Barclays Securitized Products Weekly Looking Past the EM Contagion

Securitization Research 31 January 2014

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 40

Securitized Products Weekly

Looking past the EM contagion Emerging market concerns pushed long-term yields lower, but we expect the normalization in rates, home prices and credit performance to continue in 2014. We maintain our underweight recommendation on the agency MBS basis and favor non-agency MBS.

Agency MBS

Continuing down a straight path 4 At Chairman Bernankes last FOMC meeting, the Fed decided to continue tapering the asset purchases with an overall reduction of $10bn, of which $5bn would be in mortgages. The total mortgage purchase rate is now $30bn plus paydowns. With the Fed continuing its tapering, the technicals for the mortgage basis have started to look weaker.

Prepayment commentary 10 We present our short-term prepayment projections for the February, March and April reports.

Residential Credit

Non-agencies pare gains 16 Non-agencies pared some gains this week, in line with a global correction in risk assets. The Bank of America $8.5bn settlement was approved, except on modification claims. January remittance reports show severe drops in bond cash flows on many previously BofA serviced deals that were transferred to Nationstar in the past few months. The Dutch state announced the auction of the remaining $2.1bn UPB of bonds from the ING IABF.

CMBS

Volatility may present buying opportunity 20 The volatility in emerging markets and equities spilled into CMBS this week. We believe the steady pace of improvement in the domestic economy provides a strong backdrop for credit-sensitive bonds to outperform; we expect only a limited adverse effect on the growth story from an emerging market slowdown. We revisit our low-quality 07 AM recommendation from November 2013. Much of the alpha in this trade appears to have been squeezed out, but the bonds remain attractive short duration tranches, paying above-average yields compared with alternatives.

Estimating lease renewal probability in CMBS 23 We propose a method to predict lease renewal likelihoods from CMBS remittance data and identify certain properties, geographies and tenant types that are more at risk.

Non-mortgage ABS

A good start to the year for ABS 30 ABS issuance was healthy in January, while credit performance across ABS sectors was mostly stable. ABS spreads tightened modestly during the month, giving the ABS component of the Barclays Agg index a year-to-date return of +37bp. We also discuss several developments in the ABS market during the month.

Views on a Page 2

Overview 3

Convexity Portfolio 14

Credit Portfolio 37

Ajay Rajadhyaksha +1 212 412 7669 [email protected] www.barclays.com

Barclays | Securitized Products Weekly

31 January 2014 2

VIEWS ON A PAGE Category Comments Trade recommendations

Agency basis Fed tapering represents a challenge for the basis over the longer term, as private demand will need to supplant the Fed. Although a gradual tapering of MBS purchases will keep demand from the Fed strong in the near term, over the longer run, the technicals should turn negative in the absence of Fed support, leading to spread widening. Within the mortgage sector, we expect shorter-duration and shorter-spread-duration assets to outperform. Consequently, we recommend going up in coupon in the 30y sector, and 15s versus 30s. We recommend expressing this view in a short position in FN 3.5s versus Treasuries and long FN 30y 4.5/3.5 swap.

Short FN 3.5 vs Tsy Long GN/FN 4 swap Long FN 30y 4.5/3.5 swap Long 15y 3.5 vs. 30y 4s

Prepayments Given rates and the MBA index, refinance risk seems muted for now. The Treasurys stance against changing the HARP cut-off date is a positive for IOs off conventional and GNMA 2009/10 collateral. Watts decision to delay g-fee increases points to a more modest trajectory of guarantee fees relative to the current FHFA framework. We expect new production FNCL discount speeds of 5-6 CPR and longer-run GNMA discounts to be 3-4 CPR faster, on higher buyouts and FHA to conventional refinances.

Housing Through November, US housing prices were up 11.8% y/y, with Nevada (+25.3%), California (+21.3%), and Michigan (+14.4%) leading all states. The Corelogic Home Price Index increased 0.9% m/m seasonally adjusted in November, in line with the 0.7-0.9% gains in H2 13. Year-to-date, HPA (seasonally adjusted) stands at 11.1%, which is close to our 11% forecast for 2013. Given the low inventory levels and signs of widening credit availability, we continue to expect home prices to rise 7% in 2014. Formerly distressed markets should continue to propel the recovery into 2014, due to attractive valuations and declining distressed inventory; however, we see downside risks to high-priced metros from rising mortgage rates. Our regional forecasts are available on Barclays Live (keyword HPA).

Residential credit

We remain constructive and recommend alt-A FRM SSNRs in cleaner collateral and option ARM SSNRs/subprime PAAA/LCF AAAs in weaker credit. We also believe that a 50bp pickup in new issue AAAs vs. agency MBS more than compensates for worse liquidity, a lack of a government guarantee and slightly worse convexity. We are neutral on GSE credit risk-sharing deal M1/M2 bonds after the most recent rally.

Long fixed coupon alt-A FRM SSNRs (duration-hedged) leveraged and unleveraged

Long option ARM SSNRs and subprime LCFs Prefer new issue non-agency AAAs vs TBA

CMBS The steady pace of improvement in the domestic economy provides a strong backdrop for credit-sensitive bonds to outperform. Emerging market volatility could spill into CMBS in the short run, but is unlikely to have a major effect on the growth story. Our favorite trade is to take advantage of any significant widening in 3.0 mezz, especially 2013 BBBs. Despite recent weakness, our long CMBX.6 BBB vs. short A trade is pricing close to its tights; we will look for opportunities to roll the trade into CMBX.7. Buy AAA rated new issue X-A IOs (with leverage), which should benefit from higher rates, but stay neutral on dupers. Spreads on lower-quality 2007 AM bonds have come in 150-200bp in the past two to three months; much of the alpha appears to have been extracted, but these safe, short duration tranches still look attractive versus comparable alternatives. Stay cautious on cuspy discount priced 07 AJ/mezz tranches, for which we believe the market is mispricing maturity risk in a rising rate environment. Go long agency CMBS senior bonds; demand should be boosted by the impending addition to the Agg index and crossover interest from the agency MBS sector, as investors look for extension protection options.

Buy 2013 vintage BBB Buy back-end re-REMICs off 2007 GG10 A4s Buy Freddie K 10y senior IOs Buy CMBX.6 BBB- vs. short CMBX.6 A Buy new issue X-A IOs Buy Freddie K 10y A2

Non-mortgage ABS

Among traditional non-mortgage ABS sectors, we prefer senior credit card, equipment, auto lease, and student loan ABS tranches. We are also overweight subordinates off of dealer floorplan and equipment ABS deals; however, we are neutral on subprime auto subordinates. Finally, in esoteric ABS, our favorite asset classes are aircraft ABS, small balance commercial ABS, whole business securitizations, and cell tower ABS.

Buy credit card, equipment, auto lease, and student loans ABS seniors

Overweight dealer floorplan & equipment subs Buy aircraft ABS, SBC, cell tower ABS, and WBS

Rates, curve, and volatility

We expect the improving economic outlook to put upward pressure on rates in the intermediate sector over the coming months. We maintain our shorting duration view via OTR 7s and paying 4y1y swap rates, as they have limited room to rally, and our long 2s3s5s and short 5s7s10s flys recommendations, as they offer asymmetric risk-reward. 2y1y-3y1y swap curve steepeners also look attractive.

Source: Barclays Research


31 January 2014 3

OVERVIEW

Looking past the EM contagion Emerging market concerns pushed long-term yields lower, but we expect the normalization in rates, home prices and credit performance to continue in 2014. We maintain our underweight recommendation on the agency MBS basis and favor non-agency MBS.

Emerging market concerns dominated the market last week, with flight to quality pushing 10y Treasury yields to levels last seen in November 2013. The primary concern was whether EM contagion would continue to drive US markets, and especially rates lower. While these concerns can continue to flare up in the near term, our rate strategists believe that any adverse effects on the US from emerging markets are likely to be limited. First, US exports to the countries experiencing a crisis are only a small fraction of overall trade and GDP. Second, the market seems to be differentiating more between asset classes and there has been no broad-based tightening in financial conditions so far. Further, emerging market countries have built significant foreign currency reserves, which should provide some cushion in negative scenarios. Overall, they believe that the emerging market crisis is likely to have limited effects on the US, but if there is a disorderly selloff in US equities, the Fed may turn dovish. Please see US Rates Strategy for more details.

Remain underweight on agency MBS, constructive on resi credit The week was no different for securitized products. Performance seesawed as rates and the broader market moved up or down depending on EM headlines. Agency MBS performance was mixed as the middle of the coupon stack fared well but both lower and higher coupons underperformed. We continue to expect the Fed to move down the taper path in a straight line and recommend an underweight to the agency MBS basis. With the Fed expected to continue to taper in a straight line, demand supply technicals will soon turn negative for agency MBS. We also recommend initiating a long position in IOS 4.5 09 as the possibility of a HARP data extension has diminished significantly.

In the securitized credit sectors, prices ended weaker w/w in sympathy with other risky assets. In the near term, it is not inconceivable that emerging market concerns could flare up even more. That said, we expect the normalization in rates, home prices, and credit performance to continue in 2014. Rates should be biased higher, while home price growth and credit performance improvement should continue. In particular, we continue to favor alt-A fixed-rates, negam super-seniors, and subprime PAAAs/LCFs in non-agency MBS. In CMBS, we also recommend staying long equity-like assets such as 2013 BBBs versus super dupers. In consumer ABS, we favour AAA securities of traditional sectors and subordinates of equipment, dealer floorplan ABS and private student loans.

Ajay Rajadhyaksha +1 212 412 7669 [email protected] Sandeep Bordia +1 212 412 2099 [email protected] Nicholas Strand +1 212 412 2057 [email protected]


31 January 2014 4

AGENCY MBS TRENDS

Continuing down a straight path At Chairman Bernankes last FOMC meeting, the Fed decided to continue tapering the asset purchases with an overall reduction of $10bn, of which $5bn would be in mortgages. The total mortgage purchase rate is now $30bn plus paydowns. With the Fed continuing its tapering, the technicals for the mortgage basis have started to look weaker.

The FOMC statement focused more on recognizing further firming in the economy on the back of robust GDP numbers over past two quarters. Prospectively, the Fed also now looks for the economy to expand at a moderate pace instead of picking up as fiscal policy restraint is diminishing.

A recent FHA mortgagee letter clarifies underwriting standards for certain debt-to-income (DTI) thresholds. We believe the increased guidance is designed to encourage FHA lending to the lower end of the credit spectrum. While it is unclear whether lenders will embrace the initiative, the net long-term effect is a loosening of the credit box, in our view.

With the Treasury Department indicating that it is against any change in HARP cut-off date, this has reduced the possibility of a HARP date extension significantly, in our view. Although IOS for 4.5 and 5 of 09 and 10 have tightened after the announcement, we believe that the policy risk is still being overestimated, therefore, we are initiating a long position in IOS 4.5 10.

At the highly anticipated FOMC meeting, the Fed reduced the monthly pace of asset purchases by another $10bn to $65bn per month as was widely expected. Purchases of agency MBS now stand at $30bn per month plus paydown reinvestment. The FOMC upgraded its assessment of economic activity, indicating that it believes that the recent weakness in economic data may be transitory in nature and related to weather disruptions. The Q4 GDP growth estimate came in along expectations at a robust 3.2%.

Even though the Fed continued with tapering, rates surprisingly rallied over the week, and a large part of that came after the FOMC statement. The rally was driven mainly by an increase in risk aversion emanating from credit concerns in the emerging market. 10y yields ended the week at 2.7% down 7bp from last weeks close.

Nicholas Strand +1 212 412 2057 [email protected] Lokesh Chandra +1 212 412 2099 [email protected] Sandipan Deb +1 212 412 2099 [email protected] Wei-Ang Lee +1 212 412 5356 [email protected] Leo Wang +1 212 412 7571 [email protected]

FIGURE 1 Lower coupons underperformed the most over the past week

FIGURE 2 Fed purchased $12.6bn agency MBS over the past week

Coupon Conv 30y Conv 15y GN 30y Total

2.5 100 100

3 1,050 1,050

3.5 1,700 400 600 2,700

4 6,700 1,500 8,200

4.5 400 150 550

Total 8,800 1,550 2,250 12,600

Note: Performance from Jan 23 close to Jan 30 close. Source: Barclays Research Source: Federal Reserve, Barclays Research

-5

-4

-3

-2

-1

0

1

2

3

FNMA 3s FNMA 3.5s

FNMA 4s FNMA 4.5s

FNMA 5s FNMA 5.5s

vs 10y swap vs 10y Tsy vs Tsy curve


31 January 2014 5

Mortgage performance was mixed over the week. The middle of the stack fared well, while lower and higher coupons underperformed their Treasury hedges. FN 3s were down by 3 ticks while 3.5 were flat. FN 4s and 4.5s outperformed their duration hedges by 1-2 ticks each. We continue to have a negative view on the basis and expect it to underperform, especially in the lower coupons. With the Fed continuing on its path to gradually taper the asset purchases, demand supply technicals should soon turn negative for the basis.

Parting shot Fed Chairman Bernankes last meeting as the head of the FOMC resulted in a statement much less surprising than that from the penultimate one, as the tapering policies and pace specified at the December meeting continued in a predictable pattern for the January decision. Purchases will be reduced by another $10bn per month, split evenly between agency MBS and Treasuries, bringing the total gross pace for February to $30bn and $35bn, respectively, before reinvestment of paydowns.

Note that as agency MBS purchases taper further, the amount of paydowns reinvested from the Feds agency debt holdings becomes a higher percentage of total purchases, when added to the scheduled flat amount and any reinvestment of MBS paydowns. This progression is somewhat front-loaded, with about $16bn more maturing through year-end, $11bn of which rolls off through the remainder of H1. Maturities are lower in 2015, but then increase back to $17bn in 2015 and $12bn in 2016 (Figure 3).

With the FOMC making the widely expected decision to continue tapering, the statement focused more on recognizing further firming in the economy, and elucidating the conditions under which the Fed could decide to change the pace of tapering. Specifically, the Fed noted that economic growth has been picking up in recent quarters, a remark borne out by the Q3 4.1% GDP print and advanced indications that Q4 GDP, which we expect to print in the 3.4% area after mostly steadily increasing data year-to-date (Figure 4). Prospectively, the Fed also now looks for the economy to expand at a moderate pace instead of picking up as fiscal policy restraint is diminishing.

Thus, the Fed has retained its language surrounding further decisions to change the pace of monthly purchases as requiring data to be consistent with further improvement in the labor market and inflation moving back toward its longer-run objective. It also retained the right to vary purchases outside of a preset course if the expected aforementioned economic momentum does not continue.

FIGURE 3 Maturing agency debt owned by Fed ($mn)

FIGURE 4 GDP tracking estimate over time

Release date Indicator Period

Q4 GDP tracking, %

3-Jan Vehicle sales Dec 2.8

6-Jan Factory orders Nov 2.8

7-Jan Trade Nov 3.3

10-Jan Wholesale inventories Nov 3.4

14-Jan Retail sales Dec 3.4

14-Jan Business inventories Nov 3.5

17-Jan Housing starts Dec 3.6

17-Jan Industrial production Dec 3.4

28-Jan Durable goods orders Dec 3.4

30-Jan GDP Q4-1st 3.2

Source: Barclays Research Source: Barclays Research

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Maturing agency debt owned by Fed $ mn


31 January 2014 6

Notably, the Fed made no mention of the recent volatility of financial conditions in emerging markets, also as expected; we would look for the FOMC to make further acknowledgments and/or assessments of their impact in future meetings.

Upside for IOS 4.5s and 5s of 2010 from lower HARP risk As we wrote last week (Securitized Products Weekly, January 24, 2014), the Treasury department has indicated that it is against any change in a HARP cut-off date. This has reduced the possibility of a HARP date extension significantly, with the administration withdrawing its push to extend the date by a year. Although Mel Watt could still unilaterally extend the cut-off date, this would be increasingly less likely in the absence of the administrations support, as well as in the face of opposition from investors.

As expected, the coupons most exposed to the risk of a HARP expansion tightened on this announcement. IOS 4.5s and 5s of 2009 and 2010 and IOS 4s of 2009 cohort outperformed their TBA and curve hedges significantly into the announcement (Figure 5). IOS 5s of 2009 have outperformed by over 30 ticks while IOS 4.5s of 2010 have outperformed by over 16 ticks.

Although pricing has tightened significantly, we believe that there is more upside potential in some of these coupons, along with attractive hedged carry. We expect policy risk to these cohorts exposed to a one-year HARP date expansion to have declined significantly. However, pricing does not fully reflect this lower likelihood.

Looking at the valuation of multiples over the past six months, these coupons seem to be fairly priced, with current valuations right in the middle of the overall range (Figure 6). However, given the muted prepayment reports over the past two months, this figure actually shows these coupons to be on the cheaper side, in our view.

Moving on to the OAS framework, we find that the greater clarity in policy direction is not being fully reflected in pricing of 2010 cohorts. Although there has been some divergence from 2009 collateral that still remains exposed to HARP, 2010 cohort continues to have significantly wider spreads than the 2011 cohort, even after adjusting for collateral characteristics (Figure 7). We believe that the spread should continue to move toward 4.5s of 2011 and away from the 2009 cohort, as the policy risk is more comparable with the 2011 cohort now.

FIGURE 5 TBA 3.5 and curve hedged daily returns across cohorts

FIGURE 6 Moneyness vs. IO multiples

Note: 30-year collateral. Source: Freddie loan level data, Barclays Research Note: 30-year collateral. Source: Freddie Mac loan level data, Barclays Research

-20

-10

0

10

20

30

40

31-Dec 7-Jan 14-Jan 21-Jan 28-Jan

ticks

IOS 4 09 IOS 4.5 09

IOS 4.5 10 IOS 5 09

IOS 5 10

0

1

2

3

4

5

6

7

8

-100 0 100 200 300 400

IO Multiple

Moneyness (bp)

All IOS 4 09

IOS 4 10 IOS 4.5 09

IOS 4.5 10 IOS 5 09


31 January 2014 7

FIGURE 7 OAs divergence between IOS 4.5 cohorts

FIGURE 8 Outstanding balances and notional

Outstanding balance ($bn)

4 4.5 5

H1 09 23.3 40.6 9.8

H2 09 16.4 43.2 20.1

H1 10 2.8 29.2 22.9

H2 10 52.9 30.0 9.5

Net IOS notional ($bn)

4 4.5 5

2009 1.57 1.76 1.10

2010 3.66 2.88 2.97

2011 0.86 1.65

Note: 30-year collateral. Source: Freddie loan level data, Barclays Research Note: 30-year collateral. Source: Freddie Mac loan level data, Barclays Research

We therefore initiate a long position in IOS 4.5s of 2010 in our portfolio. The coupon offers attractive loss-adjusted yield of about 5% and hedged carry of 7.6 ticks a month. IOS 5s of 2010 also look attractive on these metrics but we like the less volatile position in 4.5s better. The tranche has reasonable outstanding balance in the affected H2 09 - H1 10 time frame (Figure 8). Additionally, the net notional outstanding for these coupons is also high relative to other less liquid tranches.

The position does entail certain risks. Although very small, any discussion of a HARP cut-off date extension from the FHFA would make these tranches retrace all their recent gains. Additionally, if rates keep rallying, prepayment expectations may be revised upward, leading to spread widening.

FIGURE 9 IOS analytics

Price 1y/3y CPR Libor OAS

Libor ZV Yield

Loss adjusted yield

Hedge adjusted carry

IFN-34009 IO 22.4 15.4/14.9 76 4.88 3.2% 8.4

IFN-34509 IO 22.1 16.4/15.8 288 6.31 5.2% 9.1

IFN-34510 IO 23.5 14.3/14.1 266 5.85 5.0% 7.5

IFN-35009 IO 21.3 15.4/15.2 610 8.54 8.3% 7.7

IFN-35010 IO 22.7 14.5/14.4 512 7.55 7.4% 7.6 Source: Barclays Research

150

170

190

210

230

250

270

290

2-Jan 6-Jan 10-Jan 14-Jan 18-Jan 22-Jan 26-Jan

LOAS (bp)

IOS 4.5 09 IOS 4.5 10 IOS 4.5 11


31 January 2014 8

HUD/FHA seeks to expand the credit box A recent FHA mortgagee letter clarifies underwriting standards for certain debt-to-income (DTI) thresholds. We believe the increased guidance is designed to encourage FHA lending to the lower end of the credit spectrum. While it is unclear if lenders will embrace the initiative, the net long-term effect is a loosening of the credit box in our view.

The guidelines are for loans that are underwritten manually (as opposed to the automated Total Scorecard system). For purchase loans, borrowers with DTI ratios above the 31/43 base threshold could likely get flagged as a loan that must be underwritten manually. Overall, the mortgagee letter accomplishes the following (Figure 10):

Compensating factors: The FHA has outlined acceptable compensating factors that may help the borrower obtain financing. This includes sufficient cash reserves, new payment and delinquency test, other income sources and the residual income test. The residual income test is based off the Veteran Affair (VA) program, which takes gross monthly income and nets out additional sources of potential debt to come up with a residual value (Figure 11). The borrower passes the test provided the residual value is greater than the threshold value, which varies depending on geography (Figure 12).

Stretch DTI ratios: For the first time, the FHA has addressed the relationship between compensating factors and higher allowable DTI ratios. For instance, 37/47 DTI is allowed provided one compensating factor from options 1, 2, or 4 is met (Figure 10). 40/50 DTI is permitted if two compensating factors out of options 1-4 are met.

No discretionary debt: The FHA is also addressing the case where the front-end DTI exceeds 31 but the borrower does not have any discretionary debt (for instance, no carry-over balance on a credit card). In this case, a 40/40 DTI threshold is permitted.

FICO score: Previously, compensating factors could only be cited for 620+ FICO borrowers. Under the new guidance, this has been reduced to 580+ FICO.

Applicability: The application of DTI thresholds and compensating factors applies to purchase loans and certain refinance transactions. However, it does not apply to non-credit qualifying streamline refinances. This type of refinance accounts for the bulk of all FHA refinances and do not require an income/employment test.

FIGURE 10 FHA DTI thresholds and compensating factors

FIGURE 11 Residual income test calculation

Note: For manually underwritten loans. Source: HUD, Barclays Research Source: HUD, Barclays Research

Compensating factors

Allowable DTI

FICO bkt Req number of factors

Choices Description

31/43 500-579 - -1. Cash reserves of at least three mortgage payments

31/43 580+ - -

2. New payment cannot increase by $100 or 5% higher than prior loan. No more than one DQ30 over the last 12m

37/47 580+ 1 1, 2, 43. Significant additional income that is not considered effective income.

40/40 580+ 1 54. Residual income test (based on VA guidance)

40/50 580+ 2 1, 2, 3, 45. No discretionary debt (ie., revolving credit is paid-in-full for the last 6m)

Gross monthly income

- State income taxes

- Federal income taxes

- Other taxes

- Retirement or Social Security

- Proposed monthly fixed payment

- Estimated maintenance and utilities

- Job related expenses (eg., child care)

= Residual income


31 January 2014 9

The improved guidance is designed to encourage lending to less pristine FHA borrowers, in our view. Currently, many lenders set their own minimum FICO standard, which is well above what is mandated (FHA requires a 10% down-payment for sub-580 FICO loans). This reflects an effort on the part of lenders to mitigate their put-back liability. Lender overlays are a key reason why average origination FICOs has improved so sharply in recent years (Figure 13). Indeed, in the context of these changes, FHA Commissioner Carol Galante, stated:

We want to provide revised guidance for our lenders so that they are confident in offering affordable mortgage loans to responsible borrowers under a reasonable set of guiding principles. We hope to bring more certainty to the market by helping lenders apply a set of consistent underwriting standards.

In terms of implications for GNMA MBS, non-credit qualifying FHA streamline refinances are excluded from the updated rules, so the direct prepayment effect should be minimal. Rather, the new rules reflect a recognition that the credit pendulum has swung too far and is in need of normalization. To the extent that lenders reduce overlays, the increased guidance point to a gradual loosening of the credit box.

FIGURE 12 Residual income thresholds by geography

FIGURE 13 FHA FICO distribution has shifted sharply

Source: HUD, Barclays Research Source: HUD, Barclays Research

Family size Northeast Midwest South West

1 $ 450 $ 441 $ 441 $ 491

2 $ 755 $ 738 $ 738 $ 823

3 $ 909 $ 889 $ 889 $ 990

4 $ 1,025 $ 1,003 $ 1,003 $ 1,117

5 $ 1,062 $ 1,039 $ 1,039 $ 1,158

6-7 Add $80 for each additional member

05

101520253035404550

300-500 500-580 580-620 620-680 680-720 720+

Pct

FICO bucket

FY 2013 Q3 FY 2007 Q3


31 January 2014 10

PREPAYMENT COMMENTARY

We present our short-term prepayment projections for the February, March and April reports. These numbers are unchanged from Short-term prepayment projections from January 10, 2014.

FIGURE 1 FNMA 30y short-term Barclays forecasts

Note: Includes our estimated prepayment effect from HARP 2.0. As of January 30, 2014, no-point mortgage rate at 4.50% (10y at 2.75%). Source: Barclays Research

Cpn Vintage WAC $Bal 3m CPR Jan-14 Feb-14 Mar-14 Apr-143 2012 3.59 147.6 3.8 3.8 3.2 2.7 3.2

3.5 2012 4.01 189.1 5.5 5.5 4.8 4.1 4.82011 4.04 32.4 6.2 6.0 5.0 4.1 5.02010 4.13 13.1 7.8 7.6 6.4 5.3 6.3

4 2012 4.47 59.8 7.9 8.1 7.2 6.2 7.12011 4.47 70.4 8.9 8.9 7.5 6.1 7.22010 4.49 60.7 9.6 9.8 8.3 6.8 7.92009 4.56 39.8 11.1 11.6 10.2 8.6 9.9

4.5 2012 4.96 6.8 10.3 10.9 9.6 8.2 9.32011 4.93 58.4 11.8 12.3 10.6 8.9 10.22010 4.94 58.5 13.6 14.1 12.5 10.7 12.12009 4.94 83.6 15.6 16.6 15.2 13.3 15.0

5 2011 5.37 18.4 14.5 15.5 13.7 11.7 13.22010 5.36 32.0 16.5 17.2 15.4 13.3 14.92009 5.42 25.1 19.1 19.5 18.3 16.4 18.22008 5.65 10.0 30.4 30.1 28.7 25.8 28.42005 5.65 18.4 25.4 24.7 23.4 21.0 23.22004 5.55 10.8 22.5 21.7 20.4 18.3 20.32003 5.51 25.3 22.0 20.7 19.4 17.3 19.3

5.5 2009 5.94 3.9 20.4 20.9 19.8 17.9 19.82008 6.04 16.3 33.7 33.0 31.8 29.0 31.72007 6.14 15.2 33.9 31.8 30.6 27.9 30.52006 6.16 7.4 33.1 31.4 30.3 27.7 30.22005 5.99 18.5 27.8 26.1 25.0 22.7 24.92004 5.94 16.0 24.1 23.1 21.9 19.8 21.92003 5.95 25.8 23.6 22.4 21.3 19.2 21.22002 6.03 5.2 24.0 22.6 21.5 19.3 21.4

6.0 2008 6.53 9.1 36.2 35.6 34.5 31.7 34.52007 6.57 20.6 35.7 34.2 33.1 30.4 33.12006 6.56 15.9 34.1 32.1 31.0 28.4 31.0

6.5 2008 6.99 2.9 35.2 34.5 33.4 30.8 33.42007 7.07 6.2 34.8 33.3 32.3 29.8 32.32006 7.03 7.2 33.5 32.2 31.1 28.7 31.1

No-point mortgage rate 4.51 4.39 4.59 4.70 4.69Day count 21 21 21 19 21

Projected (report month)Actual FNMA

Wei-Ang Lee +1 212 412 5356 [email protected] Leo Wang +1 212 412 7571 [email protected]


31 January 2014 11

FIGURE 2 FNMA 15y short-term Barclays forecasts

Note: Includes our estimated prepayment effect from HARP 2.0. As of January 30, 2014, no-point mortgage rate at 3.55% (10y at 2.75%). Source: Barclays Research

Coupon Vintage WAC $Bal 3m CPR Jan-14 Feb-14 Mar-14 Apr-142.5 2012 3.01 72.7 4.8 4.9 4.3 3.6 4.33 2012 3.45 42.6 6.8 7.0 6.0 4.9 5.8

2011 3.46 26.3 7.6 7.6 6.5 5.4 6.42010 3.59 3.2 9.9 9.7 7.9 6.1 7.2

3.5 2012 3.97 6.9 10.8 11.1 9.5 7.5 8.72011 3.91 24.2 10.5 10.2 8.6 6.9 8.12010 3.92 19.5 11.7 12.4 11.1 9.3 10.8

4 2011 4.37 12.1 13.3 13.9 12.3 10.2 11.82010 4.41 15.4 15.8 15.6 14.4 12.3 14.12009 4.49 12.1 17.0 17.2 15.7 13.3 15.2

4.5 2010 4.84 3.9 16.8 16.7 15.3 13.0 14.92009 4.89 5.9 17.9 17.2 15.6 13.2 15.02008 5.07 2.3 22.8 23.0 21.5 18.4 20.82005 5.13 1.2 18.4 18.8 17.5 15.1 17.22004 4.97 3.0 17.4 17.1 15.9 13.8 15.72003 4.97 10.1 16.7 16.5 15.3 13.2 15.0

5 2009 5.47 0.5 17.8 18.5 17.4 15.2 17.32008 5.56 2.2 23.8 21.2 20.0 17.5 19.82007 5.71 0.7 23.1 22.9 21.8 19.1 21.62006 5.64 0.5 20.2 20.8 19.6 17.1 19.32005 5.49 2.3 18.3 17.7 16.6 14.5 16.62004 5.43 2.4 16.1 16.0 14.9 13.0 14.82003 5.45 6.7 16.7 16.5 15.4 13.5 15.42002 5.52 2.5 17.7 17.7 16.7 14.6 16.6

3.55 3.45 3.60 3.71 3.7121 21 21 19 21

Mortgage RateDay-Count

Actual FNMA Projected (report month)


31 January 2014 12

FIGURE 3 GNMAI 30y short-term Barclays forecasts

Note: BoA buyout effect assumes cleanup in one month. As of As of January 30, 2014, no-point mortgage rate at 4.50% (10y at 2.75%). Source Barclays Research

Additional 1M CPR

Coupon Vintage WAC Bal ($bn) 3m CPR Jan Feb Mar Apr if BoA buys out

3 2012 3.50 17.1 5.4 5.4 4.6 3.9 4.8 0.03.5 2012 4.00 23.4 9.9 10.3 9.2 8.0 9.5 0.7

2011 4.00 8.8 9.8 9.8 8.3 7.0 8.6 2.0

2010 4.00 2.5 8.8 9.1 7.8 6.8 8.0 8.64 2012 4.50 2.1 13.2 14.1 13.2 12.3 13.8 2.3

2011 4.50 18.9 12.1 11.9 10.3 8.8 10.7 5.32010 4.50 23.3 11.7 11.3 10.2 9.0 10.6 7.72009 4.50 7.6 12.5 12.7 10.2 9.0 10.6 8.4

Pre-May 09 4.50 2.1 12.9 12.6 9.5 8.1 9.9 8.6Post-May 09 4.50 5.5 12.4 12.7 10.5 9.4 10.9 8.3

4.5 2011 5.00 7.4 14.5 13.8 12.2 10.8 12.8 10.32010 5.00 32.0 14.5 14.5 12.9 11.4 13.3 9.8

2009 5.00 48.2 16.8 16.2 13.9 12.4 14.4 14.2

Pre-May 09 5.00 16.4 19.9 18.9 16.1 14.1 16.6 17.3

Post-May 09 5.00 31.8 15.2 14.8 12.8 11.5 13.3 12.1

5 2011 5.50 0.6 15.6 16.9 13.6 12.3 14.2 3.42010 5.50 8.6 15.9 15.6 13.8 12.7 14.4 12.2

2009 5.50 34.1 19.2 18.6 16.3 14.9 16.9 15.9

Pre-May 09 5.50 11.8 23.1 22.6 20.3 18.5 21.0 17.1

Post-May 09 5.50 22.4 17.0 16.4 14.1 13.0 14.7 15.0

2008 5.50 3.4 26.1 26.6 23.6 21.4 24.3 19.1

2005 5.50 2.1 19.4 18.7 16.7 15.1 17.2 7.8

2004 5.50 1.4 16.4 14.6 12.8 11.2 13.2 3.6

2003 5.50 4.5 15.4 15.1 13.1 11.5 13.5 5.6

5.5 2009 6.00 3.7 22.3 20.9 19.4 18.0 20.1 8.3Pre-May 09 6.00 1.8 27.5 25.0 23.0 21.2 23.8 9.6

Post-May 09 6.00 1.9 16.9 16.9 15.8 14.9 16.5 7.0

2008 6.00 7.8 30.7 28.2 26.5 24.7 27.3 14.7

2007 6.00 1.2 25.1 21.2 21.0 19.6 21.8 16.3

2006 6.00 1.1 24.1 26.2 24.1 22.0 24.6 11.6

2005 6.00 2.3 20.9 19.6 17.9 16.5 18.6 8.3

2004 6.00 2.5 18.2 18.2 16.8 15.3 17.3 5.7

2003 6.00 5.1 18.6 17.7 16.0 14.4 16.4 3.8

2002 6.00 0.9 18.8 17.8 16.4 14.7 16.7 3.4

6.0 2008 6.50 6.4 29.0 27.5 26.8 25.3 27.7 12.32007 6.50 2.2 26.8 23.5 22.8 21.5 23.7 13.4

2006 6.50 2.1 24.0 22.0 21.5 20.1 22.3 11.3

6.5 2008 7.00 1.2 26.9 24.8 25.3 24.2 26.4 12.42007 7.00 0.7 26.4 22.5 23.6 22.5 24.7 7.0

2006 7.00 0.7 24.2 22.3 21.7 20.6 22.7 10.8

4.51 4.39 4.59 4.70 4.6921 21 21 19 21


Actual Projected (report month)


31 January 2014 13

FIGURE 4 GNMAII 30y short-term Barclays forecasts

Note: BoA buyout effect assumes cleanup in one month. As of As of January 30, 2014, no-point mortgage rate at 4.50% (10y at 2.75%). Source Barclays Research

Additional 1M CPR

Coupon Vintage WAC Cbal 3M CPR Jan Feb Mar Apr if BoA buys out

3 2012 3.38 81.7 5.3 5.4 4.7 3.9 4.7 0.03.5 2012 3.81 145.6 8.8 9 7.7 6.3 7.7 0.2

2011 3.89 21.8 9.7 9.9 8.1 6.6 8.1 0.0

2010 4.01 0.9 11.4 11 8.0 6.3 8.1 0.04 2012 4.31 27.3 14.1 13.7 11.9 9.9 11.1 1.5

2011 4.35 43.3 12.9 12.7 10.8 9.1 10.9 1.32010 4.37 28.8 11.7 11.4 9.4 7.9 9.5 1.62009 4.45 1.5 12.9 15.3 11.5 9.4 11.6 3.5

Pre-May 09 4.47 0.6 13.6 15.1 11.2 8.9 11.2 6.2Post-May 09 4.44 0.9 12.5 15.4 11.7 9.7 11.8 2.2

4.5 2011 4.82 43.3 15.5 15 13.7 11.9 13.7 4.42010 4.87 47.1 14.7 14.6 12.9 11.3 13.0 4.8

2009 4.91 23.9 14.7 14.4 12.4 10.8 12.4 8.4

Pre-May 09 4.96 4.4 18.1 18 15.4 13.2 15.5 10.1

Post-May 09 4.90 19.4 13.9 13.5 11.7 10.2 11.7 7.0

5 2011 5.29 5.5 18.3 17.5 15.1 13.1 14.4 3.32010 5.29 29.4 16.6 16.1 14.7 13.0 14.7 14.6

2009 5.36 31.9 17.3 16.5 14.8 13.2 14.8 8.3

Pre-May 09 5.40 6.1 21.0 20.1 18.3 16.3 18.4 3.5

Post-May 09 5.35 25.8 16.4 15.7 13.9 12.4 14.0 8.9

2008 5.51 1.5 26.8 27.1 24.8 22.8 24.9 3.1

2005 5.61 2.2 19.6 19.4 17.0 15.1 17.1 0.6

2004 5.57 1.1 17.4 16.2 14.5 12.8 14.6 0.1

2003 5.56 2.0 16.3 16.0 13.2 11.4 13.2 0.1

5.5 2009 5.86 4.1 19.6 18.4 17.3 15.8 17.4 1.5Pre-May 09 5.97 0.7 25.0 24.6 22.8 20.5 22.8 1.2

Post-May 09 5.84 3.3 18.3 17.0 16.1 14.8 16.2 1.5

2008 5.95 7.1 26.6 24.7 23.9 21.8 24.0 3.6

2007 6.01 2.2 24.9 22.1 21.8 20.0 21.8 4.2

2006 6.03 1.9 28.7 27.5 26.2 24.6 26.3 2.6

2005 5.98 2.8 20.4 19.8 19.4 17.7 19.4 1.9

2004 5.94 3.1 18.0 17.6 16.3 14.7 16.4 0.6

2003 6.01 2.6 18.4 18.5 17.5 15.8 17.6 1.2

2002 6.28 0.5 18.4 18.8 17.7 15.4 16.8 2.8

6.0 2008 6.46 5.9 28.7 27.1 26.9 24.9 26.9 3.72007 6.47 3.9 26.7 24.6 25.2 23.4 25.3 7.0

2006 6.48 2.1 25.7 23.5 23.1 21.3 23.1 2.8

6.5 2008 6.88 2.3 27.7 24.3 24.0 22.4 24.1 2.72007 6.90 1.8 25.6 22.8 21.9 20.4 21.9 5.6

2006 6.89 1.0 25.4 23.7 23.0 21.5 23.0 4.0

4.51 4.39 4.59 4.70 4.6921 21 21 19 21


Actual Projected (report month)


31 January 2014 14

CONVEXITY PORTFOLIO

Portfolio outperforms The convexity portfolio outperformed by 0.35% over the week.

Our short FN 3.5s versus Tsy gained 1.3bp, and our long GN/FN 4 swap gained 4.7bp over the week. The long FN 30y 4.5/3.5 swap gained 5.5bp.

The 2014 year-to-date return is 2.1%, while the one-year return is -9.7%.

Changes to the portfolio We are adding a long position in IOS 4.5 of 2010 with $250mn notional, duration hedged with TBA 3.5 and curve hedged with Treasury.

FIGURE 1 Convexity portfolio trade performance

Portfolio return statistics

Initial Equity

($mn) YTD P/L

($mn) Total P/L

($mn) YTD %

ROE 1 yr % ROE 1-Week P/L

($mn) 1-Week %

ROE

Convexity portfolio 100 5.60 174.9 2.1% -9.7% 0.97 0.35%

Convexity trades Total P/L

(bp) 1-wk

P/L (bp) Equity ($ mn)

Avg. eq ($mn) Leverage

Total P/L ($ 000) % ROE

1 week P/L ($ '000) Start date

Long GN/FN 4 49.2 4.7 25 25 20 2,484 9.9 235 7/26/13

Long 15y 3.5s vs 30y 4s 51.1 1.1 50 50 20 5,148 10.3 108 9/7/13

Short 30y 3.5s vs treasuries -30.3 1.3 25 47 20 -2,827 -6.0 67 9/7/13

Long FN 30y 4.5/3.5 swap 18.6 5.5 50 32 20 1,199 3.7 555 12/13/13

Note: The performance is from Thursday, January 23, 2014, close, to January 30, 2014, close. Past performance is not necessarily indicative of future results. Source: Barclays Research

FIGURE 2 Current convexity portfolio trades

Trade Long in face value terms

Short in face value terms

Hedge details

Equity ($mn) Leverage Notional

Initiation level

Current level

Initiation date

1 Short FN 3.5 vs. Tsy 320 2y, 350 10y 500 FN 3.5 Curve hedge 25 20 500 18.3 bp OAS

27 bp OAS

10/4/13

2 Long GN/FN 4 swap 500 GN 4 500 FN 4 1:1 25 20 500 18 ticks 40 ticks 7/26/13

4 Long 15y 3.5 vs. 30y 4 1000 FN 15y 3.5s, 56 10y

597 FN 4s, 251 2y

Curve hedge 50 25 1000 1-30+ 0-20 9/6/13

5 Long FN 30y 4.5/3.5 swap

500 FN 4.5s 289 FN 3.5s Duration hedge 25 20 500 6-19 5-25 12/13/13

Cash 119

Note: Pricing is as of the close on January 30, 2014. Source: Barclays Research

Leo Wang +1 212 412 7571 [email protected] Lokesh Chandra +1 212 412 2099 [email protected]


31 January 2014 15

FIGURE 3 Retired trades Past 12 months

Retired trades Start date End date P/L (bp)

total

Leveraged portfolio statistics

Equity ($mn)

Avg equity Leverage

P/L ($mn) % ROE

1 Long FN 4 fly 7/12/12 9/6/12 2.1 20 20 40 0.18 0.9

2 Short FN 3.5 fly 7/27/12 9/6/12 -13.9 20 20 40 -1.10 -1.1

3 Long GD/FN 3.5 swap 2/17/12 9/27/12 29.7 20 20 40 -1.10 2.4

4 Long 30y 3.5s vs. Tsy 5/31/12 10/5/12 122.8 25 25 20 6.14 24.6

5 Down-in-coupon FN 30y 4/3 swap 5/31/12 10/5/12 180.2 30 30 20 10.83 42.0

6 Long GN1 4.5s vs. 5y Swaps 9/7/12 10/5/12 -29.3 25 25 20 -1.46 -5.9

7 Long 30y 3s vs. Tsy 7/27/12 10/25/12 234.5 50 40.8 20 19.16 47.0

8 Long 15y 2.5s vs. Tsy 5/31/12 10/25/12 184.0 25 25 20 9.22 36.9

9 Long G1/G2 4.5 swap 10/5/12 12/6/12 78.4 25 25 20 3.93 15.7

10 Down-in-coupon FN 30y 3.5/3 swap 10/5/12 1/18/13 -13.8 30 30 20 -0.80 -2.7

11 Long Gold/FN 3 9/28/12 1/24/13 -33.2 20 20 40 -2.64 -13.2

12 Short GN2/FN 3.5 swap 9/21/12 2/15/2013 76.2 20 20 20 3.06 15.3

13 Short G1/G2 4 swap 1/25/13 5/10/2013 25.0 25 25 20 1.26 5.1

14 Short GN2/FN 3 4/19/2013 5/16/2013 16.0 20 20 15 0.48 2.4

15 Long MLB 3s vs. swaps 2/15/13 5/24/2013 -43.4 25 25 20 -2,154 -8.6

16 Short 15/30 2.5/3 swap 4/12/13 5/24/2013 -12.0 25 25 20 -594 -2.4

17 Long IOS 4 10 vs. IOS 3.5 10 4/26/13 5/24/2013 -87.7 20 20 15 -2,629 -13.1

18 Long 30y 3s vs. Tsy 12/14/12 8/23/2013 -215.5 60 60 20 -25,778 -43.0

19 Long 30y 3.5s vs. Tsy 1/18/13 8/23/2013 -138.2 30 30 20 -8,259 -27.5

20 Long IOS 4 2010 vs. FN 3s 1/18/13 8/23/2013 72.1 36 36 7 1,845 5.2

21 Short FN 5 fly 6/28/13 9/20/2013 -20.5 5 5 15 -254 -5.1

22 Short FN 30y 5/4.5 swap 8/16/13 12/13/2013 -77.2 13 13 20 -1922 -15.4


FIGURE 4 Cumulative ROE over the past year (%)


-20%

-15%

-10%

-5%

0%

5%

Jan-13 Apr-13 Jul-13 Oct-13


31 January 2014 16

RESIDENTIAL CREDIT TRENDS

Non-agencies pare gains Non-agencies pared some gains this week, in line with a global correction in risk assets. The Bank of America $8.5bn settlement was approved except on modification claims. January remittance reports showed severe drops in bond cash flows on many previously BofA serviced deals that were transferred over to Nationstar in the past few months. The Dutch state announced the auction of the remaining $2.1bn UPB of bonds from the ING IABF. Case-Shiller HPI showed a 0.9% m/m increase in November, while home sales indices declined.

Non-agencies pared some gains in tandem with risk assets, which dropped across the board as EM risks flared up. Selling by legacy non-agency holders including the $1.2bn list put out by Freddie Mac added to the downward pressure on prices. Cash bonds corrected pt across sectors except for jumbo SSNRs, which held firm. The ABX 06-2 AAA dropped 2pt over the week. The GSE credit bonds were unchanged. However, this reaction has been more restrained than what has occurred in other risk asset classes, and prices remain higher than a month ago by 1.5-2 points across the legacy non-agency sectors. TRACE data reported average daily trading volumes of about $2bn, and we expect this to stay strong next week as well, given the upcoming auction for the remaining part of the ING IABF portfolio.

FIGURE 1 Non-agency prices

Sector Price 1w 1m 3m

Jumbo Fix SS AAA 97.5 0.0 0.5 0.8

Jumbo Hyb SS AAA 90.5 0.0 1.3 1.5

Alt-A Fix SS AAA 87.5 (0.5) 2.0 2.5

Alt-A Hyb SS AAA 73.5 (0.5) 2.3 3.0

MTA SS AAA 72.5 (0.5) 2.3 2.5

ABX 06-2 PAAA 85 0.0 2.0 3.0

ABX 06-2 AAA 75 (2.1) (0.1) (0.3)

ABX 07-1 PAAA 70 0.0 0.0 5.0

ABX 07-1 AAA 59 0.0 0.0 3.3

PrimeX FRM.2 103 0.0 0.0 0.0

PrimeX ARM.2 103 0.0 0.0 0.0

Re-REMIC SSNR AAA S + 135 0 0 (15)

Re-REMIC SSNR A S + 170 0 0 (5)

Note: Prices as of January 29, 2014, for cash bonds and January 30, 2014, for synthetic indices. Weekly changes are Wednesday-Wednesday for cash bonds and Thursday-Thursday for synthetic indices. Source: Barclays Research

Notwithstanding the ongoing risk flare-up due to EM concerns, we expect the normalization in rates, home prices, and credit performance to continue in 2014. Rates should be biased higher, while home price growth and credit performance improvement will likely slow from 2013 levels. We expect demand-supply dynamics for non-agencies to go from being lopsided in the past few years to being more evenly matched. That said, most of the positive factors from 2013 including higher yields/spreads than comparable assets, continued HPA/credit performance, and an accommodative Fed should persist, which bodes well for non-agencies.

Overall, we remain constructive and recommend alt-A FRM SSNRs in cleaner collateral and option ARM SSNRs/subprime PAAA/LCF AAAs in weaker credit. We also believe that a 30-50bp pickup in new issue AAAs versus agency MBS more than compensates for worse

Sandeep Bordia +1 212 412 2099 [email protected] Jasraj Vaidya +1 212 412 2099 [email protected] Dennis Lee +1 212 412 2099 [email protected] Harkaran Talwar +1 212 412 2099 [email protected] Tejvansh Thakral +1 212 412 2099 [email protected]


31 January 2014 17

liquidity, the lack of a government guarantee, and slightly worse convexity. We are neutral on the GSE credit risk-sharing deal M1/M2 bonds after the rally in Q3/early Q4 13. However, they have lagged the rally in cash bonds in the past few weeks and may start to look attractive in relative terms if the dichotomy continues.

The biggest risk to our broadly optimistic view is a sharp spike in interest rates that would cause an adverse reaction in risk premiums and slow HPA in certain areas. However, on the flipside, rep and warranty scenarios could enhance non-agency returns significantly in an upside scenario. We assign a very low likelihood to other risks, such as eminent domain, but remain on the watch for any developments on that front.

Bank of America $8.5bn settlement approved except on modification claims Justice Barbara Kapnick authorized the $8.5bn rep and warranty settlement between Bank of America and Bank of New York (as trustee) on about 530 Countrywide shelf trusts. However, the judgement excluded releases on certain modification related claims for which the court found that the trustee acted unreasonably or beyond the bounds of reasonable judgement.

BofA/trustee may need to re-approve this Final Order Given that the full releases provided for in the proposed settlement were not fully accepted by the Court, we believe that the parties involved may need to come to a written agreement accepting this order, assuming that the exclusion of the modification claims is considered to be material (see below for the relevant text from the Proposed Settlement Section 2a),

provided that if the Settlement Court enters an order that does not conform in all material respects to the form of order attached as Exhibit B hereto, the Parties may, by the written agreement of all Parties, deem that order to be the Final Order and Judgment

It is possible that BofA will view this as a minor issue and go ahead with the settlement anyway since it provides broad relief from rep and warranty and servicing liabilities. Still, this issue has the prospect of adding another wrinkle in the timing of the next steps and eventually in determining when the cash flows get paid to bond holders.

What are the likely next steps? Apart from the written agreement that may be required, as mentioned above, and the possible pitfalls in obtaining that, there are a couple of things that could potentially delay the payment of cash into deals. The first is if the intervenor-objectors decide to appeal the judgement; the second is that the trustee will need to obtain IRS/state tax approvals to be able to pass the cash flow on through the REMIC structure without any tax implications for the investors. As such, if there are no adverse delays to any of these issues, it is possible that the final approvals may be available by Q2 14. The cash has to be paid out within 90 days of this, so investors could receive the cash sometime in H2 14. However, it is possible that there are some delays in the process, which could push this timing to late 2014-15.

The excluded modification claims could be more valuable on certain deals Some investors, such as Triaxx CDO, have been claiming that many of the PSAs require Countrywide to repurchase loan modifications made in lieu of refinancing and a smaller subset of PSAs also require it to repurchase mods regardless of the reason (refinancing or loss mitigation). The court found that the trustee had not considered these distinctions and had gone ahead and settled on those claims. As a result, the court decided to exclude these releases from the settlement. It is hard to gauge the total magnitude of the potential claims that could arise from this. While Triaxx has claimed in the past that these claims alone could be worth $31bn across the trusts, the economic value of such buybacks is likely to be smaller. However, if BofA were forced to buy back all the modified loans on certain deals and a small part of them on a large fraction of the CWL shelf deals, the effect could still be


31 January 2014 18

significant. It remains to be seen how the trustee and BofA approach this subject. On one extreme, it is possible that BofA will agree to increase the payout on a small fraction of deals that were most affected by this PSA language. In the case at the other extreme, it is also possible that BofA will determine that the best course is to fight on mod claims separately or even try to delay the whole settlement as a bargaining chip to reduce its potential payouts on the mod claims. As such, while we believe that cash flowing to deals in H2 14 remains likely, this exclusion could be another factor that delays the timing of the payouts while possibly adding to the payouts on some of the deals.

Nationstar recoups advances on servicing transfers from BofA Bonds in many previously Bank of America (BofA) serviced deals that were transferred over to Nationstar received no principal payment and little or no interest payment this month (Figure 2). For most deals, this seems to have resulted from Nationstars heavy recoupment of P&I advances made by BofA in the past. These deals were part of the BofA to Nationstar servicing transfer announced last January and seemed to have transferred over in September/October 2013 based on the remittance reports. While typically the acquiring servicers such as Nationstar and Ocwen increase modifications to recoup advances, in this case, advances were recouped on a large number of delinquent loans without any modifications as non-recoverable advances.

FIGURE 2 Select deals with no principal payment in January remit

Deal Collateral Bal ($mn) Last Month Payout ($k) This Month Payout ($k)

Principal Interest Principal Interest

FFMER 2007-H1 290 1,864 383 - 233

BOAA 2007-2 177 1,802 960 - 3

HVMLT 2005-3 289 1,705 648 - 273

HVMLT 2004-11 204 1,685 439 - 0

HVMLT 2005-1 186 1,358 405 - -

BAFC 2007-B 156 1,259 50 - 42

HVMLT 2005-10 466 2,968 1,052 153 -

Source: Bloomberg, Barclays Research

Unusual loan-level reporting The accounting of the advance recoupment on the above deals was somewhat unusual. Normally when a servicer recoups past advances (eg, at loan modification), it usually capitalizes the entire principal and interest that has been advanced. On the deals listed above, Nationstar seems to have capitalized just the advanced principal while not capitalizing the advanced interest amount; hence, the full amount of advances recouped cannot be captured from the loan-level balance capitalization. The recouped interest advances seem to have been directly recovered from the total cash flow collection for the deals. In many cases, these were reported with a negative scheduled interest or non-recoverable advances. In most of the affected deals, the total advanced P&I amount on all delinquent loans is likely to be more than the January trust collection. It is possible that such deals will possibly see the bond payouts close to zero in the next several months as well.

Mortgage insurers make payments on AHM/AHMA and RFC/GMAC shelves As we highlighted in January Remittance Early Look, Part II, January 28, 2014, FGIC wrapped RFC and GMAC bonds received payments this month as subsequent recoveries. These payments were part of the settlement between FGIC and the Rescap estate, wherein FGIC agreed to pay $253.3mn to trusts with FGIC wrapped bonds. All FGIC policies on these bonds are now terminated, and FGIC will not pay any more claims on these bonds. This is


31 January 2014 19

different from FGICs payment plan for other shelves, where it will pay 17% of all accumulated and ongoing claims.

Triad Mortgage Insurance Co. paid out 70-75% of outstanding claims on the AHM/AHMA shelves. Triad had stopped making payments on American Home originated claims in 2009 and had filed a lawsuit to rescind all obligations related to American Home originated loans. However, that lawsuit had been dismissed and a $140mn claim against Triad was admitted by the bankruptcy court. 75% of those claims were paid out this month with the rest recorded as deferred payment obligations due against Triad. So far, we have been able to record about $58mn as payout to AHM and AHMA shelves from loan level data available. It is possible that the rest of the money has gone to American Home originated loans in other shelves or towards portfolio or GSE loans.

Dutch state announces auction for remaining $2.1bn of ING IABF assets The Dutch State Treasury Agency (DTSA) announced the auction for the remaining $2.1bn UPB of bonds. Bids are due Tuesday, February 4, 2014. The DTSA had earlier auctioned off bonds with $5.1bn and $4.3bn UPB in auctions on December 11, 2013 and January 16, 2014, respectively. Both those auctions were well bid and did not depress prices.

SEC to consider revisions to the reporting requirements for ABS The Securities and Exchange Commission announced that it will review the registration and reporting requirements for ABS deals in a meeting on Wednesday, February 5. The SEC has scheduled a vote on Regulation AB II, a revision of current Regulation AB that also applies to non-agency securities. The Commission will consider whether to adopt rules revising the disclosure, reporting, and offering process for asset-backed securities. The revisions would require asset-backed issuers to provide enhanced disclosures, including information for certain asset classes about each asset in the underlying pool in a standardized, tagged format and revise the shelf offering process and eligibility criteria for asset-backed securities.

Case-Shiller HPI gains 0.9% in November, while home sale indices decline The Case-Shiller Home Price Index for the top 20 MSAs reported a 0.9% m/m seasonally adjusted increase. This is in line with the 0.9% increase in the Corelogic Home Price Index released earlier this month. The index is up 13.7% y/y and up 12.7% year-to-November seasonally adjusted. New home sales were down 7% m/m s.a. and pending home sales declined 8.7% m/m sa. The new home sale index has been very volatile this year and we would not read too much into a sales decline in a very cold December. The number of homes sold each month has been on the decline since June 2013 when the Fed first hinted at the taper, but inventories are now at pre-bubble levels. With an improving economy, lean inventory levels, and widening mortgage credit availability, we expect housing demand to remain robust and home prices to appreciate 7% in 2014.


31 January 2014 20

CMBS TRENDS

Volatility may present buying opportunity The volatility in emerging markets and equities spilled into CMBS this week. We believe the steady pace of improvement in the domestic economy provides a strong backdrop for credit-sensitive bonds to outperform; we expect only a limited adverse effect on the growth story from an emerging market slowdown. We revisit our low-quality 07 AM recommendation from November 2013. Much of the alpha in this trade appears to have been squeezed out, but the bonds remain attractive short duration tranches, paying above-average yields compared with alternatives.

The volatility in emerging markets and equities spilled into CMBS this week. Despite a sharp relief rally on Thursday, legacy bonds ended the week somewhat wider. Generic 07 dupers gave up about 2bp, while AMs and AJs were wider by 5-10bp. Spreads in the 3.0 space were relatively more stable: the new issue MSBAM conduit duper priced at S+89bp roughly unchanged from earlier this month and down the capital stack, levels on the BBB were stable at S+365. That said, guidance on the new WFRBS deal in the market indicated that spreads were likely to move wider on Friday.

The agency CMBS market remained largely untouched by the general market weakness. Impressively, Freddie-K unguaranteed mezzanine B and C tranches tightened this week by 10-20bp, diverging from similar non-agency CMBS A and BBB- rated tranches.

A buying opportunity Last week, we reiterated our stance of staying long 2013 BBBs, with the view that the FOMC would upgrade its assessment of the domestic economy at its January meeting while continuing to taper its asset purchase program. The statement was broadly in line with our expectations. As our economists pointed out in January FOMC: Embracing a stronger growth environment (January 29, 2014), the Federal Reserve recognized that the economy had picked up in recent quarters and with appropriate policy accommodation, economic activity will expand at a moderate pace in the coming months.

While the ongoing jitters in emerging markets have the potential to cause short-term volatility, we believe the steady pace of improvement in the domestic economy provides a strong backdrop for credit-sensitive bonds to outperform. This weeks GDP release shows that the US grew at 3.7% in H2 13, compared with 1.8% in H1 13 and 2.7% in H2 12. This is the strongest half-year in a decade, although we do expect growth to moderate to 2.5% in 2014. A broad swath of other economic indicators has also shown improvement; most recently, the U.Mich index of consumer confidence released Friday surprised to the upside. Besides, as our rates strategists point out this week, a slowdown in EM will likely have only a limited effect on the US economy and could, in fact, be compensated for by a decline in commodity prices. Given this, we feel that any widening in CMBS spreads as a result of EM fears, especially lower down the capital structure, would be a buying opportunity.

Clearly, there is some danger of getting into the trade too early; some accounts may elect to wait for some stability in the broader markets before going long, and it is always hard to time investor sentiment. On our side, we recommend taking advantage of any sharp move wider; for instance, we continue to recommend expressing long views in CMBS credit through 2013 vintage BBB-s and credit curve flatteners in CMBX. On the other hand, the scope for credit spread tightening is more limited at the duper end of the capital structure; especially in an environment where we expect rates broadly to head higher.

Keerthi Raghavan +1 212 412 7947 [email protected] Aaron Haan +1 212 412 2099 [email protected]


31 January 2014 21

CMBX.7 launches; BBBs pricing 10bp wide of cash The latest series of the CMBX index began trading this week, backed by deals from H2 13. In our weekly from January 17, 2014 (CMBX.7: First Impressions), we recommended going long the BBB.7 if it opened significantly wider than the BBB.6. The synthetic index did, in fact, open relatively wide due to the natural short interest from market participants, but spreads quickly came in after trading began. As of Thursday, the BBB.7 was trading roughly 10bp wider off cash bonds at about S+380bp. As we have discussed previously, we believe the 2013 conduit quality is roughly in line with 2005 vintage, which should keep the 7% enhanced BBBs safe from losses even in a very stressful scenario.

Revisiting our lower-quality 07 AM recommendation In our 2014 outlook published in November last year, we recommended going long lower-quality 2007 AMs, which we felt were trading well wide of similar 2005 AJ tranches, which had experienced significant spread compression in 2013. In Figure 1, we revisit this analysis; once again, we plot traded spreads on the y-axis versus C/E minus estimated case deal loss on the x-axis for the universe of 07 AMs. Higher quality bonds with plenty of credit support cushion to loss estimates are placed to the right of the x-axis; they have not really had any spread tightening since November. On the other hand, lower quality bonds with lesser credit support (and placed on the left of the x-axis) have come in roughly 150bp since November. At this point, there is still some space for these bonds to tighten, but we expect much of the alpha from the trade to have already been extracted. We do, however, still like the 07 AM trade as a safe, short duration asset paying substantially higher spreads than comparable alternatives.

FIGURE 1 Lower quality AMs have come in substantially over the past two months


Starwood announces purchases from CWCapital REO sale In a press release Wednesday, Starwood Capital announced it had purchased 11 assets from the CWCapital REO sale for $191mn. The CWCapital sale, first reported in October, included $2.7bn of assets to be sold via CBRE and $0.7bn of assets to be sold through auction.com (see our notes from October 15 and November 1 for a complete list of assets up for sale). The Starwood purchase appears to have come entirely from the CBRE auction, the first reported sales from this group of assets.

Starwoods purchase included seven office properties and four retail properties. The assets backed $318mn of loans spread across GSMS 2007-GG10 ($185mn), MLCFC 2007-5 ($106mn), WBCMT 2006-C28 ($22mn), and BACM 2007-1 ($5.5mn). The properties sold at $191mn, about 23% higher than the most recent combined appraisal of $155mn, which could indicate that valuations for other auctioned assets may also surprise to the upside. The

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31 January 2014 22

sale price equates to about 55% combined severity on the underlying 11 loans, after taking into account assumed liquidation costs, ASERs, and advances. The exact price paid for each individual property, which will ultimately determine deal level cash flows, is not yet known.

We expect most other properties from the CWCapital sale to also close in time for the February remittance. The largest property in the auction, $468mn Two California Plaza in GSMS 2007-GG10, may also close this month and, according to CRE News, may have been sold to CIM. As we noted previously (CWCap to sell $2.6bn of distressed assets, October 11, 2013), special servicers have some incentive to push through large volumes of liquidations on a particular deal within a fairly narrow time frame.

FIGURE 2 Properties sold from the CWCapital REO sale to Starwood Capital

Deal Loan Orig Bal Current Bal ASER Advances Appraisal Appraisal date

BACM 2007-1 Lincoln Ridge Retail 6,200,000 5,584,247 483,338 815,414 2,600,000 7/27/2013

GSMS 2007-GG10 Maguire Anaheim

Portfolio 103,500,000 103,500,000 8,138,458 6,123,328 48,700,000 4/17/2013

GSMS 2007-GG10 3800 Chapman 44,370,000 44,370,000 133,162 880,082 21,600,000 10/16/2013

GSMS 2007-GG10 Avion Lakeside 22,300,000 22,300,000 1,799,379 1,970,416 17,200,000 9/9/2013

GSMS 2007-GG10 Arrowhead Creekside 14,500,000 14,500,000 1,189,483 765,621 5,100,000 1/17/2013

MLCFC 2007-5 Plaza Squaw Peak 50,000,000 50,000,000 1,059,241 955,859 20,700,000 1/9/2013

MLCFC 2007-5 East Thunderbird

Square North 50,000,000 43,078,768 3,926,178 5,446,910 23,000,000 4/29/2013

MLCFC 2007-5 Greenfield Gateway 15,600,000 12,864,333 1,166,592 1,261,636 5,100,000 9/13/2013

WBCMT 2006-C28 Howe Corporate

Center 12,750,000 12,750,000 581,843 783,510 6,400,000 5/14/2013

WBCMT 2006-C28 Southcreek Corporate

Center II 6,000,000 5,837,138 180,731 422,126 3,000,000 9/18/2012

WBCMT 2006-C28 Shoppes at Home

Depot 3,500,000 3,268,637 223,196 374,999 1,500,000 8/1/2013

Total

328,720,000 318,053,122 18,881,600 19,799,900 154,900,000

Source: Starwood, Trepp, Barclays Research


31 January 2014 23

CMBS FOCUS

Estimating lease renewal probability in CMBS Upcoming lease expirations can provide a downside shock to loan financials,

especially if tenants decide to vacate or reduce the leased areas.

We propose a method to predict renewal likelihoods from CMBS remittance data and identify certain property and tenant types that are more at risk.

We estimate that in about 30% of leases expiring in 2012-13, the tenant did not renew the lease in entirety. This is still substantially better than in 2009, when nearly 50% of leases were not renewed.

Office properties showed higher non-renewal rates of about 40%. Office occupancy has not kept pace with increases in employment over the past few years, due partly to the post-crisis focus on better space utilization and real estate efficiency.

Tenants associated with the finance industry are most at risk; we estimate nearly 50% of finance tenants vacated or downsized upon lease expiration in 2012-13.

Government tenants have been surprisingly stable in the aggregate; only 20% of these leases were not renewed at expiration, notwithstanding high-profile vacancies of GSA tenants, as in the case of the Skyline Portfolio.

Tenants in anchored retail malls are more likely to renew than their counterparts in unanchored shopping centres. Under-pressure retailers such as JCPenney/Sears/Best Buy do not show materially higher risk of non-renewals as yet, but this could change, given the elevated credit risk for some of these names.

Areas that show negative net absorption (more supply, less demand) of real estate space tend to have higher non-renewal rates, as tenants in these geographies have alternate options to move out of existing leases. These include some areas with a high concentration of finance tenants such as Chicago and Stamford/Hartford.

In contrast, properties in the Bay Area and Texas show strong net absorption, given the strength of the tech and oil and gas sectors. Here, non-renewal rates are as low as 20%.

The potential loss of a large tenant is unlikely to push large volumes of loans into term default; we find that most loans still report ~1.2x DSCR (down from ~1.5x), even after the dip in occupancy.

The reduced NOI will likely be a bigger factor when it comes to finding a refinance outlet at the maturity date; a 1.2x DSCR loan may be below the threshold required for a successful refinancing.

Why worry about lease renewals? CMBS credit has shown a substantial improvement over the past year, driven, in part, by higher CRE valuations and the strong re-emergence of private label securitizations. In the vintage CMBS space, for example, the monthly volume of new transfers to special servicing (a commonly used marker for credit conditions) has dropped from roughly $3bn in 2012 to about $1bn currently (Figure 1). Most market participants continue to expect a gradual recovery in economic conditions over the coming years under these circumstances, it is somewhat natural to underestimate the credit risks that are still present, albeit in a more subdued form.

Keerthi Raghavan +1 212 412 7947 [email protected] Aaron Haan +1 212 412 2099

[email protected]


31 January 2014 24

Primary among these risks is the potential for upcoming lease expirations to provide a downside shock to financials. We can get some indication of this by parsing through watchlist data reported by servicers on currently performing loans, as an early indicator of upcoming credit issues. The share of office loans in watchlist, for instance, has increased significantly over the past few years in relation to other property types. This is largely due to the effect of upcoming lease rollovers on large tenants, which has a disproportionate impact on office properties (please see Watchlist: An early indicator of default?, March 1, 2013, for a complete discussion).

NOI trends still face some deflationary pressures Is there any particular reason for investors to worry about lease renewals, especially in a scenario where the economy continues to recover? We believe there is. First, several office and retail leases were signed five to seven years ago and are still reflective of rents prevalent in the pre-crisis period. In many geographies, rents may be substantially lower now, leading to a step-down in cash flows when the lease renews.

Second, even with improving employment numbers, the amount of office space leased per employee has been steadily declining for several years, as the drive toward real-estate efficiency gains steam (Figure 3). As a result, office occupancy has not kept track with employment gains; despite the fact that there is next to no new supply coming on to the market (Figure 4). As such, even after accounting for fairly strong employment growth, there are some deflationary pressures on office NOI growth.

Finally, the underperformance of several large retailers poses fresh questions as to whether these stores will renew their leases when they come up to their expiry date. From the firms point of view, closing stores at their lease expirations is a relatively easy way to cut costs; otherwise it would require a bankruptcy filing to reject leases that are still several years away from expiration. A case in point was the recent announcement by JCPenney; most of the 33 stores slated to close in 2014 had leases coming up for renewal over the coming year (see JCPenney to close 33 stores in 2014, January 15, 2014).

FIGURE 1 New transfers to special have been trending lower

FIGURE 2 But the share of loans on watchlist has been increasing, especially in the office sector

Source: Trepp, Barclays Research Source: Trepp, Barclays Research

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31 January 2014 25

Modeling near-term lease-expirations Given these still-present risks, a CMBS investor looking to model the performance of a particular loan must, therefore, have some view on the underlying leases. More specifically, it is important to get some sense of whether a tenant is likely to renew the lease on expiration or whether there is some chance of a downsizing or even a vacancy,

The probability of lease renewal depends on two factors the asset itself and the tenant in question. Some property types and certain geographies may fare better in terms of renewal rates; on the other side particular types of tenants may be more likely to move out when their lease expires. So far, reliable data on these questions have been hard to come by. We propose a methodology to predict lease renewal rates from CMBS remittance data. We then point out some trends in renewals which can better inform how investors approach the tricky task of assigning default likelihoods and losses to the underlying loans in CMBS deals.

How we estimate lease renewal rates We first isolate all loans where the lease on one of the top three tenants was scheduled to expire in a given year. Of these, we select those loans where we have updated data on financials as of the first reporting date after the original lease expiration has passed. We then compare the reported occupancy and DSCR levels, before and after the lease expiration with some margin for small changes in the financial metrics which may be unrelated to the lease in question. If occupancy has fallen by a significant amount on a loan - in the same period when an underlying lease was coming due we assume that the tenant either vacated the property or reduced his leased area. We also compare how the NOI/DSCR changed as a result of the lease expiration.

FIGURE 3 Office tenants are leasing lesser space per employee; this trend has accelerated since the crisis

FIGURE 4 As a result, office occupancy has not kept pace with the gains in employment despite non-existent new supply

Source: Bloomberg, Barclays Research Source: Bloomberg, Census Bureau, Barclays Research

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31 January 2014 26

30% of 2012-13 lease expirations were not renewed We examine some broad results in Figure 5, where we compare lease renewal rates in 2009 with 2012-13. Clearly, there has been a considerable improvement over the past four years; we estimate that, on average, nearly 50% of leases which expired in 2009 saw the tenant either vacating or reducing the leased space. This proportion has fallen to 30% now put another way, 70% of tenants whose leases came due in 2013-14 renewed with no dip in occupancy.

That said, there is substantial variation by property type. Office properties have underperformed as we expected; we estimate about 40% of 2012-13 office lease expirations were not renewed in their entirety. These numbers are significantly lower for retail and industrial assets, where non-renewal rates are 20-30%.

Tenants could choose to vacate entirely or downsize their lease Non-renewals could be of two types either the tenant vacates entirely or downsizes his leased area. We break these out in Figure 6 if the fall in occupancy after lease expiration is approximately equal to the GLA occupied by the particular tenant, we assume that the leased area was fully vacated. If the occupancy decline is lower, we assume a partial renewal of only a portion of the originally leased space.

In the retail sector, partial and full vacancies were roughly level in 2012-13, each accounting for about 10% of all lease expirations across property types. Office tenants were more likely to vacate in full about 23% of all lease expirations, compared with ~15% of tenants who decided to downsize.

Clearly, these will have very different effects on property cash flows; Figure 7 highlights how the asset DSCR and occupancy changed depending on whether the tenant coming up to expiry in 2012-13 elected to vacate or reduce the leased space. For offices, DSCR fell to about 1.2 for full-vacancies, with an average 21% drop in occupancy; for partial renewals, the fall in DSCR was more subdued, to about 1.4, and occupancy was lower by about 8%.

FIGURE 5 About 30% of 2012-13 lease expirations were not renewed, down from 50% in 2009

FIGURE 6 23% of office tenants vacated in full; another 15% downsized their leased area


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31 January 2014 27

Average DSCR drops to 1.2x, could increase risk of maturity default In the average case, at least, the loss of a tenant at lease expiration does not push the loan below 1.0x DSCR. As such, we do not expect these loans to default immediately, as long as they are still covering debt service even at these somewhat reduced NOI levels. The key risk from lease rollover, therefore, is not so much a spike in term defaults, but the prospect of higher balloon defaults at the maturity date. Given current underwriting criteria, a 1.5-1.6x DSCR loan may be reasonably expected to get a refinancing through the conduit channel. However, a 1.2-1.3x DSCR asset (after a tenant has vacated or downsized) will likely fall below the threshold required for a successful refi.

Finance tenants show higher non-renewal rates Can we identify some tenants which are more at risk of not renewing? In the office space, much of the focus has been on leases associated with finance firms and local/federal government; both of which have seen a steep fall in payrolls since the downturn (Figure 8). We matched tenant names to the Finance or Government industry by employing some simple heuristics as a first pass, and then checking by hand. Figure 9 shows our estimated non-renewal rates for these tenant types. Finance firms (including insurers/banks/ mortgage finance companies) have shown materially worse renewal rates over the past of couple years, more than half of them have either vacated or downsized at their lease expiration date, compared with the average of about 40% for office properties. On the other hand, government tenants have been surprisingly stable in the aggregate; only 21% of these leases were not renewed at their expiration notwithstanding high-profile vacancies of GSA tenants such as in the case of the Skyline Portfolio.

For retail properties, under-pressure tenants such as JCP/Sears/Best Buy should clearly be at most risk of vacating at their lease expiration date over the coming years. So far, however, their lease renewal rates have been roughly similar to the broader retail sector and have not shown any meaningful weakness. That said, unlike office properties, which generally have a more diverse set of tenants, retail leases tend to be concentrated in a few names, and, therefore, are prone to single-name credit risk. And given that the CDS for some of these names is trading at very elevated risk of default, we continue to see a relatively high likelihood of non-renewal for these tenants over the coming years.

FIGURE 7 The effect of lease expirations on property financials

FIGURE 8 Job growth in the finance and government sector has lagged

DSCR Occupancy (%)

Old New Chg Old New Chg

Tenant Vacates in

Full

OFF 1.5 1.2 -22% 88 67 21

RET 1.4 1.3 -12% 92 73 19

IND 1.6 1.2 -24% 92 69 22

Tenant Downsizes

OFF 1.6 1.4 -13% 88 79 9

RET 1.4 1.4 -5% 91 83 8

IND 1.4 1.3 -11% 92 79 13

Source: Trepp, Barclays Research Source:: US Census Bureau, Barclays Research

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31 January 2014 28

Over the past two years, though, smaller tenants in unanchored retail properties appear to have underperformed their counterparts in anchored malls. We estimate about 30% of unanchored retail tenants either vacated or downsized their leases upon expiration in 2012-13, compared with 20% for anchored properties (Figure 10).

Negative net absorption areas face a higher risk In an area where vacancy rates are high and demand is low, tenants with expiring leases will typically have several alternate options to move out. In Figure 11, we look at some sample metro areas, and plot the estimated non-renewal rates for office properties in 2012-13. These appear to have a very strong inverse correlation to the net absorption reported for the particular geography (essentially the net of the demand and supply). Geographies that show negative absorption (more supply, less demand) typically tend to have higher non-renewal rates (Chicago and Hartford that show 60-70% non-renewal rates typically have a higher share of finance tenants). On the other hand, the Bay Area and Texas, boosted by the outperformance of the tech/oil and gas sector, have shown positive absorption rates accompanied by strong renewal statistics for existing tenants only 20-30% of properties with lease expirations in these geographies experienced a decline in occupancy.

FIGURE 9 Finance tenants are more at risk of not renewing their leases; GSA tenants are surprisingly resilient

FIGURE 10 Tenants in anchored malls show lower non-renewal rates than their counterparts in unanchored shopping centers


FIGURE 11 Geographies with negative net absorption show higher non-renewal rates

Source: Bloomberg, Trepp, Barclays Research

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31 January 2014 29

Some key takeaways Many CMBS investors are beginning to look at lease expirations as a potential credit risk to the loan, which could provide a downward shock to financials. As we demonstrated above, there are clear trends in renewal rates depending on property types, tenant industry, and geography which can be incorporated into a model or analysis of CMBS loans. The potential loss of a tenant is unlikely to push large volumes of loans into term default; in most cases, we find that the loans still report 1.2-1.3x DSCR, even after a dip in occupancy. However, the reduced NOI is likely to be a bigger factor when it comes to finding a refinance outlet at the maturity date for instance, current underwriting standards for conduit deals would typically not allow for a loan reporting DSCR in the 1.2x range.


31 January 2014 30

NON-MORTGAGE ABS TRENDS

A good start to the year for ABS ABS issuance was healthy in January, while credit performance across ABS sectors was mostly stable. ABS spreads tightened modestly during the month, giving the ABS component of the Barclays Agg index a year-to-date return of +37bp. We also discuss several developments in the ABS market during the month.

An overview of January ABS performance January was fairly active for ABS issuance, despite the interruption from the SFIG conference. We estimate that total ABS issuance climbed to around $14bn, from less than $7bn in December 2013 (Figure 1). Auto ABS represented by far the largest portion, driven by auto loan deals from Santander, Ford, Hyundai, Ally, and a handful of others (Figure 2). Credit card ABS issuance was also strong, totalling $3.4bn during the month, with Chase, Discover, and Citigroup each pricing a deal with at least $800mn in note balances. As an indication of the demand for ABS paper recently, JPMs CHAIT 2014-1 deal was upsized to twice its initial level, eventually increasing to $1.5bn from the $750mn that was initially planned. Citigroup also disclosed that it added another $8.8bn of card receivables to its master trust in late January, suggesting that the bank intends to issue additional ABS card deals this year. On the esoteric ABS front, there were two series of servicer advance deals issued by HLSS in mid-January, totalling $800mn, as well as a few SBAP deals.

Credit performance across the traditional ABS sectors was stable to modestly weaker in January remittances. Prime and subprime auto loans experienced a slight deterioration in 60+ delinquencies and annualized net losses, though both metrics are still comparatively low on a historical basis (Figure 3). We believe that some of the credit weakness is related to seasonality factors, as some consumers may have been short on cash after Christmas holiday spending. Additionally, as we have noted in the past, underwriting standards have also been gradually loosened on some auto loans over the past few years, with average original maturity terms on several shelves extending by a few months since 2007, especially on subprime auto loans (Figure 4). For now, we will continue to monitor developments on this front to see whether the credit deterioration represents a sustained trend or is simply a temporary uptick in credit weakness.

Dennis Lee +1 212 412 2099 [email protected]

FIGURE 1 Monthly ABS issuance over past 12 months

FIGURE 2 Composition of January ABS issuance

Source: Bloomberg, Barclays Research Source: Bloomberg, Barclays Research

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31 January 2014 31

In credit card ABS, charge-offs increased modestly, while 30+ delinquencies mostly declined. On a positive note, the GEMNT and WFNMT shelves saw 30+ delinquencies and charge-offs drop m/m, though Citigroup and Cabelas did see a fairly large increase in charge-offs during the month. The CCCIT shelf experienced a jump in charge-offs from 2.31% to 2.86%, while Cabelas shelf had an increase in charge-offs to 2.12% from 1.95%. Despite this increase, we believe charge-offs will ease in the next few months for these issuers, since 30+ delinquencies for both shelves have been on a stable to declining trend over the past year.

In student loan ABS, among trusts that have already reported January remittances, credit performance was relatively stable for both FFELP and private student loans (Figures 5 and 6). In FFELP ABS, SLMA and Nelnet deals experienced a drop in 30+ delinquencies in January remits, while ACCSS deals had a small increase. Meanwhile, in private student loans, ACCSS and SLMA deals experienced a modest drop in delinquencies, while SLCLT saw delinquencies climb modestly. Tiering among issuers remains relatively stable as well, with

FIGURE 3 January remittance auto ABS performance

FIGURE 4 Average maturity terms on new-issue deals each year

Source: Bloomberg, Deal remittance reports, Barclays Research Note: There were no SDART deals issued in 2008 and 2009; thus, we extrapolate

the average maturity terms between 2007 and 2010 for this shelf. Source: Bloomberg, prospectuses, Barclays Research

FIGURE 5 30+ DQ by shelf and factor date (FFELP Stafford, PLUS)

FIGURE 6 30+ DQ by shelf and factor date (private)

Note: Only deals

Documents

Barclays Securitized Products Weekly Looking Past the EM Contagion