater hurts the overall DM of the position. Investor Profile
% rate

Historical LIBOR A little history can help frame the potential performance of a toggle floater. Although a lot has changed over time, here are some summary statistics regarding LIBOR since 1985: Max LIBOR: 10.1% (3/1/1989) Total Months LIBOR > 8%: 38 Total Months LIBOR > 7%: 55 Longest Period Consistently Above 8%: 8/1/1988 10/1/1990 Longest Period Consistently Above 7%: 4/1/1988 1/1/1991 Last time 1 month LIBOR > 8%: 12/1/1990 Last time 1 month LIBOR> 7%: 1/1/1991
Figure 2. Toggle Performance 1985-Present; L+75, 8.25% Cap, 7.5% LIBOR Strike
12 10 8 6 4 2 0 LIBOR L+75 Toggle C ap 4% Coupon

Toggle floaters are probably best suited to investors more concerned with generating income by selling an out-of-themoney cap and less concerned with mark-to-market. Toggle price performance hinges largely on the level of 1-month LIBOR, the shape of the yield curve and volatilityall factors that drive the price of the caps that the toggle floater buyer has implicitly sold. As LIBOR rises, the yield curve steepens or volatility goes up, the price of the toggle floater should fall. All of these things raise the price of the embedded caps, which the toggle floater buyer has sold short. Because the cap has been sold against an underlying MBS, prepayments also have a key effect. As rate rise and prepayment slow, the principal balance backing the cap remains outstanding for longer. This magnifies the price impact of rising rates, among other things. Obviously, falling LIBOR, a flatter curve or falling volatility helps the toggle floater price performance.

Conclusion Investors can generate significant added cash flow through toggle floaters in return for mark-to-market risk. The toggle buyer is able to sell more leveraged caps than they might through traditional MBS and pick up incremental spread in the process. Although interest cash flow drops significantly if the toggle reaches the LIBOR strike, the strike levels offered are substantially above the levels of LIBOR seen for most of the last decade. The structuring flexibility available also allows the investor to manage the risk/reward relationship of the security through collateral selection, deal structure, LIBOR strikes and coupon floors.

Bear, Stearns & Co. Inc.

Ja n85 Ja n87 Ja n89 Ja n91 Ja n93 Ja n95 Ja n97 Ja n99 Ja n01 Ja n03 Ja n05

To access related research please visit: http://www.bearstearns.com/

Bear, Stearns & Co. Inc. 383 Madison Avenue New York, NY 10179 (212) 272-2000 www.bearstearns.com

DOMESTIC
(Bear, Stearns & Co. Inc.) Atlanta 3424 Peachtree Road, NE, Suite 1700 Atlanta, GA 30326 (404) 842-4000 Boston One Federal Street Boston, MA 02110 (617) 654-2800 Chicago Three First National Plaza Chicago, IL 60602 (312) 580-4000 Dallas 300 Crescent Court, Suite 200 Dallas, TX 75201 (214) 979-7900 Denver 3200 Cherry Creek South Drive, Suite 260 Denver, CO 80209 (720) 570-2327 Los Angeles 1999 Avenue of the Stars Los Angeles, CA 90067 (310) 201-2600 San Francisco Citicorp Center One Sansome Street, 41st floor San Francisco, CA 94104 (415) 772-2900 San Juan 270 Muoz Rivera Avenue, 5th Floor Hato Rey, Puerto Rico 00918 (787) 753-2327

Hong Kong Bear Stearns Asia Limited 26th Floor, Citibank Tower Citibank Plaza 3 Garden Road, Hong Kong 852-2593-2700 London Bear, Stearns International Limited One Canada Square London E14 5AD England 44-207-516-6000 Lugano Bear, Stearns & Co. Inc. Corso Elvezia 14 P.O. Box 5155 6901 Lugano, Switzerland 41-91-911-7333 Milan Bear, Stearns International Limited Via Pietro Verri 6 20121 Milano Italy 39-02-3030-1730 So Paulo Bear Stearns do Brasil Ltda. Rua Joaquim Floriano, 72 - 8 andar - cj 83 So Paulo, SP Brazil 04534-000 55-11-3457-3200 Shanghai Bear, Stearns & Co. Inc. Representative Office Unit 09, 20th Floor, Building One, Corporate Avenue No. 222 Hu Bin Road Luwan District, Shanghai 200021 Peoples Republic of China 86-21-6340-6600 Singapore Bear Stearns Singapore Pte Limited 30 Raffles Place #21-01 Caltex House Singapore 048622 65-6437-3300 Tokyo Bear Stearns (Japan), Ltd. Shiroyama JT Trust Tower 3-1 Toranomon 4-chome Minato-ku Tokyo 105-6022 Japan 813-3437-7800

The data underlying the information contained herein has been obtained from sources that we believe are reliable, but we do not guarantee the accuracy of the underlying data or computations based thereon. The information in this report is illustrative and is not intended to predict actual results, which may differ substantially from those reflected herein. Performance analysis is based on certain assumptions with respect to significant factors that may prove not to be as assumed. You should understand the assumptions and evaluate whether they are appropriate for your purposes. Performance results are often based on mathematical models that use inputs to calculate results. As with all models, results may vary significantly depending upon the value of the inputs given. Models used in any analysis may be proprietary making the results difficult for any third party to reproduce. Contact your registered representatives for explanations of any modeling techniques and the inputs employed in this report. The securities referenced herein are more fully described in offering documents prepared by the issuers, which you are strongly urged to request and review. Bear, Stearns & Co. Inc. ("Bear Stearns") and/or its affiliates or employees may have positions, make a market or deal as principal in the securities referred to herein or related instruments, while this document is circulating. During such period, Bear Stearns may engage in transactions with, or provide or seek to provide investment banking or other services to, the issuers identified in this report. Bear Stearns may have managed or co-managed a public offering of securities within the last three years for the issuers identified in this report, including regularly acting as an underwriter for Government Sponsored Enterprise issuers. Directors, officers or employees of Bear Stearns or its affiliates may be directors of such issuers. This document is not a solicitation of any transaction in the securities referred to herein which may made only by prospectus when required by law, in which event you may obtain such prospectus from Bear Stearns. Any opinions expressed herein are subject to change without notice. We act as principal in transactions with you, and accordingly, you must determine the appropriateness for you of such transactions and address any legal, tax or accounting considerations applicable to you. Bear Stearns shall not be a fiduciary or advisor unless we have agreed in writing to receive compensation specifically to act in such capacities. If you are subject to ERISA, this report is being furnished on the condition that it will not form a primary basis for any investment decision.
Copyright 2006 Bear, Stearns & Co. Inc. All rights reserved. Unauthorized duplication, distribution or public display is strictly prohibited by federal law.

INTERNATIONAL
Beijing Bear, Stearns & Co. Inc. Representative Office Room 1608 China World Tower 1 Jian Guo Men Wai Avenue Level 16, Units 06-08 Beijing 100004 People's Republic of China 86-10-6505-5101 Dublin Bear Stearns Bank plc Block 8 Harcourt Center, Floor 3 Charlotte Way Dublin 2 Ireland 353-1-402-6200