Non-Agency MBS

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER

IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.

CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION®

Client-Driven Solutions, Insights, and Access

Global Securitized Products Weekly Structured Products Strategy

Agency MBS We maintain a modest overweight on the MBS basis. The supply/demand picture for

specified pools remains robust in 2013 due to a sharp projected decline in supply

overwhelming a moderate decline in demand. Last weekend's loosening of LCR standards

by the Basel committee is near-term neutral and longer-term negative for Agency MBS.

Non-Agency MBS Non-agency markets have remained firm with balanced flows to start the year. Herein, we

provide an estimate of which private label MSRs Nationstar acquired from BofA on Monday.

On another note, we believe the amended Basel III LCR requirements were at first glance

very positive for US RMBS, but we also see a few hurdles for private label RMBS to clear in

order to be allowed as high quality liquid assets.

CMBS The CMBS market has enjoyed a strong rally since the start of the new year, not only

continuing the December spread tightening move but also with the trend accelerating. We

are not surprised by the direction of the move over the first few trading days of 2013, but the

speed and the magnitude exceeded our expectations. While the rally has been impressive,

it has not been evenly distributed over the various sectors, and bonds with more cuspy risk

profiles have been the best performers.

Consumer ABS In Auto ABS, spreads remained flat, whereas short-term performance in both the prime and

subprime sectors was stable to marginally better. Defaults inched down 6 bps in prime and

16 bps in subprime. Severities were constant and net losses were flat in prime but fell a

marginal 5 bps in subprime.

CDO / CLO The new-issue CLO market showed no signs of slowing in December. Sixteen CLOs, or a

total of $7.9bn, were issued, bringing the 2012 final tally to $54.2bn. In this section, we also

discuss the initial Equity Par Coverage (EPC) ratio as a very useful metric for analyzing

CLO equity investments.

European Update Trading volumes have been light this week with muted BWIC activity so far. Despite the

light activity, we have seen long duration paper in senior space tightening this week in core

and periphery RMBS. Longer paper continues to attract a lot of attention as spread curves

remain steep and structured product money looks to extend duration in portfolios.

Portuguese, Spanish and UK non-conforming RMBS were the biggest winners on the week.

The new issuance pipeline looks dry thus far, however, we expect activity to improve as the

New Year kicks into gear.

Modeling and Analytics A new agency model CS6.7 is currently in parallel with production CS6.6. The main updates

are modeling the volatile current coupon/swap basis due to QE3 and “sticky” primary rates.

Future additional G-fee increases are added to conventional 30year and 15year products,

as well as to the five states mandated by FHFA. Given the recent persistently high

HARP2.0 activities and newly announced HARP program changes, CS6.7 extends peak

HARP2.0 effectiveness by another six months, from November 2012 to May 2013. Finally,

MHA pools’ delinquency buyout projections are reduced by 25%-30%, due to the effects of

payment reduction and credit selection bias.

Research Analysts

GLOBAL HEAD

Roger Lehman +1 212 325 2123 [email protected]

AGENCY MBS

Mahesh Swaminathan +1 212 325 8789 [email protected]

Qumber Hassan +1 212 538 4988 [email protected]

Vikram Rao +1 212 325 0709 [email protected]

NON-AGENCY MBS/CONSUMER ABS

Chandrajit Bhattacharya +1 212 325 1546 [email protected]

Marc Firestein +1 212 325 4379 [email protected]

Gaurav Singhania, CFA +1 212 325 0620 [email protected]

CMBS

Roger Lehman +1 212 325 2123 [email protected]

Sylvain Jousseaume +1 212 325 1356 [email protected]

Serif Ustun, CFA +1 212 538 4582 [email protected]

Tee Chew +1 212 325 8703 [email protected]

CDO/CLO

David Yan +1 212 325 5792 [email protected]

EUROPEAN UPDATE

Carlos Diaz +44 20 7888 2414 [email protected]

MODELING AND ANALYTICS

David Zhang +1 212 325 2783 [email protected]

Table of Contents

Core Views 2

Agency MBS 3

Non-Agency MBS 9

CMBS 18

Consumer ABS 27

CDO / CLO 34

European Update 40

Modeling and Analytics 41

10 January 2013

Fixed Income Research

http://www.credit-suisse.com/researchandanalytics

10

Ja

nu

ary

20

13

Glo

bal S

ecuritiz

ed

Pro

ducts

Weekly

2

Core Views Sector Trends Trade Ideas

Agency MBS

Modest overweight on MBS basis

Long 15s/30s

Long ARMs over 15-yrs

Buy FN 3s versus 5-yr and 10-yr swaps

Buy DW 3/FN 3. 5 sw ap

Favor 5/1 ARMs over 15-years

Buy IOS 3.5 hedged with FN 3

Housing

After six long years of continued price declines, home prices finally found a bottom in 2012. Although prices started inching up during the first quarter, we think the foundation for a sustainable recovery was laid during the middle of 2012 as supply-demand fundamentals began to turn unequivocally in a positive direction, driven by increasing demand and plummeting supply. As we look ahead, we think much of the supply constraints will remain in place, providing support for a sustainable recovery in home prices. We expect a roughly 4.0%-4.5% increase in home prices in 2013, following an estimated 5.0%-5.25% increase in 2012.

Prepayment

Prepayment S-curve for new production (post HARP/MIP)should gradually steepen in 2013. The scheduled January launch of a bright line performance test for lenders to avoid putbacks, continued increase in lender capacity, outlook for continued increases in home prices, and possible introduction of traditional GSE streamlined refi programs are potential drivers.

Speeds on HARP-eligible cohorts may remain elevated for longer supported by active cross servicer refis, a more lender-friendly putback policy, and continuing transfers of high-risk loans to special servicers and active curing.

Non-Agency MBS

The housing market should continue to improve. We estimate home prices increased 5.0%-5.25% in 2012, followed by a 4.0%-4.5% increase this year.

Lower volatility and continued performance improvement can bring in more leverage. Yields could compress further.

Net negative issuance of $150B this year and lighter dealer balance sheets should provide technical support. Jumbo new issuance is projected to be $10-$15B.

Add with leverage or hold on to high coupon cleaner Prime and Alt- As. We still prefer fixed coupon Prime and Alt-A with slightly higher delinquency but higher optionality.

Continue to remain overweight on Inverse IOs – on muted prepays and low rates.

Overweight Alt-As and POAs due to optionality and incrementally higher carry.

Neutral on Subprime LCFs and Penns – the sector has richened significantly and has low carry.

Underweight (slightly longer duration) front pay Subprime with servicing issues.

Long Prime and Alt-A Re-Remic Mezz

Consumer ABS

Spreads ground tighter in 2012, but we maintain a bullish outlook in 2013.

Fundamental performance in major sectors continues to improve.

We project net positive issuance for 2013. We believe the hunt for yield will compress the credit curve in 2013.

Neutral on prime auto seniors. Remain overweight subprime autos and prime subs. Value in highly rated SDART & AMCAR subs, prefer SDART seniors.

Prefer auto lease and dealer floorplan (FORDF & AMOT) over prime auto due to spread pick-up.

Overweight longer duration FFELP paper and short duration PSL seniors.

Franchise deals have tightened but still have room for further tightening.

We remain neutral on 2yr COMNI paper – but risk/reward favors continued holding.

CMBS

The CMBS market has enjoyed a strong rally since the start of the new year, not only continuing the December spread tightening move but also with the trend accelerating. We are not surprised by the direction of the move over the first few trading days of 2013, but the speed and the magnitude exceeded our expectations. While the rally has been impressive, it has not been evenly distributed over the various sectors, and bonds with more cuspy risk profiles have been the best performers.

We find relative value in:

Wider AMs and select, mid-tier AJs;

Agency CMBS versus tighter super-senior bonds;

We remain cautious on new issue BBB bonds; and

More differentiation is needed on premium super-seniors.

CLO/CDO

Moderate growth and a low rate environment make corporate credit more attractive relative to other risky assets; corporate default rates should stay low – market consensus expects them to be about 2%-3% for 2013.

QE3 and the Fed’s pledge to keep interest rates low until mid-2015 will likely encourage further yield chasing; however, we remain concerned about the longer-term picture and near-term earnings slowdown and macro headwinds, such as the upcoming “debt ceiling” debate.

On the new-issue front, the pipeline looks strong for 2013. New issue AAA spreads stay around 135bp-140bp.

CLOs, in general, appear cheap to most other securitized products.

Within the non-PIK-able space, we recommend overweighting senior AAA tranches.

Within the PIK-able space, we now favor the primary equity tranches over secondary paper and also recommend an overweight in the BB tranches.

We favor new-issue mezz tranches over seasoned mezz tranches.

Source: Credit Suisse * Bolded parts are updated for the week

10 January 2013

Global Securitized Products Weekly 3

Agency MBS Strategy

We maintain a modest overweight on the MBS basis. Although valuations versus

rates benchmarks are compellingly cheap following this week’s rebound, a favorable FN

3 dollar roll, cheap valuations versus corporates, and potential for supportive Fed

comments remain positives.

The supply/demand picture for specified pools remains robust in 2013 due to a

sharp projected decline in supply overwhelming a moderate decline in demand.

Last year’s roughly 200% surge in gross supply of specified pools was largely driven by

HARP activity, which will generate a much lower volume in 2013 despite comparable

speeds because of a sharply lower starting balance. Demand technicals are somewhat

weaker, mainly due to a projected decline in REIT demand.

We believe that prepayments on high coupons (5s and above) may only rise

modestly as a result of servicing transfers from BofA (7 January 2013 Mortgage

Market Comment). We expect speeds in these coupons to rise by low- to mid-single digit

CPR compared to current BofA speeds. This is in contrast to the 15-20 CPR higher

speeds on BofA loans transferred by Fannie to specialty sub-servicers. The knee-jerk

reaction in the market potentially misses this distinction, in our view.

Last weekend's loosening of LCR standards by the Basel committee is near-term

neutral and longer-term negative for Agency MBS. Although liquidity standards have

not been the primary driver of Agency MBS demand in the current environment, delayed

implementation, reduced liquidity needs, an expansion of eligible assets, and the

absence of an upgrade to level 1 status all lower eventual potential demand for MBS.

Trade recommendations

Hold long MBS basis (buy $50MM FN 3, sell $18.2MM 10-yr swap, sell $22.6MM 5-yr

swap) based on cheap valuations, favorable supply/demand and carry outlook. This

trade is up 11.5 ticks since inception.

Hold buy DW 3/FN 3.5 swap (buy $100MM DW 3s vs. $71MM FN 3.5) based on cheap

valuations adjusted for changes in prepayment trends (10 October 2012 Global

Securitized Products Weekly). This trade is down half a tick since inception.

Hold sell G1/G2 4 ($100MM each), based on attractive risk/reward (19 September 2012

Global Securitized Products Weekly). This trade is down 24+ ticks since inception.

Hold buy DW 3.5/2.5 swap based on cheap valuations adjusted for changes in

prepayment trends (4 October 2012 Global Securitized Products Weekly). This trade is

up a tick since inception.

Hold buy IOS 3.5 versus FN 3.5 based on cheap valuations adjusted for changes in

prepayment trends (29 November 2012 Global Securitized Products Weekly). This trade

is up 10 ticks since inception.

Hold buy FN 5.5/5 swap based on cheap valuations and significant pricing in of policy

risk premium (17 December 2012 MBS Trade Note). This trade is up a tick since

inception.

Closed the remaining leg of sell G2/FN 3 swap ($50MM) at a profit of 14+ ticks

(9 January 2012 MBS Trade Note).

Closed buy NG/DW 3 swap ($100MM) at a profit of 5 ticks (8 January 2012 MBS

Trade Note).

Mahesh Swaminathan

+1 212 325 8789

[email protected]

Qumber Hassan

+1 212 538 4988

[email protected]

Vikram Rao

+1 212 325 0709

[email protected]

10 January 2013


Exhibit 1: Current trade recommendations

Actual P&L should be slightly lower as this does not reflect bid/offer spread.

Trade Idea Start Date P&L

P&L

(ticks)

Buy $50MM FN 3, sell $18.2MM 10-yr swap, sell $22.6MM

5-yr swap6-Nov-12 179,300 11.5

Buy $100MM DW 3.5s, sell $48MM DW 2.5s 4-Oct-12 26,820 0.9

Sell G1/G2 4 ($100MM) 19-Sep-12 (765,686) (24.5)

Buy DW 3 ($100MM), sell FN 3.5 ($71MM) 10-Oct-12 (19,720) (0.6)

Buy $25MM IOS 3.5 versus 25MM FN 3 29-Nov-12 78,125 10.0

Buy $66MM FN 5.5, Sell $53.8MM FN 5 17-Dec-12 9,126 1.2

Total P&L of open trades (492,035)

Total P&L of trades closed YTD 578,125

Note: Pricing date: Jan 8, 2013. Source: Credit Suisse

Maintain a modest long recommendation on MBS

We maintain a modest long MBS basis recommendation after taking partial profits on

Tuesday (8 January 2013 MBS Trade Note). Recent performance (including Wednesday’s

late day outperformance) has substantially retraced the excessive swoon following the

release of the FOMC’s minutes last Thursday.

Although current valuations are not compellingly cheap, they only correspond to a slightly

better than average level of cumulative performance in the QE3 regime (Exhibit 2).

Cheapness compared to 4-7 year AA-rated corporates is an additional positive (Exhibit 3).

Continued increase in dollar rolls on FN 3s and potential for supportive Fed comments

should support MBS near-term.

Whether or not Fed starts actively rolling FN 3s in the coming weeks would offer an

important signal on Fed’s near-term target for FN 3 dollar rolls and by extension the MBS

basis. Although Fed would potentially have to roll FN 3s beyond February settlement to

avoid richening the roll, policy goals may favor a delay.

Through January settlement, Fed appears to have taken delivery of roughly 65% of gross

issuance in FN 3s since September 2012. As we have written in the past (11 October

2012 Global Securitized Products Weekly), maintaining the settled amount below 70% of

the cumulative gross issuance is key to maintaining dollar rolls at a stable level. This

suggests that Fed may have to actively roll its purchases starting February to maintain the

FN 3 roll at current levels.

However, it is possible that Fed delays the decision to roll to encourage a somewhat

higher level of roll specialness. This would be consistent with the goal of pushing down

current coupon and through it the mortgage rate. The fact that the current coupon yield

has backed up to just 20bp below pre-QE levels potentially supports such a course of

action. For a similar reason, it is possible that FOMC members offer clarifications

regarding the apparently hawkish tone in December’s minutes (4 January 2013 MBS

Trade Note).

10 January 2013


Exhibit 2: MBS basis performance is only slightly better than its average level in the QE3 regime and could richen with increased dollar rolls

Avg: 1-025

29-Sep-12 30-Oct-12 29-Nov-12 30-Dec-12

0-160

0-240

1-000

1-080

1-160

1-240

7.0

7.5

8.0

8.5

9.0

Cum

hedged p

erf

$ r

oll

(tic

ks)

FN 3s vs. 5 and 10-yr swaps FN 3 rollCredit Suisse Locus Source: Credit Suisse

Exhibit 3: MBS yield spread to 4-7 year AA-rated corporates are at the cheap end of QE3 range

0 25 50 75 100 125 150 175 200 225 250 275

0

50

100

150

200

2s10s swaps curve (bp)

MB

S/C

orp

yie

ld s

pre

ad

(b

p)

2003 2004-2007 2010-2011 2012-2013 Pre-FOMC (12-Sep-12) Post-FOMC tights (26-Sep-12)

Super

fast refis

Goldilocks

economy

Muddling

economy

MBS/Corp

spread at

wide end of

post-QE3

range

Credit Suisse Locus Source: Credit Suisse

10 January 2013


Update on Sell G1/G2 4 recommendation

We continue to recommend this trade despite the recent sharp underperformance

(Exhibit 1). Negative carry (of roughly 3 ticks) of this swap has been the key reason for

underperformance as the G1 4 roll continues to trade special. However, both our

"Through-the-box" reports as well as our estimates of WTD speeds (Exhibit 4) show that

the G1 4 deliverable has been increasingly faster than G2 4s in recent months. Adverse

selection risk in G1 TBA is high due to availability of high-VA% and high-loss mitigation%

pools in the float. We expect the G1/G2 4 roll difference to compress and this trade to

outperform as the market returns to fundamentals.

Exhibit 4: Credit Suisse "Through-the-box" reports as well as our estimates of WTD speeds show that the G1 4 deliverable is increasingly faster than the G2 4 deliverable.

CS TTB

As of G1 4 G2 4

Dec-12 36 29

Nov-12 35 29

Oct-12 21 21

Sep-12 28 24

2011 origination

As of

G1 4s, 25%+ VA-

share, 150k+ AOLS

($7B ex-CMO balance)

G2 4

Dec-12 35 30

Nov-12 32 28

Oct-12 30 27

Sep-12 25 22

Source: Credit Suisse, CPR/CDR

Specified Sector - Supply/demand outlook remains robust despite a potential drop in REIT demand

Specified issuance exploded in 2012 with a more than 200% and nearly 500% increase in

gross and net issuance over the past two-year average, respectively (Exhibit 5). This was

driven by a massive pickup in HARP activity during the year. We note a significant

issuance increase in the loan balance sector as well over this period. However, a closer

look reveals that even this increase was driven by HARP activity. Based on Freddie Mac’s

loan-level data, we find that all of the increase in net issuance for sub-150K loan balance

paper in 2012 came from 80+ OLTV loans (Exhibit 6). Originators have been pooling

eligible HARP-ed loans into loan balance pools, whenever possible, instead of MHA pools

due to higher pay-ups on the former.

We estimate that specified issuance should decline by roughly $100B in 2013. This is

driven by an expected decline in HARP volumes as a result of the ongoing shrinking of the

HARP-eligible universe. For instance, we estimate that the outstanding universe of FN/FH

105+ LTV loans was roughly $250B at the beginning of 2012. At a roughly 39 CPR 12-

month voluntary speed (45 CPR overall speed), this contributed an estimated $96B

issuance of CQ/CR/U6/U9 pools in 2012. However, as a result, the outstanding balance of

this universe at the beginning of 2013 is reduced to $140B. This implies that even under a

relatively flat prepayment rate assumption, the issuance of 105+ LTV pools should drop by

roughly 50% in 2013. This analysis assumes a flat HPA. A rising HPA would only reduce

this supply further.

10 January 2013


This projected decline in the supply of specified pools overwhelms any potential decline in

REIT demand. REITs have absorbed a significant portion of the 2012 specified supply by

buying as much as $50B on a net basis. This demand is expected to decline in 2013

assuming a weaker outlook for equity raises compared to last year. However, even under

an extreme scenario of zero sponsorship from REITs, the overall supply/demand gap

widens in favor of the specified sector.

We do not expect any meaningful change in specified pool demand of other investor

constituencies. The overall positive supply/demand picture bodes well for specified pay-

ups, in our view.

A sharp selloff in rates driven by improved economic outlook is a key risk to this view. In

this scenario, investor appetite for call protection stories could decline, but net supply in

the specified sector should remain robust due to continued HARP refinancings (which are

relatively less rate sensitive).

Exhibit 5: Gross/net issuance of specified pools should drop by roughly $100B in 2013

All fixed-rate FN/FH products combined

Gross Issuance ($B) 2010 2011 2012 2013 est

Investor 14 15 18 25

Loan Balance 102 110 162 130

MHA 11 18 47 25

CQ/CR/U6/U9 7 14 96 49

Total 135 157 324 229

Net Issuance ($B) 2010 2011 2012 2013 est

Investor 9 9 7 14

Loan Balance -9 18 40 18

MHA 11 17 43 18

CQ/CR/U6/U9 7 14 93 46

Total 19 58 184 95

Source: Credit Suisse, CPRCDR

Exhibit 6: 2012 spike in loan balance supply is driven by HARP

Loan size <150K; FH loan-level data

Product OLTV Year

Gross Net

All fixed- <80 2011 46 10

rate 2012 60 9

80-105 2011 8 0

2012 15 5

30-year <80 2011 20 -3

2012 28 -4

80-105 2011 5 -1

2012 11 2

Issuance ($B)

Source: Credit Suisse, CPRCDR

10 January 2013


Revised LCR standards near-term neutral and longer-term negative for Agency MBS

Last weekend's loosening of LCR standards by the Basel committee is near-term neutral

and longer-term negative for Agency MBS. Although liquidity standards have not been the

primary driver of Agency MBS demand in the current environment, a delayed

implementation, reduced liquidity needs, an expansion of eligible assets, and the absence

of an upgrade to level 1 status all lower the eventual potential demand for MBS.

The key changes are:

1. Only 60% compliance is required by the start date of 1/1/2015, increasing by 10%

annually to full compliance by 2019.

2. High quality liquid assets (HQLA) will be expanded to include A+ to BBB- rated

corporates with 50% haircut, equities with a 50% haircut, and certain AA or higher

rated residential MBS with a 25% haircut. The aggregate of these new additions is

subject to a 15% cap as a share of HQLA. Note, the standards for Agency MBS have

not changed (GNMA still level 1, FN/FH MBS still level 2 HQLA subject to a 40% cap

as share of total HQLA).

3. Outflow standard has been reduced: 3% of certain retail insured deposits down from a

5% level previously; 20% of fully insured non-operational corporate deposits down from

40%; other non-operational deposit outflow rate down to 40% from 75%.

10 January 2013


Non-Agency MBS Market Views

Non-agency markets have remained firm with balanced flows. BWIC volumes were light

for the first few days of the year; yesterday was the first time since the start of the year

that BWIC volumes crossed the $1B mark. Investor participation has remained high and

prices have been firm. Although trading volumes have been low, Subprime cash bonds

have registered gains between 1-2 points since year-end. Prices on other sectors

remain unchanged.

From a technical standpoint the market remains well supported with balanced flows

between buyers and sellers. Dealers, having reduced their holdings by $700M during the

first few days in January, remain well positioned.

Meanwhile, one potential source of supply – the PPIPs – continue to pare down their

holdings. According to Treasury reports, the PPIPs holdings have dwindled from $14.9B at

the end of September to about $8.9B as of the end of November. If the same pace of

sales continued in December, then their total holdings could potentially have declined to

only about $6B by year-end. Additionally, there could be opportunistic sales out of Europe,

but we think the market remains well poised to absorb such sporadic supply.

While we look out for any pull-back in investor demand and large increases in dealer

positioning, we continue to favor high coupon Prime and Alt-A bonds for higher carry and

lower price volatility and Option Arms over Subprime due to better optionality and carry.

Post FOMC minutes last week, the market remains concerned that Fed’s QE program

could end much earlier than anticipated. As our economists have noted, any downward

adjustments or tapering off of the Fed’s QE program will have to be preceded by extremely

strong and consistent job growth scenarios. We acknowledge that an earlier-than-

anticipated Fed exit could be a potential negative technical for risky assets – resulting in

diminished demand for such assets. However, for non-agencies in particular, a better-

than-expected employment and economic outcome could act as a countervailing factor to

the pullback in incremental demand. In such a strong macro-economic scenario, we would

expect fundamental performance to register strong gains and offset much of the negative

technical fallout.

Exhibit 7: Dealer balance sheets have remained flat since the beginning of December

Exhibit 8: PPIPs continue to pare down their holdings

Credit Suisse estimates, in billions

-1.0

-3.4

-0.4

-2.7 -1

.7-4

.6-2

.2-2

.90

.31

.4-0

.9-1

.52

.1-2

.23

.4-0

.7 -0.3

0.8

0.1 0

.8-0

.7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

Ma

y-1

1

Jul-

11

Se

p-1

1

No

v-1

1

Jan

-12

Ma

r-1

2

Ma

y-1

2

Jul-

12

Se

p-1

2

No

v-1

2

Jan

-13

De

ale

r N

et

Bu

yin

g (

$B

)

30-Sep-12 30-Oct-12 30-Nov-12

AG GECC PPIF Master Fund 3.5$ 2.4$ 1.7$

AllianceBernstein -$ -$ -$

Blackrock PPIF, L.P. 1.9$ 1.7$ -$

Invesco Legacy Securities Master Fund, L.P.-$ -$ -$

Marathon 2.1$ 1.5$ 1.6$

Oaktree 2.1$ 1.7$ 1.7$

WAMCO 0.5$ -$ -$

Wellington Management Legacy Securities PPIF Master Fund4.8$ 3.5$ 3.8$

Total Holdings 14.9$ 10.8$ 8.9$

Source: Credit Suisse, FINRA Source: Credit Suisse, US Treasury Dividend and Interest paid report

Chandrajit Bhattacharya

+1 212 325 1546

[email protected]

Marc Firestein

+1 212 325 4379

[email protected]

Gaurav Singhania, CFA

+1 212 325 0620

[email protected]

10 January 2013


In another important development, the CFPB is set to release the QM (Qualified Mortgage)

or the ability to repay rule early morning on Thursday (January 10). It is widely expected to

extend a safe harbor to lenders for qualified mortgages and clearly delineate debt-to-

income ratios that lenders can use to defend against potential litigations. If the QM is

broadly defined to not only protects borrowers and limits the excesses of the boom years

but also to ease lenders’ concerns about litigation risk, we believe that together with an

appropriate QRM rule, this will set the stage for gradual expansion of credit availability.

In other news, the OCC, in conjunction with the Federal Reserve, announced an $8.5B

agreement with ten banks over their foreclosure practices on Monday, January 7, with

others coming to a deal on Tuesday. This settlement allots $3.3B to direct payments to

borrowers, with the remainder going to borrower relief, “such as principal modifications

and forgiveness of deficiency judgments.” In addition, this agreement officially ends the

Independent Foreclosure Review. While details remain vague, this will likely keep

modification activity robust through 2013, in our view, particularly if the credits system

used in the national foreclosure settlement is once again put into use.

Nationstar purchases MSRs from BofA – deals exclude those in settlement

Nationstar announced on Monday it purchased $215B of in MSRs from BofA. Of that,

about 53%, or $113B, is in private label securitizations, with the remainder is in agencies

and government-guaranteed mortgages. While we view Nationstar as a more efficient

servicer compared to Countrywide, we expect advancing rates to decline quite significantly

on the transferred loans. In addition, Nationstar purchased about $5.8B of prior advances

as a part of the transaction, and we think there is a significant risk that Nationstar could

potentially resort to aggressive recouping of prior advances.

While the acquisition of the MSRs is expected to close by the end of 1Q, these portfolios

will be onboarded over the course of the next three quarters; BofA will continue to

subservice the loans until Nationstar takes over servicing.

With regard to the private label portfolio, details remain vague. However, statements from

Nationstar’s management and statements from other involved parties highlight two critical

issues. First, they expect that the private label transactions will mostly be onboarded by

the end of the second quarter. Second, and perhaps more importantly, a Wednesday joint

statement from Gibbs and Bruns and BofA indicates that none of the 530 trusts in the

pending settlement are included in the transfer.

Using this guidance in conjunction with our loan level servicer mapping, we have

identified just over $100B in non-agency loans where servicing could be potentially be

transferred from BofA to Nationstar. We have provided a list of deals where Bank of

America currently owns at least 50% of the MSRs that could be included in this

transaction at the end of this section.

In our view, Nationstar is a more efficient servicer of delinquent loans than

Countrywide. We believe that Nationstar will more aggressively modify these incoming

loans. With a much smaller book of loans, Nationstar cures (a proxy for successful

modifications) a much higher proportion of their delinquent book than Countrywide every

month (Exhibit 9) in the credit-impaired sectors; in addition, they maintained a high cure

rate for Aurora-serviced loans after the transfer occurred in July 2012. Furthermore,

Nationstar outperforms Countrywide in generating cash flows from delinquent loans, as

measured by our SACR (Servicer Annual Cashflow Rate) metric (Exhibit 10).

10 January 2013


Exhibit 9: Nationstar cures more of its Subprime book every month than BofA …

Exhibit 10: … while generating more cash flow from them as well

Subprime, 90+ and FC loans curing to current per month Based on cash flow generated during Jul-11 to May-12 as % of 60+ balance, total cash flows net of balance capitalization

0%

2%

4%

6%

8%

10%

12%

14%

Jan

-10

Mar-

10

Ma

y-1

0

Jul-1

0

Se

p-1

0

Nov-1

0

Jan

-11

Mar-

11

Ma

y-1

1

Jul-1

1

Se

p-1

1

Nov-1

1

Jan

-12

Mar-

12

Ma

y-1

2

Jul-1

2

Se

p-1

2

Nov-1

2Subprim

e S

erio

us D

Q C

ure

Rate

(%) Aurora

BOA/CW

Nationstar

1.1%0.8%

5.3%

6.9%

3.3%

0.5%

3.4%

6.1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

Advances onDQ Loans

ReperformingCF

Recovery fromLiquidations

TotalCashflows

Nationstar

BOA/CW

Source: Credit Suisse, LoanPerformance Source: Credit Suisse, LoanPerformance

Potential for prior-advance recouping

Another major impact of the servicing transfer will be on advancing activity in Subprime.

On the surface, Countrywide’s Subprime stop advance rate is relatively high, though below

that of Nationstar (Exhibit 11). However, from our Subprime servicer advancing model, we

estimate that Nationstar has a much higher resistance to advancing than Countrywide; we

have seen the application of this methodology in Aurora’s Subprime book, where the stop

advance rate has climbed nearly 14 points since the transfer. We applied our advancing

model to a sample Subprime deal serviced by Countrywide, CWL 2007-12, to see the

potential impact on advancing. When we run this deal with Nationstar as the new servicer,

we find that the stop advance rate increases 14 points for both groups (Exhibit 12).

Furthermore, as a part of this MSR transfer, Nationstar purchased about $5.8B of prior

advances (although this includes Agency MBS too). Although Nationstar represented at

the time of Aurora’s MSR transfer “that it will, for a period of 24 months, defer the

recovery of certain outstanding advances that have been made to the affected RMBS

trusts if recovering those advances would cause the trust to default on its obligations to

make monthly net swap payments or monthly interest distributions to holders of

currently investment grade or higher rated bonds.” – given the dearth of IG rated

bonds in the current transaction, it leaves a lot of room for Nationstar potentially to

recoup prior advances.

To this end, we used the model-based approach to test how much of the prior advances

Nationstar could possibly recoup. In this example (CWL 2007-12), we estimate that

Nationstar could deem just under 10% of prior advances (about $89MM in prior advances)

non-recoverable.

10 January 2013


Exhibit 11: Nationstar has a high stop advance rate, Aurora’s stop advance rate jumped post-transfer

Exhibit 12: Nationstar would, in our example deal, increase stop advance rates by about 14 points

Subprime only, stop advance rate on the 60+ population stop advance rate on the 60+ population

0%

10%

20%

30%

40%

50%

60%

70%

80%

Jan

-10

Mar-

10

Ma

y-1

0

Jul-1

0

Se

p-1

0

Nov-1

0

Jan

-11

Mar-

11

Ma

y-1

1

Jul-1

1

Se

p-1

1

Nov-1

1

Jan

-12

Mar-

12

Ma

y-1

2

Jul-1

2

Se

p-1

2

Nov-1

2

Subprim

e S

top A

dvance R

ate

(%

)

Aurora

Nationstar

BOA/CW

20%

30%

40%

50%

60%

70%

80%

Nov-1

2

Fe

b-1

3

Ma

y-1

3

Au

g-1

3

Nov-1

3

Fe

b-1

4

May-1

4

Au

g-1

4

Nov-1

4

Fe

b-1

5

Ma

y-1

5

Au

g-1

5

Nov-1

5

Pro

jecte

d S

top A

dvance R

ate

(%

)

Group 1 - CWGroup 1 - NationstarGroup 2 - CWGroup 2 - Nationstar

Source: Credit Suisse, LoanPerformance Source: Credit Suisse

Basel III – Amended Liquidity Coverage Ratio (LCR) should be positive for future new issue private label RMBS, but the “devil is in the details”

On January 6, 2013 the Basel Committee on Banking Supervision approved amendments

to the minimum Liquidity Coverage Ratio (LCR) standards. The amendments expand the

list of high quality liquid assets (HQLA) that count towards the LCR and reduced the net

outflow assumptions reducing the amount of high quality liquid assets banks need to hold.

The amendment also phases in the implementation of the LCR standards starting with

60% compliance as of January 1, 2015, increasing 10% annually to reach 100% of the

LCR on January 1, 2019.

While the initial press release stating that certain residential mortgage-backed securities

rated AA or higher will be included in the list of HQLA appeared very positive for US

private label RMBS, the details released later (that the underlying mortgages need to

be full-recourse) reveal that there are a few hurdles to clear for private label RMBS

to be included in the list of approved assets, unless U.S banking regulators make

suitable adjustments when they propose the LCR through a formal rulemaking process

sometime later this year.

Expanded List of HQLA

The list of qualifying high quality assets have been expanded to include A+ to BBB- rated

corporate securities with a 50% haircut, certain residential mortgage-backed securities

rated AA or higher with a 25% haircut (a 25% haircut implies that only 75% of the market

value of assets will count towards the HQLA), and certain equities with a 50% haircut. In

addition, these new assets should be limited to 15% of the total stock of HQLA.

The LCR standards aim to ensure that banks have enough high quality liquid assets that

can be converted into cash with little or no loss in private markets to fulfill a bank’s liquidity

needs for a 30-day period of liquidity stress. Thus any asset class included in the list of

qualifying HQLAs will have a natural demand base from banks to meet their LCR targets.

From this perspective, the inclusion of “residential mortgage backed securities rated AA or

higher” should be a positive for new issue private label RMBS and will ensure a greater

level of private capital participation in the market.

10 January 2013


Conditions

However, there are certain conditions attached to the inclusion of these assets that, in our

view, could pose problems for the inclusion of US private label RMBS as a HQLA.

Below we list the conditions that residential mortgage-backed securities must satisfy to be

included.

1. not issued by, and the underlying assets have not been originated by the bank itself or

any of its affiliated entities;

2. have a long-term credit rating from a recognized ECAI (external credit assessment

institution) of AA or higher, or in the absence of a long-term rating, a short-term rating

equivalent in quality to the long-term rating;

3. traded in large, deep, and active repo or cash markets characterized by a low level of

concentration;

4. have a proven record as a reliable source of liquidity in the markets (repo or sale) even

during stressed market conditions, i.e., a maximum decline of price not exceeding 20%

or increase in haircut over a 30-day period not exceeding 20 percentage points during

a relevant period of significant liquidity stress;

5. the underlying asset pool is restricted to residential mortgages and cannot contain

structured products;

6. the underlying mortgages are “full recourse’’ loans (i.e., in the case of foreclosure

the mortgage owner remains liable for any shortfall in sales proceeds from the

property) and have a maximum loan-to-value ratio (LTV) of 80% on average at

issuance; and

7. the securitizations are subject to “risk retention” regulations which require issuers to

retain an interest in the assets they securitize.

Of note, all the above conditions will have to be satisfied for the asset to be included as

an approved HQLA. Even if future private label residential mortgage securitizations

manage to fulfill conditions 3 and 4 (about deep, active and liquid markets during stressed

market conditions), the condition about the underlying mortgages being full recourse

can be a potential show stopper unless national authorities intervene (inclusion of these

assets are at the discretion of national authorities).

For the majority of the US states, a lender can legally pursue deficiency judgments against

the borrower in case of a loss (although this is seldom enforced). Even in the 11 non-

recourse states, there are ways a lender can be granted a deficiency judgment (for

example, the lender can pursue a judicial foreclosure or a court sale). But in California

and North Carolina lenders cannot pursue such an option on purchase loans under

any circumstances. And in Arizona, a deficiency judgment is not possible for loans

backed by single-family or duplex properties occupying 2.5 acres or less. The above

conditions essentially makes loans from these states legally non-recourse. This makes

any US RMBS containing loans from these states ineligible as a HQLA.

In conclusion, while we welcome the inclusion of highly rated RMBS-backed securities

rated AA or higher as an extremely positive development for US private label RMBS, there

are a few conditions within the standards that will be extremely difficult for private label

RMBS to meet. We hope U.S banking regulators make suitable adjustments to these

conditions when they propose the LCR through their rulemaking process.

10 January 2013


Exhibit 13: Deals potentially involved in transfer

Percentage indicates share of collateral balance that BOA, CW, or First Franklin currently services

Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

SURF 2006-BC4 194 100.0%

SURF 2006-AB3 151 100.0%

SURF 2007-BC2 169 100.0%

SABR 2005-FR4 112 100.0%

SURF 2006-BC2 160 100.0%

SABR 2005-FR5 166 100.0%

SURF 2007-AB1 167 100.0%

SAMI 2005-AR4 132 100.0%

SVHE 2007-WMC1 497 100.0%

SAMI 2005-AR8 336 100.0%

SURF 2006-BC1 313 100.0%

SAMI 2006-AR2 222 100.0%

SURF 2006-BC3 233 100.0%

SAMI 2006-AR6 585 100.0%

SURF 2006-BC5 295 100.0%

VHVML 2009-1 257 100.0%

SURF 2007-BC1 301 100.0%

SURF 2006 132 100.0%

SVHE 2005-DO1 82 100.0%

SURF 2006-AB1 127 100.0%

SURF 2006-AB2 100 100.0%

SQALT 2006-1 84 100.0%

PPSI 2004-MCW1 181 100.0%

MSAC 2005-WMC3 79 100.0%

MSAC 2004-WMC3 76 100.0%

LUM 2006-1 169 100.0%

MSAC 2006-HE7 439 100.0%

MABS 2007-NCW 640 100.0%

PPSI 2005-WCW2 435 100.0%

MLMI 2004-A3 60 100.0%

MSAC 2005-WMC1 78 100.0%

MLMI 2004-FM1 23 100.0%

MSAC 2005-WMC5 137 100.0%

MLMI 2005-A3 62 100.0%

NCHET 2005-A 391 100.0%

MLMI 2005-FM1 141 100.0%

PPSI 2004-WCW2 337 100.0%

MLMI 2005-HE2 103 100.0%

MSAC 2004-NC5 60 100.0%

MLMI 2005-HE3 105 100.0%

MSAC 2005-NC2 167 100.0%

PPSI 2005-WCW3 293 100.0%

MSAC 2005-WMC2 102 100.0%

MLMI 2005-SD1 13 100.0%

MSAC 2005-WMC4 97 100.0%

MLMI 2005-WMC2 65 100.0%

MSAC 2005-WMC6 134 100.0%

MLMI 2006-FF1 611 100.0%

MSAC 2006-NC5 517 100.0%

MLMI 2006-HE1 151 100.0%

Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

NHELI 2005-FM1 121 100.0%

MLMI 2006-WMC1 232 100.0%

PPSI 2004-WCW1 185 100.0%

MSAC 2004-HE9 155 100.0%

PPSI 2005-WCW1 436 100.0%

MSAC 2004-NC2 44 100.0%

MSAC 2004-NC3 86 100.0%

MLMI 2005-NC1 86 100.0%

HVMLT 2006-11 149 100.0%

GSCC 2006-1 123 100.0%

FFML 2007-FF2 979 100.0%

CWALT 2005-55CW 92 100.0%

HVMLT 2005-1 230 100.0%

CWHL 2005-19 146 100.0%

IXIS 2005-HE1 34 100.0%

CWHL 2005-4 158 100.0%

GSAA 2005-10 85 100.0%

CWL 2004-BC1 67 100.0%

HEMT 2006-1 0 100.0%

CWL 2007-BC3 287 100.0%

HVMLT 2005-16 403 100.0%

FFMER 2007-1 885 100.0%

HVMLT 2006-9 1,121 100.0%

FFMER 2007-2 833 100.0%

FFML 2006-FFH1 107 100.0%

FFMER 2007-3 810 100.0%

GSAA 2004-9 8 100.0%

FFMER 2007-4 679 100.0%

GSAMP 2004-AR1 140 100.0%

FFMER 2007-5 388 100.0%

GSR 2004-7 111 100.0%

FFMER 2007-H1 353 100.0%

HVMLT 2004-2 45 100.0%

FFML 2004-FF10 145 100.0%

HVMLT 2005-12 325 100.0%

FFML 2004-FF11 118 100.0%

HVMLT 2005-3 354 100.0%

FFML 2004-FF4 55 100.0%

HVMLT 2006-4 609 100.0%

FFML 2004-FF6 85 100.0%

IMSA 2007-3 397 100.0%

FFML 2004-FF8 91 100.0%

JPMAC 2006-CW1 236 100.0%

FFML 2005-FF11 156 100.0%

FFML 2007-FF1 755 100.0%

FFML 2005-FF12 423 100.0%

GSAA 2004-10 89 100.0%

FFML 2005-FF2 191 100.0%

GSAA 2004-CW1 34 100.0%

FFML 2005-FF4 186 100.0%

Source: Credit Suisse, Loan Performance

10 January 2013


Exhibit 14: Deals potentially involved in transfer (cont.)


Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

GSAA 2005-2 14 100.0%

FFML 2005-FF7 150 100.0%

GSAMP 2005-AHL 86 100.0%

FFML 2005-FF8 254 100.0%

GSCC 2006-2 123 100.0%

FFML 2005-FFH1 77 100.0%

GSR 2006-7F 210 100.0%

FFML 2005-FFH3 216 100.0%

HVMLT 2004-11 249 100.0%

FFML 2005-FFH4 202 100.0%

HVMLT 2004-9 163 100.0%

FFML 2006-FF1 215 100.0%

HVMLT 2005-10 593 100.0%

FFML 2006-FF13 640 100.0%

HVMLT 2005-13 222 100.0%

FFML 2006-FF16 395 100.0%

HVMLT 2005-2 339 100.0%

FFML 2006-FF18 890 100.0%

HVMLT 2005-8 589 100.0%

FFML 2006-FF3 214 100.0%

HVMLT 2006-3 134 100.0%

FFML 2006-FF4 341 100.0%

HVMLT 2006-5 665 100.0%

FFML 2006-FF5 297 100.0%

IMSA 2006-5 769 100.0%

FFML 2006-FF6 101 100.0%

IXIS 2004-HE4 49 100.0%

FFML 2006-FF7 291 100.0%

IXIS 2005-HE2 65 100.0%

FFML 2006-FF8 229 100.0%

JPMAC 2006-CW2 320 100.0%

FFML 2006-FF9 468 100.0%

GSAMP 2004-AR2 79 100.0%

BOAMS 2004-4 153 100.0%

BOAMS 2005-E 161 100.0%

BOAMS 2004-K 132 100.0%

ABFC 2004-FF1 39 100.0%

BOAMS 2008-A 317 100.0%

ABSHE 2005-HE3 76 100.0%

BOAMS 2004-C 119 100.0%

ABSHE 2005-HE5 118 100.0%

BOAMS 2005-6 91 100.0%

ACE 2006-CW1 267 100.0%

BOAMS 2006-1 104 100.0%

ACE 2006-FM2 292 100.0%

BOAMS 2004-10 77 100.0%

ACE 2006-NC2 264 100.0%

BOAMS 2004-8 67 100.0%

ACE 2006-NC3 558 100.0%

BOAMS 2004-G 186 100.0%

Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

ACE 2007-WM1 301 100.0%

BOAMS 2005-11 122 100.0%

BAFC 2005-B 223 100.0%

BOAMS 2005-A 145 100.0%

BAFC 2005-C 121 100.0%

BOAMS 2005-I 255 100.0%

BAFC 2005-F 292 100.0%

BOAMS 2007-1 332 100.0%

BAFC 2005-G 87 100.0%

CMLTI 2004-NCM2 114 100.0%

BAFC 2005-H 340 100.0%

BOAMS 2004-2 69 100.0%

BAFC 2006-B 170 100.0%

BOAMS 2004-6 105 100.0%

BAFC 2006-C 159 100.0%

BOAMS 2004-A 69 100.0%

BAFC 2006-E 205 100.0%

BOAMS 2004-E 272 100.0%

BAFC 2007-5 309 100.0%

BOAMS 2004-I 95 100.0%

BAFC 2007-E 487 100.0%

BOAMS 2005-1 73 100.0%

BALTA 2004-13 62 100.0%

BOAMS 2005-3 161 100.0%

BALTA 2005-1 128 100.0%

BOAMS 2005-8 76 100.0%

BCAP 2006-AA1 88 100.0%

BOAMS 2005-C 92 100.0%

BCAP 2007-AA5 117 100.0%

BOAMS 2005-G 245 100.0%

BOAA 2004-1 93 100.0%

BOAMS 2005-K 168 100.0%

BOAA 2004-10 93 100.0%

BOAMS 2006-A 93 100.0%

BOAA 2004-11 85 100.0%

BOAMS 2007-3 253 100.0%

BOAA 2004-12 107 100.0%

CMLTI 2004-HYB1 32 100.0%

BOAA 2004-2 80 100.0%

CMLTI 2007-AHL3 483 100.0%

BOAA 2004-3 69 100.0%

BOAMS 2004-11 118 100.0%

BOAA 2004-4 117 100.0%

BOAMS 2004-3 123 100.0%

BOAA 2004-5 151 100.0%

BOAMS 2004-5 115 100.0%

BOAA 2004-6 139 100.0%

BOAMS 2004-7 178 100.0%

BOAA 2004-7 114 100.0%

BOAMS 2004-9 66 100.0%


10 January 2013




Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

BOAA 2004-8 69 100.0%

BOAMS 2004-B 109 100.0%

BOAA 2004-9 75 100.0%

BOAMS 2004-D 173 100.0%

BOAA 2005-1 101 100.0%

BOAMS 2004-F 313 100.0%

BOAA 2005-10 223 100.0%

BOAMS 2004-H 89 100.0%

BOAA 2005-11 206 100.0%

BOAMS 2004-J 124 100.0%

BOAA 2005-12 257 100.0%

BOAMS 2004-L 183 100.0%

BOAA 2005-2 94 100.0%

BOAMS 2005-10 185 100.0%

BOAA 2005-3 87 100.0%

BOAMS 2005-2 78 100.0%

BOAA 2005-4 141 100.0%

BOAMS 2005-4 76 100.0%

BOAA 2005-5 85 100.0%

BOAMS 2005-7 76 100.0%

BOAA 2005-6 263 100.0%

BOAMS 2005-9 132 100.0%

BOAA 2005-7 159 100.0%

BOAMS 2005-B 83 100.0%

BOAA 2005-8 164 100.0%

BOAMS 2005-D 148 100.0%

BOAA 2005-9 197 100.0%

BOAMS 2005-F 233 100.0%

BOAA 2006-1 152 100.0%

BOAMS 2005-H 234 100.0%

BOAA 2006-2 183 100.0%

BOAMS 2005-J 157 100.0%

BOAA 2006-3 144 100.0%

BOAMS 2005-L 142 100.0%

BOAA 2006-4 187 100.0%

BOAMS 2006-2 118 100.0%

BOAA 2006-5 194 100.0%

BOAMS 2006-B 223 100.0%

BOAA 2006-6 122 100.0%

BOAMS 2007-2 191 100.0%

BOAA 2006-7 300 100.0%

BOAMS 2007-4 143 100.0%

BOAA 2006-8 226 100.0%

BVMBS 2005-2 62 100.0%

BOAA 2006-9 163 100.0%

CMLTI 2004-NCM1 122 100.0%

BOAA 2007-1 179 100.0%

CMLTI 2007-AHL2 492 100.0%

BOAA 2007-2 213 100.0%

CMLTI 2007-AMC1 670 100.0%

Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

BOAMS 2004-1 72 100.0%

BOAMS 2006-3 89 100.0%

SAMI 2006-AR7 1,134 99.6%

MARM 2007-2 434 99.2%

BSARM 2006-2 418 98.5%

GSAMP 2005-HE3 138 98.5%

SAMI 2006-AR3 687 98.4%

MSAC 2006-HE6 481 97.6%

BAFC 2007-B 196 97.4%

GSR 2005-3F 106 97.0%

BSARM 2004-3 280 96.9%

GSR 2004-11 165 95.7%

DBALT 2006-OA1 291 93.4%

MANA 2007-OAR5 338 92.8%

ARMT 2005-6A 47 92.7%

HVMLT 2005-7 138 92.7%

HVMLT 2004-8 163 92.6%

BAFC 2004-C 67 89.2%

GSR 2006-6F 166 87.6%

BAFC 2004-B 126 87.1%

BAFC 2005-A 160 86.7%

GSR 2004-5 62 85.9%

MLMI 2006-A1 210 85.5%

DBALT 2007-OA4 1,145 85.3%

GSR 2006-2F 300 84.0%

GSR 2006-1F 569 81.8%

GSR 2004-15F 99 81.1%

GSR 2005-9F 300 80.9%

GSAA 2005-15 261 80.7%

MLMI 2005-A6 260 80.7%

BSARM 2004-6 76 80.7%

IMM 2004-11 154 80.1%

IMSA 2007-2 737 79.8%

TMTS 2004-5HE 24 79.7%

BSARM 2005-7 204 79.6%

GSAA 2006-4 339 79.4%

GSR 2006-3F 258 79.3%

GSR 2004-9 130 77.6%

BSARM 2004-2 81 77.6%

DBALT 2006-AR6 624 76.7%

GSAA 2007-6 331 76.5%

CSMC 2007-2 346 76.4%

HVMLT 2005-14 286 76.2%

BSARM 2005-3 182 76.0%

GSAMP 2004-HE2 106 74.7%

BAFC 2007-7 302 73.9%

JPMMT 2006-S3 312 73.5%

DBALT 2007-AR3 857 73.3%

MARM 2005-8 239 73.1%

GSR 2005-1F 159 73.0% Source: Credit Suisse, Loan Performance

10 January 2013




Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

ACE 2005-HE4 190 72.7%

GSAA 2006-3 304 71.6%

BSARM 2004-1 145 71.3%

BAFC 2006-D 643 70.9%

JPALT 2006-A4 334 70.5%

BALTA 2007-1 279 70.4%

DBALT 2007-OA3 747 69.8%

GSR 2006-9F 440 68.9%

BSARM 2004-8 131 68.6%

SEMT 2006-1 242 68.6%

BCAP 2007-AA4 331 68.3%

MSAC 2007-HE4 265 68.2%

BAFC 2007-A 294 67.8%

BAFC 2004-D 80 67.4%

MLMI 2005-A7 168 67.4%

BAFC 2005-E 277 67.1%

GSR 2005-6F 260 67.0%

JPALT 2006-S3 439 66.6%

MANA 2007-A1 291 65.9%

MARM 2004-2 13 65.9%

BSAAT 2007-1 722 65.4%

DBALT 2006-AR4 317 64.9%

MSAC 2004-HE1 116 64.5%

HVMLT 2004-5 115 64.3%

SAMI 2005-AR2 153 64.0%

MLMI 2005-A4 127 63.7%

GSAA 2006-11 481 63.2%

CMLTI 2006-AR5 325 61.6%

HVMLT 2005-4 137 61.5%

BSARM 2007-2 448 61.4%

BAFC 2006-A 398 61.4%

GSR 2004-10F 166 60.0%

SAMI 2004-AR5 108 59.3%

GSAA 2006-14 416 58.8%

GSAA 2006-12 336 58.3%

GSAA 2006-9 441 58.2%

BSARM 2004-10 368 58.2%

BAFC 2007-D 414 58.0%

GSAA 2006-1 259 57.9%

GSAA 2007-5 632 57.8%

GSAA 2006-16 451 57.8%

HALO 2007-AR2 187 57.7%

BVMBS 2005-1 101 57.6%

ARMT 2005-8 458 57.5%

BSARM 2004-7 47 57.3%

GSAA 2004-8 47 56.9%

BALTA 2006-7 405 56.4%

MANA 2007-AF1 314 56.3%

MARM 2007-3 996 56.3%

GSAA 2007-1 388 56.0%

Deal Name

Collateral

Balance ($MM)

BOA/CW/FF

Serviced %

BSARM 2006-4 520 55.9%

GSAA 2007-3 462 55.6%

DBALT 2005-AR2 198 55.5%

SAMI 2004-AR6 60 55.4%

GSR 2005-8F 317 55.1%

CMLTI 2005-8 348 54.4%

MARM 2004-1 26 54.2%

BAFC 2006-J 452 54.2%

BSARM 2005-1 159 54.1%

MSAC 2007-NC2 388 53.9%

SAMI 2007-AR3 782 53.9%

GSR 2006-10F 147 53.7%

BCAP 2007-AA1 529 53.4%

GSAA 2005-14 246 53.4%

BCAP 2007-AA3 536 53.3%

DBALT 2005-4 112 53.1%

MSAC 2004-HE6 126 52.0%

HASC 2006-HE2 460 51.8%

ZUNI 2006-OA1 341 51.5%

GSAA 2005-11 285 51.3%

SAMI 2006-AR8 695 51.3%

BAFC 2006-3 314 51.1%

MSAC 2006-HE8 495 50.5%

BALTA 2006-6 553 50.5%

BAFC 2007-8 239 50.5%

DMSI 2004-2 37 50.1%

MARM 2006-OA2 789 50.0%

ARMT 2005-11 319 50.0%

BAFC 2006-I 486 50.0%


10 January 2013


CMBS Market activity and relative value

The CMBS market has enjoyed a strong rally since the start of the New Year, not

only continuing the December spread tightening move but also with the trend

accelerating. Perhaps the initial impetus for the latest move was the agreement to avert

the fiscal cliff, which sent equities up and credit tighter, but the commercial mortgage

market has continued to do well in the time since, even while the move in other sectors

has stalled.

We are not surprised by the direction of the move over the first few trading days of

2013, but the speed and the magnitude exceeded our expectations. Over the past,

few years, a January rally has become commonplace. Additionally, as we laid out in our

2013 Year Ahead Outlook, we entered the year with a very positive outlook for the sector.

While the rally has been impressive, it has not been evenly distributed over the

various sectors, and bonds with cuspy risk profiles have been the best performers.

For example, in the legacy sector, AJs are between 4 and 8 points higher since the end of

December, while legacy AMs have rallied between 2 and 4 points.

Last cash flow legacy super-seniors, however, have been far less impressive and, outside

of GG10s and a few other bonds, have only tightened 5 bp or so. The benchmark GG10

A4s are in about 15 bp year-to-date, but most of that move occurred early on the first

trading day with little movement after that.

We see a similar story play out in recently issued deals. This is indicated by secondary

trading as well as the first conduit deal of the year, which priced this week (the $1.4 billion

MSBAM 2013-C7 deal). While the new issue super-seniors are marginally tighter versus a

few weeks ago (with the new deal pricing at S+72 bp), the mezzanine part of the curve is

up significantly. The MSBAM 2013-C7 triple-B minus bonds came at S+325 bp compared

to new issue deals pricing at S+475 to S+500 bp in late November and early December –

up more than 10 points in price. Other recently issued BBB- bonds traded in the S+low-

300s bp today. There has been a similarly large move for the below-investment grade new

issues as well.

The CMBS rally, as well as the outperformance compared to other sectors, has left

many investors wondering if the sector has gotten rich or gone too far, too fast. We

see reasons for caution, but there are still many positives as well.

There is little doubt that the rally and outperformance versus other securitized products,

corporate credit, and equities (which rallied January 2 and have since flat lined) has made

the sector’s risk/reward profile relatively less compelling than just a few weeks ago. In

addition, we believe there are other potential risks to the rally. The most obvious of these

is the looming debate over the debt ceiling and the potential for further legislative battles.

The CMBS market is also about to see a heavy slate of new deals. While the first deal was

in high demand, and was reportedly well oversubscribed, the market’s capacity, especially

down the credit stack, could potentially be tested as we expect the highest quarterly

issuance in five years.

We also are going to monitor the supply and demand dynamics carefully. Trading volume

has been relatively high since the start of the year. TRACE data indicates that over the

past five days, the average daily volume has been $1.8 billion, the highest since the

middle of October 2012. We show daily volume and the five-day moving average in

Exhibit 17.

Roger Lehman

+1 212 325 2123

[email protected]

Serif Ustun, CFA

+1 212 538 4582

[email protected]

Sylvain Jousseaume

+1 212 325 1356

[email protected]

Tee Chew

+1 212 325 8703

[email protected]

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10 January 2013


Exhibit 17: CMBS volume has been the highest in several months

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1/9

/13

12/2

4/1

2

12/1

0/1

2

11/2

6/1

2

11/8

/12

10/2

3/1

2

10/9

/12

9/2

4/1

2

9/1

0/1

2

8/2

4/1

2

8/1

0/1

2

7/2

7/1

2

Daily Volume 5-Day Average Trading Volume$million

Source: TRACE, Credit Suisse

While trading volume has been high, the flows have, so far, been two-way and relatively

balanced between buyers and sellers. Since the start of the year, investors have added

approximately $177 million (face) in investment grade risk while shedding $313 million

(face) of bonds below-investment grade, altogether relatively small moves in light of the

total trading volume.

A variety of investor types have been adding as well, including levered investors, longer-

term oriented players and buyers that are returning to the CMBS market after being on the

sidelines for several years. As we have previously discussed, we believe that the past year

has also brought an important shift in the investor base as the sector has attracted more

longer-term oriented participants. We see this move in demand to “stronger hands” as a

positive, as it has created an environment in which we believe spreads are less volatile

and less susceptible to a shift in the macro picture compared to just a year ago.

It is also worth noting that much of the trading volume has been concentrated in

below-investment grade bonds and specifically in the AJ sector. In fact, we have seen

nearly $800 million of conduit AJs out for the bid in the past week (about half of the bid

list volume).

At present, it appears that there is still strong investor demand and lots of cash that needs

to be deployed. However, if the selling volume remains consistently high, a macro event

takes place, or demand slows, we could see prices stall or even pull back.

That said, barring a large macro event or a large change in our base case US economic

outlook (or both), we would expect that any price decline would be relatively modest, as

the environment remains supportive of gradually improving real estate fundamentals, in

our view. Furthermore, we believe demand will only increase on any spread widening

serving to limit the downside.

As we laid out in our Outlook piece, the market continues to gain comfort in taking

risk in CMBS as the duration of legacy paper continues to shorten and as many

problem loans are finding a resolution through modification or liquidation. As more

clarity on losses on these problem loans is achieved, there should be less weight placed

on negative tail risk scenarios across deals, cohorts, and the legacy sector as whole. This

is a positive dynamic for spreads at the top part of the capital stack and, perhaps, for some

of the more cuspy bonds.

Despite the recent strong performance, we are not yet ready to suggest scaling

back exposure in CMBS. That said, we believe that a pause in the spread tightening

trend is a distinct possibility. Even over the past few days, as trading volume have

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10 January 2013


remained robust, the rally has seemed to lose steam. While we see an increased

probability of a moderate and temporary pullback, we have offsetting concerns about the

ability to replace good bonds that are sold into the market today, as we believe many of

these are winding up in more buy-and-hold oriented accounts.

Instead, we would suggest that investors continue to use the recent rally to pare

back on weaker positions. We continue to believe that during the coming quarters, as

greater clarity on loan losses is realized, the sector will do well, but some individual names

could fare poorly and deals will start to experience a greater dispersion of realized losses

and changes in credit enhancement. The recent rally has made less of a distinction

between good names and poor names and thus presents an opportune time to reduce

exposure to the latter.

While we do not believe a large scale

selloff is imminent, we continue to look

for signs that the risk of one increases.

We are keeping our eye on other markets

(equity and credit). This would include the

VIX index, which has declined sharply

since the fiscal cliff was averted.

We will also continue to watch the volume

of bid lists and selling in the sector and

where these bonds are going. We believe

dealers entered the year with reasonably

light positions, but if the Street’s balance

sheets continue to increase in the face of

heavy selling, that would be an early

warning sign of possible spread widening.

Lastly, in the face of heavy new issue

calendar, demand for the forthcoming

deals bears monitoring.

In the meantime our intra-sector relative value view remains unchanged. We remain

concerned about the high dollar price legacy super-seniors given what we see as

increased cash flow volatility. As a result, there remains better value in AMs and select,

mid- and upper-tier AJs, in our view. We have also recommended, on a select basis,

pushing even further down the credit spectrum (below original triple-As) on the better

legacy deals.

We underestimated the performance of new issue triple-Bs and the spread tightening

exceed our expectations. In light of the heavy new issue calendar set to come, and the

tighter spreads, we would not chase these bonds. Instead we prefer the middle of the new

issue credit curve (single-As and double-As). These have also tightened but have room to

move further, in our view.

CMBS loans in the news

Continental Towers listed for sale; potential large loss

CWCI 2006-C1

Real Estate Alert reported that CWCapital, the special servicer of the loan that was

secured by the Continental Towers, is marketing the property to value-added investors.

The building backed a $115 million loan that was part of CWCI 2006-C1 comprising 5.9%

of the deal. The property is now REO. Continental Towers is a three-building office

complex located in Rolling Meadows, IL.

Exhibit 18: Sharp decline in VIX index

10

15

20

25

30

35

40

45

50

Jul-

11

Oct-

11

Jan

-12

Ap

r-12

Jul-

12

Oct-

12

Jan

-13

Source: the BLOOMBERG PROFESSIONAL™ service

10 January 2013


The loan was transferred to the special servicer three years ago due to low occupancy. Its

largest tenant, Ameriquest Mortgage, occupying about one-quarter of the leasable space,

had vacated a year after the loan was securitized. The borrower subsequently agreed to a

deed-in-lieu of foreclosure and the special servicer took over the property in mid-2010.

Occupancy, according to the most recent special servicer comments, is currently at 60%.

When the loan was securitized, the property was appraised at $147.0 million (as of

September 2006). The most recent appraisal, dated January 2012, came in at $42.0

million, a 71% reduction. If the loan liquidates at this valuation, it would result in a loss

severity of close to 65%. This estimate excludes $10.0 million of ASERs, which is still

accumulating monthly, and $12.8 million of servicing advances, which could drive the

potential loss severity even higher.

Lease signed at One Liberty Plaza

CGCMT 2008-C7, GCCFC 2007-GG11

Brookfield Office Properties announced that a lease was signed at One Liberty Plaza, an

office building located in lower Manhattan. According to the announcement, the new

tenant, Transatlantic Reinsurance Company, signed a 15-year lease to occupy 134k

square feet (or about 6% of the building’s space) spanning across three floors.

The property backs a loan split, pari-passu, into a $344.5 million note securitized in

GCCFC 2007-GG11 (14.7% of the deal) and a $246.1 million note in CGCMT 2008-C7

(16.2% of the deal). In addition, another $246.1 million portion, also pari-passu, did not

appear to be securitized.

The loan switched from interest-only payments to amortizing payments in August 2011

and had been performing thus far, even though it was put on watch recently due to low

DSCR. The most recent reported financials as of September 2012 reported a 99%

occupancy and a debt service coverage ratio of 1.1x (on a net cash flow basis). The loan

matures in August 2017.

Large lease renewed at 2550 M Street

LBUBS 2007-C2

The single tenant at 2500 M Street, Patton Boggs, has renewed its lease for another 20

years according to the building owner, Tishman Speyer. The property is a 183k square

foot office building located in Washington DC and is part of a pool of collateral backing the

Tishman Speyer DC Portfolio II loan securitized in LBUBS 2007-C2. The loan currently

has a balance of $400 million and is the largest loan in the deal (13.9% of the balance).

The 2550 M Street property is the fourth largest property in the portfolio, representing

8.7% of the total leasable space.

This is welcome news for the loan, as the lease now stretches well beyond the loan’s

maturity date of January 2017. The interest-only loan has been performing; most recent

occupancy came in at 85% and the loan reported a DSCR of 1.7x (on a net cash flow

basis) for the first nine months of 2012.

REIT purchased grocery-anchored retail properties

BACM 2005-1, MSC 2005-T19, WBCMT 2006-C25

Regency Center Corp., a Florida REIT, recently purchased several retail properties

anchored by grocery stores. Three of the purchases serve as collateral for loans in CMBS.

The largest of these is the $44.5 million Phillips Place loan (1.8% of WBCMT 2006-C25).

The retail property backing the loan is located in Charlotte, NC and had an appraisal of

$56.5 million as of February 2006. The recent purchase price was $55.4 million (of which

10 January 2013


Regency paid 50%) came fairly close to the securitization appraisal. This values the

property at about $428 per square foot. According to the most recently reported financials,

for a nine-month period ending in September 2012, the property Is 98% occupied.

The Uptown District Shopping Center is the next largest loan at $28.0 million (or 2.2% of

BACM 2005-1). The collateral is located in San Diego, CA, and was appraised in January

2005 for $45.3 million. The purchase price was more than 1.5x that valuation at $81.1

million, or $569 per square foot. The current implied loan-to-value ratio is now 34.5%. The

property is currently 98% occupied, according to the most recent financials reported for the

six-month period ending in June 2012.

The smallest of the three loans is the $16.7 million Sandy Springs Plaza Retail Center,

back by the property located in Atlanta, GA. The $35.3 million purchase price (or $286 per

square foot) was also higher than $23.8 million appraisal dated April 2005 and gives an

implied current LTV of 47.3%. The property is similarly well leased at 94%, according to

the most recent financials reported for the six-month period ending in June 2012.

The updated NAIC designations

In 2010, the National Association of Insurance Commissioners (NAIC) changed the way

that risk-based capital was calculated for the CMBS holdings of insurance companies as

they moved from a ratings-based approach to a modeled loss approach.

Since implementing the new method, the securities’ modeled loss estimates are updated

and released at the end of each year. Any changes in the loss estimates could affect the

risk-based capital (RBC) charge for individual securities for these entities and therefore

alter the relative value and, potentially, the demand. Although the impact of the changes

from year to year are most acutely felt on insurance companies, since they are

cumulatively a large investor in the CMBS sector, the annual release can have impact on

demand and value on an individual security basis.

In this write-up we briefly review the methodology that is used by the NAIC and then take a

look at both the distribution of results and, perhaps more importantly, the changes that

resulted from the 2012 modeling effort versus the prior year. At the very end of the report

we go in slightly more detail on the methodology.

Our analysis shows that the year-over-year changes are relatively benign and in fact are a

slight positive for the CMBS market. In fact a greater number of bonds went from having a

modeled loss to a zero loss (lowering the risk-based capital requirements) than the other

way around. This is good news, as we had expected changes to the inputs and scenario

weighting introduced at the end of last year to be slightly negative in the aggregate.

A brief review of the modeling process

In 2010, the NAIC changed its method for determining RBC charges for CMBS. In doing

so it moved away from relying on ratings from rating agencies (nationally recognized

statistical rating organizations) to a process relying on modeled expected recovery values

and comparing the results with book or adjusted carrying value (BACV). Blackrock

Solutions is the vendor responsible for the modeling of the CMBS bonds. The change

mimicked the move NAIC made a year earlier with RMBS.

Under the calculation, each bond’s expected loss is estimated using a model, under five

different economic scenarios. A weighted-average expected loss is calculated based on

the probability weightings for each scenario and assuming each bond is held to maturity.

The NAIC determines the scenarios and the weights given to each. The expected loss is

then translated into an expected recovery value (what the NAIC calls the Intrinsic Price).

10 January 2013


There are six NAIC designations (NAIC 1 to NAIC 6) and each carries progressively higher

RBC charges (with NAIC 1 being the lowest)1. A break point carrying price is then

calculated for each of the NAIC designations. This is based on the modeled expected

losses and the specific NAIC RBC charge at each designation.

Finally, the price at which the insurance company carries the security is then compared

against the break point price to determine the NAIC designation. If the security is modeled

to take a loss, the higher the carrying value, the greater the RBC charge.

Zero loss bonds are all NAIC 1

Importantly, however, if the security has no expected loss under any of the selected

modeling scenarios, that bond is assigned an NAIC 1 designation, regardless of what price

it is held at, and receives the lowest capital charge. The NAIC refers to these as “zero

loss” bonds.

Because of this, there is significant focus on the modeled results for bonds that have a

modeled loss versus zero loss bonds.

Changes to modeling inputs this year

The NAIC proposed two changes to the model’s inputs for 2012, which were both adopted.

One change was to the macroeconomic assumptions associated with the various

scenarios, while the second adjustment changed the weights assigned to each scenario.

As we show in Exhibit 19, the more conservative scenarios were made less severe in

terms of the assumed change in real estate prices (and the timing). However, a greater

weight was also placed on these scenarios. The changes are discussed in more detail in

our CMBS Market Watch Weekly dated October 11, 2012.

Exhibit 19: Comparison between 2012, 2011, and 2010 scenarios

CMBS Scenarios

Probability weightings (%) Timing of lowest trough Peak to trough price change (%)

2012 2011/10 Change 2012 2011 2010 2012 2011 2010

Aggressive 10 20 -10 Q1 2010 Q1 2010 Q1 2010 -32 -32 -32

Baseline 55 55 0 Q1 2010 Q1 2010 Q2 2011 -32 -32 -32

Conservative 25 20 5 Q1 2010 Q3 2013 Q4 2012 -32 -39 -37

Most conservative 10 5 5 Q1 2014 Q4 2014 Q1 2014 -34 -49 -49

Note: We only show four scenarios here as the fifth "Most Aggressive" scenario has a 0% weighting Source: NAIC, Credit Suisse

2012’s results show more bonds modeled to a zero loss

In 2012, just over 3,700 different securities from conduit deals were modeled. Of these,

68% were modeled to a zero loss versus only 64% of the bonds modeled in 2011. Not

surprisingly, the higher-rated bonds and those from the more seasoned vintages were

more likely to result in a zero loss result under the model. We show the percentage of

each category that is assumed to have a zero loss based on the original rating and vintage

in Exhibit 20.

1 The RBC charges at each designation are different for life insurance companies and property & casualty insurance companies.

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10 January 2013


Exhibit 20: Distribution of bonds modeled with zero loss

Original rating Pre-2005 2005 2006 2007 2008 Post-2008 Total Count

Super Senior 100% 100% 100% 100% 100% 100%* 100% 1054

AM 0% 97% 89% 61% 88% 79% 142

AJ 100% 81% 24% 3% 33% 41% 80

AA 100% 64% 8% 4% 23% 100% 58% 358

A 93% 31% 3% 0% 0% 100% 50% 338

BBB 82% 22% 3% 2% 0% 100% 53% 346

Below I-grade 61% 60% 55% 0% 0% 100% 62% 205

Total 86% 64% 46% 44% 57% 100% 68%

Count 1090 450 321 276 45 341 2523

* We group all AAA bonds together for newer vintage for this. Source: Credit Suisse, NAIC

In the conduit universe, 100% of the legacy super-senior bonds, as well as all of the post-

2008 original triple-As, have zero loss under the modeled scenarios. As we move further

down the capital stack, more of the securities are met with losses. And this generally

increases with vintage as well. For example, within the 2007 vintage, 61% of the AMs are

modeled with zero loss but only 3% of the AJs are so.

Interestingly the percentage of 2008 vintage bonds with zero loss is higher than for those

of the 2007 vintage, but this is small sample size.

Below triple-As, the numbers are somewhat skewed by the seasoned legacy vintages

(pre-2005) and the newer vintages (post-2008). Stripping these out, we see the number of

bonds in the 2005 to 2008 vintages modeled with zero loss decline as we go down the

rating curve and represent a small portion of the universe.

The change from 2011; few bonds are now modeled at a loss

Of the 3,705 conduit cusips that were modeled at the end of 2012, 3,432 were also

modeled in the prior year as well. We also took a look at the bonds that were modeled in

both years to see how the treatment changed. The vast majority of these securities

modeled in both years (93%) experienced no change in the loss/zero loss flag (what we

call switchers).

Most of the bonds where a switch took place showed improved performance and are now

being modeled with zero loss. There are now an additional 205 such bonds, accounting for

6% of the total securities in the data set (and 85% of the switchers) now assumed not to

take a loss under the NAIC framework.

Only 37 securities switched the other way where the model estimates them to take a loss

(versus zero loss a year ago). We summarize the switches in Exhibit 21 broken down by

original rating class.

It is interesting to note that more bonds switched to zero loss (than shifted to a loss)

despite a greater weight being placed on the more conservative scenarios.

Exhibit 21: Bonds switching loss status from 2011 to 2012 by original rating

Super Snr AM AJ AA A BBB Below I-Grade Total

Now has a loss 0 1 2 0 4 14 16 37

Now zero loss 8 33 27 41 35 38 23 205

Source: Credit Suisse, NAIC

Most of the bonds that are now being modeled as taking a loss (which were designated as

zero loss last year) had lower original ratings (triple-B and below). Only three originally

rated triple-As (two AJs and one AM) suffered this shift.

10 January 2013


Conversely, there were numerous original triple-As from legacy conduit deals that are now

assumed under the model to have zero loss and consequently carry a NAIC 1 designation

after this year’s exercise. All of these came from the 2006 to 2008 vintages.

We also looked at how the size of the modeled loss changed for bonds over the past year.

This analysis was restricted to the 1,131 bonds that were run in both years and projected

to have a loss at the end of 2011 and 2012. About 60% of these carried higher modeled

loss severities in 2012 than a year ago. The percentage of bonds with rising modeled

losses was reasonably consistent among vintages, although the proportion in the 2007

vintage was a little lower. The 2008 vintage, however, bucked the trend with less rising

modeled losses. The number of bonds with exactly the same losses are understandably

far and few in number.

We also noticed reasonable consistency by original rating. About 53% of the original triple-

As forecasted to take a loss had the modeled loss rise.

Not all new issuance modeled to zero loss

On a final note, one of the factors that surprised us was three tranches from two deals

issued in the past year, where the modeled results show the bonds take a loss. These

were the bottom tranches of single-borrower deals. These tranches were all rated

investment grade (and one single-A minus).

We believe that this is something to keep in mind, as we expect issuance of single-

borrower deals to remain high in 2013.

Appendix – more details on the NAIC ratings

In this section, we provide more detailed explanation on the calculation of the NAIC

designation. The example we use relies on an example provided by the NAIC when it

made the request for proposal for the CMBS model back in June 2010. The example uses

the RBC charges for life insurance companies. The RBC charges will be different for

property & casualty and health insurers, but the process is the same.

1. The Discounted Expected Loss and intrinsic price

The first step in the process is to determine what the NAIC calls the Discounted Expected

Loss. This is defined as the discounted model expected losses weighted across the

various scenarios. They use the coupon rate of the security as the discount rate.

From this, an Intrinsic Price is calculated by subtracting the Discounted Expected Loss

from par.

So, using the NAIC’s example, if the modeled Discounted Expected Loss is 24 points, the

Intrinsic Price is 76 (100-24=76).

2. Breakpoint Expected Losses and Breakpoint Carrying Price

At each NAIC designation a Breakpoint Carrying Price will be calculated for each bond.

This is a function of the Discounted Expected Loss and the RBC charges incurred at each

NAIC designation.

We show the RBC charges, and other parts of the calculation, in Exhibit 22.

10 January 2013


Exhibit 22: RBC charges and other parts of the calculation

Discounted Loss $24

Intrinsic Value $76

NAIC designation RBC charge Breakpoint Expected losses * Breakpoint Carrying Price

1 0.4% 0.85% 76.65

2 1.3% 2.95% 78.31

3 4.6% 7.30% 81.98

4 10.0% 16.50% 91.02

5 23.0% 26.50% 103.40

6 30.0%

* This is the midpoint between the RBC charge for this NAIC designation and the next one. For example, 7.3% for NAIC 3 is the average of 4.6% and 10.0% Source: Credit Suisse, NAIC

The RBC charge incurred at each designation is averaged with the RBC charge at the

designation below to calculate what the NAIC calls a Breakpoint Expected Loss. So,

continuing our example, the Breakpoint Expected Loss for NAIC is 7.3% (the average

RBC Charge on NAIC 3 and NAIC 4 or the average of 4.6% and 10.0%).

The Breakpoint Carrying Price can then be calculated from the Intrinsic Price and the

Breakpoint Expected Losses using the formula:

Breakpoint Carrying Price = Intrinsic Price / (1 – Breakpoint Expected Losses)

Continuing with the NAIC’s example, the Breakpoint Carrying Price for NAIC 3 in this case

is:

76 / (1 – 7.3%) = 81.98

A security that has a carrying price of 81.0 will be designated NAIC 3, since it is above the

NAIC 2 Breakpoint Carrying Price (78.31) but below the NAIC 3 Breakpoint Carrying Price

(81.98) as shown in Exhibit 22.

As a reminder, any bond that is not forecasted to take a loss will be designated NAIC 1

regardless of the Carrying Price.

10 January 2013


Consumer ABS Consumer credit continues to grow unabated driven by non-revolving credit

November consumer credit numbers released by the Federal Reserve yesterday show

continued expansion in credit led by the non-revolving sector and it currently stands at

$2.8T. The pace of increase in total consumer credit has been driven by the pace of the

non-revolving sector, which has continued to grow unabated for the past 15 months. In

fact, barring the August 2011 decline, non-revolving credit has grown for the past 30

months. While the amount of revolving credit has growth the past few months, annual

growth rates have been choppy with more frequent periods of contraction.

Latest data for the month of November show that the total outstanding consumer credit

increased by $16B in the month of November 2012. This is a 7% seasonally adjusted

annual rate of increase over October. Almost all of this increase ($15.2B of the $16B)

came from the non-revolving sector, which grew at a 9.6% seasonally adjusted annual rate

after posting 6.8% growth in October. Compared to this, the revolving sector continues to

grow at a tepid pace – it was flat in November after growing at a 4.8% seasonally adjusted

annual rate in October. This could be driven by both a reluctance on the part of the

borrowers to take on additional debt as well as a much tighter credit regime.

Exhibit 23: Consumer credit continues to expand … Exhibit 24: … led by the growth in non-revolving credit

$ B, seasonally adjusted seasonally adjusted annual growth rate

830

835

840

845

850

855

860

1,500

1,700

1,900

2,100

2,300

2,500

2,700

2,900

Total Consumer Credit Outstanding (LHS)

Non Revolving (LHS)

Revolving (RHS)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Total Consumer Credit Outstanding

Revolving

Non Revolving

Source Credit Suisse, the BLOOMBERG PROFESSIONAL™ service Source Credit Suisse, the BLOOMBERG PROFESSIONAL™ service

Chandrajit Bhattacharya

+1 212 325 1546

[email protected]

Gaurav Singhania, CFA

+1 212 325 0620

[email protected]

Marc Firestein

+1 212 325 4379

[email protected]

10 January 2013


RoadMAPs: Monthly Auto Performance Summary

Short-term performance in both the prime and subprime sectors was stable to marginally

better. Defaults inched down 6 bps in prime and 16 bps in subprime. Severities were

constant and net losses were flat in prime but fell a marginal 5 bps in subprime.

Prepayments slowed by 1.5% in prime and 1.85% in subprime. While the 30+

delinquencies were mostly constant for the month, we observed a 6% increase in prime

turn rates on the heels of an increase in the 60+ delinquency levels. While the high turn

rate may translate into a possible near-term increase in defaults, we note that long-term

prime delinquency trends remain strong (Exhibit 34).

While the prime 30+ delinquencies increased by 16bps this month, the long-term

delinquency trends remain strong. Subprime 30+ delinquencies have bounced around

near the 10% range for the past few months, settling down at 10.24%, down 21 bps from

the previous month. Prime turn rates have risen sharply, increasing 6% to an all-time

high of 27%. Subprime turn rates have been constant.

Prime CDRs declined by a marginal 6 bps after increasing 24 bps last month. Subprime

CDRs fell 16 bps this month, but they remain elevated mostly on the back of newer

deals. CPRs fell marginally, dropping 1.5% in prime and 1.85% in subprime.

Prime and subprime severities moved largely sideways this month, with prime

severities inching down just a tad, whereas subprime severities inched up a smidge.

However prime severities have remain elevated since the 12% ramp-up in the month

of October, which we attribute to seasonal weakness. Prime annualized net loss rates

caught a break and remained constant this month after consistently increasing over

the past three months. Subprime severities have held constant while the net loss rates

fell 5 bps to 5.5% .

Newer vintage prime deals remain far stronger than their older counterparts based

mostly on much stronger borrower performance; they also continue to post significantly

lower delinquency rates and CDRs, in addition to slightly faster prepayments. Even with

higher severities (skewed by few vehicle liquidations as pointed out in our prior report),

net loss rates on newer deals are still the lowest among all vintages.

Newer subprime deals, on the other hand, have delinquency rates that are noticeably

weaker, but CDRs remain in line with the 2010 vintage. With lower CDRs and marginally

lower severities, the net loss rates on newer vintage deals are still lower than their 2008-

2009 counterparts.

The Manheim Index continued to show strength with the index, climbing 1.5% after the

increase seen over last two months. This is the third monthly gain since last March, and

despite the softening in the index during Q2-Q3 last year, recent strength in the index

reiterates our belief that the used car fundamentals remain strong, as outlined most

recently in our Global Securitized Products 2013 Outlook.

Spreads remained flat across the board. Although prime and subprime seniors continue to

exhibit strength, we think pressure on senior spreads could increase as the new issue

calendar rolls out. We favor subprime seniors over prime seniors. We prefer dealer

floorplan and auto lease transaction seniors based on wider spreads and comparable

credit performance. We expect used car prices to soften in 2013 but believe that it

should remain firmly higher than pre-crisis levels. We think prime subordinates

provide solid spread pick-up given their strong performance; we outlined these

recommendations in our 2013 outlook.

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1004965761&source_id=emcmt&serialid=tiMV6l0cn%2fqE%2bIeJZzcmEnP19CBimCQuufT6T2k3STY%3d

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1002901421&source_id=emcmt&serialid=CUgAuki8zfdC5paWkvYJKNjeEF18Xe%2f07DEix9zgB%2fw%3d

https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&document_id=1004965761&source_id=emcmt&serialid=tiMV6l0cn%2fqE%2bIeJZzcmEnP19CBimCQuufT6T2k3STY%3d

10 January 2013


Spreads and Manheim Index

Exhibit 25: Generic auto ABS spreads

7

1318

65

80

95

18

25

7

1318

65

80

95

18

25

7

1318

65

80

95

18

25

0

10

20

30

40

50

60

70

80

90

100

Prime AAA 1-yr Prime AAA 2-yr Prime AAA 3-yr Prime A 1-yr Prime A 2-yr Prime A 3-yr Subprime AAA1-yr

Subprime AAA2-yr

Spre

ad (bps)

12/7/2012

12/19/2012

12/31/2012

Source: Credit Suisse

Exhibit 26: Prime-Subprime AAA spread basis (bp) Exhibit 27: Manheim Index

0

40

80

120

160

4/2

3/2

010

7/2

3/2

010

10/2

3/2

010

1/2

3/2

011

4/2

3/2

011

7/2

3/2

011

10/2

3/2

011

1/2

3/2

012

4/2

3/2

012

7/2

3/2

012

10/2

3/2

012

Prim

e-S

ubprim

e S

pre

ad (bps) 1 year basis

2 year basis

95

100

105

110

115

120

125

130

Fe

b-9

5

Fe

b-9

6

Fe

b-9

7

Feb-9

8

Fe

b-9

9

Fe

b-0

0

Feb-0

1

Fe

b-0

2

Fe

b-0

3

Fe

b-0

4

Fe

b-0

5

Fe

b-0

6

Fe

b-0

7

Fe

b-0

8

Fe

b-0

9

Fe

b-1

0

Fe

b-1

1

Feb-1

2

Index V

alu

e

Source: Credit Suisse Source Credit Suisse, the BLOOMBERG PROFESSIONAL™ service, Manheim Consulting

10 January 2013


Short-Term Performance

Exhibit 28: 30+ delinquency rate Exhibit 29: Turn rate (share of 60+ among all past due loans)

1.89

10.45

2.05

10.24

0

2

4

6

8

10

12

Prime Subprime

1-Nov-12

1-Dec-12

21.49%

29.29%

26.68%

29.69%

0%

5%

10%

15%

20%

25%

30%

35%

Prime Subprime

1-Nov-12

1-Dec-12

Source: Credit Suisse, Intex Source: Credit Suisse, Intex

Exhibit 30: CPR Exhibit 31: CDR 18.98

17.0417.49

15.19

0

2

4

6

8

10

12

14

16

18

20

Prime Subprime

1-Nov-12

1-Dec-12

1.24

9.31

1.18

9.15

0

1

2

3

4

5

6

7

8

9

10

Prime Subprime

1-Nov-12

1-Dec-12


Exhibit 32: Severity Exhibit 33: Annualized net loss rate

43.04%

54.64%

42.74%

55.43%

0%

10%

20%

30%

40%

50%

60%

Prime Subprime

1-Nov-12

1-Dec-12

0.50

5.60

0.49

5.55

0

1

2

3

4

5

6

Prime Subprime

1-Nov-12

1-Dec-12


10 January 2013


Long-Term Performance


0

2

4

6

8

10

12

14

16

18

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12

Prime (LHS)

Subprime (RHS)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12

Prime (LHS)

Subprime (RHS)


Exhibit 36: CPR Exhibit 37: CDR

0

5

10

15

20

25

30

35

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12

Prime

Subprime

0

2

4

6

8

10

12

14

16

18

20

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12

Prime (LHS)

Subprime (RHS)



0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0%

10%

20%

30%

40%

50%

60%

70%

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12

Prime (LHS)

Subprime (RHS)

0

2

4

6

8

10

12

14

16

0.0

0.5

1.0

1.5

2.0

2.5

Nov-

04

Nov-

05

Nov-

06

Nov-

07

Nov-

08

Nov-

09

Nov-

10

Nov-

11

Nov-

12Prime (LHS)

Subprime (RHS)


10 January 2013


Prime Recent Vintage Data


0

1

2

3

4

5

6

1 4 7

10

13

16

19

22

25

28

31

34

37

40

43

Age (months)

2008

2009

2010

2011

2012

0%

5%

10%

15%

20%

25%

30%

1 5 9

13

17

21

25

29

33

37

41

45

Age (months)

2008

2009

2010

2011

2012



0

5

10

15

20

25

30

1 5 9

13

17

21

25

29

33

37

41

45

Age (months)

2008

2009

2010

2011

2012

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

1 5 9

13

17

21

25

29

33

37

41

Age (months)

20082009201020112012



0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1 5 9 13

17

21

25

29

33

37

41

Age (months)

2008

2009

2010

2011

2012

0.0

0.5

1.0

1.5

2.0

2.5

1 5 9 13 17 21 25 29 33 37 41

Age (months)

2008

2009

2010

2011

2012


10 January 2013


Subprime Recent Vintage Data


-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

1 5 9

13

17

21

25

29

33

37

41

45

Age (months)

2008

2009

2010

2011

2012

0%

5%

10%

15%

20%

25%

30%

35%

40%

1 5 9

13

17

21

25

29

33

37

41

Age (months)

2008

2009

2010

2011

2012



-

5.00

10.00

15.00

20.00

25.00

30.00

35.00

1 5 9

13

17

21

25

29

33

37

41

Age (months)

2008

2009

2010

2011

2012

0

2

4

6

8

10

12

14

16

18

1 5 9

13

17

21

25

29

33

37

41

Age (months)

2008

2009

2010

2011

2012



0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 5 9

13

17

21

25

29

33

37

41

Age (months)

2008

2009

2010

2011

2012

0

2

4

6

8

10

12

1 5 9

13

17

21

25

29

33

37

41

45

Age (months)

2008

2009

2010

2011

2012


10 January 2013


CDO / CLO Initial Equity Par Coverage

The new-issue CLO market shows no signs of slowing in December. So far, 12 CLOs, or a

total of $5.9bn, were issued, bringing the 2012 YTD tally to $52.3bn. In this section, we

also discuss the initial Equity Par Coverage (EPC) ratio as a very useful metric for

analyzing CLO equity investments.

CLO new-issuance finished 2012 strongly

Even as 2012 was coming to an end, the new-issue CLO market showed no signs of

slowing in December. Sixteen CLOs, or a total of $7.9bn, were issued (Exhibit 52),

bringing the 2012 final tally to $54.2bn.

Exhibit 52: U.S. CLO 2.0 Issuance by Month

As of 12/30/12

2.5 2.5

5.1

2.9

4.1

2.5

5.2

6.26.7

7.77.9

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

$7.0

$8.0

$9.0

Mar-

10

Apr-

10

May-1

0

Ju

n-1

0

Ju

l-10

Aug

-10

Sep

-10

Oct-

10

No

v-1

0

De

c-1

0

Ja

n-1

1

Feb

-11

Mar-

11

Apr-

11

May-1

1

Ju

n-1

1

Ju

l-11

Aug

-11

Sep

-11

Oct-

11

No

v-1

1

De

c-1

1

Ja

n-1

2

Feb

-12

Mar-

12

Apr-

12

May-1

2

Ju

n-1

2

Ju

l-12

Aug

-12

Sep

-12

Oct-

12

No

v-1

2

De

c-1

2

Source: Credit Suisse

Among the 16 deals, Great Lakes CLO is a middle-market deal managed by BMO Capital

Markets, Vibrant CLO is managed by DFG Investment Advisors – a first-time manager,

and KKR CLO 2012-1 is managed by KKR Financial Advisors, which has been missing

from the new-issue market since the 2008-2009 crisis. Another interesting deal is Mercer

Field CLO by Guggenheim – first, it has a size of $1.05bn, making it the largest deal since

the crisis; second, it has a 40% bucket for high yield bonds, making it more like a mix of

CLO and CBO; and third, as a result of the large bucket of bonds, it is structured with

higher subordinations and a lower leverage, with the tranches below AA all fixed-rated.

Finally, the liability spreads stayed largely the same as in November – for example, AAAs

are mostly priced in the 139bps-143bps range.

David Yan

+1 212 325 5792

[email protected]

10 January 2013


Initial Equity Par Coverage

In this section, we will discuss a very important metric for investing in CLO equities – the

so-called initial Equity Par Coverage (EPC) ratio.2 We define “initial” here as of the

effective date – because the collateral should be fully ramped up by the effective date.

The EPC is defined as: (Collateral Par – Liability Notional)/Equity Notional. After

rearranging the terms, we can calculate the EPC in the following formula: EPC = D/E * (Jr.

OC - 1), where D/E is the debt-to-equity ratio of the CLO equity tranche and Jr. OC is the

most junior – i.e., right above equity – OC (overcollateralization) ratio. For example, if a

CLO has a total initial size (i.e., deal balance) of $500mn, and the equity tranche is $50mn,

the D/E ratio will be 9 (i.e., 450/50).

Keep in mind that the numerator of the OC ratio is usually the collateral par adjusted for

haircuts such as default, excess CCC exposure, deep discount, etc.; however, at the initial

date (i.e., as of the effective date in our analysis), the OC numerator usually equals the par

value of the collateral.

There are at least two important factors an equity investor needs to consider: leverage and

funding cost. Interestingly, both factors are reflected in our formula for EPC. First,

needless to say, the D/E ratio is one popular measure of leverage – the higher the D/E or

leverage, the higher the par coverage; Second, the OC ratio, or more precisely, the initial

OC ratio, is at least partially and indirectly related to the funding cost, and the key lies in

the numerator of the OC ratio.

The second factor needs further detailed explanations. Keep in mind that the

issuer/structurer of a CLO always has to strike a balance between the nominal

coupon/spread and the selling price of the debt tranches. Obviously, the higher the

spread or coupon, the higher the (on-going) funding cost, But, the trade-off is that, the

higher the spread or coupon, the higher the price at which the debt tranches could be sold,

all else being equal – which means the issuer could raise more proceeds to purchase the

underlying collateral. Given the same purchase prices, more collateral par could be built

with more proceeds – thus, the higher numerator of the OC ratio.

So, if a CLO has a higher initial EPC due to a higher OC ratio, the next question an

investor should ask is: how is this higher OC ratio achieved – is it achieved by sacrificing a

higher funding cost (i.e., higher liability spread) for more proceeds from issuance or is it

achieved by buying/ramping the collateral at a relatively lower cost? Assuming the

collateral credit quality stays the same, we would prefer the higher OC is achieved by

acquiring assets at cheaper prices – which could be a function of how fast the assets

could be acquired and the timing of ramping up the collateral.

In addition, other factors could also impact the OC ratio, such as the structuring fees and

other initial transaction costs. All else being equal, the higher the transaction cost, the less

proceeds are available for acquiring the collaterals, thus resulting in a lower OC ratio.

We randomly selected 15 2012-vintage CLOs and calculated their initial EPC, as shown in

Exhibit 53.

2 There are other important measures investors need to check, such as the market value or NAV coverage ratios. However, we

limit our discussion to the par coverage ratio here.

10 January 2013


Exhibit 53: Calculation of Equity Par Coverage (EPC)

Deal Name Closing Date As of Date D/E Ratio Jr. OC EPC (= D/E * (Jr. OC – 1))

Sample_1 Mar 19 2012 Oct 24 2012 8.63* 110.11% 87.24%

Sample_2 Apr 5 2012 Oct 31 2012 8.13 109.92% 80.62%

Sample_3 Mar 20 2012 Nov 5 2012 9.22 107.53%** 69.45%

Sample_4 May 1 2012 Nov 2 2012 7.33 110.65% 78.07%

Sample_5 Apr 19 2012 Nov 7 2012 7.71 111.09% 85.54%

Sample_6 Mar 27 2012 Oct 15 2012 7.78* 109.45% 73.56%

Sample_7 Apr 11 2012 Nov 2 2012 8.23 109.09% 74.84%

Sample_8 Mar 21 2012 Nov 5 2012 9.22 108.57% 79.01%

Sample_9 Mar 8 2012 Nov 6 2012 8.52 111.37% 96.92%

Sample_10 Mar 22 2012 Nov 2 2012 8.13* 110.51% 85.47%

Sample_11 Feb 23 2012 Nov 5 2012 8.07 110.08% 81.33%

Sample_12 May 8 2012 Nov 13 2012 8.66 108.37% 72.49%

Sample_13 Jan 20 2012 Nov 5 2012 8.84 108.16% 72.08%

Sample_14 Feb 15 2012 Nov 5 2012 9.38 108.13% 76.26%

Sample_15 Jan 19 2012 Nov 6 2012 7.03* 110.62% 74.63%

Source: Credit Suisse, INTEX * Equity includes unrated debt tranches ** OC ratio is at Single-B level

First of all, as we can see, there is generally an inverse relationship between the D/E ratio

and the Jr. OC ratio, which can be shown by plotting the numbers in Exhibit 54. This

should be expected because, the higher the leverage or D/E ratio – i.e., the more the debt

– the higher the denominator for the OC ratio, and thus the lower the OC ratio, all else

being equal. Interestingly, the net effect of these two offsetting ratios will be reflected in

one number: the EPC.

Exhibit 54: Inverse relationship between D/E ratio and initial OC ratio

R² = 0.5286

107.0%

107.5%

108.0%

108.5%

109.0%

109.5%

110.0%

110.5%

111.0%

111.5%

112.0%

6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0

Jr.

OC

Rati

o

D/E Ratio

Source: Credit Suisse, INTEX

As we look at the EPC column, we see a wide range – from below 70% to almost 97%.

A special comment on the deal with the lowest EPC – Sample #3 – is needed: what

makes this deal different from all the other sample deals is that it has a Single-B tranche

and there is an OC test set at this level. Consequently, its equity has a higher leverage

and a lower junior OC ratio, and the net result is that it has the lowest EPC among all

sample deals.

10 January 2013


One way to better understand the EPC ratio is as follows: if we run the cash flows,

assuming zero prepayment, zero default, and no reinvestment (even during the

reinvestment period), we should get a principal writedown amount on the equity

tranche, as a percentage of its notional, close to (1-EPC). However, what we found is

that, for some deals, that is not the case. For example, take Sample #3 as an example

again, if we run the cash flows, the principal writedown on the equity actually turns out to

be close to 40%, about 10% higher than what its EPC ratio suggests (which is supposed

to be around 30%). Isn’t it strange?

As it turns out, the answer to this “puzzle” is that, under this particular scenario – i.e.,

no prepay, no default, and no reinvestment – there will be money taken out of the

principal proceeds to pay the incentive fee to the manager once the equity reaches the

hurdle IRR rate. In this particular deal, if we hypothetically add these incentive fees

back to the principal proceeds and assume they will be paid to the equity holder

instead, the writedown on the equity tranche actually turns out to be very close to 30%

– as the EPC suggests.

EPC versus potential equity return

Ignoring everything else, CLO equity investors likely prefer a higher EPC, simply because

they will get more notional back at the end, all else being equal. However, there are other

factors that could also impact the ultimate return to equity investors.

In this section, we ignore prepayment, default risk/loss, and reinvestment; we simply look

at a “static” scenario, whereby there is no prepayment, no default, and no reinvestment. In

Exhibit 55, we show the equity yields/returns – assuming a par purchase price – under this

“static” scenario, versus the EPC ratios. As we can see, in some cases, an equity tranche

with a high EPC could actually have a low “static” yield. The best example is Sample #9 –

it has the highest EPC of 96.9%, but with the lowest yield. Why?

That’s because, although a higher EPC means the equity investor would get more notional

(or initial investment) back, there are other factors that could also determine the ultimate

return of the equity. More specifically, one of the most important factors is the “arbitrage,”

or the excess spread between the collateral spread/yield (i.e., WAS/WAC) and the funding

cost. Exhibit 55 shows these numbers of each sample CLO.

As we mentioned earlier, a higher OC ratio means a higher EPC with the same leverage.

However, if it is achieved – even if partially – at the expense of a higher funding cost, it

could hurt the equity return. In the case of Sample #9, its funding cost is around 193 bps,

higher than the average of these samples: 189 bps. Even more important, its collateral has

a very low WAS (weighted average spread) of only 285 bps, compared with the average of

the samples: 414 bps. As a result, its excess spread is only 92 bps. Thus, despite its

highest OC ratio of 111.4%, given its relatively higher funding cost and a higher price paid

for the collateral – relative to the spread it can earn from the assets, it will only achieve a

low equity return of 11.8% under this “static” scenario.

10 January 2013


Exhibit 55: Equity Par Coverage (EPC) vs. funding cost and excess spread

Deal Name EPC “Static” Par Yield*** Current Funding Cost (bps) Collateral WAS (bps)**** Excess Spread (bps)

Sample_1* 87.24% 25.4% 158 455 297

Sample_2 80.62% 19.1% 188 440 252

Sample_3** 69.45% 13.2% 214 434 220

Sample_4 78.07% 17.2% 172 449 277

Sample_5 85.54% 14.1% 173 282 109

Sample_6* 73.56% 22.2% 207 461 254

Sample_7 74.84% 16.7% 166 419 253

Sample_8 79.01% 13.5% 197 432 235

Sample_9 96.92% 11.8% 193 285 92

Sample_10* 85.47% 18.8% 204 413 209

Sample_11 81.33% 23.6% 184 425 241

Sample_12 72.49% 18.4% 176 433 257

Sample_13 72.08% 19.0% 195 447 252

Sample_14 76.26% 14.8% 194 400 206

Sample_15* 74.63% 19.6% 210 439 229

Average 79.73% 17.8% 189 414 225

Source: Credit Suisse, INTEX * Equity includes unrated debt tranches ** OC ratio is at Single-B level *** Assuming zero prepayment, zero default and no reinvestment (even during the reinvestment period) at all **** Ignoring fixed assets, as they are typically 5% or lower of the collateral

A similar observation could be made on Sample #5 – it has a relatively high EPC of 85.5%,

but its excess spread level is low: 109 bps, due to its low collateral WAS. As a result, its

equity yield is only 14%. Exhibit 56 shows the positive relationship between the excess

spread and the “static” par yield, and we can clearly see Sample #5 and Sample #9 falling

to the far lower left, compared with the rest of the samples.

Exhibit 56: Relationship between excess spread and equity yield/return

R² = 0.4334

50

100

150

200

250

300

350

10.0% 15.0% 20.0% 25.0% 30.0%

Co

llate

ral W

AS

-O

n-g

oin

g F

un

din

g C

ost

(bp

s)

"Static" Par Yield Source: Credit Suisse, INTEX

10 January 2013


Certainly, one could argue that, maybe the assets in Sample #9 and Sample #5 have a

higher credit quality (and thus the lower spread) – which means, if adjusted for potential

default risk, their risk-adjusted returns could be higher than other sample deals.3

If we put default risk aside, these examples show the limitation of the EPC ratio. As useful

as it is – as we show in this section, it needs to be combined with other measures – such

as NAV coverage, funding cost, and collateral yield – to evaluate an equity investment

comprehensively.

And, of course, default, prepayment, and reinvestment are all very important factors.

Further analysis should be conducted with regard to these factors as well. Nevertheless, at

least as a “starter,” EPC could be a valuable measure for CLO equity investing, in our view.

3 The WARF (weighted average rating factor) of these two deals - around 2480 to 2560 - don't really provide an evidence on this

argument, as they are in line with other deals.

10 January 2013


European Update Market Commentary

Trading volumes have been light this week with muted BWIC activity so far. Despite the

light activity, we have seen long duration paper in senior space tightening this week in

core and periphery RMBS. Longer paper continues to attract a lot of attention as spread

curves remain steep and structured product money looks to extend duration in portfolios.

Portuguese, Spanish and UK non-conforming RMBS were the biggest winners on the

week.

In The Pipeline

The new issuance pipeline looks dry thus far, however, we expect activity to improve as

the New Year kicks into gear.

Carlos Diaz

+44 20 7888 2414

[email protected]

10 January 2013


Modeling and Analytics Mortgage rates processes under QE3 and “sticky” primary rates Expect additional g-fee increases for 2013-2014; HARP2.0 effectiveness extended by six months; lower delinquency buyout speeds for MHA/CQ/CR pools due to payment reduction and credit selection

We have released an updated agency model CS6.7 into the CS+/Locus calculator. Clients can parallel the model runs through the model dropdown menu in Locus agency calculators. The main changes from CS6.6 are as follows:

Mortgage rates processes under QE3 and “sticky” primary rates

Primary/secondary spread: the sensitivity of the primary mortgage rate to shocks in the secondary rate, the “p/s beta,” is a function of direction of secondary rate movement, mortgage origination capacity, and relative attractiveness of the current mortgage rate. When the secondary rate rises, this beta ranges from 1 at high capacity to 0.75 at low capacity. When the secondary rate rallies, this beta extends from 0.45 to 0.25 depending on the attractiveness of the new mortgage rates.

Agency current coupon/swap basis: CS6.7 keeps the current QE3-induced tight cc/swap basis for 12 months, then mean-reverts to long-term mean as in CS6.6.

Given the challenges of modeling the mortgage origination landscape longer term and the specialness of the current situation, we have decided to deploy these two model changes in a short-term model component, while keeping the long-term model parsimonious and transparent.

G-fee updates

We expect conventional g-fee increases of 25bps for 30yr products and 10bps for 15yr products in 2013-2014. Hence, long-term primary/secondary spread is increased from 75bps (in CS6.6) to 100bps for 30yr products and 85bps for 15yr products.

State level g-fee: CS6.7 factors in additional upfront g-fee increases for the five states (NY, NJ, IL, FL, CT) mandated by FHFA, effective January 2013.

HARP2.0 timeline: current CS6.6 forecasted that overall HARP2.0 effectiveness peaks between May and November 2012, and starts to burn out afterwards. In October 2012, after the announcement of FHFA’s new reps/warrants policy on HARP loans, we increased our cross-servicer HARP effectiveness, starting in 2013. Given the recent persistently high HARP2.0 activities and newly announced HARP program changes, CS6.7 extends peak HARP2.0 effectiveness by another six months, from November 2012 to May 2013.

Added effects of payment reduction and credit selection bias to the delinquency roll rates for MHA pools: MHA pools’ delinquency buyout projections are reduced by 25%-30%.

The impact on prepayment projection and valuation from CS6.6 to CS6.7 varies

Cusp coupons are most affected by the new agency cc/swap basis assumption: CS6.7 keeps the current QE3-induced tight cc/swap basis for 12 months, then mean reverts it to long-term mean as in CS6.6. One-year speeds will be 3-6 CPR higher for cusp coupons, while long-term CPR changes less due to higher g-fee. CUSP TBA OAS tighten 2-3 bps, IOS OAS tighten ~150bps.

High coupons’ one-year speeds will increase 5-6 CPR due to the six-month extension of HARP2.0 peak effectiveness in CS6.7. IOS OAS tightens ~150bps.

CQ/CR pools’ long-term speeds reduced ~ 1CPR due to lower delinquency roll rates, caused by payment reduction and credit selection.

Clients can parallel the model runs between CS6.7 and CS6.6 through the model dropdown menu in Locus agency calculators. The model default setting will be switched to CS6.7. We welcome feedback from clients on the new model.

David Zhang 212 325 2783

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Yihai Yu 212 325 7922

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Jack Yu 212 538 5597

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Joy Zhang 212 325 5702

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This is an exact excerpt from Modeling and Analytics,

published 11 December 2012.

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