MBS - Lehman - Specified Pool Handbook

8/6/2019 MBS - Lehman - Specified Pool Handbook

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Fixed Income Research

PLEASE SEE IMPORTANT ANALYST CERTIFICATION AT THE END OF THIS REPORT.

The Specified Pool HandbookINTRODUCTION

Specified collateral provided significant call protection during the 2003 refinance wave, and

these stories are well documented. Specified collateral stories for extension protection, however,

are relatively less understood. In this article, we take a closer look at discount prepayments for

different collateral types. We draw our results primarily from agency discount prepayment data

for 2003-2004 and non-agency loan level data for 1999-2000. The non-agency data was

particularly useful in corroborating our analysis as agency discount prepayment data with

expanded disclosures is relatively limited.

We also review different collateral stories that provide call protection. Most of the results wepresent on the call side are based on agency data. It suffices to say that the results are very

similar to what we find in non-agency loan level data.

PRIMARY CONCLUSIONS

There is significant variation in prepayments across collateral types for both discounts and

premiums. Prepayment differentials are mainly due to differences in credit, demographics, loan

size and economic incentive to trade up or cashout. Our primary conclusions are as follows:

Low FICO, high LTV and non-owner-occupied pools provide significant call and

extension protection. Low FICO pools in particular have always prepaid faster in a

discount environment and slower during refinance waves.

Prepayments on new high LTV pools are dependent on the strength of the housing market.

However, high LTV conventional pools prepay very similarly to GNMA. The housing

market notwithstanding, high LTV pools are a cheap substitute for GNMA-discount pools.

Low loan balance refinancings are significantly slower than typical collateral. However, we

do not have conclusive data on their behavior in a backup. At the margin, we believe that

low-loan-balance collateral is likely to prepay faster in a serious backup.

Pools with a higher share of refinancers season faster but to a similar turnover rate as purchase

borrowers. Moreover, refinance borrowers are more callable than purchase borrowers.

States with higher transaction costs have consistently prepaid slower in a refinance

environment. Discount prepayments by geography, however, seem to be driven largely by

the economy and home price appreciation.

March 17, 2005

Sandeep Bordia

212-526-9325

[email protected]

Prasanth Subramanian

212-526-8311

[email protected]


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Lehman Brothers | MBS Research The Specified Pool Handbook

March 17, 2005 2

SUMMARY OF SPECIFIED POOL STORIES

Low FICO Refinance Behavior: Low FICO borrowers have lower opportunities to refinance. 0-12 month 700 FICO

pools prepaid 12% CPR slower than a 750 FICO pool for a 100bp rate incentive. The differences decrease

with age, 12-24 month pools prepaid only 6% CPR slower. 650 FICO pools prepaid 14% CPR and 4% CPR

slower than 700 FICO pools within the 0-12 WALA category and 12-24 WALA categories respectively.

Turnover Behavior: Due to defaults and credit curing, turnover on low FICO pools is higher. A typical 12-

18 months seasoned, 700 FICO agency pool prepaid about 1.5-2% CPR faster than a 750 FICO pool when

50bp out of the money. 650 FICO pools prepaid almost 5% CPR faster than an average 750 pool.

Amount Outstanding in the Category: Almost 50% of the total outstanding conventional 4.5s, 5s and 5.5s

of the 2003 and 2004 vintage have an average FICO of 725 or below.

Valuation and Relative Value: Current coupon medium FICO pools (average FICO 700) should trade at a

payup of 15/32nds over TBAs. Currently there is no payup for this collateral.

High LTV Refinance Behavior: Similar to weaker credit borrowers, high LTV borrowers have fewer refinancing

opportunities. Newly issued high LTV pools prepaid almost 15%CPR slower than high LTV pools in the

2003-04 refinance episode. The differences decreased with seasoning as the high LTV loans accumulated

equity and could qualify for lower rate loans.

Turnover Behavior: The incentive to get rid of the mortgage insurance payment causes high LTV discounts

to prepay faster. However, this is contingent on a strong housing market.


of the 2003 and 2004 vintage have an original LTV > 75.

Valuation and Relative Value: High LTV conventional discounts are an ideal substitute for GNMAs.

Prepayments on these two collateral types have been on top of each other. The GNMA universe is primarily

comprised of high LTV borrowers.

Non-OwnerProperties

Refinance Behavior: Non-owners pay higher rates than owners and have fewer opportunities to refinance. A

typical 12-24 WALA non-owner pool prepaid about 20% CPR slower than an owner pool for a 100bp rate

incentive in 03-04.

Turnover Behavior: Moving costs for non-owners are lower as they do not live in the house. Within non-

agencies, discount investor properties have prepaid almost 2% CPR faster than owner properties.

Amount Outstanding in the Category: Almost 7% of the total outstanding conventional 4.5s,5s and 5.5s of

the 2003 and 2004 vintage have less than 75% owner occupied properties.

Valuation and Relative Value: Current coupon 100% investor properties are trading at a 4+/32nd payup

currently. Their fair value is close to 20/32nds. The value of these pools up 50 bp in rates is close to 28/32nds.


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March 17, 2005 3

SUMMARY OF SPECIFIED POOL STORIES

Purchase Borrowers Refinance Behavior: Refinance borrowers have demonstrated their efficiency in refinancings and are more

callable than pools backed by purchase borrowers. Prepayment differences converge over time. Prepayment

differences on pools with 25% and 75% share of refinancers (both 100 in-the-money) go from 22% CPR in

the first 12 months to 7% CPR in the next 12 months.

Turnover Behavior: Refinance borrowers benefit from a modest amount of pre-seasoning as they have been

in the house longer. The extension properties are therefore worth as much as a moderately seasoned bond.

Amount Outstanding in the Category: Purchase borrower, pools where % purchase is >50% comprise

almost 30% of the 2003-04 vintage discounts.

Valuation and Relative Value: Because of their worse callability refinance pools are worth less than purchase

pools across coupons and even when the pool is almost 100bp in the money. We think the fair value of 50%

purchase pools on current coupons is 6+/32nds over TBAs. This is a sector to pick up some cheap call

protection.

Low loan Balance Refinance Behavior: Because of the fixed costs of refinancings, low loan balance borrowers have less of a

monetary incentive to refinance for the same rate incentive.

Turnover Behavior: Primarily from empirical findings, 50 bp discount LLB collateral prepaid about 1.5%-

2% CPR faster than the average in both 1999-2000 and 1994-1995. There can be a case made for LLB

borrowers to turnover faster primarily from the argument of a greater motivation to trade up. We believe

LLB collateral discounts will prepay faster in a serious backup.


of the 2003 and 2004 vintage have a loan size less than $100K.

Valuation and Relative Value: Prepayments on the 2003 vintage 4.5s have shown a clear dependence on

loan balance. Currently the market does not charge a premium for LLB 4.5s; we believe the fair value on

these pools is around 20/32nds.

Geographies Refinance Behavior: Transaction costs are very different across geographies and are a big determinant of a

borrowers callability.

Turnover Behavior: On the turnover front, differences across geographies are driven primarily by the

strength of the local economy and local home price appreciation.

Valuation and Relative Value: It is very hard to take a view on regional differences in home price

appreciation.


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March 17, 2005 4

LOWER FICO - SLOWER REFINANCING, FASTER TURNOVER

Low FICO pools have always prepaid faster in a discount environment and slower during a

refinance wave.

A typical 700 FICO pool should command a 15/32nds pay-up over TBA 5.5s; these pools are

currently trading flat to TBAs. There is therefore substantial repricing potential in this

sector.

Weaker Credit Borrowers - Better Convexity

FICO is the most direct measure of credit available for agency pools. Like other credit impaired

borrowers, opportunities available for a low FICO borrower to refinance are relatively limited.

As a result, refinancings on low FICO pools are likely to be substantially lower than regular

pools. Moreover, as weaker credit pools season, there is a greater likelihood of both credit

curing and default. As such, discount prepayments for low FICO pools are likely to be faster

than high FICO pools. Weaker credit pools in the agency market have been valued for their

better call protection so far. However, the better extension properties of this collateral have

been more or less ignored and this is an area of potential significant repricing in the market.

The Outstanding Balance in Low FICO Pools

Typical agency fixed-rate pools have FICO scores highly skewed to the high end of the range.

For instance, taking the example of the 2003 vintage 30-year conventional 5s (Figure 1 &

Appendix A):

Almost 70% of the vintage has a FICO score of 725-775 (Figure 1).

The next rung is medium FICO pools, which have FICO scores of 675-725 and

represent almost 25% of the outstanding balance in this cohort.

The last rung of low FICO pools is, as would be expected, a small proportion of the

agency universe. For instance, among conventional 5s, this category accounts for only

1.5% of the outstanding.

On average, most other pool level characteristics are fairly uniform across FICO gradations.

The only characteristic that stands out is the original loan to value (LTV). Average LTV

increases by 5% on moving from 750 FICO pools to 650 FICO pools (Figure 1). Since other

characteristics are fairly uniform on aggregate, it is possible to assign a value for lower FICO

pools that is independent of other pool characteristics.

Figure 1. Other Characteristics Are Uniform across FICO Buckets

Avg LTV Avg FICO % Refi % OwnerLoan Size

($K)% Bal

All 70 728 76% 95% 168 100.0%Low FICO (625-675) 74 652 77% 98% 180 1.5%

Medium (675-725) 72 717 75% 95% 169 28%

High (725-775) 69 733 76% 96% 167 70.5%

Low FICO borrowers shouldhave better convexity

characteristics.

On average, most poolcharacteristics are fairly

uniform across FICOgradations.


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March 17, 2005 5

Low FICO Pools Refinance Slower

In Figure 2, we show the refinance curves of agency pools in the 2003-2004 refinance episode.

The curves suggest that a borrowers responsiveness to refinancing opportunities is highly

correlated with his FICO score. Moreover, the effect of FICO on prepayments is visible for a

wide range of credit scores, tapering off only for borrowers with FICOs north of 750. For

example, a typical 0-12 month seasoned 700 FICO pool prepaid about 12% CPR slower than a

750 FICO pool for about 100bp rate incentive. 650 FICO pools prepaid another 14% CPRslower. While the differences in prepayments for FICO buckets reduce with seasoning (and

burnout), the effect is fairly persistent. A 12-24 month seasoned 650 FICO pool in 2003-2004

prepaid 4% slower than a 700 FICO pool, which, in turn, prepaid another 6% CPR slower than

a 750 FICO pool. These differences were higher for greater rate incentive buckets. In fact, given

these differences in callability, the call protection on low FICO pools appears to be similar to

low loan balance collateral.

Figure 2. Agency Refinance Curves 2003-2004, 0-12 WALA

Low FICO Pools Turn Over Faster

As we noted earlier, there is greater likelihood of both credit curing and default in a low FICO

pool. Discount prepayment data confirms this reasoning (Figure 3). A typical 12-18 months

seasoned 700 FICO agency pool prepaid about 1.5%-2.0% CPR faster than a 750 FICO pool for

-50bp rate incentive over the last two years. Moreover, the incremental prepayment effect of

every 50 point move in FICO is even bigger as we moved down in FICO scores. 12 WALA 650

FICO pools prepaid almost 5% CPR faster than 750 FICO pools.

01530456075

0 50 100 150 200

FICO=650

FICO=700

FICO=750

% CPR

Rate Incentive (bp)

Lower FICO pools refinanceslower.

Low FICO agency discountsprepaid faster in 03-04.


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March 17, 2005 6

Figure 3. Agency Seasoning Curves 2003-2004, 50 bp out-of-money

Clear Trends Seen in Non-Agency Prepayments

Agency discount prepayment data in 2003-2004 was rather sparse, especially for high negative

rate incentives given the premium nature of the MBS index in this period. To have more

conviction for our analysis, we resorted to non-agency prepayment data from the 1999-2000

backup episode. Specifically, we compared deep out-of-money seasoning profiles of all non-

conforming jumbo and jumbo Alt-A loans by FICO and found the behavior very similar to

agencies (Figure 4). On average, >700 FICO (average FICO 750) borrowers consistently

prepaid about 1%-2% CPR slower than 50 bp out-of-money

Sources: MIC, Lehman Brothers

0369

12

2 6 12 18 23 29 35

FICO=700

% CPR

WALA (Months)

048

121620

0 6 12 18

FICO=650

FICO=700

FICO=750

% CPR

WALA (Months)

Non-agency discount datafrom 99-00 confirms the low

FICO high turnoverbehavior.


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March 17, 2005 7

The Valuation of Low FICO Pools

12-24 WALA Medium FICO pools when 100bp in the money have prepaid 6% CPR slower

than high FICO pools in 2003-2004. The market recognizes the value of weaker credits on the

call side and 100bp premium low FICO pools currently command a 12/32nd premium over

TBAs. The true value of the low FICO story derives, however, from its better extension

protection properties. Fully seasoned medium FICO (700 FICO) pools turnover 1% CPR faster

than TBAs. The turnover of low FICO pools (650 FICO) is almost 5% CPR faster. Figure 5shows the fair value of lower FICO pools on an even OAS and even ZV basis. The even OAS

payups fully reflect the shorter durations and better convexity of these pools, while the even ZV

payups do not capture the better optionality in these pools. As one can see, the fair payup of

current coupon low FICO pools is over a point, while medium FICO pools should command a

payup of close to half a point. The fair value of 50 bp discount medium and low FICO pools is

14/32nds and 1-21/32nds, respectively.

Value in low FICO pools: With current coupon low FICO pools trading almost flat to TBAs, there

is substantial value to be extracted from the better properties of low FICO pools. With almost 30%

of agency pools in the medium FICO bucket, the effect of a repricing in this sector can besubstantial.

Figure 5. Substantial Value in Low FICO Pools : 12-24 WALA Pools

Relative Coupon on Passthrough

-100 -50 CC +50 +100

Even OAS Payup 2 7/32 1 21/32 1 6/32 29/32 28/32Low FICO Pool(625-675 FICO) Even ZV Payup 1 27/32 1 6/32 18/32 5/32 4/32

Even OAS Payup 22/32 14/32 15/32 13/32 14/32Medium FICO Pool(675-725 FICO) Even ZV Payup 16/32 14/32 7/32 2/32 4/32Current Market Payups for Low FICO N/A N/A 1/32 7/32 13/32

Note: Valuations assume that in addition to better call protection, the base case turnover on low FICOpools is 5% CPR faster and is 1.5%CPR faster on medium FICO Pools

There is substantial value to beextracted from the better

extension properties of lowFICO.


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March 17, 2005 8

HIGH LTVS: SLOWER REFINANCINGS, DISCOUNT SPEEDS LEVERAGED TO

HOME PRICE APPRECIATION

High LTV borrowers prepay slower than typical pools in a refinance environment.

Discount high LTV pools are a cheap substitute for GNMA pools.

Equity Constrained Borrowers: Better ConvexityOriginal LTV is a proxy for borrowers equity constraint. It acts primarily to separate low LTV

(LTV80) borrowers. High LTV borrowers pay an

insurance premium for the higher amount of risk they carry. Similar to weaker credit

borrowers, they have fewer refinancing opportunities. However, as housing prices rise, a drop

in actual LTVs allows some of the >80 LTV borrowers to trade up or do a cashout. This also

helps them get rid of their mortgage insurance payment. As a result, we would expect discount

prepayments for high LTV borrowers to be higher in a strong housing environment.

The Outstanding Balance in High LTV Pools

Whereas almost 30% of the outstanding population is in the medium FICO bucket, the amountoutstanding in higher LTV pools is more modest. For instance, within the 2003 vintage 30-year

5s, high LTV (>80%) pools represent only 3% of the total outstanding (Figure 6). Across

coupons, the amounts outstanding are fairly substantial. Almost 20% of the total outstanding

conventional 4.5s, 5s and 5.5s of the 2003 and 2004 vintage have an original LTV > 75

(Appendix A). The characteristics of a high LTV borrower are also very different from a


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March 17, 2005 9



High LTV Turnover Faster in a Strong Housing Market

There is relatively less prepayment variation for discounts within the LTV80 original LTV

have prepaid significantly faster than the average loan in 2003-2004 (Figure 9). Given the

strength of the housing market over the last couple of years, 85-95 LTV borrowers prepaid faster

than an average pool, even with a few months of seasoning. 95-105 LTV borrowers, however, had

to season for a few extra months before some of the borrowers in the pool had their LTVs fall

below 80. So while prepayments on 95-105 LTV pools were slightly slower than a typical borrowerin the first few months, they turned out to be significantly faster when moderately seasoned. We

find similar prepayment behavior in non-agencies in 1999-2000. However, one should note that

strong home price appreciation occurred in both 1999-2000 and 2003-2004 . For newer collateral,

high LTV discount prepayments are a function of the housing market. Still, we expect high LTV

pools in cohorts with significant accumulated home price appreciation (e.g., 2003 vintage) to

prepay faster than low LTV pools in the foreseeable future.

01530456075

0 50 100 150 200

LTV=70

LTV=80

LTV=90

LTV=100

% CPR

Rate Incentive (bp)

01530456075

050 100 150

200

LTV=70

LTV=80

LTV=90

LTV=100

% CPR

Rate Incentive (bp)

High LTV discountprepayments in 99-00 and 03-04 were very much in line with

intuition.


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March 17, 2005 10

Figure 9. 03-04 Agency Seasoning Curves, -50 bp rate incentive (diff from overall, % CPR)

Original LTV

WALA 45-55 55-65 65-75 75-85 85-95 95-105

0 -0.2 0.0 0.0 0.1 0.4 -0.4

6 -0.4 0.0 0.0 0.2 0.3 -0.5

12 -3.3 -0.8 -0.1 1.7 3.2 6.4

18 -0.3 0.0 -0.1 1.4 4.5 4.9

The Relationship of Prepayments to GNMAs and Low FICO Pools

Fast GNMA Speeds Are Primarily LTV Related

Interestingly, high LTV conventional pools prepay very similar to GNMA collateral (Figure 10).

For example, 95-100 LTV FNMA 03 5s prepaid on top of GNMA collateral for several months

in a row. This is not surprising because high LTV FNMA borrowers also pay an insurance

premium like GNMA borrowers. As home prices rise, they can potentially get rid of the

insurance premium by refinancing into a regular


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March 17, 2005 11

Figure 11. Jul04-Dec04 Prepaymentson 03 5s by FICO/LTV, % CPR

Figure 12. %Balance Outstandingon 03 5s by FICO/LTV

LTV

FICO 60 70 80 90

600 19.1 25.3 40.9

650 16.9 15.4 21.8 29.4

700 9.5 12.0 14.7 18.1750 10.3 10.8 10.9 11.7

LTV

FICO 60 70 80 90

600 0.1 0.1 0.0

650 0.1 1.0 0.2 0.1

700 1.2 23.4 4.7 0.5750 6.8 58.6 2.6 0.1

Discount High LTV Pools: Cheap GNMA Substitutes

The better call protection of high LTV pools is reasonably well appreciated by the market. We

estimate that the better call convexity on higher LTV pools should be worth 19/32nds on a

100bp premium pool. Current market payups for these premium pools are around 6/32nds.

Higher LTV pools have much more favorable properties on the turnover front. On average

high LTV pools have prepaid 3-5% CPR faster than lower LTV pools. The discount prepayment

behavior of higher LTV borrowers is however, significantly leveraged to home prices. The

valuation of higher LTV pools is complicated because valuation would need to explicitly project

home prices going forward. However, it is safe to say that in the absence of a very serious crash

in the housing market, high LTV pools in seasoned vintages (2003s and earlier) should

continue to prepay fast, reflecting the substantial built up equity in these vintages. Based on the

base differences in prepayments, a 50bp discount high LTV discount pool should command a

payup of 1-12/32nds a low LTV pool (Figure 13).

Since higher LTV pools in the conventional space have prepaid as fast as GNs, an easier

benchmark for valuation is to the prices on GN/FN swaps. Of course there are differences

between the two strategies including the fact that unlike a GN pool, a high LTV pool will not be

TBA eligible (the payup is lost if a high LTV pool is delivered, a GN pool retains its value) and

cannot benefit from any special roll financing and the TBA liquidity. Also there are differences

in payment delays on the two programs. Together, these factors should be worth around

10/32nds, or in other words the fair value for high LTV conventional pools is around 10/32nds

lower than the corresponding GN payup.

Value in high LTV Pools: Currently new issued current coupon high LTV pools are trading flat to

TBAs. The GN/FN 5.5 swap is valued at 23/32nds. Given that there is almost no cost in buying

high LTV pools, these are an ideal substitute for similar vintage GNMA pools.

Figure 13. Fair and Actual Payups on High LTV Pools, Create Cheap GNMA Substitutes

Relative Coupon on Passthrough : CC is Current Coupon

-100 -50 CC +50 +100

Even OAS Payups 1 28/32 1 12/32 30/32 21/32 19/32

Even ZV Payups 1 18/32 1 16/32 4/32 2/32

GN Payups 28/32 29/32 23/32 19/32 22/32

Current Market Payups N/A N/A 0 5/32 6/32

Note: Valuation assume that in addition to better call protection, the base case turnover is 4% CPRhigher on high LTV pools.

Discount LTV pools are cheapsubstitutes for GNMA.


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March 17, 2005 12

NON-OWNERS: LOWER REFINANCING, HIGHER TURNOVER

Pools with higher share of non-owners are less callable.

Lower transactions costs of moving also lead to faster speeds on discounts.

Non-Owners: Lower Opportunities to Refinance and Lower Moving Costs

As for credit impaired borrowers, refinancing opportunities for non-owner occupied properties

are relatively lower. As such, their in-the-money prepayments are significantly lower thanregular pools. When it comes to turnover, transaction costs are much lower for a non-owner

occupied loan. This is due mainly to lower hassle and moving costs because the borrower is

not living in the house. Moreover, discount prepayments for investor properties are likely to be

higher in a strong housing environment because the housing market activity is high.

The Outstanding Balance in Non-Owner Pools

Investor properties tend to attract a 20-30 bp higher rate than owner-occupied properties.

Therefore, the amount outstanding in investor property pools is fairly small in the lower

coupons (Appendix A). Among 2003 5s, for instance, only 3% of all pools are less than 75%

owner occupied. Their proportion within premium mortgages is larger: for instance. almost

55% of all outstanding pools in 6s today are less than 75% owner occupied (Figure 14).

Figure 14. Share of Non-owner Occupied Pools Is Higher in Premiums

5s of 2003 5.5s of 2003 6s of 2002 6s of 2003

Share of


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March 17, 2005 13

Non-Owner Discounts are Faster

The concentration of non-owner properties is fairly small in lower coupon cohorts such as 4.5s

and 5s, which form the bulk of agency discount prepayment data over the last year. Therefore,

agency discount prepayment data by occupancy do not reveal much information (Figure 16).

However, from the little information we have, pools with a higher share of non-owner

occupied propertied have prepaid faster within 4.5s. We would pay less attention to the

prepayment behavior of 5s because their prepayments have been clouded by the many nearmoney refinancings in the current environment. Please read our Mortgage Outlook 2005 for

more details on this issue.

Figure 16. Discount Agency Prepayments, % Owner Occupied, July 2004-December 2004

Non-Agency Prepayment Behavior of Discounts Concurs

In the absence of any conclusive data within agencies, we resorted to non-agencies from the

1999-2000 backup episode. Specifically, we compared the deep out-of-money seasoning

profiles of all non-conforming jumbo and jumbo Alt-A loans by occupancy type (Figure 17).

On average, investor properties prepaid about 1% CPR faster than seconds, which prepaid

another 1% CPR faster than owner occupied properties.

Figure 17. Seasoning Curves by Occupancy, 1999-2000 Non-Agency, >50 bp out-of money


05

10152025

0 25 50 75 100

03 4.5s

03 5.0s

% CPR

% Owner Occupied

0369

12

6 12 18 24 30 36

OwnerSecondInvestor

% CPR

WALA (Months)

Non-owner discounts seem tobe faster within agencies.

Non-agency non-ownerproperties prepaid faster in the

1999-2000 backup.


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March 17, 2005 14

Value in Discount Investor Properties

Given that the lions share of investor property pools is within the higher coupons, the call

protection of these pools is well understood and priced by the market. Investor pools that are

100bp in the money prepay almost 20% CPR slower than owner occupied pools. While the fair

payup for these pools is around 29/32nds, the market is currently assigning a 13/32nd premium

over TBAs. However, investor properties are valuable for their extension protection as well.

From the limited data available on agency prepayments and from data on non-agencies,discount investor properties can be expected to turnover 1%-2%CPR faster than owner

occupied properties. The fair value of a 100bp discount investor property pool is around

28/32nds (Figure 18). Ignoring the better optionality and just focusing on the ZV valuations,

these pools should trade at a 19/32nds payup over TBAs.

Value in low Investor Properties: Current coupon investor property pools are trading at a 4+/32nd

payup to TBA. At these valuations, we view these pools as a cheap put on the market. As the market

sells off, the value of the pool should increase because of the lower extension on the collateral.

Figure 18. Fair Payups on Investor Properties (100% Investor Owned)

Relative Coupon on Passthrough : CC is Current Coupon

-100 -50 CC +50 +100

Even OAS Payup 31/32 28/32 20/32 19/32 29/32Even ZV Payup 24/32 19/32 7/32 3/32 20/32

Current Payups N/A N/A 4+/32 10/32 13/32

Note: Valuations assume that in addition to superior call protection, the base case turnover is 2% CPRfaster on investor properties

A non-owner 50bp discountpool should have a 19/32ndspayup even after ignoring its

better optionality.


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March 17, 2005 15

REFINANCERS BENEFIT FROM PRE-SEASONING BUT REFINANCE FASTER

Pools with greater share of refinance borrowers are more callable.

Discount refinance borrowers season faster but not necessarily to a higher fully seasoned

turnover rate.

Refinancers Are More Sophisticated

Borrowers who have refinanced before have revealed themselves to be more efficientrefinancers and are likely to prepay faster, should another refinancing opportunity come by. On

the turnover front, transaction costs of a home purchase are far higher than a refinance

transaction. As a result, a purchase borrower with a short horizon is more likely to rent than

purchase. In contrast, a refinance borrower, who also has a short horizon. may still benefit

from refinancing and move after some time. The implication is that purchase borrowers, on

average, have longer horizons than refinance borrowers and are likely to turn over slower, at

least to begin with. Alternatively, one can also argue that refinancers have already been in their

homes for some time (are seasoned to some extent) and will turnover faster.

Refinancers Prepay Faster as Premiums

A closer look at the agency data suggests that premium pools with greater share of refinancers

have historically prepaid faster. However, 2003-2004 agency prepayment data indicate that

initial differences between purchase and refinance borrowers become much weaker as the pool

seasons (Figure 19). For example, the prepayment difference between pools with 25% and 75%

shares of refinancers (both 100 in-the-money) goes from 22% CPR in the first 12 months to

only 7% CPR in the next 12. This behavior is due, at least in part, to the strong correlation

between share of refinancers and LTV. As the pools season, the refinancer loses this advantage.

Figure 19. Agency Prepayments by Purpose, 2003-2004

Share of Refinancers

WALA Rate Incentive (bp) 0 25 50 75 100

0-12 50 20 20 22 30 32

100 28 32 42 54 57150 40 46 55 52 66

12-24 50 34 31 31 30 32

100 46 46 48 53 57

150 60 62 64 68 67

Refinancers: Are Pre-seasoned, Faster Turnover on New Pools

We had argued earlier that transaction costs in a home purchase are higher and refinancers

have already been in their homes for some time. In line with this reasoning, agency prepayment

data suggest that discount pools with a greater share of refinance borrowers seasoned faster.

However, the initial differences between purchase and refinance borrowers fade away with

seasoning (Figure 20). Part of the reason is that purchase borrowers in general have higher

average LTV ratios and ramp up as they accumulate equity in the house. Once they are fully

seasoned, there should be no difference between a purchase and refinance borrower in terms of

mobility.

Borrowers who haverefinanced earlier have

revealed themselves to be moreefficient refinancers.

Refinancers are alsopre-seasoned and turn over

faster initially.


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March 17, 2005 16

Figure 20. FNMA 03 5s by Purpose in 2003-2004, 50 bp out-of-money

Source: Lehman Brothers

Non-Agency Refinancers Have Seasoned Faster

We see similar behavior in non-agency collateral in 1999-2000. Figure 21 shows the seasoning

profiles of 50 bp out-of-the-money non-agency collateral. Refinance borrowers seasoned faster

than purchase borrowers but actually prepaid slower after about 20 months of seasoning. We

do not see any reason for differences in fully seasoned turnover of refinancers versus purchase

borrowers. However, given their longer stay in the house, refinancers should season faster.

Figure 21. Non-agency Refinance vs. Purchase Borrowers in 1999-2000, >50 bp out-ofmoney


The Value Lies with Purchase Borrowers

Most pools in the agency universe have a high share of refinancers. For instance, among 2003

5s, almost 90% of the pools have more than 75% refinancers. We find that the pre-seasoning of

refinance borrowers is overwhelmed by their worse callability. Pools with a high share of

refinancers do benefit from the pre-seasoning of these borrowers. However, refinance

borrowers are also more likely to refinance than purchase borrowers. We find that the better

extension properties of refinancers are overwhelmed by their worse callability. We find that

048

1216

1 3 5 7 9 11 13 15 17 19

Purchase

Refinance

% CPR

WALA (Months)

02468

10

2 6 12 17 23 29 35

PurchaseRefinance

% CPR

WALA (Months)

Fully seasoned turnover speedsfor refinance borrowers are not

different from purchaseborrowers.

Preseasoning of refinancers isoverwhelmed by their worse

callability.


17/27


March 17, 2005 17

across coupons, purchase pools should command a payup over TBAs. On current coupons, the

better call protection on purchase borrowers is worth 4/32nds. When 100 bp in the money,

purchase pools should command a payup of almost 10/32nds (Figure 22).

Value in Purchase Pools: The faster seasoning of refinancers is overwhelmed by their worse

convexity on the call side. We think purchase borrower pools are worth more than refinance pools

across coupons. The market does not currently assign any payup to purchase borrowers. Given their

better convexity on the call side, these should be worth 6 and 10/32nds over TBA for 50 bp

premiums and 100 bp premiums, respectively.

Figure 22. Fair Payups on Pools with Less than 75% Refinancers

Relative Coupon on Passthrough : CC is Current Coupon-100 -50 CC +50 +100

Even OAS Payup 1/32 6/32 4/32 6/32 10/32

Even ZV Payup - 1/32 4/32 - 1/32 1/32 6/32

Note: Valuations assume that refinancers season 10 months faster but are 15% more efficient inrefinancings.


18/27


March 17, 2005 18

LOW LOAN BALANCE: SOLID CONVEXITY STORY

Low loan balance refinancings are significantly slower than typical collateral.

At the margin, we believe that low loan balance collateral is likely to prepay faster in a serious

backup.

Low Loan Balance: Lower Monetary Benefits from Refinancing

The basic premise behind better callability of low loan balance pools is fairly straightforward.Because of fixed refinancing costs (e.g., legal fees; application fees and add-ons; appraisal fees;

and the hassle costs of searching for best rates, collecting documents, and closing), smaller

loans tend to prepay slower than larger ones for a given level of rate incentive. A case can be

made for lower loan balance collateral to turn over faster primarily from a low loan size

borrowers having more of an incentive to trade up to a bigger house. While this is not a very

compelling hypothesis, there is empirical evidence to suggest higher discount prepayments on

LLBs. In any case, we view the better extension properties of LLB pools as an added bonus to

the very established call protection of this collateral.

Lower Loan Balance Collateral Is Less Callable

Much has been written about the slower low loan balance premiums in the last few years. In

fact, the market actively trades not only the low loan balance collateral (LLB,


19/27


March 17, 2005 19

Figure 24. FNMA Seasoning Profiles in 1999-2000, 50 bp outof-money

4

6

8

10

12

0 6 12 18 24 30 36 42 48 54 60

Size100K

% CPR

Loan Size ($K)

Figure 25. FNMA Seasoning Profiles in 1994-1995, 50 bp outof-money

But Havent LLBs Discounts Prepaid Slower in 03-04?

This may appear to be true based on prepayments on 03 5s. There is no doubt that higher loan

balance 03 5s prepaid faster than LLBs in 2003-2004. However, prepayments on more out-of-

the-money collateral paint a different story (Figure 26). In particular, within 03 4.5s, 150K

balance collateral has prepaid faster than 200K, which, in turn, has prepaid faster than 250K

collateral. We believe that faster prepayments for higher loan balance on 03 5s are an indication

of near-money refinancings in the current environment (fixed to ARM, cash-out, etc.) and will

die down in a big sell-off. Please see ourMortgage Outlook 2005 for more details.

02468

0 6 12 18 24 30 36 42 48 54 60

Size100K

% CPR

Loan Size ($K)

Lower loan balances haveprepaid faster within 03 4.5s.


20/27


March 17, 2005 20

Figure 26. Conventional Prepayments by Loan Size, July 2004-December 2004

LLBs Should Prepay Faster in a Large Backup

Based on the above analysis, we do not expect low loan balance collateral to prepay below high

loan balance in a serious backup. At the margin, we expect low loan balance collateral to prepayfaster than high loan balance collateral. Given that the market currently does not recognize the

fast turnover on this collateral, we view this as an added bonus.

Valuation of LLB Pools

Low loan balance collateral forms a sizeable chunk of the 30-year universe. For instance, among

2003 5s, pools with a loan size less than 100K comprise almost 10% of the vintage. Like most

call protection stories, the call protection of lower loan balances is very well priced by the

market. We estimate than low loan balance, 100 bp premium pools should trade at a payup of

25/32nds to TBAs; current market payups are around 23/32nds. If we assume that the trends

seen on LLB turnover in 1999-2000 and 1994-1995 are likely to repeat, there is substantial value

in this story on the extension side. 50 bp discount low loan balance pools currently have no

payup in the market. In past discount episodes, low loan balance pools have prepaid 1%-2%

CPR faster when 50 bp out of the money. The faster turnover is worth close to a point on

discount low loan balance collateral (Figure 27).

Value in LLB 4.5s: Prepayments on 2003 vintage 4.5s have shown a clear dependence on loan

balance. Lower loan balances have consistently prepaid faster in 2004. Currently, the market does

not demand any premium for LLB 4.5s. We believe this is cheap optionality waiting to be

monetized. The fair value on these pools is close to 29/32nds.

Figure 27. Fair Payups on LLB Pools (


21/27


March 17, 2005 21

GEOGRAPHIES: INHERENTLY FAST AND SLOW STATES

States with lower transactions costs have consistently prepaid slower in a refinance

environment.

Discount prepayments by geography, however, seem to be driven largely by economy and home

price appreciation.

Geographical Variation: Economic Conditions and Transaction CostsTransactions costs are a big determinant of collateral callability because borrowers compare

these costs to the benefits from refinancing. Given how widely title insurance and mortgage

taxes wary across states, we would expect some regions consistently to prepay slower or faster

than others. On the turnover front, regional variations in economy and home price

appreciation can cause collateral to prepay differently. Transaction costs should have a minor

effect on turnover because the costs of moving are usually much higher than these costs.

Refinancing Are Very Different across Regions

Figure 28 shows the actual prepayment differences for a high-cost region (Mid-Atlantic) and a

low-cost one (New England) versus the U.S. average over the last two years. It is worth noting

that the same regions have prepaid faster or slower in every refinancing episode over the last

decade, even after controlling for loan size and credit differences. Mid-Atlantic, East South

Central, and West South Central have higher-than-average transaction costs, while New

England and East North Central have lower than average transaction costs.

Figure 28. Prepayments across Geographies, 2003-2004

Diff from US Average, % CPR

WALA Rate Incentive (bp) MAT (Slow) NEG (Fast)

0-12 50 -7 7

100 -14 15

150 -16 10

12-24 50 -1 13

100 -4 10

150 -6 9

Discount Prepayments across Regions Also Vary

There is significant variation in discount prepayments across geographies. Figure 29 shows the

differences in prepayments on 2003 5s from the average across states. A large number of states

prepaid 2%-4% CPR slower than the average for 03 5s. On the other hand, California prepaid

about 4% CPR faster than the average (taking the average up by 1% CPR due to its share being

about 25% share in total outstanding). However, most of the differentials across states are

driven primarily by home price appreciation and the economy. For example, the two fastestprepaying states in Figure 32 (California and Nevada) had 21% and 25% annualized home

price appreciation at the end of June 2004. In contrast, some of the slower prepaying states

(Texas and North Carolina) had very modest home price appreciation of 3%-4%.

Differences in transaction costsand economic conditions cause

regions to prepay differently.

States with higher transactioncosts have refinanced slower.

There is significant variationin discount prepayments

across geographies.


22/27


March 17, 2005 22

Figure 29. July 2004-December 2004 Prepayments on FN 03 5s by States, difference fromaverage (% CPR)

Differences in Turnover are Primarily Home Price/Economy DrivenFigure 30 shows prepayments on FN 03 5s for different US states against their 1-year home

price appreciation at the end of June 04. There is a strong correlation between the two and

there are few outliers. This analysis is rather simplistic but shows that most of the regional

differences can be explained by differences in home price appreciation. A few states that appear

to be slower after adjusting for differences in home price appreciation look familiar as states

with higher transaction costs (NY, NJ, PA etc.). That said, we are less comfortable with trades

involving discount prepayment differences across geographies. Home price appreciation has

varied significantly across regions and time periods and it is anybodys guess what it will be in

future across regions. Moreover, unlike other specified pool stories that have similar or better

call characteristics, regions with lower transaction costs are also likely to prepay faster in a rally.

Figure 30. July 2004-September 2004 Prepayment Rate on FN 03 5s vs. HPA

Sources: Lehman Brothers, Freddie Mac

-6-4-20246810

% CPR

48

121620

0 5 10 15 20 25

% CPR

% HPA

Regional differences inturnover are primarily home

price and economy driven.


23/27


March 17, 2005 23

Summary

Before we finish, let us recapitulate the main results. There is significant variation in

prepayments across collateral types for both discounts and premiums. Prepayment differentials

are due mainly to differences in credit, demographics, loan size, and economic incentive to

trade up or cash out. We can briefly summarize the findings as follows:

Low FICO, high LTV, and non-owner occupied pools provide significant call and

extension protection. Low FICO pools, in particular, have always prepaid faster in a

discount environment and slower during refinance waves.

Prepayments on new high LTV pools are dependent on the strength of the housing market.

However, high LTV conventional pools prepay very similarly to GNMA. The housing

market notwithstanding, high LTV pools are a cheap substitute for GNMA discount pools.

Low loan balance refinancings are significantly slower than typical collateral. However, we

do not have conclusive data on their behavior in a backup. At the margin, we believe that

low loan balance collateral is likely to prepay faster in a serious backup.

Pools with higher shares of refinancers season faster to a similar turnover rate as purchaseborrowers. Moreover, refinance borrowers are more callable than purchase borrowers.

States with lower transactions costs have consistently prepaid slower in a refinance

environment. Discount prepayments by geography, however, seem to be driven largely by

economy and home price appreciation.


24/27


March 17, 2005 24

APPENDIX A: OUTSTANDING & AVG. CPRs of 2003-04 LOWER COUPONS

1. AMOUNT OUTSTANDING AND CPRs BY FICO

2003 Vintage 2004 Vintage

Average

FICO4.5s 5.0s 5.5s 4.5s 5.0s 5.5s

Amount Outstanding ($B)

625-675 0 4 7 0 1 4

675-725 5 90 200 1 42 77

725-775 45 206 120 5 60 30

>775 0 0 0 0 0 0

Total 50 300 328 6 104 111

Average CPR (Jul-Dec 2004)

625-675 17.1 21.2 26.2 10.5 8.3 16.1

675-725 10.5 13.3 18.2 7.2 5.5 11.1

725-775 6.1 11.1 15.6 3.4 4.9 10.8

>775 8.1 6.5 13.0 0.4 0.7 18.6

Total 7.0 11.0 18.0 3.0 6.0 11.0

2. AMOUNT OUTSTANDING AND CPRs BY LTV


Original

LTV (%)4.5s 5.0s 5.5s 4.5s 5.0s 5.5s


95 0 1 2 0 0 1

Total 50 300 328 6 104 111


95 12.3 17.0 26.0 7.8 5.7 12.9

Total 7.0 11.0 18.0 3.0 6.0 11.0


25/27


March 17, 2005 25

3. AMOUNT OUTSTANDING AND CPRs BY % REFINANCERs


% Refi 4.5s 5.0s 5.5s 4.5s 5.0s 5.5s


0-12.5 0 1 3 0 1 2

12.5-37.5 1 3 10 0 4 18

37.5-62.5 5 30 90 1 37 51

62.5-87.5 39 221 191 4 56 37

>87.5 5 45 35 0 5 3

Total 50 300 328 6 104 111


0-12.5 9.0 15.2 24.3 4.8 5.6 11.8

12.5-37.5 8.7 12.5 17.4 3.5 5.1 10.6

37.5-62.5 7.5 11.1 17.0 3.3 5.8 10.7

62.5-87.5 7.1 11.4 17.6 3.2 6.2 12.3

>87.5 8.0 11.3 18.0 3.2 7.5 12.5

Total 7.0 11.0 18.0 3.0 6.0 11.0

4. AMOUNT OUTSTANDING AND CPRs BY % OWNER OCCUPIED


% Owner 4.5s 5.0s 5.5s 4.5s 5.0s 5.5s


37.5-62.5 0 0 1 0 0 0

62.5-87.5 0 8 37 0 2 14

>87.5 49 292 290 6 101 97

Total 50 300 328 6 104 111


37.5-62.5 19.8 14.2 19.4 18.8 5.6 12.9

62.5-87.5 9.4 14.3 19.7 6.4 5.1 12.1

>87.5 7.3 11.3 17.2 6.1 5.8 11.2

Total 7.0 11.0 18.0 3.0 6.0 11.0


26/27


March 17, 2005 26

5. AMOUNT OUTSTANDING AND PREPAYMENTS BY AVERAGE LOAN SIZE


Loan Size

($000s)4.5s 5.0s 5.5s 4.5s 5.0s 5.5s


225 5 30 19 1 23 18

Total 50 300 328 6 104 111


225 6.3 10.8 16.9 3.5 6.7 12.9

Total 7.0 11.0 18.0 3.0 6.0 11.0


27/27

The views expressed in this report accurately reflect the personal views of Sandeep Bordia & Prasanth Subramanian, the primaryanalyst(s) responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst(s)compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein.

Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copiesof these reports and their certifications, please contact Larry Pindyck ([email protected]; 212-526-6268) or Valerie Monchi([email protected]; 44-(0)207-102-8035).

Lehman Brothers Inc. and any affiliate may have a position in the instruments or the companies discussed in this report. The firmsinterests may conflict with the interests of an investor in those instruments.

The research analysts responsible for preparing this report receive compensation based upon various factors, including, amongother things, the quality of their work, firm revenues, including trading, competitive factors and client feedback.

Lehman Brothers usually makes a market in the securities mentioned in this report. These companies are current investmentbanking clients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.

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