[Bank of America] Outlook for the RMBS Market in 2007

8/14/2019 [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 [email protected]


Ohmsatya [email protected]

Qumber Hassan212.933.3308 [email protected]

Sunil Yadav212.847.6817 [email protected]

Ankur Mehta212.933.2950 [email protected]

RMBS Trading Desk Modeling

ChunNip [email protected]

Marat [email protected]

Vipul [email protected]

Review of 2006: Mortgages had a Great Year (p. 2)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 stronggrowth in MBS holdings of overseas investors and domestic money managerscharacterized supply and demand technicals in the mortgage market in 2006. Themortgage basis has also benefited enormously in 2006 from swap spread tightening,the decline in implied volatilities and very low realized volatilities. While relativelyfast discount prepayment speeds and muted premium speeds were observed in2006, sharp declines in HPA and the consequent mortgage credit issues started toattract the markets attention by the end of the year.

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

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

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

We see little upside from owning mortgages in the short-term for relative value players (pure OAS players). However, from a long-term perspective, werecommend an overweight on the mortgage basis to real money managers becauseof our expectations for a range-bound rates environment and strong demandtechnicals for MBS. We also recommend overweighting 30-yr 5.5s and 6.5s versus5s and 6s, 15-yr MBS versus 30-yr MBS, and 15-yr 4.5s and 6s versus 5s and 5.5s.

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

Hybrids are attractively priced relative to the fixed rate sector with 5/1s offeringmore than 30 bps in OAS pickup relative to 15-yrs. However, based on our macro

picture range bound interest rates, low realized volatility and lack of surge inimplied volatilities much like this year, we expect hybrids to lag fixed-rate MBSin 2007. However, from a short term perspective, we recommend a tacticaloverweight on the hybrid basis due to favorable technicals caused by the inclusionof 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 documenthas 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 holdout 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 deskstrategists.


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The mortgage basis had a greatyear.

Net supply of agency fixed-rateMBS was very high.

Overseas investors anddomestic money managers

provided a firm bid for MBS.

More than 60% of the mortgageoutperformance versus swaps isdue to declines in volatilities.

I. Review of 2006

Mortgages outperformed Treasury hedges by about 1 point and swap hedges by 21-25 ticksin 2006 (at closes of 12/22/2006). The following themes dominated the MBS marketsentiment in 2006:

Heavy net production of fixed-rate agency MBS Strong growth in MBS holdings of overseas investors and domestic money

managers Continued declines in implied volatilities and very low realized volatilities Relatively fast discount prepayment speeds (but slower than the discount speeds

in 2005) and muted premium speeds Sharp slowdown in home price appreciation and higher delinquencies on new

origination mortgage pools relative to older cohorts Higher servicing spreads being retained by servicers on their books Strong outperformance of 30-yr MBS versus 15-yrs and hybrid ARMs as

investors rushed to sell convexity which helped the 30-yr sector more than others Positive net production of GNMAs and the dramatic cheapening of GN/FN swaps

One of the biggest surprises associated with the mortgage market in 2006 was the strongsupply of agency fixed-rate passthroughs. We estimate that net supply of fixed-rate agencyMBS (gross issuance less pay-downs) totaled $254 billion in 2006 versus $110 billion in2005 and a negative $27 billion in 2004. This net supply is substantially higher than whatthe 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 yieldcurve environment that prevailed in 2006 (we will discuss this topic in more detail in thefollowing section).

While the heavy net supply of fixed-rate agency MBS in 2006 was a big surprise, what waseven more interesting was the strong performance of the mortgage basis in 2006 despitethis trend and very low net purchases of MBS by domestic banks. It turned out that theheavy net supply of agency MBS was comfortably absorbed by overseas investors anddomestic money managers. As we have repeatedly commented before, historically netoverseas investor purchases of agency debt and MBS have shown a strong correlation withthe 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 concernand, in an environment of very tight spreads on AA and A rated corporate bonds, moneymanagers 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 viewon the direction of implied and realized volatilities.

The mortgage basis also benefited enormously in 2006 from the sharp decline in impliedvolatilities and very low realized volatilities. In fact, we attribute more than 60% of theoutperformance of mortgage basis versus swaps this year to declines in implied volatilities.


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Relatively fast discount speedsand muted premium speedscharacterized prepayments in2006.

Servicers are retaining moreinterest cash flows on their

balance sheets.

30-yrs outperformed 15-yrs andhybrid ARMs.

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

As long-term rates continued to stay in a narrow range and the marginal buyer of MBS isnot a Gamma and Vega hedger, demand for volatility has plummeted which helpedmortgages 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 were100 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 housingslowdown in 2006, is the fact that these pools had already seen fairly solid equity growthfrom the previous year. On the other hand, slower speeds of deep in-the-money pools can

be attributed to weaker borrower characteristics with higher spreads at origination (SATO)for these pools. On the hybrid ARMs side, the markets fear of extremely fast tail speeds onhybrids waned over the course of the year as prepayments around the first reset proved to

be a lot more docile than the markets initial expectations. An interesting trend observed inhybrid speeds in 2006 is the presence of a second spike in prepayment speeds at the secondreset. 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 andthe net coupon of fixed-rate agency mortgage pools increasing substantially over the pastseveral 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 aGWAC of 6.25% versus 5.96% 1-yr ago. On average, the spread between the aggregateGWAC and the net coupon of new production 30-yr mortgage pools was close to 47-48 bpsin 2003 and 2004 versus 56 bps over the past year. We believe that originators/servicers areretaining more interest cash flows on their balance sheets as the MBS market came out of asignificant 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 thefollowing sections.

30-yr mortgages outperformed 15-yrs and hybrid ARMs by more than 20 ticks on aduration and curve adjusted basis in 2006. This was largely because 30-yrs benefited morethan 15-yrs and hybrid ARMs from low realized volatilities and sharp declines in impliedvolatilities 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 outperformed15-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 netsupply in GNMAs coupled with the increased comfort level of overseas investors with theMBS backed by the GSEs caused this sharp cheapening of GNMAs versus conventionalMBS in 2006. This has created an interesting opportunity in that the government guaranteeon 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 GNII/FN swaps still seem to offer government guarantee for only a modest pay-up.


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II. Macro Themes Relevant for the RMBS Market in 2007

Looking ahead to 2007, we believe that the following issues will have a significant impacton the relative performance of mortgages versus other fixed income sectors:

Outlook for Interest Rates and Volatilities: Remarkably range bound long-terminterest rates and the consequent low realized volatilities and sharp declines inimplied volatilities helped the MBS sector put in a strong performance versusTreasuries and swaps in 2006.

Mortgage Supply Technicals: Despite all the talk about the housing marketslow-down, the net supply of fixed-rate agency MBS was very strong in 2006.

Overseas Investors: Overseas investor demand for MBS stayed very strong in2006 and made a significant contribution to the outperformance of the mortgage

basis.

Domestic Money Managers: Cross-over buying of MBS by domestic moneymanagers has been at very high levels since the 4Q05.

Domestic Banks: Excluding the impact of Golden Wests acquisition, deposits onthe books of large banks have grown by only 1.5% in 2006 versus an annualgrowth rate of 7%-8% during 2002-2005.

Agency Portfolio Issues: The 2004-2005 trend of the GSEs substituting agencymortgages with subprime MBS appeared to subside in 2006.

Convexity Hedging Related Issues: The last time convexity flows haddominated 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 areaof concern due to continued softness in the housing market.

Housing Slowdown and Mortgage Defaults: New origination pools are showingsignificantly higher 90+ day delinquencies than the older cohorts. As heavyvolumes of ARMs (prime and subprime) come up for resets in 2007, the impact of housing slowdown on potential mortgage delinquencies becomes an importantissue.

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 tospike up substantially from current multi-year lows.

10-yr swap spreads are likely to tighten by 8-9 bps and 2-yr swap spreads arelikely to tighten by 4-5 bps in 2007.


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Long-term interest rates were ina very narrow range over the

past 3 years.

We expect only a single 25 bpsFed easing in 2007.

Over the past three years, long-term interest rates have remained in a very narrow range. Infact, the 10-yr CMT yield had been within a 155 bps range (3.70%-5.25%) over the past 3years 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 coupledwith the fact that interest rates have moved away from the levels where another mortgagerefinancing wave could be of some concern have made mortgages the asset class of choicefor domestic money managers since the 4Q05. 1

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

2000 2001 2002 2003 2004 2005 2006Max 6.79 5.54 5.44 4.61 4.89 4.66 5.25

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 ratesover the year will have a significant impact on mortgage performance versus other assetclasses. 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 moreimportant than realized and implied volatilities of interest rates because the GSEs wouldactively hedge volatility exposure in their portfolios. Similarly, these factors were less

important when banks were marginal buyers because their funding costs were very lowrelative to mortgage yields to begin with. At the moment, domestic money managers are animportant segment of marginal buyers of MBS (along with overseas investors) and thecross-over demand from domestic money managers has been a significant contributor tothe recent strong performance of mortgages. The magnitude of this cross-over buying in2007 clearly depends on the expected range of interest rates and the perceived prepaymentrisk 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 toreach 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 endof the year (with the risk skewed towards a slightly steeper curve). Our estimates are basedon 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 inflationshould stay above the Feds comfort zone of 1%-2% for most part of 2007 because theunemployment rate is below the generally accepted level of NAIRU. In this scenario, anyeasing by the Fed should be limited to a modest insurance cut in the first half of the year and our view differs from markets expectations for a 4.72% funds rate by the end of 2007(or two to three 25 bps easings in 2007). The biggest risk to our rates view comes from the

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


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

possibility of a deepening housing slump. If the housing slump turned out to be muchlonger and deeper than what we are projecting, reduced consumer spending could weakenthe economy further and may warrant further Fed easings. Such a scenario is likely to beassociated 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 totighten to 40 bps (8-9 bps tightening from last weeks levels) and the 2s/10s swap spreadcurve to flatten in 2007. 2 Because mortgage spread movements tend to follow swap spreadsrather closely for instance, a substantial portion of the mortgage outperformance versusTreasuries over the past 2 months can be attributed to swap spread tightening we expectmortgages to outperform Treasuries in 2007 due to swap spread tightening alone.

Realized Volatility Should Remain Very LowThe negative convexity of mortgages implies that they will outperform positively convex

assets like Treasuries and non-callable agency and corporate bonds when realized volatilityis low. MBS investments have benefited a lot over the past 3 years as realized volatility hasdeclined sharply (Figure 2).

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

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10-yr Treasury yields shouldremain in the 4.35%-5.15%range and realized volatilityshould be very low in 2007.

As our base line economic forecast above indicates, we expect interest rates to remainrange-bound in 2007 and the 10-yr Treasury to end the year only 35 bps above its current

level. We do not expect the 10-yr Treasury to rally below 4.35% as long as the Fed fundsrate is at or above 5% and there are no hints of the Fed embarking on an easing cycle.Similarly, the 10-yr Treasury is unlikely to backup above 5.15% as the overseas demandfor the U.S. assets remains strong and is likely to increase further at higher yield levelswhich 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 moneymanagers.

An interesting point about realized volatility is worth making here. In general, MBS market

2 See Global Rates Focus report dated December 14, 2006


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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 thatit is not the correct way to track realized volatility in the current environment and here iswhy. 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 realizedvolatility based on daily changes of 10-yr swap rates over Period#1 was 48 bps while thesame number for Period#2 was 64 bps. The 60-day realized volatility was higher inPeriod#2 because interest rates fluctuated wildly during this period although the net effectof 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 steadilydeclined 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

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Historically, measures of realized volatility based on daily interest rate changes have beenfollowed in the MBS market because convexity hedging activity from GSEs was supposedto 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 theMBS market, but this is not the case at the moment. Overseas investors and domesticmoney managers are dominant players in the mortgage market now and these two groupsof investors typically buy mortgages to earn the additional carry offered by them in arange-bound environment (i.e., they dont actively hedge negative convexity). In thisscenario, as far as the MBS market is concerned, we think that the range in which interestrates move over few weeks or months is a better indicator of realized volatility than themeasures based on daily rate fluctuations. From this perspective, realized volatility shouldremain very low in 2007 and continue to propel demand for mortgage assets.


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

Implied Volatilities are Unlikely to Bounce Back from Their Multi-year LowsImplied 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 thenegative convexity of the mortgage universe is very high, marginal buyers of MBS are notconvexity hedgers. Second, as long-term interest rates have moved in a very narrow rangeover the past three years and the market still expects long-term rates to remain range-

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 yieldcurve 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 impliedvolatilities to jump up substantially from their multi-year lows any time soon.

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

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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 avigorous rate cutting path next year, uncertainty in the market would increase and thecurve will steepen, both of which are likely to cause implied and realized volatilities tospike up.

Mortgage Sup ply Technicals

We see mortgage debt growing by 7% in 2007 after averaging 13.8% in 2005 and8.9% in 2006.

We project the net supply of agency fixed-rate MBS to total $220 billion in 2007versus $254 billion in 2006 and $110 billion in 2005.

The supply of affordability products is likely to decline following the inter-agencyguidance issued a few months ago and also because of well-advertised credit

problems in the mortgage market.


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Should we expect fixed-rateagency MBS supply to remainas strong as it was in 2006?

The amount of equity cashedout by prime conventionalmortgage holders soared to$296 billion in 2006.

One of the biggest surprises associated with the mortgage market in 2006 was the strongsupply of agency fixed-rate MBS. We estimate that the net issuance of agency fixed-rateMBS 3 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-ratesupply to remain as strong as it has been in the past. Unfortunately, it is quite difficult toforecast this number with any degree of certainty. As we will discuss in detail later, thedramatic increase in agency fixed-rate MBS issuance was due to a number of factorsincluding a decline in the ARM share of mortgages, a large volume of resetting ARMs, anunprecedented level of cash-out refinancing activity, and an improvement in the GSEsshare of the mortgage market.

To build our forecast, lets begin with an examination of the fundamental forces that resultin the growth of outstanding home mortgage debt. In general, the net supply of mortgagesis 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 peopleowning a house versus renting;

Home Price Increases. An increase in the value of homes so that for the sameLTV, 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 mortgageis larger than the old one.

Figures compiled by the Federal Reserve show that the net supply of all home mortgages 4 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 theincrease in home prices in conjunction with increases in LTV ratios accomplished throughcash-out refinancings. The importance of cash-out refinancing in terms of creating newmortgage debt is summarized in Figure 6. Notice the remarkable strength of the numbersin 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 equitycashed 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 resultedfrom cash-out refinancings. In fact, the Freddie Mac numbers graphed in Figure 6understate the net supply created by cash-out refis since the estimates do not include theequity 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.


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

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

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

Given the discussion above, an integral part of the forecast is coming up with estimates for home price growth and cash-out refinance volume in 2007. Our forecast is built along the

following assumptions:

Home Price appreciation : After averaging 13.4% in 2005 and 5.7% in 2006, we believe home price growth will further moderate to about 3% per year in 2007.

Cash -out Equity volume : Freddie Macs estimates have cash-out volumedropping by more than $100 billion in 2007. While we do think that we will seecash-out volume moderating, we think the magnitude of the drop projected byFreddie Mac is too punitive.

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


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

amount of equity withdrawn by homeowners, we see mortgage debt growing by 7% in2006 after averaging 13.8% in 2005 and 8.9% in 2006. A growth rate of 7% on anestimated 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 inthis sector will not decline by as much as the overall universe. First, there are signs thatthe agency share of the mortgage market has been improving over the last couple of yearsafter 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 7shows, there was negative net issuance of agency fixed-rate MBS in 2004. While some of this was due to the increase in the popularity of ARMs as affordability issues began toshow up in the mortgage market, many conforming balance agency-eligible loans weresiphoned off into the non-agency alt-A sector over this period. The rebound in agencyfixed-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. Weexpect this trend to continue in the next year. Another factor that will help fixed-ratesupply is the flat FRM-ARM slope which we expect to persist into next year. A moremoderate 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 resettingARM borrowers in 2007 should also gravitate towards fixed-rate mortgages for the samereason. 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 Markets2003 2004 2005 2006 (E) 2007 (F)

Home Price Appreciation (%) 7.8 11.9 13.4 5.7 3ARM Share of Applications (%) 19 32 31 28 24

Growth in Home Mortgage Debt (%) 14.3 14.1 13.8 8.9 7Net Issuance of Home Mortgages ($bb) 801 1055 1135 835 715

Net Issuance of Agency Fixed-rate MBS ($bb) 227 -27 110 254 220Net Issuance of Agency ARM MBS ($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 byBanc of America Securities.

Overseas Investors

We estimate that overseas investors have been net buyers of $288 billion agencydebt and MBS in 2006. Based on our forecast for a slightly lower trade deficit anda weaker dollar versus other currencies, we expect combined net overseasinvestor 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 fundsout of Treasuries into agency debt and MBS.

We estimate that the net purchases of agency MBS by overseas investors in 2007will be $150-$170 billion which is slightly higher than their net purchases in 2006.


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Net overseas investor purchasesof agency debt and MBS shoulddecline slightly in 2007.

MBS holdings of overseasinvestors as a percentage of their combined agency debt andMBS portfolios have beengradually increasing.

Despite the heavy net supply of agency fixed-rate MBS, the mortgage basis did extremelywell 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 buyersof $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 iscrucial for the MBS market in 2007.

Figure 8 shows the actual annual net purchases of agency debt and MBS by overseasinvestors 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 MBSover the past few years. Based on our forecast for a slightly lower trade deficit and weaker dollar versus other currencies, we expect combined net overseas investor purchases of agency debt and MBS in 2007 to decline slightly from 2006. As far as the agency debt andMBS 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 arelikely 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

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

N e t

P u r c

h a s e s

( $ B B )

Actual Purchases Model Purchases

Actual purchases for 2006 are estimated by extrapolating the first 10 months of data.Source: Banc of America Securities

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 past3 years. For instance, the fraction of agency MBS in total agency debt and MBS holdingsof overseas investors rose from 25% in 2003 to 33% in 2005 (the latest year for which thedata are available). We ascribe this trend to the following three factors: a) Reducingissuance level of agency debt; b) Increasing comfort level of Asian investors with

prepayment risk; and, c) the range-bound rates environment that made additional carryoffered by mortgages over agency debt very attractive.

5 2006 numbers have been extrapolated based on the data from January to October.


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Mortgages look somewhatattractive versus corporates.

Figure 10: Excess Returns on MBS over Equal dv01 Swaps with Different ParallelShifts 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 tospreads on corporate bonds and our credit strategists are slightly bearish on corporatespreads. 6 In Figure 11, we show Treasury Z-spreads (ZVOAS) of 30-year current couponMBS 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

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Tsy Z-spread of CC MBS Tsy Z-spread of AA&A Corporate Debt Source: Banc of America Securities

Notice that mortgage spreads were very wide relative to spreads on corporate bonds back in Nov05 Dec05. Money managers took advantage of these wider spreads by buyingseveral billion MBS ($35-$45 billion by our estimates) and, as the spread differentialcompressed, there was some profit taking in late April and early May. At the beginning of the 2H06, we commented that mortgage valuations were very cheap relative to corporate

bonds and that money managers are likely to provide strong cross-over bid for MBS. Wewere certainly not disappointed as domestic money managers were heavy buyers of MBSover the past 3-4 months which is partly responsible for the strong performance of MBS. Itis possible that money managers may take short-term profits on their mortgage overweightif relative spreads between MBS and corporate bonds tighten another 4-5 bps, but from along-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.


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Large bank holdings of MBShave declined by $62 billionsince peaking in late August.

The deposit base of large banksis not growing.

There is very little spread between mortgage yields andthe marginal cost of funds for

banks.

Bank Purchases of Mortgages

Changes in large bank holdings of MBS and their deposits have been heavilyskewed by the acquisition of GoldenWest by Wachovia in 2006. Excluding the

impact of Golden Wests acquisition, deposits on the books of large banks havegrown by only 1.5% in 2006 versus an average annual growth of 7%-8% during2002-2005.

Although the spread between mortgage yields and average funding costs of banksis 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&Iloans can accommodate most of their deposit growth, the marginal cost of fundingfor 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 donot 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 theacquisition of Golden West by Wachovia. After correcting for this, large bank holdings of MBS grew by $27 billion while their whole loan holdings rose by $40 billion in 2006.Bank holdings of mortgages grew very rapidly until August, but have stalled since then. Infact, large bank holdings of MBS declined by nearly $62 billion from their peak reached inlate August (after adjusting for Golden West numbers). We attribute this drop to thefollowing three factors:

First, deposits on the books of large domestic banks are not growing (Figure 12).

Historically bank holdings of MBS have a strong correlation with excess deposits(deposits less C&I loans). Banks have added $67 billion of mortgages and $46 billionC&I loans thus far in 2006 although deposit base rose by only $36 billion. 7 Over the past 6years, (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 currentcoupon mortgage yield. At a time when the growth in C&I loans can accommodate most of the deposit growth, the marginal cost of funding for banks to buy MBS is much higher thantheir average cost of funds. We believe that there is very little spread between currentcoupon mortgage yields and the marginal cost of funds for banks to buy MBS at themoment. 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 andestimated pay-downs) are in-the-money at the moment. Therefore, banks could shedmortgages if the current situation with deposits and C&I loans persists without having toworry about recognizing losses in their income statements. This is unlike the situation inJune/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.


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

Agency portfolio size should

remain unchanged in 2007.

In summary, we believe that deposit growth of large domestic banks will remain sluggishin 2007 and given the current situation with the C&I loan growth, banks are unlikely togrow their MBS portfolios in 2007. At the same time, we do not expect banks to activelysell 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 depositgrowth doesnt keep pace with the C&I loans.

Figure 12: Large Bank Holdings of Mortgages, C&I Loans and Deposit Growth

Large Banks As Reported Excl. Golden West 2005 2004 2003 2002 2001 Net Mortgage Purchases

MBS 65 27 35 97 36 44 84Whole Loans 148 40 73 12 45 102 -14

Total Net Mortgages 213 67 107 108 82 146 69C&I Loan Growth 49 46 45 2 -41 -58 -72

Deposit Growth 104 36 157 226 128 118 101

2006

All numbers are in billion dollarsSource: Banc of America Securities

Agency Portfolio Issues

Mortgage holdings of the GSEs have declined slightly in 2006 (by $12-$14 billion). Considering the current regulatory environment, we expect agency portfolio sizes to remain unchanged in 2007.

The trend of the GSEs substituting agency mortgages with subprime mortgagesthat prevailed in 2004-2005 seems to have subsided in 2006. We expect the GSEsto be net buyers of agency mortgages in 2007 (although their overall portfolio sizeis likely to remain unchanged) following the recent directive from the OFHEOabout non-traditional mortgages.

30-yr mortgages need to be 5-10 bps cheaper relative to agency debt for the GSEsto actively buy them as a substitute for subprime mortgages. In the short-term, weexpect 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 andFreddie Mac together have to sell $8-$9 billion MBS for a 25 bps rally in rates. Subsequentchanges in the GSE portfolios have supported our assertion to some extent. However,

going forward the cap should be much less of an issue assuming our expectations of 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 agencymortgages by non-agency mortgages (primarily, subprime mortgages) seems to havesubsided in 2006. As shown in Figure 13, the GSEs bought about $170 billion subprimeMBS per year during 2004-2005 but the recent changes in the non-agency mortgageholdings of the GSEs indicate that the substitution of agency MBS by subprime MBS hasstopped. In fact, we expect the GSEs to substitute a portion of their subprime holdings withagency MBS in 2007 because of the recent directive from the OFHEO about non-


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

CC MBS may have to widen 5-10 bps for the GSEs to buyfixed-rate MBS.

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

billion of agency mortgages in 2007.

Figure 13: Annual Purchases of Subprime MBS by the GSEs

Year 2005 2004 2003 2002

Subprime Purchases 169 176 81 38

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

From the valuations side, we show the history of the OAS of the 30-yr current couponMBS relative to the agency curve in Figure 14. Mortgage spreads are near the tighter endof the past 1.5-yr range relative to agency debentures. Thus the GSEs are unlikely to buy30-yr mortgages at current valuations but mortgage spreads need to widen by no more than5-10 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 inhybrid ARMs because of their cheap valuations in OAS terms.

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

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A g e n c y

O A S ( b p


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 notnon-existent). In our base case interest rate scenario, convexity hedging shouldnt

be an issue for the market in 2007.

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


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Interest rates need to rally 60-70 bps for convexity hedgingactivity to become important.

Relatively fast discount speedsand muted premium speedscharacterized prepaymentspeeds in 2006.

(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 billion10-yr Treasury equivalents for a 25 bps change in rates. We also believe that servicers arestill 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, convexityrelated flows should be very limited if rates backup 25 bps.

In our view, convexity hedging activity will have a heavy impact on rates, volatility andMBS markets only if another refinancing wave is initiated. Based on the current GWACdistributions, 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

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Interest Rate Shift from the Base Case (bp)

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6/20/2006 12/22/2006


Outlook for Prepayment Speeds in 2007

For the range bound rate scenario during 2007, the out-of-the money and at-the-money speeds of recent originations are of chief concern due to continued softnessin the housing market.

We estimate that discount speeds for 2006 originations could be slower by up to2%-3% after the initial ramp up period as compared to the discount speeds during2006 for 12-24 WALA FNCL pools.

Even though we are not expecting mortgage rates to rally 50 bps from the currentlevels, 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 wereobserved during 2006. We expect prepayment speeds to be closer to 45% CPR asopposed 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 5years for various incentives in Figure 16. Overall, the prepayment experience during 2006resembled the 2005 experience i.e. relatively fast discount speeds and muted premiumspeeds. Pools that were 100 bps in the money prepaid at roughly 33% CPR (a far cry from60%-70% CPR during 2002-2003) and pools that were 50 bps out of the money prepaid at10% CPR.


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

Figure 16: FNCL Prepay Response Curves Over the Past 5 years (12-24 WALA)

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-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Incentive (bps)

C P R ( % )

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 sharpdifferences in the borrower characteristics of in-the-money mortgage pools relative to prior years can be clearly seen in Figures 17. It shows that 12-24 WALA pools with 100 bps of incentive during 2006 had average FICO score of 655 and OLTV of 82%, suggesting that

borrowers in theses pools belonged to the lower end of the credit spectrum. In contrast,FICO score ranged between 700-720 and OLTV was closer to 75% for 100 bps in-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)

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O L T V ( % )

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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 loansizes (see Figure 18) and at the macro level the media effect was virtually non-existent in2006.


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Lower loan sizes, higher LTVsalso dampened premiumspeeds.

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

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-150 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

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A C L S ( 0 0 0 s )

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 stillfairly 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 PoolsOver the Past 5 years (12-24 WALA, $150K-$200K average loan size)

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14

2002 2003 2004 2005 2006

Year

C P R ( % )


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 fairlysolid equity growth from the previous year as can be seen in Figure 20. The cumulativeEquity 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 thecash-out activity at an elevated level even for discount collateral. The quarterly refinance


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The robust discount speeds aredue to the solid equity growththese pools have experienced.

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

statistics released by Freddie Mac provides credence to this hypothesis as it indicates thatcash-out activity during 2006 was at an all time high on an absolute dollar amount basisand the cash-out borrowers were willing to pay slightly higher mortgage rates (2%, 8%,12% higher during Q1, Q2, Q3 of 2006, respectively) to tap home equity.

Figure 20: Average Cumulative EGSO for 12-24 WALA FNCL Pools

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i v e

E G S O ( % )

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 andATM speeds of recent originations are of chief concern due to continued softness in thehousing market. Our estimates indicate that discount speeds for 2006 originations could beslower by up to 2%-3% CPR after the initial ramp up period as compared to discountspeeds during 2006 for 12-24 WALA FNCL pools. Our estimate of the potential drop inspeeds for recent originations is based on three different computations. First, we usediscount speeds in 2002, as shown in Figure 19, to gauge the potential decline in discountspeeds. The 12-24 WALA pools during 2002 had a cumulative EGSO of approximately10%, which is actually higher than our baseline forecast of a flat housing market in realterms. During 2002, speeds were approximately 2% CPR slower as compared to the speedsin 2006.

Another estimate can be obtained by grouping 12-24 WALA pools from 2006 byannualized EGSO. The results are shown in Figure 21. This analysis also indicates thatramped 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 Maestate 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 candrop by 3% CPR in a low HPA environment.


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If interest rates rally 50 bps,100 bps ITM pools could

prepay substantially faster thanwhat were observed in 2006with similar incentive.

Figure 21: Prepayment Speeds in 2006 for 12-24 FNCL Pools by Annualized EGSO

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5 10 15 20

HPA (%)

C P R ( %


Earlier OTM cohorts will not be affected to the same degree by the housing slowdown asthey already have substantial built in equity. They would be impacted more in a scenariowhere home sales were to slow down further from the current levels and result in lower levels of baseline turnover speeds. At this point we are not anticipating such a scenario.

Even though we dont expect mortgage rates to rally 50 bps from the current levels,nevertheless, if such a scenario were to materialize, prepayment speeds of pools that are100 bps ITM (FNCL 6s) will be significantly higher than what were observed during 2006.Our expectation in such a scenario is that prepayment speeds could shoot up to 45% CPR for 100 bps ITM 30-yr fixed rate agency pools. The reasons for this expectation are two

fold. First, the collateral characteristics of the pools with 100 bps of incentive will be much better as compared to the 12-24 WALA pools that had 100 bps of incentive in 2006 andconsequently, will not face the same barriers to refinancing. The summary of collateralcharacteristics for FNCL 5.5s and 6s by various incentive buckets (assuming currentmortgage rate of 6.1%) is presented in Figure 22. For a 50 bps rally, FNCL 6s with currentincentive of 25 bps or 50 bps will have incentives of 75 bps and 100 bps, respectively, andcorrespond 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

2006 Average


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2006 vintage alt-A ARMs is theworst performing vintage fromthe past 4 years.

the distribution of the universe by incentive on the December factor date for the past 5years. 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 nowhere close to that in Dec2002, it will be much closer to Dec2003 and Dec2004 factor

dates. In the periods following those factor dates media effect was modestly higher thanthe current levels. To estimate prepayment speeds of FNCL 6s with 100 bps of incentivein a 50 bps rally scenario, we use prepayment experience during 2004 (see Figure 16) asour 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

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U n i v e r s e

200212 200312 200412200512 200612 200612 - 50bps rally


Outlook for Mortgage Credit in 2007

We believe that residential mortgage credit will continue to make negative headlinenews 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 paymentdefaults 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 forwardas 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. Weexpect the home prices to stay flat in real terms or increase by 2%-3% in nominalterms during 2007.

We believe that residential mortgage credit will continue to make negative headline newsfor a large part of 2007. Cracks have already started appearing in the credit performance asindicated 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 recentlyoriginated alt-A ARM loans as compared to the earlier vintages, and rise in early paymentdefaults during 2006. In fact, the 2006 vintage of alt-A ARMs (excluding Option ARMs) isthe worst performing (90+ delinquencies) vintage from the past 4 years and early paymentdefaults for the alt-A sector have almost doubled during 2006 as compared to 2004.Furthermore, the credit performance of alt-A ARM loans from California is close to the US


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average for the 2006 vintage as opposed to outperformance for the earlier vintages 8. The primary reason for worsening in credit is the slower housing market and weak underwritingas indicated by increased origination of leveraged loans without full documentation (Figure24).

Figure 24: Prime RMBS Collateral Characteristics.

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

Leverage

Source: LoanPerformance

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

2006 alt-A ARM cohort isunderperforming the 2000 alt-Afixed cohort.

At this point, HPA is continuing to slowdown and the inventory of unsold homes is at avery high level (7.4 month supply for existing homes according to NAR). However, thereare some preliminary signs that housing market may stabilize going forward as new andexisting home sales are leveling off. Furthermore, home builders have reacted promptly tothe housing slump by lowering the construction of new homes which will further supportthe housing market. Having said this, we still think it is too early to expect a reversal to thedownward 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 acontinued 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 worthkeeping an eye on as a lot of these areas are experiencing negative HPA already and havehigher concentrations of leveraged borrowers. For 2007, the major risks for the investorsare the widening of mortgage credit spreads and higher default rates combined with higher loss severities. Careful analysis of the collateral characteristics will be of paramountimportance while taking credit exposure.

Given our bearish outlook on credit performance especially for the 2006 cohort, thequestion is how bad can it get? At the national level, the 2000 vintage that corresponded toloans from prior purchase environment stands out for poor performance in recent times.The cumulative defaults for alt-A fixed rate loans (alt-A ARMs were a much smaller

portion of the alt-A universe in 2000) were close to 5.9% and cumulative losses were 69 bps. The reasons for poor performance were weaker underwriting standards during 2000and weak economic climate post 9/11. However, the drop in interest rates after 9/11 didhelp 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 thehousing market, it is possible for defaults and losses to reach or exceed 2000 levels. Figure25 compares the delinquency ramp of 2006 alt-A ARMs with the 2000 cohort of alt-Afixed 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.


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underperforming the 2000 alt-A fixed cohort.

Figure 25: 90+ Delinquencies for Recent alt-A ARM Cohorts versus 2000 alt-AFixed

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i n q u e n c y

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2003 a lt-A ARM 2004 a lt-A ARM 2005 a lt-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 lowand 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 amarginal decline in trade deficit.

We expect domestic money managers to continue to provide a strong bid for MBSin 2007. The range-bound rates environment coupled with mortgage rates stayingabove the levels where refinancings could be an issue should make MBS the assetclass of choice for domestic money managers.

Excluding the impact of Golden Wests acquisition, deposits on the books of large banks have grown by only 1.5% in 2006 versus the average annual growth of 7%-8% during 2002-2005. Considering our macro-theme that rates will remain range-

bound next year, we do not expect banks to actively shed mortgages in 2007, butwe 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 islikely to remain unchanged) due to the recent directive from the OFHEO aboutnon-traditional mortgages.

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


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2%-3% after the initial ramp up period as compared to the discount speeds during2006 for 12-24 WALA FNCL pools. On the other hand, if interest rates were torally by 50 bps, prepayment speeds of 100 bps ITM pools will be significantlyhigher 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 paymentdefaults for the alt-A sector have almost doubled during 2006 as compared to 2004.


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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 coupon30-yr valuations are at the very rich end of the past 2-yr range. In addition, mortgageshave benefited enormously from faster discount and muted premium prepayment speeds in2006, but as our outlook for prepayments discussed in the previous section suggests, themortgage 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 anoverweight on the mortgage basis (with the end of 2007 end as the horizon period) to realmoney managers for the following reasons:

We expect a range bound rates market with very low convexity losses whichgenerally 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 intothe agency fixed-rate MBS market in 2007.

Corporate bonds continue to look rich relative to MBS and the cross-over buyingfrom domestic money managers will continue in 2007.

Although banks are unlikely to grow their MBS holdings in 2007, we expect theGSEs to be better buyers of agency mortgages.

Considering that the mortgage universe has very limited refinancing risk atcurrent rate levels, the mortgage basis should trade somewhat tight.

As shown in Figure 10, 30-yr current coupon passthroughs outperform swaps even if interest rates move towards either the upper or lower ends of our projected range for 2007.

Note that this outperformance doesnt even account for a few basis points of likelyadditional gains from roll specialness. Considering that our base case scenario is for the10-yr Treasury yield to reach 4.95% by the end of 2007 which is only 35 bps away fromcurrent 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 modestunderweight on the mortgage basis versus swaps as mortgages are trading near their 2-yr


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tights in LOAS terms. In addition, mortgage spreads are also at 1.5-yr tights versuscorporate bonds and agency debentures (although still cheap by historical standards) andthis 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

-20

-15

-10

-5

0

5

J a n -

0 5

M a r - 0

5

M a y - 0

5

J u l - 0 5

S e p -

0 5

N o v - 0

5

J a n -

0 6

M a r - 0

6

M a y - 0

6

J u l - 0 6

S e p -

0 6

N o v - 0

6

L O A S ( b p


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 Market 9 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 moreinterest cash flows on their balance sheets as the MBS market came out of a significantRefi wave and the media-effect subsided. In addition, originators/servicers may be takingadvantage of FAS 156 which allowed mark-to-market accounting treatment for servicingrights. 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.


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average loan size on MBS pools. At the moment, the average loan-size for new production30-year 6s is $225K versus $170K one year ago. Similarly, newly issued 30-year FNMA5.5s 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 morenegatively convex than the same net coupon pools originated one year ago which has somesignificant implications for their valuations. For instance, the higher loan size coupled withhigher 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 loansizes are somewhat lower on FNCL 5.5s since it is a discount coupon. Considering the verynarrow range in which spreads have traded over the past few months, differing assumptionsabout TBA collateral characteristics can make the difference between viewing couponswap valuations as rich or cheap.

Prepayment Response CurvesAs 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 speedsduring 2006 for 12-24 WALA FNCL pools. Similarly, even though we are not expectingmortgage rates to rally 50 bps from the current levels, prepayment speeds of pools that are100 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 werecommend 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 that15-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 currentlyappears not to be paying attention to this trend. At the moment, Dw 4.5s pick-up 6-8 bpsLOAS versus FN 5s after adjusting for the recent faster than model estimated prepaymentspeeds on Dw 4.5s. We also recommend Dw 5.5s/FN 6s swap as a good hedge versus our mortgage overweight position if rates rally more than our expectations.


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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 TBAdeliverable on this coupon shifts from the current 8-9 WALA to 2-3 WALA over the nextcouple of months. However, since overweighting 15-yr 4.5s versus 5s and 5.5s will be anegative 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 thecollateral 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 Goldsare more difficult to be squeezed relative to 15-yr FNMAs. We believe that 15-yr Goldsare 6.0-7.5 ticks cheap versus 15-yr FNMAs and recommend overweighting Golds versusFNMAs 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 couponagency 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 guaranteefor 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 neworigination GN II 6s versus FN 6s. 11 Below we look at some important reasons behind thesharp 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 becauseof the negative net supply of GNMAs and the strong demand for this product fromoverseas investors. The sharp rise in GN/FN swap valuations forced shorts in GNMAs tocover 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 graduallyweakened and were trading at close to their two-year wides in early December. AlthoughGN/FN swaps have bounced off from their lows by 5-6 ticks, we think that premium GN

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


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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 pastfew months. First, after dwindling rapidly for 2-3 years, the size of GNMA market startedexpanding this year. The net production of GNMAs has turned positive this year due to acombination of factors that include streamlining of the underwriting process by FHA,reduced down payment requirements on FHA mortgages and higher subprime mortgagerates. The spread between subprime and FHA mortgages tightened from 200-220 bps in2000 to 80-100 bps in 2004. Since then, this spread has widened back to 170-200 bps. Atcurrent relative mortgage rate levels, borrowers are unlikely to treat subprime and FHAmortgages as substitutes for one another. Second, overseas investors are getting morecomfortable with MBS backed by the GSEs and their purchases have been less concentratedthan before in GNMAs. Consequently, the weak supply/demand technicals resulted inGN/FN swaps weakening a lot from their lofty valuation levels. In addition, there is someconcern in the market that discount GNMAs could prepay substantially slower thanconventional mortgages in a weak housing environment.

Figure 27 shows the current valuations of 30-yr GNMA and FNMA pass-throughs. Thenumbers under Model in this figure show where GN I/FN and GN II/FN swaps shouldtrade on an equal OAS basis accounting for only the differences in the TBA collateralcharacteristics 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 with6.55% 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 OASvalue (as of 12/12/2006) which essentially means that the market has not priced in any valuefor 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

30-yr TBA Price OAS GNSF G2SF Model Actual Model Actual5.0s 97-19+ -14.4 97-27+ 97-24+ 8 21 5 95.5s 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+

GN II/ FN SwapFNCL Equal OAS Price GN I/ FN Swap

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

Figure 28 shows the prepayment S-curves for 30-yr GN I, GN II and FNMA pools for 2004and 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 differentwith the 2005 cohort. As an example, for the 2005 cohort, 50 bps in-the-money GN II poolsare prepaying at about 22% CPR versus 26.5% CPR on FNMA pools. One of the primaryreasons behind the slower prepayment speeds of 2005 cohort GNMAs when in-the-money isa 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 intoa conventional mortgage will not receive the pro-rated initial mortgage insurance premiumthey paid to FHA for mortgages originated after 2004, which is unlike the FHA mortgages


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originated in prior years. In addition, FHA also reduced the pro-rated period from 5 years to3 years, which means that FHA borrowers will receive less of the initial insurance paymenteven if they refinance into another FHA mortgage. Essentially, these rule changes red

Documents

[Bank of America] Outlook for the RMBS Market in 2007