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CMOs, GNMAs and Other Complex Securities: What Are They and Do They Have a Place in Your Portfolio May 20, 2008

Agenda. GNMA and the GSEs

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CMOs, GNMAs and Other Complex Securities: What Are They and Do They Have a Place in Your Portfolio May 20, 2008

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    8. Collateralized Mortgage Obligation Security which pools together mortgages and separates them into tranches (French for “slice”) Tranches are short-, medium-, and long-term Yield on each tranche differs by maturity/type CMO structures can provide P&I payments in a more predictable manner than pass-throughs

    9. CMO Market

    10. Tranche: Class of securities with same characteristics. French for “slice” Principal Window: Represents time from First Principal Payment to Last Principal Payment First payment ends lockout period Prepayments: The unscheduled partial or complete payment of the principal amount outstanding. CPR (Constant Prepayment Rate): The percentage of principal expected to prepay over the next 12 months. PSA (Prepayment Standard/Speed Assumption): The relationship between the actual prepayment and expected CPR. Weighted Average Life (WAL): Average number of years that each dollar of unpaid principal remains outstanding. OAS (Option Adjusted Spread): The incremental spread earned to the treasury curve (treasury OAS) or the swap curve (LOAS) at a particular dollar price after adjusting for embedded options.

    11. CMO Flavors

    12. Key Items to Consider Type and structure of CMO Anticipated basecase performance Impact of changing interest rates on: Yield Average life Payment window

    13. Types of CMOs “Endless” list of CMO names Most common CMO structures Generic or Sequential Pay Planned Amortization Class (PAC) Companion or Support Class

    14. How A CMO Is Created

    15. Slice it up

    16. The Sum of the Parts

    17. Sequential (SEQ) Structure Each tranche or class is paid down in sequential order Tranche A receives principal payments first Tranche B does not receive principal payments until Tranche A is paid out Tranche C does not receive principal payments until Tranches A and B are paid out SEQs provide some protection against call and extension risk Exchange tranches are used in “Custom CMO Creation” to provide different coupons and/or principal windows

    18. Sequential Pay CMO

    19. Sequential Pay CMO

    20. Sequential Pay CMO

    21. Planned Amortization Class – PAC-1 Very stable CMO class Provides call protection in declining interest rate environments and extension protection in rising interest rate environments Assumes underlying collateral prepays within a specified PAC Band example: 100 - 350 PSA Prepayment speeds outside the band can affect the stability of the payment window Usually inverse spread relationship with SEQs

    22. PAC and Companion Class Structure

    23. PAC and Companion

    24. PAC and Companion

    25. Sequential

    26. Sequential

    27. PAC

    28. PAC

    29. The PAC’s Companion

    30. The PAC’s Companion

    31. PAC and Companion

    32. Weekly Fixed Income Spreads as of 5/12/08

    33. What Causes Spread Differences?

    35. SEQ vs Benchmark Agency

    36. SEQ vs 10-Year MBS

    37. PAC-1s vs Callable Agencies 2.6-Year PAC vs Similar Call & Price Risk One-Time Call PAC picks up 87 to 93 bps yield in -100 to +100 PAC demonstrates less extension risk in +300 PAC has 1.5-Year longer basecase principal window

    38. Indexed Amortizing Note - IAN Cashflow graph looks like balloon collateral More conservative than SEQs Generally 5-, 7- or 10-Year Stated Final Prepayments are indexed to a reference pool of 30-Year Agency collateral Prepayment experience of IAN mirrors ref pool Classified as CMO due to amortizing nature Technically a Debenture, as IANs are not secured by underlying collateral (as traditional CMOs are) FHLB name may provide state tax benefits

    39. Very Accurately Defined Maturity VADM More Conservative than PACs Short Stated Final Maturity Provides Improved Extension Protection PAC Band includes 0% PSA versus only 100 - 150 PSA for most PACs Worst Case Scenario is known

    40. Distressed/Busted PAC Originally a PAC CMO Results from Accelerated Prepayments Distressed (Bruised) = PAC Bands have Narrowed increased prepayments remaining amount of support tranches Busted (xPAC) = PAC Bands No Longer Exist Sequential Pay Spreads with Less Risk Dependent on Structure

    41.

    42. Why CMOs? Large, liquid market Help fit investment portfolio needs Payment windows Lockout periods More predictability of cash flows Structured cash flows vs pass-throughs High credit quality, high yield and low negative convexity versus alternative products Easier to express interest rate opinion Available analytics (Bloomberg, Yield Book) Model the cashflow, price risk and impact on the overall portfolio in a variety of interest rate scenarios

    43. Fitting Portfolio Needs More defined cash flows Short-term, intermediate, or long-term Cash flows Average lives Variety of cash flow streams Manage call and/or extension risk

    44. Tailoring Your Portfolio Needs Laddering portfolio cashflows: Payment windows Lockout periods Express interest rate opinion WAL/Duration Payment Window Lockout Coupon Many CMOs have cashflows that resemble other bond types Improve yield Improve predictabilty and stability Improve cash flow Manage Risk Call/extension risk Variability

    45. The Other Complex Securities There are so many variables across portfolio needs and resources. More complex securities require more time. More specialization. Many do not fit at all. Complex ? Evil

    46. Disclaimer

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