Nomura MBS Research 9-16

MGM Mirage
Securitized Products Weekly

Credit Research | United States
Securitized Products Research | Americas
24 SEPTEMBER 2010
Agency MBS: Market Overview and Relative Value Fixed Income Research
During the past week, 30-year lower coupon agency MBS (4.0s and 4.5s) have lagged Contributing Research Strategists
their Treasury hedges by 10-12 ticks and swap hedges by 7-9 ticks. 30-year and 15-
year 3.5s passthroughs were the best performers across the respective coupon stacks. Ohmsatya Ravi
Although we are holding on to our tactical modest overweight on agency MBS versus +1 212 667 2338
Treasuries and swaps because of the current cheap valuations of agency MBS, we ohmsatya.ravi@nomura.com
have little conviction on this trade as supply/demand technicals are negative for the
Gaetan Ciampini
agency MBS sector. We have initiated up-in-coupon trades across the 15-year and 30-
+1 212 667 2408
year coupon stacks to take advantage of the recent sharp underperformance of the gaetan.ciampini@nomura.com
higher coupons.
Agency MBS: How Bad are the Bad Billions? Dhivya Krishna
+1 212 667 2183
The fastest paying $20bn pools (excluding pools locked in CMOs and held by the Fed) dhivya.krishna@nomura.com
are prepaying marginally faster than breakeven speeds implied by 30-year Fannie
dollar rolls. Based on recent prepays on these worst to deliver pools and our Ankur Mehta
expectations of a further increase in speeds over the next two months, we think that +1 212 667 2330
dollar rolls are still trading rich. ankur.mehta@nomura.com
Agency MBS: Outlook for Domestic Bank Demand
Paul Nikodem
Although the yield curve is steep and loan demand has been weak, which typically +1 212 667 2130
point to strong demand for agency MBS from domestic banks, we have been paul.nikodem@nomura.com
maintaining a bearish stance on the magnitude of likely demand for agency MBS from
domestic bank portfolios since the beginning of 2010. As we have 7-8 months of data Lea Overby
related to changes in bank holdings of agency MBS in 2010 and there is some clarity +1 212 667 9479
around required bank capital and liquidity ratios from Basel III, we are revisiting the lea.overby@nomura.com
issue of bank demand for agency MBS this week.
Sean Xie, CFA
Mortgage Credit: +1 212 667 9081
The non-agency mortgage market was fairly active in the past week, with about $3bn sean.xie @nomura.com
bonds trading off bid lists. Prices were firmer for Alt-A and Prime Fixed-rate bonds, and
subprime seasoned mezz bonds.
Consumer ABS: Primer on Pooled Aircraft Securitization
We analyze the main drivers of performance for pre-9/11 pooled aircraft (―classic‖)
securitizations. At current valuation, we find that the rebound in the transportation
sector has been fully priced and deals have limited upside. Table of Contents Page
Agency MBS: Overview 2
CMBS Market
Agency MBS Prepays 7
Spreads remain firm as we head into quarter end, with Super Senior CMBS closing at
Agency MBS: Bank Demand 10
300bp over swaps. We take a closer look at the relationship between commercial real
Mortgage Credit 15
estate prices and loss severities. We also highlight two recent loan workouts and the
effects of each on certain tranches in their respective deals. Consumer ABS 17
CMBS Market 29
Nomura Securities International Inc.

See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
Nomura | Structured Products Weekly 24 September 2010
Agency MBS: Market Overview and Relative Value

Recent Performance and Market flows
During the past week, 30-year lower coupon agency MBS (4.0s and 4.5s) have lagged their Ohmsatya Ravi
Treasury hedges by 10-12 ticks and swap hedges by 7-9 ticks (Thursday – Thursday closes). 30- +1 212 667 2338
year and 15-year 3.5s passthroughs were the best performers across the respective coupon ohmsatya.ravi@nomura.com
stacks. The strong variation in the performance of different coupon passthroughs over the week
could be gauged from the fact that the dollar prices of FN 5.0s-6.0s have declined by 2-4 ticks Ankur Mehta
over the week even as the dollar price of FN 3.5s increased by close to 1-point over the same +1 212 667 2330
time period. Renewed concerns about the possibility of the Fed increasing the size of its Treasury ankur.mehta@nomura.com
purchases and potential changes to the streamlined refinancing programs of the GSEs have
dominated overall market sentiment this week.
Dhivya Krishna
Last week, Trust IOs have continued to lag their current coupon TBA hedges by 20-24 ticks which +1 212 667 2183
is in addition to the 1-2 point underperformance seen over the prior several weeks. Although a dhivya.krishna@nomura.com
major portion of this underperformance could be attributed to market pricing in the very high
callability of 2009 and 2010 vintage collateral, we believe that Trust 4.5% and 5% IOs are
attractively priced at current price levels. While we believe that long-term investors should start
initiating modest long positions in Trust IOs (or IOS) considering the current attractive valuations,
we want to emphasize again that the Trust IO market is suffering from the negative technicals
coming from heavy issuance of structured IOs and we are not sure when its effect will subside.
MBS Basis: Modest Overweight but not with Much Conviction....

Below we summarize some positive and negative technicals for the agency MBS basis at the
moment:
Positive Factors:
a) Agency MBS are trading at wide spreads versus Treasuries and swaps relative to the
spreads seen over the past several months.
b) Money managers are still significantly underweight on agency MBS which puts a cap on
how much MBS could widen from here.
c) There is very limited float available in the agency MBS market (although the float
situation is improving every single month).
d) Current low absolute levels of yields which means MBS could trade at tighter spreads
than historical averages.
Negative Factors:
a) Heavy net supply of agency MBS to private investors from paydowns on Fed and
Treasury holdings of MBS.
b) Dollar rolls have weakened recently which reduced carry attractiveness of mortgages.
c) Any activity from the Fed on initiating a new QE 2 over the next two Fed meetings is
likely to be unfavorable to MBS versus Treasuries.
d) High prepay uncertainty because of the possibility of streamlined refis.
e) Overseas investor demand for MBS is likely to disappoint the market: Recent sharp
decline in Fed's custody holdings is indicating at least a small decline in overseas
holdings of MBS in August and September (although the magnitude is highly uncertain).
f) Growth in bank holdings of agency MBS is uncertain: Recent growth in bank holdings of
agency MBS was primarily driven by MSR hedging. This flow should go away from now
onwards or could even reverse in a backup in rates. At the same time, Liquidity
constraints imposed by Basel III on banks should push banks to continue to use
2
paydowns on their loan and securities holdings to reduce reliance on whole sale funding
rather than to buy new assets.
g) MBS investments are unlikely to benefit from a sharp decline in implied volatilities as
seasonal factors are such that implied volatility will have a bias to move higher between
now and the end of the year.
Figure 1 shows our estimates of the likely net supply/demand for agency MBS from September-
December of this year assuming that the 30-year mortgage rate remains below 4.50% (these are
average monthly supply/demand technicals and the demand numbers corresponding to different
market participants are net of paydowns).
Figure 1: Estimates of Monthly Supply/Demand Technicals for Agency MBS
Net Growth of Agency MBS market

Net supply (excl. GSE buyouts) $21bn
GSE buyout volume -$12bn
Net growth of agency MBS $9bn
Likely net demand for agency MBS
Federal Reserve + Tsy -$36bn
Domestic banks $7bn
Overseas investors $5bn
GSEs -$10bn
Others (Domestic Money Managers) $20bn
Excess Supply $23bn
Note: We believe that the risk to our estimates of net demand from banks, overseas investors and GSEs is to the downside.
Source: Nomura Securities International
th
Our strategy team initiated a tactical modest overweight on agency MBS on September 10 when
mortgages were lagging their Treasury and swap hedges by 4-6 ticks on the day. Although we are
holding onto this recommendation for now, we don’t expect mortgages to either significantly
outperform or underperform Treasuries and swaps from a long-term perspective. Agency MBS
look cheap in terms of both nominal and option-adjusted spreads, but the long-term
supply/demand technicals are somewhat negative for the mortgage basis because of the heavy
net supply of agency MBS to private investors. A sustained outperformance of agency MBS
probably requires domestic bank portfolios (instead of their servicing arms) to grow their MBS
holdings significantly which we doubt will materialize in the remainder of 2010. Thus, as
discussed in our last weekly report, our overweight on MBS is more of a short-term tactical trade
rather than a core view on the long-term direction of MBS spreads.
Relative Value in Agency Passthrough Market1

 UIC in 30-year MBS: Long 30-year 5.5s/4.5s Swap (New Trade)
 UIC in 15-year MBs: Long DW 5.0s/4.5s Swap (New Trade)
 15-year MBS vs. 30-year MBS: Long DW 3.5s/FN 4.0s Swap (New Trade)
 Take Profits on Short DW 4.0s Butterfly (Since 9/16/2010)
Figures 2 and 3 show the valuations of 30-year and 15-year coupon stacks on our models as of
yesterday’s closes (YieldBook models adjusted to reflect our expectations for prepayment speeds).
1
This subsection is a reprint of the short-note published earlier today.
3
Following the significant underperformance of the up-in-coupon trades over the past several weeks,
higher coupons are beginning to look attractive versus lower coupons in both 15-year and 30-year
markets. We recommend long 30-year FN 5.5s/4.5s swap (at a hedge ratio of 45%) and long 15-
year DW 5.0s/4.0s swap (at a hedge ratio of 50%) trades to take advantage of the current
cheapness of higher coupons. Obviously, there is some idiosyncratic risk in these trades in that
FN/FH could ease requirements for refinancing existing agency mortgages further which could hurt
higher coupons in the short-term. However, we believe that current valuations of higher coupons
are such that there is enough risk premium built in the dollar prices of higher coupons to buy FN
5.5s/4.5s and DW 5.0s/4.0s swaps. Our conviction on the up-in-coupon trade in 15-year MBS is
somewhat better than that in 30-year MBS market however. Both these coupon swaps are lagging
by 0.5 tick on the day today and we will track the performance of these swaps without curve
hedges starting from current levels.
We are also reinitiating the long DW 3.5s/FN 4.0s trade that we closed last week to take advantage
of the strong positive carry offered by this swap. At current dollar roll levels, DW 3.5s/FN 4.0s swap
is offering 2.75 ticks per month of positive carry and the swap still looks slightly cheap. We expect
the demand for DW 3.5s from money managers and domestic banks to remain strong and
recommend buying it for November settlement (to lock in Oct/Nov rolls).
th
Finally, our strategy team recommended shorting the DW 4.0s butterfly on September 16 when
this fly was bid at 21 ticks. As DW 3.5s have significantly outperformed across the 15-year coupon
stack, this fly had come down to 14/15 tick levels over the past one week. Although the strong
demand for DW 3.5s could drive this fly further down to 10-11 ticks, we recommend taking profits
on the short DW 4.0s fly trade now as fundamentally the fly looks close to fairly priced at the 14/15
2
tick level .
Figure 2: Valuations of the 30-year Coupon Stack (as of September 23, 2010)
Security TBA Assumption (Oct) Yield Tsy ZV (bp) Swap ZV (bp) Tsy OAS (bp) LOAS (bp)
FNCL 4.0s 2 WALA, 4.55 GWAC, $300 K 3.24% 90 93 17 17
FNCL 4.5s 6 WALA, 4.95 GWAC, $290 K 2.94% 116 114 28 24
FNCL 5.0s 20 WALA, 5.45 GWAC, $280 K 2.50% 123 115 34 25
FNCL 5.5s 28 WALA, 6.05 GWAC, $240 K 2.22% 124 110 57 43
FNCL 6.0s 24 WALA, 6.53 GWAC, $220 K 2.04% 115 99 77 62
Source: YieldBook, Nomura Securities International
Figure 3: Valuations of the 15-year Coupon Stack (as of September 23, 2010)
Security TBA Assumption (Oct) Yield Tsy ZV (bp) Swap ZV (bp) Tsy OAS (bp) LOAS (bp)
FNCI 3.5s 2 WALA, 4.05 GWAC, $230 K 2.67% 75 66 34 24
FNCI 4.0s 2 WALA, 4.50 GWAC, $260 K 2.49% 86 76 31 20
FNCI 4.5s 6 WALA, 5.10 GWAC, $220 K 2.20% 88 75 33 19
FNCI 5.0s 24 WALA, 5.55 GWAC, $200 K 2.09% 96 81 47 31
FNCI 5.5s 30 WALA, 6.05 GWAC, $180K 2.05% 94 78 51 34
Source: YieldBook, Nomura Securities International
VA Prepays Much Faster than FHA

Besides a couple of months in late 2009 and early 2010, when servicer related buyouts were fairly
high, VA prepay speeds have been noticeably faster than FHA. We show a snapshot of prepays
in August (September factor) on FHA and VA loans backing Ginnie Is in Figure 4. VA loans
prepaid anywhere between 2%CPR to 15%CPR faster than FHA loans. We attribute the faster
prepays on VA loans to their relatively relaxed streamline refinance program and lower
refinancing cost (Figure 5). The FHA UFMIP of 225bps versus the 50bp of VA guarantee fee
coupled with the fact that the VA’s IRRRL program (the VA Streamline refinancing program) does
not require any credit check and additional documentation is causing VA speeds to be higher
2
This subsection is a reprint of the short-note published on September 22nd.
4
across the coupon stack. We expect the difference between FHA and VA prepay speeds to
increase further as the new insurance premiums for FHA borrowers become effective in October
2010. Based on our estimates, we expect the change in FHA insurance premiums to add an
3
additional 36bps of disincentive for FHA borrowers .
Figure 4: Comparison of FHA and VA prepay speeds for different coupons and vintages for August 2010
50
45
40
35
30
CPR (%)
25
20
15
10
5
0
2009 2010 2009 2010 2009 2008 2005 2009 2008 2007 2006 2005 2009 2008 2007 2006 2005 2008 2007 2006
4 4.5 5 5.5 6 6.5
FHA VA
Source: Ginnie Mae, Nomura Securities International
Figure 5: Comparison of FHA and VA Streamline Refinance Programs

FHA Streamline Refinance VA Interest Rate Reduction Refinancing Loan (IRRRL)
Borrower must have made at least 6 payments on the
Seasoning None.
FHA-insured mortgage being refinanced.
Borrower has made all the prior three payments and
Borrowers who are 30-days or more delinquent can also
Payment History experienced only one 30-day late payment. For less than
refinance through IRRRL if VA approves.
12-month payment history all payments must be made
New total mortgage payment (principal, interest, taxes
Reduction in Total and insurances, homeowners’ association fees, ground
New payment is lower.
Mortgage Payment rents, special assessments and all subordinate liens) is 5
percent lower.
Appraisal Required if borrower rolls closing costs into the loan. Not required.
CLTV limit of 125% is only applicable if a loan has
LTV Limits None.
subordinate financing
Required only if loan to be refinanced is delinquent or if
Credit Score Lender reports credit score to FHA if available.
new monthly payment (PITI) increases more than 20%.
Income, Employment
Lender must verify and document borrowers income, Required only if loan to be refinanced is delinquent or if
and Asset
employment and assets. new monthly payment (PITI) increases more than 20%
Documentation
• Closing costs: Can be rolled into new loan amount only
with and appraisal. • Closing costs: Can be rolled into new loan amount.
Costs • Upfront Mortgage Insurance Premium of 225bps • VA Guarantee Fee of 50bps (UFMIP): Can be rolled into
(UFMIP): Can be rolled into new loan amount. new loan amount.
• Monthly Annual Premium of 50bps.
Can roll in upto 2% of discount points into new loan
Discount Points Cannot be rolled into new loan.
amount.
Source: FHA, VA, Ginnie, Nomura Securities International
3
―Impact of a Change in Insurance Premiums‖ in Securitized Products Weekly August 20th 2010
5
August Freddie Transition Rates

Freddie released the 90-day and 120-day delinquency matrices along with their monthly volume
summary today. The 120-day delinquencies were marginally higher than expected (Figure 6)
because of higher 90-120 day roll rates in August (Figure 7). As per the latest release, 90-day
delinquencies at the end of August were lower than the prior month. As a result we expect the
4
120-day delinquencies for the end of September to be lower than August (Figure 6) .
Figure 6: Projected and Actual End of August 120-day Delinquencies
Source: Freddie Mac, Nomura Securities International
Figure 7: Ratio of Freddie August and July 90-day delinquency and 90-120 roll rates
4
Note that the projected 120-day delinquencies for September will be eligible for repurchase in October.
6
Agency MBS: How Bad are the Bad Billions?

Summary
The fastest paying $20bn pools (excluding pools locked in CMOs and held by the Fed) are Ankur Mehta
prepaying marginally faster than breakeven speeds implied by 30-yr Fannie dollar rolls. Based on +1 212 667 2330
ankur.mehta@nomura.com
recent prepays on these worse to deliver pools and our expectations of a further increase in
speeds over the next two months, we think that dollar rolls are still trading higher than fair value.
Dhivya Krishna
Dollar Rolls and Worst Billions +1 212 667 2183
dhivya.krishna@nomura.com
Dollar rolls across the coupon stack have collapsed over the last few cycles as a combination of
higher dollar prices and faster prepays resulted in prepay speeds on TBA deliverable collateral to
worsen significantly (partly because some real money investors that usually didn't dollar roll sold Ohmsatya Ravi
passthroughs and delivered fast prepaying pools worsening the overall pool available to be +1 212 667 2338
delivered towards TBA). Figure 1 shows breakeven speeds on Oct/Nov rolls assuming a funding ohmsatya.ravi@nomura.com
rate of 25bps.
Figure 1: Oct/Nov Rolls and Breakeven Speeds assuming 25bp Funding
Oct/Nov Roll b/e CPR assuming

Coupon
(ticks) 25bps funding (%)
4.0s 9 0%CPR
4.5s 6.75 25%CPR
5.0s 3.125 43%CPR
5.5s 3.25 42%CPR
6.0s 3.75 40%CPR
Clearly, October prepay speeds (November factor) that are being priced into the Oct/Nov roll are
fairly high. To see how these implied speeds compare with prepays on some of the fastest paying
pools, we summarize collateral characteristics on the worse $20bn pools for each FNMA coupon in
the table below. We exclude pools locked up in CMOs and held by the Fed since they are very
unlikely to be delivered into TBA. To eliminate pools which had just a one month jump in prepays,
we sorted out fast paying pools based on 3-month CPRs.
Figure 2: Collateral Characteristics of Fastest Paying 30-yr FN $20bn Pools (Excl. Pools locked in CMOs and Fed held pools)
Coupon WAC WALA AOLS WAM FICO LTV 1-mo CPR (%) 3-mo CPR (%)
4.0s 4.60 17 242,682 338 766 65 7 5
4.5s 5.17 51 225,531 301 748 69 35 28
5.0s 5.61 38 239,923 315 745 72 48 39
5.5s 6.02 42 236,072 312 733 74 44 39
6.0s 6.53 41 224,823 314 719 77 43 42
6.5s 7.04 41 174,802 314 696 81 36 36
Source: Fannie Mae, Nomura Securities International
Based on the data presented in Figure 2, the $20bn fastest prepaying pools (excluding pools
locked up in CMOs and held by the Fed) prepaid at 35% CPR for FN 4.5s, 48% CPR for FN 5.0s,
44% CPR for FN 5.5s and 43% CPR for FN 6.0s. Interestingly enough, the WALA on the worst to
7
deliver pools in FN 4.5s is 56 months, much higher than what we have been seeing through-the-
box. Similarly, the average WALAs on 5.0s-6.0s are also higher than the pools that are being
delivered through-the- box. Although it can be argued that these fast paying seasoned bonds
should be delivered into TBA, it is possible that they are in held to maturity portfolios of Banks or
Overseas Investors and are thus not delivered out. To adjust for this, we only consider pools with
WALA less than 48 months and re- calculate the worse $20bn pools across the coupon stack in
Figure 3 After putting the WALA restriction, the average WALA on the worst to deliver pools are
much closer to the through-the-box pools.
Figure 3: Collateral Characteristics of Fastest Paying 30-yr FN $20bn Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)
4.0s 4.58 13 245,936 342 768 65 6 5
4.5s 5.04 17 261,318 339 761 69 31 23
5.0s 5.62 26 236,877 329 747 72 47 38
5.5s 6.05 32 237,364 323 733 75 42 37
6.0s 6.54 34 226,668 322 719 78 40 39
6.5s 7.05 36 175,068 321 695 82 33 33
Source: Fannie Mae, Nomura Securities International
The 1-month CPRs on the worse to deliver pools considered above are much higher for 4.5s and
5.0s and more-or-less inline for 5.5s and 6.0s as compared to the implied breakeven CPRs on the
Oct/Nov roll. Apart from comparing prepays on this table to breakeven prepays on the roll,
investors need to consider the following important factors:
 The 1-month CPRs in the table above correspond to August prepays (September
factors). We expect speeds to increase by around 15% in September (October factor)
and another 5% in October (November factor) with a majority of the increase occuring in
4.0s through 5.0s. Hence, prepays on worse to deliver pools are likely to be higher
corresponding to the Oct/Nov roll.
 The deliverables have gradually deteriorated over time as dollar prices increased and
prepays jumped. Investors holding consistently fast paying seasoned bonds seem to be
gradually delivering these pools into TBA and this may lead to a further deterioration of
TBA deliverables (as shown above, prepays on the worse $20bn pools without WALA
restriction are faster).
 We have considered the worse $20bn bonds for each coupon. As we move higher
across the coupon stack, liquidity decreases and the size of the trades goes down.
Arguably, one should consider a smaller float (for example, instead of the worse $20bn
pools, one should consider the worse $5bn or $10bn pools for FN 6s) for the worse to
deliver. This will result in worse collateral characteristics (and prepays) than the ones
outlined in the tables above.
 We have not accounted for pools held by investors (like some overseas
investors/banks/insurance companies) who may choose not to roll the bonds that they
hold. This could improve the actual float that is delivered into TBA.
Overall, based on recent prepays on worse to deliver pools and our expectations of a further
increase in speeds over the next two months, we think that 30-year Fannie Mae dollar rolls are
still trading higher than fair value.
8
Worst Billions for Freddie and Ginnies

We summarize the collateral characteristics and prepays on the worse $20bn Freddie, GN I and
GN II pools (WALA<48) based on 3-month CPRs in Figure 4, 5 and 6 below.
Figure 4: Collateral Characteristics of Fastest Paying $20bn 30-yr FH Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)
4.0s 4.62 11 253,008 345 770 64 8 6
4.5s 5.03 15 254,867 341 763 68 32 22
5.0s 5.61 28 222,711 327 747 70 43 34
5.5s 6.04 29 216,214 326 738 74 42 37
6.0s 6.52 32 217,413 324 721 78 41 38
6.5s 7.02 34 175,920 321 700 82 29 29
Figure 5: Collateral Characteristics of Fastest Paying $20bn 30-yr GN I Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)
4.0s 4.50 11 182969 346 - 94 4 4
4.5s 5.00 17 221794 341 - 94 28 17
5.0s 5.50 18 184979 340 - 94 42 34
5.5s 6.00 27 72015 331 - 94 38 35
6.0s 6.50 28 69973 329 - 94 35 36
6.5s 7.00 29 102886 327 - 93 31 40
Figure 6: Collateral Characteristics of Fastest Paying $20bn 30-yr GN II Pools (WALA < 48, Excl. Pools in CMOs and Fed held pools)
4.0s 4.52 6 188040 352 - 95 3 4
4.5s 4.94 11 191159 347 - 95 10 7
5.0s 5.44 20 171536 338 - 94 27 21
5.5s 5.96 26 146827 331 - 94 32 29
6.0s 5.96 26 146827 331 - 94 32 29
6.5s 6.88 27 122734 329 - 94 32 37
9
Agency MBS: Outlook for Domestic Bank Demand
Since the beginning of 2010, large bank holdings of Treasuries and agency debentures have Ohmsatya Ravi
increased by $87bn, while those of agency MBS have increased by $34bn (Figure 1). Most of the +1 212 667 2338
rise in large bank holdings of agency MBS can be attributed to the $57bn increase seen in July and ohmsatya.ravi@nomura.com
August of this year and banks were actually net sellers of agency MBS in 1H’10. Several investors
have asked us if the recent rise in bank holdings of agency MBS represents a true pick-up in
demand for MBS from bank portfolios or will bank holdings of MBS revert back to the pattern seen Ankur Mehta
+1 212 667 2330
in 1H’10. ankur.mehta@nomura.com
Although the yield curve is steep and loan demand has been weak, which typically point to strong
demand for agency MBS from domestic banks, we have been maintaining a bearish stance on the
magnitude of likely demand for agency MBS from domestic bank portfolios since the beginning of Dhivya Krishna
5 +1 212 667 2183
2010 . We opined that the overall demand for ―all securities‖ from domestic banks in 2010 will be
dhivya.krishna@nomura.com
less than in 2009 as loan holdings of domestic banks are unlikely to decline by as much as they did
in 2009, FAS 166/167 brings additional assets onto bank balance sheets and there is lot of
uncertainty about regulatory issues surrounding bank capital ratios. In addition, even if bank
demand for "all securities" remains as high as in 2009, we thought that domestic banks will
continue to prefer other securities (predominantly Treasuries) over agency MBS unless current-
coupon MBS spreads widen meaningfully. As we have 7-8 months of data related to changes in
bank holdings of agency MBS in 2010 and there is some clarity around required bank capital and
liquidity ratios from Basel III, we are revisiting the issue of bank demand for agency MBS this week.
Figure 1: Changes in Large Bank Holdings of MBS, Treasuries, Loans and Deposits ($bn)
Total Agency Treasuries & Other Loans &
Year Securities MBS Agency Debt Securities Leases Deposits
2001 82 65 -33 50 -6 122
2002 96 51 33 12 139 151
2003 64 33 9 22 190 152
2004 127 97 3 27 440 347
2005 21 4 -17 34 282 208
2006 107 71 -12 48 309 238
2007 54 -47 -5 105 456 285
2008 105 132 -7 -20 315 507
2009 222 60 95 66 -383 58
YTD 2010 57 34 87 -65 153 35
Note: Effect of consolidations due to new accounting regulations in 2010: Loans & Leases: $397bn; Other Securities = -$28.7bn
Source: Fed’s H.8 Report, Nomura Securities International (as of September 1, 2010)
Below we discuss some recent trends in bank demand for mortgages and present our assessment
of some important factors that are likely to drive bank holdings of agency MBS going forward.
Recent Trends in Bank Demand for Agency MBS

Figure 2 shows changes in the mortgage loan and MBS holdings of large domestic commercial
banks over the past few years. The top half shows numbers as reported in the Federal Reserve’s
H.8 report while the bottom half shows corresponding numbers after subtracting assets acquired by
large commercial banks from non-bank institutions through a corporate transaction. Although the
data as reported in the standard H.8 report (top half of Figure 2) is indicating that bank holdings of
all mortgages (MBS + closed end residential mortgage loans) have increased by $85-$90bn per
year over the past two years, it is obscuring some important trends about bank demand for
residential mortgage assets because of the acquisition related changes.
5
See our 2010 Outlook for the RMBS Market published in January 2010 for details.
10
Large domestic banks have acquired about $153bn and $124bn closed-end residential mortgage
loans from non-bank institutions in 2009 and 2008, respectively. They have also acquired $4.9bn
and $11bn agency MBS over the same two-year period. If we exclude acquisitions of mortgage
assets from non-bank institutions, domestic banks do not seem to have grown their exposure to
mortgage assets over the past two years (as shown in bottom half of Figure 2). The sharp growth
in bank holdings of agency MBS in 2008 came from simply reinvesting paydowns on their
unsecuritized mortgage loan holdings back in the agency MBS market. Similarly, the actual net
demand for mortgages provided by domestic banks in 2006 was a lot lower than is indicated by the
standard H.8 reports.
Figure 2: Annual Changes in Large Bank Holdings of Mortgages, C&I Loans and Deposits ($bn) Mort
Not adjusted for acquisition of assets from nonbank institutions & accounting rule changes
Large Banks YTD 2010 2009 2008 2007 2006 2005 2004 2003 2002
Net Mortgage Purchases
Agency MBS 34 60 132 -47 71 4 64 33 51
Whole Loans -5 27 -44 125 178 64 47 59 65
Agency MBS + Whole Loans 29 87 87 78 250 68 112 92 115
C&I Loans -37 -160 46 122 65 61 16 -15 -25

Deposit Growth 35 58 507 306 238 208 195 152 151
All numbers are in billion dollars.
Adjusted for acquisition of assets from nonbank institutions & accounting rule changes
Large Banks YTD 2010 2009 2008 2007 2006 2005 2004 2003 2002
Net Mortgage Purchases
Agency MBS 34 55 121 -51 31 4 64 33 51
Whole Loans -26 -125 -168 120 47 64 47 59 65
Agency MBS + Whole Loans 7 -70 -47 70 78 68 112 92 115
C&I Loans -67 -166 27 110 61 61 16 -15 -25

Deposit Growth 35 -34 292 235 141 208 195 152 151
All numbers are in billion dollars.
Source: The Fed’s H.8 Report, Nomura Securities International (YTD 2010 numbers are as of September 1, 2010)
During 1H’10, bank holdings of agency MBS have declined even as their Treasury holdings have
increased meaningfully. However, this trend of weak demand for agency MBS had reversed since
the beginning of 2H’10 and large bank holdings of agency MBS rose by $57bn in July and August
alone. However, most likely, more than half of this growth came from rebalancing of servicer
duration hedges as servicers took delivery of MBS from their origination arm directly and, the
historical data presented in Figure 3, which shows changes in bank holdings of agency MBS over a
three month time period immediately preceding the peak of Refi index in several instances since
6
2001, seem to support this view . Note that agency MBS holdings of banks increased significantly
every time there was a meaningful pickup in Refi activity (except in late 2007/early 2008, when
banks were actively selling agency MBS to raise cash).
Figure 3: Approximate changes in bank holdings of agency MBS ($bn)

Peak Refi Index Change in
No. Date Level MBS Holdings
1 11/9/2001 5,528 $34bn
2 10/4/2002 6,927 $40bn
3 3/14/2003 9,354 $27bn
4 5/30/2003 9,978 $55bn
5 3/19/2004 4,973 $65bn
6 1/25/2008 5,103 $4bn
7 1/9/2009 7,404 $57bn
6
We first discussed this issue in the short-note titled ―Bank Holdings of Agency MBS‖ published on August 3.
11
We believe that this growth in bank holdings of agency MBS at the onset of a Refi wave is because
of the duration rebalancing of their MSR books and the increase in bank holdings seen thus far in
2H’10 is not unusual. In fact, in prior instances, a meaningful portion of MSR books were with non-
bank financial institutions which have become part of commercial banks since then and the
convexity hedging related demand for agency MBS from banks should be higher now than before,
all else being equal. While it is difficult to estimate exactly what percentage of the recent growth in
bank holdings of agency MBS is because of convexity hedging related activity because of the
differences between the accounting treatment of TBAs at different firms, based on the flows seen
by the Street, we believe that a significant portion of recent growth in agency MBS holdings of
domestic banks had occurred because of convexity hedging related activity.
What Factors will Drive Bank Demand for MBS Going Forward?
Over the past several months, regulatory issues (capital and liquidity related issues) rather than the
availability of cash for investments seem to have been the driving force behind bank demand for
agency MBS. There are two important consequences of this trend in terms of the preference of
domestic banks for Treasuries over other securities classes and their eagerness to reduce
dependency on wholesale funding mechanism versus core deposits.
The first trend related to the preference of banks for Treasuries can be seen in Figure 4 which
shows bank holdings of Treasuries as a percentage of their total securities holdings have
increased noticeably over the past several months. Prior to 2009, most of the growth in securities
portfolios of domestic banks came from ―agency MBS‖ and ―other securities,‖ while their Treasury
holdings have actually declined (both in absolute and percentage terms). Although this trend had
reversed since the beginning of 2009, Treasury holdings by domestic banks is still somewhat lower
than what it was in the 1990s after adjusting for the size of their portfolios.
Figure 4: Different Security Types in Large Bank Portfolios of a % of Total Securities Holdings Mort
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
1997-01-01
1998-02-11
1998-09-02
1999-03-24
2000-05-03
2000-11-22
2002-01-02
2002-07-24
2003-02-12
2004-03-24
2004-10-13
2005-05-04
2006-06-14
2007-01-03
2007-07-25
2008-02-13
2008-09-03
2009-03-25
2010-05-05
1997-07-23
1999-10-13
2001-06-13
2003-09-03
2005-11-23
2009-10-14
Agency MBS Treasuries & Agency Debt Other Securities
Source: The Fed’s H.8 Report, Nomura Securities International
Similarly, banks seem to be reducing leverage on their liabilities side by increasing the percentage
of assets funded by core deposits and reducing their dependence on wholesale funding (Figure 5).
Based on the FDIC data, the percentage of all bank assets funded by core deposits has declined
from 62.4% in 1992 to 42.5% in 2008 but this trend had reversed over the past two years as this
number rose to 49.8% by the end of 2009.
12
Figure 5: Percentage of All Bank Assets Funded by Core Deposits (%)
70.0%
65.0%
60.0%
55.0%
50.0%
45.0%
40.0%
35.0%
30.0%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2009 2Q'10
Note: 1H’10 data includes assets consolidated under new accounting regulations
Source: The Fed’s H.8 Report, Nomura Securities International
Looking ahead, we expect the regulatory issues rather than the combination of the availability of
cash, loan demand and the slope of the yield curve to continue drive bank demand for agency
MBS. Specifically, Basel III imposed a couple of capital and liquidity related issues that are likely to
play an important role in determining bank demand for MBS over the next several quarters as
discussed below.
Capital Related Issues

Although the market’s attention seems to have been focused mainly on the total Tier-1 capital
ratios imposed by Basel III, there is a limit on the contribution of mortgage servicing rights (MSRs)
to Tier-1 capital that could become an important factor for the mortgage market. As per the
guidelines issued by the Basel Committee on Banking Supervision, the value of mortgage servicing
rights (MSRs) needs to be capped at 10% of the bank’s Tier-1 equity capital. An earlier version of
the package issued by the Basel Committee on Banking Supervision would have required
deducting the entire value of MSRs from Tier-1 equity capital but the amendment released in July
only limits MSRs to 10% of the Tier-1 equity capital. However, this is still a lot more restrictive than
the current limit in the U.S. of 50% of MSRs in total common equity.
Right now, most domestic banks seem to be below the 10% cap imposed on the contribution of
MSRs to Tier-1 capital, but this is primarily because of the historically low mortgage rates which led
to very low valuations of MSRs. If mortgage rates backup 100-150bp from here, MSRs could easily
appreciate by 60%-80% from their current values (For example, Trust IOs are trading in the range
of $14-$15 at the moment while they are likely to trade in the range of $25-$30 if mortgage rates
backup 100-150bp from here) and several banks are likely to hit the 10% cap based on the data
presented in the 10-Qs published by different firms for 2Q’10. Essentially, this restriction makes
MSRs less attractive as an asset class for domestic banks. If the US regulators implement Basel III
guidelines without making any changes, we could see servicers more actively securitize MSRs
(through excess servicing IO deals) which should be a modest negative for bank/servicer demand
for agency MBS.
Liquidity Related Issues

The following two liquidity related constraints imposed by Basel III are also likely to play a
meaningful role in the preference of banks for agency MBS versus Treasuries and GNMA MBS
versus conventionals:
 As per Basel III guidelines, the ―Liquidity Coverage Ratio,‖ defined as the ratio of the stock
of high-quality liquid assets to net cash outflows over a 30-day time period, should be
above 100%. Agency MBS count towards liquid assets (with a 15% haircut on FN/FH
13
MBS and 0% hair-cut on GNMA MBS and Treasuries) but FN/FH MBS fall under ―Level 2‖
of liquid assets which cannot be more than 40% total liquid assets as per current Basel III
guidelines. As of now, most of the ―Level I‖ liquid assets of banks are in cash and cash
equivalents (essentially excess reserves) and it is likely that they will consider the
scenario of excess reserves being pulled out of the system by the Fed in the future while
making their investment decisions. If they are worried about this scenario, banks will
prefer Treasuries and GNMA MBS over FN/FH MBS.
 The ―Net Stable Funding Ratio,‖ defined as the ratio of the available amount of stable
funding to the required amount of stable funding, also should be above 100% as per
Basel III guidelines. This constraint is likely to lead banks to prefer MBS over mortgage
loans (because agency MBS need a lot lower lower percentage of stable funding than
mortgage loans) but it is also likely to lead banks to continue to use paydowns on their
loan books to delever on the liabilities side by reducing their exposure to wholesale
funding sources.
Summary Outlook for Bank Demand for Agency MBS

As discussed before, over the past several months, regulatory issues (capital and liquidity related
issues) rather than the availability of cash for investments have been driving bank demand for
agency MBS. Some of the liquidity related constraints imposed by Basel III on domestic banks
should be a positive factor for agency MBS versus mortgages and other loans, but it is also likely
that these constraints will limit the ability of the banks to grow their overall balance sheets. From
valuations side, agency MBS are looking quite attractively priced versus Treasuries and swaps in
terms of both nominal and option-adjusted spreads.
In our base case, we expect the net bank demand for agency MBS from domestic banks to be $6-
$8bn per month (net of paydown reinvestments) over the next several months unless mortgage
spreads widen meaningfully from here. However, we acknowledge that there is still lot of
uncertainty about how regulators will interpret Basel III guidelines in the US and its potential impact
on the preference of banks to buy agency MBS.
14
Mortgage Credit: Market Summary and HAMP update

Market Summary
Non-agency mortgages continued to trade at a torrid pace this week, with about $3 billion in bid
Paul Nikodem
lists circulated around the market. Demand continues to be strong, with buyers outnumbering +1 212 667 2130
sellers by a large margin. Market participants were broad based, with both buyers and sellers paul.nikodem@nomura.com
coming from all types of accounts, including banks, money managers, insurance companies and
hedge funds. Prices were flat to slightly higher during the week.
Sean Xie, CFA
In Alt-A and prime space, roughly $1 billion bonds changed hands. The focus continued to be on +1 212 667 9081
clean fixed-rate passthrough products, with prices firming by approximately half a point during the sean.xie @nomura.com
week. Elsewhere, in the Alt-A and prime space, prices were mostly flat on the week.
About $2.4 billion bonds were in for bid in the subprime and Option ARM markets. Trades in
seasoned Mezz bonds continued to dominate, with prices up by 1-2 points. Yields grinded tighter
as investors are re-evaluating their default expectations in light of the recent fall in current-to-30
day roll rates. Investment grade seasoned Mezz bonds are trading in the 5-7% yield range, while
levered bonds are trading in the low single digits. Supply came from bank prop desks and hedge
fund profit-taking as prices in this sector have risen 10+ points in the past few months. About 400
million bonds in the Option ARM market traded last week, with prices mostly unchanged.
News Update
On Tuesday, Housing Starts in August came in at 598,000, higher than the expected 550,000
units. However, the increase was buoyed by a 32% jump in multi-family and apartment
construction. Single family construction continues to be sluggish, highlighting the lack of
confidence in the housing recovery among the home builders.
The FHFA purchase only house price index for July was released on Wednesday. U.S home
prices dropped 3.3% in July from a year earlier, and fell 0.5% from June. At the same time FHFA
revised the May-to-June decline to 1.2% from the previous estimate of 0.3%. The month-over-
month drop in house prices is primary due to an increase in distressed home sales. The largest
drop occurred in the southeast which fell 1.6%, followed by a 1.5% drop in the states of Arizona
and Nevada. The report highlights the fact that distressed inventory will be an obstacle for home
price recovery going forward. Although the FHFA index only surveys houses with conforming
balance loan, it is highly correlated with more widely watched Case-Shiller index that is to be
release on September 28th.
After hitting all time low in July, existing home sales for the month of August rebounded slightly to
a 4.13 million seasonally adjusted annual rate. New home sale numbers released Friday morning
were lower than expected, at a seasonally adjusted rate of 288,000. Both indices are at the
second lowest level in history, highlighting the lack of demand for housing after the expiration of
home-buyer tax credit in June.
HAMP report update

The August HAMP report was updated on September 22nd and showed that a total of 33,342
permanent modifications have begun since July, compared to 36,695 last month. The number has
continued to decline over the past few months as servicers struggle to verify borrowers’ income, a
requirement to convert a trial modification to a permanent one. At the same time, reported trial
modifications were 26,628, largely unchanged from the previous month. We do not expect the
speed of trial and permanent modifications to pick up significantly from here
This month, the HAMP report added a quarterly compliance review section. This report revealed
that, for loans sampled from large servicers, fewer than 5% were evaluated incorrectly. For these
loans, servicers are required to forestall foreclosure sales and re-evaluate homeowners under
15
HAMP guidelines. The two servicers with the highest percentage of compliance review issues
were Wells Fargo and JP Morgan Chase. As the Treasury Department is serious about ensuring
the servicers adhere to the HAMP program guidelines, a foreclosure forestall and other actions
could potentially elongate the already extended liquidation timeline.
16
Consumer ABS
Discover to acquire SLC’s private student loan business

On Friday, the Student Loan Corporation announced that Discover Financial Services had agreed
to purchase SLC’s private student loan business and $4.2bn of private student loans. At the same Gaetan Ciampini
time, Sallie Mae will acquire $28bn of federal loans from SLC while Citibank will purchase FFELP +1 212 667 2408
gaetan.ciampini@nomura.com
and private loans totaling $8.7bn. SLC is 80% owned by Citibank and the sale of its assets is part
of Citibank’s plan of shedding non-core businesses.
 We view the acquisition by Discover as positive for future private student loan issuance
and neutral to slightly positive for the existing SLCLT ABS transactions.
 SLC’s existing FFELP transaction should start trading on top of the Sallie Mae shelf as
they will benefit from the same servicer.
As of June 30, SLC owned $28.5bn of FFELP loans and $9.8bn of private student loans. The
acquisition continues Discover’s foray in the private student loan business after exiting the FFELP
business. Discover has grown its private student loan business quickly and as of May 31, it
owned $819mn of private student loans up from $580mn in 2009. With the FFELP program
ending on June 30, Discover announced it would sell it Federal student loans to Department of
Education before October 15, 2010.
Effectively, Discover is acquiring the residual interest in the following three ABS transaction:
SLCLT 2006-A, SLCLT 2010-A and SLCLT 2010-B along with the private student loan origination
business. The TALF-eligible SLCLT 2009-AA is not included in the transaction along with any non
securitized private student loans.
Loans in the three ABS transactions are a mix of privately insured and uninsured loans. Between
2003 and 2007, SLC was insuring losses on its private student loan portfolio with United Guaranty
(subsidiary of AIG) and Royal & Sun Alliance (its US operation was subsequently acquired by
Arrowpoint Capital). According to Discover’s filing, 70% of the loans are covered by insurance and
65% are in repayment. The average FICO is 724 with 74% of cosigners. Discover is purchasing
the loans with an estimated book value of $4.2bn at 8.5% discount leading to an acquisition price
slightly under par according to our estimates.
Discover’s commitment to the private student market is a clear positive. We believe the
acquisition is positive for future ABS origination: Discover could rely on securitization in the future
as they grow their private student loan business. SLC will continue to service SLCLT loans. In the
short run, servicing could deteriorate slightly as the platforms are combined but in the long run
Discover’s experience as a collection oriented servicer is likely to lift SLCLT credit performance.
17
Value in the “Classic” Pooled Aircraft Securitization

Recent Market Activity
Throughout 2008 and 2009 the recession affected both passenger and air freight traffic. Looking
at international traffic, Revenue Passenger Kilometers (RPK) dropped 11.1% between March
2008 and March 2009 and in January 2009, freight traffic (measure by Freight Ton Kilometers)
had decreased by 23.2% year-on-year.
Demand has bounced back in 2010 along with the global economy. According to the International
Air Transport Association (IATA), July 2010 global passenger traffic was up 9.2% year-on-year
and 3% higher than the pre-crisis levels of early 2008. Similarly, cargo traffic was up 22.7% year-
on-year and 4% higher than pre-crisis levels.
As traffic has rebounded, aircraft financing has followed with a number a transactions:
 In late May, AWAS priced a $530mn six-year term loan at L+575bp. The loan was
secured by a portfolio of 30 aircraft at a 64% LTV (loan to value).
 In July, Aircastle announced the pricing of $300mn 9.75% senior unsecured notes.
 In August, ILFC priced $3.9bn of senior secured notes with a four-year note at 6.50%,
six-year notes at 6.75% and eight-year at 7.125%.The notes were secured by a pool of
122 aircraft. ILFC further priced $500mn of second-lien notes at 8.875%.
In addition, airlines were able to tap the EETC (Enhanced Equipment Trust Certificates) and
senior secured debt market: United Airlines priced a transaction backed by US-Japan routes and
gates and Delta issued a $450mn EETC transaction, refinancing its 2000-1 EETC transaction and
adding two recently delivered B777-200. In July, Air Canada issued $600mn of a senior-secured
notes (B2/B+), along with $500mn of subordinated debt, and in early August, Continental offered
$800mn of five-year senior-secured notes backed by a mix of collateral (route, gates and
Continental’s equity interest in its Micronesia based subsidiaries).
In the pooled aircraft securitization space, we distinguish between the ―classic‖ transaction issued
before 9/11 and ―next generation‖ transactions issued after 9/11.The moniker refers to the type of
B737 present in the pool and the overall age of the airplanes. Boeing 737 Classic is the name
given to the 300/400/500 series after the 600/700/800/900 ―next generation‖ series were
introduced. Classic production ended in 2000, while deliveries of the more fuel-efficient ―next
generation‖ aircraft started in December 1997.
18
―Next generation‖ deals are reaching their expected repayment date and sponsors will need to
refinance to avoid losing residual cash flows. Prices have rallied 8 to 10 points and reflect the
increasing probability of refinancing.
Pre 9/11 ―classic‖ deals have appreciated 8 to 12 points also suggesting even higher returns
given those bonds’ lower dollar prices. Classic transactions have gone through two airline industry
recessions and have experienced large price declines and, those transactions are more difficult to
value. Structures are usually distressed with subordinates not receiving any cash flows. Deal
portfolios are composed of older airplanes with more volatile values and reduced lease rates.
Higher maintenance costs and expenses can reduce overall payments to the structures.
Furthermore, the servicer’s ability to keep airplanes flying becomes paramount as repossession
and storage reduce lease revenues.
In this write up, we provide an introduction to aircraft financing and describe the main drivers of
performance for pre-9/11 pooled aircraft securitization. We describe how the securitization
structures have fared through the last two industry downturns. We review the collateral
characteristics of the current plane portfolio and take a simple approach to analyze risk across
different deals. Finally, we attempt to model the entire lease cycle, taking into account aircraft
value, lease expiration, sale timing, maintenance expenses and the costs associated with planes
on ground.
Our model offers interesting relative value recommendations within the ―classic‖ pooled aircraft
market: LIFT benefits from younger aircraft and lower price-adjusted LTV. By contrast, PALS
1999-1A and its re-packaged version PJETS 2007-1A are severely distressed.
At current valuation, we find that the rebound in the transportation sector has been fully priced
and deals have limited upside. Clearly, the reach for yield has been a strong technical support for
―classic‖ pooled aircraft ABS, but in the long run we believe the sector’s rich valuations will fall.
Current state of aircraft securitization

As aircraft technology has evolved since the early DC-3 and B-247, so has aircraft financing. The
emergence of asset-based lending in the late 1980s has increased the diversity of funding
sources for airlines and leasing companies. Historically, aircraft financing has relied on a
combination of bank loans, credit export agencies and manufacturer. However, starting in the
early 1990s, aircraft-backed securities have made a growing share of the funding. The two main
forms of asset-backed securities are EETC (Enhanced Equipment Trust Certificates) and pooled
aircraft securitizations.
EETC is corporate debt secured by a set of aircraft as collateral. EETCs permit airlines to access
lower costs of financing to fund purchases of aircraft. In contrast with pooled aircraft ABS, EETCs
rely on the credit and cash flows of a single corporate issuer and EETC investors are exposed to
the credit quality of the airline and the collateral value. EETCs benefit from structural
enhancements to reduce the risk of default and impairment.
 Liquidity facility: a highly rated financial institution that covers missed interest
payments up to 18 months.
 Over-collateralization: Typical EETC deals have 2 to 4 tranches; the most senior
tranche has the first claim on collateral and benefits from low loan-to-value. The A class
is rated 6 to 8 notches higher than the unsecured airline credit.
 Protection under Bankruptcy Code (§1110): investors get rapid access to the
collateral following bankruptcy filing (60 days) if the airline does not resume debt
servicing.
19
EETC structures were tested during the last round of airline bankruptcies (2001-03). The most
senior tranche performed well, as either the obligation was confirmed in reorganization, or terms
were renegotiated resulting in full recovery value, or aircraft repossession led to full recovery.
Pooled aircraft securitizations rely on the cash flows generated by a pool of aircraft. The servicer
actively manages the aircraft portfolios to maximize the number of aircraft on lease. Similar to
other transportation sectors such as container leasing, securitization is used by operating
lessors to diversify their funding and free up balance sheets. Securitization also allows the
sponsor to match its funding to the useful life of its aircraft fleet. The operating lease market is
fairly concentrated with GECAS and ILFC managing nearly 39%.
Across pooled aircraft securitizations, we differentiate the pre 9/11 ―classic‖ transactions from the
more recent ―next generation‖ deal-like GNFL, ACST or BBAIR. Following the terrorist attacks of
9/11, air travel, both domestic and international, has dropped significantly. The number of
airplanes on the ground increased sharply and there was a wave of airline bankruptcies, which
sent lease rates down 25% to 60%. This industry-wide recession forced issuers to re-assess the
structures and collateral used for pooled aircraft transactions.
 Collateral: ―next generation‖ deals are composed of newer aircraft types such as the
B737NG family and the A320 family. Base value and lease rates have held up better
through the recession than older aircraft, as those aircraft tend to have lower storage
percentages, broader user base and healthy order books.
20
 Monoline insurance: the majority of ―next generation‖ deals benefit from a monoline
wrap. Securities are structured as soft bullet (typically with an underlying rating of single
A) and all the cash flows are used to pay down the senior bonds past the expected
repayment date. Given most monolines current ratings, next-gen ABS ratings do not
give any benefit to the wrap.
 Structural enhancement: post 9/11 transactions have introduced enhancements that

protect senior bond holders and avoid interest leakage to subordinate holders such as
DSCR tests (ACST, GNFL), senior debt/equity structures and full turbo mechanisms
(AERLS).
Collateral valuation is driven by industry changes

Understanding airplane valuation necessitates analyzing supply and demand dynamics in the
industry. The demand for an airplane is a function of the cost of exploitation for different airlines.
This cost is shaped by competing factors: airplane characteristics, regional and global traffic
growth, existing models in the fleet, as well as fuel prices. The life cycle of a given aircraft model
plays an important role in setting the level of supply. In the first years of production, supply comes
exclusively from new aircraft, but as initial leases expire, older aircraft come back on the market.
At the end of the life cycle, the percentage of airplanes in storage or kept on the ground for spare
parts increases, putting a cap on lease rates and valuation. Technological changes such as
winglets and fly by wire have affected those supply-demand dynamics as new technology
increases the obsolescence of older models.
21
The recent downturn was similar to the recession that followed the 9/11 terrorist attacks in the
sense that it forced the retirement of a large number of obsolete models nearing the end of their
useful lives. For example, Japan Airline’s bankruptcy put further pressure on classic aircraft
values as it announced the retirement of 103 aircraft (MD-90, B747-400 and A300-600).
 Depreciation of older planes accelerated during the downturn and we do not expect
them to recover meaningfully. We expect sales and storage of MD80s, and older
generation B737 classics to continue.
 Least efficient planes are put in storage. Figure 9 shows that aircraft storage increased
significantly in the last two years. The recent drop in storage has been driven by aircraft
consignment rather than aircraft coming back on lease.
 Lease rates have dropped more for classic aircraft than for ―next generation‖ aircraft.
According to Ascend Worldwide, market lease rates for 1992 B737-300 decreased 40%-
45% in the last two years, while same vintage A320s decreased to 25%-30%. For
classic planes at the end of their useful life, the economic value is realized by the
operator rather than the lessor.
 As more airlines filed for bankruptcy during the recession, the deals incurred higher
expenses due to higher repossession costs and aircraft on ground.
22
Structures in “classic” aircraft securitization are distressed

Classic aircraft securitizations have gone through two industry downturns and underlying
securities are paying slower than scheduled. Lease payments have been less than their predicted
values due to a distressed lease market and longer re-marketing periods. As a consequence,
structures have not de-levered and currently only senior securities are expected to receive
principal payment. Valuations have also been affected by the higher level of expenses.
Maintenance expenses, repossession costs, storage costs (due to longer re-marketing periods)
and lessee bankruptcies have remained high and we expect these costs to represent a higher
fraction of total collections in the future.
Additionally, bonds that had been scheduled as soft bullets have failed to refinance which
significantly extended their average lives. Figure 11 and Figure 12 compare the expected and
actual bond balance for EAST 2000-A. The expected refinancing rate for class A-1 was August 15,
2003, but it failed to receive principal until September 2007.
Additionally, a number of trusts have hedged the basis risk between their floating-rate liabilities
and fixed-rate assets by entering swap agreements or purchasing interest rate caps. Given the
current low interest rate environment, these swaps are out of the money and represent a drag on
revenue. As some of these swaps expire, we expect the trusts to enter new hedges at lower rates,
which should benefit the senior bonds.
Two transactions, EAST and AFT, had entered interest rate hedges with Lehman Brothers
Special Financing (LBSF). As the hedges were out of the money, LBSF requested payment
equivalent to the market value of the swap and the indenture trustee segregated respectively
$12.2mn for AFT and $16.3mn for EAST in a separate account. In February 2010, a settlement
between the EAST trustee and LBSF led to a release of the account and a $8.1mn principal
payment to EAST 2000-A A1 and A2. A similar settlement between AFT and LBSF would be
positive for the AFT seniors.
23
Subordinated bonds are not receiving interest or principal payment after issuers exhausted
reserve funds to make interest payments. In most transactions, the senior liquidity reserve
amount is standing at its required level. One exception is PALS 1999-1A, which exhausted its
liquidity reserve; if a class A interest shortfall occurs, the senior notes will be accelerated.
Given the depressed lease rates and low aircraft valuations, a number of provisions in the
indenture have prevented issuers from maximizing cash flows to senior bond holders through
aircraft sales. In December 2009, AERCO successfully amended the indenture to permit aircraft
sales without a minimum sale price, relax concentration limits and lower the minimum liquidity
reserve amount. EAST bondholders agreed to similar amendments to its indenture in August. In
general, indentures for different trusts have different provisions, but we view positively any
amendment that increases the operational flexibility of the issuer.
Aircraft portfolios are older and less fuel efficient

In Figure 14, we show a high level collateral profile of different classic securitizations. With the
exception of LIFT 1A and AFT 1999-1A, the aircraft are very seasoned and close to the end of
their expected useful lifes (25 years for passenger planes and approximately 35 years for
freighters). At that point in the lifecycle of the portfolio, most of the value will be released through
sales rather than lease revenue. That being said, keeping planes flying is extremely important as
plane repossessions and storage costs can represent a significant cash drain for the trust.
24
The value of wide-body and narrow-body aircraft varies markedly due to wide-body vulnerability to
lease-rate volatility (Figure 15). Long-range wide-bodies tend to exhibit large swings in lease rates
depending on economic conditions. During the 2001 downturn, A330-200 lease rates dropped
32%, while narrow-bodies such as the ―next generation‖ B737-700 only decreased 10%.
Classic pooled aircraft ABS tend to be heavily weighted towards older narrow-body aircraft. Most
of those aircraft (B737-300, MD-80) are out of production and are therefore unlikely to witness a
recovery in lease rates or value. Typically, we observe a one-time drop in value during a downturn
across aircraft types; afterwards, values and lease rates recover more or less strongly depending
on age (older aircraft do not recover as much) and aircraft lifecycle.
 Early in the lifecycle of a given aircraft type, market values and lease rates tend to
bounce back quickly after a recession due to growing order books.
 In general, mature models benefit from a diversified lessee base in developed markets
and while lease rates drop in a downturn, they tend to recover (albeit at a lower level).
 At the end of its lifecycle, a model has been replaced by more fuel efficient and
technologically advanced series. The lessee base is concentrated in developing
countries (usually with a higher bankruptcy rate) and supply depends mainly on storage
and part-outs. External shocks usually increase the pace of storage, keeping lease rates
and valuations low.
25
Quantifying collateral risk in pooled aircraft transactions

While pooled aircraft securitizations rely on base value to determine bond amortization schedules,
we believe that market value is more appropriate when analyzing classic securitizations.
 Base value is the appraiser’s opinion of the underlying value of an aircraft in an open,
unrestricted, stable market environment with a reasonable balance of supply and
demand.
 Market value is the appraiser’s opinion of the most likely trading price that may be
generated for an aircraft under the market circumstances at the time.
7
We argue that market LTV and more precisely price-adjusted LTV capture more accurately the
risk profile of classic transactions. For each classic transaction, a majority of aircraft are coming
off lease in the next three years. Since aircraft are close to the end of their expected usable life,
the lessor has extracted most of the rent revenue, and the best way to unlock the remaining
economic value in the transaction is through collateral sale. Moreover, costs from aircraft on the
ground (AOG) and repossession-related expenses represent a clear strain on the balance sheet
of the issuer. Most issuers have already started selling their oldest and most obsolete planes
(B727-200, B737-200, DC-9, and DC-10) and we expect the trend to continue. As a result, classic
aircraft ABS transactions are exposed to market value risk rather than base value risk.
7
Price-adjusted LTV is computed by dividing the current market value of the securities (the current balance of
the securities weighted by their market price) and the market value of the aircraft portfolio.
8
We assume that the three planes currently leased to Mexicana are returned to the lessor.
26
In Figure 17, we computed three different LTV measures for the senior tranche: base LTV and
market LTV rely on base value and market value respectively, while price-adjusted market LTV
further takes into account the current price at which the senior bonds are trading. The recent rally
in price combined with the lower market value has moved price-adjusted LTV from the mid 80s to
the high 90s.
At a high level, priced-adjusted LTV summarizes collateral leverage in a simple measure and
allows investors to rank order risk across transactions. Under this framework, LIFT 1A and PALS
1999-1A are the least levered transactions with a price-adjusted LTV of 93%. That being said, we
think investors should not rely exclusively on a single measure as it fails to capture the
idiosyncrasies of each structure. For example, PALS 1999-1A (or its repackaged version PJETS
2007-1A) has a number of delinquent accounts and a large percentage of planes on the ground (8
out of 22). Moreover one of the aircraft is on lease with Mexicana, which recently filed for
bankruptcy.
Modeling classic aircraft securitization

While a simple measure such as price-adjusted LTV is a good first step towards analyzing classic
aircraft ABS, it simply assumes that planes are sold immediately at their market value and does
not take into account the fact that airplanes are income-generating assets. We think a better way
to analyze classic aircraft ABS is to model revenue and expenses on a plane-by-plane basis. By
running individual airplane cash flows through the deal waterfall, investors can properly stress the
transaction based on their assumptions on expenses, leases revenue and sale price.
Clearly, developing a full model for classic aircraft ABS, along with the correct set of assumptions
is not an easy task: servicers do not always publish lease expiration schedules or individual lease
payments in monthly reports and information on hedges through swaps and cap is usually limited.
At a high level, our model takes into account the following to analyze classic ABS securities:
 We use lease termination dates from the issuer quarterly report or Ascend Worldwide
database.
 We estimate lease payments using the Ascend Worldwide database based on lease
commencement. Only a few issuers such as PALS 1999-1A or EAST 2000-A offer
leases at the aircraft level.
 We make assumptions for time on the ground and associated expenses (repossessions
and storage costs).
 We project future base and market values for each aircraft based on aircraft age and
model.
 We apply a fixed lease rate factor to our projected aircraft market values to derive future
lease rates.
 Aircraft are sold at the end of the expected usable life with a 15% discount to market
value to account for the fact that most aircraft types will be out of production at the sale
date.
 We use information from the deal annual reports to estimate interest rate swap and cap
schedules.
 Finally, we run cash flows associated with each aircraft through the deal waterfall under
the Libor forwards path.
Relative value
In Figure 18, we present bond yields under our base case and two scenarios: stress and
optimistic. In the stress scenarios, we further decrease lease revenue by 20% and sale value by
an extra 15%, as well as increase the re-marketing time and repossession expenses for aircraft
on the ground. In the optimistic scenario, we increase lease revenue by 20%, sale value by 15%
and shorten the re-marketing period. We note that model results are highly sensitive to
27
assumptions. In particular, higher expenses can markedly reduce yields since they are taken out
at the top of the waterfall.
Yields on classic ABS have decreased from the low to mid teens at the beginning of the year to
the high single-digits currently. At $87 LIFT 1-A A3 offers a 10.6%, the highest among classic
aircraft securities. As a senior amortizer, the A3 class receives a majority of the cash flows
(compared with the A1 and A2 tranches) and reaches a 0% yield by November 2012. At a lower
price point, AFT 1999-1A A1 offers a 9.8% yield, while PALS 1999-1A is the least attractive
security. Our model shows that PALS 1999-1A could hit an event of default owing to a class A
interest shortfall as early as June 2011. The acceleration of the A class is obviously a positive for
the trust as it prevents cash flow leaking to pay interest on the subordinates, but the age and
lessee composition of PALS 1999-1A portfolio remains a significant drag, in our view.
The rally in the pooled aircraft ABS sector (Figure 1) has compressed yields from the mid teens to
the high single-digits. While the sector still looks attractive compared with the rest of the
transportation sector and versus the broader high yield sector, we believe that the rebound in the
airline sector has been priced in and valuations look full. Clearly, the reach for yield has been a
strong technical support for ―classic‖ pooled aircraft ABS, but in the long run we believe the
sector’s rich valuations will fall.
28
CMBS
Market Overview
CMBS super senior spreads remained unchanged on the week, and bid list activity began to
Lea Overby
subside as we head into quarter end. Super senior 2007 vintage spreads ended the week at
+1 212 667 9479
300bp over swaps. Bid lists this week were more heavily weighted towards the super senior
lea.overby@nomura.com
space. However, we continue to see interest in higher quality AM and AJ bonds. Spreads on AM
bonds continue to improve with better performing 2006 and 2007 AM bonds now trading in the
mid to high 300s over swaps. We expect the CMBS market to continue to perform well going into
year-end as buyers seek yield. We recommend remaining near the top of the capital structure in
wider last cash flow super seniors, later-vintage AMs and higher quality AJs.
Collateral Update: Moody’s/REAL Commercial Property Price

Indices and Loss Severities
th
On September 20 , Moody’s Investor Service reported that their All Property Type Aggregate
1
Index dropped 3.1% in July and has declined 4.0% since the beginning of the year . The index is
now 43.2% below the peak in October 2007 and is only 0.9% above the recession low that
occurred in October 2009. Moody’s expects prices to remain volatile over the near term and
forming a bottom as the economy recovers.
Universe
As property prices have dropped considerably over the past three years, we have seen an
increase in CMBS loss severities as well. Below we show the six-month rolling average loss
severity for conduit CMBS loans securitized since 2000. While commercial real estate prices
began to drop in early 2008, CMBS recovery rates started to fall approximately a year later.
Through December 2008, loss severities generally averaged around 25%, while in 2009 average
severities reached the high-30% range.
29
50%
40%
30%
20%
10%
0%
Universe
With property prices stabilizing along with the broader economy, we expect CMBS loss severities
to peak near 45%. However, the range of loss severities is likely to remain very wide. This month,
the Macon and Burlington Mall loan in WBCMT 2005-C20 finally sold, resulting in a 97% loss
severity and a $127 million loss to the Trust. In contrast, the 90+ delinquent 1775 Broadway loan
in WBCMT 2006-C20 was purchased out of the Trust, resulting in no loss for investors.
The data set used to calculate the CPPI remains sparse, with 119 repeat sales included in the
latest calculation. Moody’s CPPI Index references property transaction data rather than appraisals,
and it incorporates all sales over $2.5 million. Over the last five months, repeat sales have
averaged 124 per month. While this is a substantial increase from the 52 transactions used to
calculate the CPPI in May 2009, it remains well below the 300 – 400 eligible monthly transactions
in 2007.
We expect the number of transactions contributing to the CPPI to increase as lending conditions
improve. Already, we are beginning to see a rise in CMBS liquidations as special servicers are
more able to dispose of troubled loans and properties. There were only 100 stressed dispositions
during the first six months of 2009, while the number has increased to over 100 per month over
the last quarter. Similarly, the disposed balance has risen sharply, with over a billion in resolutions
for each the two prior months.
0.25%
0.20%
0.15%
0.10%
0.05%
0.00%
Universe
30
A Tale of Two Loans: Pay downs, extensions, and short WAL super
senior classes
The performance of certain CMBS tranches often hinges on the cash flows from only a single loan
within the pool. This month, the CMBS market saw both an early prepay and an extension that
altered the expected principal cash flows for several super senior tranches. The five- and seven-
year tranches in WBCMT 2006-C23 were shortened considerably when the 1775 Broadway loan
in paid in full, while the five- and seven-year tranches in MSC 2007-HQ12 extended when the
Columbia Center loan received a modification. Both results highlight the current instability within
the commercial real estate market and the effects that loan workouts may have on CMBS tranche
performance.
1775 Broadway
An office building located near Columbus Circle in Manhattan serves as collateral for this $250
million ten-year loan. At origination, the property was appraised at $350 million and was 95%
occupied, with Newsweek taking 33% of the available space. Several firms vacated in 2008, and
Newsweek left in May 2009, causing the occupancy to fall to only 25%. The sponsor, Joseph
Moinian of The Moinian Group, began an extensive renovation to rebrand the property in late
2008. His plans were estimated to cost almost $100 million and included replacing the brick
facade with a glass curtain, redesigning the entrance, upgrading the elevators and office suites,
and renaming the property to ―3 Columbus Circle‖.
In January 2010, with the renovation nearing completion, the borrower informed the servicer that
he would no longer be able to cover the debt service shortfall. In spite of the renovation, he was
unable to fill the vacant space, and the building is currently only 23% occupied. According to the
special servicer comments, Mr. Moinian and CWCapital, the special servicer, began negotiating a
loan workout. A new appraisal valued the building at $202 million, increasing the LTV to 124%.
Because of the strength of the submarket and the borrower’s commitment to the property, we
believed that a modification involving forbearance and a hope note were the likely outcome.
However, in the August remittance report, the special servicer commented that they were
th
discussing a loan payoff with the borrower. On September 8 , the Wall Street Journal reported
that Stephen Ross’s firm, Related Cos., and Deutsche Bank AG had purchased the mortgage
2
from the Trust , paying the loan in full. The article states that Related might demolish the property
and build a new tower for Nordstrom. The New York Post reports that Moinian has turned to SL
3
Green Realty Trust to lend him the funds to pay off the mortgage that is now in the hands of
Stephen Ross.
As a result of this early pay down, tranches A2 and A3 paid in full, and A-PB was curtailed by $57
million. Prior to this pay down, the five year A-2 tranche had been scheduled to pay in full in
February 2011, while the A-3 had been scheduled to pay in full between November 2012 and
January 2013. In general, amortizing balance classes such as this A-PB tranche are designed to
pay down over several years according to a predetermined schedule. However, this $190 million
tranche in this deal is now the current pay class with a weighted average life less than year.
Columbia Center
A trophy office tower located in downtown Seattle serves as collateral for two five-year A notes
totalling $380 million and accounting for 20.2% of the current balance of MSC 2007-HQ12. The
property also serves as collateral for a $100 million B-Note held outside the Trust. Built in 1985,
the building was purchased by Beacon Capital Partners in 2007. The loan was underwritten using
pro forma financials, with underwritten NOI 36% higher than the most recent annualized figure.
The first full-year Trust DSCR was reported at 1.04x, showing that the building produced barely
enough income to cover the debt service on the A-Notes.
This deal also contains a $161 million pari passu portion of the five-year $2.9 billion Beacon
Seattle & DC Portfolio loan. Collateral for this larger loan consists of 20 office buildings, with eight
in the Seattle and Bellevue, WA, and it is also underperforming. Although the loan is current, the
31
sponsors have requested a modification. The special servicer reports that they are not willing to
continue covering leasing costs and debt service shortfalls.
The borrower stopped making payments on the Columbia Center loan in March 2010. With a
2009 DSCR of 0.74x and occupancy of only 77%, the property did not generate enough income to
cover the debt service. Additionally, the largest tenant, Amazon.com with 12% of the net rentable
square feet, announced their plan to vacate their space within the next year. PPR reports that the
second quarter 2010 vacancy rate in the Seattle CBD is nearly 20%, indicating that the borrower
will most likely not be able to lease the vacant space quickly.
The special servicer, LNR Partners, began discussions with Beacon Capital Partners for a loan
modification shortly after the default. The most recent appraisal, dated March 2010, valued the
property at only $330mm, down from $648 million at origination, causing the Trust LTV to
increase from 58.6% at origination to 115%. We believed that the modification might not
materialize for Columbia Center given the anticipated decline in financials upon Amazon.com’s
departure at lease maturity and the reluctance of Beacon Capital to further support similar
properties.
However, in the September remittance, the special servicer reported that both A notes have been
modified. Both were extended 36 months to May 2015 with two 1-year extension options. The
borrower has agreed to bring the $300 million A1 note current, while the $80 million A2 note will
defer interest until maturity, resulting in an ongoing $375,000 interest rate shortfall to the Trust.
The borrower will also fund a $30 million rollover reserve immediately and another $19.2 million
reserve in 2013. The $49.2 million in borrower reserves is senior to the A2 note. The modification
does not reduce the A1 note interest rate, however, and we calculate an in-place DSCR of only
0.95x, based on year-end 2009 net cash flow. While we cannot rule out the likelihood of default
after Amazon.com leaves, the loan will likely perform in the short term, as Beacon Capital has
agreed to fund a sizeable reserve.
At origination, 79% of the five-year bullet super senior tranche principal balance in this deal was
scheduled to be paid by the Columbia Center and Beacon Seattle & DC Portfolio loans. As a
result of the maturity extension on the Columbia Center loan, the expected final distribution date
for classes A-2, A-2FL, and A-2FX, and A3 in this deal also extended to May 2015. The weighted
average life of all four classes extended over a year. With a modification and loan extension also
likely for the Beacon Seattle & DC Portfolio loan, the expected principal cash flow for these four
tranches may extend further.
Conclusion
As these two examples demonstrate, the early pay down or extension of large loans within a
CMBS pool can drastically alter the cash flows and yields for certain short WAL super senior
tranches. With these tranches generally trading well above par, an unexpected early pay down
can damage returns, while an extension can be quite beneficial. In addition to monitoring these
holdings closely, we recommend that investors maintain a diversified portfolio when investing in
this type of CMBS class.
1
Nick Levidy, Andrea M. Daniels, Seth Anspach, Tiffany Putman, ―Moody’s/REAL Commercial Property Price
Indices, September 2010,‖ Moody’s Investors Service, 20 September 2010
2
Lingling Wei and Eliot Brown, ―Ross Raids Wobbly Tower,‖ Wall Street Journal, 8 September 2010
3
Lois Weiss, ―Moinian’s Columbus Circle,‖ New York Post, 13 September 2010
32
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Agency MBS: Market Overview and Relative Value

MBS Basis: Modest Overweight but not with Much Conviction....

d) High prepay uncertainty because of the possibility of streamlined refis.

Figure 1: Estimates of Monthly Supply/Demand Technicals for Agency MBS

Net Growth of Agency MBS market

Relative Value in Agency Passthrough Market1

 UIC in 15-year MBs: Long DW 5.0s/4.5s Swap (New Trade)

 Take Profits on Short DW 4.0s Butterfly (Since 9/16/2010)

VA Prepays Much Faster than FHA

4 4.5 5 5.5 6 6.5

Source: Ginnie Mae, Nomura Securities International

Figure 5: Comparison of FHA and VA Streamline Refinance Programs

Source: FHA, VA, Ginnie, Nomura Securities International

August Freddie Transition Rates

Figure 6: Projected and Actual End of August 120-day Delinquencies

Source: Freddie Mac, Nomura Securities International

Source: Freddie Mac, Nomura Securities International

Agency MBS: How Bad are the Bad Billions?

Figure 1: Oct/Nov Rolls and Breakeven Speeds assuming 25bp Funding

Oct/Nov Roll b/e CPR assuming

Worst Billions for Freddie and Ginnies

Agency MBS: Outlook for Domestic Bank Demand

Recent Trends in Bank Demand for Agency MBS

C&I Loans -37 -160 46 122 65 61 16 -15 -25

C&I Loans -67 -166 27 110 61 61 16 -15 -25

Figure 3: Approximate changes in bank holdings of agency MBS ($bn)

Agency MBS Treasuries & Agency Debt Other Securities

Source: The Fed’s H.8 Report, Nomura Securities International

Figure 5: Percentage of All Bank Assets Funded by Core Deposits (%)

Capital Related Issues

Liquidity Related Issues

Summary Outlook for Bank Demand for Agency MBS

Mortgage Credit: Market Summary and HAMP update

HAMP report update

Discover to acquire SLC’s private student loan business

Value in the “Classic” Pooled Aircraft Securitization

Current state of aircraft securitization

 Structural enhancement: post 9/11 transactions have introduced enhancements that

Collateral valuation is driven by industry changes

Structures in “classic” aircraft securitization are distressed

Aircraft portfolios are older and less fuel efficient

Quantifying collateral risk in pooled aircraft transactions

Modeling classic aircraft securitization

Collateral Update: Moody’s/REAL Commercial Property Price

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