June 12, 2006

Agency CMOs
Steven Abrahams
(212) 272-2206
sabrahams@bear.com

Scott Buchta
(312) 580-4161
sbuchta@bear.com

Understanding CMO Toggle Floaters

Basic Characteristics of the Toggle Floater

Most of todays outstanding toggle floaters have a coupon that
floats at 1-month LIBOR plus a spread with a relatively high
cap for five to seven years after settlement. After this initial
period, the toggle feature applies. This feature allows the
floater to pay its coupon until LIBOR hits a certain level or
strike. At the strike, the coupon on a typical toggle floater
drops to zero instead of remaining capped like a standard
CMO floater. Some toggle floaters drop to a minimum or
floor coupon instead of going all the way to zero.
The buyer of a toggle floater has effectively sold a digital cap
that toggles the floater coupon down to a lower fixed level.
Due to the toggle, the LIBOR strike on the floater is typically
much higher than that of a standard floater, and the spread
over the floating index is much higher as well. The structure
allows the investor to sell a more leveraged set of caps and
consequently earn increased spread in the process.
PRLM BS-773 TF is an example of a toggle floater with a
floor coupon. This structure offers a coupon of 1-month
LIBOR plus 60 bp as long as LIBOR remains below 7.40%.
If LIBOR goes above the strike, the coupon goes to 4%. A
version of this bond (PRLM BS-772 TF) that is structured
without the 4% coupon floor would be priced at L+110 bp as
long as LIBOR remains below 7.40%. Figure 1 shows the
effective coupon on this toggle floater as interest rates change.
A floater structured with a fixed cap off of the same
underlying CMO class would have a coupon of roughly
LIBOR + 45 bp with a 7.00% cap. A 3-year floater backed by
home equity loans would offer roughly LIBOR
+ 17 bp (30/360) with an available funds cap.

Table 1. Profile of a Toggle Floater

Security

PRLM BS-773 TF
L +60

Coupon
Structure

TAC

Collateral

FHLMC 6.5's

LIBOR Strike

7.40%

Price

100

Average Life

9.20

Yield

5.85

Duration

2.45

Convexity

-3.31

Note: all market data as of 6/5/06. Source: Bear Stearns.

Table 2. Discount Margin Profile: Constant Price of Par

123%
PSA

152%
PSA

217%
PSA

527%
PSA

746%
PSA

15.8

13.7

9.2

1.0

0.5

5.13

Prepay
Avg.
Life
DM

60

60

60

60

60

7.40

DM

60

60

60

60

60

7.41

DM

-336

-336

-336

-336

-336

LIBOR

Figure 1. Yield Comparison of MBS Floaters Priced at Par

10.00
9.00
8.00
Yield

Floating-rate investors, particularly those looking to generate

excess returns over LIBOR, have been faced with falling
spreads in most products. Increased demand, tighter credit
spreads, a flatter yield curve and lower volatility have all
contributed. The CMO market in turn has introduced toggle
floaters, which allow investors to sell a leveraged cap in return
for a coupon that floats at a relatively high margin over
LIBOR. For portfolios comfortable that LIBOR will remain
below the toggle floaters cap, the structure can be a good way
to add spread income.

7.00
6.00
5.00
Toggle Floater
CMO Floater

4.00

HEL Floater
3.00
5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

LIBOR

The research analysts who prepared this research report hereby certify that the views expressed in this research report
accurately reflect the analysts personal views about the subject companies and their securities. The research analysts also
certify that the analysts have not been, are not, and will not be receiving direct or indirect compensation for expressing the
specific recommendation(s) or view(s) in this report.

Understanding CMO Toggle Floaters

Compared to a Corridor Floater

Historical LIBOR

An interesting comparison can be made between a toggle

floater and some of the corridor floaters that are in the
marketplace today. Both offer relatively high margins and
caps, but for different reasons. The margin and cap on the
toggle floater comes from the embedded sale of the digital
cap. The margin and cap on a corridor floater comes from the
combined sale of a low-strike cap and from a subtle form of
prepayment risk. In a corridor floater, the investor is buying a
security with a below market cap usually 5%-6%. The lowstrike cap gets raised, often to around 9%, through the
purchase of an amortizing cap corridor. As long as
prepayments stay above a pre-determined speed (usually 75%
or 100% PPC) the full coupon of the security is realized up to
the level of the cap corridor. If prepayments fall below the
amortization schedule and LIBOR rises above the initial stated
cap, however, the realized DM of the bond falls. That
happens when the outstanding amount of the low-capped
floater exceeds the outstanding amount of the cap corridor.
The excess low-capped floater hurts the overall DM of the
position.

A little history can help frame the potential performance of a

toggle floater. Although a lot has changed over time, here are
some summary statistics regarding LIBOR since 1985:

Figure 2. Toggle Performance 1985-Present; L+75, 8.25% Cap,

7.5% LIBOR Strike
12

Bear, Stearns & Co. Inc.

4% Coupon

10
8
% rate

Investor Profile

6
4
2

LIBOR

L+75 Toggle

C ap

Ja
n85
Ja
n87
Ja
n89
Ja
n91
Ja
n93
Ja
n95
Ja
n97
Ja
n99
Ja
n01
Ja
n03
Ja
n05

Toggle floaters are probably best suited to investors more

concerned with generating income by selling an out-of-themoney cap and less concerned with mark-to-market. Toggle
price performance hinges largely on the level of 1-month
LIBOR, the shape of the yield curve and volatilityall factors
that drive the price of the caps that the toggle floater buyer has
implicitly sold. As LIBOR rises, the yield curve steepens or
volatility goes up, the price of the toggle floater should fall.
All of these things raise the price of the embedded caps, which
the toggle floater buyer has sold short. Because the cap has
been sold against an underlying MBS, prepayments also have
a key effect. As rate rise and prepayment slow, the principal
balance backing the cap remains outstanding for longer. This
magnifies the price impact of rising rates, among other things.
Obviously, falling LIBOR, a flatter curve or falling volatility
helps the toggle floater price performance.

Max LIBOR: 10.1% (3/1/1989)

Total Months LIBOR > 8%: 38
Total Months LIBOR > 7%: 55
Longest Period Consistently Above 8%:
8/1/1988 10/1/1990
Longest Period Consistently Above 7%:
4/1/1988 1/1/1991
Last time 1 month LIBOR > 8%: 12/1/1990
Last time 1 month LIBOR> 7%: 1/1/1991

Conclusion
Investors can generate significant added cash flow through
toggle floaters in return for mark-to-market risk. The toggle
buyer is able to sell more leveraged caps than they might
through traditional MBS and pick up incremental spread in the
process. Although interest cash flow drops significantly if the
toggle reaches the LIBOR strike, the strike levels offered are
substantially above the levels of LIBOR seen for most of the
last decade. The structuring flexibility available also allows
the investor to manage the risk/reward relationship of the
security through collateral selection, deal structure, LIBOR
strikes and coupon floors.

To access related research please visit:

http://www.bearstearns.com/

Bear, Stearns & Co. Inc.

383 Madison Avenue
New York, NY 10179
(212) 272-2000
www.bearstearns.com

The data underlying the information contained

herein has been obtained from sources that we
believe are reliable, but we do not guarantee
the accuracy of the underlying data or
computations based thereon. The information
in this report is illustrative and is not intended
to predict actual results, which may differ
substantially from those reflected herein.
Performance analysis is based on certain
assumptions with respect to significant factors
that may prove not to be as assumed. You
should understand the assumptions and
evaluate whether they are appropriate for your
purposes. Performance results are often based
on mathematical models that use inputs to
calculate results. As with all models, results
may vary significantly depending upon the
value of the inputs given. Models used in any
analysis may be proprietary making the results
difficult for any third party to reproduce.
Contact your registered representatives for
explanations of any modeling techniques and
the inputs employed in this report. The
securities referenced herein are more fully
described in offering documents prepared by
the issuers, which you are strongly urged to
request and review. Bear, Stearns & Co. Inc.
("Bear Stearns") and/or its affiliates or
employees may have positions, make a market
or deal as principal in the securities referred to
herein or related instruments, while this
document is circulating. During such period,
Bear Stearns may engage in transactions with,
or provide or seek to provide investment
banking or other services to, the issuers
identified in this report. Bear Stearns may have
managed or co-managed a public offering of
securities within the last three years for the
issuers identified in this report, including
regularly acting as an underwriter for
Government Sponsored Enterprise issuers.
Directors, officers or employees of Bear
Stearns or its affiliates may be directors of
such issuers. This document is not a
solicitation of any transaction in the securities
referred to herein which may made only by
prospectus when required by law, in which
event you may obtain such prospectus from
Bear Stearns. Any opinions expressed herein
are subject to change without notice. We act
as principal in transactions with you, and
accordingly, you must determine the
appropriateness for you of such transactions
and address any legal, tax or accounting
considerations applicable to you. Bear Stearns
shall not be a fiduciary or advisor unless we
have agreed in writing to receive compensation
specifically to act in such capacities. If you are
subject to ERISA, this report is being furnished
on the condition that it will not form a primary
basis for any investment decision.
Copyright 2006 Bear, Stearns & Co. Inc. All rights
reserved. Unauthorized duplication, distribution or public
display is strictly prohibited by federal law.

DOMESTIC
(Bear, Stearns & Co. Inc.)
Atlanta
3424 Peachtree Road, NE,
Suite 1700
Atlanta, GA 30326
(404) 842-4000
Boston
One Federal Street
Boston, MA 02110
(617) 654-2800
Chicago
Three First National Plaza
Chicago, IL 60602
(312) 580-4000
Dallas
300 Crescent Court, Suite 200
Dallas, TX 75201
(214) 979-7900
Denver
3200 Cherry Creek South Drive,
Suite 260
Denver, CO 80209
(720) 570-2327
Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067
(310) 201-2600
San Francisco
Citicorp Center
One Sansome Street, 41st floor
San Francisco, CA 94104
(415) 772-2900
San Juan
270 Muoz Rivera Avenue, 5th Floor
Hato Rey, Puerto Rico 00918
(787) 753-2327

INTERNATIONAL
Beijing
Bear, Stearns & Co. Inc.
Representative Office
Room 1608
China World Tower
1 Jian Guo Men Wai Avenue
Level 16, Units 06-08
Beijing 100004
People's Republic of China
86-10-6505-5101
Dublin
Bear Stearns Bank plc
Block 8
Harcourt Center, Floor 3
Charlotte Way
Dublin 2 Ireland
353-1-402-6200

Hong Kong
Bear Stearns Asia Limited
26th Floor, Citibank Tower
Citibank Plaza
3 Garden Road, Hong Kong
852-2593-2700
London
Bear, Stearns International Limited
One Canada Square
London E14 5AD
England
44-207-516-6000
Lugano
Bear, Stearns & Co. Inc.
Corso Elvezia 14
P.O. Box 5155
6901 Lugano, Switzerland
41-91-911-7333
Milan
Bear, Stearns International Limited
Via Pietro Verri 6
20121 Milano
Italy
39-02-3030-1730
So Paulo
Bear Stearns do Brasil Ltda.
Rua Joaquim Floriano,
72 - 8 andar - cj 83
So Paulo, SP Brazil 04534-000
55-11-3457-3200
Shanghai
Bear, Stearns & Co. Inc.
Representative Office
Unit 09, 20th Floor, Building One,
Corporate Avenue
No. 222 Hu Bin Road
Luwan District, Shanghai 200021
Peoples Republic of China
86-21-6340-6600
Singapore
Bear Stearns Singapore Pte Limited
30 Raffles Place
#21-01 Caltex House
Singapore 048622
65-6437-3300
Tokyo
Bear Stearns (Japan), Ltd.
Shiroyama JT Trust Tower
3-1 Toranomon 4-chome
Minato-ku Tokyo 105-6022
Japan
813-3437-7800