[JP Morgan] MBS Primer

J U N E 2 0 0 6

M B S

J P M O R G A N M B S P R I M E R

ST

RI

CT

LY

PR

IV

AT

EA

ND

CO

NF

ID

EN

TI

AL

M B S

Analyst CertificationThe strategist(s) denoted by an asterisk (“*”) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.

This research contains the views, opinions and recommendations of research strategists with JPMorgan US Fixed Income Strategy. Research strategists routinely consult with JPMSI trading desk personnel in formulating views, opinions and recommendations in preparing this research. Trading desks may trade or may have traded as principal on the basis of the research strategist(s) views and report(s). Therefore, this research may not be independent from the proprietary interests of JPMSI trading desks which may conflict with your interests. In addition, research strategists receive compensation based, in part, on the quality of their analysis, firm revenues, trading revenues, and competitive factors.

Copyright 2006 J.P. Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for J.P. Morgan Chase & Co. and its subsidiaries and affiliates worldwide. J.P. Morgan Securities Inc. is a member of NYSE and SIPC. JPMorgan Chase Bank is a memberof FDIC. J.P. Morgan Futures Inc. is a member of the NFA. J.P. Morgan Securities Ltd. and J.P. Morgan plc are authorised by the FSA and members of the LSE. J.P. Morgan Europe Limited is authorised by the FSA. J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. J.P. Morgan Securities (Asia Pacific) Limited is registered as an investment advisers with the Securities & Futures Commission in Hong Kong and itsCE numbers is AAJ321 Jardine Fleming Singapore Securities Pte Ltd is a member of Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (“MAS”). J.P. Morgan Securities Asia Private Limited is regulated by the MAS and the Financial Supervisory Agency in Japan. J.P.Morgan Australia Limited (ABN 52 002 888 011) is a licensed securities dealer.

This material is provided for information only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. JPMorgan and its affiliates may have positions (long or short), effect transactions or make markets in securities or financial instruments mentioned herein (or options with respect thereto), or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of, issuers mentioned herein. The information contained herein is as of the date and time referenced above and JPMorgan does not undertake any obligation to update such information. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Transactions involving securities and financial instruments mentioned herein (including futures and options) may not be appropriate for all investors. Clients should contact their salespersons at, and execute transactions through, a JPMorgan entity qualified in their home jurisdiction unless governing law permits otherwise J.P. Morgan Securities Inc. is a member of NASD, NYSE and SIPC In the UK and other EEA countries, this material is not available for distribution to persons regarded as private customers (or equivalent) in their home jurisdiction.

JP

MO

RG

AN

MB

SP

RI

ME

R

Market Overview and Origination 1

M B S

Demand 11

Mortgage Cashflows and Intro to Prepayments 23

Valuation and OAS 32

Prepayments Analysis and Reports 46

TBA Market and Specified Pools 62

Relative Value Trading 74

JP

MO

RG

AN

MB

SP

RI

ME

R

Case Studies 99

ARMs 110

CMOs 116

MBS Index 163 1

Agency MBS market composition and issuance

M B S

Securitized agency market compositionSecuritized agency market composition Annual fixed-rate net issuance ($ billions)Annual fixed-rate net issuance ($ billions)

30-year

($2.2

trillion)

65%

Other Fixed

($157.2

billion)

5%

Hybrid ARM

IO ($107.1

billion)

3%

1/1 ARM

($29.4

billion)

1%

Hybrid ARM

($229.5

billion)

7%

15-year

($650 billion)

19%

Source: JPMorgan, FNMA, FHLMC, GNMA

Total = $__mm

217276

156

292211 231

-17

109 93

1998 1999 2000 2001 2002 2003 2004 2005 2006


MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

Annual hybrid ARM net issuance ($ billions)Annual hybrid ARM net issuance ($ billions)

-31-13

10

-11

49

74 79

52

13

1998 1999 2000 2001 2002 2003 2004 2005 2006Total = $3.4 trillion


2

MBS in the U.S. fixed income market

M B S

Fixed income market compositionFixed income market compositionOverviewOverview

Largest US fixed income asset class

Many products to choose from within the MBS market

Agency fixed-rates and ARMs

Non-agency fixed-rates and ARMs (Jumbos, Alt-As)

Whole loans

CMOs and other structured MBS

Superior liquidity

The TBA market adds unique liquidity to MBS

MBS market often used to express duration and curve views (due to its liquidity and size)

Agency fixed-rate pass-throughs is 34% of the Lehman U.S. Aggregate Index (a benchmark of the U.S. investment grade debt).

Municipal

9%

Mortgage

Related

23%

Fed Agencies

10%

Money

Market

14%

Asset-

backed

8%

Corporate

19%

U.S.

Treasury

17%

Source: The Bond Market Association, as of March 2006

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

Total = $25.9 trillion

3

The mortgage market has surged, thanks to a strong housing market and cash-out refis

M B S

5,133

5,614

6,317

7,120

8,079

8,6838,978

2000 2001 2002 2003 2004 2005 2006

1-4 Family Mortgage Debt Outstanding ($ billions)1-4 Family Mortgage Debt Outstanding ($ billions)

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

Source: Bond Market Association, Federal Reserve Board

4

The MBS market links borrowers and investors

M B S

Agencies

Mortgage lenders

MBS Dealers

Borrowers MBS Investors

Mortgage Loans MBS Pass-through

Securitization

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

The issuer of the pass-through obtains the mortgages either by purchasing or originating the loans

Loans with similar characteristics are pooled together; loans are securitized

The investor has undivided ownership interest (the investor is entitled to the pro-rata share of interest and principal payments of the underlying loans)

A “pass-through” is the basic MBS structure

It passes the monthly principal and interest payments, minus a servicing spread, from a pool of mortgages to investors

5

Origination: The Menu of Mortgages Has Expanded

M B S

Origination: production of new loans in primary market

Products

– Fixed-rate mortgages (30-year / 20-year / 15-year)

– Adjustable rate mortgages (Hybrid ARMs: 3/1, 5/1, 7/1, 10/1)

– Interest-Only

– MTAs; Option ARMs

– OtherBalloon mortgages (5-year / 7-year)Prepayment penalty mortgages

“Conforming” balance loans

“Non-conforming” loans (Private label, Non-agencies)

Jumbos and Alt-As

6MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

Understanding Mortgage Collateral : Borrower Credit & Housing Leverage

M B S

Borrower Credit and Information

FICO Score – Historical Credit Use and Management— Avg FICO Score for Jumbo Mortgages : ~730— Avg FICO Score for Alt-A Mortgages : ~700— Avg FICO Score for Subprime Mortgages : ~600— Non-Linear Relationship Between FICO and Propensity to Default

Documentation— Full vs. Limited/Reduced/No Doc

Leverage (Debt to Income Ratios)

Reserves : Staying Power in the event of financial trouble

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

7

Understanding Collateral cont…

M B S

Housing Leverage

Loan-to-Value Ratio— House Value / Mortgage Amount

— Higher LTV Less Equity Protection for the Mortgage Investor Higher Risk

Occupancy— Owner Occupied – Borrower Lives in the Property (Most Secure)— Second Home – Borrower has personal ties to the property— Investor – Business Decision on Economic Situation (Least Secure)

Property Type— Single Family Property (Most Secure)— Condos— Multi-Family

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

8

Conforming loan limits rose by 16%, reaching $417,000 in 2006

M B S

Conforming Limits ($’000)Conforming Limits ($’000)

150

200

250

300

350

400

450

1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: FHFB, JPMorgan

Conforming loan limit for 2006

MA

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

9

Origination channels

M B S

$3.0 trillion origination volume in

2005

Retail (42%) - loan officer employed by mortgage banking company; mortgage loan is closed in the name of the lender

Broker (34%) – mortgage loan broker represents borrower to lending institution; mortgage loan is closed in the name of the lender

Correspondent (24%) – independent mortgage banking company; mortgage loan is closed in “ABC” Mortgages name and sold to mortgage banker

Internet – mortgage loan originated and funded by mortgage banking company through website

Top 5 mortgage banking companies account for over 48% of all new origination volume

1. Countrywide

2. Wells Fargo

3. Washington Mutual

4. Chase Home Finance

5. CitiMortgage

Source: National Mortgage News, as of Q1 2006

RK

ET

OV

ER

VI

EW

AN

DO

RI

GI

NA

TI

ON

MA

10


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 163

11

Major MBS investors

M B S

MBS Investor BreakdownMBS Investor BreakdownMBS Investors ($ billion)MBS Investors ($ billion)

% Chg Investor Type All MSRs Non-Agency All MSRs Non-Agency % of MSRs since 2004Fannie Mae/Freddie Mac 1,261$ 267$ 1,192$ 363$ 26% -5%FDIC Commercial Banks 876$ 124$ 913$ 158$ 20% 4%Life Insurance Cos. 465$ N.A. 480$ 150$ 10% 3%Foreign Investors 280$ 30$ 400$ 50$ 9% 43%Mutual Funds 318$ N.A. 325$ N.A. 7% 2%Personal Sector 270$ N.A. 290$ N.A. 6% 7%Public Pension Funds 270$ N.A. 275$ N.A. 6% 2%All Thrifts 234$ 7$ 228$ 6$ 5% -3%Priv. Pension Funds 125$ 13$ 128$ 15$ 3% 2%FHLBanks 113$ 71$ 117$ 71$ 3% 3%REITs 95$ 50$ 105$ 60$ 2% 11%Finance Companies 85$ N.A. 88$ N.A. 2% 4%MBS Dealer Inventory 41$ 15$ 55$ 20$ 1% 34%Federal Credit Unions 28$ N.A. 29$ N.A. 1% 2%Subtotal: 4,462$ 577$ 4,625$ 893$ All Other Investors* 317$ 474$ Total Outstanding 4,779$ 1,076$ 5,098$ 1,289$

Mid-2005YE 2004

Agencies

29%

Foreign

Investors

9%Insurance

Companies

10%

Mutual Funds

7%

REITs

2%

Finance

Companies

2%

Dealer

Inventory

1%

Pension

Funds

9%

Personal

Sector

6%

Banks

25%

Source: Inside MBS & ABS

Source: Inside MBS & ABS


DE

MA

ND

12

Foreign demand has dominated the mortgage market over the past several years

M B S

Source: US Treasury, Federal Reserve, FNMA, FHLMC, JPMorgan* Foreign purchase data: March ’06, GSE: April ’06, Bank: May ‘06

Net Purchases ($ billions, annual)Net Purchases ($ billions, annual)

-150

-100

-50

0

50

100

150

200

250

2001 2002 2003 2004 2005 2006

Foreign GSE Bank

DE

MA

ND

13

Trends in bank demand

M B S

Bank holdings are still growing, but at a slower pace.

Some signs that bank demand could slow:

MBS holdings as a percentage of deposits have increased

C&I loan growth has picked up

But, there are mitigating factors:

Deposit rates have remained sticky

Unrealized losses are significant

Mortgages remain one of the few sectors that offers the size and

liquidity that large banks need

DE

MA

ND

14

Large banks have been drawn to the mortgage market

M B S

Top 3 Bank Holdings as % of Total Banks’Top 3 Bank Holdings as % of Total Banks’

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

40%

Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06

Source: Federal Reserve, JPMorgan

Large banks have enjoyed the liquidity of the mortgage market for large trades,

and average trade size has increased significantly.

Diversification and movement away from credit risk have been themes, but could

shift if mortgages remain tight.

DE

MA

ND

15

Top 10 banks ranked by MBS portfolios as of 1Q 2006

M B S

Bank Holding Company Total MBS Change Pass-through Change CMO ChangeBANK OF AMERICA CORPORATION 212,273,791 15,121,205 206,670,221 15,808,550 5,603,570 -687,345WACHOVIA CORPORATION 94,293,000 3,173,000 78,527,000 2,338,000 15,766,000 835,000JPMORGAN CHASE & CO 41,644,000 18,775,000 40,354,000 18,633,000 1,290,000 142,000WELLS FARGO & COMPANY 40,042,000 7,676,000 33,969,000 8,729,000 6,073,000 -1,053,000US BANCORP 35,975,000 -1,547,000 22,928,000 -576,000 13,047,000 -971,000CITIZENS FINANCIAL GROUP INC 31,828,058 1,087,257 11,429,339 176,681 20,398,719 910,576BANK OF NEW YORK COMPANY INC 22,671,000 189,000 2,908,000 -129,000 19,763,000 318,000COMMERCE BANCORP INC 20,908,478 1,076,917 3,651,529 104,519 17,256,949 972,398STATE STREET CORPORATION 20,252,615 581,874 6,324,590 -626,064 13,928,025 1,207,938SUNTRUST BANKS INC 17,287,171 264,477 11,580,470 -159,294 5,706,701 423,771

·The top 10 banks account for over 58% of all bank MBS holdings.


DE

MA

ND

16

Bank MBS holdings continue to grow

M B S

MBS Holdings of Large Banks ($ billions)MBS Holdings of Large Banks ($ billions)

200

250

300

350

400

450

500

550

600

650

May-99 May-00 May-01 May-02 May-03 May-04 May-05 May-06

Source: Federal Reserve

DE

MA

ND

17

Security purchases and C&I loan growth has typically been inversely correlated

M B S

MBS and C&I Holdings (Annual changes since 2000)MBS and C&I Holdings (Annual changes since 2000)

R2 = 0.6155-15%

-10%

-5%

0%

5%

10%

15%

-5% 0% 5% 10% 15% 20% 25% 30% 35%

MBS Annual % Chg

C&

I An

nu

al %

Ch

g


DE

MA

ND

18

With many bank positions underwater, it is unlikely that there will be large selling

M B S

(100)

(50)

0

50

100

150

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Cha

nges

in s

ecur

ities

hol

ding

s ($

bn)

(20)

(15)

(10)

(5)

0

5

10

15

20

Unr

ealiz

ed g

ains

/loss

es ($

bn)

Quarterly Changes in Security Holdings

Unrealized Gains/Losses

Banks did not sell amid losses in 2000…… While most bank sales have occurred amid

gains

DE

MA

ND

19

The GSEs

M B S

•Fannie Mae

•Freddie Mac

•Ginnie Mae

•FHLBs – the MPF and MPP programs

•GNMA pools are backed by FHA/VA loans which are government insured.

These pools have an explicit U.S. government guarantee and a zero risk-

capital weighting.

•FNMA and FHLMC pools are backed by conventional conforming loans, have an

implicit U.S. government guarantee, and a 20% risk-capital weighting. Single-

family loan limit is $359,650 in 2005.DD

EM

AN

20

Unique role of GSEs: issuer / investor

M B S

Mission is to facilitate secondary mortgage market in U.S. which provides

steady flow of low cost mortgage funds

Issue agency debt

Hold MBS, CMOs, and loans as well as ABS, CMBS, and mortgage-related spread

products

Large portfolios (FN + FH hold over $1.4 trillion loans and MBS) demand active

hedging via swap and swaption markets

DE

MA

ND

21

Agency portfolio growth has slowed

M B S

Retained Portfolio ($ billions)Retained Portfolio ($ billions)

300

400

500

600

700

800

900

1000

Apr-01 Oct-01 Apr-02 Oct-02 Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06

FNMA Portfolio FHLMC Portfolio

Source: FNMA, FHLMC, JPMorgan

DE

MA

ND

22


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 16323

MBS Terminology

M B S

Pools are comprised of mortgage loans with similar rates and terms

WAC – weighted average coupon of all loans in pool (vs Coupon)

WAM – weighted average maturity of loans in pool

WALA – weighted average loan age

Original face – original principal amount of pool

Current face – remaining principal balance of pool

Origination year – average origination year of loans in pool; age (WALA) is important in prepayment

assessment (“seasoning”)

CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

24

Mortgage cash-flow characteristics

M B S

FHLMC FNMA14th 24th

August 1st September 1st October 1st30 days in arrears 14 to 24 days processing

44 to 54 day delay

Homeowner's August payment due (in arrears)

After processing, security holders receive shares of

August payment

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

25

Mortgage cash-flow

M B S

Example: $500,000 purchase price; $400,000 loan amount; 6% mortgage rate; 30-year fixed-rate loan

Using “MP” function on BBG…

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

Source: Bloomberg

26

Mortgage cash-flows: without prepayments

M B S

Interest

Principal

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

Source: Bloomberg

27

Mortgage cash-flows: with prepayments

M B S

Interest

Pre-paid Principal

Principal

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

Source: Bloomberg

28

Prepayments: source of MBS optionality

M B S

Borrowers have the right to prepay at any time without penalty – in effect “calling” their loans away from investors; prepayments may be partial or complete

Valuing this call option and the cash flow uncertainty it creates is the key to understanding MBS

Timing and rate of prepayments vary and produce non-level, less-predictable cash flows

Prepayment (Call) Risk vs extension risk

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

29

Determinants of prepayments

M B S

Prepayments can be for economic / non-economic reasons

Interest rate incentive

Yield curve shape: refi down the curve

WALA: mobility increases over time

Seasonality: Summer months have the fastest speeds owing to school vacation

“Burnout”: Remaining borrowers in a pool may be credit constrained

Cash-out refinancing: Take built-up equity out of the home

Default: Shows as a prepayment in agency pools

MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

30

Prepayment standards

M B S

CPR – Constant Prepayment Rate – annualized percentage of remaining principal prepaid

PSA – prepayment vector expressed as a series of CPRs; begins at .2% in the first month, increases .2% per month, leveling out at 6.0% in month 30; prepayment assumptions for pricing stated as linear multiples of PSA schedule

0

2

4

6

8

10

12

14

0 10 20 30 40 50Age

CPR

(%)

200 PSA

100 PSA

31MO

RT

GA

GE

CA

SH

FL

OW

SA

ND

IN

TR

OT

OP

RE

PA

YM

EN

TS

M B SMBS Index

CMOs

ARMs

Case Studies

Relative Value Trading

TBA Market and Specified Pools

Prepayments Analysis and Reports

Valuation and OAS

Mortgage Cashflows and Intro to Prepayments

Demand


11

23

32

46

62

74

99

110

116

163JP

MO

RG

AN

MB

SP

RI

ME

R

32

Many Different Types of Spreads

M B S

Basic: static yield spread over a single point on the curve

“I” : spread to Treasury

“N” : spread to swaps

Intermediate: zero volatility yield curve spread

“Z” : spread to Treasury curve

“E” : spread to Libor/swap curveLibor ZSpread on JPMorgan’s analytic reports.

Advanced

OAS : option-adjusted spread

LIBOR OAS

Treasury OAS

VA

LU

AT

IO

NA

ND

OA

S

33

Yield analysis in the MBS market

M B S

Static Spread (Yield Spread): standard measure of incremental return over a single benchmark Treasury

Compares MBS to single point on the yield curve, usually to the interpolated point closest to the Weighted Average Life of the MBS

But MBS does not return principal in one lump sum but over many periods. A better assumption would include multiple data points on the yield curve. Z Spread takes this another step further.

Z Spread (Yield Curve Spread) : discounts each monthly MBS cashflow by the monthly forward rates derived from the current yield curve

More accurate for securities that return principal over many periods as opposed to bullets

Still a static measure since it assumes that interest rates and MBS cashflows remain constant

VA

LU

AT

IO

NA

ND

OA

S

34

Evaluating pass-throughs: yield / average life

M B SVA

LU

AT

IO

NA

ND

OA

S

Source: Bloomberg

35

Prepayments and OAS

M B S

Prepayment issues:

Reinvestment risk: When rates decline and speeds increase the investor has to reinvest an increased amount of principal at lower ratesWhen rates increase and speeds decline, the investor has less cashflow to reinvest at higher rates

Discount bonds: when rates decline, the benefit of earlier return of principal at par may mitigate reinvestment risk

Premium bonds: when rates increase, the benefit of a larger outstanding principal balance and longer average life means higher and more interest payments which may mitigate the reinvestment risk

OAS has been derived to account for the dispersion and uncertainty associated with this return of principal from MBS

VA

LU

AT

IO

NA

ND

OA

S

36

OAS Calculation

M B S

To incorporate prepayment volatility in the valuation of MBS, we can calculate a theoretical price for a given OAS1. Hundreds of hypothetical interest rate paths are simulated2. On each interest rate path the prepayment model is used to predict prepayment speeds and thus,

MBS cashflows3. For each path, the present value of the projected cashflows are calculated using a specified spread,

s, which is added to the forward rates4. Value of MBS = Average value of PV(s) over all simulated interest rate paths

= AVGPV(s) where s is OAS

To find OAS given market price:1. Start with an initial estimate for OAS2. Calculate AGVPV(s) and keep adjusting until AVGPV(s) = market price

Drawback of OAS:1. The spread earned by the investor depends on the actual path realized and can be drastically

different from the OAS2. Wide differences in OASs are produced by different firms models due to different term structures,

volatility assumptions and prepayment projections3. Doesn’t account for dollar roll financing4. Is a “black box” – difficult for investors to decompose OAS into its component parts.

VA

LU

AT

IO

NA

ND

OA

S

37

Pass-through risk measurement (duration)

M B S

Various measures of duration: % change in price for a 1% change in rates.

Modified duration is inappropriate for pass-throughs as it cannot accommodate varying cash flows.

OAD is found by calculating constant OAS prices for parallel curve shifts.

Empirical duration uses actual observations regressed against a Treasury benchmark. Directional/empiricals could be different against different parts of the yield curve.

None of these measures is perfect. We tend to use a combination of them all.

SV

AL

UA

TI

ON

AN

DO

A

38

Empirical durations

M B S

FN 6

y = -3.3453x + 0.0015R2 = 0.8266

-0.5

0.0

0.5

1.0

-0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%)

% P

x Ch

g

FN 5.5

y = -4.8009x + 0.0056R2 = 0.8927

-1.0-0.50.00.51.0

-0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%)

% P

x Ch

g

FN 6 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06)FN 6 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06) FN 5.5 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06)FN 5.5 Empirical Durations (using 10-yr Tsy; Dec.05 – Jun. 06)

Source: JPMorgan

VA

LU

AT

IO

NA

ND

OA

S Source: JPMorgan

39

Rates have little effect on OAS

M B S

FN 5.5 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06)FN 5.5 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06)

FN 5.5y = 6.455x - 0.0508

R2 = 0.0713

-4.0-2.00.02.04.0

-0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%)

OAS

Chg

(bps

)

FN 6 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06)FN 6 OAS vs rates (using 10-yr Tsy; Dec.05 – Jun. 06)

FN 6

y = -2.2723x - 0.0758R2 = 0.0079

-4.0-2.00.02.04.0

-0.15 -0.10 -0.05 0.00 0.05 0.10

Yield Chg (%)

OAS

Chg

(bps

)

Source: JPMorganSource: JPMorgan

VA

LU

AT

IO

NA

ND

OA

S

40

Pass-through risk measurement (convexity)

M B S

Convexity: the rate at which the duration of a security changes as interest rates change.

– Positive convexity implies that for small, equal and opposite changes in interest rates, the increase in price if rates go down will be more than the decrease in price if rates rise.

– Negative convexity implies that the increase in price if rates go down will be smaller than the decrease in price if rates rise.

– Bullet Treasuries have positive convexity. Pass-throughs typically have negative convexity.

VA

LU

AT

IO

NA

ND

OA

S

41

Negative convexity of mortgages

M B S

80

85

90

95

100

105

-300 -225 -150 -75 0 75 150 225 300Bps

FN 6

Px

($)

FN 6 prices ($) vs shift in rates (bps)FN 6 prices ($) vs shift in rates (bps)

Source: JPMorgan

VA

LU

AT

IO

NA

ND

OA

S

42

Mortgages have embedded options – valuation needs to incorporate vol

M B S

Homeowners have the right to prepay at any time during the life of the mortgage

Consequently, an MBS investor is short many options to the homeowner:

Short LongShort 1m x 1y 1m x 10yLong 5m x 1y 5m x 10y

Underlying

Option

Term structure models are calibrated to the entire vol surface in swaptions

Higher vol should cause mortgages to cheapen

FN 30 Vega FN15 Vega

5.0 -0.21 4.5 -0.091

5.5 -0.26 5.0 -0.123

6.0 -0.27 5.5 -0.145

6.5 -0.23 6.0 -0.111

VA

LU

AT

IO

NA

ND

OA

S

Source: JPMorgan

43

Mortgage efficiency of pricing in changes in implied vol has been increasing

M B S

Correlation of 1-week change in current coupon ZV spread and 3x7 swaption premium, rolling

six-month window

(0.6)

(0.4)

(0.2)

0.0

0.2

0.4

0.6

0.8

1.0

97 98 99 00 01 02 03 04 05 06Source: JPMorgan

VA

LU

AT

IO

NA

ND

OA

S

44

Changes in mortgage market duration can impact the rates markets

M B S

The rate of extension of the mortgage market will slow in a sell-off

A sell-off could cause the curve to steepen

Change in 10-year equivalents for the mortgage market across the curve for a parallel +50 rate shock

Change in 10-year equivalents of the agency fixed rate market for various parallel shifts in rates

-800

-600

-400

-200

0

200

400

-100 -75 -50 -25 0 25 50 75 100

Rate change (bp)

Cha

nge

in 1

0-yr

equ

ivs

($bn

)

-50

0

50

100

150

200

2 5 10 30Tenor10

-year

Equ

iv ($

bn)

VA

LU

AT

IO

NA

ND

OA

S

45


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 163

46

A closer look at turnover

M B S

Existing Home Sales (EHS)

Strong Lock-in

Seasonality and Calendar Effect

Cumulative Home Appreciation (CHPA)

Overall Shorter Baseline Ramp:

Interaction between EHS, CHPA, Lock-in and Aging Ramp successfully captures periods of apparent shorter and longer ramps

In effect lower CHPA lengthens the ramp

Lock-in also lengthens the apparent ramp

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

47

Home price appreciation and discount speeds have been highly correlated…

M B S

87% correlation between discount speeds and the housing strength now

… in the weaker housing environment of 2000, there was no correlation.

Discount Speeds by State (Last 12 mo.) versus HPI in 2005

4

5

6

7

8

9

10

11

12

13

14

0 5 10 15 20 25 30 35 40Home Price Appreciation,%

1-ye

ar C

PR, %

CA

AZ

NYTX

MDVA

MA

OH

MIPA

FLNJ

Discount Speeds by State vs. HPI in 2000

4

5

6

7

8

9

10

11

12

13

14

0 5 10 15 20 25 30 35 40

Home Price Appreciation, %

1-ye

ar C

PR, %

CA

NY

FL

AZ

MA

TX

VA

MD

WA

OH

PAMI

NJ

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Notes: Deep discount: 75bps or more out of the money; balance weighted average 12-month CPR observed in the past year

48

Seasoning ramps under different HPA assumptions

M B S

0.00.10.20.30.40.50.60.70.80.91.0

1 11 21 31 41 51 61 71 81 91 101 111

WALA

Turn

over

Mul

tiplie

r

0pct hpa 1pct hpa 4pct hpa 8pct hpa

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: JPMorgan

49

Turnover (cont’d)

M B S

Lock-in (disincentive to move)

Captures the relationship between turnover and refinancing “disincentive”

Strong Lock-in. However, home price appreciation can strongly mitigatelock-in

Lock-in (long WAM)

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1 1.1 1.2 1.3 1.4 1.5 1.6

MtgRate/WAC

Mul

tiplie

r

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

50

Turnover (cont’d)

M B S

Seasonality: Patterns tend to be impacted by weather and school schedules

School schedules and weather conditions are the main reasons for seasonal behavior

There is also a separate “day count” adjustment to account for different collection days in each month

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

51

Economics of refinancing

M B S

• CATO (curve at origination) – borrowers who take out a 30-year mortgage in a steep curve

environment are likely to exhibit slow turnover

• SATO (spread at origination) – high mortgage rates relative to prevailing rates at origination

indicate credit impairment. These borrowers are less likely to refinance

• Loan size – with similar fixed costs for refinancing, borrowers with larger loan sizes are more

likely to refi

• Home price appreciation – higher HPA allows borrowers to “cash-out refi”, or may allow some

borrowers to “cure” and obtain a better mortgage rate with A lower LTV

• Mortgage banking capacity – in large refi waves mortgage bankers may become inundated

with supply, causing mortgage spreads to widen

RE

PO

RT

SA

NA

LY

SI

SA

ND

PR

EP

AY

ME

NT

S

52

The Refinancing Index

M B S

Seasonally-adjusted refinancing indexSeasonally-adjusted refinancing index

0

2,000

4,000

6,000

8,000

10,000

12,000

Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: MBAA

53

Burnout

M B S

0

0.2

0.4

0.6

0.8

1

1.2

10 30 50 70 90 110

130

150

170

190

210

230

250

270

290

310

330

350

370

390

410

430

450

470

490

Cumulative Incentive (bps)

Bur

nout

Mul

tiplie

r

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: JPMorgan

54

Primary differences between GNMA and conventional pools

M B S

Characteristic Conventional GNMA I GNMA II

Assumable No YesPass-through rate 25 to 250bps below loan rate 50bps below 50 to 150bps below loan rateGuarantee fee Negotiated (10 to 25bps) 6bps 6bpsServicing fee 25bps minimum 44bps 44bps minimumMortgage insurance LTVs worse than 80% Mandatory MandatoryExcess servicing Allowed Not allowed AllowedBuy-ups/-downs Allowed Not allowed 10% buy-down allowedDelay days 24 for FNMA, 14 for Golds 14 days 19 daysPrepayment reports Fifth business day Fifth business day Seventh business day

Revised GNMA II pooling guidelines came into effect July 1, 2003.

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S


55

GNMA prepayments

M B S

Refinancing into conventionals

Servicer buy-out

Higher delinquencies

Rolling 90-days delinquent with only one missing payment;

changed in 2003 to 90-days delinquent

NA

LY

SI

SA

ND

RE

PO

RT

SP

RE

PA

YM

EN

TS

A

56

GNMA delinquencies

M B S

2

4

6

8

10

12

14

Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05

Tota

l Pas

t Due

(%)

Conventional (Prime) VA FHA

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: JPMorgan, MBA

57

Prepayment reports: speeds by origination year

M B S

Source: JPMorgan

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

58

Prepayment reports: speeds by WALA

M B S

Source: JPMorgan

PR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

59

Prepayment reports: speeds by servicer

M B SPR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: JPMorgan

60

Prepayment expectations

M B SPR

EP

AY

ME

NT

SA

NA

LY

SI

SA

ND

RE

PO

RT

S

Source: JPMorgan

61


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 163

62

TBA pass-through market

M B S

TBA = “To Be Announced”. Essentially, a cheapest-to-deliver market (like a futures contract). Most liquid market.

As with other delayed delivery transactions, a seller agrees to issue a TBA security at a future date. However, in a TBA trade, the seller and the buyer do not identify the specific underlying mortgage pools, simply certain pre-specified terms

TBAs are identified by agency, term, coupon, settle month, and traded on a dollar-price basis

“Cheapest-to-deliver” gives the seller a delivery option that the buyer is short

Standardized delivery dates (see Bloomberg TDAT).

Settles once a month like a futures contract

Delivering pools: seller must provide pool information by 3 p.m. 2 business days prior to

settlement (48-hour day).

Variance: the amount by which the face value at delivery can vary from the amount

specified at the time of the trade, expressed as a percentage of the initial face value

requested. The Bond Market Association suggests 0% variance on all TBA tradesET

AN

DS

PE

CI

FI

ED

PO

OL

ST

BA

MA

RK

63

Bloomberg Generic TBA Tickers

M B STB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

64

Dollar rolls

M B S

Dollar rolls are transactions where an institution sells mortgage

backed securities with a commitment to buy similar, but not identical,

mortgage backed securities on a future date at a lower price.

In the case of mortgage pass-throughs, “similar” securities refers to

securities with the same coupon, security type, and mortgage

collateral.

Dollar rolls offer an attractive means of borrowing at a low cost

primarily because they allow dealers to cover their short positions.

SP

EC

IF

IE

DP

Dollar rolls offer dealers a convenient way to obtain promised

mortgage securities, avoiding the higher costs of failing to deliver.

AR

KE

TA

ND

OO

LS

TB

AM

65

TBA transactions: evaluating dollar rolls

M B S

Drop

Coupon

Prepayments

Delivery optionality

Re-investment rateSP

EC

IF

IE

DP

OO

LS

TB

AM

AR

KE

TA

ND

66

TBA transactions: evaluating dollar rolls

M B STB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

Source: Bloomberg

67

Roll Specialness

M B S

-4

-2

0

2

4

6

8

10

12

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Curr

ent

Coup

on r

oll s

peci

alne

ss (

tks) 30-yr CC

15-yr CC

TB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

Source: JPMorgan

68

Price spreads influence coupon production

M B S

TBA 6.0% TBA 6.5%Mortgage note rate (a) 6.88 6.88Less agency guaranty fee (b) 0.15 0.15Retained servicing spread (c) 0.25 0.25Remaining note rate (a-b-c) 6.48 6.48Excess servicing (a-b-c-e) 0.48 0.00Buydown of Guaranty Fee (%) 0.00 0.03Cost to buydown guaranty fee (d) 0.00 0.12Desired MBS coupon (e) 6.00 6.50Market price of MBS (f) 98.05 100.13Adjustment to TBA price for low WAC (g) 0.00 0.03Price adjusted for cost of buydown (f+g-d) 98.05 100.04Value of excess servicing (h) 2.09 0.00Price adjusted for servicing value (f+g+h) 100.14 100.04

TB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

Note: Prices are for illustration purposes only

Source: JPMorgan

69

The many dimensions of specified pools

M B S

WALA

FICO

Low WAC

Low loan balance (LLB)

Geographic

Prepayment penalty

Relocation

Originator

OO

LS

High LTVPT

BA

MA

RK

ET

AN

DS

PE

CI

FI

ED

70

Specified pools make up roughly 80% of the mortgage market

M B S

Spec pool market compositionSpec pool market composition

New TBA

20%

Seasoned

(>30 WALA)

49%

New

Specified

4%

Moderate

(13-30

WALA)

27%

Source: JPMorgan

TB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS


Data is as of May 2006

71

New issue specified pools report

M B STB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

Source: JPMorgan

72

Seasoned specified pools report

M B STB

AM

AR

KE

TA

ND

SP

EC

IF

IE

DP

OO

LS

Source: JPMorgan

73

M B S

Case Studies




Valuation and OAS


Demand


11

23

32

46

62

74

99

ER

JP

MO

RG

AN

MB

SP

RI

M

ARMs 110

CMOs 116

MBS Index 16374

Relative value strategies and analysis

M B S

Trading StrategiesTrading Strategies Evaluation ApproachesEvaluation Approaches

Mortgage - Swap basis

Mortgage - Tsy basis

Coupon swap

15s / 30s

Ginnie / Fannie

TBA / Seasoned

Agency / Non-agency

Pass-through / ARM

CMO / Collateral

OAS

Spread

Hedge-Adj Carry

Regressions

Deliverable

Sponsorship

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

75

Where to find JPMorgan MBS data

M B S

Factor Where to find itSupply Net supply MRV charts, Dataquery

Gross supply MRV charts, Daily Packet, DataqueryDemand Banks Federal Reserve Website

JPM quarterly bank report

Agencies Fannie, Freddie website

Dealers Bloomberg (PDPPMORT <index>)

Non-US investors TIC dataPrepayments by WALA, servicer, etc. JPM Monthly Prepay Appendix

MorganMarkets.comOAS TBAs Current

Specifieds, strips, hybrids, etc Daily packetCoupon swap history Daily packetHedge adjusted carry Daily packet (soon)Volatility swaption premiums, bp vol Daily packet, DataqueryRegression Historical OAS by relative coupon JPM trading bloomberg

Coupon swaps, butterflies MBS AnalyzerMBS Index/performance Performance by coupon vs swaps and Treasuries Index Monitor

DataqueryDaily packet TBA Performance ReportDataquery

Other Analytics/historical data Daily packetMBS Analyzer

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

76

Mortgages have widened back to the widest levels since the beginning of the year – but are they fundamentally cheap?

M B S

30-year current coupon OAS (bps)

(30)

(20)

(10)

0

10

20

30

40

50

60

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

77

Declining long-dated vol has caused nominal spreads and OAS to diverge

M B S

OAS vs. CC ZV spread (bps)

(20)

(15)

(10)

(5)

0

Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

50

60

70

80

OAS ZV spreadCurrent coupon OAS has been relatively stable, while nominal spreads have continued to tighten recently …

3YX10Y swaption premium (bps)… Declining long-dated vol has been the driver

Source: JPMorgan

375

385

395

405

415

425

435

445

455

465

475

Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06

3Yx1

0Y S

wap

tion

Pre

miu

m (

bps)

78

GR

EL

AT

IV

EV

AL

UE

TR

AD

IN

Mortgage / Swap basis

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

79

30- and 15-year current coupon OAS

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

80

MBS Fixed-Rate Daily Analytics

M B S

COB June 9, 2006

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

81

Hedge-adjusted carry

M B S

We introduce a hedge-adjusted carry methodology which provides a short-

term (1- to 2-month) measure of performance using rather

straightforward calculations

Option-adjusted spreads serve as a long-term spread measure and assume

vega hedging, among other risk measures

It serves as a good complement to OAS valuations, capturing the return

for taking duration and convexity risks

Essentially, hedge-adjusted carry gives us the net carry of holding a TBA

after hedging for duration and adjusting for convexity hedging costs

Higher carry could suggest overweighting certain coupons. However, this

valuation ignores other risks like vega and mortgage Libor spread

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

82

Hedge-adjusted carry components

M B S

The valuation incorporates factors such as the roll, hedge ratios, durations,

convexities. Specifically, the main components of the analysis are:

Swap Hedge Ratios (using partial durations).

Duration Hedged Carry

Total Negative Convexity

Convexity Hedging Cost

RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

83

Hedge-adjusted carry components

M B S

We hedge three partial durations on the swap curve (2-yr, 5-yr and 10-yr) with the cost being the carry and rolldown on each of the swaps

To figure out the duration adjusted carry we simply calculate:

Duration Hedged Carry= TBA roll – ∑(cost of swap hedge)

Cost of swap hedge = hedge ratio * swap carry

In calculating total convexity cost, we incorporate swap convexity since we are long MBS and short swaps (which are positively convex)

Total Convexity = MBS convexity – swap convexity

We can estimate the convexity cost using short-dated swaption implied vols (1-month x 10-year swaptions)

TBA Passthroughs - 30 Year ConventionalsRoll

(32nds)Dur Hedged

CarrySec Price .. (32nds)FN 30 4.5 91-00 1.25 .. 0.1FN 30 5.0 93-29 1.87 .. 0.8FN 30 5.5 96-12 2.25 .. 1.2FN 30 6.0 98-25+ 3.00 .. 2.1FN 30 6.5 100-29 3.25 .. 2.6FN 30 7.0 102-14+ 2.00 .. 1.5

TBA Passthroughs - 30 Year ConventionalsRoll

(32nds)Dur Hedged

CarryCnv. Hedging

CostHedge Adj.

CarrySec Price .. (32nds) (32nds) (32nds)FN 30 4.5 91-00 1.25 .. 0.1 -0.7 -0.6FN 30 5.0 93-29 1.87 .. 0.8 -1.1 -0.4FN 30 5.5 96-12 2.25 .. 1.2 -1.6 -0.4FN 30 6.0 98-25+ 3.00 .. 2.1 -1.9 0.3FN 30 6.5 100-29 3.25 .. 2.6 -2.1 0.4FN 30 7.0 102-14+ 2.00 .. 1.5 -2.1 -0.6

( ) 3222122

21 ∗∧⎥

⎦

⎤⎢⎣

⎡∧∗⎟⎟

⎠

⎞⎜⎜⎝

⎛∗ days

daybpC

VA

LU

ET

RA

DI

NG

RE

LA

TI

VE

Source: JPMorgan (as of June 1, 2006)

84

Hedge Adjusted Carry Report

M B S

New York J.P. Morgan Securities Inc.Jun 05, 2006 MBS Research

(1-212) 834-3121MBS Research morganmarkets.jpmorgan.com

MBS Hedge Adjusted Carry

TBA Passthroughs - 30 Year Conventionals Settle Dates Spot = [Jun-13-2006], 1M = [Jul-13-2006], 2M = [Aug-14-2006]

TotalSec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2mFN 30 4.5 91-21 1.25 2.25 6.0 -5 0.21 0.32 0.49 0.3 0.6 -1.2 -0.8 -1.6 -0.4 -1.0FN 30 5.0 94-16+ 1.87 3.37 5.5 -6 0.28 0.33 0.42 1.0 1.8 -1.9 -1.2 -2.5 -0.2 -0.6FN 30 5.5 96-29+ 2.12 4.12 4.8 -7 0.37 0.32 0.34 1.3 2.7 -2.4 -1.6 -3.2 -0.3 -0.5FN 30 6.0 99-07+ 3.00 6.00 3.8 -9 0.49 0.25 0.23 2.4 4.9 -2.8 -1.8 -3.7 0.6 1.2FN 30 6.5 101-05+ 3.25 6.50 2.9 -1 0.51 0.20 0.15 2.7 5.7 -3.2 -2.0 -4.2 0.7 1.5FN 30 7.0 102-19 2.00 4.00 1.9 0 0.51 0.11 0.07 1.7 3.5 -2.9 -1.9 -3.9 -0.2 -0.4

TBA Passthroughs - GNMA I 30 Years Settle Dates Spot = [Jun-19-2006], 1M = [Jul-18-2006], 2M = [Aug-17-2006]

TotalSec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2mGN 30 4.5 92-29 2.00 4.00 5.4 -6 0.24 0.30 0.42 1.2 2.6 -1.2 -0.7 -1.5 0.5 1.1GN 30 5.0 95-26+ 2.00 4.00 5.2 -23 0.29 0.32 0.40 1.2 2.6 -1.8 -1.1 -2.3 0.1 0.3GN 30 5.5 97-31 2.50 5.00 4.8 -20 0.37 0.32 0.34 1.8 3.8 -2.4 -1.5 -3.1 0.3 0.7GN 30 6.0 100-06+ 2.50 5.00 3.7 -20 0.47 0.26 0.22 1.9 4.0 -2.9 -1.8 -3.7 0.2 0.3GN 30 6.5 102-03 3.00 6.00 2.3 -21 0.50 0.17 0.09 2.7 5.5 -2.7 -1.7 -3.5 1.0 2.0GN 30 7.0 103-14 0.00 0.00 1.4 -31 0.52 0.09 0.01 -0.2 -0.3 -2.3 -1.4 -3.0 -1.6 -3.2

TBA Passthroughs - 15 Year Conventionals Settle Dates Spot = [Jun-21-2006], 1M = [Jul-20-2006], 2M = [Aug-21-2006]

TotalSec Price 1m 2m OAD OAS 2Y 5Y 10Y 1m 2m Cnvx 1m 2m 1m 2mFN 15 4.0 93-00 0.50 1.00 4.3 -1 0.30 0.35 0.25 -0.1 -0.1 -1.0 -0.6 -1.3 -0.7 -1.3FN 15 4.5 95-06+ 0.75 1.25 4.3 -15 0.34 0.35 0.25 0.1 0.2 -1.3 -0.8 -1.7 -0.7 -1.5FN 15 5.0 97-01 1.75 3.75 4.0 -15 0.40 0.33 0.22 1.1 2.7 -1.7 -1.1 -2.2 0.1 0.5FN 15 5.5 98-28+ 2.00 4.00 3.4 -14 0.48 0.28 0.17 1.5 3.1 -2.1 -1.3 -2.8 0.2 0.4FN 15 6.0 100-26 3.50 6.50 3.0 -8 0.48 0.23 0.14 3.0 5.8 -2.1 -1.3 -2.7 1.7 3.0FN 15 6.5 101-28 2.00 4.00 2.2 5 0.51 0.18 0.06 1.7 3.5 -1.8 -1.1 -2.3 0.6 1.2

Rolldown and Carry of Swaps between settlesSwap 1m 2m Dur2Y 0.29 0.36 1.895Y 0.82 1.46 4.3810Y 1.25 2.32 7.68

Hedge Adj. Carry(32nds)

Roll(32nds) Hedge Ratio / Swap

Dur Hedged Carry(32nds)

Cnv. Hedging Cost(32nds)









RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

85

Performance vs. swaps and Treasuries

M B SCOB June 9, 2006 86RE

LA

TI

VE

VA

LU

ET

RA

DI

NG

MBS Issuance Report

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

87

MBS coupon price spread

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

88

MBS butterfly price spread

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

89

Mortgage/swap basis vs Index

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

90

Mortgage/Agency basis vs Index

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

91

Longer-dated Vol vs Index

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

92

Shorter-dated Vol vs Index

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

93

30-year relative coupon OAS

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

94

30-year relative coupon swaps

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

95

15-year relative coupon OAS

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

96

15-year relative coupon swaps

M B SRE

LA

TI

VE

VA

LU

ET

RA

DI

NG

Source: JPMorgan

97

M B S

Trust IO analyticsR

EL

AT

IV

EV

AL

UE

TR

AD

IN

G

98


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 16399

Case Study #1: FNMA 6.5s – The Deliverable

M B S

Aggregate 1-month speeds on TBA 6.5s (3-17 WALA) for different delivery size (based on Apr prepayments)

2030405060708090

100

0 1000 2000 3000 4000 5000 6000Balance, $mil

1mo

CPR,

%

Distribution of 1-mo speeds on 3-17 WALA FNMA 6.5s, (April 2006)

0

500

1000

1500

2000

2500

60+ 50-60 40-50 30-40 20-30 10-20 0-10CPR Range

Bala

nce,

$m

il

•There are still a lot of fast pools available in TBA 6.5s

Over $400mm TBA 6.5 pools prepaid above

60CPR

The relationship between delivery size and paydown cost is non-linear; smaller trades

are far more exposed to adverse selection

CA

SE

ST

UD

IE

S

100

Case Study #1: FNMA 6.5s – Issuance and supply

M B S

•FN 6.5 supply should be robust

FN 6.5Issuance Projection ($bn)

Apr-06 3.8 May-06 5.1 Jun-06 6.7 Jul-06 8.9

FNMA 30-year relative coupon issuance Issuance by coupon as a % of total FNMA 30

year issuance

(10)%

0%

10%

20%

30%

40%

50%

% o

f FN

30

Issu

ance

(1.00) (0.50) 0.00 0.50 1.00 1.50 2.00Relative coupon

R2 = 0.8793R2 = 0.8045

(1,000)

2,000

5,000

8,000

11,000

14,000

17,000

(1.00) (0.50) 0.00 0.50 1.00 1.50 2.00

Relative Coupon

FN 3

0-yr

Issu

ance

($M

M)

Source: JPMorgan, FNMANote: Since September 2005

Source: JPMorgan, FNMANote: Monthly issuance of FN 5s through 6.5s plotted as relative

coupons vs CC, since September 2005

F N 6 .5Issu a n ce P r o je c tio n ( $ b n )

A p r - 0 6 3 .8 M a y - 0 6 5 .1 Ju n - 0 6 6 .7 Ju l- 0 6 8 .9

CA

SE

ST

UD

IE

S

101

Case Study #1: FNMA 6.5s – Fundamentals

M B S

(14)

(12)

(10)

(8)

(6)

(4)

(2)

00 4 8 12 16 20

40

50

60

70

80

90

100

110

OAS SATO

Short WALA 6.5s have tight OAS and low SATOOAS (left axis, bps) and SATO (right axis, bps) on FN 6.5s by WALA (in months)

•FNMA 6.5s: New

issue pools have

worse loan

characteristics than

more seasoned

pools

Source: JPMorgan, FNMA

FNMA 6.5s are fair fundamentallyLIBOR static spread of FNMA 6.5s by CPR, in bp

CA

SE

ST

UD

IE

S

CPR10 20 30 40 50

101—01 73 60 44 25 2

102

Case Study #2: DW 4.5s – Regressions

M B S

Rich / cheap of the Dwarf 5 / 4.5 swapThe Dwarf 5 / 4.5 is cheap historically

Residual of Dwarf 5 / 4.5 swap vs 15-year current coupon yield, in ticks

Jun06-8

-2-4-6

02468

10

Feb06 Apr06

Dwarf 5/4.5 swap (y-axis, in ticks) versus 15-year CC yield (x-axis, %)

60

50

45

65

70

5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9

55

CA

SE

ST

UD

IE

S

103

Case Study #2: DW 4.5s – Fundamentals

M B S

0

2

4

6

8

10

12

1 3 5 7 9 11 13 15 17 19 21 23WALA (mos)

1-m

o C

PR

(%)

02468101214161820

Cum

ulat

ive

Bala

nce

($ B

)1mo CPR

Cum bal

0

2

4

6

8

10

12

14

1 3 5 7 9 11 13 15 17 19 21 23WALA (mos)

1-m

o C

PR

(%)

0

5

10

15

20

25

30

35

Cum

ulat

ive

Bal

ance

($ B

)1-mo CPR

Cum Bal

Dwarf 5s are fundamentally cheaper than Dwarf 4.5s.LIBOR static spread on Dwarf 4.5s and 5s by CPR

Price 6 CPR 7 CPR 8 CPR 9 CPR 10 CPRDwarf 4.5s 95-08 -7 -3 1 6 10Dwarf 5s 96-31 6 9 11 14 17

LIBOR Static Spread (bp)

Outstanding balance and 1-month CPR

of Dwarf 4.5s by WALA

Outstanding balance and 1-month CPR

of Dwarf 5s by WALA

CA

SE

ST

UD

IE

S

104

Case Study #3 (Seasoned pricing): Lower the dollar price, higher the price spread between seasoned and new WALA pools

M B S

Payups by WALA vs. TBA Price

WALA

0

2

4

6

8

10

12

14

0 5 10 15 20 25 30 35

Pay

up, 3

2nd

$96 $97 $98

Pricing assumptions:1. 24-month aging ramp2. Peak speed of 9% CPR for $96 TBA3. Peak speed of 10% CPR for $97 TBA4. Peak speed of 11% CPR for $98 TBA

ST

UD

IE

SC

AS

E

105

Case Study #3 (Seasoned pricing): Peak speeds versus the length of the ramp

M B S

Payups by WALA vs. peak speed ($97 TBA, 24-mo ramp)The peak speed plays an

insignificant role when pricing seasoned pools

(Payup versus TBA assuming constant LIBOR static spread)

0.0

2.0

4.0

6.0

8.0

10.0

12.0

0 5 10 15 20 25 30 35WALA

Payu

p, 3

2nd

10CPR 11CPR9CPR

Payups by WALA vs. aging ramp ($97 TBA price)

02468

101214

0 5 10 15 20 25 30 35WALA

Payu

p, 3

2nd

34mo ramp 24mo ramp 14mo ramp

However, the length of seasoning ramp is crucial

A longer seasoning ramp leads to higher payups for seasoning

CA

SE

ST

UD

IE

S

106

Case Study #3: Aging ramp on moderate discount collateral

M B S

Moderate discounts have two peaks: 14 months and 24 months

The 24 months peak is driven by

Tax-advantaged capital gains treatment of two-year old primary residences

Cash-out refinancing has been front-loaded

Aging curve: moderate discount, -25 to -75bps incentive

0

4

8

12

16

1mo

CP

R, %

Age0 5 10 15 20 25 30 35 40

2000~20012005~2006

CA

SE

ST

UD

IE

S

Note: Average prepayment aging curves observed from 2000 to 2001 and from 2005 to March 2006

107

Case Study #3: Specified Pools WALA- Actual versus theoretical payup

M B S

Seasoned payups suggest that the market is priced to a 24 months ramp

Potential lengthening of the aging ramp should translate to higher payups for seasoned discounts

Relative value advantage in the’04 discounts versus the ’03s

FNMA 5: Actual vs. theoretical FNMA 5.5: Actual vs. theoretical

02468

1012141618

5 10 15 20 25 30 35WALA

Payu

p, 3

2nd

’05–’06 ramp (24-mo.) ’00–’01 ramp (34-mo.)

02468

10121416

0 5 10 15 20 25 30 35WALA

Payu

p, 3

2nd

24-mo. ramp 14-mo. ramp34-mo. ramp

CA

SE

ST

UD

IE

S

Note: As of: 5/3/2006; FNMA 5s are priced to 9% CPR terminal speed; FNMA 5.5s are priced to 10% CPR terminal speed

108

Case Study #4: Specified Pools LLB – Call/extension protection

M B S

The trend points to faster LLB discount speeds similar to 1999-2000Prepayment S-Curve differences (LLB (<$100k) minus generics ($>150k)), in 1999-2000, 2004, 2005 and since fall 2005: 1mo CPR vs. Rate Incentive,bps.

-3

-2

-1

0

1

2

-125 -100 -75 -50 -25

Incentive, bps

1moCPR1999~2000 20042005 2005 Oct~2006 Apr

Low loan balance discounts are priced at a small fraction of their combined call and extension value.

Payups and model valuations of MLB ($110k max) pools

TBA MarketCall

Protection 10% Faster Turnover 20% Faster TurnoverCoupon Price Payup Payup Ext. Protection Total Ext. Protection Total

FNCL 5 94-05 0.5 2 9 11 17 19FNCL 5.5 96-22+ 1.5 3 6 9 11 14FNCL 6 99-05 4 7 4 11 7 14

CA

SE

ST

UD

IE

S

109


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 163110

ARM share has remained close to half of total applications

M B S

ARM share of total applications by $ volume (%)ARM share of total applications by $ volume (%)

0

10

20

30

40

50

60

Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06

ARM

Sha

re o

f Ap

ps b

y $

Volu

me

(%)

Source: MBA

AR

MS

111

Hybrids contributed to most of the growth of the non-agency market

M B S

Year-end outstandings ($ billions)Year-end outstandings ($ billions)

0

100

200

300

400

500

600

700

800

200620052004200320022001200019991998

Jumbo Fixed Jumbo ARM Alt-A Fixed Alt-A ARM

Source: JPMorgan, Loan Performance. 2006 data as of April.

AR

MS

112

Hybrid ARM Structure and Valuation

M B S

ExampleExampleStructureStructure

Typically 30-year terms

Fixed Rate Cash-Flows3, 5, 7,10 Year Fixed-Rate

Hybrid ARM TailsLibor/CMT Floaters

Resets subject to Caps (initial/periodic/life)

2/2/6

5/2/5

5/1 Hybrid ARM borrower with an initial coupon rate of 4.5% and a 5/2/5 cap structure pays 4.5% for 5 years

The highest the borrower’s rate can reset after the 5 year fixed rate period ends is (4.5%+5%), or 9.5%

The on-going periodic cap restricts the borrower from resetting up more than 2% at each yearly reset

The life cap also protects the borrower by ensuring that the coupon cannot reset above 9.5% for the life of the loan

AR

MS

113

Hybrid ARM Key Terminology

M B S

Rate caps (initial, periodic, and lifetime) offer protection from large interest rate movements by providing a cap and a floor, limiting the amount the resetting contract rate can increase or decrease on each adjustment date

The initial adjustment cap provides a cap and floor on the interest rate at the first adjustment date

Periodic adjustment caps restrict upward and downward movements at each subsequent reset date

Lifetime caps dictate the maximum interest rate of the mortgage loan at any given time

MTR (months to reset) is defined as the number of months until the Hybrid ARM resets off its specified Index. In other words, the number of months until the fixed rate portion of the bond ends

Once a Hybrid ARM loan reaches reset, the borrower’s new coupon is determined off a specified index

The most popular indices are LIBOR and CMT

The gross margin is the spread added to the Index that determines the mortgage holder’s new rate

The net margin is what is passed on to the investor. The net margin is the spread added to the Index that determines the coupon the investor receives. Typically, unless otherwise specified, LIBOR-indexed ARMs have approximately 175bps net margin, while CMT-indexed bonds have approximately 225bps margin

AR

MS

114

How are Non-Agency MBS Valued and Traded

M B S

Non Agency MBS do not trade ‘in the screens’ thus valuation and pricing levels reflect this uncertainty

Trading is Negotiated around structure, settlement and collateral composition

Relative Value and performance analytics help drive trading levels

Pricing Conventions

N-A Fixed Rates; Pass throughs relative to agency pass throughs

N-A ARMs : Swaps, Treasuries

Prepayment Analytics

OAS Methodology : Prepayment Modeling

Credit Analytics

Liquidity Premiums

AR

MS

115

M B S

MBS Index

CMOs

ARMs

Case Studies




Valuation and OAS


Demand


11

23

32

46

62

74

99

110

116

163

JP

MO

RG

AN

MB

SP

RI

ME

R

116

FNMA Current Coupon Yield vs. UST 10 Year Yield

M B S

3

3.5

4

4.5

5

5.5

6

6.5

6/2/2003 12/1/2003 5/31/2004 11/29/2004 5/30/2005 11/28/2005 5/29/2006

Yiel

d

Current Coupon 10 yr

CM

OS

117

Why Agency CMOs?

M B S

To broaden the investor base by customizing cash flows for investor needs while providing key advantages over other instruments:

Excess Returns

Greater Liquidity

Virtually Zero Credit Risk

Can address the following specific needs of investors:

Enhanced Yields/Spreads

Targeted Average Life Profiles

Targeted Duration Profiles

Customize the risk/reward profiles for investor’s views on:interest ratesyield curve shapeprepaymentsvolatility

CM

OS

118

CMOs as % of the Fixed Rate MBS Market

M B S

0

10

20

30

40

50

60

70

Jan-01 Jan-02 Jan-03 Jan-04 Jan-05

CMO

Issu

ance

($

Billi

ons)

0

10

20

30

40

50

60

70

% o

f Fi

xed-

Rate

Pas

s-Th

roug

h Is

suan

ce

CMO Issuance % of Pass-Through

CM

OS

119

CMO Principal Types

M B S

SEQ – Sequential

PAC – Planned Amortization Class

TAC – Targeted Amortization Class

AD or VADM- Accretion-Directed/Very Accurately Defined Maturity

FFIEC Bonds

SUP - Support or Companion

Z - Accrual bond

CM

OS

120

SEQs - Sequentials

M B S

Collateral principal payments are reallocated sequentially into a series of short, intermediate and long maturity bonds

Sensitive to prepayments:

Prepayments faster than expected: SEQs shorten

Prepayments slower than expected: SEQs extend

The shorter average life sequentials (that pay before the longer SEQs within the structure) provide prepayment protection for the longer average life SEQs

Shorter principal window than collateral

CM

OS

121

SEQ Yield Tables

M B S

Front SEQ

Last Cashflow (LCF) SEQ

CM

OS

122

PACs - Planned Amortization Class

M B S

Principal repaid according to a schedule within a specified range of prepayment assumptions called PAC bands

Principal schedule provides protection from average life volatility and reinvestment risk associated with prepayments

Principal schedules are maintained by redirecting cashflow uncertainty to Support bonds

Average Life is less volatile with speeds outside the bands because the supports continue to provide stability

Corporate bond and agency bond surrogate

CM

OS

123

PAC Yield Tables and Cashflow Graph

M B S

Yield table

Cashflow Graph

CM

OS

124

TACs - Targeted Amortization Class

M B S

Structured to pay principal according to a schedule determined by one constant prepayment speed - a “one sided” PAC

No protection against extension: TACs only have call protection because a TAC provides protection against faster but not slower prepayments

Prepayments faster than TAC speed: Excess principal to supports

Prepayments slower than TAC speed: TAC and Support extend

Offer higher yield than PACs based on increased extension risk

More call protection than a SEQ

Yield Table

CM

OS

125

AD/VADMs - Accretion Directed / Very Accurately Defined Maturity

M B S

All cashflows are derived from the interest accretions of the Z bond

VADM tranches must mature prior to the start of the amortization on their corresponding Z because when the Z becomes current pay the Z accretion is no longer available to amortize the VADMs

Very stable bond since cashflow is from interest accretion which is NOT affected by prepayments

VADMs do not extend even under a zero prepayment scenario

No whipsaw risk

Pay up for the extension protection results in lower yields and better convexity

CM

OS

126

VADM Yield Table and Cashflow Graph

M B S

VADM yield table in SEQ Z structure

WAL Graph

CM

OS

127

FFIEC Bonds

M B S

Federal Financial Institutions Examination Council (FFIEC) derived guidelines to determine if MBS investments are suitable for US depository institutions

Bonds that meet these guidelines have a wider audience, are more liquid, and trade at tighter spreads than comparable non-FFIEC average life bonds

FFIEC test:

Test 1) WAL must be less than 10 years

Test 2) +300 shift less than 4 years extension

-300 shift less than 6 years contraction

Test 3) +300 shift less than 17% price change

-300 shift less than 17% price change

CM

OS

128

SUPs - Supports or Companions

M B S

Supports are cashflow shock absorbers for PACs

Faster prepayments - excess cash flow paid to supports providing call protection for PACs

Slower prepayments - any shortfall in cash flow is absorbed by supports which may not receive principal until PAC schedule is met, providing extension protection for PACs

High average life and cashflow volatility

Higher yields compensate for volatility

CM

OS

129

Support Yield Table and Weighted Average Life

M B S

Sequentially Tranched Support

Weighted Average Life Graph

CM

OS

130

Z bonds - Accrual Bonds

M B S

No interest until principal payment window starts

Interest due is added to outstanding principal of the bond = Z accretion

Z accretion accelerates the maturity of shorter tranches or more accurately defines the maturity of others (VADMs)

Receive principal payments and interest once other bonds are retired

Addition of Z bond to a structure can improve the convexity of the other bonds by reducing extension risk

CM

OS

131

Sequential Z Bond Yield Table & Cash Flow Graph

M B S

Yield Table

Cash Flow Graph

CM

OS

132

Support Z Bond Yield Table & Cash Flow Graph

M B S

Yield Table

Cash Flow Graph

CM

OS

133

Rocket Z Yield Table & Cash Flow Graph

M B S

Type of support Z that has a possibility of paying off very fast (“rocket”).

Yield Table

Weighted Average

Life Graph

CM

OS

134

CMO Interest Types

M B S

Floater

Inverse Floater

IO - Interest Only (Trust and Structured)

PO - Principal Only (Trust and Structured)

Inverse IO

CM

OS

135

Floaters

M B S

Coupons reset periodically, usually monthly, at a rate of an index, usually 1mLibor, plus a spread, know as the margin

Created with an inverse or inverse IO such that the weighted-average coupon of the pair is always equal to the underlying fixed-rate bond

Shorter and less negatively convex than underlying fixed rate

Offers protection against interest rate risk up to the cap

The cap adds some duration and negative convexity. Without a cap the duration would be negligible and convexity neutral

Shorter durations= less price volatility than fixed-rate CMOs unless rates rise and the coupon reaches its cap

CM

OS

136

Floater Yield Table & Coupon Graph

M B S

Yield Table

Coupon Graph

CM

OS

137

Support Floater Yield Table & Coupon Graph

M B S

Yield Table

Coupon Graph

CM

OS

138

Inverse Floaters

M B S

Pays down simultaneously with their corresponding floater

Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow

High yields frequently compensate for the increased risks

Floored inverses: a “baby” inverse floater - coupon moves inversely but can never drop below a designated fixed coupon

Provide a way to leverage MBS if you are bullish on the MBS sector

Provide a way to leverage views in one package if you disagree with

forward rate curve

FED expectations

prepayment forecasts

volatility views

CM

OS

139

Inverse Yield Table & Coupon Graph

M B S

Yield Table

Coupon Graph

CM

OS

140

Floored Inverse Yield Table & Coupon Graph

M B S

Yield Table

Coupon Graph

CM

OS

141

IO - Interest Only

M B S

Receive only interest cash flow from the notional amount of the underlying bond

Since IOs do not pay principal, cashflows exist only if principal remains outstanding

The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class

Benefit from slowing prepaymentsFaster prepayments reduce the notional balance more rapidly leading to smaller interest payments

Bearish security that usually have negative durations

Interest stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets

Interest stripped from CMOs are known as Structured IO and can be customized for investor needs on:lockout

PAC bands

underlying collateral STIPs

CM

OS

142

IO Yield Tables

M B S

Structured PAC IO

Trust IO

CM

OS

143

PO - Principal Only

M B S

Stream of principal payments purchased at a discount

Hedge for prepayment risk since POs benefit from faster prepayments:Principal is returned at par at a faster rate

Lower discount rates boost the price

The amount of cash flows received is highly dependent upon the amortization and prepayments of the underlying class

Bullish security with large, positive duration and positive convexity

Super PO’s provide a more levered prepay bet

Principal stripped from designated pools of collateral are known as STRIPS and are traded in liquid broker markets

Principal stripped from CMOs are known as Structured PO and can be customized for investor needs on:lockout

PAC bands

underlying collateral STIPs

CM

OS

144

PO Yield Tables

M B S

Structured SUP PO

Trust PO

CM

OS

145

IO/PO Reports

M B S

Trust IO/PO reports from JPMorgan provide daily price data:

CM

OS

146

Inverse IO

M B S

Pays down simultaneously with their corresponding floater like an inverse except the Inverse IO does not pay principal

Coupon falls when the index rate rises and are typically levered positions in the underlying fixed rate cash flow

Faster prepayments reduce the notional balance more rapidly leading to smaller interest payments

Provide a way to leverage views in one package if you disagree with

forward rate curve

FED expectations

prepayment forecasts

volatility views

CM

OS

147

Inverse IO Yield Table and Coupon Graph

M B S

Yield Table

Coupon Graph

CM

OS

148

Recent Innovations in CMO Market

M B S

AS/NAS – Accelerated Security/Non-accelerated Security

TTIB – Two Tiered Index Bonds

Super-Floater

Customized Floater: FHR 3069 CF

RELO – Relocation collateral deals

Pre-pay Linked Notes/Interest Accrual Notes (IANs)

Freddie Mac Reference Notes

CM

OS

149

AS and NAS - Accelerated and Non-Accelerated Securities

M B S

AS security receives principal payments more quickly than its respective collateral.

NAS Security receives principal more slowly than its respective collateral

NAS + AS = SEQ

The AS bond receives the “accelerated” principal payments that would have otherwise been allocated to the NAS bonds

The NAS bond is locked out until the AS bond is paid off; then the NAS begins receiving its pro-rata principal payments

NAS is better than a PAC = no whipsaw risk

CM

OS

150

AS and NAS Yield Tables

M B S

AS

note the average life of 5.30 at 0 PSA

NAS

CM

OS

151

TTIB - Two Tiered Index Bond

M B S

A type of inverse floater that pays a fixed rate as long as 1m Libor stays below a certain threshold

Once 1m Libor crosses the threshold the coupon declines on a levered basis within a corridor of rates until it reaches 0%

Essentially shorting an option that 1m Libor will not increase beyond a certain threshold

Compensating for shorting the option by getting a higher coupon.

Historical 1m Libor graph

Digital TTIBs: Once 1m Libor crosses the threshold the coupon declines immediately to 0%

Floored TTIB: Once 1m Libor crosses the threshold the coupon declines immediately to a fixed rate floor

CM

OS

152

TTIB Yield Tables and Coupon GraphsDigital TTIB yield table Digital TTIB coupon graph

M B S

1 bp Corridor TTIB yield table1 bp Corridor TTIB coupon graph

CM

OS

153

TTIBs with additional features

M B S

TTIBs with lock-out: coupon rate is not conditional on 1m Libor for an initial period, ensuring desirable rates over that period.

Initial reset date can be several years into bond’s lifetime.

Locked-out Digital TTIB yield tableLocked-out Digital TTIB coupon graph

CM

OS

154

TTIBs with additional features (cont.)

M B S

Floating-rate TTIBs: when 1m Libor is below a threshold, bond pays as a floater.

Floating-rate TTIBs with lock-out: bond maintains its initial coupon formula for an initial period, regardless of 1m Libor.

Example: FHR 3140 CF- Is a regular L + 165 bp bondfor first 7 years, beforeconverting into a regularfloating-rate TTIB.

CM

OS

155

Super-Floater

M B S

A type of floater that pays a fixed rate as long as 1m Libor stays above a certain threshold (usually greater than current levels).

Essentially shorting an option that 1m Libor will remain below a certain threshold.

Compensated for shorting the option by receiving a VERY high coupon should 1m Libor go above the threshold.

Example: FHR 3111 HF (receives 66% coupon if 1m Libor > 6.5%)

Coupon Graph

CM

OS

156

Customized Floater: FHR 3069 CF

M B S

Classified on Bloomberg as “Complex” because the formula for calculating the payment is not the standard Libor + discount margin

Unique structure

Payment Formula:If Libor is less than 4.8%, bond pays Libor + 2.35%If Libor is greater than 4.8% but less than 7.15%, bond pays 7.15%If Libor is greater than 7.15%, bond pays 0%

Coupon Graph

CM

OS

157

RELO – CMO Backed by Relocation Mortgages

M B S

Relocation Mortgage: a mortgage made to a transferred employee to finance a home purchase at a new job location

Mortgage usually requires an employer to contribute to mortgage funding

Mortgage typically originated by an agreement between the employer and the lender under a relocation program administered by the employer or its agent

Prepayment speeds depends on typical prepayment behaviors and other RELO factors:Whether the mortgages are made in connection with a permanent relocation of a corporate headquarters

The likelihood that borrowers will be relocated again

The frequency with which further relocations may occur

Historically this sector has fast prepay speeds

CMOs backed by RELO collateral usually trade at a deep discount

CM

OS

158

RELO Yield Table and Weighted Average Life Graph

M B S

Yield Table

Weighted Average Life graph

CM

OS

159

Prepay Linked Notes or Interest Accrual Notes (IANs)

M B S

Agency debt and MBS hybrid

Redemption schedule is based on a pre-selected reference pool

Like MBS (unlike agency debt) there is no explicit call date

Like agency debt (unlike MBS) there is a stated final maturity

Effective duration management tool for those who like MBS sector

Yield TableRecently-priced deals

CM

OS

160

Freddie Reference Notes

M B S

A Pre-pay linked note that trades live on Trade Web; an automated broker

Availability by all dealers on Trade Web meansBetter liquidity andBetter price transparency than pre-pay linked notes that do not trade live on Trade Web

Trades at slightly lower yields than other pre-pay linked notes due to the advantage of greater liquidity and greater price transparency

Trade Web Screen Offering:Yield Table

CM

OS

161

Conclusion

M B S

As a premier investment bank, strives to be a leader in the CMO market

The CMO team’s recent production is growing rapidly:In April & May 2006, the #1 FNMA issuer!

The #3 overall conventional issuer (FNMA + FHLMC) over same period.

Over $5 billion in deal volume in those two months alone!

The CMO team can provide the following client needs:Unique trade ideas through structuring capabilities

Relative value analysis

Marked-to-market valuations & portfolio analysis

Liquidity through market making

Let the CMO team help you maximize the total return of your portfolio!

162CM

OS


M B S

Demand 11






Case Studies 99

JP

MO

RG

AN

MB

SP

RI

ME

R

ARMs 110

CMOs 116

MBS Index 163163

JPMorgan MBS Index

M B S

The JPMorgan Mortgage Index (“the Index”) measures the performance of fixed-rate agency-backed mortgage pass-through securities

• Included:

– Thirty-year and 15-year fixed-rate pass-through securities issued by FNMA, FHLMC, and GNMA

• Excluded:

– ARMs

– Non-Agency (whole loan), Jumbo, and 10- or 20-year securities

– Balloons, GPMs, and TPMs

– FHLMC 75-day delay mortgages

– FNMA Mega, FHLMC Giant, and GNMA Platinum pools

MB

SI

ND

EX

164

JPMorgan MBS Index

M B S

Due to paydowns and new pool issuance which are reported monthly, the mortgage universe undergoes monthly transformations

JPMorgan re-balances the Index automatically to reflect the changing compositions of the mortgage market. Once a month, on the last business day of the month, all the pools represented in the Index are re-aggregated for use next month

At the end of each business day, JPMorgan trader marks are used to price all the constituent securities in the Index

Traders mark benchmark issues (TBAs) and specified pools

Algorithm is used to price securities that are not actively traded

MB

SI

ND

EX

165

Calculation of Index Returns

M B S

Daily total return of the Index is the market value weighted average of the daily returns of its constituent securities

The daily total return of a security is defined as its daily change in market value over its previous market value. The change in market value equals change in price plus change in accrued interest. Interest is accrued daily at the net coupon rate based on 30/360 day-count convention. Using formulas, the relationship is as follows:

The Index starts at 100 on January 1st, 2000. On every business day after market close, a daily Index return is computed. A new index value is then calculated as the product of the previous Index value and the daily Index return

This methodology assumes that the Index settles daily (on business days) and that returns are reinvested into the Index on a daily basis. Using raw Index values, one can easily calculate the periodic total return of the Index between any two business-days by dividing the ending Index value by the starting Index value

MB

SI

ND

EX

166

Total return swaps on the JPMorgan MBS Index

M B S

•Investors can receive (or pay) the total rate of return of the JPMorgan Mortgage Index and pay (or receive) LIBOR – a specified spread

•Advantages of the TROR Index Swap:

– MBS returns competitive and less volatile than corporate debt– Ease of execution– Sector exposure with no security selection required– No MBS delivery / allocation required– Locked-in funding spread– Finite investment term– Paydowns automatically reinvested in Index– Pay or receive Index

Investor

Index Return LIBOR - spread

JPMorganChase Bank

EX

MB

SI

ND

167

Mortgage Index returns

M B SMB

SI

ND

EX

Source: Bloomberg

168

Index Composition

M B S

Index composition in June 2006, par weighted (%) and month/month changes in 10-year equivalents ($bn)Index composition in June 2006, par weighted (%) and month/month changes in 10-year equivalents ($bn)

MB

SI

ND

EX

Source: JPMorgan

169

Index Performance

M B S

Index duration and convexity profile, as of 5/31/06Index duration and convexity profile, as of 5/31/06

Index statistics, May 31st, 2006Index statistics, May 31st, 2006 Index statistics, May 31st, 2006Index statistics, May 31st, 2006

MB

SI

ND

EX

170

Index Performance

M B S

Index returns and excess returns by sector and coupon (bps), in May 2006Index returns and excess returns by sector and coupon (bps), in May 2006

MB

SI

ND

EX

171

[JP Morgan] MBS Primer

Documents

Transcript of [JP Morgan] MBS Primer