A Primer on Agency CMOs

Residential Mortgage Research Sharad Chaudhary (704) 386 2135 Laurent Gauthier (212) 583 8209 Agency CMO Trading Naveed Ameen Steve Choran Nick Letica (212) 583 8340 December 2001

Summary
n

Market Overview Creating CMOs A Detailed Look at CMO Structures The Evolution of CMO Structures

Residential Mortgage Research, Banc of America Securities, LLC.

Page 2

Market Overview
n n n n

Basic Concepts Growth of the Market Market Liquidity Major Underwriters

Creating CMOs A Detailed Look at CMO Structures The Evolution of CMO Structures

Residential Mortgage Research, Banc of America Securities, LLC.

Page 3

Basic Concepts
n

A CMO (collateralized mortgage obligation) reallocates the pass-through cash-flows from its underlying mortgage obligations to a series of different bond classes (called tranches) with varying maturity characteristics The mortgage obligations (or collateral) backing the CMO bond classes may consist of mortgage pools, whole loans, or even other CMO bond classes
n

Agency CMOs are collateralized by Fannie Mae, Freddie Mac, or Ginnie Mae-issued pools. Credit risk is minimal for Agency CMOs since these pools carry government (Ginnie Mae) or implied government (Fannie Mae, Freddie Mac) guarantees Non-Agency CMOs are not backed by these guarantees and therefore are usually credit-enhanced and rated by the bond rating agencies

Redirecting pass-through cash-flows to different bond classes is equivalent to redistributing the prepayment (interest-rate) and credit risk in these cash-flows. This redistribution can be achieved in a number of different ways and allows bonds to be tailored to the risk appetites of investors

Residential Mortgage Research, Banc of America Securities, LLC.

Page 4

Growth of the Market

The Agency CMO market has grown significantly over the past decade
n

In mid-1983 Freddie Mac issued the first CMO, and the market has grown rapidly since then with issuance typically averaging more than $100 billion a year. Over $300 billion Agency CMOs were issued in 1993
n

The overall level of Agency CMO issuance usually tracks mortgage rates with the highest rates of issuance corresponding to periods of heavy refinancing activity The current interest rate environment is very favorable to Agency CMO issuance: production for 2001 is estimated above $250 billion
Annual Issuance of Agency CMOs
350 300 Issuance ($ bb) 250 200 150 100 50 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
GNMA FNMA FHLMC

Residential Mortgage Research, Banc of America Securities, LLC.

2001 (est)

Page 5

Market Liquidity
A significant pool of Agency CMOs with customized characteristics is available for investors
n

The Agency CMO market consists of over $900bb in outstanding securities and is one of the largest sectors in the fixed-income universe CMOs issued by Freddie Mac and Fannie Mae constitute the lions share of the market. Ginnie Mae CMOs also represent a significant portion of the market with nearly $90bb outstanding securities and strong investor sponsorship
Outstanding Amount of Agency CMOs
1000 900
Outstanding ($ bb) GNMA FNMA FHLMC

800 700 600 500 400 300 200 100 0 1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Residential Mortgage Research, Banc of America Securities, LLC.

2001 (est)
Page 6

Major Agency and Non-Agency CMO Underwriters

Bank of America plays a prominent role in the Agency and Non-Agency CMO markets as an underwriter and market-maker
CMO Underwriting for Q1-Q3 2001 Dealer UBS Warburg Bear Sterns Salomon Smith Barney Credit Suisse First Boston Lehman Brothers Bank of America Greenwich Capital Goldman Sachs Merrill Lynch JP Morgan
Source: Bloomberg

Rank 1 2 3 4 5 6 7 8 9 10

Amount ($ bb) 46 46 37 36 36 29 18 17 16 7

Residential Mortgage Research, Banc of America Securities, LLC.

Page 7

Market Overview Creating CMOs

n n n n

Cash-flow Structuring Methods: I Cash-flow Structuring Methods: II Analyzing CMO Classes Payment Windows and Average Life

A Detailed Look at CMO Structures The Evolution of CMO Structures

Residential Mortgage Research, Banc of America Securities, LLC.

Page 8

Cash-flow Structuring Methods: I

CMOs cash-flows are created by slicing up the pass-through cash-flows on a mortgage pool
n

The cash-flows on a CMO bond class (tranche) are built by redistributing the principal (both scheduled and prepaid) and interest cash-flows on the underlying mortgage pools A number of different methods may be used to redirect these passthrough cash-flows:
Methods for Creating CMOs Cash-flow Structuring Method Direct transfer of Cashflows Sequential allocation of principal Allocation of principal depending on prepayment speeds Allocation of interest to pay principal Allocation of interest versus principal Indexing of coupon payments Examples Passthrough Sequentials PACs, TACs, Companions Z-bonds, VADMs IOs, POs Characteristics The simplest security; most common in non-agency CMOs Creates securities with a wide range of average lives Creates tranches with more or less average life variability than collateral Increases the average life stability across the structure while increasing duration on the accrual tranche Creates tranches with strong directionality with respect to interest rates Creates securities that are sensitive to both short-term factors (index changes) and long-term factors (prepayment rates)

Floaters and Inverse floaters

Residential Mortgage Research, Banc of America Securities, LLC.

Page 9

Cash-flow Structuring Methods: II

Combining different structuring methods leads to a wide range of structures with a variety of risk profiles
n

Cash-flow structuring methods can be further applied to the cash-flows of the deal itself or to the cash-flows of a particular tranche in the deal For example, structuring methods to create Interest-only (IO) or Principal-only (PO) cash-flows can be applied at the deal level or at the tranche level
n n

at the deal level, IO-ettes can be created by stripping out a portion of the coupon cash-flow to reduce the coupon on the entire deal At the tranche level, IOs and POs can be created by separating the interest and principal from a specific tranche. For example, Support-IOs and Support-POs can be created from a Support tranche

Structuring methods used to create Floater or Inverse Floater cashflows are generally applied at the tranche level
n

For example, PAC-Floaters and PAC-Inverse floaters can be created from PAC tranches

Residential Mortgage Research, Banc of America Securities, LLC.

Page 10

Analyzing CMO Classes

No single relativevalue measure fully captures the risk/reward profile of a CMO class; OAS is the most widely used
n

Most CMO classes pay interest monthly on their current face amount. However, depending upon the allocation of cash-flows, a CMO class may be locked out of principal for some time (the Lockout Period). The Payment Window of a CMO class refers to the period in which principal payments are received, for a given prepayment speed assumption The Weighted Average Life of a tranche measures the average time until the principal is paid, for a given prepayment speed assumption
n n

Average life variability looks at how average life changes when prepayment assumptions are changed Keep in mind that the average life is an average of an entire payment window, which may also widen or tighten as average life changes

The OAS measure values the prepayment option embedded in CMO bonds
n

n n

The option cost from the OAS model captures the variability of average life and duration on a CMO class, and values its potential negative effects. However, it does not take into account potential changes in the Mortgage-LIBOR basis or uncertainty about prepayment assumptions Some CMO bonds are extremely sensitive to the models prepayment assumptions OAS is generally a better measure of relative value for CMOs than classical measures such as yield spread
Page 11

Residential Mortgage Research, Banc of America Securities, LLC.

Payment Windows And Average Life

Principal Cash-flows on Sequentials at 20% CPR $2,500,000

Principal payment ($)

Both the average life and window size of a bond are important in assessing its characteristics

The legal maturity, or stated maturity corresponds to the last cash-flow date, assuming there are no prepayments The payment window tells us the time span between the first principal cash-flow and the last principal cash-flow on the security, for a given prepayment speed. When the payment window starts in the future, we say the bond is locked-out The average life of a bond is the average time until the bonds principal is paid. It lies in the payment window

Window on B
$2,000,000

Tranche B Tranche D

Legal maturity on D
$1,500,000

Legal maturity on B
$1,000,000

$500,000

Window on D Avg Life on D

61 121 181 Time (Months) Principal Cash-flows on Sequentials at 10% CPR 241 301

Avg Life on B
$1

$2,500,000 $2,000,000 Tranche B Tranche D

Principal payment ($)

For reasonable prepayment assumptions, the payment window gives a fairly accurate representation of when the bonds principal will be paid Shorter tranches typically show less variability in average life and window size than longer tranches

Legal maturity on D
$1,500,000

Window on B
$1,000,000

Legal maturity on B

$500,000

Window on D Avg Life on D

61 121 181 Time (Months) 241 301

Avg Life on B
$1

Residential Mortgage Research, Banc of America Securities, LLC.

Page 12

Market Overview Creating CMOs A Detailed Look at CMO Structures

n n n n n n n n n n

Passthrough Sequentials PACs and Supports TACs and Supports Z-Bonds and VADMs Floaters Interest-Only and Principal-Only The Effect of a Structures Coupon The Effect of the Underlying Collateral The Effect of Changes in Collateral Refinancing Incentive

The Evolution of CMO Structures

Residential Mortgage Research, Banc of America Securities, LLC.

Page 13

A Typical Mortgage Pass-Through Payment Structure

The pass-through channels all principal and interest payments to the investor
n

A pass-through MBS transfers principal and net interest payment to the investor Prepayments significantly affect the pass-throughs cash-flow profile and shortens its average life relative to the scheduled payments
Principal and Interest Payment on a 30-year Mortgage with no Prepayments 9 Payment (in % of balance) 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 2 2 2 3 2 4 2 5 2 6 2 7 28 29 30 Years
Principal Interest

Principal and Interest Payment on a 30-year Mortgage with Prepayments

18 Payment (in % of balance) 16 14 12 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Years Principal Interest

Residential Mortgage Research, Banc of America Securities, LLC.

Page 14

Sequentials: Payment Structure

Sequentials are among the simplest CMO structures
n

All the principal cash-flows from the underlying collateral are allocated to one tranche at a time. When that tranche pays off, the next tranche receives all the principal payments and so on. In other words, the tranches in the CMO are sequentially allocated principal payments Principal payments are therefore segmented into different average-life securities. However, the average life of these securities can change depending on prepayments By convention, average lives are calculated at a Pricing Speed (a constant prepayment speed assumption used to calculate yields from prices)
Principal Cashflows on a Sequential Structure at 100 PSA
$1,000,000 $900,000 Tranche A Tranche B Tranche C Tranche D

Principal Cashflows on a Sequential Structure at 200 PSA

$1,000,000 $900,000 $800,000 Principal payment ($) $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121 181 Time (Months) 241 301 Tranche A Tranche B Tranche C Tranche D

Principal payment ($)

$800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121

181 Time (Months)

241

301

The graphs demonstrate how the underlying collaterals propensity to refinance directly impacts the cash-flows from a Sequential class
Page 15

Residential Mortgage Research, Banc of America Securities, LLC.

Sequentials: Relative Value

Sequentials retain most of the collaterals negative convexity while offering a wide range of durations
n

The collaterals prepayment risk is not evenly distributed across the different sequential classes
Typical Relative Value Indications for Sequentials Bond Average Life 2-year Option Cost 35 Effective Duration 1.0 Effective Convex. -1.5 Remarks The smaller option cost is generally due to the lack of collateral seasoning Very similar to collateral at issuance This tranche gets the cash-flows that on average are the most prone to refinancings The slightly lower option cost is due to burnout on underlying collateral

5-year 10-year

65 75

3.0 5.0

-2.0 -2.0

20-year

60

9.0

-1.0

Collateral

65

3.8

-1.6

Residential Mortgage Research, Banc of America Securities, LLC.

Page 16

PACs and Supports: Payment Structure

A substantial portion of the collaterals prepayment risk is diverted from the PACs to the Support bonds
n

A PAC (Planned Amortization Class) maintains the same principal redemption schedule across a range of prepayment rates and therefore offers protection against prepayment risk Support (or Companion) classes allow the PAC to maintain its redemption schedule by absorbing faster than expected prepayments and contributing principal cash-flows if prepayments are slower than expected
Principal Cashflows on a PAC / Companion Structure at 100 PSA
$1,000,000 $900,000 Companion PSA 100 PAC 80-250

Principal Cashflows on a PAC / Companion Structure at 200 PSA

$1,000,000 $900,000 Principal payment ($) $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $Companion PSA 200 PAC 80-250

Principal payment ($)

$800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61

121

181 Time (Months)

241

301

61

121

181 Time (Months)

241

301

The range of prepayment speeds for which the PACs can meet their schedule, called the PAC band, depends on the size of the PACs relative to the supports
n

The wider the PAC band, the fewer the PACs in the structure
Page 17

Residential Mortgage Research, Banc of America Securities, LLC.

PACs and Supports: Relative Value

PACs offer a wide range of durations, along with better convexity characteristics than Sequentials
n

PACs are generally sliced into smaller tranches with distinct averagelife characteristics
Typical Relative Value Indications for PACs and Supports Bond Average Life 2-year PAC 5-year PAC 10-year PAC 20-year PAC 2-year Support 5-year Support 10-year Support 20-year Support Option Cost 10 35 50 35 135 125 100 90 Effective Duration 1.5 2.5 4.5 7.5 2.7 5.0 5.3 5.6 Effective Convex. -0.7 -2.0 -1.6 -0.5 -3.0 -2.5 -1.3 -1.9 Remarks All the PACs have a smaller option cost than collateral Shorter PACs benefit from lower refinancings like sequentials The shortest support bonds have the greatest option cost and negative convexity, because their principal schedule can vary significantly

Collateral

65

3.8

-1.6

The structuring technology used to create PAC and Support cash-flows can also be applied recursively at the tranche level
n n

Applied to the support bonds, it creates PAC IIs and PAC IIIs Applied to the PACs, it creates Super-PACs and Sub-PACs
Page 18

Residential Mortgage Research, Banc of America Securities, LLC.

TACs and Supports: Payment Structure

TACs offer asymmetric protection against prepayments
n

TACs (Targeted Amortization Classes) offer protection only against faster prepayments
n n

They are similar to PACs with a lower band equal to the pricing speed For prepayments slower than the pricing speed, the principal payments on a TAC extend in a manner similar to a Sequential class
Principal Cashflows on a TAC / Support Structure at 100 PSA
$1,000,000

Principal Cashflows on a TAC / Support Structure at 200 PSA

$1,000,000 $900,000 Principal payment ($) $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121 181 Time (Months) 241 301 TAC Support TAC 250
Principal payment ($)

$900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121

TAC Support TAC 250

181 Time (Months)

241

301

TAC Supports extend less than PAC Supports when prepayments slow down and behave similarly to PAC Supports when prepayments rise

Residential Mortgage Research, Banc of America Securities, LLC.

Page 19

TACs and Supports: Relative Value

TACs are more stable than Sequentials but less stable than PACs. This is exhibited in their option-adjusted characteristics
n

As with PACs, TACs can be segmented and offer a wide range of average-lives and durations The option cost on TACs is about 15-25bps more than on similar average life PACs and about 5-10bps less than on Sequentials
Typical Relative Value Indications for TACs and Supports Bond Average Life 2-year TAC 5-year TAC 10-year TAC 20-year Support Option Cost 25 60 60 92 Effective Duration 1.5 3.0 5.5 5.5 Effective Convex. -1.0 -2.2 -1.5 -2.2 Remarks Short TACs have little optionality, while longer TACs have option costs similar to collateral Long TAC Supports have optional characteristics similar to long PAC Supports

Collateral

65

3.8

-1.6

Residential Mortgage Research, Banc of America Securities, LLC.

Page 20

Z-Bonds and VADMs: Payment Structure

Z-bonds tend to stabilize average lives in a structure. VADMs can be structured to benefit from this increased stability
n

Z-bonds are initially locked out of interest and principal payments. The interest payments due on the principal balance of the class are allocated to other tranches and the Z gets credit for these payments by accreting principal. Once the classes before the Z are fully paid down, the Z class begins to receive principal and interest Interest payments on the Z may be allocated to:
n n n

Sequential classes; Specific tranches called VADMs (Very Accurately Defined Maturities). VADMs generally benefit from very stable average-life profiles; Or to other tranches to retire them earlier

Principal Cashflows on a Z-Bond / Accrual Structure at 100 PSA

$1,000,000 $900,000 Principal payment ($) $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121 181 Time (Months) 241 301 Tranche A Tranche B
Principal payment ($)

Principal Cashflows on a Z-Bond / Accrual Structure at 200 PSA

$1,000,000 $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $1 61 121 181 Time (Months) 241 301 Tranche A Tranche B Tranche C Tranche Z

Tranche C Tranche Z

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Page 21

Z-Bonds: Relative Value

Sequential Zbonds typically have much longer durations and more moderate negative convexity compared to collateral
n

Since Z-bonds start paying interest only after the sequentials and/or VADMs have been paid down, they resemble zero-coupon bonds (from which they draw their name). In particular, a Z-bond is characterized by:
n n

Long duration Increased convexity

Typical Relative Value Indications for Sequentials and Z Structures Bond Average Life 2-year Sequential 5-year Sequential 10-year Sequential 20-year Z-Bond Option Cost 35 65 65 75 Eff. Duration 1.0 2.8 5.0 13.0 Eff. Convex. -1.4 -2.0 -1.8 -1.0 Remarks The sequentials in this structure have slightly lower option costs than those in a structure without Z The duration on the Z is significantly longer than on a similar average-life sequential

Collateral

65

3.8

-1.6

Z-bonds can be structured out of PAC cash-flows, instead of sequentials, and are then called Z-PACs

Residential Mortgage Research, Banc of America Securities, LLC.

Page 22

VADMs: Relative Value

The very low option costs on VADMs show they are generally much more stable than PACs or TACs
n

Since they get their principal from the interest payments on the outstanding balance of the Z, VADMs (especially the short ones) are virtually insensitive to variations in prepayments
Typical Relative Value Indications for Sequential-pay/Z-bond structures with VADM Tranches Bond Average Life 2-year Sequential 5-year Sequential 10-year Sequential 20-year Z -Bond Option Cost 35 65 75 70 Eff. Duration 1.0 3.0 5.0 12.5 Eff. Convex. -1.4 -2.0 -2.0 -0.9 Remarks The option cost on the sequentials are 110bps greater than in the case of a structure with no VADMs The characteristics of the Z are very similar to the structure with no VADMs The VADMs have extremely low option costs, reflecting their low average life variability

2-year VADM 5-year VADM 10-year VADM Collateral

2 15 45 65

1.7 3.2 4.6 3.8

-0.1 -0.9 -1.2 -1.6

Residential Mortgage Research, Banc of America Securities, LLC.

Page 23

Floaters: Payment Structure

n

Any fixed-rate paying bond can be sliced into a floater and an inverse floater
n

Fixed-rate interest payments can be transformed into a capped floater and an inverse floater
n n

Fixed-rate interest = Floater + Inverse Floater The cap on the floater comes from the implicit floor on the inverse floater (no negative interest) For example
$50mm 8% = $25mm (LIBOR + 1%, cap at 16%) + $25mm (15% - LIBOR, floor at zero)

n n

The floater generally benefits from attractive characteristics (reduced exposure to prepayment risk, moderate negative convexity) The inverse floater is more leveraged relative to prepayments, and is considered a mortgage derivative

Agency CMO floaters are most often indexed off 1-month LIBOR, but other indices are available in the market, such as COFI

Residential Mortgage Research, Banc of America Securities, LLC.

Page 24

Floaters: Relative Value

Floaters have attractive features since they are not very sensitive to prepayments
n

Floaters have short durations and attractive convexity (slightly negative or sometimes positive)
Typical Relative Value Indications for CMO Floaters Bond characteristics Strip 6% Floater, L+50bps capped at 8.5% Option Cost 51 Eff. Duration 1.1 Eff. Convex. -0.5 Remarks The strip floater amortizes like a passthrough. It benefits from a small option cost relative to collateral, and very moderate negative convexity The PAC floater is a very stable bond, with risk characteristics similar to a very short VADM (but with a longer average life) Support floaters are more leveraged relative to prepayments. They are between plain sequentials and PACs in terms of option cost and risk

Intermediate 6% PAC Floater, L+50bps capped at 8.5%

27

0.3

-0.5

Short 6% Support Floater, L+50bps capped at 8.5% Intermediate 6% Support Floater, L+50bps capped at 8.5%

65

2.0

1.6

65

2.4

-2.9

Residential Mortgage Research, Banc of America Securities, LLC.

Page 25

Interest-Only and Principal-Only: Payment Structure

POs are strongly bullish, while IOs are strongly bearish. They can be used to create synthetic coupons
n

Stripping interest and principal payments from the cashflows on a CMO tranche creates an IO (which get the interest) and a PO (which get the principal). IOs are the ultimate premium cash-flow, while POs are the ultimate discount cash-flow The value of these securities greatly depends on prepayments
n n

Faster prepayments reduce the total amount of interest paid out, which is bad for IOs Slower prepayments mean that PO holders receive their cashflows later, which is bad for them

Interest Flow at Different Prepayment Speeds

700,000 600,000 500,000
800,000 1,200,000

Principal Flow at Different Prepayment Speeds

1,000,000

400,000 300,000 200,000 100,000 0 1 61 121

PSA 200 PSA 100

600,000

PSA 200 PSA 100

400,000

200,000

181

241

301

61

121

181

241

301

Residential Mortgage Research, Banc of America Securities, LLC.

Page 26

The Effect of the Structures Coupon

CMOs can have a different coupon from the underlying collateral
n

By stripping out PO or IO cashflows, the coupon on a CMO tranche can be artificially increased or decreased. The characteristics of the bond are significantly affected
n n

a higher coupon generally shortens duration and widens spread a lower coupon generally lengthens durations and tightens spread

Comparison of a CMOs Characteristics Depending on its Coupon Bond characteristics Front Sequential off 6s 5% coupon 6% coupon 7% coupon IO PO Locked-out 5-year Sequential off 6s 5% coupon 6% coupon 7% coupon IO PO Option Cost 75 95 114 2818 -28 60 90 119 1219 -116 Eff. Duration -0.2 -1.2 -2.2 -110.2 5.2 5.6 3.3 1.2 -50.1 20.9 Eff. Convex. -1.5 -0.8 0.0 80.6 -5.5 -2.3 -3.4 -4.3 -27.7 4.6 Remarks For the short sequential, a lower coupons extends duration and significantly decreases option cost. Since the IO on this short sequential has a positive convexity, lowering the coupon does not improve convexity. The effect of a lower coupon on the intermediate sequential is even stronger: option cost decreases from about 120bps to 60bps. Convexity is also improved by the lower coupon.

Residential Mortgage Research, Banc of America Securities, LLC.

Page 27

The Effect of the Underlying Collateral

The underlying collateral contributes very significantly to a CMOs characteristics
n

Keeping the same structure, changing the underlying collaterals characteristics impacts the bonds risk measures We make such a comparison with PACs, which have stable cashflows under a wide range of scenarios
Comparison of a CMOs Characteristics Depending on its Underlying Collateral Bond characteristics Front PAC (100-300 PSA bands), 6% coupon 6.80 WAC 7.30 WAC 7.80 WAC 15-yr collat Option Cost 42 76 95 52 Eff. Duration 0.4 -0.4 -1.3 0.1 Eff. Convex. -2.2 -2.6 0.0 -1.8 Remarks Increasing the underlying WAC shortens duration (faster prepayments), but it does not necessarily improve convexity. Indeed, the bonds dollar price will be lower, rather than higher since the net coupon is unchanged. Option cost also increases with WAC With the longer PAC, we observe a similar pattern. The improvement in convexity is helped in this case by the larger degree of burnout that will have been experienced by the collateral over the life of the bond

Locked-out PAC (100-300 PSA bands), 6% coupon

6.80 WAC 7.30 WAC 7.80 WAC 15-yr collat

70 88 114 71

1.9 1.6 2.3 1.3

-1.6 -0.2 -0.3 -1.4

Residential Mortgage Research, Banc of America Securities, LLC.

Page 28

The Effect of Changes in Collateral Refinancing Incentive

As refinancing incentives change, the option cost on CMOs is significantly affected
n

The level of refinancing incentive incurred by collateral directly affects its option cost. In the example below, the collaterals option cost varies from 40bps to 120bps The more prepayment protection is offered by a structure, the lowest its option cost The spread between the option cost on these PACs and on collateral is relatively constant over a wide range of refinancing incentives
Option Cost on Structures as a Function of Collateral Refinancing Incentive 140 Collateral 120 100 80 60 40 20 0 -100 PAC (100-250) Super PAC (100-500) Option Cost (bps) PAC-2 (100-250)

-80

-60

-40

-20

20

40

60

80

100

Interest Rate Shift (bps)

Residential Mortgage Research, Banc of America Securities, LLC.

Page 29

Market Overview Creating CMOs A Detailed Look at CMO Structures The Evolution of CMO Structures
n n n n n n n n

The Changing Aspects of CMO Structures The Evolution of a Bonds Average Life Sequentials and Collateral PACs and Supports The PAC Band Drift PAC-2s and PAC-1 Supports Directed Accretion and Zs No VADM Band Drift

Residential Mortgage Research, Banc of America Securities, LLC.

Page 30

The Changing Aspects of CMO Structures

CMO structures evolve through time, mostly as a function of the collaterals prepayments
n

Bond structures are strongly affected by the bonds relative balances. Prepayment protection or leverage always comes down to how large the supporting tranche is compared to the protected tranche As prepayments come in, fast or slow, some bonds are paid down faster or slower than projected at pricing speed. This affects the entire structure, and changes the protection or leverage on the bonds These evolutions take place in addition to the evolution of collateral itself. As mortgages season, their prepayment characteristics also change, sometimes in a dramatic way OAS is the only approach that can at the same time take into account the path-dependent behavior of the collateral and of the structures

Residential Mortgage Research, Banc of America Securities, LLC.

Page 31

The Evolution of a Bonds Average Life

The average life converges towards the beginning of the payment window at first, and then towards maturity
n

A bonds payment windows shape conditions the way its average life will decrease across time
n

When the bond is not paying back principal (during the lock-out period for example), its average life at a given assumed prepayment speed decreases in parallel with time When the bond is paying principal, its average life decreases more slowly than time
The Evolution of Average Life on a Bond
4.0 3.5

Remaining Average Life (years)

3.0 2.5 2.0 1.5 1.0 0.5

Payment window

Avg life
0.0 0 10 20 30 40 Time in months 50 60

Maturity
70 80

Residential Mortgage Research, Banc of America Securities, LLC.

Page 32

Sequentials and Collateral

n

As expected future prepayments change, the anticipated average life on the bonds also changes Relative to their underlying collateral, sequentials have more potential for relative variations in average life However, short sequentials extend much less than collateral in absolute terms and long sequentials shorten much less than collateral
Average Life Profiles on Sequentials vs Mortgage Collateral
30
Collateral

25
Average Life (years)

Sequentials 1 to 4

20

15

10

0 0 100 200 300

Life PSA Assumption

400

500

600

Residential Mortgage Research, Banc of America Securities, LLC.

Page 33

PACs and Supports

PACs offer stable average lives relative to sequentials and collateral
n

PACs offer a flat average life profile for a range of prepayment speed assumptions Typically, shorter PACs have less potential variations in average life relative to longer PACs, in absolute terms Average lives on support bonds are the most variable within the PAC ranges they are supporting
Average Life Profiles on PACs (100-300 PSA bands) and Supports
30
Front PAC

25

Intermediate PAC Long PAC Front PAC support Intermediate PAC support Long PAC support

Average life (years)

20

15

10

0 0 100 200 300 Life PSA Assumption 400 500 600

Residential Mortgage Research, Banc of America Securities, LLC.

Page 34

The PAC Band Drift

Potential Band Drift on a PAC 1000 900 Bands at 5% CPR Bands at 20% CPR

PAC bands do not remain the same over the life of a bond, they tend to drift away

The outstanding balance on the PAC support bonds decays differently depending on the prepayment experience of the collateral When prepayments are fast, the lower PAC band increases and the upper band decreases, since there is less and less support to absorb very fast or very slow prepayments in the future When prepayments are slow, the support tranches size increases relative to the PACs. It increases the upper band, providing a better prepayment protection. However, the lower band does not decrease, since the support needs to be paid down

800 700 PSA Band 600 500 400 300 200 100 0

Jun-02

Jun-03

Feb-02

Feb-03

Aug-01

Aug-02

Aug-03

Feb-04

Jun-04

Apr-02

Apr-03

Apr-04

Aug-04

Dec-01

Dec-02

Dec-03

Oct-01

Oct-02

Oct-03

Time into the future

PAC Average Life Profile 16 14 12 Average life (years) 10 8 6 4 2 0 0 100 200 300 400 500 600 Life PSA Speed Assumption Original profile After 15 months at 5% CPR After 15 months at 20% CPR

Residential Mortgage Research, Banc of America Securities, LLC.

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Oct-04

PAC-2s and PAC-1 Supports

n

PAC-2s are carved out of PAC-1 supports, and offer more stable characteristics than PAC-1 support bonds The supports of the PAC-2s (which also support PAC-1s) are extremely sensitive to prepayments
Average Life Profiles on PAC 2s (150-250 PSA bands) and Supports
30

25

Front PAC-2 Intermediate PAC-2 Long PAC-2 Front PAC-1 support Intermediate PAC-1 support Long PAC-1 support Long Support for the PAC 2

20
Average life (years)

15

10

0 0 100 200 300

Life PSA Assumption

400

500

600

Residential Mortgage Research, Banc of America Securities, LLC.

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Directed Accretion and Zs

n

When the accrued interest from Z tranches is directed to the sequentials that precede it, they benefit from a more stable average life profile
n n

For very fast prepayments, accretion-directed sequentials and non accretion-directed sequentials behave similarly For slow prepayments, the accretion-directed sequentials benefit from a lower average life extension, since in this case the Z tranche generates more interest payments, which are channeled to the sequentials
Average Life Profiles on Plain Sequentials vs Accretion-directed Sequentials

25 Non-accreted intermediate sequential 20 Accreted intermediate sequential Non-accreted front sequential Accreted front sequential
average Life (years)

Final Z tranche 15

10

0 0 100 200 300

Life PSA Assumption

400

500

600

Residential Mortgage Research, Banc of America Securities, LLC.

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No VADM Band Drift

Although sometimes VADMs look like PACs, they are much more protected against changes in prepayments
n

VADMs derive their cash-flow stability from the interest payment on the Z tranche, and not from a schedule
n n

This makes them much less sensitive to whipsaw prepayment scenarios Whether prepayments have been fast or slow, VADMs always benefit from a strong extension protection, since the Z tranche is always present to support them
Average Life Profiles on VADMs

Average life (years)

4 Short VADM 3 Intermediate VADM 5-year VADM 2 Intermediate VADM after 2 years at 50% CPR 5-year VADM after 2 years at 50% CPR 1

0 0 100 200 300 400 500 600 700 800 900 1000 Life PSA Assumption

Residential Mortgage Research, Banc of America Securities, LLC.

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Disclaimer
n

This report is for information purposes only and is based on information available to the public from sources believed to be reliable, but no representation is made that it is accurate or complete, and no information herein should be relied upon as such. Opinions and projections found in this report reflect our opinion as of the report date and are subject to change without notice. This report is neither intended nor should be considered as an offer to sell, or solicitation or basis for any contract, for the purchase of, any security, loan or other financial product. Banc of America Securities LLC, its affiliates, Bank of America Corporation and their respective directors, officers and employees, from time to time may maintain a long or short position in, act as a market maker for, or purchase or sell a position in, securities, loans or other financial products mentioned herein, or of the entities referred to herein, or related investment securities or products. Banc of America Securities LLC or its affiliates may have acted as manager or co-manager for a public offering of securities of companies mentioned herein. Banc of America Securities LLC or its affiliates may be performing, have performed or seek to perform investment banking, advisory, banking or other services for any company mentioned herein. Certain securities in this report may not have been registered under the Securities Act of 1933 as amended (the "Securities Act") and may not be offered or sold except in a transaction pursuant to SEC Rule 144A, Regulation S or otherwise exempt from or not subject to the registration requirements of the Securities Act. Past performance of securities, loans or other financial instruments is not indicative of future performance. This report may not be circulated or reproduced without prior written permission from Banc of America Securities LLC. Further information on any security mentioned herein may be available upon request. Banc of America Securities LLC is a subsidiary of Bank of America Corporation and is a member of NYSE, NASD and SIPC. 2001 Banc of America Securities LLC.

Residential Mortgage Research, Banc of America Securities, LLC.

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